December 20, 2010
Ernst & Young suit looming? Bigger than SEC v. Goldman?
Posted by Erik Gerding

The Wall Street Journal reports on its front page that the NY Attorney General is close to filing a civil suit against Ernst & Young for fraud in connection with its audit work for Lehman Brothers and the now infamous "Repo 105" transactions.  Lehman allegedly used complex repurchase transactions to engage in "window dressing" and mask leverage and thus risk just before the close of financial quarters.  (You can find the Examiner's Report from the Lehman Chapter 11 Proceedings, which analyzed Repo 105 among other transactions, here.)

It is hard to say anything detailed about a suit that has not been filed yet, but this type of suit could have even broader implications that this summer's SEC v. Goldman case for the sole reason that lots of financial institutions used repos and other financial instruments at the heart of the financial crisis to move assets -- and thus risk -- off-balance sheet and to arbitrage  bank capital regulations.  Think of it this way -- if the Goldman suit alleged that a big investment bank arranged complex transactions to help a hedge fund bet against asset-backed securities, this type of suit might focus on some of the reasons that firms invested on the other side of shadow banking transactions -- lowering leverage and engaging in capital arbitrage.  This type of arbitrage would thus involve not only big investment banks, but their clients as well.  Consider how one of the banks named in the SEC's suit against Goldman that suffered considerable losses, IKB of Germany, has itself been the subject of regulatory investigations and some of its executives prosecuted in connection with off-balance sheet transactions (an early PWC report on IKB (in German) here, and a more easy-to-follow IKB analyst conference call transcript on the fallout here; the IKB story continued after 2007, but that's for another day, another post -- see the FT blog here,).     

General counsel might be very interested to see what a NY AG case says about when the flavor of aggressive off-balance sheet accounting becomes a poison.  Moreover, the NY Attorney general can wield the Martin Act, one of the more fearsome weapons in the public litigation arsenal, even if the Journal report seems to indicate that the NY AG won't be seeking criminal penalties. 

Bottom line: the normally sleepy weeks around Christmas and New Year could get very interesting.  Moreover, repurchase transactions and their role in the crisis were left relatively unaddressed by the otherwise sprawling Dodd-Frank Act.  For now, let's have some egg nog, but not too much, and see what materializes.

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