The now notorious Repo 105 transactions that Lehman Brothers used to manipulate its balance sheet may have technically complied with accounting rules—but that’s unlikely to keep Lehman’s executives or its accountants at Ernst & Young out of legal trouble.
At issue is the fact that Lehman used an over-collateralized repurchase transaction to move assets off its balance sheet around the time of three different quarterly reports. The moves made Lehman appear to be shrinking its balance sheet and delivering at a time when the markets were intensely focused on investment bank balance sheet risk
The Repo 105 deals were what one accounting expert described to us as “round trip sales.” Usually these are treated as financings—a way of borrowing liquid funds by putting up illiquid assets as collateral. But because the collateral offered by Lehman exceeded the cash received, accounting rules may have allowed these to be booked as true sales. It seems that Ernst & Young signed off on this accounting treatment.
But don’t get confused by this technical compliance with GAAP rules. As the bankruptcy examiner explains, technical compliance is irrelevant if the overall effect is to create a misleading impression of the financial condition of the company.
Here’s the examiner (emphasis added):
Even if Lehman’s use of Repo 105 transactions technically complied with SFAS 140, financial statements may be materially misleading even when they do not violate GAAP. The Second Circuit has explained that “GAAP itself recognises that technical compliance with particular GAAP rules may lead to misleading financial statements, and imposes an overall requirement that the statements as a whole accurately reflect the financial status of the company.”
Similarly, as noted in In re Global Crossing Ltd. Securities Litigation, even if a defendant established that its accounting practices “were in technical compliance with certain individual GAAP provisions . . . this would not necessarily insulate it from liability. This is because, unlike other regulatory systems, GAAP’s ultimate goals of fairness and accuracy in reporting require more than mere technical compliance.” The court explained that “when viewed as a whole,” GAAP has no “loopholes” because its purpose, shared by the securities laws, is “to increase investor confidence by ensuring transparency and accuracy in financial reporting.” Technical compliance with specific accounting rules does not automatically lead to fairly presented financial statements. “Fair presentation is the touchstone for determining the adequacy of disclosure in financial statements. While adherence to generally accepted accounting principles is a tool to help achieve that end, it is not necessarily a guarantee of fairness.”
The bankruptcy examiner concludes that a court could very well find that Lehman’s use of tens of billions of dollars of Repo 105 transactions at quarter‐end in late 2007 and early 2008 rendered the firm’s financial statements and related disclosures materially misleading.
“Indeed,” the examiner wrote, “audit walk‐through papers prepared by Lehman’s outside auditor, Ernst & Young, regarding the process for reopening or adjusting a closed balance sheet stated: ‘Materiality is usually defined as any item individually, or in the aggregate, that moves net leverage by 0.1 or more (typically $1.8 billion).’ Repo 105 moved net leverage not by tenths, but by whole points.