New York's attorney general is suing accounting giant Ernst & Young, accusing it of helping defunct investment bank Lehman Brothers hide billions of dollars in debt from investors even as it teetered on the brink of financial collapse.
The civil lawsuit, filed by Attorney General Andrew Cuomo on Tuesday, days before he's due to be sworn in as the state's governor, marks the first government legal action stemming from the collapse of Lehman Brothers, one of the first milestones of Wall Street's 2008 meltdown.
It targets a practice known as "Repo 105," in which - the lawsuit says - Lehman Brothers made temporary overseas sales of securities, often lasting only days, and then used the money to pay off debts ahead of key quarterly reports to investors.
The system allowed the company to hold on to the inventory required by its customers while concealing debts from nervous investors, who otherwise might have sold off their shares.
The lawsuit claims that, as auditor, Ernst & Young signed off on the practice with full understanding that it was being used to deceive investors. From the launch of "Repo 105" in 2001 until the Lehman Brothers bankruptcy in 2008, Ernst & Young was paid more than $150 million for its auditing and accounting work for Lehman Brothers.
'No Factual or Legal Basis'
Ernst & Young said in a statement that it would defend itself in court and called the lawsuit "a significant expansion of the Martin Act" used to prosecute the case.
"There is no factual or legal basis for a claim to be brought against an auditor in this context where the accounting for the underlying transaction is in accordance with the Generally Accepted Accounting Principles," the statement said. "Lehman's audited financial statements clearly portrayed Lehman as a highly leveraged entity operating in a risky and volatile industry."
The lawsuit claims the accounting firm betrayed the public's trust.
"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," the lawsuit claims. "Lehman had no legitimate business reason to enter into such transactions, and could have obtained sufficient financing through less costly means."
Even though Lehman Brothers was legally obligated to buy back the "Repo 105" securities within a brief time, the company reported the transactions as sales rather than loans, the lawsuit claims. As much as $50 billion in Lehman assets were shuffled in the transactions, the lawsuit said.
Such massaging of the numbers is commonplace, but usually firms explain their practices in footnotes on quarterly reports, said Arthur Bowman, who publishes the accounting industry newsletter Bowman's Accounting Report. To his knowledge, this is the first time the government has gone after an accounting firm for its part in the Wall Street debacle, Bowman said.
Seeing Through the Window Dressing
After Lehman collapsed, federal regulators began scrutinizing other banks for similar deals meant to make their finances seem stronger. Much of this so-called "window dressing" is legal but regulators want to put an end to it.
One solution the feds have proposed: To require banks to report the maximum levels of certain kinds of debt every quarter, instead of yearly, as is now required.
"Window dressing to disguise debt is common," although the methods apparently used in this case are unusual, said Robert Willens, a tax and accounting expert who worked at Lehman Brothers but wasn't involved in internal accounting issues at the firm. "Whether it's against the law is another matter."
Now, operating in hindsight, Cuomo is treading a gray area in the lawsuit, Willens argues.
"One of the big imponderables is: What is an auditor's responsibility? Is an auditor simply there to assure that transactions are in accordance to accounting principles? Or is it to make sure they aren't misleading?" he asked
The lawsuit is seeking unspecified restitution and damages, and it also asks that Ernst & Young give more than $150 million in Lehman Brothers fees earned since 2001 to New York state.
Settlement Expected Quickly
Willens said he expects Ernst & Young to settle with the attorney general quickly.
"Chances are clients won't withdraw but the case could harm (Ernst & Young's) reputation," he said. "And that could put it at a disadvantage in attracting new clients."
Damaged reputation killed accounting firm Arthur Anderson. In a criminal fraud suit, the firm was convicted for destroying auditing documents while energy giant Enron was being investigated by regulators. But even before that conviction, clients fled the firm.
The conviction was eventually overturned by the Supreme Court in 2005, but for Andersen it was too late; the firm had basically gone out of business by then.
Willens said that civil charges against accounting firms are not unusual and so he doesn't expect people will view the Ernst & Young case as seriously as they did the one against Andersen.