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Lehman Case Hints at Need to Stiffen Audit Rules

By FLOYD NORRIS Published: July 28, 2011

The company misled investors and its officers and directors may be held liable. But the companys auditor seems likely to escape any responsibility for an audit that wrongly concluded the companys financial statements were completely proper.
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Patrick Andrade for The New York Times

A judge said that Lehman Brothers misled investors, but threw out a claim against its auditor.

Economix Blog: Legal Payday in the Lehman Case(July 28, 2011)

That, anyway, is the conclusion a federal judge has reached regarding Lehman Brothers. The judge said this week that it appeared Lehman had violated Generally Accepted Accounting Principles, or GAAP, even if it was in technical compliance with accounting rules. But he threw out a claim against Ernst & Young, whose 2007 audit certified that Lehman had followed GAAP. The ruling ought to raise a few eyebrows at the Public Company Accounting Oversight Board, which sets auditing standards and regulates auditing firms. If the Lehman audit was in compliance with the auditing rules, it is time to review the rules. A little history: As the financial position of Lehman Brothers grew more and more perilous in 2007 and 2008, the company assured investors it was reducing its leverage by selling assets. That was, to put it ever so gently, a lie. Without that lie, Lehman probably would have failed anyway. But regulators and investors might have seen the disaster coming a little earlier.

As always happens when a company collapses, class-action suits were filed by suffering investors. They sued Lehmans executives and its outside directors. They sued Ernst. They sued all the investment banks 51 of them that underwrote securities issued by Lehman. As always happens, the defendants tried to get the suit thrown out before any evidence could be collected. This week the judge, Lewis A. Kaplan, refused to dismiss most of the suit. But Ernst came close to getting off entirely. The judge ruled that although there was evidence that Ernst should have done something differently in the final weeks of Lehmans existence, there would be no trial on whether the firms audit of the 2007 financial statements was bad. Lehman managed to hide as much as $50 billion of borrowing and reduce its assets by the same amount through something that has become immortalized as Repo 105 transactions. Those transactions, completely hidden from investors while Lehman was heading to disaster, were disclosed last year in a blistering report by Lehmans bankruptcy trustee. The fiddling did not affect profits, but it did make the company appear to be taking fewer risks than it was. Judge Kaplans decision, it should be noted, was on a motion to dismiss and was not a finding that anyone had acted wrongly. In reaching his decision, he was required to assume that facts in the complaint were accurate and could be proven. But the current state of class-action litigation makes the dismissal ruling very important. The law lets companies essentially tell the judge that the plaintiff has no evidence we misbehaved, so you have to throw the case out before discovery lets the plaintiff find out if there is any evidence. It is not unusual for a suit to be settled once a judge lets a case proceed. At the heart of the Lehman case are repurchase agreements, commonly called repos, which are a common form of financing on Wall Street. The borrower sells securities for cash and agrees to repurchase them at a set price in a brief period. Normally, repos are accounted for as borrowings, which is what they are. The borrower retains all the upside and downside of the securities in question. The lender gets an interest rate. But Lehman found a loophole in an accounting rule, and concluded that if it put up $105 in collateral for every $100 borrowed, it could claim it really was a sale. At the end of each

quarter, the company would decide just how much it needed to beautify its balance sheet, and would do repos to produce the desired result. They would be reversed a few days later. The judge concluded that Lehman did not violate the accounting rule. But, he added, the fact that Lehmans accounting for the Repo 105 transactions technically complied with the rule does not mean that Lehmans financial statements complied with GAAP. Although companies hate it, that is the law. The United States Court of Appeals for the Second Circuit, in refusing to throw out the conviction of Bernie Ebbers, the former chief executive of WorldCom, said in 2006 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. In the Lehman case, Judge Kaplan focused on the lack of evidence that Ernst had noticed what was going on. Allegations that a company violated GAAP in preparing financial statements are not sufficient, in and of themselves, to state a claim that an auditors opinion of GAAP compliance is a factual misstatement, the judge wrote. Instead, there must be evidence that the auditor did not actually hold the opinion it expressed or that it knew it had no reasonable basis for holding it. So even if Lehman is liable for violating GAAP, concluded Judge Kaplan, the question boils down to whether Ernst knew enough about Lehmans use of Repo 105s to window-dress its period-end balance sheets to permit a finding that E&Y had no reasonable basis for believing that those balance sheets fairly presented the companys financial condition. The bankruptcy trustees report, which basically is all the plaintiffs have to go on if they cannot obtain documents through discovery, quoted Ernst officials as saying that their review applied only to the accounting basis for these transactions, not to their volume or purpose. It quoted William Schlich, the Ernst partner in charge of the Lehman audit, as saying he did not know how many Repo 105 transactions Lehman had booked. Ernst & Young, the report stated, did not evaluate the possibility that Repo 105 transactions were accounting-motivated transactions that lacked a business purpose.

The Securities and Exchange Commission, in a 2005 report by the office of the chief accountant, warned about such accounting-motivated transactions, saying any attempts to portray the transactions differently from their substance do not operate in the interests of investors, and may be in violation of the securities laws. But Ernst evidently was not interested, and that lack of interest is helping, not hurting, it in court. Ernst did not get out of the case completely. The judge was impressed that Ernst failed to do much of anything after it interviewed a Lehman whistle-blower in June 2008. So while the 2007 audit is O.K., the judge thinks there can be a trial on the question of whether Ernst was guilty of misrepresentation when it signed off on Lehmans report for the second quarter of 2008, saying it was not aware of any material modifications that should be made to the consolidated financial statements. Ernst was relieved by the decision. We are pleased that Judge Kaplans ruling dismisses most of the claims against us in this matter, and we strongly believe that we will ultimately prevail on the remaining claim, said Charles Perkins, a spokesman for the firm. As we have said consistently, we stand behind our work on the Lehman audit and our opinion that Lehmans financial statements were fairly stated in accordance with U.S. GAAP, applying the rules that existed at the time. Those rules, by the way, are changing, but not very rapidly. Starting in 2012, Repo 105 transactions will clearly have to be treated as borrowings under the new rule issued by the Financial Accounting Standards Board. In his ruling, Judge Kaplan said some of the auditing standards issued by the accounting oversight board were couched in rather general and in some cases inherently subjective terms that were subject to a wide range of interpretations. More is necessary to make out a claim that the statement of opinion was false than a quarrel with whether these standards have been satisfied, he wrote. If the accounting oversight boards standards are so vague as to be unenforceable, they need to be toughened. You might wonder if the board has pursued a disciplinary case against Ernst or any of the Ernst auditors. There is no way to know. The law requires that such cases be kept secret, even after the board issues a ruling, until all appeals have been heard. The board has asked Congress to allow it to disclose investigations when it brings charges. As it is, the board says, auditors engage in delaying tactics to avoid negative publicity.

This case indicates that secrecy could save a firm money as well as reputation. Had the plaintiffs been able to point to an enforcement action, Judge Kaplan might well have allowed the claims over the 2007 audit to go to trial. Floyd Norris comments on finance and the economy at nytimes.com/norris.
A version of this article appeared in print on July 29, 2011, on page B1 of the New York edition with the headline: Lehman Case Hints at Need To Stiffen Audit Rules.

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