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A possible civil fraud case against Ernst & Young LLC over its role in the collapse of Lehman Brothers could be the biggest government attack on an accounting firm since the collapse of Arthur Andersen over the Enron scandal.
New York prosecutors are close to filing civil fraud charges against Ernst & Young, the Wall Street Journal said Monday, citing people familiar with the matter. If a case is brought, it would be one of the first government lawsuits targeting practices that some claim Lehman and other financial firms used to mask debt.
The lawsuit, led by outgoing New York Attorney General Andrew Cuomo, could come as early as this week and might seek to impose fines and other penalties, the Journal said.
Experts said Ernst & Young likely would try to settle any lawsuit because damages sought by Cuomo’s office are bound to be among the biggest of any of the lawsuits stemming from the financial crisis. Lehman had well over $600 billion in assets when it filed the biggest bankruptcy in history, about 10 times the assets that Enron did when it filed for bankruptcy, according to Bankruptcydata.com.
A spokeswoman for Ernst & Young said the company did not comment on speculation, and repeated a previous statement made by the firm about its dealings with Lehman Brothers.
“Throughout our period as the auditor of Lehman, we firmly believe our work met all applicable professional standards, applying the rules that existed at the time,” the statement said.
Cuomo’s office did not respond to requests for comment.
The U.S. Securities and Exchange Commission declined to comment, but said previously that it is looking at a number of firms involved with Lehman at the time of its collapse.
Cuomo is set to become governor of New York in just a few weeks. Experts said that the timing of the lawsuit could mean that Cuomo expects the suit to settle quickly because otherwise it would be taken over by his successor.
“Cuomo doesn’t like to be caught on the losing side,” said Anthony Sabino, a professor of law and business at St. John’s University in New York. “This is something that is going to be discussed behind closed doors, and I expect it will go away rather quietly.”
Cuomo has previously sued Bank of America Corp and its former CEO Kenneth Lewis over the bank’s 2008 takeover of Merrill Lynch.
It has been rare for prosecutors to charge audit firms directly since auditor Arthur Andersen collapsed after it was indicted for its role in the crumbling of energy trader Enron.
While the Ernst & Young case would be a civil matter, rather than a criminal case, a big settlement could be difficult in an accounting industry that is still feeling the effects of the collapse of Arthur Andersen. That reduced the number of big accounting firms that audit most large companies globally to just four, including Ernst & Young.
Since then, prosecutors have been wary of charging entire firms with fraud amid worries that another firm could collapse and endanger the financial system.
The Ernst & Young case would stem from Lehman’s use of a accounting technique called Repo 105, the Journal said.
Lehman’s court-appointed bankruptcy examiner, Anton Valukas, has said that the use of Repo 105, which dates to 2001 and was used without telling investors or regulators, gave the appearance that Lehman was reducing its overall leverage levels in 2008, when it was not.
Lehman used Repo 105 to temporarily remove $50 billion of assets from its balance sheet in 2008, according to the examiner’s report released in March. At the time, Valukas said Lehman’s bankruptcy estate could have grounds to sue Ernst & Young for negligence and professional malpractice amid concerns the accounting firm had not dealt properly with a whistleblower’s concerns.
Earlier this year, in a letter to its clients, Ernst & Young offered a preview of its defense against such claims, saying the Lehman bankruptcy was caused by a “collapse in its liquidity” and not by accounting or disclosure issues.
“Could Ernst & Young have done a better job? Maybe, but claiming they could have done a better job doesn’t necessarily make them liable,” Sabino said. “Even the best of auditors can be fooled.”
Action by Cuomo could help Lehman’s creditors recover more money from the firm’s collapse, said Michael Missal, an attorney at the K&L Gates law firm in Washington, who was the examiner in New Century Financial Corp’s bankruptcy and worked with the examiner in the WorldCom bankruptcy.
Lehman’s creditors have requested the power to investigate possible claims against the auditor and are still likely to bring their own lawsuit, according to court records. Lehman investors have also already sought to file class-action lawsuits against the auditing firm.
(Reporting by Emily Chasan. Additional reporting by Tom Hals in Wilmington, Rachelle Younglai in Washington, Santosh Nadgir in Bangalore and Kylie MacLellan in London. Editing by Greg Mahlich, Gerald E. McCormick and Robert MacMillan)