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Editor: Eric C. Chaffee
Univ. of Toledo College of Law

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Tuesday, December 21, 2010

New York Sues Ernst & Young Alleging Involvement in Lehman Fraud

As the Wall St. Journal earlier predicted, today the New York Attorney General sued accounting firm Ernst & Young LLP (“E&Y”), charging the firm with helping Lehman Brothers Holding, Inc. (“Lehman”) engage in an accounting fraud involving the surreptitious removal of tens of billions of dollars of fixed income securities from Lehman’s balance sheet in order to deceive the public about Lehman’s true liquidity condition.  (Contrary to some earlier reports, the complaint does not name individual defendants.)

The Attorney General’s lawsuit claims that for more than seven years leading up to Lehman’s bankruptcy filing in September 2008, Lehman had engaged in so-called “Repo 105” transactions, explicitly approved by E&Y. The transactions purpose was to temporarily park highly liquid, fixed-income securities with European banks for the sole purpose of reducing Lehman’s financial statement leverage, an important financial metric for investors, stock analysts, lenders, and others interested in Lehman.

Specifically, Repo 105 transactions involved transfers by Lehman of fixed income securities to European counterparties in return for cash - often at the end of a financial quarter - with the binding understanding that Lehman would shortly repurchase the equivalent securities from these counterparties only a few days later for more money. Lehman then used the cash to pay down liabilities and improve its leverage and balance sheet metrics, while failing to disclose to the investing public the obligation to repurchase the securities at a higher price. Lehman did so, with E&Y’s explicit approval, by characterizing these financing transactions as “sales.” Indeed, the sole purpose of characterizing these transactions as “sales” was to reduce Lehman’s leverage on its financial statements and public filings, thereby deceiving the investing public.

The complaint alleges that E&Y was fully aware of Lehman’s fraudulent Repo 105 transactions, specifically approved of Lehman’s use of them, and gave Lehman an unqualified audit opinion every year from 2001 to 2007, despite knowing that they concealed the Repo 105 transactions. Further, the lawsuit alleges that in 2007 and early 2008, when Lehman was facing demands to reduce its leverage, Lehman rapidly accelerated its use of Repo 105 transactions, removing up to $50 billion from its balance sheet on a quarterly basis without disclosing the use of the Repo 105 transactions.

The complaint also alleges that E&Y failed to object when Lehman misled analysts on its quarterly earnings calls regarding its leverage ratios, and that E&Y did not inform Lehman’s Audit Committee about a highly-placed whistleblower’s concerns about Lehman’s use of Repo 105 transactions.

The Attorney General seeks the return of the entirety of fees E&Y collected for work performed for Lehman between 2001 and 2008, exceeding $150 million, plus investor damages and equitable relief.

http://lawprofessors.typepad.com/securities/2010/12/new-york-sues-ernst-young-alleging-involvement-in-lehman-fraud.html

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