Ernst & Young is sued over Lehman Bros. collapse

A lawsuit filed against accounting giant Ernst & Young marks one of the biggest government efforts to date to assign blame for the financial crisis.

The suit by Andrew Cuomo, the outgoing New York state attorney general, accuses Ernst & Young of helping Lehman Bros. cover up its declining health in the months before the investment bank’s collapse in September 2008.

Cuomo’s complaint, filed in state court, focuses on a set of short-term transactions, begun in 2001, that allowed Lehman to look healthier and less risky when it reported quarterly financial data.


The suit accuses Ernst & Young of approving the so-called Repo 105 transactions and signing off on financial reports that did not disclose them.

Ernst & Young “sat by silently while Lehman deceived the public,” the complaint says.

The New York accounting firm issued a statement saying it would fight the suit.

“Lehman’s audited financial statements clearly portrayed Lehman as a highly leveraged entity operating in a risky and volatile industry,” the accounting firm said. “Lehman’s bankruptcy was not caused by any accounting issues.”

The suit recalls accusations that followed the collapse of energy giant Enron in 2001, when prosecutors blamed accounting firm Arthur Andersen for many of Enron’s problems.

A criminal indictment of Andersen forced it out of business, reducing the five big U.S. accounting firms to four, including Ernst & Young.

The case filed Tuesday, however, is civil, not criminal, and will probably end with a monetary settlement. The complaint asks the court to order Ernst & Young to pay New York the more than $150 million in fees that the firm collected from Lehman.

Although there have been reports of similar accounting maneuvers at other big banks, legal experts say they do not expect a wave of litigation seeking to blame the accounting industry for the financial crisis.

The financial crisis wasn’t “driven by misconduct or poor performance by the accounting firms,” said John Eickemeyer, a New York lawyer and expert on accounting law. “I really don’t think that this is going to start a trend.”

The case is the latest effort by government authorities to expose behavior that contributed to the crisis; perhaps the biggest case to date was a regulatory action that the Securities and Exchange Commission brought against Goldman Sachs in April and settled in July.

So far, federal authorities have struggled to bring and sustain big cases arising from the crisis, and some of the more dramatic enforcement actions have been initiated by state authorities such as Cuomo.

“It’s interesting that again the New York attorney general is going out and addressing something that a bunch of different regulators have hemmed and hawed about,” said Jill Fisch, a professor of securities law at the University of Pennsylvania.

Cuomo is leaving office at the end of the year to become governor of New York.

The accounting maneuvers discussed in Cuomo’s suit were first uncovered and discussed by the court-appointed examiner in Lehman’s bankruptcy case.

In a report released in March, the examiner, Anton Valukas, described in detail how Lehman — the fourth-largest investment bank at the time of its demise — increasingly used Repo 105 transactions as the bank’s financial condition worsened.

Shortly before the end of each quarter, Lehman would give fixed-income securities to other banks in exchange for cash, with the understanding that Lehman would buy back the securities as soon as the quarter ended, according to the examiner’s report and Cuomo’s complaint. Lehman would use the cash to temporarily pay down some of its debts.

As a result, Lehman’s quarterly financial reports indicated the firm had less debt than it actually did most of the time. That made the firm look more stable to investors and rating agencies.

The scale of this quarterly shuffle became quite large. In May 2008, for example, Lehman exchanged $50 billion of securities for cash, Cuomo’s complaint says. The company collapsed less than four months later.

U.S. law firms refused to sign off on the maneuver, Valukas said, but Lehman found a European law firm that would, and consequently all the Repo 105 deals were done by Lehman’s European operation.

Internal Lehman documents called the technique “window dressing” and an “accounting gimmick,” and the bank’s chief operating officer wrote in an e-mail, “it is another drug we r on.”

The report by Valukas said Ernst & Young was “professionally negligent in allowing” the financial reports to go “unchallenged,” a sentiment that Cuomo echoed in stronger terms, arguing that the auditing firm “directly facilitated a major accounting fraud.”

In addition to the civil penalties sought by Cuomo, Ernst & Young faces potential liability in a class-action lawsuit filed after Valukas released his report by investors who lost money when Lehman failed.