My Commentary Part 2: Ernst & Young’s Letter To Audit Committee Members

On March 31^st I gave you my comments on the introduction and General Comments portions of Ernst & Young’s letter to audit committee members regarding Lehman.

In the letter, EY attempts to defend themselves against claims of malpractice included in Anton Valukas’ Lehman Bankruptcy Examiner’s Report published March 11^th.

The introduction and General Comments include statements that are refuted by the facts uncovered by the bankruptcy examiner. EY counts on half-truths and clever ellipsis to persuade current and future clients that they will prevail in any legal claim against them.

Unfortunately for Ernst & Young, even before the release of the Lehman report, too many things had already gone wrong. Their credibility is, pretty much, shot to hell. Their only hope may be that both civil and criminal proceedings take so damn long that they’ll instead die a slow and painful death by litigation and suffocating legal fees than by the swift sword of an Arthur Andersen-type criminal indictment by the US Department of Justice.

I make no guarantees.

My critique of their defense on the remaining issues, Accounting and Disclosure Issues Relating to Repo 105 Transactions and Handling of the Whistleblower’s Issues, and a final comment.

EY: Accounting and Disclosure Issues Relating to Repo 105 Transactions

There has been significant media attention about potential claims identified by the Examiner related to what Lehman referred to as “Repo 105” transactions. What has not been reported in the media is that the Examiner did not challenge Lehman’s accounting for its Repo 105 transactions.

Really?

Please allow four Wharton professors to tell you how it looks from the outside and why the bankruptcy examiner did find fault with EY’s approval of the Repo 105 transactions.

Among the report’s most disturbing revelations, according to Wharton finance professor Richard J. Herring, is the picture of Lehman’s accountants at Ernst & Young. “Their main role was to help the firm misrepresent its actual position to the public,” Herring says, noting that reforms after the Enron collapse of 2001 have apparently failed to make accountants the watchdogs they should be.

“It was clearly a dodge…. to circumvent the rules, to try to move things off the balance sheet,” says Wharton accounting professor Brian J. Bushee, referring to Lehman’s Repo 105 transactions. “Usually, in these kinds of situations I try to find some silver lining for the company, to say that there are some legitimate reasons to do this…. But it clearly was to get assets off the balance sheet.”

The use of outside entities to remove risks from a company’s books is common and can be perfectly legal. And, as Wharton finance professor Jeremy J. Siegel points out, “window dressing” to make the books look better for a quarterly or annual report is a widespread practice that also can be perfectly legal…Bushee notes, however, that Lehman’s maneuvers were more extreme than any he has seen since the Enron collapse.

Wharton finance professor Franklin Allen suggests that the other firms participating in Lehman’s Repo 105 transactions must have known the whole purpose was to deceive. “I thought Repo 105 was absolutely remarkable – that Ernst & Young signed off on that. All of this was simply an artifice, to deceive people.”

As Professor Herring said, “…reforms after the Enron collapse of 2001 have apparently failed to make accountants the watchdogs they should be.” Why should we care about Repo 105 and things like “window-dressing” a balance sheet to temporarily make results look better? If it’s technically legal, what’s the beef?

There’s two reason why we should care about the use of Repo 105 transactions and why plaintiff’s lawyers, prosecutors and regulators who enforce the securities laws and the provisions of Sarbanes-Oxley should enforce them much more strenuously.

The first reason is although an accounting treatment may technically compliant with GAAP, that’s no “safe harbor.”

James Peterson in re: Balance:

The [media] analyses of the bankruptcy examiner’s report on Lehman Brothers, released on March 14 (here), show a number of serious shortcomings in reasoning or conclusions – none so difficult to have gotten right as to be tolerable without comment.

Take the misperception repeatedly put forward by the Financial Times, that the “rules-based” nature of accounting principles in the United States, ostensibly contrasted with the broader principles as articulated in the United Kingdom, are effective to mitigate the large accounting firms’ litigation risk (see here and here).

Simply — wrong. That a “culture of box ticking … helps firms defend themselves against law suits” is both unsupported and contrary to the accounting profession’s exposure to devastating claims in the American courts.

Empirically, first: the large firms have no track record of successful trial outcomes in the billion-dollar US cases that threaten their survival – precisely because their leaders cannot tolerate the risk of actually going to trial in a bet-the-firm contest before a jury.

Which, secondly, is for good strategic reasons: there is no legal defense or “safe harbor” in American law based on proof of compliance with professional standards – box ticked or otherwise – a proposition established in a criminal prosecution over forty years ago.

The second even more important reason why we should prosecute accounting manipulation that’s intended to deceive, with no other business purpose than to “window-dress” the financial results, is that it’s self-serving. Selfish executives and, at times, directors and other insiders manipulate financial results because it puts more money in their pockets. Executive management have not learned the lessons of Sarbanes-Oxley because it serves them personally to find ways around them.  Constantly. They manipulate the results to achieve their  incentive compensation targets and enhance the stock price to give value to stock option grants.

What is the average tenure of a CEO and CFO post-Sarbanes-Oxley? Not too long, with a few exceptions like Dick Fuld of Lehman. But just look at how many CFOs went through the Lehman revolving door in the ten years prior to their failure? The average CFO tenure post-Lehman IPO 1994 was 540 days. The Examiner’s report refers to three CFOs during the period under examination alone. There were at least four that I can count since 2000 and two of them were former EY auditors.

CEO’s and CFO’s, in particular those in financial services, tend to focus too much on maximizing wealth while in the C-suite.  They gotta get what they came for, as soon as possible, because who knows when or why they may be out of a job. In particular, the CFOs that come from the audit firms ache for the big bucks – the stock options, the perquisites, and the multimillion-dollar contracts with generous retirement benefits. Many also look forward to the ego-trip that comes from being the CFO of a brand-name public company versus a subservient worker-bee toiling in obscurity, that is, a partner in an audit firm.

When management is happy the auditors are happy. What senior executives want, the auditor wants. When directors are aligned with senior executives, personally and professionally, everyone wants the same things – quarterly results that hit targets and a stock price that keeps going up. There’s a strong financial motivation to delay bad news, and its impact, as long as possible. When auditors threaten to “harsh the buzz” no one is happy and audit firms get fired.

It’s as simple as that.

EY: As recognized by the Examiner, all investment banks used repo transactions extensively to fund their operations on a daily basis; these banks all operated in a high-risk, high-leverage business model.

Yes, that’s true. And some banks also used Repo 105 type transactions to “window-dress” their balance sheet. JP Morgan Chase already admitted they did so until 2005. Bank of America is vague on the subject.

Soon we will know all. The SEC recently wrote its own letter. “Dear CFO” it starts…

Edith Orenstein at FEI Blog suggests, “…companies, auditors, legal counsel, and audit committees consider such “Dear CFO” letters as illustrative of the SEC’s general view on accounting and disclosure matters for the issue(s) addressed in the letter.”

Clearly the SEC suspects EY’s use of “window-dressing” may not be isolated. The transactions required counterparties, willing partners. Given the competitive nature of the financial services business it would surprise me if everyone else was oblivious of these techniques and did not use them. With only four big audit firms on the street, it doesn’t take long for word to get around about an auditor acceptable loophole via the backchannel, too.

Like everything else on Wall Street that got out of hand during the financial crisis, one auditor calling the bluff would have had a significant ripple affect on not only their other clients but everyone else’s. There was strong financial motivation to keep all the major clients happy.

EY: Most repo transactions are accounted for as financings; some (the Repo 105 transactions) are accounted for as sales if they meet the requirements of SFAS 140. The Repo 105 transactions involved the sale by Lehman of high quality liquid assets (generally government-backed securities), in return for which Lehman received cash. The media reports that these were “sham transactions” designed to off-load Lehman’s “bad assets” are inaccurate.

Initial factual errors by the media gave EY some grounds to hit back. The subtle advantage to leverage ratios when Level 3 assets stayed on the books while marketable securities were “sold” was lost on a few journalists who jumped into the story feet, rather than head, first.

The overall Repo 105 strategy, unless coupled with other “roundtrip” shenanigans” to create “sham” higher market prices for the illiquid assets such as I described several weeks ago, would have left the balance sheet even more heavily skewed towards depressed Level 3 assets during each quarter end. Why didn’t EY notice that? Or did they look the other way when “round trip” sales and purchases of illiquid assets with these same counterparties were passed off as true observable prices?

EY: Because effective control of the securities was surrendered to the counterparty in the Repo 105 arrangements, the accounting literature (SFAS 140) /required /Lehman to account for Repo 105 transactions as sales rather than financings.

This is the “sale accounting treatment follows from the business decision” theory of rationalization rather than admitting the reality that Lehman set up the transaction in order to achieve a particular accounting treatment that met a business strategy of “window-dressing” the balance sheet at quarter-end.

Effective control of the asset was not surrendered, in my opinion. Lehman still collected the coupon payment after the asset was effectively sold. I bet a deeper investigation by plaintiffs’ lawyers will find that the “sold” assets were never removed from Lehman’s accounting systems nor were they ever added to the counterparty “purchaser’s” systems. Instead, a workaround was created to subtract the value of these assets from totals for financial statement purposes temporarily, while they were on Repo 105 hiatus.

EY: The potential claims against EY arise solely from the Examiner’s conclusion that these transactions ($38.6 billion at November 30, 2007) should have been specifically disclosed in the footnotes to Lehman’s financial statements, and that Lehman should have disclosed in its MD&A the impact these transactions would have had on its leverage ratios if they had been recorded as financing transactions.

While no specific disclosures around Repo 105 transactions were reflected in Lehman’s financial statement footnotes, the 2007 audited financial statements were presented in accordance with US GAAP, and clearly portrayed Lehman as a leveraged entity operating in a risky and volatile industry. Lehman’s 2007 audited financial statements included footnote disclosure of off balance sheet commitments of almost $1 trillion.

The emphasis above is mine. I suspect the disclosure issues will be heavily litigated and debated.Examples such as JPM Chase’s reported use of the same technique with disclosures will not bode well for EY. What is not debatable, however , is that EY’s exposure extends through 2008 and beyond. This was discussed in more detail in my previous commentary.

EY: Lehman’s leverage ratios are not a GAAP financial measure; they were included in Lehman’s MD&A, not its audited financial statements. Lehman concluded no further MD&A disclosures were required; EY did not take exception to that judgment.

If the Repo 105 transactions were treated as if they were on the balance sheet for leverage ratio purposes, as the Examiner suggests, Lehman’s reported gross leverage would have been 32.4 instead of 30.7 at November 30, 2007. Also, contrary to media reports, the decline in Lehman’s reported leverage from its first to second quarters of 2008 was not a result of an increased use of Repo 105 transactions. Lehman’s Repo 105 transaction volumes were comparable at the end of its first and second quarters.

Emphasis is mine. These are probably the most disingenuous statements in the whole letter. Since the Repo 105 transactions were not disclosed or isolated in any way, we have no way of knowing whether the level of reported leverage changed because of some other set of transactions not disclosed either, because of the Repo 105 transactions or as a result of some combination of the two.

In addition, EY emphatically stated earlier in the letter that they claim no responsibility for the numbers reported in the 1^st and 2^nd Quarter of 2008.  They were aware of no “material errors in financial reporting” at the end of each of those quarters. The 1^st and 2^nd Q numbers were not audited but only “reviewed”. This is “negative assurance” not EY’s “opinion”.

But now EY wants us to take their word for it that Repo 105’s did not cause the change in leverage and that the level of Repo 105 volumes was the same in 1^st and 2^nd Quarters.

Which is it, EY?  Do you stand behind the numbers reported in the 10Q or not?  Do you want to sail into open seas, telling us what you know and don’t know, or stay in the “safe harbor,” deaf, dumb and dry?

EY: Handling of the Whistleblower’s Issues

The media has inaccurately reported that EY concealed a May 2008 whistleblower letter from Lehman’s Audit Committee. The whistleblower letter, which raised various significant potential concerns about Lehman’s financial controls and reporting /but did not mention Repo 105/, was directed to Lehman’s management. When we learned of the letter, our lead partner promptly called the Audit Committee Chair; we also insisted that Lehman’s management inform the Securities & Exchange Commission and the Federal Reserve Bank of the letter. EY’s lead partner discussed the whistleblower letter with the Lehman Audit Committee on at least three occasions during June and July 2008.

Most of this is just the media again probably misreading the account in the Examiner’s report. We know that the whistleblower’s letter went to management and the Audit Committee asked their Internal Auditor to investigate with the assistance of EY. The errors in this approach have been described here.

The rest of the facts here are easily proven with a look at the documents in the Bankruptcy Examiner’s repository, including auditors’ notes and Audit Committee minutes. A dissing match is futile without access to those documents

EY: In the investigations that ensued, the writer of the letter did briefly reference Repo 105 transactions in an interview with EY partners. He also confirmed to EY that he was unaware of any material financial reporting errors. Lehman’s senior executives did not advise us of any reservations they had about the company’s Repo 105 transactions.

Why would EY take the whistleblower’s word that there were no material financial reporting errors? EY was now playing two roles:  1) Investigator – which means exploring the truth of any allegations, and 2) Auditor – which means testing management’s assertions outside of any additional allegations and revising that testing approach if there’s additional risk of fraud, such as might be suspected if a high level financial accounting executive alleges it.

Why would Lehman’s senior executives advise EY of any reservations about Repo 105? That’s why a “whistleblower” felt the need to write a letter to the Audit Committee. Lehman’s senior management were “on a drug” they couldn’t kick.

EY: Lehman’s September 2008 bankruptcy prevented EY from completing its assessment of the whistleblower’s allegations. The allegations would have been the subject of significant attention had EY completed its third quarter review and 2008 year-end audit.

I expected this excuse. To investigate and fully review the allegations from an auditor’s perspective, with an eye to the potential impact on the financial statements, EY needed more time than they were probably given as part of the formal investigation. That is another reason why EY should have stayed on the sidelines and done their duty as an auditor rather than agreeing to be involved in the investigation. They would have come out much better in this particular issue.

EY: Should any of the potential claims be pursued, we are confident we will prevail.

They will be pursued, criminally and civilly. If the civil claims go to trial, which is always a crapshoot with auditors, EY’s position is very weak in several areas.

In the meantime, the lawyers are going to eat them alive, gnawing at the carcass while they’re on the ground, on their backs.

Are they dead and buried yet?  Not yet.

Outlaw Josey Wales:

Jamie: I wish we had time to bury them fellas.

Josey Wales: To hell with them fellas. Buzzards gotta eat, same as worms.