Will Ernst & Young Ever Be Held Accountable for the Lehman Failure?
I’d be exaggerating if I told you the Lehman bankruptcy examiner’s report, and its scathing indictment of Ernst & Young’s role in the biggest failure on Wall Street, answered my prayers.
I pray for very little.
Peace of mind. Social justice. The health of family and friends. Increased scrutiny of the role of the largest global audit firms in the international financial markets.
They’re modest entreaties but I sometimes wonder whether the gods are listening.
The Lehman bankruptcy examiner’s report, issued in March 2010, is a 2,000-word work of compelling non-fiction. Anton Valukas, the examiner, gave us a model by which all future examination documents will be judged.
The report startled the media. Repo 105 – its creation and proliferation throughout the Lehman balance sheet – provided reporters, bloggers, pundits with something unexpected to write about. The inclusion of “colorable claims” against Lehman’s auditors, Ernst & Young, drove renewed interest in the audit firms, their role and responsibilities to shareholders, and the history of their regulation.
Coverage of Ernst & Young (EY) by major media lasted, in earnest, about two months.
In April, US media reported the investigation of EY was “picking up steam”, based on sources pointing to an investigation by the PCAOB. Hot air. The PCAOB’s investigations are secret and it would be odd for them not to start some kind of an investigation under the circumstances.
There’s been nothing much new written about EY and the Lehman case since. There were a few stories right away about plaintiffs adding EY to their existing lawsuits. In June, the UK’s Financial Reporting Council (an accounting regulator) also initiated an investigation of EY’s Lehman activities. In September, they added an investigation of EY’s reporting to UK regulators regarding Lehman’s handling, or rather mishandling, of client assets.
Ernst & Young was mentioned briefly in early September in a ~700 word Wall Street Journal article on the ongoing SEC investigation of Lehman’s executives.
As part of its probe, the SEC is also investigating the role of Ernst & Young, Lehman’s outside auditing firm. The examiner concluded that Ernst & Young “took virtually no action to investigate the Repo 105 allegations.” A representative for [EY] declined to comment Thursday.
Lawyers for the former Lehman executives have previously denied any wrongdoing related to the accounting moves, while Ernst & Young said it complied with generally accepted accounting principles.
Ernst & Young, take my word for it, will never be indicted by the U.S. government, as a firm, for its role in any Lehman fraud that’s eventually proven. It’s also highly unlikely – 1000 to 1 odds I’d say – EY will be fined by the SEC or the PCAOB, as a firm, in a civil or disciplinary case.
The Ernst & Young partners named in the bankruptcy examiner’s report, and maybe a national practice partner, might be sanctioned by the PCAOB or SEC. Later. Much later. We can predict the timing based on the SEC’s handling of the Bally’s sanctions. Even with a slam dunk case, the SEC waited six years before they settled with EY. The eventual sanctions against six Ernst & Young partners for the Bally’s fraud were too little and much too late to provide a deterrent or any real justice.
Ernst & Young, as a firm, and their individual partners are named as additional defendants in private lawsuits against Lehman executives. But the New York Court of Appeals in a 4-3 opinion refused to hold the auditors responsible for their role in frauds perpetrated by management in the Kirschner (Refco Trustee) v. KPMG and Teachers’ Retirement v. PwC (re: AIG 2002-2005 fraud) cases. The opinion reaffirmed the application of the in pari delicto doctrine and the principle of imputation in these cases.
The judges who disagreed with the majority opinion said it best:
These simplistic agency principles as applied by the majority serve to effectively immunize auditors and other outside professionals from liability wherever any corporate insider engages in fraud…it is unclear how immunizing gatekeeper professionals, as the majority has effectively done, actually incentivizes corporate principals to better monitor insider agents. Indeed, it seems that strict imputation rules merely invite gatekeeper professionals “to neglect their duty to ferret out fraud by corporate insiders because even if they are negligent, there will be no damages assessed against them for their malfeasance”
The more successful a fraud case is against Lehman’s executives, the less likely EY or any of its partners will suffer any consequences for their acquiescence to or complicity in the fraud. That’s not to say the firm won’t suffer slowly and painfully from the enormous amount of time and money devoted to defending themselves in Lehman litigation and the rest of the suits they face. And, of course, there is reputational damage with some clients. That’s why their Chairman has gone on the PR defensive.
But with regard to Lehman cases, EY can now take a breath. When executives commit fraud and are held liable, and especially when there’s a bankruptcy involved, auditors are rarely held responsible.
The judges make it almost impossible.
The majority of the New York Court of Appeals feels we should be as sympathetic to the partners of the poor “duped” accounting firms as we are to the creditors and shareholders of the companies, Refco and AIG, whose executives stole from them.
… plaintiffs’ proposals may be viewed as creating a double standard whereby the innocent stakeholders of the corporation’s outside professionals are held responsible for the sins of their errant agents while the innocent stakeholders of the corporation itself are not charged with knowledge of their wrongdoing agents… The owners and creditors of KPMG and PwC may be said to be at least as “innocent” as Refco’s unsecured creditors and AIG’s stockholders.
That leaves few avenues of recourse for the shareholders and creditors against the aiding and abetting service providers. If only the Department of Justice and the SEC, followed closely by the PCAOB, led the way in calling the audit firms to account for their professional impotence and the occasional deliberate legal deviance.
But the regulators will disappoint me.
The U.S. government needs Ernst & Young more than it needs me.
From The Congressional Oversight Panel Report, Examining Treasury’s Use of Financial Crisis Contracting Authority:
Ernst & Young has the largest amount of expended value attributable to its work. Ernst & Young has performed work as a contractor under a procurement contract as well as a subcontractor under financial agency agreements. Of the $32.2 million in expended value attributable to Ernst & Young, $10.7 million is related to a procurement contract for accounting services, and $21.5 million is related to subcontracts under financial agency agreements, $17.7 million of which was expended under a contract with Freddie Mac and the remaining $3.8 million was expended under a subcontract with Fannie Mae. In addition, Ernst & Young has been granted the same $22 million multiple awards as PricewaterhouseCoopers.
Well, you might say, those contracts were handed out at the peak of the crisis, September 2008. What could the U.S. Treasury do? There are only four large accounting firms that could possibly get the tough job done.
PricewaterhouseCoopers – auditor of Goldman Sachs, AIG, JP Morgan Chase, Bank of America, the twelve Federal Home Loan Banks and Freddie Mac – is the largest contractor to the Treasury under the financial crisis contracting authority. KPMG is the Treasury’s own auditor and was preoccupied with auditing failed New Century and Countrywide, getting sued by former client Fannie Mae, and trying to hold on to troubled Citigroup, Wells Fargo and Wachovia. What were Deloitte’s conflicts? Deloitte was busy with its own problems as auditor for Bear Stearns, Washington Mutual, Merrill Lynch, GM, and Fannie Mae as well as auditor of the Federal Reserve Bank system, itself.
However, in a slap in the face to Lehman employees and shareholders all over the world and to the U.S. taxpayer who’s paying the bill, Ernst & Young was awarded another contract by the U.S. Treasury in July of 2010, two years after the crisis and only three months after the Lehman bankruptcy examiner’s report was published. This contract, a blanket purchase contract for Program Compliance Support Services effective until July 2015, is essentially a blank check.
In addition to the contracts with the U.S. Treasury, Ernst & Young – along with Deloitte and PricewaterhouseCoopers – is a key vendor at the New York Federal Reserve Bank.
From the New York Federal Reserve Bank Vendor Information page:
Maiden Lane LLC (re: Bear Stearns)
2 Although the detailed description of the scope of work set forth in this contract has been redacted due to confidentiality concerns, a general description of the scope of work is as follows: E&Y was contracted to perform due diligence on the assets in the Maiden Lane LLC portfolio to assess and evaluate the quality and accuracy of financial information provided by Bear Stearns & Co. and obtained from external sources prior to acquisition by the LLC. E&Y identified all cashflows from the determination date through the closing date to facilitate settlement of the assets into the LLC. E&Y tracked and verified post close cash flow adjustments with the Investment Manager.
4 Although the detailed description of the scope of work set forth in this contract has been redacted due to confidentiality concerns, a general description of the scope of work is as follows:
With respect to AIG, E&Y was contracted to provide advice on the insurance businesses; to perform valuations of the entities posted as collateral; to provide assistance in developing cash flow projections; to provide support for the divestiture process; to provide advice and assistance with domestic and global regulatory issues; to identify and report on compliance with covenants within the Credit Agreement; to provide assistance in assessing accounting and tax considerations, including off-balance sheet arrangements; to provide project management support; to provide advice and assistance on compensation issues; to provide assistance and support in assessing internal audit at the firm; to provide advice and due diligence on contemplated transactions, including SPVs and securitizations; to develop a document repository; and to provide advice and assistance in monitoring business unit performance within AIG.
With respect to ML LLC, ML II, ML III, E&Y was contracted to perform a diagnostic on the operational and financial close procedures, and to assist with the analysis of accounting matters. In addition, with respect to ML II, E&Y was contracted to perform due diligence on the assets to assess and evaluate the quality and accuracy of financial information provided by AIG and obtained from external sources prior to inclusion in the trust. E&Y identified all cashflows from the pricing date through the closing date to facilitate settlement of the assets into the LLC. E&Y tracks and verifies with the administrator all post close factor changes through August 31, 2009. With respect to ML III, E&Y was contracted to perform due diligence on the assets to assess and evaluate the quality and accuracy of financial information provided by AIGFP and obtained from external sources prior to inclusion in the trust. E&Y identified all cashflows from the pricing date through the closing date to facilitate settlement of the assets into the LLC. E&Y tracks and verifies with the administrator all post close factor changes through August 31, 2009. With respect to TALF, E&Y assisted with accounting procedures and the analysis of accounting matters.
Even I have to admit that this work makes EY pretty indispensable.
And, therefore, immune from prosecution.
But don’t take my word for it.
On October 14, the Congressional Oversight Panel (COP) issued its monthly oversight report, “Examining Treasury’s Use of Financial Crisis Contracting Authority”. The report highlights many of the issues raised in testimony by the Project on Government Oversight (POGO) and in their letter to Congress.
The Panel highlighted two big reasons why the U.S. Treasury and, by extension, their subordinate agencies the SEC and PCAOB and sister department Justice won’t jeopardize the viability of vendors they’re counting on the most to support them during these very trying times.
a. Future Industry Regulation
Acting in its regulatory capacity, Treasury may need to regulate a business that it is also employing to do work. It is hard to see how Treasury could avoid the perception of a conflict of interest if it implements industry-specific regulations or regulates an individual business, and such oversight could have direct implications for the ability of a contractor or financial agent to perform…It is also possible that a firm could attempt to leverage its relationship with Treasury to enhance its capacity to lobby effectively with other regulators…particularly relevant in the wake of Dodd-Frank Wall Street Reform…
You may have noticed that the audit industry was pretty much left out of the Dodd-Frank reform bill, even as the bill destroyed the business model of the ratings agencies. The ratings agencies, as you know, operate under the same direct-pay business model that compromises the independence and objectivity of the audit firms. The SEC also quickly enacted additional safeguards after the Supreme Court reaffirmed the viability of the PCAOB under the Sarbanes-Oxley Act. These “safeguards” provide an appeals process for audit firms that feel victimized by the PCAOB’s “arbitrary and capricious” disciplinary actions.
c. Overreliance on Individual Firms
Ensuring that contracts and agreements are awarded to a broad group of firms may be critical to minimizing conflicts of interest. Awarding a large number or value of contracts or agreements to one specific firm may leave Treasury overly reliant on that particular institution. Such overreliance may cause Treasury to be disproportionately dependent on certain firms or industries…Forcing senior Treasury officials into the simultaneous role of regulator and client may place them in an awkward position. Likewise Treasury may be hesitant to implement certain types of accounting reforms when it has an outstanding contract of $24.6 million with PricewaterhouseCoopers (pwc), particularly when such reforms would subject the investment of taxpayers funds to more risk.
Translated, that means don’t count on the Department of Justice or the SEC to question pwc’s role in the Satyam or Glitnir frauds, to pressure pwc to resign as auditor of AIG even though their true client, AIG shareholders, has sued them repeatedly, or to answer for their duplicity with regard to allowing widely different valuations of the same assets at Goldman Sachs and AIG.
Main page image courtesy of NowPublic, Crowd Powered Media, Creative Commons License, The Serenity Prayer in Spanish on the Mexican Side of the Border
“The U.S. government needs Ernst & Young more than it needs me.”
Of course it does…it is a Firm of thousands of individuals contributing to the US and global economy….not a blogger who issues long winded rants day after day about the same thing.
Great article on the failure of Ernst & Young in its audit of Lehman Brothers. You touched on virtually all of the important issues. I would add one more for your consideration. The New York Board of Regents is responsible for the final disposition of all disciplinary matters against licensed CPAs and CPA firms practicing public accountancy in New York State. Typically a state agency doesn’t bring a disciplinary action until all lawsuits against auditors and any regulatory action is completed. The NY Board of Regents should bring an action against EY because it violated the professional misconduct provision as defined in Education Law and in the Rules of the Board of Regents. Professional misconduct includes being convicted of a crime but, as you point out, that hasn’t occurred. However, the Board can bring an action based on the firm engaging in acts of gross incompetence or gross negligence on a single occasion, or negligence or incompetence on more than one occasion. It may be wishful thinking to believe the Board will move against EY although it did take action against Davide Friehling, Bernie Madoff’s auditor for 17 years, because of Friehling’s issuance of audit reports without being independent and his failure to conduct an audit of Madoff’s financial statements. Friehling surrendered his license as part of the disciplinary action. Unfortunately, the NY Board of Regents seems to have no problem going after sole practitioners but seems to avoid going after the Big-Four CPA firms. Alas, that may be the subject of another article.
In response to “Get off your high horse”.
You need to realize that this is an impediment to the functional and efficient allocation of capital by markets. Investors/Creditor are unable to make allocation decisions because of the trend in the accounting industry to rubber stamp audits. If we can not rely on financial statements because a partner wants to make another dollar a share then we can’t provide proper analysis to support investment decisions. It wont be solved in the foreseeable future, but eventually this issue will need to be confronted, most likley in the way no one, especially audit firms, will want. The government will have to allow complete corporate and personal financial liability for grossly negligent audits. Try convincing a politician that it is in their best interest to support the big audit firms over millions of constituents who might lose a portion of their retirement savings because of a new audit failure. Simple economics, the potential liability of an audit failure needs to be large enough to override any marginal increase in income the firms(partners) receive from their “rubber stamping”.
You should go tell all of the auditors on those engagements who put in over 80 hours a week to stop “rubber stamping”.
If you think for one minute I’m not sympathetic to the efforts of the average staff person and the partners with integrity who do their part well and try to do the right thing you are sadly mistaken. The problem is the leadership who overrules the right decision and ignores the evidence such as in the Enron, Bally’s or New Century case. The problem is firm leadership who compromise the integrity of the profession in order to retain clients like AIG and Satyam at all costs. The problem is the partners who screw it up for the rest of you by abusing their power, ignoring their duty of stewardship by selling illegal tax shelters at KPMG, BDO and EY or trading on inside information like Flanagan at Deloitte.
This site is intended to criticize the business model of the firms, the leadership who sell out the shareholders for the sake of client management’s self interest and the regulators and legislators who let them all get away with it.
@high horse, FM, et al
When John Dean said there was a cancer growing on the presidency, he was told to stifle.
The Prince of Wales once said “Although one should always bear in mind Winston Churchill’s very temperamental personality when considering his remarks, they nevertheless deserve particular attention.”
If Joseph Berardino knew then what he knows now, who would he have most likely wanted to listen to?
Entire countries are declaring bankruptcy over this. Why? Because stacking the deck is so easy.
Wow! Never been compared to Winston Churchill before…
Thanks for your support. I know it’s been longstanding.
Yes, the opinions expressed in this blog are almost comparable to the resignation of Nixon and World War II.
Those are some pretty big leaps right there. But what else should be expected on the internet?
Here, I’ll try one.
When Chicken Little told everyone the sky was falling, he was told to stop overreacting.