“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.”
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Fraud Experts: Calls for Criminal Charges Against Ernst & Young Are ‘Absurd’
Since Andrew Cuomo decided to make our lives insanely busy this week, we’ve been talking to lots of different people about what will happen next in the Ernst & Young saga. We stumbled across a couple of experts, Dr. Mark Zimbelman an Accounting Professor who specializes in fraud, forensic accounting and auditors’ detection of fraud at BYU’s Marriott School of Business, along with his son, Aaron Zimbelman, a doctoral student at the University of Illinois at Urbana-Champaign whose research interests include auditing, financial statement fraud and corporate governance.
The father and son team have a blog, Fraudbytes, that discusses, well< arious forms including a post from yesterday about this week’s developments.
We corresponded with the Zimbelmans by email for this interview. They have combined their positions to provide us with the answers to our questions.
Going Concern: Does E&Y risk losing creditability with the market at large (á la Andersen) because of these civil fraud charges?
Zimbelmans: We don’t think this case will hurt E&Y’s credibility, based on what we know at this point. Lehman’s accounting for Repo 105 transactions was in accordance with GAAP and appears to have been a common practice for similar transactions in the industry. In other words, E&Y was probably following the letter of the law in signing the audit opinion. In Andersen’s case, the firm had shredded documents and faced criminal charges. Until we see a clearer act of wrongdoing (e.g. a clear departure from auditing standards), we don’t see E&Y individually facing a significant loss of credibility. More likely, the auditing and accounting profession as a whole will take a credibility hit as individuals question the standards and industry norms adhered to by E&Y in auditing Lehman.
GC: Reports say that E&Y is in talks to settle – how do you interpret their willingness to settle rather than litigate in this matter?
MZ/AZ: We think a willingness to settle speaks mostly to the great deal of uncertainty associated with the litigation process in auditing cases. Jury trials in cases like these can be very unpredictable and may not be strongly related to whether or not E&Y actually did anything wrong. Juries tend to have a poor understanding of auditing and accounting issues and also tend to side with victims and against deep pockets. In this case in particular, were the case to go to trial, E&Y has a good chance to become a scapegoat for the collapse of Lehman and perhaps even the economic crisis as a whole. Even if the probability of a verdict against E&Y were fairly low, the damages assigned by a runaway jury could be devastating. This gives E&Y a strong incentive to settle, regardless of whether or not they did anything wrong.
GC: Is there any advantage to litigating?
MZ/AZ: If the requested settlement amount would be devastating to E&Y, the firm is better off litigating. The firm may also be better off litigating if the requested settlement amount is high and E&Y feels they have a very solid case that has a good chance at overcoming the common jury biases we discussed in the previous question.
GC: How would you react to those who feel that are calling for criminal charges against the firm?
MZ/AZ: We don’t really see any criminal behavior here–E&Y allowed Lehman to account for Repo 105 in accordance with GAAP and in accordance with what was fairly standard in the industry. Until we see evidence of potentially criminal behavior, calls for criminal charges seem absurd.
GC: Prediction time: what happens next? Fine of $X and….?
MZ/AZ: We doubt there are any criminal issues here. E&Y will likely try to settle as quickly as possible to get this behind them. Cuomo is likely to want a huge settlement because of the magnitude of the bankruptcy and because of the potential for a runaway jury. Given that Lehman’s bankruptcy was $691 billion, this settlement could easily exceed E&Y’s Cendant settlements which were over $600 million.