Legal Opinions and Ernst & Young: The Grim Repo’s next targets? – Westlaw Business

December 23, 2010

By Erik Krusch (Westlaw Business)

Legal opinions underpin the Lehman-related lawsuit against Ernst &Young (E&Y) by New York Attorney General Andrew Cuomo, and both lawyers and auditors can’t help but take note. The AG alleges that Lehman’s then-auditor E&Y provided substantial assistance to Lehman in its perpetrating a massive financial fraud. In particular, Cuomo has charged the accounting giant with three counts of securities fraud under the Martin Act and a charge of persistent fraud and illegality brought under the Executive Law § 63(12) of New York.

The AG’s case centers on Lehman’s use of the now notorious Repo 105 to lower its leverage levels. Lehman accounted for Repo 105, which amounts to selling securities for 105% of their value to counterparties with the agreement to repurchase the securities later, as sales rather than loans. It is standard practice to account for securities repos as loans. Repo 105 allowed Lehman to shift assets (and more to the point, “net leverage”) from the curious eyes of the ratings agencies, investing public and regulators. Ernst & Young signed off on this accounting from 2001 until Lehman’s demise in 2008. For additional information on Repo 105 please see the previous Westlaw Business Currents article The Tale of the Grim Repo: Lehman’s Link to True Sales.

Notably, AG Cuomo’s complaint includes allegations of opinion-shopping on the part of Lehman. In order to categorize Repo 105 transactions as sales, Lehman required a legal opinion stating that the transfers complied with certain legal criteria relating to transfer of control of the securities. Lehman, however, was unable to obtain a true sales opinion for the transaction under U.S. law. Lehman obtained a true sale opinion blessing on Repo 105 from the UK law firm Linklaters. The opinion letter laid out the circumstances under which Lehman’s London affiliate could structure Repo 105 transactions as true sales under English law. The true sales opinion, however, only opined on the transactions based in the United Kingdom, subject to English law, and involving securities “sited” in the United Kingdom. For additional information on true sale opinions please see the previous Westlaw Business Currents article Opinion Letters: When a Sale is Not a Sale.

The Cuomo complaint alleges that Lehman increased its use of Repo 105 during the onset of the financial crisis and far exceeded the limits of the Linklater’s true sale opinion. It further alleges that Ernst & Young approved Lehman Brother’s financial statements utilizing Repo 105 transactions to conceal the bank’s true leverage. The complaint alleges that the ultimate effect of Repo 105 and lax auditing are:

E&Y substantially assisted Lehman … to engage in a massive accounting fraud, involving the surreptitious removal of tens of billions of dollars of securities from Lehman’s balance sheet in order to create a false impression of Lehman’s liquidity, thereby defrauding the investing public.

The Martin Act gives the New York AG the power to fight financial fraud by prosecuting any sort of scheme to defraud for the purpose of gaining money or property through false representations. A key difference between the Martin Act and federal securities fraud is that liability can be established under the Martin Act without proving scienter or intent, a must for federal securities fraud. This difference could explain why Cuomo and the State of New York are pursuing Ernst & Young, as opposed to federal authorities.

(This article was originally published by Westlaw Business Currents (, a ThomsonReuters publication. Westlaw Business Currents delivers lawyer-authored content and Westlaw Business source documents together with Reuters news to keep you informed of the latest developments in your areas of interest. Available online and delivered directly to your desktop, Westlaw Business Currents provides you with the news and timely analysis you need to stay on top of current trends and maintain a competitive edge for your organization and your clients.)

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