Dec. 20 (Bloomberg) -- Ernst & Young LLP will be sued for fraud by New York Attorney General Andrew Cuomo for allegedly helping Lehman Brothers Holdings Inc. mislead investors, according to a person familiar with the matter.
The suit will focus on audits and quarterly reviews of Lehman financial statements by Ernst & Young, which helped downplay the firm’s liabilities, said to the person, who wasn’t authorized to speak publicly about the case. The suit will charge violations of New York’s securities fraud statute, the Martin Act, said the person.
Lehman, once the fourth-largest investment bank, failed in September 2008 because of risky real estate bets and too much debt, which it tried to hide from investors, partly by using so-called Repo 105 trades, according to bankruptcy examiner Anton Valukas’s report. Valukas, in his report, said Ernst & Young could be accused of “professional malpractice” for its role as auditor.
“They should have reviewed enough of the firm’s transactions to see that it was engaging in window dressing,” said Barry Epstein, an accountant who has done work for the U.S. Justice Department and Securities and Exchange Commission.
Charles Perkins, a spokesman for Ernst & Young, declined to comment, as did Richard Bamberger, a spokesman for Cuomo’s office.
The Valukas report was surely “the spark that ignited” Cuomo’s interest, said Harvey Miller, Lehman’s lead bankruptcy lawyer, in an interview. “I don’t know what the new attorney general will do when he takes over,” he said.
Cuomo will be sworn in as governor on Jan. 1. His successor will be New York Democratic state Senator Eric T. Schneiderman.
Repo 105 transactions are a form of short-term financing that Valukas said Lehman used to move as much as $50 billion off its balance sheet temporarily to show investors it wasn’t carrying too much debt.
The Repo 105 transactions were sale and repurchase agreements, so that Lehman was obligated to buy them back, swelling its leverage again.
“The balance sheet manipulation was intentional, for deceptive appearances, had a material impact on Lehman’s net leverage ratio” and caused financial reports to be misleading, Valukas wrote of the defunct New York-based company. Higher leverage undermines a firm’s capacity to absorb financial shock.
‘Responsibility of Management’
Responding to the Valukas report in March, Ernst & Young said leverage ratios reported in Lehman’s management discussion and analysis “were the responsibility of management, not the auditor. They are not part of the audited financial statements.”
Epstein said auditors are required to read such statements by management in case something conflicts with details in the financial statements they’ve audited.
A spokesman for the Securities and Exchange Commission, John Heine, declined to comment on whether the SEC is investigating or negotiating with Ernst & Young.
The accounting firm has been named in at least one class-action lawsuit accusing former Lehman Chairman Richard Fuld and other executives of misleading investors by using devices such as Repo 105. One suit, based on Valukas’s 2,200-page report, was filed April 23 on behalf of retirement funds including the Alameda County Employees’ Retirement Association in Oakland, California, and the Government of Guam Retirement Fund.
The Lehman executives asked a judge in June to dismiss the suit, denying in court papers that the investors had lost money on Lehman securities because of misstatements and omissions in offering documents.
Lehman’s accounting for Repo 105 transactions conformed to generally accepted accounting principles and was approved by Ernst & Young, they said in a filing in federal court in Manhattan.
Ernst and Young also asked the judge in June to dismiss the class-action suit, saying in court papers that even Valukas “did not find that Lehman’s accounting for the Repo 105 transactions was wrong.”
In his report, Valukas said Ernst & Young tried to make sure Lehman’s accounting for Repo 105 complied with generally accepted accounting practices in the U.S. at the time. The firm may have been negligent even if Repo 105 trades “technically” complied with U.S. rules, he said.
He faulted the firm because it didn’t audit individual Repo 105 trades, “did not evaluate the possibility that Repo 105 transactions were accounting-motivated transactions that lacked a business purpose,” and didn’t take a stand on whether Lehman’s extensive use of the device was “material” and should be reported.
“Financial statements may be materially misleading even when they do not violate GAAP,” he wrote in his report.
Ernst & Young was told by a whistleblower at Lehman that Lehman was using the device extensively, and didn’t tell the investment bank’s audit committee about it, Valukas said.
The investment bank, which had been using the repos since 2001, stepped up their use in mid-2007, breaching internal limits, the Valukas report shows. Lehman’s former president, Herbert “Bart” McDade, commented on them in an April 2008 e-mail exchange, after he was asked whether he knew about their effect on the balance sheet, Valukas said. “I am very aware,” McDade wrote back. “It is another drug we’re on.”
The U.K. accounting regulator, the Financial Reporting Council, said earlier this year it was investigating Ernst & Young’s auditing of Repo 105 transactions. The deals helped Lehman downplay its leverage in late 2007 and 2008 by temporarily moving assets off the firm’s balance sheet, Valukas said.
The Wall Street Journal said earlier today a lawsuit might be filed this week.
The bankruptcy case is In re Lehman Brothers Holdings Inc., 08-13555, U.S. Bankruptcy Court, Southern District of New York (Manhattan). The class action lawsuit is In re Lehman Brothers Equity/Debt Securities Litigation, 08-cv-05523, U.S. District Court, Southern District of New York (Manhattan).
To contact the editor responsible for this story: David Rovella at email@example.com