Some Questions About the N.Y. AG's Lehman-Related Complaint Against E&Y

New York Attorney General Andrew Cuomo's December 21, 2010 filing of a civil fraud lawsuit against Ernst & Young in connection with the audit firm's services to Lehman Brothers has captured headlines in business pages around the world. The complaint itself, which can be found here, raises some serious allegations. But the complaint also raises a number of interesting questions, as discussed below. The NYAG's December 21, 2010 press release about the lawsuit can be found here.

The Complaint

The 32-page complaint alleges that between 2001 and September 2008, E&Y "facilitated" Lehman Brothers' "massive accounting fraud." The complaint alleges that during that period E&Y earned over $150 million in compensation from Lehman, which allegedly was one of E&Y's largest clients.

The complaint alleges that Lehman manipulated its balance sheet through quarter-end sales of billions of dollars of fixed-income securities to European banks, with the express understanding that the Lehman would repurchase the securities days later. Lehman's use of these transactions, know as Repo 105 transactions, allowed Lehman to mask its balance sheet leverage. The scale of these transactions grew as Lehman's financial condition deteriorated in 2007 and 2008.

The complaint alleges that E&Y was aware of Lehman's use of these transactions, yet approved Lehman's use of financial statements that did not disclose the existence of the transactions or their effect on Lehman's balance sheet. These actions, the complaint alleges, "directly facilitated a major accounting fraud, and helped mislead the public."

The complaint alleges that these actions by E&Y violated New York's Martin Act. The complaint seeks to compel E&Y to repay the fees it earned from Lehman as well as investor damages.

Discussion

There are a number of very interesting things about the NYAG's complaint against E&Y. The first is that the only defendant in the lawsuit is E&Y itself. There are no other individuals or entities names as defendants. On the one hand, it is hardly a surprise that a governmental authority has decided to pursue a regulatory claim against E&Y, in light of the March 2010 report by the Lehman Brothers bankruptcy examiner Anton Valukas (about which refer here). In his report, Valukas had concluded "there are colorable claims" against E&Y for its "failure to question and challenge improper or inadequate disclosures." Given the bankruptcy examiner's conclusions it seemed probable that there might eventually be some kind of regulatory action taken against E&Y.

On the other hand, the bankruptcy examiner's report not only concluded that there are "colorable claims" against E&Y, but also concluded that there are "colorable claims" against the senior Lehman officials who "oversaw and certified the misleading financial statements," including Lehman's CEO Richard Fuld and its CFOs, Christopher O'Meara, Erin Callan and Ian Lowitt. Moreover, the NYAG's complaint expressly refers to other financial executives at Lehman who were involved in the company's use of the Repo 105 transactions.

The NYAG's complaint does not name any of these individuals as defendants. Indeed, one of the very curious aspects about the NYAG's complaint is that it is virtually silent about the role or involvement of the most senior Lehman officials in the Repo 105 transaction; the individuals referred to by name in the complaint are by and large not the most senior executives.

And just as the complaint names no Lehman executives as defendants, the complaint also names no E&Y-related individuals as defendants. The sole defendant is E&Y itself, even though the individual E&Y audit partners responsible for Lehman's audit and financial reporting are identified by name in the NYAG complaint. Yet it is the audit firm itself that is named as defendant, not the individuals.

The complaint's firm-level focus is all the more interesting as allegations in the complaint do not seem to suggest that the decision to allow Lehman the accounting treatment it received was made at a firm-wide level or that anyone at E&Y other than the specific individual audit partners were aware of Lehman's use and reporting of the Repo 105 transactions. 

Setting aside the question of who been sued, there is also the question of the timing of the filing of this complaint. The complaint was filed by New York's departing AG, Andrew Cuomo, who is just days away from taking up his duties as New York's incoming Governor. Of course, it was his deputies and assistants who prepared and filed the complaint, but the timing of their actions means that this case will shortly become the responsibility of the incoming NYAG Eric Schneiderman.

Given that the incoming AG will be responsible for the case, it seems odd that he was not allowed control over its filing. On the other hand, under the heading of media relations, it may not be surprising that the outgoing AG wanted to make sure that everybody knew this complaint was filed on his watch.

Read the article in its entirety at the D&O Diary, a blog by Kevin LaCroix.