$99 Million Buys EY Ticket Out Of Private Lehman Litigation, Finally

Last defendant standing. Not an enviable place for EY in the case, In re Lehman Brothers Securities and Erisa Litigation.

Everyone else had folded their tent, paid the price to cross this dog off the list. Lehman underwriters agreed in 2011 to a $426.2 million settlement. UBS, one of the underwriters, held out and settled last August for another $120 million. Even before the UBS and EY settlements, Bernstein Litowitz Berger & Grossmann, attorneys for the plaintiffs, claimed the combined recovery of $516,218,000 is the third largest recovery to date in a case arising from the financial crisis.

The $99 million EY will pay is more than Lehman’s officers and directors, who settled for $90 million. That’s a big deal considering the executives typically say, “The auditors said it was ok,” and the auditors say, “Management duped us.” But it’s not that much considering that EY agreed to pay C$117 million ($117.6 million) last December to settle claims in a Canadian class action suit against Sino-Forest Corp, a Chinese reverse merger fraud. That settlement is the largest by an auditor in Canadian history, according to the the law firms.

And it’s not as much as some thought EY would pay for Lehman. In fact, many thought Lehman would finish off EY for good.

John Carney, now of CNBC, writing for Business Insider at the time:

“The Examiner concludes that sufficient evidence exists to support colorable  claims against Ernst & Young LLP (“Ernst & Young”) 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.”

That may not sound like a mortal threat against Ernst & Young. But the damages here could be enormous. A successful lawsuit against E&Y could result in a court finding that the failure to properly advise the audit committee prevented Lehman from taking genuine steps to substantially reduce its leverage, which may have saved the firm from bankruptcy. Which is to say, E&Y could find itself blamed for all the losses to Lehman shareholders. That would be a stretch—such a claim would be speculative—but it still should be scaring the heck out of the partners.

When the bankruptcy examiner’s report on Enron came out, the language about Arthur Andersen was quite mild. It merely noted there was “sufficient evidence from which a fact-finder could conclude that Andersen: (1) committed professional negligence in the rendering of accounting services to Enron…” It went on to note that Andersen likely had a strong defense against liability since so many Enron executives were implicated.

“Enron brought down Arthur Andersen,” Felix Salmon notes. “Will Lehman do the same for E&Y?”

In July of 2011, New York Federal Court Judge Lewis Kaplan decided to allow substantially all of the allegations against Lehman executives and at least one of the allegations against Ernst & Young to move forward to discovery and trial. One month later Lehman Brothers executives, including its former chief executive Richard S. Fuld Jr., agreed to pay $90 million to settle. Insurance proceeds paid for their settlement.

What was the remaining allegation against Ernst & Young? That the auditor had reason to know Lehman’s 2Q 2008 financial statements could be materially misstated because of the extensive use of Repo 105 transactions.

How could EY know this? Here’s what the report from the Lehman Bankruptcy Examiner, Anton Valukas, says:

Lehman’s own Corporate Audit group led by Beth Rudofker, together with Ernst & Young, investigated allegations about balance sheet substantiation problems made in a May 16, 2008 “whistleblower” letter sent to senior management by Matthew Lee. On June 12, 2008, during the investigation, Lee informed Ernst & Young about Lehman’s use of $50 billion of Repo 105 transactions in the second quarter of 2008. At a June 13, 2008 meeting, Ernst & Young failed to disclose that allegation to the Board’s Audit Committee. (Bankruptcy Examiner’s Report V3 page 945)

What did EY do wrong here? I explained it in March of 2010 after the examiner’s report was published:

The Audit Committee asks EY to support Lehman’s internal auditor in investigating a “whistleblower’s” allegations of balance sheet improprieties.  The auditors interview the “whistleblower” and then don’t say anything at any of the Audit Committee meetings. Turns out what Mr. Lee, the “whistleblower”, was alleging is what the examiner believes is the fundamental problem and grounds for “colorable claims” against top officers and EY.

The word “whistleblower” is tainted with tons of emotion post-Enron. We now look at those called “whistleblowers” and see heroes. But let’s look at what I think may have actually happened. Lehman’s Internal Audit department “naturally” asked their trusted, all-things-to-all-people advisor, EY, to help with the investigation of the “whistleblower’s” claims. The Internal Audit Department, not EY, was in charge of the investigation.

That was their first mistake. If I’ve said it once, I’ve said it a thousand times: The external auditor should not be conducting or assisting with internal investigations of potential fraud or illegal acts by top executives. I wrote about it at Siemens, subject of the largest ever FCPA settlement in history. KPMG, their auditor, got sued.

The external auditor should stay the hell away from internal investigations because they may get caught up in something they would rather not know. They may want to claim plausible deniability. And a company should not engage the external auditor to support internal investigations especially involving fraud or illegal acts by top management. Do they do it to be cheap or to keep dirty laundry inside? The external auditor is too often part of the problem, an enabler, instead of part of the solution.

If Lehman had hired another firm – a law firm or anyone except their external auditor – to perform the investigation, the investigation would have been covered end to end in privilege, the external auditor may or may not (in this case EY would have been better not to) have been included in the “circle of privilege,”  and the investigation would have been completed professionally.

However, by supporting this investigation, EY was essentially doing internal audit work, a prohibited service under Sarbanes-Oxley for independence reasons. It’s shocking to me that the EY audit partners did not at least turn over the investigation to EY’s Forensic Accounting and Investigations Practice in order to provide some semblance of independence and professionalism.

Even though EY may have been an unwilling party to knowledge of an ugly situation right before an audit committee meeting, they got stuck. They had an obligation under AU 380, as the external auditor  – not as an investigator – to inform the Audit Committee. They could have been on the other side being informed – or not – instead of being the one supposed to be doing the informing.

AU 380, the  rules for auditor communication with the Audit Committee, are very clear. But they relate to the auditors’ role as an auditor not the role  of an auditor who is lent as muscle to an internal investigation. By playing the “trusted advisor” they screwed themselves.

Making it worse for EY was its auditor reviews of the Qs were in written form and included in the filings to the SEC. That is standard practice for investment banks, but not so much everywhere else. Why? A physical report of the auditor’s Q review adds additional potential liability for auditors when things go wrong.

I explained it in March 2010:

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.

Looks like the Q report of the review was the hook that cost EY $99 million. Attorney for the plaintiffs David Stickney of BLBG told me in an interview Friday that, “The parties reached an agreement after discovery and after having obtained a firm grasp on the strength of each others’ cases and the risks associated with their respective positions.”

That’s a nice way of saying EY knew the plaintiffs had the goods on the firm.

Michael Rapoport, in his story in the Wall Street Journal on the settlement, reminds us that EY still faces one more hurdle—assuming you believe the SEC and DOJ will never charge the firm or its partners—before putting Lehman behind it. The New York Attorney General’s office made similar fraud  allegations against Ernst in a lawsuit filed in 2010.

That suit is still pending. Will this private settlement affect the NYAG’s case?

I wrote in Forbes in December of 2012:

Justice Jeffrey Oing said the New York Attorney General cannot claim $150 million in fees that Ernst & Young earned from Lehman Brothers Holdings from 2001-2008, when the firm filed bankruptcy.

Attorney David Ellenhorn of the NYAG claimed the fees represented “disgorgement” of “ill gotten gains” since the Attorney General says Ernst & Young repeatedly committed “fraudulent acts” as auditor of Lehman Brothers all those years. When Ellenhorn tried to explain this to the judge, Oing told Ellenhorn he had the wrong remedy.

Rapoport quotes a spokeswoman for New York Attorney General Eric Schneiderman: “We have no intention of dropping our case” in the wake of the settlement.

The New York Attorney General can still pursue its request that Ernst & Young “pay restitution, disgorgement and damages caused, directly or indirectly, by the fraudulent and deceptive acts and repeated fraudulent acts and persistent illegality complained of herein plus applicable pre-judgment interest.” David Ellenhorn, the attorney representing the Attorney General’s office, was not very sanguine about his case last December. He worried aloud to the judge, according to Reuters, that the private class action litigation still facing Ernst & Young over Lehman would beat him to the punch in claiming compensation for investor losses.

It did. Your move, Mr. Schneiderman.

Funny aside…  Reuters initially published a story about the settlement Friday by Nick Brown with this opening or lede:

NEW YORK | Fri Oct 18, 2013 5:18pm EDT

Oct 18 (Reuters) – Former Lehman Brothers investors have reached a $99 million settlement with Ernst & Young, the defunct financial firm’s erstwhile auditor, over allegations it helped Lehman misstate its financial records.

Lawyers for Ernst and Young, “did not immediately respond to a request for comment.”

By 6:24pm on Friday the lede had changed, Ernst & Young had given a comment, and the “erstwhile” reference had been deleted.

EY is still in denial in spite of becoming $99 million poorer:

Ernst & Young said it denied all liability, settling the case “to put this matter behind us.”

“Lehman’s audited financial statements clearly portrayed Lehman as what it was – a highly leveraged entity operating in a risky and volatile industry; and Lehman’s bankruptcy was not caused by any accounting issues,” Ernst & Young said in a statement.

I guess Ernst & Young, or whoever objected to the word, doesn’t know “erstwhile” just means “former”. That’s a fact that can not be denied.

The case is In re Lehman Brothers Securities and Erisa Litigation, 09-md-02017, U.S. District Court, Southern District of New York (Manhattan).