Thursday, July 28, 2011

Federal Judge Rules on Investor Federal Securities Claims Against Outside Auditor of Lehman Financial Statements

The September 2008 collapse of Lehman Brothers Holdings Inc. disrupted the entire economy and greatly affected owners of the company’s securities. A federal judge ruled that investors failed to state a claim that the company’s outside auditor violated Section 11 of the Securities Act and also failed to state a claim that the auditor misrepresented compliance with generally accepted auditing standards. But investors did sufficiently allege that the outside auditor made a false or misleading statement in Lehman’s 2Q08 in that it professed ignorance of facts warranting material modifications to Lehman’s balance sheet when in truth it had received information concerning Lehman’s use of Repo 105s temporarily to move $50 billion of inventory off that balance sheet, information that cast into doubt the balance sheet’s consistency with GAAP. (In re Lehman Brothers Securities and ERISA Litigation, 09 MD 2017, SD NY, July 27, 2011).

This case concerns more than $31 billion in Lehman debt and equity securities issued pursuant to a May 30, 2006 shelf registration statement, a base prospectus of the same date, and various prospectus, product, and pricing supplements, which incorporated by reference several of Lehman’s SEC filings. Investors who purchased some of these securities brought a federal securities action against Lehman’s former officers, directors, and auditors, as well as underwriters of the securities, under Rule 10b-5 and Sections 11 of the Securities Act.

The allegation is that Lehman’s offering materials were false and misleading because they incorporated by reference Lehman’s financial statements, which in turn contained misleading statements and omissions concerning Lehman’s use of “Repo 105 transactions and their effect on Lehman’s reported net leverage, risk management policies, liquidity risk and concentrations of credit risk.

The investors alleged that the outside auditor’s statements in Lehman’s 2007 10-K concerning its audit and Lehman’s financial statements, and (2) Lehman’s quarterly reports on Form 10-Q for the second and third quarters of 2007 and the first two quarters of 2008 concerning its review of Lehman’s financials were materially false and misleading. The investors alleged misstatements with regard to compliance with generally accepted auditing standards (GAAS) and generally accepted accounting principles (GAAP).

The investors also claimed that the auditor violated requirements of due professional care and professional skepticism by ignoring or failing to respond adequately to three red flags: namely 1) Lehman’s inability to obtain from a U.S.-based law firm a true sale opinion regarding Lehman’s accounting treatment of Repo 105s, (2) a netting grid that identified and described the Repo 105s, and (3) the auditors June 12, 2008 interview with the senior vice president in charge of Lehman’s Global Balance Sheet and Legal Entity Accounting

The court found that Lehman’s use of a true sale at law opinion letter from a U.K.-based law firm was not a red flag for two reasons. First, given that the US legal system sprung from the English one, it would be odd to conclude that the use of an opinion from a well known U.K.-based law firm on a question of common law calls into question the accuracy of the opinion’s conclusion. Second, and more importantly, the letter is not said to have provided the auditor any indication that Lehman improperly increased its use of the Repo 105 transactions at the end of each reporting period because the opinion that a Repo 105 involved a true sale did not address the issue that is pertinent here. The opinion went only to the question whether the Repo 105s were properly accounted for as sales under FASB strandards and not the question of whether the financial statements
nevertheless were misleading because the manner in which the Repo 105s were used presented a deceptive picture as to Lehman’s net leverage.

Nor was the netting grid a red flag that Lehman used the Repo 105 transactions at the end of each quarter to manipulate its reported net leverage ratio. The netting grid disclosed the volumes of Repo 105 transactions on Lehman’s balance sheet on November 30, 2006, and February 28, 2007, but did not disclose to E&Y when these transactions were entered into or that they were unwound promptly after the end of each reporting period. The grid therefore could not have alerted the auditor to the possibility that Lehman was using these transactions to manipulate its net leverage and overall financial position at the close of each reporting period.

The executive interview, but for its timing, would have been different. The executive allegedly told the auditor that Lehman had used Repo 105 transactions to remove temporarily $50 billion from its balance sheet at the end of the second quarter of 2008. Although Lehman’s audit committee allegedly had instructed the auditor to report to it any allegations of financial improprieties, the auditor allegedly failed to relay the senior officer’s concerns or investigate them itself.

In these circumstances, said the court, and bearing in mind that the issue might appear differently on a fuller record, a trier of fact reasonably might find that the auditor knew by June 2008, when it interviewed the officer, that the Repo 105s may have been used to manipulate the balance sheet, at least at the end of the second quarter of that year. Had the auditor subsequently issued a clean audit opinion, knowing that it had not followed up appropriately on the executive’s allegations, that opinion could well have been false. But the only audit opinion at issue here was the one the auditor expressed with respect to its 2007 audit and that appeared in the 2007 10-K, issued on January 28, 2008.

The court noted that the firm’s GAAS opinion, just like those rendered by all or substantially all accounting firms, is explicitly labeled as just that, an opinion that the audit complied with these broadly stated standards. More is necessary to make out a claim that the statement of opinion was false than a quarrel with whether these standards have been satisfied.

The court also noted that the auditor’s statement regarding GAAS compliance inherently was one of opinion. In order for the investors sufficiently to have alleged that it was false, they had to allege facts that, if true, would permit a conclusion that the auditor either did not in fact hold that opinion or knew that it had no reasonable basis for it

The standard for evaluating assertions of an auditor’s scienter is demanding, said the court, because it must be alleged that the auditor’s conduct was highly unreasonable, representing an extreme departure from the standards of ordinary care and approximating an actual intent to aid in the fraud being perpetrated by the audited company. The accounting judgments which were made must have been such that no reasonable accountant would have made the same decisions if confronted with the same facts.

The investor’s allegations respecting red flags therefore bear not only on whether the firm violated the pertinent GAAS requirements, but also on whether it did so with the requisite state of mind. The true sale opinion and netting grid were not red flags, the disregard of which could be called highly reckless. And, while the auditor’s alleged failure to follow up on the executive interview arguably would have been a departure from GAAS, the only subsequent E&Y statement at issue is the report on the interim financials in the 2Q08, which contained no statement of a GAAS-compliant audit. Accordingly, the investors failed to allege that the outside auditor made any false or misleading statements with respect to GAAS compliance either in the 2007 10-K or in any of the subsequent 10-Q’s, ruled the court, much less that it did so with scienter.

The investors also alleged that the auditor’s opinions as to Lehman’s preparation of its financial statements in accordance with GAAP were statements of fact and that they were false because those financial statements in fact did not comply with GAAP.

The only alleged departure from GAAP relates to Lehman’s use of Repo 105s and the only such departure that the court found sufficient was the claim that Lehman’s use of such transactions at each quarter-end to reduce its net leverage temporarily resulted in the financial statements portraying the company’s leverage in a misleading way, this notwithstanding that the investors did not sufficiently allege that the accounting treatment of those transactions, in and of itself, was inconsistent with GAAP.

Since there was no claim that the auditor did not in fact hold the opinion that it expressed with respect to Lehman’s compliance with GAAP, the question is whether investors sufficiently alleged that E&Y had no reasonable basis for believing that Lehman’s financial statements were prepared in accordance with GAAP. In other words, did they sufficiently allege that the auditor knew enough about Lehman’s use of Repo 105s to window-dress its period-end balance sheets to permit a finding that E&Y had no reasonable basis for believing that those balance sheets fairly presented the financial condition of Lehman.

The investors relied for this purpose on precisely the same alleged red flags discussed previously in connection with the auditor’s GAAS opinion. The true sale opinion and the netting grid were no stronger in this context than in that, said the court, but the executive interview was a different matter.

The investors said that the senior officer told the auditor in June 2008 that Lehman moved $50 billion of inventory off its balance sheet at quarter-end through Repo 105 transactions and that these assets returned to the balance sheet about a week later. Assuming that is so, said the court, the auditor arguably was on notice by June 2008 that Lehman had used Repo 105s to portray its net leverage more favorably than
its financial position warranted, a circumstance that could well have resulted in the published balance sheet for that quarter being inconsistent with GAAP’s overall requirement of fair presentation. Thus, the court found that the investors adequately alleged that the auditor misrepresented in the 2Q08 that it was not aware of any material modifications that should be made to the consolidated financial statements referred to above for them to be in conformity with U.S. GAAP, notwithstanding the executive’s disclosure to it.

Turning to the Securities Act claims against the auditor, which were based on the same statements regarding GAAS and GAAP compliance as the Exchange Act claims, the court noted that accounting firms are subject to Securities Act Section 11 liability only if the alleged misstatement or omission occurs in a portion of a registration statement, or a report or valuation used in connection with the registration statement, prepared or certified by it.

SEC rules provide that a report on an unaudited interim financial statement by an independent accountant must not be considered a part of a registration statement prepared or certified by an accountant or a report prepared or certified by an accountant within the meaning of Section 11. Thus, misstatements or omissions in a report on unaudited interim financial information cannot give rise to accountant liability under Section 11(a)(4). Since the outside auditor made the only otherwise actionable statements in reports on unaudited interim financial information, the Securities Act claims against it failed.

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