NY v E&Y Tackles White Collar Crime

This Valentine’s Day signifies another year of recovery from the Global Financial Crisis (“GFC”) in markets around the world. Although there are some promising economic signs, part of the recovery is much less romantic and more about pointing fingers. There has been a wave of white-collar crime cases directed at those alleged to have acted inappropriately or fraudulently before and during the crash.

Background

On December 21, 2010, the Supreme Court of the State of New York, County of New York, filed a 32 page civil complaint against Ernst & Young LLP (“E&Y”) for its role in the demise of Lehman Brothers Holdings (“Lehman”) (“NY v E&Y”). The complaint followed the demise of Lehman on September 15, 2008 after it filed for protection under Chapter 11 of the U.S. Bankruptcy Code with a record-setting $US613 billion in total debt.

According to the complaint, Lehman’s auditor, E&Y, helped “facilitate fraud” within Lehman. The allegations centre on the use of so-called “Repo 105 transactions” that are said to have begun early in the 2000’s. These transactions were in essence the bank parking “tens of billions of dollars of highly liquid fixed income securities” in European banks in order to reduce their balance sheet leverage. The allegations suggest these transactions had “no independent business purpose,” and that they painted a false picture of an important financial metric for investors, stock analysts, lenders, and others involved with Lehman.

Andrew Cuomo, then the Attorney General of the State of New York, handed down an incisively worded complaint. It opened with harsh allegations that:

E&Y substantially assisted Lehman Brothers Holdings Inc….now bankrupt,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 complaint went on to allege that E&Y “failed to meet” Generally Acceptable Auditing Standards (GAAS) by playing a key role in artificially inflating its client’s year-end balance sheet:

E&Y permitted Lehman to engage in an accounting fraud, while reaping over $150 million in fees. E&Y, as a purported independent auditor, was obligated instead to ensure that Lehman’s financial statements disclosed the Repo 105 transactions. The financial statements said not a word about Repo 105, falsely represented that Lehman was treating all repo transactions as financings, and E&Y accordingly must be held accountable for the consequences of this fraud.

If successful, subsequent litigation could result in E&Y losing its accounting license (among other sanctions) that, in turn, could reduce the major international “Big Four” accounting firms to a mere three. Judicial attention has already seen demise of another large accounting firm, Arthur Anderson LLP, when it voluntarily surrendered its license after being criminally convicted for destroying documents relating to the Enron fraud investigation in 2002.

What About Canada?

In R v Drabinsky (2009), 242 CCC (3d) 449 (ONSC) [Drabinsky], Garth Drabinsky, former CEO and his business partner, Myron Gottlieb, of Livent Inc., a live theatre company based in Toronto, were found guilty last year by the Ontario Superior Court of Justice of the fraud and forgery in financial statements presented to their investors.

Over a decade ago, one of the other then “Big Five” accounting firms, KPMG, responsible for auditing Livent’s financial statements, lost a civil lawsuit launched by Drabinsky for a conflict of interest by alerting to “financial irregularities” in due diligence reports on behalf of Michael Ovitz, a prominent Hollywood talent agent, who was buying control in the company. Only after the deal that resulted in new management was suspicion raised about Livent’s deliberate act of “cooking the books;” however, neither KPMG nor Deloitte & Touche, another one of Livent’s auditing firms effectively silenced by their clients, was prosecuted as a part of a white collar crime that convicted Drabinsky and Gottlieb for fraud and forgery.

As for the convicted parties in Drabinsky, they were released in Ontario upon serving notice of appeal with an extension granted to file necessary court papers. Their appeal to the ONCA is speculated to be heard this year with some predicting that it will be appealed up to the SCC if the Court does not reduce their respective six and seven year sentences.

Conclusion

Meanwhile, NY v E&Y has shown that U.S. authorities have taken a hard-lined stance on accounting fraud compared to its Canadian counterparts. While accounting firms may argue that their services can only audit financial statements with information given to them by their clients, some journalists and critics have argued that, in comparison, Canada’s more lenient approach has made this country a “safe haven” for white-collar crime. The ultimate result of these two cases may change the role of auditors in addressing accounting fraud during the GFC in Canada and the United States in the future. It may also affect whether enforcement for the sake of investor protection ought to spell the demise of large accounting firms.