It wasn’t even a verdict. Just a decision by New York Federal Court Judge Lewis Kaplan in one Lehman failure case Ernst & Young is fighting. A decision to allow substantially all of the allegations against Lehman executives and at least one of the allegations against Ernst & Young to move forward to discovery and trial.

That is, if there’s not a settlement first.

Yesterday I wrote up my analysis of the decision by Judge Kaplan for my column, “Accounting Watchdog”, at Forbes. In the interest of time and space, I stuck to commenting on the Ernst & Young portion of the decision.

Judge Kaplan dismissed the majority of the allegations against Ernst & Young. The same things auditors are always dismissed for. The only thing that’s new about the judge’s opinion is an indictment of the accounting standards themselves.

The Third Amended Complaint points to several General Standards (“GS”), interpretive Statements on Auditing Standards (“AU”), and Statements of Fieldwork that allegedly are part of GAAS and that E&Y allegedly violated. Many 288 of those standards are couched in rather general and in some cases inherently subjective terms. They require, for example, that the auditor plan the audit engagement properly, use “due professional care,” exercise “professional skepticism,” and “assess the risk of material misstatement due to fraud” – all matters as to which reasonable professionals planning or conducting an audit reasonably and frequently could disagree. Bearing in mind that E&Y’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.

Or is this really news?

Judge Richard Posner during oral arguments in Fehribach v. Ernst & Young LLP, 2007 WL 2033734 (7th Cir. 7/17/07) (pdf), “Posner: The auditor’s responsibility … so far as the company is concerned … is to make sure the [numbers] are accurate…. You don’t need an auditor to tell you your market is collapsing…. The auditors are not supposed to have business insight. They’re counters. They’re not supposed to make predictions about how your markets are doing. They’re supposed to reconcile your books and indicate you’re not a going concern because your debt is too high and so on…. Do you think the auditor is supposed to know about market power?… An auditor is not an economic consultant who goes out and figures out what the market trends in an industry are!…Your trends? That’s what the company knows. [Plantiff’s Attorney: You’re right. Here’s what the auditor’s responsibility under SAS 59…] Posner: That is too vague for me…”

To his credit, Judge Kaplan does leave one important one allegation for Ernst & Young to defend:

Ernst & Young had reason to know that Lehman’s 2Q 2008 financial statements could be materially misstated because of the extensive use of Repo 105 transactions.

John McDermott of FT Alphaville does a good job explaining why:

Kaplan dismisses the majority of the specific allegations against the auditors but writes that one particular incident means that the case against them cannot be thrown out [when] he stops to ask another question on Repo 105: In other words, have plaintiffs sufficiently alleged that E&Y 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 answer: yes, in one case. Plaintiffs rely for this purpose on precisely the same alleged red flags discussed previously in connection with E&Y’s GAAS opinion – the “true sale” opinion, the netting grid, and the Lee interview. The first two are no stronger in this context than in that. The Lee interview, however, is a different matter. The “Lee interview” pertains to warnings allegedly made by Matthew Lee, Lehman’s SVP for Global Balance Sheet and Legal Entity Accounting, that Ernst & Young were told of a $50bn repo 105 move in June 2008 but did not pass on the full information to Lehman’s board. Thus, it failed to fulfill GAAP requirements as part of its Q2 2008 auditing.

I’ve been saying for a while that there’s too much deflective focus on the accounting for Repo 105 and not enough on the disclosure. And I took particular exception early on to Ernst & Young’s handling of the Matthew Lee “whistleblower” situation:

Ernst & Young failed to follow professional standards of care with respect to communications with Lehman’s Audit Committee. Ernst & Young failed to follow professional standards of care with respect to an investigation of a whistleblower claim Lehman’s own Corporate Audit group led by Beth Rudofker, together with Ernst & Young, investigated allegations about balance sheet substantiation problems made in a May 16, 2008 “whistleblower” letter sent to senior management by Matthew Lee. On June 12, 2008, during the investigation, Lee informed Ernst & Young about Lehman’s use of $50 billion of Repo 105 transactions in the second quarter of 2008. At a June 13, 2008 meeting, Ernst & Young failed to disclose that allegation to the Board’s Audit Committee. (Bankruptcy Examiner’s Report V3 page 945) As the lawyers would say, the optics are bad here. The Audit Committee asks EY to support Lehman’s internal auditor in investigating a “whistleblower’s” allegations of balance sheet improprieties. The auditors interview the “whistleblower” and then don’t say anything at any of the Audit Committee meetings. Turns out what Mr. Lee, the “whistleblower”, was alleging is what the examiner believes is the fundamental problem and grounds for “colorable claims” against top officers and EY. The word “whistleblower” is tainted with tons of emotion post-Enron. We now look at those called “whistleblowers” and see heroes. But let’s look at what I think may have actually happened. Lehman’s Internal Audit department “naturally” asked their trusted, all-things-to-all-people advisor, EY, to help with the investigation of the “whistleblower’s” claims. The Internal Audit Department, not EY, was in charge of the investigation. That was their first mistake. If I’ve said it once, I’ve said it a thousand times: The external auditor should not be conducting or assisting with internal investigations of potential fraud or illegal acts by top executives. I wrote about it atSiemens, subject of the largest ever FCPA settlement in history. KPMG, their auditor, got sued. The external auditor should stay the hell away from internal investigations because they may get caught up in something they would rather not know. They may want to claim plausible deniability. And a company should not engage the external auditor to support internal investigations especially involving fraud or illegal acts by top management. Do they do it to be cheap or to keep dirty laundry inside? The external auditor is too often part of the problem, an enabler, instead of part of the solution. If Lehman had hired another firm – a law firm or anyone except their external auditor – to perform the investigation, the investigation would have been covered end to end in privilege, the external auditor may or may not (in this case EY would have been better not to) have been included in the “circle of privilege,” and the investigation would have been completed professionally. However, by supporting this investigation, EY was essentially doing internal audit work, a prohibited service under Sarbanes-Oxley for independence reasons. It’s shocking to me that the EY audit partners did not at least turn over the investigation to EY’s Forensic Accounting and Investigations Practice in order to provide some semblance of independence and professionalism. Even though EY may have been an unwilling party to knowledge of an ugly situation right before an audit committee meeting, they got stuck. They had an obligation under AU 380, as the external auditor – not as an investigator – to inform the Audit Committee. They could have been on the other side being informed – or not – instead of being the one supposed to be doing the informing. AU 380, the rules for auditor communication with the Audit Committee, are very clear. But they relate to the auditors’ role as an auditor not the role of an auditor who is lent as muscle to an internal investigation. By playing the “trusted advisor” they screwed themselves. Stoplight? Yellow. Looks bad, but EY may be able to talk their way out of this one once it gets to court. They need to explain how they were still looking into the issue, doing their “auditor” work and make sure their full but limited role and responsibilities for the process are explained. If they lose on this chalk it up to another case of audit partners wanting to be supermen to their clients, the corporation’s executives, rather than looking out for their own best interests. Unfortunately in this situation, the shareholders were probably going to lose either way.

For a few dollars more… Or, more likely, no additional fee for helping with the internal investigation, Ernst & Young got stuck. Unfortunately, Berkshire Hathaway ignored this lesson in the Sokol case. They used a non-independent attorney and his law firm to investigate Sokol’s suspicious Lubrizol trades. And News Corp. is ignoring it, too. They also are using insiders to investigate the phone hacking allegations.

Despite what some columnists are saying…

Floyd Norris, The New York Times, July 28, 2011: The company misled investors and its officers and directors may be held liable. But the company’s auditor seems likely to escape any responsibility for an audit that wrongly concluded the company’s financial statements were completely proper. That, anyway, is the conclusion a federal judge has reached regarding Lehman Brothers. The judge said this week that it appeared Lehman had violated Generally Accepted Accounting Principles, or GAAP, even if it was in technical compliance with accounting rules. But he threw out a claim against Ernst & Young, whose 2007 audit certified that Lehman had followed GAAP.

…I believe Ernst & Young has not escaped anything. Here’s what I emailed Lynn Turner, former Chief Accountant at the SEC, after he circulated Norris’ column to his newsletter subscribers:

They are on the hook for something, it allows discovery, and this is not the only case against them.

This Lehman suit over a securities offering is not Ernst & Young’s biggest worry. They are a bit player. The New York Attorney General’s case against them, the one about fraud, is where they star.

Nevertheless, this dangling allegation is serious – scienter regarding their client’s deliberate material misstatement of a quarterly financial statement filing and public disclosure.

Here’s an excerpt from what I wrote on March 31, 2010 after the Lehman Bankruptcy Examiner’s report came out and EY defended itself with a letter to Audit Committee members:

EY: General Comments EY’s last audit was for the year ended November 30, 2007. Our opinion stated that Lehman’s financial statements for 2007 were fairly presented in accordance with US GAAP, and we remain of that view. We reviewed but did not audit the interim periods for Lehman’s first and second quarters of fiscal 2008. Although technically correct, EY is not yet off the hook. In fact, EY did something that seems odd to me – issue an actual report of their review of the 10Qs in 2008 that were included in Lehman’s regulatory filings. I credit Jonathan Weil of Bloomberg for bringing this potential Achilles’ heel in EY’s defense to my attention. However, he incorrectly used the term “opinion” in his most recent commentary to refer to EY’s reports of their review that were included in Lehman’s 10Q’s. It’s an oddity that investment banks insist on a report for the 10Q review from their audit firms. A review is required. A report is not. I still don’t know why Lehman requested reports to be included in quarterly filings. I certainly can’t, for the life of me, figure out why the auditors would do it. Post- Private Securities Litigation Reform Act, auditors (and law firms) have escaped liabilities for misstatements in quarterly reports because they do not make “explicit” statements. That is, their review is done in the background, they provide no written report and their review is not technically, or in their opinion, an “opinion.” But providing an actual report of the 10Q review, one that is included in the regulatory filing, may be what opens EY to liability for Lehman’s 2008 financials. Auditors also provide reports documenting their 10Q reviews for Goldman Sachs (PwC) and Morgan Stanley (Deloitte). Deloitte also provided reports of their 10Q reviews for Merrill Lynch prior to their absorption by Bank of America and for Bear Stearns prior to their bankruptcy and absorption into JPM Chase. The auditor’s report of their review for Bear Stearns’ 10Q as of February 28, 2008 actually had a “going concern” warning. Bear Stearns agreed to be bought by JPM Chase in early March.That was crucial but too little too late. The actual 10Q was not issued until April, after the JPM purchase had been proposed. Notably, EY does not provide these reports of their review of 10Qs for UBS, PwC does not do this for JPM Chase or Bank of America, and KPMG does not do so for Citigroup. Cases such as Lattanzio v. Deloitte & Touche LLP, 476 F.3d 147, 154 (2d Cir. 2007) make it clear that an explicit statement by the auditors is necessary to hold them liable. I have not been able to find any cases where auditor reports of their 10Q reviews made the difference in auditor liability. It may difficult to find case like this since so many complaints of malpractice against the auditors settle rather than go to trial. I have the distinct impression Jonathan Weil thinks that provision of a report of the auditor’s 10Q review may strengthen the possibility of liability for EY. I agree, but recognize I have nothing but hope to base this conclusion on.

In addition to the New York Attorney General’s case against Ernst & Young, they still have to worry about the SEC and Department of Justice. Serious sanctions against Ernst and Young by the SEC, or criminal charges from the Department of Justice for Lehman executives possibly fraudulent Section 302 certifications, are unlikely. However, the SEC and PCAOB would be remiss if they did not eventually sanction some individuals at least, if not the firm as a whole.

What I wrote October 31, 2010: