Can You Break the Law by Complying With It?

Another great article by Peter Henning @ DealBook.

Ernst & Young’s assertion that accounting issues did not cause Lehman to declare bankruptcy is most likely correct. Accounting rules are created to give a snapshot of a company’s financial position and cannot on their own cause a liquidity squeeze or decline in revenue that can lead to a company’s demise. But Ernst & Young’s statement is also a non sequitur because the issue in the attorney general’s complaint is not whether the Repo 105 transactions triggered Lehman’s collapse – they did not – but whether investors failed to comprehend the risks on Lehman’s balance sheet because those transactions obfuscated the firm’s precarious position.

I doubt either side really wants to see this case go to trial. Arguing about the propriety of a company’s accounting treatment in front of a jury is not very appealing for the state, given the complexity of the matter. And the accounting firm will undoubtedly bring in experts to opine that the Repo 105 transactions complied with SFAS 140 and there was no obligation to make further disclosure.

For Ernst & Young, a public airing of its willingness to allow Lehman to aggressively use accounting window dressing while arguing that it was technically correct under the rules is an equally unattractive option. Moreover, the Martin Act does not require proof of “scienter,” or fraudulent intent. So the firm could be found liable for negligence, which may not be too difficult to show in light of the bankruptcy.

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