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$99 Million Buys EY Ticket Out Of Private Lehman Litigation, Finally

 Last defendant standing.  Not an enviable place for EY in the case, In re Lehman Brothers Securities and ERISA Litigation.

Everyone else had folded their tent, paid the price to cross this dog off the list. Lehman underwriters agreed in 2011 to a $426.2 million settlement. UBS, one of the underwriters, held out and settled last August for another $120 million. Even before the UBS and EY settlements, Bernstein Litowitz Berger & Grossmann, attorneys for the plaintiffs, claimed the combined recovery of $516,218,000 is the third largest recovery to date in a case arising from the financial crisis.

The $99 million EY will pay is more than Lehman’s officers and directors, who settled for $90 million. That’s a big deal considering the executives typically say, “The auditors said it was ok,” and the auditors say, “Management duped us.” But it’s not that much considering that EY agreed to pay C$117 million ($117.6 million) last December to settle claims in a Canadian class action suit against Sino-Forest Corp, a Chinese reverse merger fraud. That settlement is the largest by an auditor in Canadian history, according to the law firms.

And it’s not as much as some thought EY would pay for Lehman. In fact, many thought Lehman would finish off EY for good.

John Carney, now of CNBC, writing for Business Insider at the time:

The Examiner concludes that sufficient evidence exists to support colorable  claims against Ernst & Young LLP (“Ernst & Young”) for professional malpractice arising from Ernst & Young’s failure to follow professional standards of care with respect to communications with Lehman’s Audit Committee, investigation of a whistleblower claim, and audits and reviews of Lehman’s public filings.

That may not sound like a mortal threat against Ernst & Young. But the damages here could be enormous. A successful lawsuit against E&Y could result in a court finding that the failure to properly advise the audit committee prevented Lehman from taking genuine steps to substantially reduce its leverage, which may have saved the firm from bankruptcy. Which is to say, E&Y could find itself blamed for all the losses to Lehman shareholders. That would be a stretch—such a claim would be speculative—but it still should be scaring the heck out of the partners.

When the bankruptcy examiner’s report on Enron came out, the language about Arthur Andersen was quite mild. It merely noted there was “sufficient evidence from which a fact-finder could conclude that Andersen: (1) committed professional negligence in the rendering of accounting services to Enron…” It went on to note that Andersen likely had a strong defense against liability since so many Enron executives were implicated.

“Enron brought down Arthur Andersen,” Felix Salmon notes. “Will Lehman do the same for E&Y?”

In July of 2011, New York Federal Court Judge Lewis Kaplan decided 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. One month later Lehman Brothers executives, including its former chief executive Richard S. Fuld Jr., agreed to pay $90 million to settle.  Insurance proceeds paid for their settlement.

What was the remaining allegation against Ernst & Young? That the auditor had reason to know Lehman’s 2Q 2008 financial statements could be materially misstated because of the extensive use of Repo 105 transactions.

How could EY know this? Here’s what the Lehman Bankruptcy Examiner, Anton Valukas’, report says:

Lehman’s own Corporate Audit group led by Beth Rudofker, together with Ernst & Young, investigated allegations about balance sheet substantiation problems made in a May 16, 2008 “whistleblower” letter sent to senior management by Matthew Lee. On June 12, 2008, during the investigation, Lee informed Ernst & Young about Lehman’s use of $50 billion of Repo 105 transactions in the second quarter of 2008. At a June 13, 2008 meeting, Ernst & Young failed to disclose that allegation to the Board’s Audit Committee. (Bankruptcy Examiner’s Report V3 page 945)

What did EY do wrong here? I explained it in March of 2010 after the examiner’s report was published.

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

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