Ernst & Young’s jujitsu defense

December 23, 2010, 4:42 PM UTC

Can an embattled accounting firm turn the New York attorney general’s greatest strength against him?

Ernst & Young may try to do just that as it braces against a civil fraud suit claiming it helped conceal Lehman Brothers’ accounting games in the years before its 2008 collapse.

In the best shape of his life?

Ernst promised in a statement this week to defend itself vigorously in the complaint, which seeks at least $150 million in damages. The firm said it believes there is “no factual or legal basis for a claim to be brought against an auditor in this context,” arguing Lehman’s books didn’t run afoul of accounting rules.

But the accounting firm also took aim at the statute that New York is pursuing much of its case under, a 1921 law known as the Martin Act that thanks to its broad sweep has become a favorite of crusading prosecutors in the state.

Ernst & Young served notice Tuesday that it will argue the attorney general, Andrew Cuomo (right), and his staff are overreaching by causing an old law to perform new tricks.

What we have here is a significant expansion of the Martin Act. Although the Martin Act is almost 90 years old, we believe this is the first time that an Attorney General is attempting to use this law to assert claims against an accounting firm, rather than the company that took the alleged actions.

Cuomo’s office didn’t return calls seeking comment, but E&Y’s attack on its use of the Martin Act is no surprise. The Martin Act, which was passed to crack down on securities fraud, has been interpreted by New York courts in a way that gives the attorney general unparalleled license.

Under the law, the government needn’t prove a defendant intended to defraud its victims, as it must under many other circumstances. A 2000 appeals court ruling held that offenses under the act include “all deceitful practices contrary to the plain rules of common honesty and all acts tending to deceive or mislead the public,” regardless of intent.

That sets the bar pretty low, which is certainly useful for the state in this case. Two years later, after all, seemingly reasonable people are still debating what exactly brought Lehman and other financial giants down. What’s more, this case will revolve in large measure around interpretations of arcane accounting rules.

“These sorts of claims are not slam dunks for anyone,” said Sam Rosenfarb, a certified public accountant who is the partner-in-charge of the advisory services group at Marcum LLP. “The state could have some high hurdles to clear.”

Of course, trying to get the courts to narrow the scope of the law is no Sunday afternoon stroll either.

The Ernst & Young statement suggests the firm will argue that it can’t be prosecuted under the Martin Act because Lehman, not E&Y, was the outfit actually producing the financial reports, and because it was Lehman, not E&Y, that was peddling billions of dollars of securities just months before its implosion.

In this view, E&Y was just a gatekeeper hired to vouch for Lehman’s books, something it will claim it did well within the confines of the law. This strikes lawyers who are familiar with the law as an eminently reasonable approach, if not exactly a surefire recipe for success.

“If I were Ernst & Young, I would assert I was not a primary actor,” said Margaret Bancroft, a partner at Dechert LLP and author of a 2004 memo that explained the Martin Act soon after Spitzer began brandishing it against Wall Street. “You can say that with more than a straight face.”

One gathers Bancroft is not exactly betting the ranch on that defense working. Even so, it is worth a try in a case where the news for Ernst & Young could yet get much worse.

Consider the silence so far from the Securities and Exchange Commission and the Justice Department, both of which presumably have heard by now that Lehman Brothers has collapsed and possibly have even read the Valukas report on which the Cuomo suit is largely based.

“It’s always easier said than done to match the actual conduct in a case with the statutory language,” said Wally Dietz, a co-chair of Bass Berry & Sims PLC’s Internal Investigations and Special Projects group. “But in terms of what Ernst & Young is up against, the big story isn’t this case. It’s what happens next in Washington.”