Will Ernst & Young Survive the Lehman Scandal?

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.  

 

Lehman regularly increased its use of Repo 105 transactions in the days prior to reporting periods to reduce its publicly reported net leverage and balance sheet, says Valukas. The bank’s Repo 105 practice consisted of a two-step process: 1) undertaking Repo 105 transactions followed by 2) the use of Repo 105 cash borrowings to pay down liabilities, thereby reducing leverage.

 

A few days after the new quarter began, the report goes on, Lehman would borrow the necessary funds to repay the loans plus interest, repurchase the securities it pledged and restore those assets to the balance sheet. “Lehman,” wrote Valukas, “never publicly disclosed its use of Repo 105 transactions, its accounting treatment for these transactions, the considerable escalation of its total Repo 105 usage in late 2007 and into 2008, or the material impact these transactions had on the firm’s publicly reported net leverage ratio.”

 
Why did Lehman resort to this alleged ploy? The key reason appears to be the pressure from the market for investment banks to reduce their leverage. “The inability to reduce leverage could lead to a ratings downgrade, which would have had an immediate, tangible monetary impact on Lehman,” says Valukas.
 
He goes on to charge that “unbeknownst to the investing public, rating agencies, Government regulators, and Lehman’s Board of Directors, Lehman reverse engineered the firm’s net leverage ratio for public consumption.” It then hid its actions from the public. During the bank’s 2008 earnings calls, analyst frequently asked how Lehman was reducing leverage. Then-CFO Erin Callan said it was through the sale of less liquid asset categories, but said nothing about Lehman’s use of Repo 105 transactions.
 
Professional Negligence
What about Ernst & Young’s alleged failure to meet professional standards? Valukas believes that Lehman’s failure to disclose its use of Repo 105 transactions and the big volumes involved – US$38.6 billion in fourth quarter 2007, US$49.1 billion in first quarter 2008 and US$50.38 billion in second quarter 2008 – “materially misrepresented Lehman’s true financial condition.” Ernst & Young, he says, “was professionally negligent in allowing those reports to go unchallenged.”
 
On May 18, 2008, a Lehman senior vice president, Matthew Lee, wrote a letter to management alleging possible accounting improprieties. Lee told Ernst & Young the following month that Lehman had used US$50 billion of Repo 105 transactions to temporarily move assets off the balance sheet and quarter end. The next day, Ernst & Young met with the Lehman board audit committee, but did not say anything about Lee’s assertions. “Ernst & Young took virtually no action to investigate the Repo 105 allegations,” says Valukas.
 
The accounting firm denies the charges. In an e-mailed statement to the New York Times, spokesman Charles Perkins said: “Our last audit of the company was for the fiscal year ending Nov. 30, 2007. Our opinion indicated that Lehman’s financial statements for that year were fairly presented in accordance with Generally Accepted Accounting Principles (GAAP), and we remain of that view.”
 
There has been no word so far from the ex-Lehman executives named in the report, although a lawyer for former CEO Richard Fuld told the New York Times that her client “did not know what those transactions were — he didn’t structure or negotiate them, nor was he aware of their accounting treatment.”
 
It’s still early days, though. Lehman went bust in September 2008, becoming the largest bankrupt in U.S. history with assets of US$600 billion. It took Valukas more than 18 months to conclude his review. It will take more time for the matter to wend through the courts if criminal charges are filed. More civil cases are also likely – Fuld and other Lehman executives are already facing such claims.
 
Ernst & Young will now become a target of civil claims as well. It is a prospect devotedly not to be hoped for, but there is a small possibility that today’s Big Four could end up just being the Big Three.
 
About the Author
Cesar Bacani is senior consulting editor at CFO Innovation.

 

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