A.G. Schneiderman Announces Settlement With Ernst & Young Over Auditor’s Involvement In Alleged Fraud At Lehman Brothers

Agreement Resolves Allegations Firm Enabled Bank To Paint False Picture Of Its Financial Statements By Temporarily Removing Tens Of Billions Of Dollars Of Securities From Its Balance Sheet Without Disclosing Those Transactions On Financial Statements

Schneiderman: Auditors Will Be Held Accountable For Failures To Honestly And Fairly Audit Public Companies

NEW YORK– Attorney General Eric T. Schneiderman today announced a $10 million settlement of a lawsuit filed against the auditing firm Ernst & Young LLP (“Ernst & Young”) over its involvement in a financial statement fraud at the now-defunct investment bank, Lehman Brothers Holdings, Inc. That money will be distributed as restitution to investors in Lehman securities, along with some $99 million being paid by Ernst & Young to settle a private federal class action that relied in part on facts uncovered by the Attorney General’s investigation. No other law enforcement authority has brought an enforcement action in connection with the 2008 collapse of Lehman. Moreover, today’s settlement resolves the first lawsuit brought against an auditor of a public company under New York’s securities laws. The case also resulted in an important decision by the Appellate Division’s First Department, which confirmed the Attorney General’s power to obtain disgorgement of professional fees received by a firm, in this case Ernst and Young’s fees.

“The basic duty and legal obligation of auditors is to ensure that the public companies they audit provide reliable and unbiased information about their operations to the investing public. If auditors issue opinions that are unreliable or provide cover for their clients by helping to hide material information, that harms the investing public, our economy, and our country,” Attorney General Schneiderman said. “Auditors will be held accountable when they violate the law, just as they are supposed to hold the companies they audit accountable.”

Under the terms of the settlement, Ernst & Young will pay $10 million—most of which will go to investors, with the remaining settlement funds to be used to reimburse New York State for investigation and litigation costs.

The Attorney General’s case, People v. Ernst & Young LLP, filed in Manhattan Supreme Court pursuant to the Martin Act and Executive Law § 63(12) in December 2010, concerned Ernst & Young’s role, as Lehman’s auditor, in an alleged fraud involving Lehman’s use of “Repo 105” transactions. Repo 105s were transactions in which Lehman transferred to various overseas counterparties investment grade securities in return for cash, with the binding understanding that Lehman would repurchase the same securities within a very short time, often just a few days. As alleged in the Attorney General’s lawsuit, Lehman, with Ernst & Young’s approval and complicity, treated the Repo 105s as sales, which enabled Lehman to temporarily remove tens of billions of dollars of securities from its balance sheet without requiring Lehman to disclose the Repo 105 transactions as financings on its financial statements. The Repo 105s served no legitimate business purpose. As alleged in the suit, Lehman used the funds derived from the transactions to pay down billions of dollars of liabilities, which had the effect of temporarily and misleadingly reducing Lehman’s leverage ratios, an important metric for analyzing Lehman’s liquidity and financial health.

As alleged by the Attorney General, Ernst & Young approved Lehman’s accounting for the Repo 105 transactions and issued unqualified opinions certifying Lehman’s financial statements, in spite of knowing that Lehman was not disclosing the existence or impact of the Repo 105s in its annual and quarterly consolidated financial statements, all of which Ernst & Young audited or reviewed. Ernst & Young also failed to object when Lehman allegedly misled analysts on its quarterly earnings calls regarding its leverage ratios, and did not inform Lehman’s Audit Committee about a highly-placed whistleblower’s concerns about Lehman’s use of Repo 105 transactions.

The lawsuit charged that Ernst & Young’s assent to Lehman’s failure to include any indication in its financial statements about the Repo 105 transactions was fraudulent and deceptive under the Martin Act and Executive Law § 63(12), as was allowing Lehman to the use the Repo 105s to manipulate its balance sheet and leverage ratios.

The case against Ernst & Young was prosecuted by Senior Trial Counsel David N. Ellenhorn, Assistant Attorneys General Armen Morian and Tanya Trakht, and Bureau Chief Chad Johnson, all of the Investor Protection Bureau, and Executive Deputy Attorney General for Economic Justice Karla G. Sanchez.

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