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December 22, 2010
Cuomo Sues Ernst & Young Over Lehman Brothers Accounting
    by Robert Kropp

New York Attorney General says accounting firm knew that investment banker engaged in fraudulent transactions to conceal debt on balance sheet and mislead investors.

So much for the myth that lame duck government officials get nothing done before leaving office.

In what is likely to be his last official action as Attorney General of New York, Andrew Cuomo, who will assume the Governorship of that state next month, has filed a lawsuit against Ernst & Young, charging that the accounting firm helped the now-bankrupt investment banker Lehman Brothers "engage in an accounting fraud involving the surreptitious removal of tens of billions of dollars of fixed income securities from Lehman's balance sheet in order to deceive the public about Lehmanís true liquidity condition," according to a statement issued yesterday by the Attorney General's office.

The 2008 collapse into bankruptcy of Lehman Brothers, once the fourth-largest investment banker on Wall Street, was an event that was central to the financial crisis that soon engulfed the global economy.

lawsuit charges that Ernst & Young "substantially assisted" Lehman Brothers in the "removal of tens of billions of dollars of securities from Lehmanís balance sheet in order to create a false impression of Lehman's liquidity, thereby defrauding the investing public." The alleged fraud was accomplished through recourse to Repo (or repurchase) 105 transactions, in which one company effectively borrows money from another by transferring some asset to the lender.

According to an explanation of the practice provided by
NPR in March of this year, "The assets a bank uses in repo deals stay on the bank's balance sheet."

However, Lehman Brothers sought a way around this obligation by taking "slightly less cash than the asset was worth" from the lenders, the NPR explanation continued.

The statement from the Attorney General's office continued, "The transaction's purpose was to temporarily park highly liquid, fixed-income securities with European banks for the sole purpose of reducing Lehmanís financial statement leverage, an important financial metric for investors, stock analysts, lenders, and others interested in Lehman."

According to NPR, "During the (housing) boom, there was about $12 trillionÖloaned out in this market at any given time."

The degree to which Lehman Brothers used Repo 105 in the months leading up to the financial crisis was revealed in a 2,200-page report submitted by Anton Valukas to the bankruptcy court in March. In his investigation, Valukas found that Lehman had utilized Repo 105 to reduce its leverage by $39 billion in the fourth quarter of 2007, $49 billion in the first quarter of 2008, and $50 billion in the second quarter of 2008.

Because Lehman reportedly sold $12 billion worth of stock during this time, the impact on investors of its balance sheet manipulations was considerable. The lawsuit charges, "At a time when it was critical for investors to make informed decisions as to whether to keep or buy Lehman stock, E&Y assisted Lehman in defrauding the public about the Company's deteriorating financial condition, particularly its leverage."

In his report, Valukas also noted that Lehman did not disclose its use of Repo 105 to the Government, rating agencies, its investors, or even its own Board.

After Valukas submitted his report, the Securities and Exchange Commission's (SEC) Division of Corporation Finance sent a
letter to 20 financial firms, requesting that they provide information "accounting for certain of your repurchase agreements, securities lending transactions, or other transactions involving the transfer of financial assets with an obligation to repurchase the transferred assets."

The SEC is expected to decide soon whether to file civil charges against Lehman or other financial firms that used Repo 105.

In response to the lawsuit, Ernst & Young issued a statement denying the charges, saying, "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." Notably, the lawsuit does not name any Ernst & Young executives.

According to an
article in Financial Times, Ernst & Young's defense against the lawsuit will hinge on whether an accounting rule known as FAS 140 is applicable. According to the rule, three conditions must apply for transfers such as those under Repo 105.

Of particular interest in the lawsuit will be the third condition listed by FAS 140: "The transferor does not maintain effective control over the transferred assets through either (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity or (2) the ability to unilaterally cause the holder to return specific assets."

The lawsuit seeks the return of the entirety of fees collected by Ernst & Young for work performed for Lehman between 2001 and 2008, reportedly more than $150 million, as well as investor damages and equitable relief.

"This practice was a house-of-cards business model designed to hide billions in liabilities in the years before Lehman collapsed," Cuomo said. "Just as troubling, a global accounting firm, tasked with auditing Lehman's financial statements, helped hide this crucial information from the investing public. Our lawsuit seeks to recover the fees collected by Ernst & Young while it was supposed to be using accountable, honest measures to protect the public."


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