Senate Questions Auditors’ And SEC’s Roles In Financial Crisis

Two and a half years after the collapse of Lehman Brothers almost every possible cause for the failure has been examined. Last week, auditing companies were in the spotlight as the Senate Banking Committee considers stricter regulation for the industry.

Prompted by the bankruptcy examiner’s report, authored by Jenner & Block Chairman Anton Valukas, the government decided to examine oversight of auditing companies, what role they played in the financial crisis and how future problems can be prevented. The role of the SEC, and alleged failures to report problems at Lehman, also came under scrutiny.

Valukas appeared before the Senate Banking Committee to provide his insights into the financial crisis, with a particular focus on the events at Lehman. While not laying blame directly on any one group, the Valukas report did highlight failures by auditors that could have helped prevent, delay or mitigate the Lehman bankruptcy. “The auditors did play a role in the disclosure, or non-disclosure, of information that would have been critical for the public to know about and which masked Lehman’s financial condition,” In the full report from March 2010, he pointed directly to the auditor’s failure to object to the omission in Lehman’s public filings of any reference to Repo 105 transactions (which were conducted in the U.K. because the way they were recognised as “sales” is not considered legal in the U.S.). Valukas also spoke of his concern that the auditor did not examine the assets in Lehman’s liquidity pool to determine the actual value (or if the assets were in fact liquid at all).

Valukas told the Committee, “I found that Lehman’s decision not to disclose to the public a fair and accurate picture of its financial condition gave rise to colorable claims against senior officers who oversaw and certified misleading financial statements. Nevertheless, and wholly apart from the claims involving Lehman’s auditors, we must recognise the general principle that auditors serve a critical role in the proper functioning of public companies and financial markets.

“Boards of directors and audit committees are entitled to rely on external auditors to serve as watchdogs—to be important gatekeepers who provide an independent check on management. And the investing public is entitled to believe that a ‘clean’ report from an independent auditor stands for something. The public has every right to conclude that auditors who hold themselves out as independent will stand up to management and not succumb to pressure to avoid rocking the boat. I found that colorable claims exist against Lehman’s external auditor in connection with Lehman’s issuance of materially misleading financial reports.”

For the full transcript of Valukas’ testimony please click here.

Also at the hearing before the Senate Banking Committee, SEC Chief Accountant James Kroeker was called on to answer questions that the SEC had information about problems at Lehman, specifically concerns about liquidity pools, and failed to adequately take action.

The Valukas report suggested that the now-defunct Trading and Markets unit at the SEC knew about problems and did not inform officials at other divisions of the Commission. Kroeker says the SEC took the report seriously and has responded: “It is a very serious observation, but it has been addressed.” It was not explained exactly how the problem was addressed beyond the fact that the SEC went through a reorganization of divisions in late 2008.

In addition to Valukas and Kroeker, the chairman of PCAOB was also called on to give testimony. James Doty admitted that auditors should have been more vigilant, not just at Lehman, but across the board. “There were a number of areas where auditors should have delved more deeply,” Doty said. He pointed to serious ongoing problems with valuations and end-of-period transactions.

The findings of the committee will likely have a serious impact on the oversight of the auditing industry as a whole. The government is currently examining various aspects of the way auditing firms are regulated and their level of accountability to companies and investors who relay on their assessments.

For the full Jenner & Block examiner’s report on the Lehman Brothers bankruptcy, please click here.