Examiner Fingers Lehman’s Management And Outside Auditor For Serious Accounting Misreporting

March 2010

Lehman Brothers is the largest bankruptcy in U.S. history. A report by a U.S. bankruptcy examiner investigating the collapse of Lehman Brothers blames senior executives and auditor Ernst & Young for serious accounting misreporting. At approximately 2200 pages, the report is exceptionally detailed. It describes how Lehman manipulated its balance sheet, inflated the value of its assets, and withheld information from the board. According to the Examiner:

"... unbeknownst to the investing public, rating agencies, Government regulators, and Lehman's Board of Directors, Lehman reverse engineered the firm's net leverage ratio for public consumption ..."

The Examiner’s report details the high risks that Lehman accepted. The Examiner concludes that, although deciding to accept these risks probably falls within the business judgment rule against liability, Lehman and its auditors took the next and inappropriate step of issuing misleading financial statements and other reporting to hide what was actually happening. The Examiner explains [citations are omitted for all Examiner report quotes throughout this article]:

“But to buy itself more time, to maintain that critical confidence, Lehman painted a misleading picture of its financial condition.

Lehman required favorable ratings from the principal rating agencies to maintain investor and counterparty confidence; and while the rating agencies looked at many things in arriving at their conclusions, it was clear – and clear to Lehman – that its net leverage and liquidity numbers were of critical importance. Indeed, Lehman’s CEO Richard S. Fuld, Jr., told the Examiner that the rating agencies were particularly focused on net leverage. Lehman knew it had to report favorable net leverage numbers to maintain its ratings and confidence. So at the end of the second quarter of 2008, [Lehman] trumpet[ed] that it had significantly reduced its net leverage ratio to less than 12.5, that it had reduced the net assets on its balance sheet by $60 billion, and that it had a strong and robust liquidity pool”…

“Lehman did not disclose, however, that it had been using an accounting device (known within Lehman as “Repo 105”) to manage its balance sheet. With Repo 105 transactions, Lehman’s reported net leverage was 12.1 at the end of the second quarter of 2008; but if Lehman had used ordinary repos, net leverage would have to have been reported at 13.9.

So far, there have been no criminal prosecutions of Lehman executives. While the Examiner generally indicates that the wrongful conduct probably does not rise to criminal wrongdoing, the Examiner reports that civil claims are sufficiently strong to be pursued. The largest source of financial recovery may be Lehman’s auditors, Ernst & Young. The Examiner concluded that:

“There are colorable claims against Lehman’s external auditor Ernst & Young for, among other things, its failure to question and challenge improper or inadequate disclosures in those financial statements. … a colorable claim is one for which the Examiner has found that there is sufficient credible evidence to support a finding by a trier of fact.”

Lehman executives purposefully hid the accounting shenanigans

The Repo 105 transactions had no purpose other than to hide the truth. The Examiner’s report extensively discusses knowledge by Lehman’s executives and its auditors. For example:

… their [Repo 105 transactions] sole function as employed by Lehman was balance sheet manipulation. Lehman’s own accounting personnel described Repo 105 transactions as an “accounting gimmick” and a “lazy way of managing the balance sheet as opposed to legitimately meeting balance sheet targets at quarter end. …

In 2007-08, Lehman knew that net leverage numbers were critical to the rating agencies and to counterparty confidence. Its ability to deleverage by selling assets was severely limited by the illiquidity and depressed prices of the assets it had accumulated. Against this backdrop, Lehman turned to Repo 105 transactions to temporarily remove $50 billion of assets from its balance sheet at first and second quarter ends in 2008 so that it could report significantly lower net leverage numbers than reality. Lehman did so despite its understanding that none of its peers used similar accounting at that time to arrive at their leverage numbers, to which Lehman would be compared. …”

Kelly [Lehman’s Financial Controller] further attributed his discomfort with Lehman’s use of Repo 105 transactions to the fact “that the only purpose or motive for the transactions was reduction in balance sheet” and that “there was no substance to the transactions.” Kelly thought that the lack of business purpose for these transactions, combined with the magnitude of Lehman’s Repo 105 usage at quarter-end (at $38.6 billion at fiscal year end 2007, when Kelly became Global Financial Controller) carried a potential for “reputational risk” to Lehman and that, should it become public knowledge, it may “reflect poorly on the firm.” Kelly further explained that “the size of the program in an absolute sense was of a size that presented headline risk,” particularly as “the program was skewed to quarter ends.” When asked by the Examiner what he meant by “headline risk,” Kelly stated that “if there were more transparency to people outside the firm around the transactions, it would present a dim picture” of Lehman.

Lehman’s increasing reliance on the Repo 105 transactions and the absence of any disclosure of that fact in Lehman’s Forms 10-Q and 10-K disquieted Kelly; he remarked that if an analyst or a member of the investing public were to read Lehman’s Forms 10-Q and 10-K from cover to cover, taking as much time as she or he needed, “they would have no transparency into [Lehman’s] Repo 105 program”

Lehman’s reported liquidity was also misleading. According to the Examiner’s report:

“But Lehman did not publicly disclose that by June 2008 significant components of its reported liquidity pool had become difficult to monetize. As late as September 10, 2008, Lehman publicly announced that its liquidity pool was approximately $40 billion; but a substantial portion of that total was in fact encumbered or otherwise illiquid. From June on, Lehman continued to include in its reported liquidity substantial amounts of cash and securities it had placed as “comfort” deposits with various clearing banks; Lehman had a technical right to recall those deposits, but its ability to continue its usual clearing business with those banks had it done so was far from clear. By August, substantial amounts of “comfort” deposits had become actual pledges. By September 12, two days after it publicly reported a $41 billion liquidity pool, the pool actually contained less than $2 billion of readily monetizable assets.”

CEO Richard Fuld claims that he “could not recollect” the misleading transactions or their impact. The Examiner responds that Mr. Fuld was "at least grossly negligent" for allowing Lehman to file financial reports which were misleading because a key gauge of financial strength was "reverse-engineered" through transactions with no economic substance.

Whistleblower’s claims were whitewashed

As occurred with many of the major financial frauds over the last decade, Lehman’s misdeeds were reported by an in-house whistleblower. At Lehman, the whistleblower’s assertions were not properly investigated and addressed. According to the Examiner’s report:

“On May 16, 2008, Matthew Lee, then-Senior Vice President in the Finance Division responsible for Lehman’s Global Balance Sheet and Legal Entity Accounting, sent a letter to certain members of Lehman’s senior management identifying possible violations of Lehman’s Ethics Code related to accounting/balance sheet issues. Lehman involved Ernst & Young in its investigation of the concerns raised in Lee’s May 16, 2008 letter. …

On June 13, 2008 – the day after Lee informed Ernst & Young of the $50 billion in Repo 105 transactions that Lehman undertook at the end of the second quarter 2008 – Ernst & Young spoke to Lehman’s Audit Committee but did not inform the committee of Lee’s allegation, even though the Chairman of the Audit Committee had clearly stated that he wanted every allegation made by Lee – whether in Lee’s May 16 letter or during the course of the investigation – to be investigated. Ernst & Young met with the Audit Committee on July 8, 2008, to review the second quarter financial statements and again did not mention Lee’s allegations regarding Repo 105. On July 22, 2008, Ernst & Young was also present when Beth Rudofker, Head of Corporate Audit, gave a presentation to the Audit Committee on the results of the investigation into Lee’s allegations.”

Audit Committee members stated that they were not aware of the Repo 105 transactions, and that they expected Ernst & Young to report additional information to them than what they actually were told. On this topic, the Examiner concludes that:

“Ernst & Young met with the Lehman Board Audit Committee but did not advise it about Lee’s assertions, despite an express direction from the Committee to advise on all allegations raised by Lee. Ernst & Young took virtually no action to investigate the Repo 105 allegations. Ernst & Young took no steps to question or challenge the non-disclosure by Lehman of its use of $50 billion of temporary, off-balance sheet transactions.”

Lehman’s audited financial statements were also misleading

As Lehman’s problems escalated during its fiscal 2008 first and second quarters, Lehman’s use of the misleading transactions increased. However, the annual 2007 financial statements were also affected. This is important to Ernst & Young since they have heightened responsibility for the annual statements. According to the Examiner’s report:

“The financial statements accompanying the 2007 Form 10-K were audited – as opposed to “reviewed” – by Ernst & Young and thus higher standards and requirements of professional care applied.

Lehman’s 2007 Form 10-K contained essentially the same statements as those in its later 2008 Forms 10-Q. In its 2007 Form 10-K, Lehman represented that it treated repurchase agreements as financings (i.e., not as sales) even though Repo transactions were treated as sales. In Note 1 to Lehman’s Consolidated Financial Statements, Lehman stated that Lehman treated “[r]epurchase and resale agreements” as “collateralized agreements and financings for financial reporting purpose” which Lehman described were “collateralized primarily by government and government agency securities.” In addition, Lehman stated that “[o]ther secured borrowings principally reflect transfers accounted for as financings rather than sales under SFAS 140.” Lehman disclosed that it recognized the transfer of financial assets as sales pursuant to SFAS 140 – but it said so only with respect to “securitization activities.”

The Examiner concludes that Ernst & Young should face malpractice claims in connection with its 2007 audit, as follows:

“There is also sufficient evidence for a trier of fact to conclude that Ernst & Young knew or should have known that that those statements were materially misleading and failed to provide necessary disclosures concerning Lehman’s use of Repo 105 transactions …. in connection with its 2007 audit of Lehman”

GAAP requires more than technical compliance

Ernst & Young has already claimed that accounting for the Repo 105 transactions was technically in compliance with certain accounting rules (specifically SFAS 140), and that it is not their job to address anything further. The Examiner’s report nicely rebuts this notion and summarizes the broader requirements of generally accepted accounting principles (GAAP), as follows:

“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 recognizes 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.” Moreover, registrants are “required to provide whatever additional information would be necessary to make the statements in their financial reports fair and accurate, and not misleading.”

This view is echoed in an SEC enforcement order, concluding that GAAP compliance does not excuse a misleading or less than full disclosure regarding a transaction, especially if the transaction’s purpose is “the attainment of a particular financial reporting result. [E]ven if the transactions comply with GAAP, the issuer is required to evaluate the material accuracy and completeness of the presentation made by its financial statements.” Issuers must “ensure that the way they publicly portray themselves discloses, as required, the material elements of [their] economic and business realities and risks.”

For additional explanation of this, see How Principles-Based Accounting Affects Lawyers.

By any measure, the Lehman Brothers bankruptcy in September 2008 is important in U.S. financial history. Lehman’s bankruptcy converted the country’s until-then mild recession into a full-scale panic. It is unfortunate to learn that the events caused by Lehman’s demise may have been exacerbated by not timely reporting what was actually happening.

Fulcrum Inquiry performs forensic accounting investigations. We offer whistleblower reporting systems to public companies, and nonprofit organizations interested in improving corporate governance. .