Wednesday, December 22, 2010

Ernst & Young accused of hiding Lehman troubles




A view of the Ernst & Young headquarters in New York December 20, 2010. REUTERS/Lucas Jackson

A view of the Ernst & Young headquarters in New York December 20, 2010.
Credit: Reuters/Lucas Jackson
By Grant McCool

NEW YORK (Reuters) - Accounting firm Ernst & Young was sued by New York prosecutors over allegations it helped to hide Lehman Brothers' financial problems, in the first major government legal action stemming from the Wall Street company's 2008 downfall.

The civil fraud case contends that Ernst & Young stood by while Lehman used accounting gimmickry to mask its shaky finances. The lawsuit says Lehman ran "a massive accounting fraud," but it did not name as defendants any former top executives at the investment bank whose September 2008 collapse helped spark the global financial crisis.


The lawsuit seeks more than $150 million in fees that Ernst & Young received from 2001 to 2008 as Lehman's outside auditor -- less than 1 percent of its global annual revenue -- plus other unspecified damages.


The lawsuit was filed by New York Attorney General Andrew Cuomo. People close to Cuomo said one factor in bringing the case was that he knows that the U.S. Securities and Exchange Commission already is investigating former Lehman chief Richard Fuld and other former top Lehman executives.


Cuomo "wants to go after the one party he knows isn't being sued," said John Coffee, a professor of corporate law at Columbia University.


In a statement on Tuesday, Ernst & Young said it intended to "vigorously defend" the lawsuit.


Lehman's bankruptcy occurred in the midst of a global financial crisis and was not caused by any accounting issues, the company said.


"Lehman's audited financial statements clearly portrayed Lehman as a highly leveraged entity operating in a risky and volatile industry," the accounting firm said.


Legal and accounting experts said earlier they expect that Ernst & Young will try to settle the case rather than engage in a long court fight.


"It tends to be lot less expensive for both parties to resolve it through settling and getting it behind them," said Bruce Pounder, an expert on accounting ethics and president of Leveraged Logic, an Asheville, North Carolina, firm that provides continuing education to accountants.


He said he does not see significant fallout for Ernst & Young in terms of its viability as an audit firm.


Ernst is the third-largest by revenue of the "Big Four" U.S. accounting firms, behind Deloitte and PwC.


Cuomo filed the lawsuit days before he is to leave office and become governor of the state in January. A spokesman for incoming attorney general Eric Schneiderman declined to comment.


REPO 105


Cuomo said in the civil complaint that for more than seven years leading up to Lehman's bankruptcy, the investment bank engaged in fraudulent accounting transactions that Ernst & Young explicitly approved. The case focuses on an accounting technique known as Repo 105, which temporarily removed as much as $50 billion in assets from the balance sheet in 2008.

"This practice was a house-of-cards business model designed to hide billions in liabilities in the years before Lehman collapsed," Cuomo said in a statement.


The lawsuit comes nine months after a court-appointed examiner in the Lehman bankruptcy concluded that Ernst & Young was "professionally negligent" in its audit duties.


The report by examiner Anton Valukas also said that Lehman could also have claims against Fuld and former chief financial officers Chris O'Meara, Erin Callan and Ian Lowitt for negligence or breach of fiduciary duty related to the use of Repo 105 transactions.


PAST CASES


The case, filed in New York state Supreme Court, is one of the biggest legal cases involving an accounting firm since Arthur Andersen was criminally indicted in 2002 over the Enron scandal.


The Ernst & Young case is a civil lawsuit, while Andersen was charged criminally and later convicted of obstruction of justice for its role in Enron's collapse.


The U.S. Supreme Court reversed the Arthur Andersen conviction in 2005, but the firm was virtually out of business by then -- and its reputation was shattered.


Andersen's demise reduced the number of big accounting firms that audit most large companies globally to just four, including Ernst & Young. Since then, prosecutors have been wary of charging entire firms with fraud because of worries that another audit firm collapse would harm the financial system.


In one major settlement, KPMG agreed in 2005 to pay $456 million to settle a federal investigation into questionable tax shelters, avoiding a potentially crippling criminal indictment. The firm agreed to make internal changes and to be overseen by an outside monitor temporarily as part of the pact.


In 1999, Ernst & Young agreed to pay $335 million to shareholders of Cendant Corp to settle a case stemming from an accounting scandal at the travel and real estate service company. Ernst & Young said at the time that it was misled by Cendant and had done nothing wrong.


London-based Ernst & Young employs about 140,000 people. It had revenue of $21.3 billion in the fiscal year ended June 30.


(Reporting by Grant McCool, Dena Aubin, Scot J. Paltrow and Dan Levine. Editing by John Wallace, Robert MacMillan and Matthew Lewis)


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