Ernst & Young is nuts to say Lehman was clean

Two weeks before New York Attorney General Andrew Cuomo’s office sued Ernst & Young, a prominent U.S. consulting firm issued a press release touting its ability to help others manage the risk of fraud.

“As companies return to growth, new risks related to fraud and corruption will emerge, bringing compliance to the forefront for boards of directors, audit committees and senior management of global companies,” the firm said.

“Dealing with complex issues of fraud, regulatory compliance and business disputes can detract from efforts to achieve your company’s potential. Better management of fraud risk and compliance exposure is a critical business priority — no matter the industry sector.”

Talk about chutzpah. The firm that wrote that was none other than Ernst & Young, the longtime outside auditor for Lehman Brothers, which went bankrupt in 2008 while sporting financial statements that bore little evidence of the calamity to come. Sure, E&Y may have lots of experience in this field. Much of it, though, is the wrong kind.

In its civil lawsuit this week, Cuomo’s office alleged that E&Y helped Lehman engage in a massive accounting fraud — and committed fraud itself in the process. The surprise wasn’t in the suit’s factual assertions, many of which were contained in a March report by Lehman’s bankruptcy examiner, Anton Valukas. Allegations of misconduct at E&Y have become such a routine part of the firm’s business that they’ve come to be expected.

Rather, the big news was that anyone filed the case at all, and that it was the departing New York attorney general who did it instead of the Securities and Exchange Commission. Finally there’s a sign some outfit at the epicenter of Lehman’s collapse might be held accountable. Still, it’s more than a bit odd that the defendants in Cuomo’s suit didn’t include anyone who worked for Lehman, or any of the E&Y accountants responsible for auditing the securities firm’s books.

E&Y had established itself as a repeat offender long before Gov.-elect Cuomo filed his suit. In recent years we’ve seen four former E&Y partners sentenced to prison for selling illegal tax shelters, while other partners have been disciplined by the SEC for blessing fraudulent financial statements at a variety of companies, including Cendant Corp. and Bally Total Fitness Holding Corp.

In the Bally case, E&Y last year paid an $8.5 million fine, without admitting or denying the SEC’s professional-misconduct claims. The SEC also has imposed sanctions against E&Y three times since 2004 for violating its auditor-independence rules.

Yet it seems there’s little anyone can do to keep E&Y on the straight and narrow. Killing E&Y or any of the other Big Four audit firms — PricewaterhouseCoopers, Deloitte & Touche and KPMG — would leave just three large survivors, when the industry has too few competitors already.

We can’t have another firm go down like Arthur Andersen did after its indictment in 2002, the conventional wisdom goes. And so these firms are permitted to plod along, fending off one regulator after another, knowing they will be allowed to carry on no matter how much they offend the public’s sense of decency.

The latest case against E&Y stems from Lehman’s use of transactions the investment bank called Repo 105. Lehman used these deals to move as much as $50 billion of securities off its balance sheet in a given quarter and temporarily reduce its reported debt, usually for about a week at a time. Lehman got the assets off its books by treating the transactions as sales rather than financings for accounting purposes. This let Lehman show lower leverage ratios, according to Valukas’s report.

That E&Y hasn’t changed its ways is clear from the press release it issued this week responding to Cuomo’s suit. “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 firm said.

That isn’t an accurate depiction of the claims Cuomo brought, though. Cuomo’s suit unambiguously took the position that Lehman violated GAAP. What’s more, it’s not credible for E&Y to say that Lehman didn’t. (An E&Y spokesman, Charles Perkins, said he “can’t comment beyond our statement.”)

In the footnotes to its audited financial statements, Lehman said it accounted for all its repurchase agreements as financings. This was false, because Lehman accounted for its Repo 105 transactions as sales, a point the Valukas report chronicled in exhaustive detail.

As any freshman accounting major can tell you, it’s a violation of GAAP for a company to tell investors it’s using one type of accounting treatment when it’s actually using another, especially when the method it’s secretly employing makes its balance sheet look stronger. Yet E&Y still insists that Lehman followed the rules. It’s hard to tell which is more insane: The notion that E&Y’s bosses might believe their own spin, or that they think anybody else will.

It’s indisputable that E&Y blessed Lehman’s financial statements quarter after quarter, year after year, falsehoods and all. What the state would need to prove to win at trial is that the firm’s actions amounted to fraud.

For the time being, E&Y is saying it looks forward to presenting the facts in a court of law. If it hopes to prevail there, it will need to come up with a more believable defense than the nonsense it’s trumpeting now.
Jonathan Weil is a Bloomberg News columnist.