Ernst & Young charged with civil fraud for role in Lehman collapse

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New York Attorney General Andrew Cuomo has filed a lawsuit against Ernst & Young (E&Y) for civil fraud, accusing the Big Four accounting firm of helping Lehman Brothers Holdings Inc. hide its financial weakness from investors from 2001 until the investment bank collapsed in September of 2008.

The lawsuit is the first to be filed against any firm or individual associated with the credit crisis of 2008, and it alleges that E&Y engaged in fraud over a seven-year period.

“E&Y substantially assisted Lehman Brothers Holdings Inc., now bankrupt, to engage in a massive accounting fraud, involving the surreptitious removal of tens of billions of dollars of securities from Lehman’s balance sheet in order to create a false impression of Lehman’s liquidity, thereby defrauding the investing public. Called Repo105, these transactions, hatched in 2001, allowed Lehman to park tens of billions of dollars of highly liquid fixed income securities with European banks for the sole purpose of reducing Lehman’s balance sheet leverage, and painting a false picture of an important financial metric for investors, stock analysts, lenders, and others involved with Lehman,” the complaint states.

E&Y declined to comment.

The complaint also alleges that “as the financial crisis deepened in 2007 and 2008 and Lehman’s liquidity problems intensified, E&Y was aware that Lehman was dramatically increasing the Repo 105 transactions in a desperate effort to stave off collapse. At a time when it was critical for investors to make informed decisions as to whether to keep or buy Lehman stock, E&Y assisted Lehman in defrauding the public about the company’s deteriorating financial condition.”

A report published in March by the court-appointed bank examiner of Lehman stated that claims of negligence and malpractice against E&Y could be made in connection with its audits of Lehman and its failure to act upon claims from a whistleblower that Lehman's accounting for Repo 105 transactions was misleading. The bank examiner interviewed the whistleblower and employees of Lehman and E&Y.

Repurchase agreements are a common form of short-term borrowing used by many industries. Accounting rules permit companies to classify these transactions as sales if they are sold at a certain percentage of their worth with proper disclosures in the footnotes.

Lehman’s Repo 105 transactions usually occurred just before the end of a quarter so that, for a few days before the end of the quarter, the company’s net leverage ratio, a number that is used by ratings agencies, appeared to be lower than it actually was. A few days after the quarter ended, Lehman would repurchase the assets and the net leverage ratio would go back up.

In a letter to clients in late March, E&Y stood by its audit of the 2007 financial statements of Lehman. Lehman did not issue financial statements for 2008. The firm also defended Lehman’s footnote disclosure of the Repo 105 arrangements. The firm disputed the bank examiner’s claim that the amounts involved in the repo transactions were material.

In October, the U.S. Securities and Exchange Commission (SEC) issued a proposal to enhance disclosures of short term borrowings. Under the proposal, companies would have to disclose debt more frequently and reveal more information about borrowing arrangements they use. They would also have to tell investors of business conditions that may make it difficult for them to borrow and why debt levels fluctuate during a financial period.

The SEC issued the following comments on repurchase agreements:

Most repurchase arrangements (referred to as "repos") are accounted for as financings on the balance sheet. As such, most repos would be covered by the proposed short-term borrowings disclosure requirements.

If a repo is appropriately accounted for as a sale (and therefore is not reflected on the balance sheet as a liability), it must be assessed under the SEC's existing disclosure requirements for off-balance sheet arrangements. The SEC's existing rules require disclosure where the repo is reasonably likely to have an effect on the company that is material.

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