Anton R. Valukas, the U.S. bankruptcy court-appointed examiner of failed investment bank Lehman Bros., charged with determining the causes of the largest bankruptcy filing in U.S. history, has found that the company used “materially misleading” accounting to make its balance sheet look stronger than it really was.
Valukas concluded that “colorable claims” could be made against some former Lehman executives and Ernst & Young, Lehman’s auditor, “meaning that enough evidence existed against both parties that could lead to the awarding of damages in a trial,” The New York Times reported. He added that Lehman’s directors were not aware of the accounting engineering.
According to the examiner’s 2,200 page report, issued late last week, Lehman designed a repurchase agreement, Repo 105, which relied on a very aggressive interpretation of an accounting rule, FAS 140, which allowed the company to classify Repo 105 transactions as sales. Under accounting rules, when the assets were treated as sales, Lehman could remove them from their balance sheets.
An ordinary repurchase agreement is a common form of short-term financing and has no impact on the balance sheet. A company sells a bond or other, usually liquid, asset to a lender at market value for cash, and then repurchases the asset a few days later.
Lehman’s Repo 105 transactions usually occurred just before the end of a quarter so that, for a few days before the end of the quarter, the company’s net leverage ratio, a number that is used by ratings agencies, appeared to be lower than it actually was. A few days after the quarter ended, Lehman would repurchase the assets and the net leverage ratio would go back up.
The Repo 105 agreements differed from ordinary repurchase agreements because Lehman valued the assets pledged in the repurchase agreement at 105 percent of the cash received, less than their market value. Because the assets were worth more than the cash received, Lehman claimed that FAS 140 – Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities –allowed it to book the transactions as sales.
Lehman began using the Repo 105 agreements in 2001. In 2008, as the firm was collapsing, Lehman used Repo 105 transactions to move $50 billion of assets from its balance sheet.
The court examiner report detailed the steps Lehman took when no American law firm would give its blessing to the Repo 105 transactions. Lehman turned to British law firm Linklaters LLP, which gave Lehman a letter stating that the transaction could be recorded as a sale under British law. The 2006 version of the letter, used by Valukas, stated, “This opinion is limited to English law as applied by the English courts and is given on the basis that it will be governed by and construed in accordance with English law.”
All of Lehman’s Repo 105 transactions were then conducted by the London arm of the firm. According to The New York Times, the court examiner’s report stated that Lehman would transfer the Repo 105 assets to London. European lenders were among the principle counterparties, including Barclays of Britain, UBS of Switzerland, KBC Bank of Belgium, and Mizuho Bank and Mitsubishi UFJ Financial Group of Japan.
Claims of negligence and malpractice against Ernst & Young could be made, the report stated, in connection with its audits of Lehman and a failure to act upon claims from a whistleblower that Lehman's accounting for a trade known as "Repo 105" was misleading, The Wall Street Journal reported.
A spokesman for Ernst & Young said the firm reviewed the accounting for the Lehman's Repo 105 deals "on a number of occasions,” according to The Wall Street Journal. “Our view was, and continues to be, that Lehman's accounting policy for these repo transactions complied with generally accepted accounting principles. The examiner has not concluded otherwise."
Ernst & Young was informed about the potential impact of the Repo 105 transactions in an interview on June 12, 2008, with Matthew Lee, a former senior vice president at Lehman, according to The Wall Street Journal. Lee had sent a letter to senior management in May warning about “tens of billions of dollars of unsubstantiated balances, which may or may not be ‘bad’ or non-performing assets or real liabilities.” In the letter, Lee also expressed concern about Lehman’s accounting systems and personnel, and “potential misstatements of material facts.”
Following receipt of the letter, Lehman’s board of directors asked Ernst & Young to interview Lee. During the interview, Lee raised the issue of the Repo 105 maneuver, saying that Lehman was moving as much as $50 billion off its balance sheet using the transaction. Ernst & Young did not report back to the board of directors before Lehman collapsed three months later. Lee discussed the interview with the court examiner.
Valukas, who is a former federal prosecutor and an attorney in private practice with Jenner & Block LLP, said there were other factors besides the Repo 105 accounting which contributed to Lehman’s failure. These included the financial decline, the risk-taking culture of investment banking, and the failure on the part of government agencies to anticipate and mitigate the situation.
Goldman Sachs, Barclays Capital, and other banks said they did not use repos to hide liabilities on their balance sheets, The New York Times reported.
The court examiner spent 14 months preparing the report, which cost the government $35 million.