As the FT reports:
New York prosecutors accused Ernst & Young of helping Lehman Brothers engage in a “massive accounting fraud” by approving a move that temporarily reduced the investment bank’s debt and gave investors an impression it was in a stronger financial condition.
The civil lawsuit, filed in a New York state court, alleges the auditing firm “substantially” helped Lehman mislead investors from 2001 until the brokerage firm’s 2008 bankruptcy filing by signing off on the accounting sleight of hand.
The strongly worded lawsuit goes further than accusing Ernst & Young of misconduct. It alleges Lehman engaged in a “massive accounting fraud” by using the accounting treatment, known as Repo 105.
The form v substance debate rolls on — and is, of course, reflected in much of the tax debate as well.
The form of these transactions was compliant, I presume to E & Y’s satisfaction, with regulation.
The suggestion is the substance was not. And I think we can have little doubt, considering the language used, that motive was the key factor here. Fraud can be defined as “an intentional deception made for personal gain or to damage another individual”. Note intent is key. I think so much resolves on this in so many situations. The prosecutors will, of course, have to show this intent. If they do the form will not matter much: the substance will prevail and in that case E & Y will be in trouble. If they can’t show intent then E & Y are in the clear in all likelihood.
But right now the message to the profession could not be clearer: substance matters. That has to be the message.
PS For more on this read Francine McKenna's summary
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For 17 years Bernard Madoffs 65 billion dollar Ponzi fraud relied on David Friehling, sole practitioner in Friehling & Horowitz, to audit its “accounts”. Three months after his confession and arrest, Madoff pleaded guilty to his crime but claimed no one else was responsible and he had done it all by himself!
In February 2001, accounting company Arthur Andersen gave its official seal of approval to Enron’s annual report. Although hedged about with much legal jargon, the auditors’ statement was clear: the energy firm’s accounts presented “fairly, in all material aspects, the financial position of Enron Corp and subsidiaries.”
Nine months later, Enron admitted that its accounts for that year, and for the three previous years, had been more or less fictional …
Can anyone really trust an auditor?
A couple of observations:
– this is a civil lawsuit, and not criminal charges. This means that the prosecution’s case is extremely weak (in fact probably non-existent). Remember the SEC’s lawsuit against Goldman earlier this year over its CDO business; Goldman settled without admitting any wrongdoing and for an amount well short of the cost (not even the potential penalty) of a criminal defence. This E&Y case will never see the inside of a courtroom.
– the entire Repo 105’s were executed in London. Because Lehamn could not get a proper Wall Street law firm to opine that these transactions consituted “true sales”, it had to obtain a legal opinion from a second-tier law firm in London with a limited US profile, Linklaters. Linklaters has in the meantime earned about one hundred miilion Dollars the UK bankruptcy administrator of Lehman Brothers’ European broker-dealer businesses (PWC).
Do I detect a conflict of interest here? Am I the only one thinking that some Limklaters partners will have a stressful hoilday period?
If you read Francine’s latest post, it sounds like scienter / intent may not be required for the NY AG to prove his case under the Martin Act.
I’m no legal expert, but if that is correct, it seems like EY will have a tough time defending this one.