My Commentary Part 1: Ernst & Young’s Letter To Audit Committee Members

This is my commentary on the letter that Ernst & Young recently sent to Audit Committee members, reported first on this site on March 20. In the letter, EY attempts to defend themselves against the findings in the Lehman Bankruptcy Examiner’s report.

The Bankruptcy Examiner, Anton Valukas, found “colorable claims” against EY.

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)

Given the letter’s length, I will discuss the first half of the letter today and the rest, including the topic headings, Accounting and Disclosure Issues Relating to Repo 105 Transactions and Handling of the Whistleblower’s Issues, in my next post.

EY: The concept of an examiner’s report is a feature of US bankruptcy law. It does not represent the views of a court or a regulatory body, nor is the Report the result of a legal process. Instead, an examiner’s report is intended to identify potential claims that, if pursued, may result in a recovery for the bankrupt company or its creditors.

Paul Barrett of Business Week did a great job putting this bankruptcy examiner’s report in context given some other recent pre-financial crisis era failures – New Century and Refco. This wasn’t the first report to lay tasty breadcrumbs for plaintiffs’ lawyers but it certainly is so far the biggest and, maybe, the most eagerly awaited. Why haven’t we seen similar autopsies for the other financial firms that were bailed out, nationalized or otherwise folded into healthier institutions? Technically, most of these institutions did not file bankruptcy and come under the jurisdiction of the bankruptcy court.

EY: We are confident we will prevail should any of the potential claims identified against us be pursued. We wanted to provide you with EY’s perspective on some of the potential claims in the Examiner’s Report. We also wanted to address certain media coverage and commentary on the Examiner’s Report that has at times been inaccurate, if not misleading. A few key points are set out below.

EY was relatively silent after the Examiner’s Report was released. This initial forty-two word statement below fell short of fully responding to the hundreds of questions raised by the 2,200 page Valukas Bankruptcy Examiner report. EY made no public statements until this letter to Audit Committee members surfaced. Here’s the EY statement that was widely distributed to the media immediately after the Examiner’s Report was issued:

“Our last audit of the company was for the fiscal year ending Nov. 30, 2007. Our opinion indicated that Lehman’s financial statements for that year were fairly presented in accordance with Generally Accepted Accounting Principles (GAAP), and we remain of that view.”

This statement is not much different than the one every other firm makes after being accused of malpractice. There’s an auditor defense lawyer handbook that says: After every accusation of malpractice, repeat these words like a spell: according to GAAP, applicable standards, fairly presented, sufficient audit evidence, not illegal, we were victims too.

What did PricewaterhouseCoopers say right after Satyam’s CEO admitted fraud?

PwC is claiming that, “The audits were conducted by Pricewaterhouse in accordance with applicable auditing standards and were supported by appropriate audit evidence…”

On the Satyam scam, DiPiazza said: “What we understand is that this was a massive fraud conducted by the (then) management, and we are as much a victim as anyone. Our partners were clearly misled.”

What did KPMG say after New Century?

A KPMG spokesman, Dan Ginsburg, told Reuters that he had not seen the suit, but issued a statement saying the company had acted “in accordance with professional standards” in its dealings with New Century.

“We will vigorously defend our audit work. Any implication that the collapse of New Century was related to accounting issues ignores the reality of the global credit crisis. This was a business failure, not an accounting issue,” the statement said.

What did E&Y say after the Anglo Irish debacle?

The firm has maintained a strict silence since it emerged that directors at Anglo, in particular chairman Sean FitzPatrick, were moving their huge loans from the bank to other lenders just before audits so that they did not appear in the accounts… Mr McKerr, who was appointed last July, said they were very proud of the “fantastic job” the auditors did in signing off the accounts under a lot of pressure and press speculation.

He expects Ernst & Young to be fully exonerated in the current investigations. He said the firm had audited the accounts as presented by the board in accordance with the guidelines, regulations and the law.

“Unfortunately, some of these ‘bed and breakfast’ type loans which were made to directors were not illegal. People have said there was a whistleblowing responsibility but that is not true, because they weren’t illegal.”

It’s true that the media may have inaccurately portrayed some things EY is most defensive about. After all, no less than the New York Times had to make corrections to its initial story.

Correction: March 13, 2010 “An article on Friday about an examiner’s report detailing accounting maneuvers used by Lehman Brothers to conceal its perilous finances described incorrectly in some editions the assets that were temporarily shuffled off its books. They were mostly high-quality securities that could be easily accepted by other banks, according to the examiner’s report; they were not “troubled” and “mostly illiquid real estate holdings.” The article also misstated in some editions the status of some Lehman executives in the aftermath of the bank’s collapse. They are defendants in civil suits, not plaintiffs.”

Yikes. Those are some pretty big boo-boos for a publication that has several editors for every reporter. I also pointed out in a piece in GoingConcern.com that the media jumped quickly onto the “off-balance sheet,” “Sarbanes-Oxley was supposed to fix this,” “Lehman is EY’s Enron,” bandwagon.  These memes are at least misleading and, in my opinion, mostly inaccurate. So rather than letting the media define the EY issues, it’s good EY finally jumped into the conversation, albeit in a backdoor, go-to-our-friends-not-our- enemies and “preach to the choir” kind of way.

EY: General Comments

EY’s last audit was for the year ended November 30, 2007. Our opinion stated that Lehman’s financial statements for 2007 were fairly presented in accordance with US GAAP, and we remain of that view. We reviewed but did not audit the interim periods for Lehman’s first and second quarters of fiscal 2008.

Although technically correct, EY is not yet off the hook. In fact, EY did something that seems odd to me – issue an actual report of their review of the 10Qs in 2008 that were included in Lehman’s regulatory filings. I credit Jonathan Weil of Bloomberg for bringing this potential Achilles’ heel in EY’s defense to my attention. However, he incorrectly used the term “opinion” in his most recent commentary to refer to EY’s reports of their review that were included in Lehman’s 10Q’s. It’s an oddity that investment banks insist on a report for the 10Q review from their audit firms. A review is required. A report is not. I still don’t know why Lehman requested  reports to be included in quarterly filings. I certainly can’t, for the life of me, figure out why the auditors would do it.

Post- Private Securities Litigation Reform Act, auditors (and law firms) have escaped liabilities for misstatements in quarterly reports because they do not make “explicit” statements. That is, their review is done in the background, they provide no written report and their review is not technically, or in their opinion, an “opinion.”

But providing an actual report of the 10Q review, one that is included in the regulatory filing, may be what opens EY to liability for Lehman’s 2008 financials. Auditors also provide reports documenting their 10Q reviews for Goldman Sachs (PwC) and Morgan Stanley (Deloitte).

Deloitte also provided reports of their 10Q reviews for Merrill Lynch prior to their absorption by Bank of America and for Bear Stearns prior to their bankruptcy and absorption into JPM Chase. The auditor’s report of their review for Bear Stearns’ 10Q as of February 28, 2008 actually had a “going concern” warning. Bear Stearns agreed to be bought by JPM Chase in early March.That was crucial but too little too late. The actual 10Q was not issued until April, after the JPM purchase had been proposed.

Notably, EY does not provide these reports of their review of 10Qs for UBS, PwC does not do this for JPM Chase or Bank of America, and KPMG does not do so for Citigroup.

Cases such as Lattanzio v. Deloitte & Touche LLP, 476 F.3d 147, 154 (2d Cir. 2007) make it clear that an explicit statement by the auditors is necessary to hold them liable. I have not been able to find any cases where auditor reports of their 10Q reviews made the difference in auditor liability. It may difficult to find case like this since so many complaints of malpractice against the auditors settle rather than go to trial. I have the distinct impression Jonathan Weil thinks that provision of a report of the auditor’s 10Q review may strengthen the possibility of liability for EY.

I agree, but recognize I have nothing but hope to base this conclusion on.

EY: Lehman’s bankruptcy was the result of a series of unprecedented adverse events in the financial markets. The months leading up to Lehman’s bankruptcy were among the most turbulent periods in our economic history. Lehman’s bankruptcy was caused by a collapse in its liquidity, which was in turn caused by declining asset values and loss of market confidence in Lehman. It was not caused by accounting issues or disclosure issues.

I think the Lehman Bankruptcy Examiner’s report put the word “fraud” into the financial crisis conversation. The SEC’s request for information, via a “Dear CFO” letter to a select group of financial institutions, about their use of Repo 105-type transactions is a shot across the bow. No one, especially the plaintiff’s lawyers, will look at any of these failures, bailouts and nationalizations the same way again. Liquidity crises never happen overnight.

EY: The Examiner identified no potential claims that the assets and liabilities reported on Lehman’s financial statements (approximately $691 billion and $669 billion respectively, at November 30, 2007) were improperly valued or accounted for incorrectly.

Really?

I think 2007 is also in question. The Bankruptcy Examiner characterizes Repo 105 transactions as having no “business purpose” other than to manage the balance sheet at reporting periods. In particular, he criticizes the lack of disclosure of their “sales” nature versus financing nature. Repo 105 transactions had been used consistently from 2001 until mid-2007 and their use increased materially in late 2007 and 2008.

Lehman employed off-balance sheet devices, known within Lehman as “Repo 105” and “Repo 108” transactions, to temporarily remove securities inventory from its balance sheet, usually for a period of seven to ten days, and to create a materially misleading picture of the firm’s financial condition in late 2007 and 2008. (Lehman Bankruptcy Examiner’s Report V3, page 732)

From 2001, when Lehman first began using Repo 105 transactions, until early-to- mid-2007, Lehman engaged in a relatively consistent volume of Repo 105 transactions, including at quarter-end, generally within a range of between $20 and $25 billion.29 (Lehman Bankruptcy Examiner’s Report V3, page 762)

The Bankruptcy Examiner does not go as far as some would have liked in looking into the valuation of Lehman’s various illiquid and troubled assets. EY, in fact, was working on their 2008 review of valuations up until Lehman filed for bankruptcy in September. EY reviewed the quarterly financials and issued reports that were filed with the two 2008 10Qs indicating that they were, “not aware of any material modifications that should be made to the consolidated financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.” No material weaknesses in internal controls over the valuation process had been discussed or contemplated, that we know of, such as in the AIG case.

And yet, when asked about their review of valuations by the bankruptcy Examiner, EY claims that all audit documents for 2008 were preliminary and had not been reviewed by senior partners. Is EY saying that the work performed during the year, including the 10Q conclusions, even if they were a sort of  “negative assurance,” were preliminary? That even the reviews performed for the 10Q are the work of low-level auditors and not the conclusions of EY The Firm?  Surely there was work performed, documentation produced and conclusions made during 2008 that EY stands behind. Otherwise, how can EY stand behind their statutorily required 2008 10Q reviews?

Although E&Y audited Lehman’s valuation of the CRE portfolio as part of the 2007 audit, E&Y’s annual 2008 audit of Lehman’s valuation of the CRE portfolio was only in its beginning stages when LBHI filed for bankruptcy.

While EY had performed quarterly reviews throughout 2008, these reviews consisted of  “inquiry, observation, and analytical review,” and did not include substantive testing as to the accuracy or reasonableness of Lehman’s marks. E&Y performed “walkthrough” analyses as part of the annual audit process to understand how Lehman’s Product Control Group performed its independent price verification functions. The purpose of the walkthroughs was to document the “significant classes of transactions,” and “[v]erify that [E&Y had] identified the appropriate ‘what could go wrongs’ (‘WCGWs’) that have the potential to materially affect relevant financial statement assertions.”

In addition, E&Y identified “the design and implementation of controls” that Lehman had in place to internally regulate its price verification process. Other documents produced by E&Y personnel over the course of 2008 indicate that E&Y did not find any material flaws with Lehman’s price verification process. E&Y personnel told the Examiner that the conclusions stated in these documents were preliminary in nature and the product of work performed by lower-level auditors, and therefore were not reflective of the opinion of E&Y. (Lehman Bankruptcy Examiner’s Report V3, pages 237-239)