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  •  » WSJ article-"Auditors Face Fraud Charge" from Dec.20, 2010

#1 12.21.2010 09:27:47

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WSJ article-"Auditors Face Fraud Charge" from Dec.20, 2010

New York Set to Allege Ernst and Young Stood By as Lehman Cooked Its Books. Good to read.

New York prosecutors are poised to file civil fraud charges against Ernst & Young for its alleged role in the collapse of Lehman Brothers, saying the Big Four accounting firm stood by while the investment bank misled investors about its financial health, people familiar with the matter said.

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State Attorney General Andrew Cuomo is close to filing the case, which would mark the first time a major accounting firm was targeted for its role in the financial crisis. The suit stems from transactions Lehman allegedly carried out to make its risk appear lower than it actually was.

Lehman Brothers was long one of Ernst & Young's biggest clients, and the accounting firm earned approximately $100 million in fees for its auditing work from 2001 through 2008, say people familiar with the matter.

The suit, led by Mr. Cuomo, New York's governor-elect, could come as early as this week. It is part of a broader investigation into whether some banks misled investors by removing debt from their balance sheets before they reported their financial results to mask their true levels of risk-taking, a person familiar with the case said. The state may seek to impose fines and other penalties.

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What Did Lehman's Fuld Know? What Was Lehman Hiding? Government Could Have Saved Lehman Mr. Cuomo's office has sought documents and information from several firms, including Bank of America Corp., which earlier this year disclosed six transactions that were wrongly classified. Jerry Dubrowski, a Bank of America spokesman, said the bank's practice is to cooperate with any inquiry from regulators.

It is possible that Ernst & Young will try to settle before any suit is filed. The firm declined to comment. A spokesman for the Lehman Brothers estate also declined to comment.

Experience WSJ professional Editors' Deep Dive: Auditing High-Risk ClientsACCOUNTING TODAY
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Guidance on Auditing High-Risk ClientsIssues in Accounting Education
Internal Controls: A Compendium of Short CasesAccess thousands of business sources not available on the free web. Learn More The transactions in question, known as "window dressing," involve repurchase agreements, or repos, a form of short-term borrowing that allows banks to take bigger trading risks. Some banks have systematically lowered their repo debt at the ends of fiscal quarters, making it appear they were less risk-burdened than they actually were most of the time.

Lehman Brothers dubbed transactions of this type "Repo 105." The maneuver came to light in March, when the bankruptcy examiner investigating the firm's collapse more than two years ago found that it moved some $50 billion in assets off its balance sheet. Lehman labeled those transactions as securities sales instead of loans, which led investors to believe the firm was financially healthier than it really was.

The bankruptcy examiner's report and the attorney general's investigation found that Lehman Brothers carried out the Repo 105 transactions on a quarterly basis in 2007 and 2008 without telling investors. Mr. Cuomo's investigation found that Repo 105 transactions started as far back as 2001, said the person familiar with the probe.

The attorney general's investigation, which began after the bankruptcy examiner's report, found that Ernst & Young specifically approved of Lehman's use of Repo 105 transactions and provided the investment bank with a complete audit opinion from 2001 through 2007, said the person.

Mr. Cuomo's office has also been investigating suspected window-dressing transactions at other banks, said the person, and is probing whether they similarly misled investors.

An analysis earlier this year by The Wall Street Journal found that other banks were reducing their level of debt at quarter-end.

The attorney general's office has sought documents and information from several firms, including Bank of America Corp., which earlier this year disclosed six transactions that were wrongly classified. The Journal's analysis found that Bank of America was among the most active banks in reducing its debt at reporting time.

The state's investigations into other firms' window dressing are less advanced than its Ernst & Young probe, said a person familiar with the probes.

Other regulators have said they are looking into window dressing as well. The Securities and Exchange Commission's investigation into Lehman's collapse is focusing on Repo 105 transactions, said people familiar with the matter. It has proposed new types of disclosures to help investors identify when banks are window dressing. But the SEC has said it hasn't found any widespread inappropriate practices in that area.

Britain's Financial Reporting Council, which oversees corporate reporting rules, is also investigating Ernst & Young's role in the Lehman collapse.

The Lehman bankruptcy examiner's report also stated that there may be evidence to support negligence and malpractice claims against Ernst & Young regarding Lehman's audits and its lack of response to a whistle-blower at Lehman who raised red flags about the repo trades.

The whistle-blower was Matthew Lee, a Lehman Brothers senior vice president. He had complained to his boss, and eventually wrote a letter in May 2008 to senior Lehman executives expressing concern that the Repo 105 transactions violated Lehman's ethics code by misleading investors and regulators about the true value of the firm's assets. Days later, Mr. Lee was ousted from the firm.

According to the Lehman bankruptcy examiner's report, Ernst & Young auditors saw the letter, and later interviewed Mr. Lee after he was let go from Lehman. Ernst & Young previously said in a statement that Lehman management determined Mr. Lee's "allegations were unfounded." Mr. Lee couldn't be reached for comment.

Though accounting firms were at the center of the last major corporate scandals nearly a decade ago, they haven't been tied to any of the key causes of the recent crisis.

The case could be the last for Mr. Cuomo, the governor-elect of New York, who finishes his term as attorney general at year-end. If the case isn't filed before that, it would likely be handed over to Mr. Cuomo's successor, Eric Schneiderman.

Write to Liz Rappaport at liz.rappaport@wsj.com and Michael Rapoport at Michael.Rapoport@dowjones.com

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