In this complaint filed Tuesday, Cuomo alleges that the accounting firm helped Lehman Brothers engage in “a massive accounting fraud” before it collapsed. Following the trail forged by Lehman examiner Anton Valukas of Jenner & Block, Cuomo focuses on E&Y’s handling of the controversial Repo 105 transactions. These accounting maneuvers let Lehman temporarily move debt off its books to improve its balance sheet.
“E&Y not only approved but consistently supported Lehman’s Repo 105 policy,” Cuomo’s suit states. The accounting firm also advised Lehman how it could take advantage of a technical accounting rule, known as FAS 140, to treat these Repo 105 transactions as sales instead of financing, Cuomo alleges.
Ernst & Young is being defended by Miles Ruthberg and Jamie Wine of Latham & Watkins and Barry Berke of Kramer Levin Naftalis & Frankel.
Latham is also defending E&Y in a Lehman shareholder suit that raises similar claims. To get a sense of the arguments that E&Y might raise in Cuomo’s suit, we looked at the accounting firm’s response in the shareholder case.
In this motion to dismiss filed last June, Latham contends that Lehman’s accounting treatment of the Repo 105 transaction complied with then-existing Generally Accepted Accounting Principles. “Only in June 2009, well after EY’s audit and Lehman’s bankruptcy, did the Financial Accounting Standards Board (“FASB”) issue revised accounting standards requiring disclosure of such transactions on a prospective basis,” the firm states. During 2007 and 2008, when the Repo 105 transaction occurred, companies were not required to make any specific disclosures about repo transactions accounted for as sales, Latham argues.
In addition, Latham argues, E&Y’s audit opinion was just an opinion. “Plaintiffs have not alleged, even generally, that EY did not believe the audit opinion set forth in Lehman’s 2007 10-K,” the motion to dismiss states. In addition, Latham stresses that the accounting treatment of the Repo 105 transactions was not the cause of Lehman’s collapse. Instead, quoting Valukas’s report, it says that Lehman “failed because it was unable to retain the confidence of its lenders and counterparties and because it did not have sufficient liquidity to meet its current obligations.”
Valukas, however, found sufficient evidence to support “colorable claims” for malpractice against Ernst & Young. He also anticipated the argument that Lehman’s handling of the Repo 105 transactions complied with GAAP. In his report, he writes that financial statements that technically comply with GAAP can still be misleading. “Even if Lehman’s use of Repo 105 transactions technically complied with [FAS] 140, financial statements may be materially misleading even when they do not violate GAAP. The Second Circuit has explained that ‘GAAP itself recognizes that technical compliance with particular GAAP rules may lead to misleading financial statements, and imposes an overall requirement that the statements as a whole accurately reflect the financial status of the company.’”
The Latham and Kramer Levin lawyers representing Ernst & Young declined to comment. Ernst & Young issued this statement in which it stated: “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.”