Can E&Y escape from Lehman Repo 105 litigation for less than $120 mln?

By Alison Frankel
August 12, 2014

The big revelation in Anton Valukas‘s report on Lehman Brothers’ failure in March 2010 was the bank’s use of an accounting trick called Repo 105, in which Lehman used the cash it received from short-term sales of highly liquid securities to pay down its liabilities. Valukas’s examiner’s report said Lehman was apparently using Repo 105 transactions at the end of every quarter to make it seem as though the bank was less leveraged than it actually was. He advised that the Lehman estate had, at least, a “colorable claim” against Lehman’s auditor, Ernst & Young.

The Valukas report touched off a feeding frenzy against Ernst & Young. Lehman investors sued the auditor, as a class and in individual cases by such large investors as the California Public Employees Retirement Systems, which, by itself, blamed Ernst & Young for nearly $1 billion in Lehman losses. The New York State attorney general sued under the state’s powerful Martin Act. And the Lehman estate eventually brought a malpractice and breach-of-contract case against its former auditor, asking in an arbitration proceeding for the disgorgement of about $160 million in fees it paid to Ernst & Young, as well as unspecified damages from the auditor’s supposed failure to warn Lehman against the Repo 105 deals.

But it’s beginning to look like Repo 105 won’t be a catastrophe for Ernst & Young. In fact, the auditor may end up walking away from its disastrous Lehman engagement for less than $120 million. That’s a lot of money, of course, and there’s still a chance that Ernst & Young will have to pay back some of those tens of millions in Lehman fees. Nevertheless, Ernst & Young and its lawyers at Latham & Watkins have to be feeling like they’ve escaped a shark tank with minor wounds.

Lehman itself drew no blood in its arbitration against its former auditor. In a ruling in April that was first reported by the New York Times on Monday, the three retired judges who served as arbitrators concluded that Ernst & Young was protected by New York State’s broad interpretation of the doctrine of in pari delicto, or “in equal fault.” The stipulated facts presented to the panel, the arbitrators said, “strongly support a finding that Lehman was more culpable than E&Y” for the dubious Repo 105 transactions. So despite arguments by Lehman’s lawyers at Milbank, Tweed, Hadley & McCloy that the bank relied on E&Y’s endorsement of Repo 105, the arbitrators denied Lehman’s malpractice and contract claims. (E&Y’s lawyers at Latham moved on July 30 to confirm the take-nothing award in New York State Supreme Court. Lehman counsel David Cohen of Milbank was traveling and didn’t return my phone call.)

Lehman investors have done a little better, but not much. In 2011, U.S. District Judge Lewis Kaplan of Manhattan tossed almost all of the claims against Ernst & Young by a class of Lehman shareholders. The judge only kept alive allegations that Ernst & Young should have known Lehman was using Repo 105 transactions to tinker with its net leverage ratio after a meeting with Lehman accounting executive – and whistleblower – Matthew Lee in the spring of 2008. Kaplan’s ruling restricted the classwide fraud case to alleged misrepresentations in a single filing with the Securities and Exchange Commission in July 2008, knocking out Ernst & Young’s liability for losses before the 2008 alert from Lee.

Last November, the audit firm agreed to pay $99 million to the class. It has since settled with most of the Lehman investors who opted out of the class settlement, including a $1.5 million deal with Washington State in January and a $12.75 settlement with CalPERS in May. On Friday, Latham & Watkins moved for summary judgment in the last six remaining opt-out cases, arguing that depositions and E&Y documents haven’t given investors any convincing new evidence that Ernst & Young knew Lehman was misusing Repo 105 transactions.

The best piece of new evidence for investors seems to be deposition testimony about a meeting in late 2007 or early 2008 in which a Lehman controller supposedly discussed Repo 105 with the E&Y coordinating partner on the assignment. E&Y claims that the timing of the meeting isn’t clear and, moreover, that the testimony about what was said during the session backs the auditor’s argument that it believed Lehman’s reporting on Repo 105 complied with accounting standards. Unless the opt-out investors succeed in extending the time frame for E&Y liability beyond the limits Judge Kaplan set in his 2011 decision on class action claims, the remaining opt-out cases can’t hurt the auditor badly.

The New York AG is still circling, however. The state’s Martin Act case had been tossed, but in February the New York State Appellate Division, First Department, revived the AG’s claims for the disgorgement of $150 million in fees Lehman paid to E&Y, holding that disgorgement is available even though the AG doesn’t claim E&Y directly injured consumers or the public. E&Y asked for leave to appeal the ruling to New York’s highest court but it was turned down.

So there’s still a possibility that Ernst & Young will have to pay the New York AG the very fees that Lehman isn’t entitled to under the just-revealed arbitration award. (It’s not clear, for instance, whether the auditor can assert an in pari delicto defense against a claimant that had no part in the alleged wrongdoing.)

That would be a strange outcome, but on the other hand, the Repo 105 transactions were pretty strange themselves.

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