Will Ernst & Young Survive the Lehman Scandal?

by Cesar Bacani, 12 March 2010

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topics:
Accounting and Regulations Auditing

tags:
bankruptcy colorable claims Ernst & Young Lehman Brothers negligence Repo 105

What are ‘colorable claims’? Until this week, few CFOs and accountants probably know what this U.S. legal term means. That’s about to change. Anton R. Valukas, the U.S. examiner tasked by the Bankruptcy Court of the Southern District of New York to investigate the demise of Lehman Brothers, uses the term to describe the acts and omissions of the bankrupt bank’s CEO, three CFOs and Ernst & Young, Lehman’s external auditor.

In a 2,200-page report released on March 11, Valukas writes that “the business decisions that brought Lehman to its crisis of confidence may have been in error but were largely within the business judgment rule.” But then he goes on to conclude that “the decision not to disclose the effects of those judgments does give rise to colorable claims against the senior officers who oversaw and certified misleading financial statements – Lehman’s CEO Richard S. Fuld, Jr., and its CFOs Christopher O’Meara, Erin M. Callan and Ian T. Lowitt.”

Valukas, who is chairman of well-known U.S. law firm Jenner & Block LLP, also believes that colorable claims exist against Ernst & Young, the Big Four accounting firm whose unit in Hong Kong has been accused of irregularities in the audit of electronics firm Akai.

“Ernst & Young took no steps to question or challenge the non-disclosure by Lehman of its use of $50 billion of temporary, off-balance sheet transactions [to allegedly manipulate the balance sheet],” he wrote. “Colorable claims exist that Ernst & Young did not meet professional standards, both in investigating [allegations by a Lehman executive about the supposed manipulation] and in connection with its audit and review of Lehman’s financial statements.”

Is this Enron all over again? In that 2001 bankruptcy, senior executives including CFO Andrew Fastow were jailed for fraudulent accounting and other crimes. Its external auditor, Arthur Andersen, was found guilty of covering up the irregularities. Abandoned by clients, Arthur Andersen was broken up in 2002, although the U.S. Supreme Court overturned the judgment against it by the lower courts in 2005.

The parallels are surely disturbing to the many Arthur Andersen alumni who have found a new home in Ernst & Young. If it’s any consolation, the colorable claims the examiner is making are not actual indictments. “In this Report a colorable claim is one for which the Examiner has found that there is sufficient credible evidence to support a finding by a trier of fact,” Valukas explains.

“The Examiner is not the ultimate decision‐maker,” he goes on. “Whether claims are in fact valid will be for the triers of fact to whom claims are presented. The identification of a claim by the Examiner as colorable does not preclude the existence of defenses and is not a prediction as to how a court or a jury may resolve any contested legal, factual, or credibility issues.”

Off the Balance Sheet

The examiner’s colorable claims against the four former Lehman executives and Ernst & Young rest on the use of off-balance sheet devices known within Lehman as ‘Repo 105’ transactions. Repos – the term stands for sale and repurchase – are agreements where one party transfers an asset or security to another party as collateral for a short‐term borrowing of cash, while simultaneously agreeing to repay the cash and take back the collateral at a specific point in time.

According to Valukas, Lehman’s Repo 105 transactions were nearly identical to standard repurchase and resale transactions that investment banks use to secure short-term financing. The critical difference is that Lehman accounted for Repo 105 transactions as ‘sales,’ instead of financing transactions. By so doing, it removed the inventory from its balance sheet.

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