More Hot Water For Ernst & Young With New Lehman Allegations

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It may only be a matter of time before Ernst & Young gets in trouble in its role as auditor regarding the disintegration of Lehman Bros. The New York Times reported today that “In the years before its collapse, Lehman used a small company — its ‘alter ego,’ in the words of a former Lehman trader — to shift investments off its books.”

The smaller firm was called Hudson Castle. Some of the trading between Lehman and Hudson were more than $1 billion, the Times reports.

The Examiner,  Anton R. Valukasfor, who authored the 2,200 page report for the bankruptcy court handling the dismantling of Lehman, mentioned E&Y’s role with respect to Lehman’s bankruptcy but did not levy any specific charges against its work as Lehman’s auditors.

It appears that E&Y was aware that Lehman moved money on and off its books using Repo 105 instruments. In reaction to concerns that it had been negligent, E&Y said “Our last audit of the company was for the fiscal year ending Nov. 30, 2007. Our opinion indicated that Lehman’s financial statements for that year were fairly presented in accordance with Generally Accepted Accounting Principles (GAAP), and we remain of that view.”

While E&Y may effectively defend itself against the information in the Examiner’s report, the information about Hudson Castle may be much harder for the accounting firm to explain. The fact that E&Y may not have known about Hudson Castle could be due to the inadequacy of its audit – or it could be due to fraud carried out by Lehman executives dealing with the accounting. A careful review of the transactions between Lehman and counter parties should have discovered any fraud in the disclosure of relationships between Lehman and the smaller company.

E&Y is not out of harm’s way.

Douglas A. McIntyre