Let’s Walk Down Memory Lane with Ernst & Young and Lehman Brothers

This week, lots of people are talking about the Lehman Brothers bankruptcy because five years is half of a decade and, well, it was the biggest bankruptcy in U.S. history so that counts for something.

Yesterday, we linked to the DealBook story that explains why the SEC threw in the towel and for me, it's one of those things where I just shrug and think, "Well, that's unfortunate but not surprising." 

If a person tries to look at the situation in a legal sense, it's not difficult to understand why the SEC is passing on this. They wanted to make Lehman's bankruptcy about shady accounting and, as Matt Levine writes:

[T]hat's silly. What went wrong is that their business didn't work out, at a pretty unforgiving time, and their funding went away. Knowing that Lehman's "real" leverage was 14x, rather than 12x, wouldn't have helped you predict that. The problem wasn't leverage; it was liquidity.

[…]

Focusing on those sort of systemic issues — as regulators have mostly done since 2008 — makes sense. Pretending that the 2008 financial crisis was about a series of idiosyncratic technical accounting decisions obscures that focus. The SEC could have tried to shoehorn Lehman into a story of obscure accounting fraud, and it chose not to just because that's not the real story, and because the real story is more important.

Regardless, that doesn't satisfy a lot of people, as former SEC chair Mary Schapiro is quoted in the Times piece, "The world won't understand."

But it's not like the SEC didn't want to bring a case against Lehman; this sort of thing would look pretty good on a résumé after all. Back to DealBook:

The decision not to bring charges, the officials said, came despite early hope among investigators, whose careers likely would have benefited from bringing such a prominent case.

So Lehman's off the hook. That upsets quite a few people, but for those who would still like someone — ANYONE, really — to be held accountable for Lehman's failure, there are still some ambitious folks in the New York Attorney General's office who are on the case. Francine McKenna tweeted some links this morning and that got me feeling nostalgic for Ernst & Young's role in this whole mess. Seems as good a time as any to dig up that past, right? Right.

As you may recall, that the bankruptcy examiner's report from Jenner & Block's Anton Valukas stated this (from page 1027): 

[S]ufficient evidence exists to support colorable claims against Ernst & Young LLP (“Ernst & Young”) for professional malpractice arising from Ernst & Young’s failure to follow professional standards of care with respect to communications with Lehman’s Audit Committee, investigation of a whistleblower claim, and audits and reviews of Lehman’s public filings.

It's been nearly three years since the NYAG filed civil charges against Ernst & Young and although Eric Schneiderman was handed a setback last December, there hasn't been any indication that they're giving up on their case like the SEC.

Why wouldn't the SEC's failure to pull a case together discourage the NYAG? Great question! If Lehman's bankruptcy wasn't about shady accounting — accounting that EY signed off on — doesn't it make sense that the firm would be off the hook? Kinda seems like it, but no, the NYAG has the Martin Act, and it's the ace in the hole. Here's a good rundown of how the NYAG is using it:

In the lawsuit filed against accounting firm Ernst & Young, Andrew Cuomo brought four claims, three of them under New York’s Martin Act, one of the most powerful prosecutorial tools in the country.
 
Technically speaking, the Martin Act allows New York’s top law enforcer to go after wrongdoing connected to the sale or purchase of securities. Nothing too noteworthy there.
 
But what is noteworthy is the power the act confers upon its user. It enables him to subpoena any document from anyone doing business in New York and, if he so desires, keep an investigation entirely secret. People subpoenaed in Martin Act cases aren’t afforded a right to counsel or the right against self-incrimination. “Combined, the act’s powers exceed those given any regulator in any other state,” wrote Nicholas Thompson in this 2004 Legal Affairs article.
 
And we haven’t even gotten to the kicker. Courts in civil Martin Act cases have held that “fraud” under the Martin Act “includes all deceitful practices contrary to the plain rules of common honesty and all acts tending to deceive or mislead the public, whether or not the product of scienter or intent to defraud.”
 
In other words, in order to prove a Martin Act violation, the attorney general is not required to prove that the defendant intended to defraud anyone, only that a defrauding act was committed.
That is quite the thing, isn't it? Of course the question now is, "Did EY commit a defrauding act?" That's where things get a little tricky, but here's one example that may help — If you remember what Valukas wrote in his report about EY's "failure to follow professional standards of care with respect to communications with Lehman’s Audit Committee," this portion of the report (pages 945-946) says a lot:
Lehman’s own Corporate Audit group led by Beth Rudofker, together with Ernst & Young, investigated allegations about balance sheet substantiation problems made in a May 16, 2008 “whistleblower” letter sent to senior management by [Lehman Global Controller] Matthew Lee. On June 12, 2008, during the investigation, Lee informed Ernst & Young about Lehman’s use of $50 billion of Repo 105 transactions in the second quarter of 2008. At a June 13, 2008 meeting, Ernst & Young failed to disclose that allegation to the Board’s Audit Committee. Former Lehman director Cruikshank recalled that he made very clear he wanted a full and thorough investigation into each allegation made by Lee, whether the allegation was contained in Lee’s May 16, 2008 letter or raised by Lee in the course of the investigation. Another former Lehman director, Berlind, similarly stated that the Audit Committee explicitly instructed Lehman’s Corporate Audit Group and Ernst & Young to keep the Audit Committee informed of all of Lee’s allegations. Berlind also said that he would have wanted to know about Lehman’s Repo 105 program and that if he had known about Lehman’s Repo 105 transactions, he would have asked Lehman’s auditors to test the transactions to ensure they were appropriate. Upon learning from the Examiner, the volume of Repo 105 transactions at quarter‐end in late 2007 and 2008, Sir Christopher Gent said that he believed the volume mandated disclosure to the Audit Committee and further investigation.

Naturally, EY doesn't buy it. They believe the NYAG is being obnoxiously ambitious using the Martin Act to make their case. Here's how they responded to the claims back in 2010:

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 (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.
These things take time so feel free to re-read the examiner's report (here) and the complaint (next page) while we're all waiting. We'll probably have to do this again next year.
 

Ernst Young Complaint by Caleb Newquist

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