Ernst & Young defends its Lehman work in letter to clients

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Ernst & Young defended its audit work for client Lehman Brothers in a letter sent last week by several audit partners to the firm's key clients, and vowed to fight any legal action from regulators or creditors.

A U.S. bankruptcy court examiner’s report of the events and circumstances that led to Lehman’s collapse determined that “colorable claims” could be made by Lehman’s creditors against the assets of the Big Four firm and former executives of Lehman.

The report, released earlier this month, set off a storm of media coverage of Lehman’s accounting for Repo 105 transactions, calling the transactions an “accounting gimmick,” and going so far as to compare the Lehman bankruptcy to the fall of Enron.

The bank examiner’s report concluded that “there is sufficient evidence to support a colorable claim that: (1) certain of Lehman’s officers breached their fiduciary duties by exposing Lehman to potential liability for filing materially misleading periodic reports and (2) Ernst & Young, the firm’s outside auditor, was professionally negligent in allowing those reports to go unchallenged. The Examiner concludes . . . that a colorable claim of professional malpractice exists against Ernst & Young.”

E&Y partners told clients the firm is confident it will prevail should any of the potential claims identified against the firm be pursued. “We wanted to provide you with EY’s perspective on some of the potential claims in the Examiner’s Report. We also wanted to address certain media coverage and commentary on the Examiner’s Report that has at times been inaccurate, if not misleading.”

E&Y partners continued: "Lehman's bankruptcy was the result of a series of unprecedented adverse events in the financial markets. [Its] bankruptcy was caused by a collapse in its liquidity, which was, in turn, caused by declining asset values and loss of market confidence in Lehman. It was not caused by accounting issues or disclosure issues.”

The letter goes on to reaffirm the firm’s audit opinion for 2007 and, in very forceful terms, their response to a whistleblower letter that was sent to Lehman’s audit committee in May 2008. They explain their reasons for concurring with Lehman’s accounting for certain repurchase agreements, the Repo 105 transactions. The letter was leaked to Reuters and blog site re:The Auditors.


Materially misleading” periodic reports

The “materially misleading periodic reports” which E&Y “allowed to go unchallenged” were the annual financial statements, filed in November 2007 and the filings for the first and second quarters of 2008. E&Y stands by their signed opinions. “Our opinion stated that Lehman’s financial statements for 2007 were fairly presented in accordance with U.S. GAAP, and we remain of that view. We reviewed but did not audit the interim periods for Lehman’s first and second quarters of fiscal 2008.”

The court examiner found that Lehman’s financial reporting was “materially misleading” because Lehman had accounted for its Repo 105 transactions as sales and did not disclose them as financings in their footnotes. The failure to disclose affected Lehman’s leverage ratios, which are of concern to investors.

E&Y defends Lehman’s footnote disclosure of the Repo 105 arrangements. Repo transactions normally are used by banks for short-term borrowings. “While no specific disclosures around Repo 105 transactions were reflected in Lehman’s financial statement footnotes, the 2007 audited financial statements were presented in accordance with U.S. GAAP, and clearly portrayed Lehman as a leveraged entity operating in a risky and volatile industry. Lehman’s 2007 audited financial statements included footnote disclosure of off balance sheet commitments of almost $1 trillion.”

E&Y points out that “Lehman’s leverage ratios are not a GAAP financial measure; they were included in Lehman’s MD&A, not its audited financial statements. Lehman concluded no further MD&A disclosures were required; EY did not take exception to that judgment.”

When asked in an interview by the bank examiner if he could describe what level of impact to Lehman’s firm-wide net assets E&Y would consider “material,” the E&Y lead audit partner for Lehman, William Schlich, said that “Ernst & Young did not have a hard and fast rule defining materiality in the balance sheet context.He said that with respect to balance sheet issues, ‘materiality’ depends upon the facts and circumstances.”


Classifying the Repo 105 as sales instead of short-term financings was widely considered an aggressive interpretation of the version of SFAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, in effect at the time. FASB Statement 140 has since been amended by the Financial Accounting Standards Board’s Statement of Financial Accounting Standards No. 166, Transfers of Financial Assets, and Statement of Financial Accounting Standards No. 167. Among other things, these statements provide guidance about effective control of off balance sheet items.

In their letter, E&Y partners defend the firm’s position on the Repo 105 transactions stating that “The Repo 105 transactions involved the sale by Lehman of high quality liquid assets (generally government-backed securities), in return for which Lehman received cash. The media reports that these were ‘sham transactions’ designed to off-load Lehman’s ‘bad assets’ are inaccurate.

“Because effective control of the securities was surrendered to the counterparty in the Repo 105 arrangements, the accounting literature (SFAS 140) required Lehman to account for Repo 105 transactions as sales rather than financings.” 

According to the examiner’s report, Schlich said “Ernst & Young had been aware of Lehman’s Repo 105 policy and transactions for many years. Schlich stated definitively in his interview that Ernst & Young had no advisory role with respect to Lehman’s use of Repo 105 transactions and that Ernst & Young did not ‘approve’ the Accounting Policy.” Rather, the examiner’s report states, according to Schlich, Ernst & Young “became comfortable with the Policy for purposes of auditing financial statements.”

E&Y’s letter also objects to media reports that the decline in Lehman’s reported leverage from its first to second quarters of 2008 was a result of an increased use of Repo 105 transactions.

E&Y’s response to whistleblower letter, interview

E&Y forcefully defends its response to a whistleblower letter which was sent to Lehman’s audit committee in May 2008, another area where the examiner’s report found colorable claims against Ernst & Young for professional malpractice.

Lehman’s audit committee asked E&Y to investigate the claims in the letter and interview the author, Matthew Lee, a former Lehman vice president.

According to E&Y’s own account in the letter to clients, “The media has inaccurately reported that EY concealed a May 2008 whistleblower letter from Lehman’s Audit Committee. The whistleblower letter, which raised various significant potential concerns about Lehman’s financial controls and reporting but did not mention Repo 105, was directed to Lehman’s management. When we learned of the letter, our lead partner promptly called the Audit Committee Chair; we also insisted that Lehman’s management inform the Securities & Exchange Commission and the Federal Reserve Bank of the letter. EY’s lead partner discussed the whistleblower letter with the Lehman Audit Committee on at least three occasions during June and July 2008.

“In the investigations that ensued, the writer of the [whistleblower] letter did briefly reference Repo 105 transactions in an interview with EY partners. He also confirmed to EY that he was unaware of any material financial reporting errors. Lehman’s senior executives did not advise us of any reservations they had about the company’s Repo 105 transactions.

“Lehman’s September 2008 bankruptcy prevented EY from completing its assessment of the whistleblower’s allegations,” the E&Y partners claimed. “The allegations would have been the subject of significant attention had EY completed its third quarter review and 2008 year-end audit.”

So far, neither the SEC nor the U.S. Justice Department has taken any action against either the former Lehman executives or E&Y. After speaking at a hearing of the House Appropriations Subcommittee on Financial Services, SEC Chairman Mary Schapiro wouldn’t comment on whether the SEC is investigating Lehman or its auditor, E&Y. "Our review of activity during this period is taking us down a broad path, and we're looking broadly", she said, according to The Wall Street Journal.

The SEC wasn't aware of an accounting method, dubbed Repo 105, that allegedly allowed Lehman to hide some of the risks it took before collapsing in 2008, Schapiro added. The SEC announced Monday that it has sent a letter to 20 financial institutions asking if they have used similar tactics to obscure debt levels.

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