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Ernst & Young's defense in the Lehman fraud case is nonsense

Two weeks before New York Attorney General Andrew Cuomo's office sued Ernst & Young LLP, a prominent U.S. consulting firm issued a press release touting its ability to help others manage the risk of fraud.

"Dealing with complex issues of fraud, regulatory compliance and business disputes can detract from efforts to achieve your company's potential," the firm said. "Better management of fraud risk and compliance exposure is a critical business priority — no matter the industry sector."

Talk about chutzpah. The firm that wrote that was none other than Ernst & Young, the longtime outside auditor for Lehman Brothers Holdings Inc., which went bankrupt in 2008 while sporting financial statements that bore little evidence of the calamity to come. Sure, E&Y may have lots of experience in this field. Much of it, though, is the wrong kind.

In its civil lawsuit last week, Cuomo's office alleged that E&Y helped Lehman engage in a massive accounting fraud — and committed fraud itself in the process.

E&Y had established itself as a repeat offender long before Gov.-elect Cuomo filed his suit. In recent years we've seen four former E&Y partners sentenced to prison for selling illegal tax shelters, while other partners have been disciplined by the SEC for blessing fraudulent financial statements at a variety of companies.

Yet it seems there's little anyone can do to keep E&Y on the straight and narrow. Killing E&Y or any of the other Big Four audit firms — PricewaterhouseCoopers, Deloitte & Touche and KPMG — would leave just three large survivors, when the industry has too few competitors already. We can't have another firm go down like Arthur Andersen did after its indictment in 2002, the conventional wisdom goes.

The case against E&Y stems from Lehman's use of transactions the investment bank called Repo 105. Lehman used these deals to move as much as $50 billion of securities off its balance sheet in a given quarter and temporarily reduce its reported debt, usually for about a week at a time. Lehman got the assets off its books by treating the transactions as sales rather than financings for accounting purposes.

That E&Y hasn't changed its ways is clear from the press release it issued last week responding to Cuomo's suit. "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," the firm said.

That isn't an accurate depiction of the claims Cuomo brought. Cuomo's suit unambiguously took the position that Lehman violated Generally Accepted Accounting Principles. What's more, it's not credible for E&Y to say that Lehman didn't. (An E&Y spokesman, Charles Perkins, said he "can't comment beyond our statement.")

As any freshman accounting major can tell you, it's a violation of GAAP for a company to tell investors it's using one type of accounting treatment when it's actually using another, especially when the method it's secretly employing makes its balance sheet look stronger. Yet E&Y still insists that Lehman followed the rules. It's hard to tell which is more insane: the notion that E&Y's bosses might believe their own spin, or that they think anybody else will.

For the time being, E&Y is saying it looks forward to presenting the facts in court. If it hopes to prevail there, it will need to come up with a more believable defense than the nonsense it's trumpeting now.

Ernst & Young's defense in the Lehman fraud case is nonsense 12/26/10 [Last modified: Sunday, December 26, 2010 5:47pm]
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