Lehman Brothers’ auditor Ernst & Young was named as a defendant in a Martin Act securities fraud suit by the New York Attorney General. The complaint claims that for years the giant accounting firm issued clean audit opinions on Lehman’s financial statements while knowing that they were false and misleading. The People of the State of New York v. Ernst & Young LLP (N.Y. Sup. Ct. Filed Dec. 21, 2010). The suit is potentially one of the most significant market crisis cases. Perhaps of more significance however, is the fact that the SEC has not brought an enforcement action, choosing to issue new rules in the area of “window dressing” (here).

Mr. Cuomo’s suit revolves around Lehman’s use of what it called “Repo 105.” Repo transactions are financing arrangements in which a financial institution uses securities as collateral for a short term loan. Part of the deal is an agreement to repurchase the same or equivalent securities at a later date. The transactions are recorded as financings.

Under certain circumstances, the transactions may be booked as “sales.” FASB 140 provides that if the company gives up all control of the securities and takes a “haircut” on their value thereby putting the company in a position where it may not be able to reacquire the securities, the transaction may be booked as a sale. A legal opinion called a “true sale” opinion supports the “sale” treatment.

Lehman shopped for a “true sale” opinion so it could book period end repo transactions as sales. While no U.S. law firm would write the opinion, a U.K. firm issued one for transactions in that country under local law.

In 2001, Lehman adopted an internal Accounting Policy Statement regarding what it called Repo 105 transactions. It focused on repo transactions at period end that would be recorded as sales. E&Y approved the statement based on the understanding that the transactions were designed to “manage balance sheet metrics,” according to the complaint.

Over the years, Lehman continued to use Repo 105 and similar transactions as balance sheet metrics. The transactions were not disclosed as financings. The MD&A section of Lehman’s reports did not disclose the nature of the transactions. The sections of the company’s filings which discussed short term financing did not describe the transactions. These disclosures were false, according to the complaint. If the transactions had been booked as financing, the true extent to which Lehman was leveraged would have been disclosed. Using the transactions permitted the investment bank to conceal the true extent to which it was leveraged according to the NYAG. Since Lehman depended on short term borrowings to manage its business, the extent to which it was leveraged was critical.

As the financial market crisis unfolded Lehman increased its reliance on the transactions. It was critical that the firm not appear to be over leveraged. Increasing the use of the transactions helped the firm manage its metrics regarding leverage. E&Y was aware of these transactions and signed off on them.

Eventually, the complaint claims, Lehman’s efforts to create the false appearance that it was reducing leverage failed. The firm collapsed in bankruptcy. The complaint contains three causes of action for securities fraud under the Martin Act and a fourth for persistent fraud and illegality.

The key to the complaint, its fraud charges and its false disclosure claims is its assertion that in substance Repo 105 transactions were not “sales.” In substance, the transactions were financings, according to the complaint. If that assertion is correct not only was disclosure required, but more importantly, Lehman would not have been able to alter key metrics about it leverage. If the Repo 105 transactions were booked as financings they would not have had any impact on those metrics. In that instance, it would have been apparent that Lehman was far over leveraged long before it collapsed.

The SEC appears to have taken a different approach to the question of period end transactions used to improve the balance sheet and financial metrics. In a curious choice, the Commission elected in its release on “window dressing” earlier this year to require more disclosure. This potentially puts the Commission at odds with the NYAG who argues the rules are clear and Lehman defrauded investors and the markets.

It is no doubt correct to claim that substance rather than form should govern the recording of transactions. Viewed in this context, perhaps the central issue in this case is Mr. Cuomo’s insistence that the rules are clear and Lehman, assisted by E&Y, committed fraud, versus the SEC’s apparent view that more rules are required to deal with such situations.