Ernst & Young Lehman Litigation: It’s No Victory If You’re Going To Trial

It wasn't even a verdict. Just a decision by New York Federal Court Judge Lewis Kaplan in one Lehman failure cases Ernst & Young is fighting. A decision to allow substantially all of the allegations against Lehman executives and at least one of the allegations against Ernst & Young to move forward to discovery and trial.

That is, if there's not a settlement first.

Yesterday I wrote up my analysis of the decision by Judge Kaplan for my column "Accounting Watchdog" at Forbes. In the interest of time and space, I stuck to commenting on the Ernst & Young portion of the decision.

Judge Kaplan dismissed the majority of the allegations against Ernst & Young. It's the same thing auditors are always dismissed for. The only thing that's new about the judge's opinion is an indictment of the accounting standards themselves.

The Third Amended Complaint points to several General Standards ("GS"), interpretive Statements on Auditing Standards ("AU"), and Statements of Fieldwork that allegedly are part of GAAS and that E&Y allegedly violated. Many 288 of those standards are couched in rather general and in some cases inherently subjective terms. They require, for example, that the auditor plan the audit engagement properly, use "due professional care," exercise "professional skepticism," and "assess the risk of material misstatement due to fraud" - all matters as to which reasonable professionals planning or conducting an audit reasonably and frequently could disagree.

Bearing in mind that E&Y's GAAS opinion, just like those rendered by all or substantially all accounting firms, is explicitly labeled as just that - an opinion that the audit complied with these broadly stated standards - more is necessary to make out a claim that the statement of opinion was false than a quarrel with whether these standards have been satisfied.

Or is this really news?

Judge Richard Posner during oral arguments in Fehribach v. Ernst & Young LLP, 493 F.3d 905 (7th Cir. 7/17/07) (pdf),

"Posner: The auditor's responsibility ... so far as the company is concerned ... is to make sure the [numbers] are accurate....  You don't need an auditor to tell you your market is collapsing....  The auditors are not supposed to have business insight.  They're counters.  They're not supposed to make predictions about how your markets are doing.  They're supposed to reconcile your books and indicate you're not a going concern because your debt is too high and so on....

Do you think the auditor is supposed to know about market power?...  An auditor is not an economic consultant who goes out and figures out what the market trends in an industry are!...Your trends? That's what the company knows. [Plantiff's Attorney: You're right. Here's what the auditor's responsibility under SAS 59...]

Posner: That is too vague for me..."

To his credit, Judge Kaplan does leaves one important one allegation for Enst & Young still to defend:

Ernst & Young had reason to know that Lehman's 2Q 2008 financial statements could be materially misstated because of the extensive use of Repo 105 transactions.

John McDermott of FT Alphaville does a good job explaining why:

Kaplan dismisses the majority of the specific allegations against the auditors but writes that one particular incident means that the case against them cannot be thrown out [when] he stops to ask another question on Repo 105:

In other words, have plaintiffs sufficiently alleged that E&Y knew enough about Lehman's use of Repo 105s to "window-dress" its period-end balance sheets to permit a finding that E&Y had no reasonable basis for believing that those balance sheets fairly presented the financial condition of Lehman?

The answer: yes, in one case.

Plaintiffs rely for this purpose on precisely the same alleged red flags discussed previously in connection with E&Y's GAAS opinion - the "true sale" opinion, the netting grid, and the Lee interview. The first two are no stronger in this context than in that. The Lee interview, however, is a different matter.

The "Lee interview" pertains to warnings allegedly made by Matthew Lee, Lehman's SVP for Global Balance Sheet and Legal Entity Accounting, that Ernst & Young were told of a $50bn repo 105 move in June 2008 but did not pass on the full information to Lehman's board. Thus, it failed to fulfill GAAP requirements as part of its Q2 2008 auditing.

I've been saying for a while that there's too much deflective focus on the accounting for Repo 105 and not enough on the disclosure. And I took particular exception early on to Ernst & Young's handling of the Matthew Lee "whistleblower" situation.

Read this article in its entirety at the re: The Auditors, a blog by Francine McKenna.

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