The Feds Knew About Lehman’s Repo 105 Transactions

It is difficult to be shocked about new revelations stemming from the financial crisis, but today’s DealBook column by Andrew Ross Sorkin was a real revelation.  S.E.C. examiners, working during the watch of Christopher Cox as S.E.C. commissioner, apparently saw nothing wrong with Repo 105.  Here are a few excerpts:

“Even though Lehman dressed up its accounts for the great unwashed public, it did not try to fool the authorities,” Yves Smith, the author of “ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism,” wrote on her blog last week. “Its game-playing was in full view.”

Indeed, it now appears that the federal government itself either didn’t appreciate the significance of what it saw (we’ve seen that movie before with regulators waving off tips about Bernard L. Madoff). Or perhaps they did appreciate the significance and blessed the now-suspect accounting anyway.

Oddly, when the bankruptcy examiner asked Matthew Eichner of the S.E.C., who was involved with supervising firms like Lehman, whether the agency focused on leverage levels, he answered that “knowledge of the volumes of Repo 105 transactions would not have signaled to them ‘that something was terribly wrong,’ ” according to the examiner’s report.

There is plenty of blame to go around.  Lehman’s CEO Richard Fuld was criminally negligent, shockingly incompetent, or both.  Ernst & Young, the firm’s auditors, concluded that Repo 105 was acceptable under generally accepted accounting principles but obviously failed in their larger responsibility to users of Lehman’s financial statements.  Now we find that the S.E.C. and other government regulators were fully aware of the Repo 105 shenanigans for nearly six months prior to Lehman’s collapse.

Click on this link to read the full DealBook Column

A Modest Proposal for Audit Reform

Attempting to understand the sequence of events that led to the downfall of Lehman Brothers is normally a mind numbing process, but occasionally an obvious outrage is discovered such as Lehman’s use of “Repo 105” transactions.  While we have not perused the 2,200 page bankruptcy examiner’s report, enough information has been reported to draw some conclusions.  While Lehman’s top management deserves much criticism and blame, the firm’s auditors were derelict in their responsibilities as well.  Whether Ernst & Young is legally culpable is an open question.  However, it is obvious that the firm acted as an “enabler” to Lehman’s management when it came to the use of Repo 105.

“Lehman Complied with GAAP”

The Wall Street Journal provides the following quote from an unnamed source at Ernst & Young who commented on the use of Repo 105 transactions at Lehman:

The firm’s auditor, Ernst & Young LLP, on Friday said it reviewed the accounting for Lehman repo deals under scrutiny by the examiner “on a number of occasions. 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.”

Let us carefully consider what this statement implies.  Based on the bankruptcy examiner’s report and quotes found in multiple sources such as the Wall Street Journal and The Financial Times, top managers at Lehman specifically state that they were relying on Repo 105 at the end of reporting periods in order to move tens of billions of dollars off Lehman’s balance sheet in an attempt to create the illusion of lower leverage.  The firms auditor, Ernst & Young is now stating that they reviewed the repo transactions on a number of occasions and they complied with GAAP.  However, can anyone believe that the auditors did not understand the nature of the transactions or the illusion it was intended to create?  That is highly doubtful.

Principle vs. Rule Based Accounting

Generally Accepted Accounting Principles, or GAAP, present general principles and rules under which companies are supposed to report their business activity to investors and other interested parties.  At its very basic level, GAAP is supposed to ensure that management is accurately matching costs with revenue, recognizing revenue at the appropriate time, using consistent standards across accounting periods, and can substantiate financial statements based on evidence.  GAAP is considered a “rule based” accounting standard.  In contrast, International Financial Reporting Standards (IFRS) is “principle based”. The United States is moving toward convergence with IFRS. (It should be noted that we are not aware of whether Repo 105 would have passed scrutiny under IFRS.)

While GAAP is considered to be “rule based”, it does not follow that auditors should turn a blind eye toward obvious manipulation of accounting by management which is intended to mislead users of financial statements.  Perhaps there was no explicit rule in GAAP that prohibited the Repo 105 transactions or required disclosure of the transactions.  However, this fact alone does not mean that auditors should sign off on financial statements when such material misstatements have taken place.

Every public company files audited financial statements in which the audit firm makes a statement similar to the following:

“In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of [Company Name] and subsidiaries as of December 31, 2009 and 2008, and the results of their operations and cash flows for each of the three-year period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles.”

The last point in italics is the key problem.  If we examine the quote from the Ernst & Young official provided earlier, we can see that he or she did not claim that the Repo 105 transactions were not designed to mislead financial statement users or that they fairly represented Lehman’s financial condition.  The statement is qualified by a reference to GAAP.

A Modest Proposal

A modest proposal for audit reform would add the following statement to the auditor’s report immediately following the statement above:

“Furthermore, we are not aware of any material transactions or off balance sheet entities, even if in compliance with GAAP, that in our judgment have been designed to mislead users of the company’s financial statements.”

Would the auditors like to see such language added?  Obviously not because it would add an element of professional and perhaps legal liability that does not exist today.  Should auditors accept this additional responsibility?  It would seem that if your business is to examine the accuracy of financial statements and provide your seal of approval to the public, such responsibility goes with the territory, even if your motto is not “Quality in Everything We Do”.

Intelligent investors should always approach financial statements with a healthy level of skepticism, but at the very least is it too much to ask to be alerted when the firm’s auditor knows of material attempts to distort reality, whether or not the deception runs afoul of GAAP or not?

Was Lehman’s CEO Criminally Negligent or Merely Incompetent?

In a pattern that would be amusing if it was not so disturbing, we are again witnessing the spectacle of lawyers for a disgraced CEO who claim that their client was “unaware” of key risks that led to the downfall of their firm.  The Lehman Brothers bankruptcy examiners report has been widely covered in the business media over the past few days and, at a minimum, paints a picture of shocking incompetence and an intent to mislead among Lehman’s senior management team.  It is the type of scenario in which a former CEO’s only defense appears to rest on claims that he was incompetent rather than criminally negligent.

Repo 105 Transactions

The Wall Street Journal reports that Lehman management routinely engaged in “Repo 105” transactions in an attempt to dress up the balance sheet prior to the end of financial reporting periods.  In a normal repurchase agreement, a borrower uses a financial security as collateral for a cash loan.  The agreement generally involves the sale of the collateral combined with a commitment to repurchase the same security at a point in the future at a higher price.  In a “Repo 105” transaction, Lehman was able to book the transaction as if it was an outright sale rather than an ordinary repo transaction because the assets the firm moved were worth 105% or more of the cash it received in return.

Through this accounting maneuver, Lehman was able to appear less leveraged than it really was.  According to the Wall Street Journal, no United States based law firm would sanction this accounting treatment so Lehman secured an opinion letter from a London law firm named Linklaters.  If a U.S. based Lehman entity needed to engage in a Repo 105 transaction, it would have to move the security to a European division to execute the transaction.

Lehman executives are on record acknowledging the necessity of such transactions as the following quote from a Wall Street Journal article clearly demonstrates:

Four days prior to the close of the 2007 fiscal year, Jerry Rizzieri, a member of Lehman’s fixed-income division, was searching for a way to meet his balance-sheet target, according to the report. He wrote in an email: “Can you imagine what this would be like without 105?”

A day before the close of Lehman’s first quarter in 2008, other employees scrambled to make balance-sheet reductions, the report said. Kaushik Amin, then-head of Liquid Markets, wrote to a colleague: “We have a desperate situation, and I need another 2 billion from you, either through Repo 105 or outright sales. Cost is irrelevant, we need to do it.”

Grossly Negligent, Criminally Responsible, or Merely Incompetent?

Lehman’s CEO Dick Fuld is cited in the bankruptcy examiner’s report as being “at least grossly negligent” regarding the Repo 105 transactions:

The examiner wrote there was “sufficient evidence” to support a legal claim that Mr. Fuld was “at least grossly negligent for failing to ensure” Lehman filed proper financial statements about its accounting for the transactions, and that a key former executive of the firm, the chief operating officer, personally briefed him on the matter.

Of course, Mr. Fuld’s attorneys have decided to pursue the “incompetent” defense as opposed to taking any responsibility for the situation:

Mr. Fuld’s lawyer said on Thursday that Mr. Fuld “did not know what those transactions were” and wasn’t “aware of their accounting treatment.”

It is unclear what is more shocking:  The prospect of a CEO of a major financial institution willfully pursuing financial transactions designed specifically to mislead investors and counterparties into thinking that the firm was less leveraged than it really was or the idea that the CEO really had no idea that these maneuvers were taking place at all.

Buffett’s Decision on a Lehman Investment

The bankruptcy report also contains some interesting information regarding Lehman’s attempts to have Warren Buffett invest $2 billion in the company as a “stamp of approval”.  Of course, Mr. Buffett decided against doing so when he found problems in Lehman’s 10-K as well as negative signals from Lehman executives who were unwilling to invest in the firm on the same terms he was offered.

As is often the case, we can also look at Mr. Buffett’s statements regarding corporate governance to understand what went wrong at Lehman:

“In my view a board of directors of a huge financial institution is derelict if it does not insist that its CEO bear full responsibility for risk control. If he’s incapable of handling that job, he should look for other employment. And if he fails at it – with the government thereupon required to step in with funds or guarantees – the financial consequences for him and his board should be severe.”

— Warren Buffett’s 2009 Letter to Shareholders.

If Lehman’s story can be distilled down to its core problem, it seems to be that the company’s CEO did not regard himself as the Chief Risk Officer.  Based on Mr. Fuld’s own admission (if we are to believe him), he was not aware of critical accounting policies that misled investors and counterparties who were using Lehman’s financial statements to judge the health of the business.  Of course, the Repo 105 maneuver was only necessary because of other failures to control risk at the firm.

It would be a refreshing change if at least one CEO involved in the demise of a major financial institution would step up and admit that the responsibility was his rather than hiding behind the “incompetence” defense.