Lehman suit shreds auditors’ teflon coating

December 20, 2010, 9:47 PM UTC

One of the toothless accounting watchdogs that did so much to bring us the financial crisis is about to get an overdue scolding.

New York’s attorney general is pursuing a civil suit against Ernst & Young, the Big 4 accounting firm that signed off on Lehman Brothers’ financial reports in the years leading up to the investment bank’s panic-inducing September 2008 collapse.

Bad auditor!

The case comes nine months after the bankruptcy examiner in the Lehman case said he believed Ernst & Young could face malpractice claims for its failure to challenge “materially misleading” reports filed by Lehman’s management.

The New York suit is worth watching because it’s the first major official case against an auditor in a crisis that was characterized by unreliable financial reports at major financial institutions. Countrywide, Bear Stearns, Lehman, AIG (AIG) — all of them were teh very picture of robust good health till suddenly they weren’t. Coincidence?

You might think there’d be a line out the door to hold auditors responsible for signing off on the books of a bunch of companies that turned out to be utterly unsound, but for the moment you’d be wrong.

“There has been a reluctance to go after advisers period, whether legal advisers or auditors,” said Eleanor Bloxham, who runs the Value Alliance corporate governance advice firm in Westerville, Ohio. “There doesn’t seem to be a whole lot of will behind it.”

At issue in the Lehman case was executives’ practice of hiding the full extent of the firm’s leverage from Wall Street by classifying some loans as sales. These quarter-end transactions, known as Repo 105, allowed Lehman to make its debt-fueled high-wire act look slightly less precarious at a time when investors were starting to catch on to the unstable bubbliness of the financial system. Lehman wasn’t the only firm playing this game, either. 

The E&Y case, being pursued by soon-to-be New York governor Andrew Cuomo, is worth watching because Ernst is the first audit firm being called to account for its actions in a crisis in which financial statements frequently proved useless for investors seeking to understand their risks.

Ernst & Young didn’t respond Monday to a call seeking comment. But it has defended itself in the past by invoking the popular “storm of the century” defense, which seems to suggest that questionable practices are OK if enough people are engaging in them.

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More startlingly, E&Y has claimed, against all odds, that Wall Street wasn’t out to pull the wool over anyone’s eyes.

Take this exchange between E&Y chief Jim Turley and Fortune’s Geoff Colvin, from a September interview.

Colvin: Would it be fair to say that the crisis was caused in part by some financial firms doing misleading things that were within the rules?

Turley: I don’t know that it would be fair to say they were doing misleading things.

It’s remarkable Turley would still say that two months after the financial firm of the best and the brightest, Goldman Sachs (GS), agreed to pay $550 million to settle Securities and Exchange Commission charges that it misled investors in a bubble-era debt deal. The auditors weren’t involved in that one, but the Wall Street mindset was pretty obvious to everyone not running an audit firm.

That’s why we might hope the Cuomo case may finally shed some more light on how auditors helped let the crisis metastasize by standing mutely aside as financial operators piled on debt while, for instance, pretending not to.

KPMG has already agreed to pay $70 million to settle claims against it in two of the more notorious subprime blowups, those of New Century and Countrywide. But Francine McKenna, who writes the re: the auditors blog, notes that the biggest financial implosions, starting with Bear Stearns and continuing into the post-Lehman bailout extravaganza, remain largely unplumbed.

That’s not to say there are smoking guns everywhere. In a case brought by former shareholders of the failed Washington Mutual, the bankruptcy examiner found “little evidence to support malpractice claims” against the bank’s auditor, Deloitte & Touche.

But it is at the very least high time that the authorities are bothering to look.

“You’d think that once you’ve brought the economy to its knees and 10% of people are unemployed, someone would take interest,” said Bloxham. “Maybe it’s time to brush up on this subject.”