Case 1:09-md LAK Document 413 Filed 04/04/11 Page 1 of 29 IN THE UNITED STATES DISTRICT COURT FOR THE SOUTHERN DISTRICT OF NEW YORK

Transcription

1 Case 1:09-md LAK Document 413 Filed 04/04/11 Page 1 of 29 IN THE UNITED STATES DISTRICT COURT FOR THE SOUTHERN DISTRICT OF NEW YORK In re: LEHMAN BROTHERS SECURITIES AND ERISA LITIGATION This Document Applies To: Civil Action No. 09 MD 2017 (LAK) ECF CASE 11 CV 384 (LAK) THE PEOPLE OF THE STATE OF NEW YORK, by ANDREW M. CUOMO, Attorney General of the State of New York, - against ERNST & YOUNG LLP, Plaintiff, Defendant. ERNST & YOUNG LLP S MEMORANDUM OF LAW IN OPPOSITION TO MOTION TO REMAND Miles N. Ruthberg Jamie L. Wine LATHAM & WATKINS LLP 885 Third Avenue New York, New York Tel: (212) Robert Abrams James L. Bernard STROOCK & STROOCK & LAVAN LLP 180 Maiden Lane New York, New York Tel: (212) Date: April 4, 2011 Barry H. Berke Dani R. James KRAMER LEVIN NAFTALIS & FRANKEL LLP 1177 Avenue of the Americas New York, New York Tel: (212) Attorneys for Defendant Ernst & Young LLP

2 Case 1:09-md LAK Document 413 Filed 04/04/11 Page 2 of 29 TABLE OF CONTENTS PRELIMINARY STATEMENT...1 BACKGROUND...4 A. Distinction Between Federal Public Company Auditing Standards and Generally Accepted Accounting Principles...4 B. EY s Role as Lehman s Registered Public Accounting Firm...6 C. The NYAG s Civil Action Against EY....7 STANDARD OF LAW...8 ARGUMENT...10 A. The Complaint Makes Questions of Federal Law Necessary Elements of Each Claim PCAOB Auditing Standards Constitute Federal Law As Pleaded in the Complaint, EY s Alleged Violations of PCAOB Auditing Standards Are Essential Predicates to The Claims...13 a. The NYAG s Claims Are Based on EY s Duties as a Public Auditor As Created and Defined by the PCAOB Auditing Standards...13 b. Violations of PCAOB Auditing Standards Are Essential Elements of the First Cause of Action There Is No Merit to the NYAG s Argument That PCAOB Auditing Standards Are Relevant Only to Potential Defenses B. The Federal Interest Is Sufficient to Confer Federal Jurisdiction and Does Not Disrupt the State/Federal Balance...19 CONCLUSION...23 ii

3 Case 1:09-md LAK Document 413 Filed 04/04/11 Page 3 of 29 TABLE OF AUTHORITIES CASES PAGE(S) Bell v. Hood, 327 U.S. 678, 66 S. Ct. 773 (1946)...13 Broder v. Cablevision Sys. Corp., 418 F.3d 187 (2d Cir. 2005)...3, 9, 17, 18, 20 Massachusetts v. New Eng. Pellet, LLC, 409 B.R. 255 (D. Mass. 2009)...22 D'Alessio v. New York Stock Exch., 258 F.3d 93 (2d Cir. 2001)...1, 8, 15, 17 Deephaven Private Placement Trading, Ltd. v. Grant Thornton & Co., 454 F.3d 1168 (10th Cir. 2006) Eastman v. Marine Mechanical Corp., 438 F.3d 544 (6th Cir. 2006)...22 Fed. Ins. Co. v. Tyco Int l Ltd., 422 F. Supp. 2d 357 (S.D.N.Y. 2006)...2 Finance and Trading, Ltd. v. Rhodia, S.A., 04 Civ. 6083, 2004 WL (S.D.N.Y. Nov. 30, 2004)...17 Franchise Tax Bd. v. Constr. Laborers Vacation Trust, 463 U.S. 1, 103 S. Ct (1983)...8 Frayler v. New York Stock Exch., 118 F. Supp. 2d 448 (S.D.N.Y. 2000) Free Enter. Fund v. Pub. Co. Accounting Oversight Bd., 130 S. Ct. 3138, 177 L. Ed. 2d 706 (2010)...5, 22 Gamoran v. Neuberger Berman Mgmt., LLC, 10 Civ (LBS), 2011 WL (S.D.N.Y. Feb. 9, 2011)...18 Grable & Sons Metal Prods. v. Darue Eng g & Mfg., 545 U.S. 308, 125 S. Ct (2005)...Passim Hawkins v. NASD, 149 F.3d 330 (5th Cir. 1998)...13, 15 iii

4 Case 1:09-md LAK Document 413 Filed 04/04/11 Page 4 of 29 In re Apple Computer Sec. Litigation, 886 F.2d 1109 (9th Cir. 1989)...18 In re Scor Holding (Switz.) AG Litigation, 537 F. Supp. 2d 556 (S.D.N.Y. 2008)...18 Merrell Dow Pharms. Inc. v. Thompson, 478 U.S. 804, 106 S. Ct (1986)...15 New York v. First American Corp. No. 07 Civ (LTS), 2008 WL (S.D.N.Y. July 8, 2008)...17 Pennsylvania v. Eli Lilly & Co., Inc., 511 F. Supp. 2d 576 (E.D. Pa. 2007)...22 People v. Dell, Inc., 514 F. Supp. 2d 397 (N.D.N.Y. 2007)...17, 22 People of California v. H & R Block, Inc., No. C SC, 2006 WL (N.D. Cal. Sept 18, 2006)...17, 22 Pullman Co. v. Jenkins, 305 U.S. 534, 59 S. Ct. 347 (1939)...2 Sparta Surgical Corp. v. NASD, 159 F.3d 1209 (9th Cir. 1998)...1-2, 8-9, 15 State of New York v. Citibank, N.A., 537 F. Supp (S.D.N.Y. 1982)...9, 23 Stillwater Capital Partners, L.P. v. Bear Stearns Asset Mgmt. Inc., No. 09 Civ. 4223, bench op. (S.D.N.Y. Aug. 25, 2009)...9, 15 United States ex rel. Pervez v. Beth Israel Med. Ctr., 736 F. Supp. 2d 804 (S.D.N.Y. 2010)...18 Vera v. Saks & Co., 335 F.3d 109 (2d Cir. 2003)...2 W. 14th St. Commercial Corp. v. 5 W. 14th St. Owners Corp., 815 F.2d 188 (2d Cir. 1987)...8, 15 Wietschner v. Gilmartin, No , 2003 U.S. Dist. LEXIS (D. N.J. Jan 13, 2003)...9 iv

5 Case 1:09-md LAK Document 413 Filed 04/04/11 Page 5 of 29 STATUTES AND REGULATIONS 15 U.S.C Passim 15 U.S.C U.S.C U.S.C , 6, U.S.C. 77s U.S.C. 78aa...Passim 17 C.F.R C.F.R. Part C.F.R. Part U.S.C , 8, 9, U.S.C U.S.C , U.S.C LEGISLATIVE HISTORY The Public Company Accounting Reform and Investor Protection Act of 2002 (also known as The Sarbanes-Oxley Act ), Pub. L , 116 Stat , 5, Cong. Rec. H5462 (daily ed. Jul. 25, 2002) (Statement of Rep. John LaFalce) Cong. Rec. S6734 (daily ed. Jul. 15, 2002) (Statement of Sen. Paul Sarbanes) Cong. Rec. S6734 (daily ed. Jul. 15, 2002) (Statement of Sen. Patricia Murray)...11, 21 OTHER AUTHORITIES SEC Rel. Nos and (Apr. 25, 2003)...12 SEC Rel. No , File No. PCAOB (Jul. 16, 2003)...6 v

6 Case 1:09-md LAK Document 413 Filed 04/04/11 Page 6 of 29 SEC Rel.No ; File No. PCAOB (Oct. 31, 2003))...2 SEC Rel. No , File No. PCAOB (Mar. 25, 2004)...6 SEC Rel.No ; File No. PCAOB (April 6, 2004)...6 SEC Rel. No , File No. PCAOB (May 13, 2004)...6 SEC Rel. No , File No. PCAOB (Aug. 13, 2009)...6 PCAOB Rel. No (Apr. 18, 2003)...12 PCAOB Rel.No (June 9, 2004)...12 PCAOB Rules 2100 through PCAOB Rule PCAOB Rule 3200T...12 PCAOB AUDITING STANDARDS AU 110, Responsibilities and Functions of the Independent Auditor...7, 14 AU 316, Consideration of Fraud in a Financial Statement Audit...7, 14 AU 336, Using the Work of a Specialist...7, 14 AU 380, Communication with Audit Committees...7, 14 AU 411, The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles...7, 12, 14, 17 AU 9336, Using the Work of a Specialist: Auditing Interpretations of Section , 14 vi

7 Case 1:09-md LAK Document 413 Filed 04/04/11 Page 7 of 29 Defendant Ernst & Young LLP ( EY ) respectfully submits this Memorandum of Law in Opposition to the Motion to Remand brought by the New York Attorney General ( NYAG ). PRELIMINARY STATEMENT This case arises out of the same facts that are at issue in a multitude of cases pending before this Court in In re Lehman Brothers Securities and ERISA Litigation, Civil Action No. 09 MD 2017 (LAK). Although pleaded here as state law claims, the causes of action in the NYAG s Complaint (the Complaint ) are expressly predicated on the Complaint s allegations that EY violated the federal auditing standards promulgated by the Public Company Accounting Oversight Board ( PCAOB ), and that EY falsely stated that it complied with those federal auditing standards. Accordingly, under 28 U.S.C. 1331, the NYAG s claims raise substantial federal issues that are necessary to their resolution, and the case was properly removed on that basis. Grable & Sons Metal Prods. v. Darue Eng g & Mfg., 545 U.S. 308, , 125 S. Ct. 2363, (2005) (state action premised on violation of a federal statute gave rise to federal jurisdiction); D Alessio v. New York Stock Exch., 258 F.3d 93, 100 (2d Cir. 2001) (complaint alleging state law tort claims arose under federal law because claims were predicated on alleged violations of SEC regulations and NYSE rules that had force of federal law). That these issues are federal in nature is established beyond dispute by the Sarbanes- Oxley Act of 2002 ( SOX ). Pub. L , 116 Stat. 745 (2002). In SOX, Congress expressly provided that violations of any rule of the PCAOB shall be treated for all purposes in the same manner as a violation of the Securities Exchange Act of 1934 [the Exchange Act ] or the rules or regulations issued thereunder U.S.C. 7202(b)(1). Violations of the Exchange Act or the rules and regulations thereunder are subject to exclusive federal jurisdiction. 15 U.S.C. 78aa; see Sparta Surgical Corp. v. NASD, 159 F.3d 1209, (9th Cir. 1998) 1

8 Case 1:09-md LAK Document 413 Filed 04/04/11 Page 8 of 29 (because Sparta s state law tort claims sought relief based upon violation of exchange rules, subject matter jurisdiction was specifically vested in the federal district court under the Exchange Act... ). The instant case which alleges violations of multiple PCAOB rules and professional standards 1 is equally subject to exclusive federal jurisdiction as pleaded. Despite clear federal jurisdiction, the NYAG contends that this case should be remanded. In so doing, the NYAG disregards: The allegations of its own Complaint, predicating each claim on EY s alleged violations of federal PCAOB auditing standards. See, e.g., Compl (Section XI E&Y Failed to Meet GAAS Standards ); id. 57, 59-60, 64. The Complaint as pleaded is controlling regarding the propriety of removal; 2 and The dispositive Second Circuit law (D Alessio) and provision of SOX (15 U.S.C. 7202(b)(1)), both of which EY cited as controlling authorities in the Notice of Removal. The NYAG should not be permitted to avoid the allegations in the Complaint. Although the NYAG asserts it could prove all of the alleged Martin Act and Executive Law violations by alternative, non-federal theories, the Complaint does not plead any such alternate theories. Instead, the Complaint affirmatively alleges that Generally Accepted Auditing Standards ( GAAS ) were adopted, amended and expanded upon by the Public Company Accounting Oversight Board ( PCAOB ), and with which auditors must comply when conducting audits and reviews. Compl. 57; see also Motion to Remand at 16 (acknowledging 1 A violation of the PCAOB s auditing and related professional standards is a violation of the PCAOB s rules. See PCAOB Rule 3100 ( A registered public accounting firm and its associated persons shall comply with all applicable auditing and related professional practice standards. ) (approved by the SEC on October 31, 2003, see PCAOB Rulemaking: Order Approving Proposed Rules Relating to Compliance with Auditing and Related Professional Practice Standards and Advisory Groups, Release No ; File No. PCAOB (Oct. 31, 2003)). 2 See, e.g., Vera v. Saks & Co., 335 F.3d 109, 116 n.2 (2d Cir. 2003) ( [W]e generally evaluate a defendant s right to remove a case to federal court at the time the removal notice is filed. ); Fed. Ins. Co. v. Tyco Int l Ltd., 422 F. Supp. 2d 357, 368 (S.D.N.Y. 2006) ( [t]he propriety of removal is to determined by the pleadings at the time of removal ) (citing Pullman Co. v. Jenkins, 305 U.S. 534, 537, 59 S. Ct. 347, (1939)) 2

9 Case 1:09-md LAK Document 413 Filed 04/04/11 Page 9 of 29 that the auditing standards relied upon in the Complaint have been incorporated into specific federal regulations by a federal regulatory body, in this case the PCAOB ). Having identified PCAOB audit rules as the governing standards, the Complaint in Sections X and XI ties all of its core factual allegations to purported violations by EY of specific PCAOB auditing standards, see Compl. 64, 67-71, demonstrating that the claims (which directly follow these two sections) are fundamentally rooted in alleged violations of federal law. In any event, the necessity of resolving federal issues is undeniable with respect to the NYAG s First Cause of Action, in which the NYAG alleges that EY issued false statements regarding its audits and reviews of Lehman s financial statements. Id. 73. EY stated in particular that its audits and reviews were conducted in accordance with the standards of the Public Company Accounting Oversight Board, and such standards were the express basis for EY s audit opinions and review reports regarding Lehman s financial statements. Id. 60; see also, e.g., 2007 Form 10-K at 84 (Ex. 1) 3 ( We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). ); Second Quarter 2008 Form 10-Q at 53 (Ex. 2) ( We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). ). By definition, the alleged falsity of these statements of compliance with PCAOB auditing standards cannot be decided without determining whether EY violated these very standards, which has now been made a federal question by virtue of SOX. Thus, there is federal jurisdiction over the First Cause of Action, at a minimum, and therefore removal is proper. See Broder v. Cablevision Sys, Corp., 418 F.3d 187, (2d Cir. 2005) (removal is proper if there is federal question jurisdiction over any single claim in a complaint). 3 Citations to Ex. refer to exhibits attached to the Declaration of Brian E. Kowalski filed herewith. 3

10 Case 1:09-md LAK Document 413 Filed 04/04/11 Page 10 of 29 Further, under the Supreme Court s guidance in Grable, the exercise of such jurisdiction would not upset the division of labor between federal and state courts. Given that the NYAG elected to plead violations of PCAOB auditing standards as a fundamental element of its Complaint, there can be no doubt that the exercise of federal jurisdiction is consistent with the wishes of Congress, as reflected in 15 U.S.C. 7202(b)(1) and 78aa. In short, the NYAG cannot escape its own allegations. The claims are premised on purported violations of PCAOB auditing standards, as well as EY s statements regarding compliance with those standards, the resolution of which falls squarely within the jurisdiction of this Court. Accordingly, the NYAG s Motion to Remand should be denied and this Court should exercise federal question jurisdiction over this action. BACKGROUND A. Distinction Between Federal Public Company Auditing Standards and Generally Accepted Accounting Principles. Throughout its Motion to Remand, the NYAG collapses together GAAS (now superseded with respect to public company audits by PCAOB auditing standards), and generally accepted accounting principles ( GAAP ), loosely referring to all of them collectively as accounting rules. See, e.g., Motion to Remand at The NYAG then argues that PCAOB auditing standards are non-federal in nature by referring to provisions of GAAP and cases interpreting GAAP rather than PCAOB auditing standards. See, e.g., id. at (citing U.S. v. Ebbers, In re Global Crossing Sec. Litig., and U.S. v. Simon each of which addressed allegations of GAAP violations, not PCAOB auditing standards). Public company auditors, such as EY, are required to conduct their public company audits in accordance with auditing standards established by the PCAOB. Historically, auditing standards were developed by the American Institute of Certified Public Accountants ( AICPA ), 4

11 Case 1:09-md LAK Document 413 Filed 04/04/11 Page 11 of 29 a private, professional organization in the accounting and auditing industry. See Compl. 57. These standards were commonly referred to as generally accepted auditing standards, or GAAS. However, in 2002, Congress enacted SOX which, among other things, established the PCAOB and charged it with promulgating auditing and ethics standards governing the conduct of accounting firms in their audits of public companies, subject to specific approval by the U.S. Securities and Exchange Commission ( SEC ). Free Enter. Fund v. Pub. Co. Accounting Oversight Bd., 130 S. Ct. 3138, , 177 L. Ed. 2d 706, (2010); see Pub. L , 116 Stat. 745 (2002); 15 U.S.C Pursuant to this directive, the PCAOB established such auditing standards. In doing so, the PCAOB made clear that PCAOB auditing standards were qualitatively different from GAAS and carried the full force of federal law in the context of public company audits, a point the NYAG has specifically acknowledged in the Complaint. See, e.g., Compl. 57 (noting that GAAS has been adopted, amended and expanded upon by the PCAOB); see also Motion to Remand at 16 (acknowledging that GAAS provisions cited in the Complaint have been incorporated into specific federal regulations by a federal regulatory body, in this case the PCAOB... ); id. at 16 n.4 (identifying two particular standards the PCAOB has expanded and revised). In contrast to the auditing standards which have now been federalized for public company audits, a separate set of principles governs the accounting treatment that must be applied to transactions in the preparation of financial statements. These are known as generally accepted accounting principles, or GAAP. Except in limited instances where the SEC has directly issued pronouncements on accounting principles, GAAP has been promulgated by independent, private standard-setters, including (and now exclusively) a private entity known as the Financial Accounting Standards Board ( FASB ). See 15 U.S.C. 77s(b). While under SEC 5

12 Case 1:09-md LAK Document 413 Filed 04/04/11 Page 12 of 29 rules financial statements are presumed misleading if they do not comply with GAAP, see 17 C.F.R (a)(1), the SEC does not exercise approval authority over the FASBpromulgated private standards constituting GAAP. B. EY s Role as Lehman s Registered Public Accounting Firm. Public accounting firms like EY are prohibited by federal law from auditing public companies unless they first register with the PCAOB pursuant to SOX. As a part of the registration, the accounting firms agree to abide by a series of rules and standards of the PCAOB that become effective only after the SEC has reviewed and approved them. 15 U.S.C to 7213; PCAOB Rules 2100 through 2300 (effective pursuant to SEC Release No , File No. PCAOB (Jul. 16, 2003); SEC Release No , File No. PCAOB (Mar. 25, 2004); SEC Release No , File No. PCAOB (May 13, 2004); SEC Release No , File No. PCAOB (Aug. 13, 2009)). Through 2007, EY issued unqualified audit opinions on the financial statements of Lehman Brothers Holdings, Inc. ( Lehman ), which were included in Lehman s Forms 10-K. Id. 11, 66; see, e.g., Ex. 1, 2007 Form 10-K at 84. In issuing its opinions, EY stated that its audits had been conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), that [t]hose standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, that such audits provide a reasonable basis for our opinion, and that [i]n our opinion, the financial statements... present fairly, in all material respects, the consolidated financial position of Lehman and in conformity with U.S. generally accepted accounting principles. See, e.g., Ex. 1, 2007 Form 10-K at 84 (emphasis added). EY s review reports on Lehman s unaudited quarterly financial statements similarly stated that EY s reviews had been conducted in accordance with the standards of the Public Company Accounting Oversight 6

13 Case 1:09-md LAK Document 413 Filed 04/04/11 Page 13 of 29 Board (United States) and that [b]ased on our review, we are not aware of any material modifications that should be made to the consolidated financial statements... for them to be in conformity with U.S. generally accepted accounting principles. See, e.g., Ex. 2, Second Quarter 2008 Form 10-Q at 53 (emphasis added); see also Compl. 60. C. The NYAG s Civil Action Against EY. The Complaint alleges violations of the Martin Act and Executive Law 63(12), arising from the Repo 105 transactions that were the subject of the Lehman bankruptcy examiner s report and which are currently at the center of the consolidated securities litigation pending before this Court. Except for a few references to information obtained during the NYAG s investigation, the factual allegations in the Complaint are identical to the allegations contained in the Third Amended Complaint that was filed in In re Lehman Brothers Equity/Debt Securities Litigation, No. 08 Civ (LAK). The NYAG s Complaint includes two sections specifically detailing the PCAOB auditing standards that EY allegedly violated (which the Complaint describes as the authoritative standards with which auditors must comply when conducting audits and reviews ). See Compl. 57; see also id ( E&Y Misrepresented Lehman s Compliance with Applicable Accounting Standards ) and ( E&Y Failed to Meet GAAS Standards ) (alleging violations of the following PCAOB auditing standards: AU 380 ( Communication with Audit Committees ), AU 316 ( Consideration of Fraud in a Financial Statement Audit ), AU 336 and 9336 ( Using the Work of a Specialist ), AU 110 ( Responsibilities and Functions of Independent Auditor ) and AU 411 ( The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles )). Based on these alleged violations of the PCAOB s auditing standards, the NYAG asserts three causes of action under New York s Martin Act and a fourth cause of action under New York s Executive Law. 7

14 Case 1:09-md LAK Document 413 Filed 04/04/11 Page 14 of 29 On January 19, 2011, EY removed the NYAG action to this Court on the basis of federal question jurisdiction under 28 U.S.C and 15 U.S.C. 78aa. The NYAG seeks an order remanding the case to state court, which EY opposes. STANDARD OF LAW Federal district courts have jurisdiction to hear, originally, or by removal from a state court, those cases in which a well-pleaded complaint establishes either that federal law creates the cause of action or that plaintiff s right to relief necessarily depends on resolution of a substantial question of federal law. Franchise Tax Bd. v. Constr. Laborers Vacation Trust, 463 U.S. 1, 8, 103 S. Ct. 2841, 2845 (1983) (emphasis added). Even where, as here, a claim is created by state law, a case may arise under a law of the United States if the complaint discloses a need for determining the meaning or application of such a law. D Alessio, 258 F.3d at 100. This rule captures the commonsense notion that a federal court ought to be able to hear claims recognized under state law that nonetheless turn on substantial questions of federal law, and thus justify resort to the experience, solicitude, and hope of uniformity that a federal forum offers on federal issues. Grable, 545 U.S. at 312, 125 S. Ct. at Where as here state law claims are pleaded in a manner that requires resolution of substantial federal questions, federal courts have not hesitated to exercise jurisdiction. See, e.g., id. at 319; D Alessio, 258 F.3d at 100 (complaint alleging state law tort claims against the NYSE and its officers arose under federal law because claims were predicated on defendants violation of federal law governing securities trading on a national exchange); W. 14th St. Commercial Corp. v. 5 W. 14th St. Owners Corp., 815 F.2d 188, 196 (2d Cir. 1987) (removal appropriate because construction of a federal statute would define the relevant rights and relationships and, therefore, be decisive with respect to state law claims); Sparta Surgical Corp., 159 F.3d at (state law tort claims premised on NASD s violations of its own rules gave 8

15 Case 1:09-md LAK Document 413 Filed 04/04/11 Page 15 of 29 rise to federal question jurisdiction); Stillwater Capital Partners, L.P. v. Bear Stearns Asset Mgmt. Inc., No. 09 Civ. 4223, bench op. (S.D.N.Y. Aug. 25, 2009) (claims that defendant breached duty created by Investment Advisers Act triggered federal question jurisdiction); State of New York v. Citibank, N.A., 537 F. Supp. 1192, 1197 (S.D.N.Y. 1982) (federal jurisdiction triggered because NYAG s allegations involv[ed] and require[d] determinations of whether Citibank has violated the federal Electronic Funds Transfer Act); Wietschner v. Gilmartin, No , 2003 U.S. Dist. LEXIS 18997, at *9 (D. N.J. Jan. 13, 2003) (alleged breaches of fiduciary duty premised on the failure to comply with federal securities laws created federal jurisdiction). 4 Further, under 28 USC 1441(a) and (c), a case is removable if there is federal question jurisdiction over any claim in the complaint. For this purpose, under Second Circuit law, if multiple wrongs are combined by the plaintiff in a single cause of action, it is sufficient if any one of them raises a federal question. Broder, 418 F.3d at (in identifying a single claim over which federal question jurisdiction exists, a court is not limited to what a plaintiff presents as one count, as a single count may be understood to encompass more than one claim ). For any remaining claims not independently subject to jurisdiction under 28 U.S.C. 1331, supplemental jurisdiction lies under 28 U.S.C because all claims in this case form part of the same case or controversy. 4 Although the NYAG characterizes the numerous cases in this category as rare, Motion to Remand at 8-9, the Supreme Court recognized in Grable that the exercise of federal jurisdiction over state law claims that necessarily require resolution of a federal issue is a longstanding, if less frequently encountered form of jurisdiction. 545 U.S. at 312, 125 S. Ct. at

16 Case 1:09-md LAK Document 413 Filed 04/04/11 Page 16 of 29 ARGUMENT The NYAG argues that the case should be remanded to state court for three reasons: it asserts that (1) no question of federal law is a necessary element of the NYAG s claims for relief; (2) to the extent any federal question is presented, it is not substantial ; and (3) a finding of federal question jurisdiction would disturb the balance of federal and state judicial responsibilities. Each of these arguments is without merit. To the contrary, the NYAG s claims necessarily require resolution of federal law in the form of PCAOB auditing standards, an area of substantial federal interest that Congress has singled out for exclusive jurisdiction in the federal courts. A. The Complaint Makes Questions of Federal Law Necessary Elements of Each Claim. The NYAG argues that accounting rules are not creatures of federal law, Motion to Remand at 13-16; violations of accounting rules are not necessary elements of the claims, id. at 9-13; any alleged violations of federal law are alternative theories of liability, id. at 16-20; and allegations of violations of accounting rules only anticipate defenses that EY may assert. Id. at 20. However, these points misconstrue the distinction between federal PCAOB auditing standards and non-federal GAAP accounting principles, fail to take into consideration the specific language in the NYAG s Complaint, and ignore controlling Second Circuit law and Congress express determination establishing federal jurisdiction for alleged violations of PCAOB rules. 1. PCAOB Auditing Standards Constitute Federal Law. As described above, when Congress enacted SOX in 2002, it created the PCAOB and mandated that the PCAOB, subject to the specific approval of the SEC, promulgate auditing and ethics standards to be used by registered public accounting firms in their audits of public 10

17 Case 1:09-md LAK Document 413 Filed 04/04/11 Page 17 of 29 companies. See Pub. L , 116 Stat. 745 (2002); 15 U.S.C In so doing, Congress made unmistakably clear that auditing standards promulgated by the PCAOB would constitute federal law. Indeed, under 15 U.S.C. 7202(b)(1), Congress provided that violations of PCAOB rules would be treated for all purposes in the same manner as a violation of the Exchange Act and, as such, Congress confirmed the jurisdiction of the federal courts over violations of these rules, as well as all suits in equity and actions at law brought to enforce any liability or duty created by these rules. 15 U.S.C. 7202(b)(1); 15 U.S.C. 78aa. The extensive legislative history of SOX further demonstrates the congressional intent that the creation of the PCAOB and, in particular, its authority to set auditing standards would expand the federal government s role regarding audits of public companies. 5 See, e.g., 148 Cong. Rec. S6734, S6758 (daily ed. Jul. 15, 2002) (Statement of Sen. Patricia Murray) (SOX strengthens the Federal Government s historic role of regulating publicly traded companies and their auditors. ) (emphasis added); see also id. (noting that the State boards of accountancy will continue their important role of regulating accountants who audit private companies... ) (emphasis added). 5 In authorizing the PCAOB to require the registration of accounting firms that audit public companies and the establishment of auditing standards that carried the force of federal law, Congress made clear that the then-existing system of self-regulation via professional organizations, such as the AICPA, had proven insufficient in the context of public company audits. See, e.g., 148 Cong. Rec. S6734, S6778 (daily ed. Jul. 15, 2002) (Statement of Sen. Paul Sarbanes) ( This legislation establishes a strong independent board to oversee auditors of the public companies. The board can set standards, investigate, and discipline accountants. It will be overseen by the SEC, but it will have independent funding and membership. I think this marks the end of weak self-regulation with respect to public company auditors. ) (emphasis added); see also 148 Cong. Rec. H5462, H (daily ed. Jul. 25, 2002) (Statement of Rep. John LaFalce) ( [T]he oversight board included in the final conference report will be independently funded and will have strong disciplinary, investigatory, and, most importantly, standard-setting powers. I thought this was extremely important. No longer will the accounting industry be able to set the rules for itself without regard for the interests of shareholders. ) Accordingly, Congress determined that the prior system should be replaced by a congressionally established entity that would operate under the close oversight of the SEC, and whose standards would constitute federal law. 11

18 Case 1:09-md LAK Document 413 Filed 04/04/11 Page 18 of 29 Pursuant to its congressional directive, the PCAOB adopted auditing standards by issuing Rule 3200T, which subsequently received SEC approval. Order Regarding Section 103(a)(3)(B) of the Sarbanes-Oxley Act of 2002; Release Nos and (Apr. 25, 2003). As the PCAOB has explained, GAAS standards previously were developed at a time when auditing and accounting standards were not established with the force of law by governmental or other authoritative bodies, but rather were established by consensus among the members of the accounting profession. PCAOB Rulemaking: Public Company Accounting Oversight Board; Notice of Filing of Proposed Auditing Standard No. 1, References in Auditors Reports to the Standards of the Public Company Oversight Board, Release No ; File No. PCAOB (April 6, 2004) (emphasis added). Subsequent to the PCAOB s rulemaking, however, [w]hile [GAAS] may be generally accepted in a variety of contexts, what gives them the force of law in the context of public company audits is adoption by the PCAOB and approval by the SEC. 6 Id. (emphasis added). Further, as acknowledged in the NYAG s Complaint (Compl. 57), the PCAOB has since expanded and revised its standards such that they have diverged from pre-existing GAAS, which has resulted in different standards for auditing public companies (PCAOB auditing standards) and private companies (GAAS as defined by the AICPA), including certain PCAOB auditing standards cited in the Complaint itself. 7 6 See also Establishment of Interim Professional Auditing Standards, PCAOB Release No (Apr. 18, 2003) ( Subject to the Commission s oversight authority, the Act gives the Board the exclusive, statutory power to establish and amend Professional Auditing Standards to be used by registered public accounting firms in the preparation and issuance of audit reports. The Board s Professional Auditing Standards supersede standards established by professional organizations, with respect to the preparation or issuance of audit reports on the financial statements of issuers. ) (emphasis added). 7 See, e.g., AU 411 (which the PCAOB amended on January 29, 2008 via Auditing Standard No. 6) and AU 316 (which the PCAOB amended on September 14, 2004 via PCAOB Release and June 12, 2007 via PCAOB Release A.); see also Rule Regarding Certain Terms Used in 12

19 Case 1:09-md LAK Document 413 Filed 04/04/11 Page 19 of 29 In sum, the PCAOB s auditing standards carry the full force of federal law, and, as such, amply support the exercise of federal question jurisdiction. 2. As Pleaded in the Complaint, EY s Alleged Violations of PCAOB Auditing Standards Are Essential Predicates to The Claims. a. The NYAG s Claims Are Based on EY s Duties as a Public Auditor As Created and Defined by the PCAOB Auditing Standards. The alleged violations of the PCAOB auditing standards are pleaded as predicates to each of the NYAG s claims. Indeed, as pleaded, the central premise of the NYAG s claims is the allegation that EY violated the Martin Act and Executive Law 63(12) by failing to discharge its duties as a public company auditor. See, e.g., Compl. 5 (alleging that EY failed to discharge its absolute obligation, as the public auditor for Lehman, to ensure that Lehman s financial statements complied with GAAP and did not mislead the public ). 8 Further, the Complaint concedes, as it must, that EY s duties as a public auditor are created and defined by federal law in the form of PCAOB audit standards. Specifically, the Complaint states that: Generally Accepted Auditing Standards ( GAAS ) have been established to ensure that external auditors fulfill their obligations when auditing and reviewing financial statements and other information. GAAS consists of authoritative standards, originally established by the American Institute of Certified Public Auditing and Related Professional Practice Standards, PCAOB Release No (June 9, 2004) (establishing explicit definitions and related audit steps for varying levels of imperative language (e.g., should, must, and may ) contained in PCAOB standards, which do not apply to privately established GAAS). Accordingly, it does not matter whether the PCAOB s auditing standards originated outside of federal law and regulation, Motion to Remand at 21, since Congress has determined that such standards now constitute federal law in the context of public company audits. 8 Whether the NYAG s allegations of PCAOB violations are sufficient to state a claim is an issue for another day. See Hawkins v. NASD, 149 F.3d 330, 331 (5th Cir. 1998) ( Jurisdiction... is not defeated... by the possibility that the averments might fail to state a cause of action on which petitioners could actually recover. For it is well settled that the failure to state a proper cause of action calls for a judgment on the merits and not for a dismissal for want of jurisdiction. Whether the complaint states a cause of action on which relief could be granted is a question of law and just as issues of fact it must be decided after and not before the court has assumed jurisdiction over the controversy. ) (citing Bell v. Hood, 327 U.S. 678, 682, 66 S. Ct. 773, 776 (1946)). 13

20 Case 1:09-md LAK Document 413 Filed 04/04/11 Page 20 of 29 Accountants ( AICPA ), which were adopted, amended and expanded upon by the Public Company Accounting Oversight Board ( PCAOB ), and with which auditors must comply when conducting audits and reviews. An auditor is required to perform its annual audits and quarterly reviews of financial information in accordance with GAAS, which include, inter alia: (1) ten basic standards establishing the objections [sic] of a financial statement audit and providing guidance for the quality of audit procedures to be performed; (2) interpretations of these standards by the AICPA, set forth in Statements of Auditing Standards ( AU ); and (3) additional standards promulgated by PCAOB. Id. 57 (emphasis added); see also Motion to Remand at 16 (acknowledging that the auditing standards cited in the Complaint have been incorporated into specific federal regulations by a federal regulatory body, in this case the PCAOB.... ) Indeed, much of the NYAG s Complaint is devoted to a discussion of the alleged violations by EY of specific PCAOB audit standards. In particular, the NYAG alleges that EY violated PCAOB auditing standards AU 380 and 316 by failing to discuss with Lehman s Audit Committee a number of matters, including (a) Lehman s moving $30-$50 billion temporarily off the balance sheets at quarter-end, (the subject of Sections II ( 16-18) and VIII ( 51-53)); (b) Lehman s use of American-based securities based on an overseas True Sale opinion, (the subject of Section III ( 19-23)); (c) EY s purported concerns regarding reputational risk, (the subject of Section VII ( 41-50)); and (d) the increasing volume of Repo 105, (the subject of Section IV ( 24-31)). In addition, the NYAG alleges that EY violated PCAOB auditing standards AU 336 and 9336 in its consideration of Lehman s true sale opinion (the subject of Section III ( 19-23)), and AU 110 and 411 in issuing its opinion on Lehman s financial statements (the subject of Section X ( 57-66)). These are not merely alternate theories of liability. They are the Complaint s core allegations; indeed, no 14

21 Case 1:09-md LAK Document 413 Filed 04/04/11 Page 21 of 29 other predicate theories are pleaded. 9 See D Alessio, 258 F.3d at 101; Sparta Surgical Corp., 159 F.3d at ( [T]he rule that state law claims cannot be alchemized into federal causes of action by incidental reference has no application when relief is partially predicated on a subject matter committed exclusively to federal jurisdiction. ); see also W. 14th St. Commercial Corp., 815 F.2d at 196 (removal appropriate because the construction of a federal statute would define the relevant rights and relationships and, therefore, be decisive to state law claims). 10 The Second Circuit s holding in D Alessio is controlling. There, one basis for federal question jurisdiction was that the plaintiff had alleged a breach by the NYSE of duties that were created and defined by federal law. 258 F.3d at 101. Indeed, while the NYSE certainly may have had more general duties deriving from other sources (such as state law), the plaintiff s case, as pleaded, required the court to consider the NYSE s statutory duty to enforce member firms compliance with its own rules, as created and defined by federal law. As such, the exercise of federal jurisdiction was proper. Id. at 103; see also Stillwater Capital Partners, No. 09 Civ. 4223, bench op. (claims that defendant breached duty created by Investment Advisers Act triggered federal question jurisdiction); Hawkins, 149 F.3d at (claims articulated in terms of state law that NASD breached its duties owed to plaintiff in its role as 9 The NYAG notes that privately developed [accounting] rules, such as GAAP and GAAS, are incorporated by reference not just into federal securities law, but also, independently, into the laws of the several States, including New York, governing the licensing, registration and regulation of the accounting profession, and that accounting rules are themselves not creatures of federal law or regulation. But the Complaint alleges only that EY violated PCAOB auditing standards, and EY s own audit and review reports refer to PCAOB standards; neither the Complaint nor EY s reports refer to any New York or other state standards. 10 Recent Supreme Court authority (Grable) has clarified Merrell Dow Pharms. Inc. v. Thompson, 478 U.S. 804, 106 S. Ct (1986), previously construed at times to suggest that the borrowing of federal standards did not confer federal jurisdiction where no federal private right of action existed. Grable re-emphasized that federal jurisdiction turns on whether federal issues are necessary to resolution of the claims as pleaded, not on whether standards were somehow borrowed. 545 U.S. at 314, 125 S. Ct. at

22 Case 1:09-md LAK Document 413 Filed 04/04/11 Page 22 of 29 arbitrator sought to enforce liabilities and duties created by the Exchange Act which are governed exclusively by the federal courts). The same is true in the instant case. b. Violations of PCAOB Auditing Standards Are Essential Elements of the First Cause of Action. The necessity of addressing the federal question as to whether EY s conduct violated PCAOB rules is particularly apparent from the NYAG s First Cause of Action, which alleges solely that EY issued false statements regarding its audits and reviews of Lehman s financial statements. Compl. 73. The key statements regarding EY s audits and reviews undeniably are the statements that those audits and reviews were conducted in accordance with the standards of the PCAOB. See, e.g., Ex. 1, 2007 Form 10-K at 83 ( We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). ); Ex. 2, Second Quarter 2008 Form 10-Q at 53 ( We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). ). The Complaint itself expressly references EY s statements of compliance with PCAOB standards in the quarterly review reports. See Compl. 60 ( Similarly, each quarterly disclosure (Form 10- Q) contained a Report of Independent Registered Public Accounting Firm signed by E&Y, stating that, based on a review of Lehman s consolidated financial statements in accordance with the standards of the PCAOB, we are not aware of any material modifications that should be made to the consolidated financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles. ) (emphasis added). The NYAG can only establish the falsity of these statements by demonstrating that EY failed to comply with the referenced PCAOB auditing standards. Put differently, proving violations of PCAOB auditing standards is the sole path to proving the falsity of statements of compliance with those standards, and therefore the sole path to prevailing on the First Cause of 16

23 Case 1:09-md LAK Document 413 Filed 04/04/11 Page 23 of 29 Action. Accordingly, resolution of whether EY conducted its audits and reviews in accordance with PCAOB standards is a substantial federal question the answer to which is necessary to resolution of the First Cause of Action; it is not simply an alternate theory of liability. 11 In this regard, the NYAG s First Cause of Action is the same as the state law claims the Second Circuit (and other Circuits) have deemed to arise under federal law because they are predicated on alleged violations of federal standards. For example, in Broder, the Second Circuit held that state law claims based on defendants failure to comply with federal communications statutes and regulations gave rise to federal question jurisdiction. 418 F.3d at 196. As here, because the Broder plaintiffs claims were predicated on the defendant s violation of federal law, their claims necessarily raise[d] a stated federal issue, actually disputed and substantial. Id. at 195. The federal questions raised by the NYAG s First Cause of Action are also conceptually indistinguishable from the claims in D Alessio and Sparta. Those cases involved tort claims premised on the violation of federal securities laws related to the NYSE and NASD, respectively. As explained in Finance and Trading, Ltd. v. Rhodia, S.A., [a]s the facts were alleged in th[e] complaint, D Alessio would have had no state law cause of action if no federal law had been violated, thus his case rested substantially upon federal law and was justifiably removed. 04 Civ. 6083, 2004 WL , at *7-8 (S.D.N.Y. Nov. 30, 2004) (emphasis added). Similarly here, if the NYAG cannot demonstrate that federal law (in the form of PCAOB auditing standards) has been violated by EY, its First Cause of Action fails. Accordingly, under Broder 11 The case authority cited on this point by the NYAG is not to the contrary. In New York v. First American Corp., the federal issues presented were true alternate bases for attacking precisely the same alleged wrongs that were also addressed under state law theories. No. 07 Civ (LTS) (HP), 2008 WL , *3-4 (S.D.N.Y. July 8, 2008). The same was true in People v. Dell, Inc., 514 F. Supp. 2d 397, (N.D.N.Y. 2007) and People of California v. H & R Block, Inc., No. C SC, 2006 WL , at *3-4 (N.D. Cal. Sept. 18, 2006). That is not the case here, where alleged violations of federal PCAOB standards are pleaded as the express predicate for all of the NYAG s claims, and constitute the only conceivable basis for prevailing on the First Cause of Action. 17

24 Case 1:09-md LAK Document 413 Filed 04/04/11 Page 24 of 29 and 28 U.S.C. 1441, this entire case is properly removable because at least one claim in the Complaint is removable. Indeed, under Broder, even one alleged false statement regarding PCAOB compliance (whether in an audit opinion or a review report) constitutes a logically separate claim, even if presented by the NYAG in a single count, sufficient in and of itself to confer federal jurisdiction. Broder, 418 F.3d at 194; see, e.g., Gamoran v. Neuberger Berman Mgmt., LLC, 10 Civ (LBS), 2011 WL , at *2-3 (S.D.N.Y. Feb. 9, 2011) (finding separate federal claim pleaded as part of broader count); In re Scor Holding (Switz.) AG Litig., 537 F. Supp. 2d 556, (S.D.N.Y. 2008) ( A claim for securities fraud under the Exchange Act arises each time a defendant, in connection with the purchase or sale of securities, ma[kes] a materially false statement or omit[s] a material fact, assuming the other elements of the claim have been met.) (emphasis added). 12 Because the First Cause of Action undeniably covers multiple statements of PCAOB compliance, see, e.g., Compl. 60, it includes one or more federal claims and thus federal jurisdiction is clear See also, e.g., In re Apple Computer Sec. Litig., 886 F.2d 1109, 1118 (9th Cir. 1989) (rejecting, even prior to the PSLRA, plaintiffs argument that the trial court erred by considering each of the challenged statements in isolation, rather than looking to the overall pattern of deception carried out by Apple, because [p]laintiffs may defeat summary judgment only by showing a genuine issue of fact with regard to a particular statement by Apple or its insiders ); United States ex rel. Pervez v. Beth Israel Med. Ctr., 736 F. Supp. 2d 804, (S.D.N.Y. 2010) (analyzing statements separately under False Claims Act). 13 To the extent the NYAG may also assert claims premised on EY s opinions that Lehman s financial statements were fairly presented in accordance with GAAP, these claims would also turn on whether EY complied with PCAOB auditing standards. As the Complaint itself alleges, EY s opinions of GAAP conformity are based on PCAOB auditing standards, which define the meaning of present fairly in conformity with generally accepted accounting principles. AU 411; see Compl. 59, 64 (citing AU 110, 411); see also Compl., Section X (more generally alleging that false opinions on GAAP conformity are predicated on alleged violations of PCAOB audit standards). Accordingly, proof of a violation of PCAOB standards the express predicate that is pleaded would still be necessary to demonstrate the falsity of such opinions. Cf. Deephaven Private Placement Trading, Ltd. v. Grant Thornton & Co., 454 F.3d 1168, 1176 (10th Cir. 2006) ( Because Grant Thornton s opinion is couched in terms of a stated basis, a claim that the former is false or misleading must necessarily specify the reason 18

25 Case 1:09-md LAK Document 413 Filed 04/04/11 Page 25 of There Is No Merit to the NYAG s Argument That PCAOB Auditing Standards Are Relevant Only to Potential Defenses. The NYAG also argues that whether EY complied with accounting rules is relevant only to potential defenses that EY might raise, and such defenses are not sufficient to confer federal question jurisdiction. Motion to Remand at 20. This argument is inconsistent with the face of the Complaint and is wrong in any event. EY may well present additional defenses based on the PCAOB auditing standards, but, as demonstrated above, the NYAG s Complaint pleaded violations of these standards as central to all of its claims. As such, these allegations do not merely anticipate a defense as pleaded, they are the necessary predicates to EY s alleged violations of the Martin Act and Executive Law 63(12). See Section A.2 supra. B. The Federal Interest Is Sufficient to Confer Federal Jurisdiction and Does Not Disrupt the State/Federal Balance. The NYAG contends that even if the Complaint rests on the construction and application of federal law, the federal interest here is not sufficient to confer federal jurisdiction, and that exercising federal question jurisdiction over this case would disturb the balance of federal and state judicial responsibilities. Id. at Both contentions, however, are decisively undermined by SOX, which establishes exclusive federal jurisdiction for violations of any rule of the PCAOB as well as all actions at law brought to enforce any liability or duty created by PCAOB rules. 15 U.S.C. 7202(b)(1). In that provision, Congress has confirmed the substantiality of PCAOB rules and resoundingly endorsed the exercise of federal jurisdiction over claims premised on their alleged violation. See, e.g., Frayler v. New York Stock Exch., 118 F. Supp. 2d 448, 451 (S.D.N.Y. 2000) (identifying 15 U.S.C. 78aa, which 7202(b)(1) extends why in terms of the latter. ). In any event, under Broder, it would not matter if there is federal question jurisdiction over the GAAP opinions since there is federal question jurisdiction over the statements regarding PCAOB compliance. 19