Analysis: Ernst faces risks in fighting Lehman lawsuit

By Dena Aubin

NEW YORK (BestGrowthStock) – Ernst & Young could feel the ramifications for years of a fraud lawsuit contending it played a role in Lehman Brothers’ collapse, because a potential damage award or large legal settlement could raise its costs of doing business, accounting experts say.

The third-biggest global auditor said on Thursday that clients were sticking by it. It says it acted properly as Lehman’s outside auditor and it intends to defend itself vigorously against the civil fraud case brought this week by New York’s attorney general.

Accounting experts say that if Ernst & Young is forced to pay penalties — or if it strikes a large settlement to resolve the charges — the firm could take a hit to its balance sheet and see its professional liability insurance costs rise.

“Ernst & Young is a substantial business services company, but they do not have the balance sheet to take big losses,” said Christopher Whalen, a managing director at Institutional Risk Analytics, an advisory firm that serves the audit profession.

The auditor is accused of standing by while Lehman used an accounting gimmick known as “Repo 105” to make its leverage ratios appear less risky than they actually were. New York Attorney General Andrew Cuomo is seeking to recover $150 million in fees Ernst & Young collected from Lehman since 2001, plus investor damages and penalties.

So far, there is no sign of a client exodus from Ernst & Young. Since a Lehman bankruptcy examiner’s report detailing the Repo 105 transactions was released in March, Ernst & Young lost just 36 audit clients, a tiny fraction of the 2,424 audit clients it has worldwide, according to Audit Analytics, a firm that provides research on the accounting industry.

“Our clients are sophisticated and understand the environment in which professional services firms operate,” Ernst & Young said in a statement on Thursday. “They are consistent in their support of our firm.”

Ernst still counts major banks among its audit clients, including UBS, Toronto-Dominion Bank and US Bancorp, according to Audit Analytics.

LARGE SETTLEMENTS NOTHING NEW

Because of the potential for large damages in the Lehman case, many experts said they expect Ernst & Young to settle rather than go to trial, even if the firm has a strong defense.

“It’s not a criminal complaint, which was what sunk Arthur Andersen, but still Ernst & Young realizes they’re playing with fire here and they want this to go away,” said Anthony Sabino, a professor of law and business at St. John’s University in New York.

Audit firm Arthur Andersen went out of business after its 2002 conviction for its role in accounting scandals that toppled energy trader Enron. The Supreme Court later reversed the conviction, but it was too late to save the firm.

Ernst & Young does have a number of defenses, because auditors are not guarantors of financial statements and they can say they were deceived by Lehman Brothers like everyone else, Sabino said.

This is not the first major lawsuit Ernst & Young has faced. It paid $335 million in 1999 to settle a case stemming from an accounting scandal at travel and real estate company Cendant Corp.

Over the past five years, it also paid $142.5 million and $100 million respectively to settle lawsuits involving accounting scandals at HealthSouth and Time Warner Inc.

GAAP A POINT OF CONTENTION

One key point is that the alleged accounting gimmick did not result in a big enough change in Lehman’s reported leverage to have caused its bankruptcy, said H. David Sherman, an accounting professor at Northeastern University in Boston.

“This is not the kind of thing that major accounting scandals are made of,” Sherman said.

The firm said in a statement on Tuesday that there was no legal basis for a claim because the Lehman transactions being questioned were reported in accordance with generally accepted accounting principles, or GAAP.

While the Repo 105 transactions may have technically met some GAAP requirements, prosecutors say their purpose was to hide billions in liabilities by reducing Lehman’s apparent leverage, an important metric for investors.

GAAP also requires that the “overall impression” created by financial statements be consistent with business realities, prosecutors pointed out.

Prosecutors also claim that Ernst & Young did not properly follow up on a whistleblower complaint about Lehman’s financial statements.

Under the 2002 Sarbanes-Oxley reform act, auditors must report deceptive accounting to company managers and then to securities regulators if it is not addressed. Ernst & Young has said it reported the whistleblower complaint to Lehman’s audit committee.

Lehman is a high-profile example of the failures of accounting controls, but there are bound to be others, said David Stickney, a partner with Bernstein Litowitz Berger & Grossmann LLP in San Diego.

“Lehman is a perfect example that Sarbanes-Oxley alone is not going to stop people from misrepresenting the financial condition of the company, if they are compelled to do it,” he said.

(Additional reporting by Tom Hals in Wilmington, Delaware; Editing by Gary Hill)

Analysis: Ernst faces risks in fighting Lehman lawsuit