Ernst & Young May Face Fraud Charges in the Lehman Debacle

Lehman Brothers
Lehman Brothers

Accounting giant Ernst & Young is expected to face civil fraud charges by New York prosecutors over its alleged role in the spectacular collapse of Lehman Brothers, according to a Wall Street Journalreport. The lawsuit could come as early as this week and would mark the first time a Big Four accounting firm has been charged in regard to the financial crisis.

But for some it may come as no surprise that prosecutors are targeting Ernst & Young. In fact, it may have seemed inevitable.

Earlier this year, DailyFinance explained that a Lehman Brothers bankruptcy examiner report outlining Lehman's use of a financial maneuver called repurchase agreements, or "Repo 105," to artificially dress up its financial quarterly reports was a "roadmap" to such charges. The bankruptcy examiner also alleged that Ernst & Young engaged in professional malpractice and negligence by failing to discount the use of Lehman's Repo 105 and for failing to handle a whistleblower complaint about its use from a senior Lehman vice president. Ernst & Young allegedly dropped the ball and never reported the whistleblower's allegations to Lehman's audit committee.

An Illusory Financial Improvement

New York prosecutors apparently picked up where the bankruptcy examiner left off and delved deeper into the Lehman and Ernst & Young relationship. The investment bank reportedly used Repo 105 between 2001 through 2008 -- a time when Ernst & Young collected roughly $100 million in auditing fees, according to the Journal report. Lehman's bankruptcy racked up a historic $639 billion in assets.

Under Repo 105, Lehman would borrow cash for a short period, such as a week, and use the funds to temporarily pay off a portion of its liabilities. The investment bank characterized these transactions as securities sales rather than loans, according to the examiner's report, even though the transactions didn't quality for sales and Lehman's liabilities weren't truly going down.

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This maneuver had the affect of artificially lowering Lehman's reported debt at the end of the quarter and making the investment bank appear to be in better financial standing without cluing investors into the reason why. Ernst & Young didn't provide investors with any guidance, either. Between 2001 to 2007, the accounting behemoth issued an all-is-well audit opinion for Lehman, one of its largest clients.

In addition to Ernst & Young and Lehman Brothers, New York Attorney General Andrew Cuomo (and governor-elect) is reportedly looking at other institutions and their debt removal prior to a quarter's close and whether the results misled investors, according to the Journal.

The Ernst & Young-Lehman entanglement could add fuel to the debate of whether an independent government agency should be created to generate Corporate America's financial reports, rather than leaving it up to company executives who, in essence, write their own report cards.