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Monday, January 3, 2011

Andrew Cuomo, Ernst & Young, And Lehman

New York's now-former attorney general filed a civil fraud lawsuit against Ernst & Young. Ernst & Young was Lehman's accounting auditor. Andrew Cuomo is using the "Martin Act", a NY law. As the NY attorney general, he can't prosecute Lehman for Sarbanes-Oxley, but he can use NY-specific laws.

Corporate accountants are another example of "captured regulators". The accountants are hired by the corporation they're supposed to be auditing. The fees are ridiculously high. The incentive is for the accountants to look the other way and ignore problems. Otherwise, they risk losing the cushy auditing contract.

The partners of the "Big 4" accounting firms earn huge salaries, but perform no real work. The accountants exist to ensure compliance with State bureaucratic requirements. The accountants are there to provide the illusion of accountability, while rubberstamping whatever the CEO wants. Many CFOs and corporate accountants formerly worked for auditing firms.

Ernst & Young is accused of violating NY state laws. Lehman was located in NY, so NY law applies.

This is an interesting legal quirk. The NY attorney general can prosecute someone for violating NY state laws. He can't prosecute someone for violating Federal law. Only a Federal US attorney can do that.

Andrew Cuomo is not pursuing E&Y for violating Sarbanes-Oxley. He is using NY-specific anti-fraud laws. If there will be a Sarbanes-Oxley prosecution for Lehman Brothers, a Federal lawyer would have to do that, and not a state attorney general.

I don't understand why Lehman's CEO and CFO aren't being prosecuted for violating Sarbanes-Oxley. Sarbanes-Oxley was passed after the Enron scandal, specifically targeting this situation. The "Repo 105" transactions are almost exactly the same as the "off balance sheet partnership" trick that Enron used.

Enron used off-balance-sheet partnerships to hide losses. Lehman used Repo 105 transactions to hide losses. It's exactly the same thing! Enron's off-balance-sheet partnerships were structured as repurchase agreements. Enron agreed to buy back the assets later, using Enron common stock as collateral. When the scam was exposed, the whole thing collapsed.

Enron mentioned the "off balance sheet partnerships" in a footnote on their financial statements. Enron's CFO picked himself and his wife to be CEO of the "off balance sheet partnership", and it was listed in a "related party transactions" footnote. A clever analyst noticed the footnote. However, Enron would have imploded eventually anyway, due to the massive fraud.

Lehman didn't even mention "Repo 105" in its accounting statements anywhere, not even in a footnote. If you read their accounting statements carefully, you would not have noticed the "Repo 105" transactions. That's clearcut fraud.

Lehman should be an excellent test case for Sarbanes-Oxley. If they aren't going to prosecute Lehman's CEO and CFO, then they might as well repeal Sarbanes-Oxley. Due to high compliance costs, Sarbanes-Oxley is a huge regressive tax on public corporations.

One accounting rule is "Don't look for loopholes in the accounting rules." Ernst & Young should have insisted on mentioning the "Repo 105" transactions in a footnote, or refused to sign the statement. They didn't do that, because they didn't want to lose the lucrative accounting fees. There even was a Lehman employee who complained about Repo 105, but Ernst & Young ignored the complaint. Lehman sold common stock and bonds, while performing Repo 105 fraud.

Enron was like a Ponzi scam. As long as new investors kept buying at higher prices, the scam continues. Enron could keep selling more common stock at higher prices, to keep the scam going.

The housing bubble was also like a Ponzi scam. As long as more people kept buying, housing prices kept rising, and Lehman kept making more money.

Lehman sold approximately $50B of bonds and common stock, while performing Repo 105 fraud. That's more than Bernard Madoff stole!

Sarbanes-Oxley is a huge regressive tax on public corporations. It's a huge compliance cost. It hurts the software startup market. Previously, a successful startup would have an IPO, so that early investors could cash out. Now, the only exit option is a sale to a larger corporation. There's only a handful of potential buyers. They don't have much incentive to offer a good price. The successful startup has many fewer options, due to Sarbanes-Oxley.

If there is no Sarbanes-Oxley prosecution for Lehman, they might as well repeal that law. Lehman did the exact same thing as Enron! They both used repurchase contracts to park bad assets off their balance sheet. They both used accounting tricks to hide losses.

Lehman's CEO Dick Fuld is using the Blagojevich defense. "I did what everyone else was doing. They got bailed out, but I didn't. I was unfairly singled out. The other banks were also using dirty accounting tricks. You don't know about them because they didn't go bankrupt. Lehman's books were fully exposed due to the bankruptcy." Dick Fuld might be right. Are Federal prosecutors reluctant to prosecute Dick Fuld, because they're afraid he'll accuse other banks of doing the exact same thing?

There's an interesting clause buried in the banking "reform" law. State banking regulators now have the power to seize and bailout a troubled bank, without a formal bankruptcy filing. Due to Lehman's bankruptcy, there was public disclosure. With the next big bank failure, regulators can intervene without a formal bankruptcy filing. The banking "reform" law will lead to less public disclosure.

That also occurred in the current crisis. AIG was given bailout money, but there was no public disclosure of who was AIG's creditors. The AIG bailout money went to Goldman Sachs and other banks and hedge funds.

NY's attorney general is pursing Ernst & Young for violating NY law. There really should be a Sarbanes-Oxley prosecution of Lehman. The Federal government would have to do that, and not the NY attorney general.

1 comment:

Anonymous said...

Another excellent post. Happy New Year!

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