It's On: E&Y Fires Back, Says It Was All Lehman Management's Fault

The silence out of E&Y over the past two weeks was very odd. Some speculated that just like corrupt Arthur Anderson, a disgraced E&Y was quietly folding its business now that the "independent auditor" is one only in name. Others believed that its was merely a smart media ploy to not touch the issue until everyone gets tired of discussing the endless criminality in our daily lives and be content with late night TV, as the middle class fights for whatever remaining scraps the Goldman bankers allow it to have, even as the kleptocracy knows all too well that behind the scenes, trillions of dollars are siphoned away from America's working class (because in ten years when the country is bankrupt, the only thing that matters is who has the biggest gun and can shoot the straightest). Anyway, E&Y surprised us all (and the holders of 5 Times Square paper: CMBX 4 deal WBCMT 07-C31 specifically, who were ecstatic they would be next in line for taxpayer bailouts) by releasing the following list of rebuttals on a point by point basis, first reported by our friends at re:The Auditors and followed up by Reuters.

As Reuters reports, E&Y is scrambling to salvage whatever it can of not only its evaporating reputation but more importantly, its client base:

Some Ernst & Young partners have sent letters to audit committee members at the firm's clients over the past few days, defending their firm's audit of Lehman and how it dealt with a whistleblower's letter about the bank's accounting policies, according to Ernst & Young spokesman Charlie Perkins.
According to a copy of the letter [ID:nN22210897], the audit firm said it believes it "will prevail" if any of the examiner's potential claims against the firm are pursued by Lehman or its creditors and said some recent media coverage of the firm's role, such as the firm's use of "sham transactions" to hide bad assets, has been "inaccurate."
"The months leading up to Lehman's bankruptcy were among the most turbulent periods in our economic history," the accounting firm said in the letter.
"Lehman's bankruptcy was caused by a collapse in its liquidity, which was in turn caused by declining asset values and loss of market confidence in Lehman. It was not caused by accounting issues or disclosure issues."

Hm, one sure could argue that the reason why market confidence in Lehman evaporated overnight is because the market found out just how cooked Lehman's books had been all along, for which the party responsible was... you guessed it... Ernst & Young, and specifically "overstressed" auditor and feminist extraordinaire, Hilary Hansen, whom we profiled previously. Either way, this is one claim that the prosecution will spend exactly 10 minutes on. And speaking of, where are those class action lawsuits already?

The E&Y self-defense-cum-immolation continues:

According to the examiner's report, Matthew Lee, a senior vice president in charge of global balance sheet and legal entity accounting at Lehman, wrote to senior managers, raising concerns about "accounting improprieties" at the firm.
The whistleblower letter did not mention the Repo 105 transactions questioned by Lehman's examiner for their use in temporarily shifting some $50 billion of assets off of Lehman's balance sheet, but rather Lee brought them up in a subsequent interview with Ernst & Young auditors.
"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 and 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," Ernst & Young said in the letter.
"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."

More fluff. Yet where it gets interesting is where E&Y will likely redirect in the imminent flurry of lawsuits against the auditor: Lehman's very own management.

Offering a preview of Ernst & Young's potential legal defenses, the firm also said that Lehman's senior executives "did not advise" Ernst & Young about any reservations they had related to Repo 105 transactions, and that regardless of any potential claims it does not believe that Repo 105 brought down Lehman.
"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,"
Ernst & Young wrote. "Lehman's Repo 105 transaction volumes were comparable at the end of its first and second quarters."

While the plaintiff bar will be busy, and E&Y will be defending, one wonders what is the point? After E&Y is dragged through the mud, it will have no financial practice left, and potentially the entire business will be decimated as a result of what is sure to be extensive law suits, with the firm's name appearing on the front pages of all newspapers for months and months. In a business where integrity is everything, and defense is an indication the battle has already been lost, E&Y is over. But from denial to acceptance there are millions of fees in legal fees to be spent, and lawyers are people and need to eat and ride in private jets, just like all of us.

And ultimately, all of this is merely a distraction from the truly guilty party in this case: the Federal Reserve Bank of New York.

Full excerpts from the E&Y letter.

General Comments:

-- EY's last audit was for the year ended November 30, 2007. Our opinion stated that Lehman's financial statements for 2007 were fairly presented in accordance with U.S. GAAP, and we remain of that view. We reviewed but did not audit the interim periods for Lehman's first and second quarters of fiscal 2008.

-- Lehman's bankruptcy was the result of a series of unprecedented adverse events in the financial markets. The months leading up to Lehman's bankruptcy were among the most turbulent periods in our economic history. Lehman's bankruptcy was caused by a collapse in its liquidity, which was in turn caused by declining asset values and loss of market confidence in Lehman. It was not caused by accounting issues or disclosure issues.

-- The Examiner identified no potential claims that the assets and liabilities reported on Lehman's financial statements (approximately $691 billion and $669 billion respectively, at November 30, 2007) were improperly valued or accounted for incorrectly.

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.

-- 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. 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.

-- 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.

-- 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.

-- 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.

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 and 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.

--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.

-- 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.

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