7:57 p.m. | Updated
More than two years after Lehman Brothers imploded, nearly bringing the global economy to its knees, regulators are preparing to file the first major legal action stemming from the collapse of the investment bank.
The charges, however, are not expected to be leveled against senior executives at Lehman, but rather against the accounting firm that audited the firm's financial statements.
A civil fraud lawsuit could be brought by the New York attorney general against Ernst & Young by Tuesday, accusing the accounting firm of helping Lehman mislead investors, according to a person briefed on the matter. Ernst & Young certified the financial statements of Lehman from 2001 until the firm's bankruptcy filing in September 2008.
The two sides have had discussions on a settlement, this person said. The possibility of a lawsuit was earlier reported by The Wall Street Journal.
The move by Attorney General Andrew M. Cuomo "” coming just days before he is sworn in as New York's governor "” could spur other regulators to act. Both the Justice Department and the Securities and Exchange Commission have been investigating the demise of Lehman. The government investigations of Lehman, which began not long after its collapse, have resulted in no charges against any of the firm's executives, including Richard S. Fuld Jr., its longtime chief executive.
“The New York attorney general, whether it's Cuomo or his predecessor Eliot Spitzer, has always been aggressive when it comes to civil litigation matters," said Michael J. Missal, a government-enforcement lawyer at K&L Gates. “This appears to be another instance where the office is moving ahead of the S.E.C. and any other federal regulator."
Ernst & Young's role as Lehman's outside auditor has been under intense scrutiny since the release in March of a 2,200-page report into the investment bank's collapse. The attorney general's investigation of Ernst & Young commenced began after the release of the report, said the person familiar with the inquiry.
The stinging report, written by a bankruptcy court-appointed examiner, accused Lehman's top executives "” particularly its chief financial officers "” of manipulating the firm's balance sheet and inflating the value of its souring real-estate holdings, among other alleged misdeeds.
But the report reserved some of its harshest criticism for Ernst & Young, effectively laying out a road map for a potential legal action against the accounting firm.
The examiner, Anton R. Valukas, a lawyer at Jenner & Block, said there was enough evidence to support at least three claims against Ernst & Young over its poor supervision of Lehman's accounting practices.
Specifically, the report focused on an accounting maneuver "” known inside Lehman as Repo 105 "” that it denounced as "materially misleading." The tactic temporarily removed as much as $50 billion of assets from its balance sheet to give the appearance that the firm had reduced its debt levels. It often did this just before the end of a financial quarter, the report said.
The report said that Ernst & Young knew about this practice since 2001 and criticized the accounting firm for not exploring the possibility "that Repo 105 transactions were accounting-motivated transactions that lacked a business purpose."
Mr. Valukas's report also said that the auditors ignored warnings by a Lehman executive about potential accounting improprieties at the firm just months before its bankruptcy filing. While Ernst & Young spoke to Lehman's board about the executive's claims, it did not disclose allegations about Repo 105, the report said.
"Ernst & Young took no steps to question or challenge the nondisclosure by Lehman of its use of $50 billion of temporary, off-balance sheet transactions," the report said.
Legal and accounting experts have previously said that the report could expose Ernst & Young to civil malpractice claims and even criminal charges.
An Ernst & Young spokesman declined to comment on any potential case brought by Mr. Cuomo's office.
At the time of the examiner's report release, the Ernst & Young spokesman said that the firm stood by its work and complied with generally accepted accounting principles. He also said that Lehman's collapse was the result of "a series of unprecedented adverse events in the financial markets."
Britain's independent accounting regulator, the Financial Reporting Council, is also investigating Ernst & Young in connection with the accounting firm's role in preparing reports to British regulators related to Lehman's European operations.
To date, United States regulators have brought few cases connected to the companies at the center of the financial crisis. While shareholders have filed civil lawsuits, no senior executives at Lehman, the American International Group or Bear Stearns have been charged by government regulators.
In November 2009, in the first major criminal case connected to the financial crisis, a federal jury in Brooklyn acquitted two Bear Stearns hedge fund managers on charges that they had misled investors as their portfolio of mortgage-backed securities crumbled.
Lehman has been in regulators' cross hairs since its collapse. In 2008, federal prosecutors subpoenaed several Wall Street firms seeking information about whether their analysts had been misled by Lehman about its financial health, according to people familiar with the matter. Specifically, prosecutors have asked questions about certain statements Lehman executives made in June 2008, when it sought to raise capital to bolster its balance sheet, and its final days, when it assured analysts that it did not need new capital.
Former Lehman employees say officials from the S.E.C. have been asking how Lehman valued an investment in a power plant in India. The asset's lofty valuation may have bolstered the firm's finances in 2008 before its collapse, these people say. An S.E.C. spokesman declined to comment.
Mr. Fuld has kept a low profile since the collapse of Lehman Brothers. He started a firm called Matrix Advisors, offering advice to former Lehman clients and others on various transactions. Ian Lowitt, the firm's last chief financial officer, is the chief operating officer of the United States wealth-management business at Barclays of Britain, which bought Lehman's operations in the United States.
Erin Callan, his predecessor, left Lehman in June 2008. She accepted a job at Credit Suisse, but left not long after. She is currently not employed in the securities industry.
If the New York attorney general's office takes a different tack on Lehman, that would not be unusual. Mr. Cuomo, like his predecessor, Mr. Spitzer, has used the attorney general's office to take aggressive aim at Wall Street. For instance, Mr. Cuomo sued Bank of America and Kenneth D. Lewis, its former chief executive, accusing them of hiding billions of dollars in losses at Merrill Lynch from shareholders even after the S.E.C. reached a settlement with the bank.
With the big accounting firms and other companies, federal prosecutors have been mindful of the experience of Arthur Andersen, the accounting firm that went out of business after its conviction on obstruction of justice charges in 2002. (The Supreme Court later threw out the conviction.) In many cases, the government has struck so-called deferred prosecution agreements with companies instead of filing charges.
If a lawsuit were filed against Ernst & Young this week without a settlement, it would be handed off to Mr. Cuomo's successor, Eric T. Schneiderman.
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