Monday, March 15, 2010

Ernst & Young could be facing a world of hurt

If Arthur Andersen was destroyed by the Enron fiasco, there is a real risk that Ernst & Young could be felled by Lehman.

I noted on Friday some excerpts of Lehman's "Repo 105" program, which in my ever-so-highbrow terminology was "like a college student paying his neighbor to hide his bong during room inspections."  What I didn't know Friday was the potentially devastating involvement of Ernst & Young.  Zerohedge took a look at the bankruptcy examiner's take on E&Y's auditing over the weekend, and it appears there was some material negligence involved.  If it were simply a mistake on E&Y's performance I wouldn't be so worried....but they appear to have willfully held back information that should have been disclosed to Lehman investors. (MD&A = Management Discussion and Analysis) 

Disclosure of the agreement to repurchase component of Repo 105 transactions was required in the MD&A. Lehman’s repurchase of the securities was a known event that was reasonably likely to occur and would have had a material effect on the company’s financial condition or results of operations. Lehman’s disclosure in the Liquidity and Capital Resources section should have included a discussion of what was known with respect to the timing and/or amounts of the cash flow created by the repayment of the Repo 105 cash borrowing in the first seven to ten days after quarter-end, specifically: (1) the availability of cash as a result of the repayment of the Repo 105 cash borrowing; (2) the ability to borrow more capital because of a reduction in debt rating or deterioration in leverage ratio due to the repayment of the Repo 105 cash borrowing; (3) the effect of the repayment of the Repo 105 cash borrowing on the cost of capital/credit rating; and (4) the economic substance and business purpose of the Repo 105 arrangements.

The question on my mind is, what insurance protection  - if any - is there for E&Y here?  The fact that E&Y knew about these transactions and did not report them as required could open them up to legal action by anyone who relied on their opinion when purchasing Lehman common stock before its collapse.  I hope to God not to see a repeat of the Arthur Andersen tragedy, in which hard-working people who'd borrowed huge sums to purchase into the partnership agreement saw everything wiped out by a few rouge offices.  But the fact remains that E&Y might be on the hook for billions in investors losses.  In the meantime, expect there to be some heavy pressure by other Big 4 firms to steal E&Y's lucrative auditing business....


And for some further discussion, here's a nice analysis by The Business Insider:



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