The current issue of New York Magazine has a lengthy story about the collapse of Lehman Brothers. To cut to the chase: Management knew in June that the company was in serious, serious trouble. Which leads me to ask when their auditors knew?

This question is significant because if the auditors knew about serious problems at companies like Lehman, they may have some liability to investors. It becomes even more significant when you consider that Lehman’s auditors, Ernst & Young (E&Y) were selected to oversee the accounting and give “expert advice” for the Troubled Asset Relief Program (TARP, aka Bailout Bill).  When E&Y and PriceWaterhouse Coopers were selected to assist with overseeing TARP, I suggested this was akin to the fox guarding the henhouse, as both of these firms might have some liability in the meltdown of the financial markets.

The magazine reports on a June 11, 2008 meeting of Lehman senior investment bankers with CEO Richard Fuld:

Hugh Skip McGee, the global head of investment banking and for years a loyal Lehman employee, had requested the meeting. They gathered in Fuld’s private dining room on the 32nd floor of Lehman’s Seventh Avenue headquarters, a somber mahogany-paneled room, with a list of several demands, chief among them a change in leadership.“The board of directors is going to be under pressure,” said one banker. And then added, “It has to deliver a head to the street.”

And the response:

“I’ve given you fourteen years of earnings. I have one bad quarter. This is how you respond?” Fuld shot back. The veins on his neck popped.

But the bankers pressed their case. Actually, they wanted two heads. They would spare Fuld the indignity of a coup, but they wanted him to fire Joe Gregory, Lehman’s president, and Erin Callan, Gregory’s protégée, whom he’d made CFO and who had been the public, sunny face of Lehman as it spiraled down. Firing Gregory would be personally devastating to Fuld, as the bankers knew. Over three decades at Lehman, the two had rarely sat more than a hundred feet from each other. Professionally, they were complements: Mr. Inside and Mr. Outside.

 

“If it’s not Joe, then it would be you,” said another banker. “And that would be a disaster.”

 

Fuld has a famously voracious appetite—senior executives sometimes ordered him a mid-morning plate of ribs. The joke was that he never gained weight; his intensity burned off the calories. That day, he hardly touched his food. At the end of the meal, he pushed out of his chair. Fuld had agreed to most of the bankers’ demands, but he had been careful not to make an explicit commitment to fire his oldest ally. He wanted to know whether there was any way he could let Gregory and Callan survive without the bankers blowing him up in public.

The story goes on to document Dick Fuld’s beginnings at Lehman, joining the company as a trader in 1969. He was unexpectedly put in charge of Lehman  in 1994, when the company was spun off from American Express and it wasn’t really expected to survive.

In late 2006, some executives expressed concern that a weakening real estate market could hurt Lehman. The company had been doing extremely well, but problems in the real estate and mortgage markets would threaten this.

Things still seemed relatively rosy (amid a few skeptics) in early 2008:

Around the same time, [Erin] Callan led Lehman’s first-quarter-earnings call with analysts. Citigroup and Merrill Lynch would both announce significant first-quarter losses—Merrill at $1.97 billion, Citigroup at $5.1 billion. Lehman coolly posted a profit of $489 million. It was smaller than usual, and included some “hard-to-repeat gains,” as The Wall Street Journal put it. Still, it was Lehman’s 55th consecutive profitable quarter.

One hedge-fund owner, David Einhorn, later asserted that Lehman had overvalued important assets, in effect fudging its books. In fact, many of Lehman’s losses were “back-loaded,” already lurking on its books. But that day, Callan’s confident, optimistic account prevailed. “The Street believed that Lehman must be better risk managers [than other banks],” one executive explained. Lehman’s stock price jumped 46 percent on the earnings report. Later, Callan walked down to the Lehman trading floor and got a standing ovation.

But second quarter numbers were bad: a $2.8 million loss reported on June 9, 2008. And based on the above meeting, we know that as of June 11, upper management knew there was a serious problem. Things went down fast, with a $3.9 billion third quarter loss reported on September 10, and the bankruptcy filing on September 15.

On January 28, 2008, E&Y issued a clean opinion on the audited financial statements for the year ended November 30, 2007.  On July 10, 2008, E&Y issued a clean opinion on the reviewed financial statements for the quarter ended May 31, 2008.

The question that remains is what E&Y knew and when they knew it. Are we to believe that they had no idea the company was in big trouble when those opinions were issued? Why was there no “going concern” comment? Did no employee of Lehman talk to anyone on the E&Y audit team about the financial problems?  Doubtful. My guess is that E&Y was intimately involved in assessing the financial situation, but we’ll have to wait and see what comes out.

Of course, E&Y has been sued over its Lehman work. So stay tuned to see what evidence is produced in the case. (My guess is that E&Y will make a quick, relatively inexpensive settlement. I say “relatively” becuase if this case goes to court, we could see an end to E&Y that’s not too different from the Arthur Andersen demise.)