The Case Against Ernst & Young: NY AG Cuomo Sues Over Lehman
News broke late Sunday night, December 20, that the New York Attorney General would charge Ernst & Young (EY) with fraud over their involvement as auditors of Lehman Brothers.
Michael Rapoport of the Wall Street Journal, who you may have seen me mention here, teamed up with his fraternal news twin Liz Rappaport, to get the scoop. Rapoport told me in November when we met at the FEI Current Financial Reporting Issues Conference that he had been named the Wall Street Journal’s full time Accountancy reporter. I hope that the Wall Street Journal sees the value in full time coverage of this industry, not only when important news is breaking but when others have gone on to other things. His experience, dogged pursuit of contacts, and the desire for early scoops are what we need to tell the story of the Big 4 audit firms. The Wall Street Journal has been all over this story as it has developed.
I saw the Google Alert on the first Wall Street Journal story very early Monday morning and by 8:30 CST had my story posted at Forbes.
NY Fraud Case Against Ernst & Young Puts Feds In Bind
Ernst & Young may find a lump of coal in its Christmas stocking this year.
New York’s Attorney General Andrew Cuomo will file charges as early as this week against auditor Ernst & Young (EY) for its role in the Lehman Brothers collapse, according to the Wall Street Journal. Fraud charges against EY are expected to be focused on its role as enabler of the infamous Repo 105 transactions that Lehman used to “window-dress” its balance sheet…
Charges against EY, the firm, by US federal authorities would be embarrassing at best and catastrophic at worst. Civil charges by the SEC against Ernst & Young could put its bosses, the US Treasury, in a very bad spot. The Treasury is paying EY millions to help clean up the mess left by other firms as contractors to the government’s various bailout programs like TARP. Criminal charges against EY by the DOJ could precipitate a failure of the firm, a la Arthur Andersen. No one in the US federal government has a plan in the event another large audit firm fails and they certainly don’t want to be the ones to cause it.
Better to let New York do the dirty work.
Whether Cuomo is doing this on his own, in defiance of the Feds, or has their implicit blessing in light of the Federal Government’s seeming unwillingness to act, New York’s Attorney General is showing the world he’s the only one in the US with the nerve to shake this tree. He follows the UK House of Lords’ Economic Committee who recently asked UK leaders of all of the Big 4 audit firms – Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers – about the absence of warnings or “going concern” qualification for banks that failed or were bailed out.
The auditors’ response: The Bank of England told us, in confidence, that they would support the banks financially.
For the sake of justice, let’s hope New York State doesn’t settle for too little too soon. The state certainly could use the money from fines, but we need more illumination of the role of auditors during the financial crisis. The New York Attorney General can shine a bright light on EY – something the SEC, the Department of Justice, and Congress are not yet doing.
I also did an interview with a reporter from Marketplace that ran early Monday morning on NPR. The Street.com wrote a great story that was mostly my quotes. Colin Barr over at Fortune gave me a nice shout out in his story on Monday, too.
I started writing a followup for Forbes very early Tuesday morning, focused on the legal strategies of the New York Attorney General, the SEC, and the Department of Justice. I had to revise the story quickly to include the actual lawsuit information when it hit mid morning. Then I got a call from Dan Bigman, the Forbes Executive Editor for business news: Could I get a story ready asap to put on their online front page?
What I wrote rotated as a front page banner story on Forbes.com until this morning and still appears as their main Business story on the EY suit.
Prosecuting Lehman Bad Actors: Does Suing Ernst & Young Help?
New York’s Attorney General (NY AG) Andrew Cuomo filed his lawsuit against Ernst & Young (EY) today. We have some answers, for now, about what he’s up to. Cuomo’s following the proud tradition of former NY Governor and Attorney General Eliot Spitzer in using New York’s Martin Act to make the claims...
Why did the NY AG apparently beat the SEC or Department of Justice to the punch with charges? My theory is that Cuomo was pursuing the Lehman executives, along with other bank executives, as part of their overall investigation of the use deceptive balance sheet window-dressing techniques like Repo 105. Maybe the responses to the SEC’s “Dear CFO Letter”, which asked questions about Repo 105 use, gave Cuomo’s office a head start on potential charges of deceptive financial statements. Lehman is just the biggest and most well documented example, but the practice was pervasive.
Cuomo’s move to the Governor’s mansion may have prompted his team to put a charge, if not a settlement, with at least one of the banks on the board regarding Repo 105. The NY AG has a convenient tool, the Martin Act, to use to do this more quickly than the SEC. They can potentiallysqueeze a settlement soon, paving the way for others to fall like dominoes for Mr. Cuomo’s successor.
Why did the New York Attorney General choose to charge Ernst & Young rather than Lehman executives? Many of the conclusions and footnotes to interviews in Jenner & Block Chairman Anton Valukas’ Lehman Bankruptcy Examiner report allude to the difficulty in getting EY’s Schilch and Hansen to give straight answers. The EY partners don’t come across, to me, as very cooperative and forthcoming.
On the subject of materiality, for example, EY’s Schlich refused to do what an audit firm gets paid to do – opine:
(3) Ernst & Young Would Not Opine on the Materiality of Lehman’s Repo 105 Usage
Ernst & Young, through Schlich, was unwilling to comment to the Examiner on the materiality of the volume of Lehman’s quarter‐end Repo 105 transactions. Asked whether, as part of its responsibility to ensure Lehman’s financial statements were not materially misstated, Ernst & Young should have considered the possibility that strict technical adherence to SFAS 140 or any other specific accounting rule could nonetheless lead to a material misstatement in Lehman’s publicly‐reported financial statements, Schlich refrained from comment.
From page 954 of Volume 3 of the report
There were a lot of “I don’t recall” and “That was not part of our audit scope” responses from EY in the Valukas report. There were also fingers pointed at each other between between EY partners Schlich and Hansen. But most telling is this conclusion, included as a footnote on page 991 ofVolume 3 of the report, which focused on the Repo 105 transactions:
Prior to this invitation and during Schlich’s four‐day interview as an Ernst & Young representative, the Examiner invited Ernst & Young to opine on why Repo 105 transactions were proper and did not result in Lehman filing materially misleading financial statements…Schlich replied that the transactions were proper if they complied with Lehman’s self‐defined Accounting Policy. Id. Despite an additional invitation from the Examiner, Ernst & Young has not offered any further explanation.
I think the NY AG’s investigators questioned EY and its partners first as part of building a case against Lehman executives. When EY was as difficult and non-cooperative as they seem to have been with Valukas, the NY AG decided to redirect their energies to the auditors. They had the Lehman Bankruptcy Examiner’s report as a road map, an almost-ready for prime-time template for a complaint against the auditors.
How could they resist?
Lesson: Don’t try to play Cuomo. He hates that.
There’s more in both of my stories at Forbes, including why no EY individual partners were charged by Cuomo, so please go there and read them. (Felix Salmon also writes about the “no individual accountability” issue at his blog on Reuters. Worth a read.)
There’s been plenty of other great coverage of the story. Caleb Newquist has done a yeoman’s job compiling blurbs from other journalists, some of whom only report on the accounting industry “once during a lunar eclipse on the winter solstice.”
EY finally came out with an official response late yesterday. As you may recall, they waited quite a long time to respond to the Lehman Bankruptcy Examiner’s report, too. They wrote letters to Audit Committee members – their bread and butter clients – members defending their actions, first.
The EY response to the New York Attorney General’s lawsuit:
What’s the big deal?
The Wall Street Journal’s Deal Journal Blog has the text of their official response.
(WSJ continues to kick tail on this story.)
We intend to vigorously defend against the civil claims alleged by the New York Attorney General.
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 (GAAP). Lehman’s audited financial statements clearly portrayed Lehman as a highly leveraged entity operating in a risky and volatile industry.
Lehman’s bankruptcy occurred in the midst of a global financial crisis triggered by dramatic increases in mortgage defaults, associated losses in mortgage and real estate portfolios, and a severe tightening of liquidity. Lehman’s bankruptcy was preceded and followed by other bankruptcies, distressed mergers, restructurings, and government bailouts of all of the other major investment banks, as well as other major financial institutions. In short, Lehman’s bankruptcy was not caused by any accounting issues.
What we have here is a significant expansion of the Martin Act. Although the Martin Act is almost 90 years old, we believe this is the first time that an Attorney General is attempting to use this law to assert claims against an accounting firm, rather than the company that took the alleged actions.
We look forward to presenting the facts in a court of law.
John McDermott at FT Alphaville does a superlative job of telling us why EY may have a harder time than they think. Andrew Cuomo is the New York Attorney General who is headed to the the Governor’s mansion any day now a la Eliot Spitzer – his model for aggressive prosecution of those who cheat investors. He ripped EY to shreds in the complaint:
Breaking this down, there are three main allegations related to the way E&Y did not follow GAAS and therefore ‘permitted Lehman to engage in an accounting fraud.’
First, E&Y was required to discuss with Lehman’s Audit Committee the quality of Lehman’s accounting principles as applied to financial reporting.
What were they supposed to discuss? Um, unsurprisingly, quite a lot.
In particular, E&Y allegedly did not communicate known concerns about the legality of using American-based securities in Repo 105 transactions. As we noted in March, the UK law firm Linklaters provided a “True Sale” opinion covering non-USoperations, led by Lehman Brothers International Europe (LBIE), which naturally took the lead on Repo 105 transactions. But no US law firm had approved Repo 105. E&Y were supposed to mention this — but allegedly did not…
Other issues that Cuomo alleges E&Y should have brought to the audit committee and didn’t, include the spiralling volumes of Repo 105 transactions in 2007-08, concerns over “reputational risk” to Lehman that were made internally in E&Y, and misleading public statements from Lehman about its leverage.
Next allegation of non-GAAS activity:
Second, upon learning that Lehman intended to embark on Repo 105 transactions for no reason other than to “manage balance sheet metrics,” and the increased use of these transactions in 2007 and 2008, E&Y was required by GAAS to conduct a bona fide investigation of Repo 105 and inform management and the Audit Committee of the relevant issues.
This refers to there being no investigation into the well known (now at least) uses of Repo 105 — obfuscating “sales” and “loans”, pumping up balance sheets at reporting times, facilitating higher leverage, and so on.
And the final one:
Third, AU §§ 336 and 9336 address an auditor’s use of a legal opinion as evidential matter supporting, for instance, a management assertion that a financial asset transfer meets the “isolation” criterion in FASB 140. AU § 9336 states that a legal letter that includes conclusions using certain qualifying language would not provide persuasive evidence that a transfer of financial assets has met the isolation criterion of FAS.
Not only was the Linklaters letter replete with qualifying statements, but E&Y knew that no United States law firm had approved the Repo 105 transactions and that Lehman had to conduct the Repo 105 transactions through a United Kingdom-based affiliate, LBIE. E&Y failed to consider whether it could rely on the Linklaters opinion letter at all, much less in connection with securities that originated in the United States.
So, again the complaint comes back to the Linklaters opinion letter — or more specifically E&Y’s alleged failure to raise its narrow focus as an objection to Repo 105 practices…
Finally, the Martin Act is the law used by Cuomo to bypass all the other constraints mere mortals have in suing the Big 4 audit firms. It’s quite a powerful tool, as Eliot Spitzer showed us. Again, the Wall Street Journal is all over it. Their Law Blog explains to us how “Jedi warrior” powerful this law really is.
In the lawsuit filed against accounting firm Ernst & Young, Andrew Cuomo brought four claims, three of them under New York’s Martin Act, one of the most powerful prosecutorial tools in the country.
Technically speaking, the Martin Act allows New York’s top law enforcer to go after wrongdoing connected to the sale or purchase of securities. Nothing too noteworthy there.
But what is noteworthy is the power the act confers upon its user. It enables him to subpoena any document from anyone doing business in New York and, if he so desires, keep an investigation entirely secret. People subpoenaed in Martin Act cases aren’t afforded a right to counsel or the right against self-incrimination. “Combined, the act’s powers exceed those given any regulator in any other state,” wrote Nicholas Thompson in this 2004 Legal Affairs article.
And we haven’t even gotten to the kicker. Courts in civil Martin Act cases have held that “fraud” under the Martin Act “includes all deceitful practices contrary to the plain rules of common honesty and all acts tending to deceive or mislead the public, whether or not the product of scienter or intent to defraud.”
In other words, in order to prove a Martin Act violation, the attorney general is not required to prove that the defendant intended to defraud anyone, only that a defrauding act was committed…
Ernst & Young leadership had better hire some powerful lawyers to defend the firm.
Oh wait…They have.
At least the lawyers are talking, even if EY is pretty much speechless.
Ernst & Young’s spokesperson Charlie Perkins has not yet responded to any of my requests for comment.
Very incisive. Gets right to the heart. I smell blood in the water. Do you really think this will take us to Big 3?
@ Jonah Gibson
No, EY will be severely wounded, but $$ here are not enough to put them out for good. Reputation will be injured with employees, recruits and clients. Not because they aren’t a “going concern” but because too much time and money must be spent on defending these suits. Leadership and senior partners are preoccupied and not paying attention to either employees or clients.
I know you are giddy about E&Y being sued, but you might take a step back and think of the ramifications of this on the profession you love to bash. It is not outside the realm of possibility that this could bring them down. What happens then? The other 3 firms snatch up the crumbs and the power is consolidated even more. The firms outside the big 4 don’t have the quality control mechanisms to take on these large clients, so it would be a disaster for them to get much.
When I saw how EY reacted to the Peoplesoft scandal in 2004, when I read the assertions and talking points and quotes from the firm’s leadership, I said to myself, “There goes a firm that learned nothing–NOTHING–from the demise of Andersen.” You could have taken the words from both Andersen (2002) and EY (2004) and put them next to each other, and you could have never figured out which was which.
I am thus unsurprised that EY finds itself in its current situation. If I’m surprised at anything, it’s that it took so long for it to happen.
— Tenacious T.
If other banks used repo 105 trx to shore up their balance sheets, isn’t it reasonable to suppose that other audit firms have some exposure here, or is Lehman’s failure key in the NYAG’s ability to prosecute a claim under Martin Act?
I’m not giddy. And this won’t bring EY down, not in the same way as Andersen. The penalty and fine, after negotiation, may not be more than a few hundred million. That’s still less than Tyco/PwC or KPMG tax shelter money, for example. What’s bad is that significant time and money will be spent by the firm on litigation, not their clients, audit quality, training or their people. So noodle on that, and make the right choices for yourself, depending on your own interests.
Regarding Greg’s point, why can’t small firms audit SEC companies?
I thinkj having small firms do the audits (prefer rotation) might be better. If a small firm does the auditl, they might be scared stiff of potential liability. That;’s what you need. The auditor to know htat if there is liabiility, he or she is going to be the one to pay. And his firm’s rep is going to crash. Then the auditor wouldn’t be so complacent about allowing misrepresentations.
To David, The small firms don’t have the infrastructure to audit the largest companies in the world. In any event, having a small firm do the audit would be worse because so much more of their overall revenue would be tied to a few clients. As much as everyone wants to make a big deal out of Lehman paying E&Y $100 million over an 8 year period, that number is immaterial to E&Y over that period. Heck, they had about $20 billion in revenue last year alone. $100 million isn’t even material to their revenue for one year, much less over 8 years.
As much as people like Francine want to vilify the Big 4 and make it look like they are looking the other way for fees, they aren’t. No matter how much they are paid, no one client is material to any of these firms and none of these firms is going to blatantly participate in allowing a client materially misstate their financial statements to hold on to fees. It just isn’t going to happen. I’m a senior manager at another Big 4 firm, and I work on a couple of fairly big public companies, and I can tell you that without fail, I have never ever seen a situation where we didn’t do what we thought was right. Not once. Have we missed things? Absolutely. Does that mean it was anything other than a mistake on our part and the clients’ part? No. We had a situation three years ago where we forced the client to take a huge asset impairment. They fought us kicking and screaming and threatened to fire us. You know what, we didn’t care. We did what we thought was right, and it turns out, we were right and the client now agrees with us. Another client, we made them record a big contingent liability. They didn’t like, but we didn’t care. I had a third client fire us over disagreements on accounting issues. We didn’t care, no amount of one client’s revenues are worth it.
See people like Francine want to vilify us and make us all out to be the bad guys, when the vast majority of us go to work every day trying to do what’s right. You never hear about the thousands of things we do right, you only hear Francine and the others scream to the roof tops when something goes wrong. You know all the billions of asset impairments that have taken place over the past three years? How much of that do you think was a result of the auditors putting their foots down? Quite a bit I imagine. I know of several instances just in my office where that has happened. But you guys don’t know about it.
At the end of the day, the clients are the ones that are responsible for the financial statements, and you know what, fraud is damn hard to find when collusion is involved. It is the auditor’s responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement whether caused by error or fraud. We aren’t fraud examiners. We try to identify areas where fraud would most likely occur, but again it’s damn hard to detect. I wonder why people like Francine don’t rail on the academic world or the AICPA. How many fraud detection classes are accounting majors required to take in order to graduate? How many fraud detection classes are CPA candidates required to have passed before being eligible to sit for the CPA exam? How many fraud detection questions appear on the CPA exam?
I’m not saying that E&Y didn’t make mistakes, as they clearly did, but I still have yet to see anyone state exactly how Lehman’s financial statements were materially misstated under GAAP? I think it’s interesting how E&Y is sued before anyone at Lehman, you know the people that were responsible for the financial statements.
To Steve. It’s true that $100 million is immaterial to the firm as a whole, but I believe you did not mention the point that the fee is significantly material to the engagement partners. Without the $100 million client, the engagement partners would not able to meet the revenue goal and, the worst, if lost that client to one of the rivalry firms, they could be pushed out. That’s enough to make the partners to look the other way.
We all know how to hide behind the GAAP and GAAS, but applying it in such a ridiculous way is just stretching too far. By the way, doing some audits the right way doesn’t give auditor a license to fail. From the shareholders point of view, they chip-in $12.5 million per year to the auditor and ask for an honest opinion. What they got was to lose every single penny of their investment. Lehman’s audit report was fairly stated according to GAAP. You know what? Enron got the same statement too.
How about non-disclosure of a material accounting policy? And non-disclosure of committments?
Steve is 110% dead-on accurate.
I was waiting from Francine to come with her “cutting edge” take on the E&Y-Lehmen issue and for her clones to follow on with positive comments that only serve to pump up her ego to write more of the same.
Did she read the recent bestseller “Too Big to Fail”? This clearly shows Lehman had a lot more “issues” than Repo 105- and these issues were the real reason for the demise of that Firm – and not E&Y.
Clearly E&Y looks to have made many mistakes from the outside with 20-20 hindsight and maybe New York’s suit is justified, but the continual attacks on the Big 4 ignore the thousands of situations that occur each day as Steve describes.
If all of William Schlich’s and Hillary Hansen’s personal assets were at stake in the event of a lawsuit, would they have signed the opinion letter for Lehman Brothers? I don’t think so. And, would the government be reluctant to press criminal charges against a small firm because it might do damage to the economy. I dopn’t think so.
I am not impressed by E&Y’s defense here. Let’s make this clear. If the net leverage ratio were not important to investors, then Lehman wouldn’/t have engaged in the REPO 105 transactions. Obviously, that number was important and was always emphasized by Lehman Brothers. Lehman was repoirting that it was going down when in fafct it was going up without the REPO 105 transactions.
THe issue is not whether the REPO 105 transactions caused the firm to fail. No, they did not. But the REPO 105 transactions covered up Lehman’s problems and trend with net levrage wihich certainly contributed to Lehman’s failure.
To get off your high horse and Steve.
I’ve read ‘Too big to fail’ and I know that Repo 105 tranactions are not the main factor in the downfall of Lehman.
However, I do not think the NYAG is trying to say that these transactions, and their non-disclosure, caused the downfall of Lehman. I think what he is trying to say is that EY was paid BY the INVESTORS, to perform an audit to ensure that the Lehman financial statements were materaily correct. I fail to see how non-disclosure of $50bn of repurchase agreements can possibly have been passed over as not being material. As such EY did not do what they were paid to do. They should have forced disclosure of these transactions, and you know what, perhaps investors would have made different decisions.
Coming back to ‘too big too fail’…I find it baffling that EY have been charged before Lehman’s management. I think Dick Fuld comes off in that book as an egotistcal, arrogant man who was blind to what was going to happen. He signed off on the K’s and Q’s which appear to have been materially mis-stated. I thougth the whole point of the 302 certifications was for CEO’s and CFO’s to take greater responsibilty for what was in the financial statements.
What the profession needs to defend is the value of a certified audit. If an audit never can uncover finanicial misstatements, then the value of the entire profession is substantially dimiinihsed. So it doesn’t do the profession any good in the long term to defened audiitors who are l;etting corporate management get away with financial misstatements.
The bigger issue here is whether this is only the beginning of charges against public accounting firms from the fallout of the financial crisis. Did the firms learn the lesson of Enron and WorldCom and the resulting Sarbanes-Oxley Act? Is this “business as usual” and have the firms have reverted to their pre-SOX ways? Let’s hope not. The accounting industry may not be able to handle another round of fraud investigations of financial institutions that implicate the firms for failing to follow generally accepted auditing standards and to ensure that the financial statements adhere to generally accepted accounting principles.
I have publsihed a blog regarding EY and Lehman. You may find it in Google under Aubrey M. Farb AKA Deognes with the Green Eye Shade
This is an interesting debate.. I am not a stakeholder with E&Y in anyway so i am pretty independent. One of the things i find a bit disturbing is that Regulators try to target the party which has the deepest pockets, it is common knowledge that the Big 4 firms carry huge practice protection insurance it seems to me the idea behind suing EY is to extract money as their insurance will cover it.. secondly somewhere in this entire debate what is lost is that the primary responsibility of the management to get things right..
also one thing maybe the Big firms need to moderate is their promotional material, in their urge to project themselves what their advertising creates an aura that they know everything, they can analyse and know in advance everything, what they don’t know or can’t see will not happen or is not worth knowing.. in reality however large a firm they can only put so many people on the job (that is a client).. the partners and staff on that job are humans with finite capabilities they have access to firm knowledge but end of the day they do not have unlimited resources to devote for the audit of one client.. i have some line of site on how audits of really big companies are concluded and the biggest point the CFO of the largest companies in the world have and its very difficult to argue against is they want interpretations in line with contemporary standard.. basically if the whole industry is accounting for something in a particular way they wanna go with that. . to that extent their is some merit in EY clarification that whatever happened had a larger eco-system context to it at that time..
@ People Who Change
I like your second point a lot. The auditors have a huge disconnect between their marketing and branding and what they say in a court of law when accused. It’s called in accounting literature the “expectations gap” – the difference between what the public thinks they do and what the standards absolutely require – and they are not called out on it often enough.
On your first point, it’s a common misperception that the audit firms have insurance policies. Smaller to mid size firms do carry professional liability insurance. Their risk is so much smaller and depending on the kind of work they do and their track record, they can get some coverage. The next tier firms like Grant Thornton and BDO Seidman have some coverage but in the event of a huge loss it would not be enough. BDO Seidman had a 500+ million judgment levied against it by a jury (it was recently reversed on appeal) and they only had 50 million in insurance coverage. The rest would have to come out of partners’ pockets or they would declare bankruptcy. The Big 4 firms are self insured – pay as you go – at this point. They used to contribute jointly to a captive offshore insurance company but I’m not sure that still exists. It’s one of the great mysteries of modern business. In that case, the firms were in it together to make sure none of them ever faced a catastrophic loss. Nowadays they can pay periodic claims of up to 300-500 million each out of their pockets. When KPMG paid their big fine for their tax shelter mess, they levied each partner for their share. If any one settlement or jury verdict starts going over 1 billion, experts like Jim Peterson at the re: Balance blog have estimated that they will hit a breaking point. But we don’t know for sure since they do not publish financials or disclose their legal contingencies or reserves.
It’s annoying when people try to portray the Big 4 like “we’re the only ones with the infrastructure to do these audits,” etc, as if there is no chance anybody else could rise to the occasion. I’m sick of any industry, Big Oil, Big Banking, Big Music, Big Cellular, Big generic American grill restaurants, that has power consolidated in too few companies. Bring real competition and innovation back to the business world.
Ernst and Young: Quality in everything we do, and for everything else there’s a bailout
Deloitte: Where the best choose to use Region 10
KPMG: Think Big Tax Shelters
To People and Anonymous:
Do not be so shocked that Cuomo has decided to launch his probe first at E&Y. A good, robust defence for Fuld would be that
1. he relied on expert opinion that Lehamn Bros financial statements were materially correct, and
2. the statements were in fact materially correct.
If Cuomo (or his successor) can show in the E&Y suit that the statements were
1. materially misleading, and
2. management (including Fuld) engaged in Repo 105 transactions to cloak the true state of Lehman finances
then it will be much easier to attack Fuld and his entire team.
To my mind the major issue being overlooked by so many commentators is the lack of SEC and Administration response to continuing scandals in the financial sector. Nero fiddled while Rome burned. The Romans replaced him. Obama’s response has been as feckless as Nero’s. Right now I am not certain the Republicans would be any better than Obama, and that really bothers me.
Not sure that insurance coverage is really the major issue for smaller firms. What percentage of losses did AA cover when the Enron, Worldcom, Qwest and Global Crossing scandals hit AA in 2001? The plaintiffs got almost nothing from AA. What did the plaintiffs get from the New Century auditors?
Lets say that I inadvertently revealed to you how much insurance the Big 4 carry and trust me when I say that they have much deeper pockets than anything you imagine, after Enron all the BIg 4 firms carried out internal stress tests and the number at which they are insured at the network level secures all scenario’s that came up… this is also the real USP they now have which helps them stand-out from BDO & GT and their lot.
As regards Partners equity call to pay for the tax shelter mess that is kind of a own pay standard these firm have adopted as the firms use one common brand name across territories it often gives an external façade of one common economic interest. In practice most of the firms are not economicly integrated therefore if a loss can be localised to a particular country (territory) and the Partners of that territory are financially able to meet the costs they have to contribute.. the firm will dip into the practice protection they carry at the network level as a last resort. This is pretty much like the excess of loss reinsurance treaties common on the Lloyds market and help keep the annual premium at a reasonable level in the context scale of protection they carry..
I have to agree with Steve @10 and disagree significantly with Francine @ 7. I used to work in public accounting as a sr manager and like Steve, I never went to work thinking about ways I could jump in bed with my client and let them get away with something. It doesn’t happen. Well if it doesn’t happen, you ask, how do these situations that require bailouts occur? If I recall correctly, the audit opinion indicates whether the accounting firm believes the financial statements are fairly stated, in accordance with GAAP. An audit opinion does not ask the auditor to predict the perfomance of derivatives. There are level 3 financial disclosures in the financial statements. That would be enough to let the investor know how much illiquid junk a company has in its portfolio. As for Repo 105, this window dressing stinks, to be sure, but it is unlikely that it contravenes GAAP and it is on this point that E&Y would win their case.
As to Francine @7, there is not a distinction between fighting lawsuits and training for audit quality. One has nothing to do with the other. Each firm is so significantly reserved for litigation that even a big suit like this won’t hurt E&Y financially. They’ve already provided for it, no doubt.
I think I read here also that accountants don’t like to make decisions and don’t find fraud. Regarding fraud, it’s a no win situation for the accountants. If they find it, they’re asked why didn’t they find it earlier. No one wants to find fraud because the auditor will get wrapped up in the mess. It’s ugly. As for not making valuation decisions, have you read FAS 133/157/159? These rules are too complex. If the rule was easy then everyone could agree on its application. Problem is that there are so many interpretations of the same rules and they attempt to cover so many different things, that even the smartest minds will come to different conclusions. That’s why the accountants won’t give you a straight answer. It’s impossible to do so.
@ People who change
I don’t doubt the firms have deep pockets. I saw it myself. However, time and money spent on litigation defense take away from other things like investing in people, quality and things that are good for the public interest versus their own partners’ interest. There’s a limit. Some have tried to estimate what it might be for any one firm or at any one time. What’s bad is that the firms cry poor as an argument for liability caps and as an excuse for layoffs and other cutbacks made in order to preserve partner payouts. It’s short term thinking, inconsistent, and not good for public company shareholders and the overall financial system in the long term. And they’re not willing to open up the books to prove their claims.
Added later: I found this link in another summary of the EY case regarding Lehman. http://law.marquette.edu/facultyblog/2010/12/23/best-of-the-blogs-the-ernst-young-case/
Professor Cunningham has written extensively about the use of the captive insurance model by the Big 4. See his comment after the post for references to academic papers on the subject.
Francine, You are dead on with respect to what is going on in the Accounting world. I know because i was a Partner at one of the Big 4 for almost 20 years. Some Partners on engagements will do what ever is necessary to retain a client, as it does materially impact their compensation. This is obviously not all Partners, but certain ones that are driven by greed. There are many practices at the Big 4 that bother me. I will provide one example of a recent situation that i have witnessed. The Audit Firms Tax Partners are brought into to perform a tax provision review, very typical. The Tax Partner will say i will get my fees out of the client through: (1) being hard on the tax provision review process, or (2) the client can find another project for me to work on and I will tax it easy on the tax provision review process. I have heard this story from clients time and time again. And the clients give in!!! Because it makes their job easier and less personal exposure. Amazing!! Is this what we should expect from Independent Audit Firms?
Francine @27 – are you for real? Why would a partnership where the partners invest their own money and take their own risk not put their interests first? Of course the Big 4 want to preserve partner payouts – it’s thier capital!!! However, you are missing the link here. If the firms don’t do the right thing in the short term, then long term partner payouts will inevitably suffer. I’m a longtime reader of this blog and of going concern.com and it amazes me that the majority of commenters on here rail against the partners who want to make money. OF COURSE THEY DO!!!! The Big 4 aren’t in business as a charity case – they are not only trying to make money for their partners, they are trying to maximize it – just like any other business!! And lastly, no private enterprise is required to open up their books to prove their claims; the Big 4 don’t have to do this and they shouldn’t. They are private companies that happen to serve the public interest. If you want them to open their books, then allow them to become public and try to maximize profits for shareholder value instead of partner capital. Or maybe in your fantasy world, maybe the government should just take them over. That would guarantee perfect audits because we all know that the government does everything better, cheaper and more efficiently than the private sector.
Your excuses and “arguments” are the SOS. And I have responded to them and written about the problems with them over and over. There are 900+ posts here. Here’s one to start with:
“They are private companies that happen to serve the public interest.” No, the audit firms are in business solely to serve the public interest and they have a government sponsored franchise to do so that protects their oligopolistic business model. So… To what extent under this model is their capital really at risk? Arthur Andersen was thought at that time to be an extreme case and the government indicted them without understanding the implications. The audit failures and unethical/illegal behavior of the firms since then dwarf what Andersen had done, even if you count everything not just Enron. Now that the governments do understand the disruption that an indictment would cause, and they never planned for its necessity to enforce the rule of law and provide sufficient deterrence, the audit firms have moral hazard – that is, they are allowed to operate under the assumption that legal settlements and SEC sanctions are a cost of doing business but will have no life or death consequences like any other “private company”. They make a cost benefit calculation – more quality, less fraud equals smaller partner payouts. In any other private business they would be subject to the legal consequences of their actions or inaction. Under the current model they rarely are.
Actually, I would be in favor of at least separating audit services from the rest of the business and paying them indirectly via a regulator not directly by the clients. They are a utility for the benefit of investors. With regard to tax, consulting and other advisory services they can go wild. But when it comes to any kind of assurances for financial statements, the current model is broken. Even better, there may eventually be other ways to provide assurance to investors without the audit firm middleman via technologies such as XBRL where information can be verified at the data element level and then investors can slice or dice it as they need to for their own analysis.
Francine, well lets start with some candid admissions..the Assurance business is a terribly boring business to be only a small fraction of the total graduating population from undergraduate schools really wants to spend the best years of their life at looking at historical data than to be forward looking in building some thing new, for good audits you need Cumulative Audit Knowledge & Experience (ÇAKE’) so for the business to be sustainable it requires the partnership carrot, this is the real reason the firms are so protective about Partner payouts/salaries.
In the professional services space in the US typically all the BIG 4 Partners, I know want to benchmark there compensation with Partners in White Shoe law firms and in that context they are unable to understand what all this fuss is about, why people want so much information about what the Income & expenses of the firm are, on a ball park on an assurance revenue of US$10bn a BIG four firm after accounting for all expenses but before Partner salaries/payout would make a surplus
of US$2.5 bn this is kind of par for many industries. The most successful software companies have similarly profitability it is arguable that all large industry leaders because factors of scale are oligopoly for eg we cannot overnite stop using Microsoft word of windows and government promotes the use of Windows or word by buying it for the schools and offices it runs. For that matter you could know all the law in the world but still will not be allowed to argue in a Court of law unless you are the member of State Bar (another oligopolistic club).
As regards whether machines have reached a point where they could audit. Machines can look at transactions, but cannot make human judgement on sound application of accounting policies. The X factor the firms bring into Assurance is Professional judgement. You make the suggestion that it may help if a regulator was to select auditors and pay them in theory it looks like a great idea but it has been applied in some countries for e.g in many BRIC countries Auditors of Banks and other Government owned companies are appointed by a regulator who also determines the scale of remuneration of the Auditor. The Empirical evidence whatever is available of the operation of such a system is that overtime the firms spend more time in sucking up to the regulator and constant lobbying for reappointments to audits than really servicing client needs, one reason why this happens is that firms have people sitting on the bench who are being paid salaries if you loose large audits because the regulator rotated you out of one big company but did not give you an alternatively large company immediately as a firm you would be stuck with a payroll cost which will kill you.. the other issue which revolves around operation of such a system is that the audit reports which come out of such audits are replete with unlimited qualifications.. as the auditors slowly becomes more and more defensive and tries to win the respect of the regulator by coming out with a laundry list of qualifications many of them irrelevant or immaterial or demonstrate a clear lack of application of relevant industry knowledge..
Such a system in my view would be pretty un-American, you wrote about the Expectation Gap yesterday, I am reminded of this famous British case where a learned judge held that Auditors are the watchdogs of management (shareholders) not blood hounds.. increasingly it seems to me that idiom is lost in our expectations when we look at any business failure and associated failure of the auditor to post red flags…
All the business abuse that we have encountered over the years are largely attributed to the concentration of power in the hands of a few. E&Y, like the other Big 3, takes risks because the rewards ($$$) are great and there is a sense of confidence in these firms abilities to buy themselves out of any and all problems. It would not be bothersome to me if E&Y followed Andersen’s demise. Let’s break up these big monopoly’s and bring back fair competition. Great article, Francine.
As an individual person you would be charged with a crime if you stood in the room and watched while someone killed somebody else. Ernst & Young stood in the room and watched while Lehman Brothers killed their financial statements (with Repo 105 and a lot of other slight-of-hand). EY’s action’s are criminal, they deserve whatever the NY Attorney General can dish out (which at this point is NOT criminal charges). EY deserves to go down a la Arthur Andersen. Boo-hoo that the industry can’t handle the pressure/the consolidation into Big3/that there’s no viable alternative infrastructure to providing audit assurance for financial statements. Maybe after the entire Big4 is decimated, then the world will understand what those of us inside the Big4 already know — that an audit opinion on financial statements is worthless. I welcome the Big4 going down. The SEC, Treasury, FASB and the whole lot need to rethink the equation; an entirely new approach is needed that doesn’t include Big4 firms.