New York Attorney General Andrew Cuomo had one more piece of unfinished business before leaving for the governor’s mansion in Albany: file suit against Ernst & Young for allegedly helping its former client Lehman Brothers engage in accounting fraud.

However, Cuomo’s decision to file suit against the New York-based accounting firm will leave his successor with a case that probably won’t be easy to prosecute (see Cuomo Sues Ernst & Young over Lehman Audits). Attorney General-elect Eric Schneiderman will need to convince a jury, or a sympathetic judge, that E&Y’s reliance on some of the Financial Accounting Standards Board’s old rules under U.S. GAAP was a violation of the law.

In fact, FASB is now in the process of changing those rules as a direct result of Lehman Brothers bankruptcy examiner Anton Valukas’s report in March on the collapsed investment bank’s use of them to justify the so-called Repo 105 transactions that helped speed Lehman’s way to financial oblivion. In addition, FASB is now in the process of converging those porous rules with the broad-based principles of International Financial Reporting Standards. IFRS doesn’t provide for repurchase transactions like the kind that Lehman apparently used in the first half of 2008 to temporarily shift $50 billion worth of assets off its balance sheet when reporting its results for two successive quarters, classifying them instead as sales rather than financings.

In April, International Accounting Standards Board Chairman Sir David Tweedie told me, “We don’t allow it. That’s why we have principles, not rules, so you can’t do it. They find ways to get around rules.” The two boards have since met to discuss ways to close up the loopholes in the future standards they have been developing (see Accounting Boards to Work on Repo Transactions).

Not only that, but a group of Democratic senators wrote to Securities and Exchange Commission Chair Mary Schapiro back in August urging the SEC to require more complete and accurate corporate accounting disclosures, especially of off-balance sheet transactions like Lehman’s Repo 105 transactions (see Senators Want Better Accounting Disclosure).

Up to now, Ernst & Young has mostly argued that the bankruptcy examiner’s report spotlighted two quarters in which it did not even audit Lehman’s financial statements. The firm pointed out in March in a letter to clients that its last audit for Lehman was for the year ended Nov. 30, 2007 (see Ernst & Young Defends Lehman Audits). E&Y also blamed Lehman’s troubles on the turbulent economic climate of 2008 and a collapse in the bank’s liquidity precipitated by "declining asset values and loss of market confidence."

However, that didn’t stop shareholders from filing a class-action lawsuit against Ernst & Young over its Lehman audits, nor did it stop the SEC from investigating the firm.

Now, Cuomo’s office claims in its complaint to have uncovered instances going back to 2001 in which E&Y issued unqualified audit opinions of Lehman’s financials despite the use back then of similar repurchase transactions.

“E&Y substantially assisted Lehman Brothers Holdings Inc. … now bankrupt, to engage in a massive accounting fraud, involving the surreptitious removal of tens of billions of dollars of securities from Lehman’s balance sheet in order to create a false impression of Lehman’s liquidity, thereby defrauding the investing public,” said the complaint. “Called ‘Repo 105,’ these transactions, hatched in 2001, allowed Lehman to park tens of billions of dollars of highly liquid fixed income securities with European banks for the sole purpose of reducing Lehman’s balance sheet leverage, and painting a false picture of an important financial metric for investors, stock analysts, lenders, and others involved with Lehman. The Repo 105 transactions involved nothing other than the transfer by Lehman of investment grade securities in return for cash, which Lehman then used to pay down liabilities, with the binding understanding that Lehman would repurchase the same securities from the banks within a short time, often just a few days, in return for improved balance sheet ‘metrics.’ E&Y not only approved but consistently supported Lehman’s Repo 105 policy, and advised Lehman that it could take advantage of a technical accounting rule, known as FAS 140, to treat these Repo 105 transactions, which in reality were short-term financings, as ‘sales,’ enabling Lehman to remove the securities from inventory on its financial statements until they were repurchased. As E&Y also knew, at no time did Lehman disclose, either in its financial statements or otherwise, that it was transferring tens of billions of dollars in fixed income securities to foreign banks, on a temporary basis, often at the very end of Lehman’s fiscal quarters, with the obligation to quickly repurchase the securities.”

In response to the lawsuit, E&Y issued a statement taking issue with Cuomo’s reliance on a nearly 90-year-old New York State law known as the Martin Act that has mostly been used to prosecute companies that commit fraud rather than their accounting firms.

E&Y also invoked the accounting rules for protection. “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),” said the firm.  “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.”

However, Cuomo’s complaint lays out a series of meetings and communications involving Lehman executives and E&Y audit partners, and quotes testimony and e-mails his office has elicited from some of the principals:

“In 2001, Lehman, assisted by E&Y, decided to take advantage of FAS 140 by treating certain short-term financing transactions as 'sales,' in order to remove the securities used as collateral for the loans, from Lehman’s balance sheet on a temporary basis, even though such an arrangement was economically disadvantageous to Lehman (because of the large 'haircut' needed). Lehman decided to do this solely to create the misleading appearance that its leverage was being reduced by the removal of assets from the balance sheet and the paying down of liabilities. Lehman and E&Y also affirmatively decided not to disclose the impact of Repo 105 transactions on Lehman’s financial statements – and in particular the obligation to repurchase – to the investing public. Lehman had no legitimate business reason to enter into such transactions, and could have obtained sufficient financing through less costly means, including the use of ordinary repo transactions. Its only reason for doing Repo 105 transactions was to reduce leverage without disclosing such transactions to investors.”

“In 2001, Lehman adopted an internal Accounting Policy Statement (‘the Policy’) that enunciated Lehman’s intention to use Repo 105 transactions. Before issuing the Policy, senior Lehman personnel, including Kristine Smith, discussed the proposed Policy with Kevin Reilly, the E&Y 'engagement partner' in charge of E&Y’s relationship with Lehman, and with E&Y partners William Schlich and Matthew Kurzweil. In their discussions, E&Y specifically 'approved' the Policy. As Reilly testified, ‘I would have communicated that we believed that their conclusions were acceptable under the accounting literature.’ Q. ‘Ernst & Young approved the policy that they had adopted vis-à-vis Repo 105 transactions, correct?’ A. ‘I concluded it was acceptable, yes.’"

"E&Y understood that the Repo 105 transactions were, as Reilly described it, designed to ‘manage balance sheet metrics.’ As reflected in an August 19, 2001 memo from Smith to Reilly, Schlich, and Kurzweil, entitled ‘Rules of the Road – Repo Recharacterizations (Repo 105),’ the Repo 105 transactions gave Lehman 'the ability to recharacterize reverse repo and repo trades (meeting the criteria specified below) as inventory trades [and] will allow for an increased ability to net down Lehman’s balance sheet for matched book positions since such financial transactions once classified as inventory would then be subject to netting under cusip netting rules.'"

The complaint goes on to describe how the Lehman executives and E&Y partners later expanded the repurchase transactions in 2002 to include a related “Repo 107” structure in which Lehman provided E&Y with a memo reaffirming that the Repo 105 transactions were being done for the purpose of “balance sheet as firm inventory.” Not only that, but the bank subsequently expanded into “Repo 108” transactions, which used equities, rather than fixed-income securities, with a minimum of 8 percent "overcollateralization."

However, in order to take advantage of FAS 140 and categorize the assets as sales, Lehman’s internal accounting policy required that a legal opinion be rendered affirming that the asset transfers complied with the necessary criteria relating to the transfer of control of the securities. Failing to find a “true sale opinion” under U.S. law, Lehman turned to Linklaters, a British law firm, in March 2001 to render a favorable opinion. Linklaters accommodated the request by issuing an opinion addressed to LBIE, a United Kingdom affiliate of Lehman, which was supposed to be intended solely for LBIE’s benefit. The letter set forth the circumstances under which, in Linklaters’ opinion, LBIE could engage in transactions that, under FAS 140, could be categorized as “sales.” However, the letter expressly stated that the transactions had to be based in the U.K., subject to English law, and had to involve securities that were ‘sited’ in the U.K., according to the Attorney General’s complaint.

Nevertheless, Lehman executives used the U.K. firm’s legal opinion to justify billions of dollars worth of dubious transactions and e-mailed E&Y about Linklater’s “true sale opinion” under English law.

“Linklaters has issued a True Sale opinion covering repo transactions documented under a [Global Master Repurchase Agreement] under English Law,” wrote Lehman executive Smith. “Therefore this policy is expected to cover Reverse Repo and Repo Trades executed in London under a GMRA agreement, provided also that the customer resides in a jurisdiction covered under English Law as noted on attached Rules of the Road Document.”

The use of the repo transactions dramatically escalated at the bank in 2007-2008, according to the complaint. E&Y, according to its own client letter, was the bank’s auditor for the year ended Nov. 30, 2007.

All that time, Lehman failed to take the “haircut” required by FAS 140, under which a company is required to receive only 95 percent or less of the value of the securities it transfers, thereby (theoretically) putting the company in a position where it might not be able to reacquire the securities, because of the shortfall between the value of the securities and the amount of cash the company received, according to the complaint.

Still, New York prosecutors may have a difficult time proving that Ernst & Young violated the accounting rules. Just imagine trying to keep a jury awake long enough for attorneys to wade through the accounting guidance issued by FASB.

In the end, though, E&Y may have to cough up hefty settlements with the New York AG’s Office, the SEC and Lehman's army of unhappy shareholders, if only to keep its name off the front page of The Wall Street Journal. When that happens, the haircut will be a lot more like a scalping.

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