New York Attorney General and Governor-elect Andrew Cuomo has filed suit against Ernst & Young, charging the firm with helping former client Lehman Brothers engage in accounting fraud.

The Martin Act lawsuit, filed on Tuesday, charges E&Y with helping the now-bankrupt investment bank commit accounting fraud involving the surreptitious removal of tens of billions of dollars of fixed-income securities from Lehman’s balance sheet to deceive the public about Lehman’s true liquidity condition.

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 (see Report: E&Y to Face Fraud Charges in Lehman Collapse). 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.

“This practice was a house-of-cards business model designed to hide billions in liabilities in the years before Lehman collapsed,” said Cuomo in a statement. “Just as troubling, a global accounting firm, tasked with auditing Lehman’s financial statements, helped hide this crucial information from the investing public. Our lawsuit seeks to recover the fees collected by Ernst & Young while it was supposed to be using accountable, honest measures to protect the public.”

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.” 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, according to prosecutors.

Ernst & Young said it would fight the charges. "We intend to vigorously defend against the civil claims alleged by the New York Attorney General," the firm said in a statement forwarded by spokesman Charles Perkins. "There is no factual or legal basis for a claim to be brought in this context against an auditor where the accounting for the underlying transaction is in accordance with the Generally Accepted Accounting Principles (GAAP). Lehman’s audited financial statements clearly portrayed Lehman as a highly leveraged entity operating in a risky and volatile industry. 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. What we have here is a significant expansion of the Martin Act. Although the Martin Act is almost 90 years old, we believe this is the first time that an Attorney General is attempting to use this law to assert claims against an accounting firm, rather than the company that took the alleged actions. We look forward to presenting the facts in a court of law."

The Attorney General's complaint, filed in New York Supreme Court, 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.

The lawsuit follows on the heels of a report in March by bankruptcy examiner Anton Valukas calling attention to the Repo 105 transactions in the first and second quarters of 2008 and noting that there were “colorable claims” by Lehman’s investors over Ernst & Young’s audits (see Lehman’s Accounting Sleight of Hand Was Less Than Magical).

Later that month, E&Y defended itself in a letter to clients by noting that its last audit of Lehman preceded the two fiscal quarters in Valukas’s report (see Ernst & Young Defends Lehman Audits). The firm also wrote in the letter, “Lehman's bankruptcy was the result of a series of unprecedented adverse events in the financial markets. The months leading up to Lehman's bankruptcy were among the most turbulent periods in our economic history. Lehman’s bankruptcy was caused by a collapse in its liquidity, which was in turn caused by declining asset values and loss of market confidence in Lehman. It was not caused by accounting issues or disclosure issues.”

Nevertheless, the Securities and Exchange Commission has been probing Ernst & Young’s audits of Lehman Brothers, and a number of shareholder lawsuits have been filed against the firm (see SEC Widens Lehman Investigation and Lehman Shareholders Sue Ernst & Young). The U.K.'s Accountancy and Actuarial Discipline Board has also been investigating the firm (see E&Y Probed over Lehman Audits).

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