Law and accounting: did Lehman brothers use of Repo 105 transactions violate accounting and legal rules?

Author:Jones, Bryce
 
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INTRODUCTION

This article addresses both U.S. accounting standards and U.S. law by providing an analysis of repurchase agreements as used by the investment firm Lehman Brothers. The specific questions addressed are whether Lehman Brothers violated accounting and auditing standards and federal securities and financial regulation laws. This paper examines both the accounting practices and securities law and the conflict between them. At the time the repurchase agreements were used, the accounting treatment was considered acceptable under U.S. generally accepted accounting standards ("GAAP"). However, the authors conclude that the accounting treatment of the repurchase agreements, henceforth referred to as Repo 105 transactions, and the subsequent financial statement disclosures were done in violation of numerous U.S. laws. The contradiction between law and accounting/auditing standards is the focus of the article.

Prior to the collapse, Lehman Brothers was the 4th largest global financial services firm and the oldest of the five major global financial services firms ("Lehman Brothers"). In addition to Bear Stearns and AIG, Lehman Brothers was a major institution that failed during the financial crisis (McAfee & Johnson, 2010). The failure of Lehman Brothers is believed to have impacted financial markets for weeks ("Case Study: The Collapse of Lehman Brothers," 2009). While it was hardly the sole cause of the financial crisis, the failure of Lehman Brothers was a substantial event causing loss of confidence in the financial and banking systems. The Lehman Brothers event is considered so important in the minds of business and economic analysts that the terms "Lehman-type event" or "Lehman-type moment" is often used in the business press and business cable TV (such as CNBC). For example, analysts ask whether the possible fall of the Greek or Spanish economy would cause a worldwide catastrophe that would qualify as a "Lehman type event" (Kroft, 2012; CNBC, 2011; Pinetree Capital Ltd., 2012, Sandholm, 2011; Martinez, 2011). Lehman Brothers continues to make news with new lawsuits and news reports.

On September 15, 2008, Lehman Brothers filed for bankruptcy. The Lehman Brothers bankruptcy is the largest reported U.S. bankruptcy--twice as large as the second, Washington Mutual ("The Ten Largest Bankruptcies", 2009). Bank debt at Lehman Brothers was $613 billion. The bankruptcy was prompted by an acute cash shortage. Prior to the bankruptcy filing, investors were aware of Lehman's increasing financial difficulties. However, use of financial statement "window-dressing" through off-balance sheet transactions, such as Repo 105, disguised the extent of the financial difficulties.

One can argue that had regulators and investors been informed of the true condition at Lehman Brothers, some of the problems in the financial crisis may have been averted. (The later bankruptcy filing by Lehman Brothers provided information on the repurchase transactions. Had Lehman Brothers not filed for bankruptcy, the accounting practices may have not been disclosed. Thus, we do not know the extent to which other investment firms used similar accounting treatments to window-dress financials.) Certainly, regulators would have had a clearer picture of the deteriorating financial condition at Lehman Brothers. Of particular concern to investors in Lehman Brothers were the leverage and the leverage ratio (Valukas, 2010, p. 800). The management at Lehman Brothers understood investors' concerns and in 2007 discussed the impact a deteriorating balance sheet and leverage condition would have on the company. The concern was that market declines and ratings downgrades would result if the financial condition were not improved (Valukas, 2010, p. 800).

With the implementation of a new accounting standard, Statement of Financial Accounting Standards (SFAS) 140, effective April, 2001, Lehman Brothers began using a tool to "manage" the balance sheet situation, repurchase agreements, Repo 105 and Repo 108 (Although Repo 105 and Repo 108 are technically different, this difference is in the amount of the cash inflow. The accounting treatment for each transaction is the same. For that reason, the article will refer both to Repo 105 and Repo 108 transactions as "Repo 105" in this. For Repo 105, fixed income bonds securities were used but for Repo 108, equities were used (Valukas, 2010, p. 732). As conditions at Lehman Brothers deteriorated, the firm increased its use of the Repo 105 agreements. Prior to the bankruptcy filing, in the 2nd quarter of 2008 SEC filing, Lehman Brothers had $50 billion in Repo 105 transactions not disclosed to investors. Clearly, the intention of management at Lehman Brothers in using Repo 105 transactions was initially to bolster the financial condition of the company in order to appease investors, and in later periods to avert bankruptcy. Despite the use of Repo 105, Lehman Brothers filed for bankruptcy with investors losing an estimated $46 billion in stock value.

The article is organized as follows:

  1. First, there will be a discussion of the financial situation and events leading to Lehman Brothers bankruptcy and specifically how Repo 105 was used.

  2. The article discusses the specific accounting, auditing, and factual requirements for the use of Repo 105 transactions; asset valuation under general accounting rules; and the usage of Repo 105 transactions at Lehman.

  3. Finally, Repo 105 transactions are examined under specific laws: (1) the Securities Exchange Act of 1934, (2) Sarbanes-Oxley, and (3) the Private Securities Litigation Reform Act. Current cases and prior precedent are discussed.

    Because of the complexity of Repo 105, we provide a short summary of the transactions and the accounting treatment at Lehman Brothers:

    A repo is a short term loan. Before quarterly and annual financial statements were filed, Lehman Brothers, which was in financial trouble, would make short term loans, using securities or equities as collateral. A "loophole" in GAAP (later changed) allowed Lehman Brothers to book this as a sale rather than a loan as long as Lehman put up at least 102% (of the value of the loan) in collateral. Lehman sometimes would put up 105% in securities or 108% in equities as collateral. Lehman would then use the "loan" money to buy down temporarily its debt, which reduced its leverage ratio (debt to equity), making the firm look less risky, and misleading analysts and investors. After the short term was up and the financial statements issued, Lehman would have to repay the loan with interest (the interest is thus a loss or "haircut"). Lehman did not acknowledge in SEC filings neither the amount of Repo 105 transactions nor the amount of debt that would shortly be repaid. BACKGROUND: LEHMAN BROTHERS' FINANCIAL DIFFICULTIES: THE FINANCIAL CRISIS, AND FINANCIAL STATEMENT WINDOW-DRESSING--REPO 105

    Lehman Brothers Financial Difficulties

    Lehman Brothers was forced to file for bankruptcy in 2008. While Lehman filed for Chapter XI bankruptcy (usually meaning it might continue), the bankruptcy proceedings showed that the company needed to be liquidated and ended (as is usually the case under Chapter VII bankruptcy). Lehman Brothers, as a company, had the largest amount of assets for a firm filing for bankruptcy. At the time of the filing, it appeared that Lehman Brothers had $600 billion of assets with $30 billion in equity ("Lehman Brothers"). Months before the bankruptcy, Lehman Brothers' stock price had continued to fall.

    By the weekend preceding the bankruptcy, Secretary of the Treasury Henry Paulson determined that Lehman Brothers had one of three options: (1) a purchase by another company, (2) a bailout (with no purchase) by other large investment and commercial banks, or (3) bankruptcy. One of the three had to occur before stock trading commenced the next week. The government determined that it did not have the legal authority to bail out an investment bank (although this could be done for a commercial bank). Yet, because of Lehman Brothers' enormous size and its connections throughout the U.S. and world economies, Paulson and Tim Geithner (head of the New York Federal Reserve bank) convened in secret with the heads of other large U.S. financial institutions. The fear was that Lehman Brothers' fall (coming after the fall of Bear Stearns) would trigger a cascading, free-falling economy (Paulson, 2010, p. 182-221).

    During the weekend, the banks brought in their experts to examine Lehman Brothers' financials. They tried to value the assets and the tremendous amount of mortgage-related debt (While normally such financial dealings might seem dull, the BBC did both a movie and a documentary on that meeting ("The Last Days", 2009; "The Love of Money", 2009)). There was some concern among those present that assets might be over-valued.

    One option was to bring in a buyer for Lehman Brothers. Paulson attempted to get Bank of America (BoA) to buy Lehman. But BoA was in no position to buy another troubled company, having recently purchased Countrywide, the largest of the non-bank mortgage companies. BoA appeared interested, but it eventually declined. The other potential purchaser was a large British bank, Barclay's. While Barclay's had a great interest in Lehman Brothers, the financial position of Lehman caused Britain's financial regulators to refuse to put one of its largest banks into harm's way (Paulson, 2010, p. 207-16).

    The possible consortium of other U.S. banks reached the same conclusion. Investment of a considerable sum of money would be required to sustain Lehman Brothers. The consortium recognized both the riskiness of an investment in Lehman Brothers and the fall of Lehman Brothers would potentially result in other failures (Paulson, 2010, p. 187-221).

    The world's largest stock trading company Merrill-Lynch was bought by BoA that weekend, but another tremendous blow was impending, and that was the fall of the largest insurer in the world--AIG....

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