Did Ernst & Young really assist financial fraud?

Mar 29th 2011
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By Curtis C. Verschoor, CMA

As the auditor of Lehman Brothers, Ernst & Young approved the use of Repo 105 transactions. These transactions were characterized as sales of assets and created a misleading picture of Lehman's financial position during the financial meltdown.

After nearly two years of wondering where the auditors were during the financial meltdown, New York State Governor Andrew M. Cuomo has finally provided some possible answers regarding the activities of the auditing firm for the now bankrupt Lehman Brothers. In September 2008, Lehman's bankruptcy represented the largest such filing in U.S. history and resulted in an immediate 500-point drop in the Dow-Jones Industrial Average. This previously highly prominent global financial services giant was one of the few Wall Street firms allowed to trade directly with the Federal Reserve System, and the group's members continue to be considered the most influential and powerful nongovernmental institutions in world financial markets.

When he was New York's attorney general, Cuomo filed a lawsuit in late December 2010 in the New York Supreme Court claiming that Ernst & Young (E&Y), a Big 4 firm, helped hide Lehman's "fraudulent financial reporting." These acts were alleged to have occurred during a seven-year period leading up to the Lehman bankruptcy. What Lehman did and E&Y allegedly specifically approved was to consider some borrowing, done under agreements to later repurchase the notes, as a sale of an asset rather than a short-term borrowing arrangement.

According to the attorney general's complaint, E&Y "substantially assisted Lehman to engage in a massive accounting fraud, involving the surreptitious removal of tens of billions of dollars of securities from its balance sheet." The complaint alleges this created a false impression of Lehman's better liquidity, thereby defrauding the investing public and violating New York law.

"This practice was a house-of-cards business model designed to hide billions in liabilities in the years before Lehman collapsed", Cuomo said. He added",Just as troubling, a global accounting firm tasked with auditing Lehman's financial statements helped hide this crucial information from the investing public."

The specific mechanism used by Lehman and asserted to be approved by E&Y was to engage in what became known as Repo 105 transactions. These deals involved a transfer of liquid fixed income securities by Lehman to European counterparts for cash with the binding obligation they would be repurchased a few days or weeks later. The volume of Repo 105 transactions increased dramatically at the end of each calendar quarter.

Contrary to the usual practice of accounting for repurchase agreements, or "repos", as short-term loans, Lehman characterized Repo 105 transactions as a sale of assets. By using the cash obtained from these "asset sales" at quarter- or year-end to pay down other debts, Lehman reduced the amount of total liabilities it reported and improved its reported leverage ratios and balance-sheet metrics. The firm rapidly accelerated its use of Repo 105 transactions in 2007 and early 2008 as the financial crisis grew and Lehman was facing demands to reduce its leverage.

To date, the Securities & Exchange Commission (SEC) has neither taken any regulatory action against Lehman and its officers nor has it accused E&Y of violating any federal rules of accounting or auditing. The SEC did propose new rules on September 17, 2010, requiring public companies to provide increased information in both qualitative and quantitative terms about their short-term borrowings, including those having repurchase obligations. If adopted, these disclosures would be required in the Management's Discussion and Analysis (MD&A) section of their reports to the SEC. According to SEC Chair Mary Schapiro",misleading 'window dressing' in quarterly reports" was one obstacle to investor confidence.

A report issued in March 2010 by Lehman bankruptcy examiner Anton Valukas faults E&Y as well as Lehman senior executives. The report states that Lehman's financial statements were "materially misleading" and that executives engaged in "actionable balance sheet manipulation." The report also cites whistleblowers who attempted to correct what they viewed as improper behavior. Valukas believes that "there is sufficient evidence to support a colorable claim" that certain Lehman officers breached their fiduciary duties and that E&Y was professionally negligent.

In a March 2010 letter to its clients, E&Y defended its audit work for Lehman. The letter states that Lehman's bankruptcy resulted from unprecedented adverse events in the financial markets, declining asset values, and loss of market confidence that caused a collapse in its liquidity. The firm believes the bankruptcy wasn't caused by accounting or disclosure issues, as Lehman's financial statements clearly portrayed it as "a leveraged entity operating in a risky and volatile industry."

One possible justification for treating repo transactions as sales is contained in the infamous derivatives rule, Statement of Financial Accounting Standards (SFAS) No. 140",Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities."

This lengthy document discusses the need for the transferor of securities to relinquish all control of securities in order to consider the transaction a sale. If the transferor receives collateral to secure the transaction at less than 102 percent of the amount transferred, then SFAS No. 140 concludes no real sale has taken place. In its transactions, Lehman believed the additional 3 percent that made the total collateralization 105 percent – hence the term "Repo 105" – demonstrated excess collateral and thus resulted in a true sale of securities in spite of the binding obligation to repurchase.

SFAS No. 140 also calls for disclosure of the nature of any repurchase agreement transactions and the amounts and classification of collateral. But this requirement lacks specificity and led to later revisions to SFAS No. 140 and the very recent SEC requirement noted earlier. Lehman had footnote disclosure of off-balance-sheet commitments of almost $1 trillion, excluding the amount of Repo 105 liabilities, but no clear disclosure of the extent of repo transactions. In fact, the complaint filed by then Attorney General Cuomo asserts that Lehman reported that all of its repurchase agreements were treated as financing arrangements, not as sales.

Another obstacle to calling Repo 105 transactions true sales is the fact that apparently Lehman was unable to get any U.S. law firm to provide a legal opinion that they were in fact true sales. A U.K. law firm did provide such an opinion but added the requirement that it be applied only to U.K. repo instruments. Yet Lehman didn't limit its application of the true sale doctrine to the U.K. Instead, the firm used one of its British subsidiaries to put very significant amounts of U.S. securities into the repo pool. Apparently E&Y didn't object to this stretch of circumstances.

The most telling assertion in the complaint concerning E&Y's alleged misrepresentation of Lehman's compliance with applicable accounting standards is that E&Y didn't require the financial statements to reflect economic substance rather than just legal form. In other words, the complaint accuses E&Y of letting Lehman engage in transactions without business purpose in order to achieve a specific financial-statement result. This is similar to assertions made in the Enron case – that the auditor, Arthur Andersen, enriched itself by coaching Enron how best to structure transactions so they could remain off its balance sheet. An interesting aspect of the substance-over-form requirement is that it is contained in the auditing standards, specifically AU §411.06, not the accounting literature promulgated by the Financial Accounting Standards Board (FASB).

As accounting standards setters work to converge international and U.S. pronouncements, little attention seems to be directed toward global convergence of audit standards. In the U.K., auditor opinions specifically state that the client's financial statements do in fact present a true and fair view, whereas U.S. audit standards only opine that statements are presented in accordance with U.S. Generally Accepted Accounting Principles (GAAP). It would seem that E&Y would have had more difficulty in expressing a U.K.-type opinion on Lehman.

In summary, the ethical challenges faced by E&Y in deciding how to address issues with a long-standing and profitable client may be faced by many public accountants. In fact, accountants in all areas of the profession frequently face similar ethical issues of simultaneously complying with their duties for faithful service and loyalty to their employer or client while respecting their responsibilities to other stakeholders. "Doing the right thing" for all concerned may sometimes be an impossible assignment. Guidance such as the overarching principles of honesty, fairness, objectivity, and responsibility contained in the IMA Statement of Ethical Professional Practice will go a long way toward helping all accountants to do the right thing.

Doing the right thing is always the best policy in the long run. 

About the author:

Curtis C. Verschoor, CMA, is a member of the IMA Committee on Ethics. He is the Emeritus Ledger & Quill Research Professor at the School of Accountancy and MIS and an honorary Senior Wicklander Research Fellow in the Institute for Business and Professional Ethics, both at DePaul University, Chicago. He is also a Research Scholar in the Center for Business Ethics at Bentley University, Waltham, MA.His e-mail address is [email protected].

©2011 by the Institute of Management Accountants (IMA®),; reprinted with permission

For guidance in applying the IMA Statement of Ethical Professional Practice to your ethical dilemma, contact the IMA Ethics Helpline at (800) 245-1383 in the U.S. or Canada. In other countries, dial the AT&T USADirect Access Number from, then the above number.

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