Cuomo files fraud suit against Ernst & Young

Jessica M. Karmasek Dec. 22, 2010, 11:45am


NEW YORK (Legal Newsline) -- New York Attorney General Andrew Cuomo on Tuesday filed a lawsuit against Ernst & Young LLP, charging the accounting firm with helping Lehman Brothers Holding, Inc., engage in accounting fraud.

According to the Attorney General's Office, the fraud involved the "surreptitious removal of tens of billions of dollars of fixed income securities from Lehman's balance sheet in order to deceive the public about Lehman's true liquidity condition."

Cuomo's lawsuit claims that for more than seven years leading up to Lehman's bankruptcy filing in September 2008, Lehman had engaged in so-called "Repo 105" transactions, explicitly approved by Ernst & Young.

The transactions' purpose, Cuomo said, 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.

"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.

"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."

Cuomo's office said the Repo 105 transactions involved transfers by Lehman of fixed income securities to European counterparties 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 counterparties 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 Ernst & Young's explicit approval, by characterizing these financing transactions as "sales," the attorney general said.

Indeed, Cuomo said, the sole purpose of characterizing 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 Ernst & Young 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 Ernst & Young failed to object when Lehman misled analysts on its quarterly earnings calls regarding its leverage ratios, and that Ernst & Young did not inform Lehman's audit committee about a highly-placed whistleblower's concerns about Lehman's use of Repo 105 transactions.

The attorney general seeks the return of the entirety of fees Ernst & Young collected for work performed for Lehman between 2001 and 2008, exceeding $150 million, plus investor damages and equitable relief.

Ernst & Young, in a statement released Tuesday, says it intends to "vigorously defend" against the civil claims alleged by the 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," the company said.

"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, the company said, Lehman's bankruptcy was not caused by any accounting issues.

"What we have here is a significant expansion of the Martin Act," it said. "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."

The company said it looks forward to presenting the facts in a court of law.

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