I’m not going to repeat Anton Valukas’ superb Bankruptcy Examiner Report, public on March 11, in detail here. I’ll offer my opinion and analysis on the “colorable claims,” Ernst & Young’s (EY) potential defenses, and any details or issues I believe may not have been covered or any questions left unanswered in other reporting.
EY’s relationship with Lehman continued until the bitter end. So it comes as no surprise to me that EY had a hard time acting independently with their “sticky” client. Lehman Bankruptcy Examiner Anton Valukas, Chairman of Chicago law firm Jenner & Block, sums it up nicely:
The Examiner concludes that sufficient evidence exists to support colorable claims against Ernst & Young LLP for professional malpractice arising from Ernst & Young’s failure to follow professional standards of care with respect to communications with Lehman’s Audit Committee, investigation of a whistleblower claim, and audits and reviews of Lehman’s public filings. (Bankruptcy Examiner’s Report V3, Pg 1027)
Ernst & Young, the audit firm, had a long and lucrative relationship with Richard Fuld and Lehman Brothers. Lehman Brothers has paid EY more than $160 million in audit and other fees since fiscal year 2001. Although this isn’t nearly as much as Goldman Sachs and AIG pay PwC – almost $230 million a year combined in 2008 – it was still a huge amount and represented a significant client relationship for Ernst & Young.
It all started with Shearson Lehman American Express back in 1975. Lehman Brothers inherited an audit relationship with Ernst & Young when Lehman was spun off from American Express in 1994. Current Ernst & Young Global Chairman Jim Turley cut his teeth on American Express.
From The Washington Post: “The decision to make Lehman Brothers an independent company again, owned by American Express shareholders and Lehman employees, completes American Express’s effort to rid itself of the draining weight of its extraordinary, and ultimately unsuccessful, expansion in the 1980s…the two companies will share no directors and that Richard S. Fuld Jr. will continue as president and chief executive of Lehman. Fuld, in a brief telephone press conference, said Lehman was vigorously pursuing its plan to cut costs by $200 million but could not say if that would result in further loss of jobs. “It is much more important for us to talk in terms of dollars and not in terms of people,” he said.”
Ernst & Young was fired by American Express at the end of 2004. After a string of issues with independence that threatened EY’s credibility and their ability to accept new audit work, American Express unceremoniously dumped them and hired PricewaterhouseCoopers.
From CFO.com: “In 2003, Amex shelled out $23 million to E&Y in audit fees, and $3.5 million for other services. The audit fee was the largest paid by any U.S.-based E&Y client…an E&Y spokesman declined to comment on the reasons the firm was dropped…E&Y has been in the Securities and Exchange Commission’s (SEC) cross-hairs for about a year, including one probe into whether the audit firm violated federal auditor independence rules by entering a so-called profit-sharing agreement in the 1990s with Amex’s travel-service unit…”
For my first installment in this series, let’s take each “colorable claim” individually and give them a Red (toast) ,Yellow (may be vulnerable), or Green (not likely to be too damaging) rating.
(There’s a great summary of E&Y’s myriad sins and probably soon-to-be ill-fated Financial Services Office over at Zerohedge. I will be writing more about this story, including looking more deeply into the valuation issues, the impact on the other large audit firms, the role of Lehman’s internal audit function, the specific accounting for the Repo 105 transactions, the relationship of this bankruptcy to the Lehman bankruptcy case in the UK, and my prior theory about the fraud and additional theories for litigation.)
Ernst & Young failed to follow professional standards of care with respect to communications with Lehman’s Audit Committee.
Ernst & Young failed to follow professional standards of care with respect to an investigation of a whistleblower claim
Lehman’s own Corporate Audit group led by Beth Rudofker, together with Ernst & Young, investigated allegations about balance sheet substantiation problems made in a May 16, 2008 “whistleblower” letter sent to senior management by Matthew Lee. On June 12, 2008, during the investigation, Lee informed Ernst & Young about Lehman’s use of $50 billion of Repo 105 transactions in the second quarter of 2008. At a June 13, 2008 meeting, Ernst & Young failed to disclose that allegation to the Board’s Audit Committee. (Bankruptcy Examiner’s Report V3 page 945)
As the lawyers would say, the optics are bad here. The Audit Committee asks EY to support Lehman’s internal auditor in investigating a “whistleblower’s” allegations of balance sheet improprieties. The auditors interview the “whistleblower” and then don’t say anything at any of the Audit Committee meetings. Turns out what Mr. Lee, the “whistleblower”, was alleging is what the examiner believes is the fundamental problem and grounds for “colorable claims” against top officers and EY.
The word “whistleblower” is tainted with tons of emotion post-Enron. We now look at those called “whistleblowers” and see heroes. But let’s look at what I think may have actually happened. Lehman’s Internal Audit department “naturally” asked their trusted, all-things-to-all-people advisor, EY, to help with the investigation of the “whistleblower’s” claims. The Internal Audit Department, not EY, was in charge of the investigation.
That was their first mistake. If I’ve said it once, I’ve said it a thousand times: The external auditor should not be conducting or assisting with internal investigations of potential fraud or illegal acts by top executives. I wrote about it at Siemens, subject of the largest ever FCPA settlement in history. KPMG, their auditor, got sued.
The external auditor should stay the hell away from internal investigations because they may get caught up in something they would rather not know. They may want to claim plausible deniability. And a company should not engage the external auditor to support internal investigations especially involving fraud or illegal acts by top management. Do they do it to be cheap or to keep dirty laundry inside? The external auditor is too often part of the problem, an enabler, instead of part of the solution.
If Lehman had hired another firm – a law firm or anyone except their external auditor – to perform the investigation, the investigation would have been covered end to end in privilege, the external auditor may or may not (in this case EY would have been better not to) have been included in the “circle of privilege,” and the investigation would have been completed professionally.
However, by supporting this investigation, EY was essentially doing internal audit work, a prohibited service under Sarbanes-Oxley for independence reasons. It’s shocking to me that the EY audit partners did not at least turn over the investigation to EY’s Forensic Accounting and Investigations Practice in order to provide some semblance of independence and professionalism.
Even though EY may have been an unwilling party to knowledge of an ugly situation right before an audit committee meeting, they got stuck. They had an obligation under AU 380, as the external auditor – not as an investigator – to inform the Audit Committee. They could have been on the other side being informed – or not – instead of being the one supposed to be doing the informing.
AU 380, the rules for auditor communication with the Audit Committee, are very clear. But they relate to the auditors’ role as an auditor not the role of an auditor who is lent as muscle to an internal investigation. By playing the “trusted advisor” they screwed themselves.
Stoplight? Yellow. Looks bad, but EY may be able to talk their way out of this one once it gets to court. They need to explain how they were still looking into the issue, doing their “auditor” work and make sure their full but limited role and responsibilities for the process are explained. If they lose on this chalk it up to another case of audit partners wanting to be supermen to their clients, the corporation’s executives, rather than looking out for their own best interests. Unfortunately in this situation, the shareholders were probably going to lose either way.
“The Examiner finds that sufficient evidence exists to support the finding of colorable claims against Richard Fuld, Christopher O’Meara, Erin Callan, and Ian Lowitt in connection with their actions in causing or allowing Lehman to file periodic reports that did not disclose Lehman’s use of Repo 105 transactions and against Ernst & Young for its failure to meet professional standards in connection with that lack of disclosure…While there were credible facts and arguments presented by each that may form the basis for a successful defense, the Examiner concluded that these possible defenses do not change the now final conclusion that there is sufficient evidence to support a finding that claims of breach of fiduciary duty exist against Fuld, O’Meara [CFO 2004-2007], Callan [CFO 12/07 to 6/2008], and Lowitt [CFO 6/2008 to Chapter 11 9/08] and a colorable claim of professional malpractice exists against Ernst & Young.” (Bankruptcy Examiner’s Report V3, pages 990-991)
This one is about mandated disclosure and, unfortunately for EY and these Lehman executives, it looks like a prima facie case of securities laws violation for the executives and malpractice for EY.
Color this stoplight RED for “EY is burnt toast.”
EY’s only hope is, perhaps, an “in pari delicto” defense. The Lehman executives will surely be subject to civil and criminal fraud charges. In that case, given the challenges for a Bankruptcy Trustee who, strictly speaking, stands in the shoes of felons whose actions may be imputed to Lehman, the corporation, EY may be able to try what PwC and Grant Thornton/PwC/EY have tried in the AIG and Refco cases coming before the New York Court of Appeals. But if those questions are resolved in favor of the plaintiffs, EY will not be able to count on Fuld, O’Meara, Callan and Lowitt to shield them from accountability.
Why did this happen? Well, any obfuscation, if intentional, was meant to fool investors, ratings agencies, short sellers, counterparties and anyone else whose confidence the Lehman executives required. They wanted to appear to be in better financial shape than they really were – for as long as possible.
They may have been prolonging the inevitable, but at some point they knew the inevitable would occur. Liquidity crises are rarely sudden. But they are often suddenly acknowledged. In Lehman’s case, the Bear Stearns failure was probably the bell that tolled hollow, loud and clear.
So why did EY “fail to meet professional standards” in connection with that lack of disclosure? Brad Hintz, Lehman’s CFO in the late 1990’s told Bloomberg on March 12, “over ten years, a lot of venial sins add up…” I’m assuming Hintz means the mortal sin of accounting manipulation. I think, over the last ten years, EY may have ignored a lot of venial sins until “the drug we’re on,” as Lehman’s McDade calls the now notorious Repo 105 transactions, added up to the mortal sin of accounting manipulation that was hidden from investors by lack of disclosure.
Brad Hintz told me that the average CFO tenure post-Lehman IPO 1994 was 540 days. The Examiners’s Report refers to three CFOs during the period under examination alone. I’ve already told you what was wrong with the last two, Callan and Lowitt. You can sense their boredom and disdain for accounting details when you read their testimony.
The Examiner spent a lot of time trying to ascertain if, when and to what extent EY knew of and had been instrumental in designing and approving the Repo 105 transactions. The evidence he gathered says EY was very involved and very knowledgeable, up to and until the “whistleblower’s” report of the abuses of the Repo 105 accounting treatment at 2007-2008 quarter ends. But the spin that lead partner William Schlich puts on the Repo 105 treatment is different. EY defends the transactions as proper GAAP.
“According to Schlich, Ernst & Young had been aware of Lehman’s Repo 105 policy and transactions for many years…Schlich stated that Lehman introduced its Repo 105 Accounting Policy on the heels of the FASB’s promulgation of SFAS 140. During that time, Ernst & Young “discussed” the Repo 105 Accounting Policy (including Lehman’s structure for Repo 105 transactions) and Ernst & Young’s team had a number of additional conversations with Lehman about Repo 105 over the years. However, according to Schlich, Ernst & Young had no role in the drafting or preparation of Lehman’s Repo 105 Accounting Policy. Schlich stated definitively that Ernst & Young had no advisory role with respect to Lehman’s use of Repo 105 transactions and that Ernst & Young did not “approve” the Accounting Policy.
Rather, according to Schlich, Ernst & Young “bec[a]me comfortable with the Policy for purposes of auditing financial statements.” Following “consultation and dialogue” about the proper interpretation and application of SFAS 140, Ernst & Young “clearly …concurred with Lehman’s approach” to SFAS 140…not based upon an analysis of whether actual Repo 105 transactions complied with SFAS 140. Rather, Ernst & Young’s review of Lehman’s Repo 105 Accounting Policy was purely “theoretical.” In other words, Ernst & Young solely assessed Lehman’s understanding of the requirements of SFAS 140 in the abstract and as reflected in its Accounting Policy; Ernst & Young did not opine on the propriety of the transactions as a balance sheet management tool.” (Bankruptcy Examiner’s Report v3, pages 948-950)
Lehman initiated its Repo 105 program sometime in 2001, soon after SFAS 14o took effect in September 2000 Lehman’s outside auditors and lawyers participated in the firm’s review ofSFAS 140. Indeed, Lehman vetted the concept of a SFAS 140 repo transaction with its outside auditor, before the firm formalized a Repo 105 accounting policy and approved Repo 105 transactions for use by firm personnel. (Bankruptcy Examiner’s Report V3, page 765)
That kind of comfort and confidence in your client and their technical competence comes from a long, lucrative relationship. But it must have been more than that. It could not have possibly come from confidence in the Lehman CFO suite, given its revolving door and the lack of accounting interest and aptitude in later years.
Ernst and Young’s confidence in Lehman’s CFO leadership was rooted in fraternity. Both Christopher O’Meara and David Goldfarb, his predecessor who was CFO from 2000 to 2004, are Ernst and Young alumni. Prior to joining Lehman Brothers in 1994, Mr. O’Meara worked as a senior manager in Ernst & Young’s Financial Services practice. Prior to joining Lehman Brothers in 1993, Mr. Goldfarb served as the Senior Partner of the Ernst & Young’s Financial Services practice, where he worked from 1979 to 1993.
Mr. Goldfarb, the former EY Senior Partner, was the Lehman CFO who created the Repo 105 transactions.