Making Sense of the Ernst & Young Defense

Over at Bloomberg, Jonathan Weil (who has the tendency to let the dust settle before chiming in) takes Ernst & Young to task for their lack of willingness to take responsibility for the Lehman Brothers bankruptcy and digs up a bunch of old bodies in the process.

E&Y had established itself as a repeat offender long before Governor-Elect Cuomo filed his suit. In recent years we’ve seen four former E&Y partners sentenced to prison for selling illegal tax shelters, while other partners have been disciplined by the SEC for blessing fraudulent financial statements at a variety of companies, including Cendant Corp. and Bally Total Fitness Holding Corp.

In the Bally case, E&Y last year paid an $8.5 million fine, without admitting or denying the SEC’s professional-misconduct claims. The SEC also has imposed sanctions against E&Y three times since 2004 for violating its auditor-independence rules.

After that friendly reminder (which certainly makes some people wince), JW takes a look at the E&Y’s response to the suit, specifically the part where they more or less say that Cuomo is off his rocker, “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).”

Weil says E&Y is missing the point entirely:

That isn’t an accurate depiction of the claims Cuomo brought, though. Cuomo’s suit unambiguously took the position that Lehman violated GAAP. What’s more, it’s not credible for E&Y to say that Lehman didn’t. (An E&Y spokesman, Charles Perkins, said he “can’t comment beyond our statement.”)

In the footnotes to its audited financial statements, Lehman said it accounted for all its repurchase agreements as financings. This was false, because Lehman accounted for its Repo 105 transactions as sales, a point the Valukas report chronicled in exhaustive detail.

The question is, of course, if this all adds up to fraud on E&Y’s part. Cuomo says it does. Weil says that E&Y needs to come up with a better story. Colin Barr, on the other hand, writes that E&Y could easily turn the tables:

The Ernst & Young statement suggests the firm will argue that it can’t be prosecuted under the Martin Act because Lehman, not E&Y, was the outfit actually producing the financial reports, and because it was Lehman, not E&Y, that was peddling billions of dollars of securities just months before its implosion.

In this view, E&Y was just a gatekeeper hired to vouch for Lehman’s books, something it will claim it did well within the confines of the law. This strikes lawyers who are familiar with the law as an eminently reasonable approach, if not exactly a surefire recipe for success.

“If I were Ernst & Young, I would assert I was not a primary actor,” said Margaret Bancroft, a partner at Dechert LLP and author of a 2004 memo that explained the Martin Act soon after Spitzer began brandishing it against Wall Street. “You can say that with more than a straight face.”

“Just gatekeepers,” and not “fraudsters,” is obviously the preferred view but the catch is, E&Y would be admitting that they are really shitty gatekeepers.