Public Accounting and the Crash of 2008

The 2010 United States Census, now a public document, contains grim news for the regions of the Northeast and Midwest. New York and Ohio will soon lose two Congressional seats, and seven other northeastern and midwestern states will lose single seats as well. The Empire State, formerly home to the nation’s largest Congressional delegation, will drop into a tie for third place with Florida, well behind California and Texas in the competition for federal clout.

Surprisingly, though, New York’s Governor Elect Andrew Cuomo was not focusing on issues of population loss and economic decline this past week. Instead, in his final significant action as state Attorney General, he announced a $150 million lawsuit against the Big Four accounting firm Ernst & Young (E&Y), a successful global business with an iconic national headquarters building located in the heart of Times Square.

It’s hard to imagine such a lawsuit being launched in a place like Texas, where Governor Rick Perry routinely boasts of the Lone Star State’s “business friendly” environment. And yet many believe that Cuomo’s legal action is necessary to hold corporate America accountable for the banking scandals that caused the Great Recession of 2008.

The Public Accounting Profession

E&Y, of course, is not a financial institution, and thus did not create or sell any of the “financial weapons of mass destruction” that destroyed the global economy two years ago. Nevertheless, E&Y is a public accounting firm with a sizable presence on Wall Street; it is responsible for auditing the books and records of many of America’s largest financial organizations.

Like any auditing firm, E&Y is entrusted with the responsibility of alerting the public whenever a publicly traded client intentionally engages in a significant fraudulent transaction that results in a misleading set of financial statements. In other words, E&Y is responsible for raising a red flag whenever a client attempts to “fool” the public into believing that it is financially strong when, in fact, it is not strong at all.

Last week, though, Cuomo accused E&Y of breaching the public trust by doing nothing while its client Lehman Brothers engaged in fraudulent “window dressing” transactions, so named because they allegedly served to “dress up” the financial statements of the bank. E&Y did, in fact, issue clean opinions about Lehman’s financial reports leading up to the bank’s collapse in 2008; nevertheless, did E&Y or Lehman act inappropriately during that time?

The Simplicity of Repo 105

Although many financial transactions engineered by Wall Street are astoundingly complex, the type of contract that resides at the core of Cuomo’s accusation is a relatively simple one. These “Repo 105” agreements were repurchase arrangements that were made by Lehman to sell certain assets to temporary owners, with understandings that Lehman would repurchase them shortly afterwards.

Why would any firm agree to sell assets, only to repurchase them soon thereafter? According to Cuomo, Lehman needed to find some cash temporarily to pay off significant amounts of debt. Once it did so, it then released financial statements to the public that described Lehman as relatively free of debt and thus financially strong. Finally, once the public completed its review of those financial statements, Lehman again borrowed significant amounts of money and repurchased its assets from the temporary owners.

In other words, according to Cuomo, Lehman knew that public investors might be concerned if the bank issued financial statements that portrayed it as saddled with debt. Thus, it arranged to pay down its debts shortly before it issued its financial reports, and then re-leveraged its debt positions immediately after it issued those reports. Cuomo argues that these sale-and-repurchase transactions were solely motivated by a desire to “window dress” the financial reports, and were thus inherently misleading in nature.

What Should An Auditor Do?

It is, perhaps, understandable why Cuomo believes that E&Y failed in its duty to alert the public that Lehman was managing (or manipulating) its debt levels to impress (or fool) its investors. And yet it is reasonable to argue that firms like Lehman have a legal right to sell and buy any assets, and to borrow and repay any loans, whenever they choose to do so.

Furthermore, if other Wall Street firms (including the Federal Reserve Bank itself) often engage in such activities, how could Lehman remain competitive unless it did so as well? And if Lehman’s Repo 105 transactions were perfectly legal contracts that were commonly employed throughout the industry, why would E&Y raise red flags about them?

Window dressing is certainly not a new phenomenon; automobile manufacturers, for instance, spent years dodging accusations that they habitually increased fleet sales in order to inflate their revenues and profits. Nevertheless, it is a bit surprising that the incoming Governor of an economically struggling state would sue an iconic local firm at the very moment when its regional economy is struggling to emerge from recession.