The civil complaint filed by the outgoing New York attorney general, Andrew M. Cuomo, accusing Ernst & Young of helping Lehman Brothers mislead investors and the accounting firm's response sound like two completely different events.
The state claims Lehman's auditors aided in a fraud, using Repo 105 transactions to make the books look healthier than they actually were.
Ernst & Young proclaimed it did nothing wrong because its work complied with Generally Accepted Accounting Principles, or GAAP.
Both may well be right "” although that won't necessarily preclude a claim against Ernst & Young. The outcome of the case depends on whether a court takes a broad view of what a company's financial statements should convey to investors, or focuses only on the technical requirements for reporting transactions.
The attorney general's complaint portrays Ernst & Young as eager to please one of its largest clients by bending over backward to permit the Repo 105 transactions. The deals involved a convoluted structure to transfer the securities to Lehman's British arm since no American law firm would approve the transaction. According to the complaint, Repo 105 deals reached more than $50 billion in the last reporting period before Lehman's bankruptcy "” all blessed by clean opinions from Ernst & Young.
This issue was first sketched out in the bankruptcy examiner's report that questioned whether the Repo 105 transactions had any purpose other than painting a rosy picture of Lehman's finances. Mr. Cuomo's complaint takes those findings and fits them into New York's broad antifraud law, the Martin Act, to claim that the accountants helped Lehman mislead investors by not requiring disclosure of the balance sheet machinations.
The complaint does not claim improper accounting so much as a fast and loose shuffle of assets that "” while perhaps legal "” was created to dupe investors. The complaint claims at one point that Lehman's "characterization of what became $50 billion in Repo 105 transactions per quarter as merely "?balance sheet fluctuations' that did not require disclosure was totally ridiculous, and clearly not a justification for the fraudulent non-disclosure of the transactions."
In response to the attorney general's complaint, Ernst & Young issued the following statement:
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 US Generally Accepted Accounting Principles (US GAAP).
Lehman's bankruptcy occurred in the midst of a global financial crisis triggered by dramatic increases in mortgage defaults, associated losses in mortgage and real estate portfolios, and a severe tightening of liquidity. Lehman's bankruptcy was preceded and followed by other bankruptcies, distressed mergers, restructurings, and government bailouts of all of the other major investment banks, as well as other major financial institutions. In short, Lehman's bankruptcy was not caused by any accounting issues.
The provision applicable to the Repo 105 transactions, called SFAS 140, is subject to interpretation, like most accounting rules. Taking a liberal view of its requirements would support the conclusion that Lehman complied with the letter of the rule. And it will be difficult for the attorney general to establish that the accounting treatment violated GAAP. Thus, Ernst & Young focuses more on the technical elements of the governing provision.
By complying with those rules, one could argue, the accountants had no further obligation to make Lehman to treat the transactions differently or to disclose more about them.
One way to understand how this case may play out, if it ever gets to a trial, is that the attorney general will focus on the forest while Ernst & Young will be looking at the bushes underneath the trees.
At issue is whether there are broader obligations "“ a gatekeeper function "“ for accountants to police clients by demanding more than just plausible compliance with the accounting rules and ensure their spirit is also upheld.
Ernst & Young's assertion that accounting issues did not cause Lehman to declare bankruptcy is most likely correct. Accounting rules are created to give a snapshot of a company's financial position and cannot on their own cause a liquidity squeeze or decline in revenue that can lead to a company's demise. But Ernst & Young's statement is also a non sequitur because the issue in the attorney general's complaint is not whether the Repo 105 transactions triggered Lehman's collapse "“ they did not "“ but whether investors failed to comprehend the risks on Lehman's balance sheet because those transactions obfuscated the firm's precarious position.
I doubt either side really wants to see this case go to trial. Arguing about the propriety of a company's accounting treatment in front of a jury is not very appealing for the state, given the complexity of the matter. And the accounting firm will undoubtedly bring in experts to opine that the Repo 105 transactions complied with SFAS 140 and there was no obligation to make further disclosure.
For Ernst & Young, a public airing of its willingness to allow Lehman to aggressively use accounting window dressing while arguing that it was technically correct under the rules is an equally unattractive option. Moreover, the Martin Act does not require proof of "scienter," or fraudulent intent. So the firm could be found liable for negligence, which may not be too difficult to show in light of the bankruptcy.
In the end, Mr. Cuomo's case may be more of a sideshow if the Securities and Exchange Commission decides to pursue securities fraud charges against Lehman executives that would put the issue of responsibility for the firm's bankruptcy front and center.
Peter J. Henning, who writes White Collar Watch for DealBook, is a Professor at Wayne State University Law School.
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