Ernst and Young Found Negligent in Lehman Report, Tough Consequences


There"s been so much press on the recently released report on the spectacular failure of Lehman Brothers by Anton Valukas, so we"ll just focus on the key elements which involve Lehman"s auditor Ernst & Young.

Valukas is highly critical of E&Y"s work, claiming that they did not perform the due diligence needed by audit firms, the ultimate watchdog of investors" interests. He believes there is a case of negligence and professional malpractice against the firm. Though in a very limited sense Lehman perhaps followed standard accounting principles, and this is the basis on which E&Y signed off on their annual and quarterly filings, they wrongly categorized a repo as a sale to knowingly report a lower leverage ratio, they exceeded internal limits on the infamous Repo 105, and they found a loophole in the British system to execute these transactions, and keep them off the public eye.

Lehman was clearly at fault and grossly fraudulent in hiding this from investors, and then obfuscating answers to clear questions from analysts. Is Ernst and Young equally culpable?

E&Y should have been more rigorous in pursuing this issue, knowing that it was material, being misrepresented and highly abused. With full knowledge of its usage, and then signing off on SEC documents is definitely negligent.

E&Y is now being investigated by the FRC in the UK and very likely in due course by the SEC. The Saudi government has already cancelled E&Y"s security license in the kingdom. The law suits are yet to hit the wires, but they are coming. The key is whether a criminal indictment of the firm is likely, recall that this is what brought down Andersen. Dealing with civil suits is only a matter of money, but a criminal charge is going to send clients away in droves. The critical question is whether the industry can withstand the loss of a $20 billion accounting giant, the consequences of a Big Three are quite hard to imagine.

E&Y was recently hit with a $8.5 million fine by the SEC for its involvement with Bally Fitness, and in that settlement E&Y agreed to tighten internal procedures and refrain from audit abuse. So the SEC is unlikely to look favorably on this.

The next few days will reveal how the regulators, erstwhile shareholders of Lehman and other stakeholders will move against E&Y. Valukas" statement that there is sufficient evidence to show that E&Y was negligent is enough to spur a whole host of law suits.

E&Y is in a very tough spot now, and while it may escape an imploding collapse like Andersen, the long tail of Lehman is sure to create a strong whiplash with painful monetary, reputational and punitive consequences.