New York Suit Against Ernst & Young Fills Regulatory Gap

By Scot J. Paltrow | December 23, 2010

In choosing Ernst & Young as his target in the aftermath of the Lehman Brothers collapse, New York Attorney General Andrew Cuomo filled what looks destined to be a permanent gap in regulators’ responses to the debacle.

It has been widely known that the Securities and Exchange Commission for some time has been investigating Lehman and its former top executives, including former Chief Executive Richard Fuld.

But there has been no sign that the SEC, Justice Department or any other federal regulator has launched investigations of accounting firm Ernst & Young, even though it allegedly signed off on practices that deceived Lehman investors and contributed to the firm’s 2008 collapse.

In a 2,200-page report issued in March, Lehman bankruptcy examiner Anton Valukas criticized Ernst, spelling out in detail what he said are multiple potential grounds for lawsuits against it.

“The Examiner concludes that sufficient evidence exists to support a colorable claim for malpractice against Ernst & Young,” as well as other charges, Valukas said in his report.

Valukas “gave it on a platter to regulators and the SEC hasn’t touched it,” said John Coffee, a professor of corporate law at Columbia University.

As Cuomo is about to leave his job to be inaugurated as New York State governor, he is “getting basically very favorable publicity for taking a step that the bankruptcy examiner very strongly encouraged,” Coffee said.

While other agencies have remained on the sidelines, Cuomo’s lawsuit reminds the big auditors of lessons they should have learned after revelations of the accounting frauds at Enron, Worldcom and other big companies in 2001, Coffee and other experts on corporate malfeasance said.

As with Lehman Brothers, those companies for years had gotten away with hiding major liabilities off their balance sheets.

Ernst did not respond to requests for comment on the lawsuit.

An SEC spokesman said the agency would not comment on whether the agency has considered investigating Ernst.

Investors’ lawyers said there is another advantage for Cuomo in going after Ernst. Unlike Lehman, Ernst is a going concern with deep pockets.

If the New York lawsuit succeeds, or Ernst agrees to settle, New York State likely would get millions of dollars, and much more in compensation to Lehman investors whose holdings were wiped out by the firm’s collapse.

Because of a 2008 Supreme Court decision, investors have no standing to sue accounting firms and other outside professionals who may have abetted accounting fraud by a company, said University of Virginia Law Professor George Cohen.

Cuomo, using New York’s unique Martins Act, which gives the attorney general broad powers to go after business fraud, has been able to step in on investors’ behalf, Cohen said.

The attorney general’s legal complaint filed against Ernst reads almost as if it could be a lawsuit against Lehman executives as well.

It spells out, step by step, the actions that it says Lehman took to temporarily park liabilities overseas, using an investment device it called “Repo 105,” hiding worsening financial troubles from investors.

In essence, the lawsuit alleges that Ernst was aware of every step, starting when it became Lehman’s auditor in 2001, and until Lehman’s demise.

People with direct knowledge of the investigation said the attorney general’s investigation has been underway for some time. By making sure the lawsuit was filed just before he leaves to become governor, Cuomo gets to reap credit for it rather than leaving it to his successor, Eric Schneiderman.

(Reporting by Scot J. Paltrow. Editing by Robert MacMillan)

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