Investment banking: NY sues E&Y over Lehman

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, says the AG's office.

“This practice was a house-of-cards business model designed to hide thousands of millions in liabilities in the years before Lehman collapsed,” said Attorney General Cuomo. “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.” That's an estimated USD150 million.

"Specifically, Repo 105 transactions involved transfers by Lehman of fixed income securities to European counter-parties 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 counter-parties 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 characterising these financing transactions as “sales.” Indeed, the sole purpose of characterising these transactions as “sales” was to reduce Lehman’s leverage on its financial statements and public filings, thereby deceiving the investing public.

"The 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 whistle-blower's concerns about Lehman’s use of Repo 105 transactions. "

E&Y meanwhile say that it's not their fault and they cannot be held responsible if they follow GAAP.
"We intend to vigorously defend against the civil claims alleged by the New York Attorney General.

"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.

"We look forward to presenting the facts in a court of law."