Mirabile Dictu! Ernst & Young Faces Fraud Charges in Lehman Collapse

I had given up on the idea that anyone associated with Lehman would be charged with fraud, even though it was blindingly obvious even before the investment bank failed that it was up to no good. So tonight’s report in the Wall Street Journal, that the New York attorney general Andrew Cuomo is about to file a lawsuit against Lehman accountants Ernst and Young, is welcome news indeed.

Your humble blogger was among the Lehman critics. It was pretty easy to connect the dots simply from public information, particularly the not credible marks on highly visible positions like real estate garbage barges SunCal and Archstone. If you are cooking the books in ways third parties can readily detect, it suggests you have run out of not-so-blatantly obvious things to mismark so as to not freak out investors about your unsavory financial condition. Another big red flag was the company’s simply not credible claim in 2008 that it had deleveraged across all geographies and all books when some were far more liquid than others.

But it was nevertheless astonishing to see the media fall for the most part run with the company’s PR, and even more stunning to see how large the black hole in the balance sheet turned out to be. We’ve pointed out repeatedly that even now, the excuses made – the impact of the disorderly collapse – and the use of Repo 105 still fail to explain the magnitude of the losses. And that means that significant accounting misstatements, aka fraud, were still being swept under the rug (and we aren’t alone in that view).

The suit appears to target only the famed Repo 105, a device Lehman used to move exposures off balance sheet at quarter end and thus look sounder than it really was. But any investigation into dubious accounting ought to open other cans of worms and could well lead to further charges.

From the Wall Street Journal:

New York prosecutors are poised to file civil fraud charges against Ernst & Young for its alleged role in the collapse of Lehman Brothers, saying the Big Four accounting firm stood by while the investment bank misled investors about its financial health…

The suit stems from transactions Lehman allegedly carried out to make its risk appear lower than it actually was…

The suit, led by Mr. Cuomo, New York’s governor-elect, could come as early as this week. It is part of a broader investigation into whether some banks misled investors by removing debt from their balance sheets before they reported their financial results to mask their true levels of risk-taking, a person familiar with the case said. The state may seek to impose fines and other penalties…

The attorney general’s investigation, which began after the bankruptcy examiner’s report, found that Ernst & Young specifically approved of Lehman’s use of Repo 105 transactions and provided the investment bank with a complete audit opinion from 2001 through 2007…

The Lehman bankruptcy examiner’s report also stated that there may be evidence to support negligence and malpractice claims against Ernst & Young regarding Lehman’s audits and its lack of response to a whistle-blower at Lehman who raised red flags about the repo trades.

One can only hope turning up the heat on Ernst & Young will lead to the prosecution of Richard Fuld. The buck is supposed to stop with the CEO, particularly when they are paid as many bucks as Fuld received. Given the scale of looting that took place in the runup to and after the crisis, there is no hope of getting the banking industry back in its proper role of supporting the real economy until we see some senior bank executives in orange jumpsuits.

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  1. readerOfTeaLeaves

    Given the scale of looting that took place in the runup to and after the crisis, there is no hope of getting the banking industry back in its proper role of supporting the real economy until we see some senior bank executives in orange jumpsuits.

    Fuld comes to mind as the guy who sold his wife the $14,000,000 mansion for $100 back in late ’08. Guess she didn’t want to buy any of their other houses on the cheap?

    It’s not entirely clear to me how that house sale created new jobs or economic prosperity, but then heck, I’m only someone who reads blogs. So how would I know that the function of a bank is something other than ensuring Fuld $300,000,000+ during a period of low American job creation in an era of rampant mortgage fraud, commodities speculation, and stock manipulation? Doesn’t a bank exist primarily to concentrate wealth for a global uber-elite?

    Somehow I kind of get the sense that Fuld doesn’t really think that ‘criminogenic’ means what I think that it probably means.

    So I guess that I won’t be offered any $100 houses in the near term.

    On the other hand… has anyone around here priced the cost of a decade or so in prison…? More than $100/day? Less? In the ballpark…?

  2. addicted

    So whats the over/under on the number of months before Cuomo gets busted in a sex scandal?

    I will take the under on 1 month… It only took a day after it was revealed that WikiLeaks was going to leak information on a bank, before Swedish investigations into Assange were “reopened”. Although, Spitzer managed to last a few months and cause quit a lot of damage before he was taken down.

    1. Paul Tioxon

      At least the sex scandals these days don’t include murdering the young women. Ted Kennedy was the dry run of the we can’t keep blowing their brains out in public so let’s use a sex scandal template. It’s worked like a charm for years and years against the Kennedys. Now, they’ve extended the courtesy to keep the women alive, and they say there is no hope and change. With the repeal of don’t ask don’t tell, even the gay sex scandal will have to be retired, even the rumor that worked so well against J Edgar, fomented by Soviet Intelligence was a never enough to be more than a one liner in a movie, but still served to undermine public confidence. It looks like a whole new world of Old Nick tricks will have to be developed. Maybe tons of cash poured down the throats of politicians by anonymous corporate donors will be the next big thing.

    2. psychohistorian

      This prosecution will get sidetracked for national security reasons.

      We can’t have Fuld under oath admit that what Lehman was doing was SOP across the industry, can we?????

      It will get real interesting when the American banana republic has to resort to nuke threats to keep the world in line with the dollar as the Reserve Currency….something like, “The beatings will continue until morale improves.”

      When will the rest of the world decide to cut its losses and how will they confront American economic blackmail?

  3. tawal

    The gears of justice they do ever so well grind slowly…

    Thanks ever so much for keeping your eye on the ball, Yves.

    Rumor is that Spitzer went down for keeping the NYSE head, Grasso, from his $100MM+ ‘bonus’ (or did he, really?) — All taxpayer returns should be available on line to the public (w/o TIN’s,, of course, name and address OK); Hello O’Bama, Mr. President Transparency, HELLO….

    I believe Fuld committed crimes, but the ‘real’ reason to ashcan LEH and BS (and ML) was to eliminate competition.

    Never forget that The Bernank and Blankfein dormed together Freshman year.

    Oh and by the way 105 is so exactly what the Fed is doing with their current (discontinued?) programs.

    Can’t wait for Moynihan to secede Dimon at his FED directorship, (NOT).

  4. tawal

    Oh and by the way, Price Waterhouse Coopers Lybrand and KPMG are really ready for E&Y to go the way of Arthur Anderson.

    And the final winner will be: Price Goldman Morgan America. Double salute and click your heels thrice, gentle people.

  5. Hubert

    Repo 105 might be an opening. But it is a bad one as probably other Street Names used this or a similar approach. And it took too long after the Valukas Report to convince me that they mean it.
    The Lehman Fraud is so apparent and still nobody went there for 2 years now. So I guess this is not a mistake but policy.
    Is Cuomo part of the NY Democrat Party oligarchy? I do not know from here, but the default answer should most probably bs “yes”, so this investigation will not go far either ……

    1. bmeisen

      Regarding your algebra from September, can you link to an account of the 15 bn theft from counterparties in London?

  6. Siggy

    A civil fraud is alleged. Why not criminal?

    The Valukas report is a road map for a good prosecutor, state or federal.

    What is needed are criminal prosecutions and convictions!

    Unless TBTF, or its cousin TBTS, are repudiated we shall continue to have a failed currency, a failed fractional reserve banking system and failed regulatory and judicial systems.

    The product of these failures is burgeoning debt when the appropriate resolution of the debt burden is the restructuring of the debt.

    Quite simply, lossess must be taken, the sooner the better. The order of loss absorbtion is straight forward: shareholders get zero, unsecured creditors get very little, most probably zero, secured creditors get next to nothing potentially zero. Management gets fired and quite possibly prosecuted for financial fraud. The remaining corpus of the enterprise gets sold to new management.

    The magnitude of the corruption is so large that place where you start is at the core of the problem and you then begin to work you way out. In that there is the implication that there needs to be an examination of the Congress, the Treasury and the Federal Reserve. Now here’s the rub; who will initiate the examination?

    1. Yves Smith Post author

      You have to prove intent, which is knowledge that it was not kosher, which is a very high standard to meet. They got a law firm opinion that it was OK in the UK. So E&Y can fob off responsibility.

  7. Independent Accountant

    I applaud this. But ask: where are the SEC, PCAOB and SDNY US attorney’s office on this? Why did each of these “august’ bodies sit on its hands up to now? When will they “bust” PWC for the AIG fiasco? The SEC has plenty of money to harass obscure CPA firms and small publicly-held companies but does nothing about major league miscreants.

    1. avgJohn

      Well who can blame the accounting boards for picking on the little firms and independent professionals? I imagine a quick call from the governors office on behalf of a major accounting firm will set some little accounting board bureaucrat straight, and in a hurry.

      Agreed, underlying it all, the political processes behind the accounting oversight organizations and their heavily influenced promulgations have been one of the chief enablers of our global financial crisis. We all know they bend over backwards for the big banks with their off-balance sheet transactions, tricks and shenanigans, mark-to-make-believe book asset-valuations and their obscure financial disclosures designed to hide what seeming transparency they are charged with providing.

      And their product is why a monkey throwing darts can out perform the average retail investor(who is armed with financial statement ratios and disclosures) when it comes to picking value in the equity markets.

      Risk management for an accounting firm isn’t the risk they will issue a clean opinion in error, the risk is that they will be caught, successfully prosecuted and fined or sued for it. Two different things, entirely.

      These big investment banks and multi-nationals aren’t paying millions in annual fees to have some bean counters hassle them. Works about the same way as the credit reporting agencies do, it’s all a scam folks.

  8. bmeisen

    This blog is just a fantastic source of information – long standing ovations are due to Yves, and chops to all informed commentators.

  9. Tim Quinn

    “But it was nevertheless astonishing to see the media fall for the most part run with the company’s PR, and even more stunning to see how large the black hole in the balance sheet turned out to be”…

    I remember those quarterly conference calls with the CFOs…They fooled us all for a long time. Many of us asked the right questions and “smelled” some of the right issues.
    It is hard to do more than that when they lie to you in a systematic way…

  10. jbrk3

    I think it’s time people come to the realization that a company as large and complex as Lehman could not have been properly audited for even $500 million in fees. I wonder how the E&Y partner signing Lehman’s opinion slept at night for all those years.

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