Online Exclusive: A Q&A about Senate Financial Reform Efforts

At the heart of the sprawling report on Lehman Brothers’ downfall is an accounting gimmick that helped the investment bank hide $50 billion worth of assets to conceal its true leverage ratio. The 2,200-page tome, released in March, details the rampant use of repurchase agreements to temporarily and deceptively move the assets off the books.

The court-appointed examiner, Jenner & Block’s Anton Valukas, strongly rebuked Lehman and its executives, calling the accounting tactics “actionable balance sheet manipulation” and “materially misleading.” He also concluded that former CEO Richard Fuld was “at least grossly negligent.”

That Lehman’s balance sheet two-step was fundamentally disingenuous is obvious. Whether it was criminal is another matter.

“There certainly is a basis for criminal investigation,” says Maranda Fritz, a partner at Hinshaw & Clubertson. “The problem really is that the transaction itself is not improper. [For criminal charges] you have to establish that these people knew what they were doing was deliberately misleading in the sense of violating all of the appropriate guidelines and regulations. And that may
be difficult.”

At the very least, the report serves as a cautionary tale that Enron-esque accounting shenanigans have not exactly gone the way of the dodo–a reminder to in-house counsel that they can never let their guard down against accounting that seems too good to be true.

Repo 105

Repurchase agreements are routine transactions in the financial industry. One firm lends an asset to another firm in exchange for cash with an agreement to purchase it back. It’s an easy way to get short-term financing–the interval may be just overnight–and it is generally booked as a loan, with the obligation recorded as well as the assets.

According to the report, in 2001 Lehman started using a sketchy technique that allowed it to book the transactions as sales. By putting up assets that had a value of 105 percent of the cash received, an accounting technicality let Lehman call the move a sale–the asset no longer appeared on the books, despite the firm’s obligation to buy it back. The technique–Repo 105, in Lehman’s terminology–effectively concealed the firm’s actual debt level.

“It’s certainly playing fast and loose with the rules,” says Gary Brown, a Baker Donelson shareholder who is currently seconded to the Senate’s Permanent Subcommittee on Investigations, a role he also performed in the aftermath of the Enron crisis. “This is a good example of when somebody takes a rule and relies too heavily on it.”

For years, Lehman used Repo 105 transactions without reprimand from auditors or regulators. But the use–and disastrous effects–of Repo 105 transactions was amplified as the company drew near financial ruin in 2008.

Criminal Intent

There is a line, hazy as it may be, between “technically legal” transactions and deliberately misleading criminal behavior. In this case, it comes down to intent. Clearly, Lehman’s financials were misleading, but proving they were intended to be is another matter.

“If you’re saying it’s one thing and treating it like another, that’s where the problem arises,” Brown says. “If their accounting treatment didn’t sync up with their true intent, then yeah, the transaction itself wasn’t illegal, but the accounting treatment would’ve been misleading for their financial statement purposes.”

The report suggests that executives at Lehman were well aware of the implications of Repo 105s. E-mail messages the examiner cited refer to the practice as “window dressing” and likened the firm’s heavy reliance on Repo 105s to a drug addiction.

To date, 12 former Lehman executives including Fuld have received federal grand jury subpoenas. But despite much speculation about a criminal case, prosecutors have kept mum.

“Sometimes the prosecution of these financial-type issues is very difficult,” Brown says. “A lot of times it’s tough to pin down who was in charge. The company’s treasury department will say, ‘No, that was in finance.’ The finance department says, ‘No, that was in legal.’ But I think it’s safe to say that Lehman is pretty squarely in the crosshairs for a lot of reasons, this being one of them.”

Opinion Shopping

Another red flag is the fact that Lehman’s domestic outside counsel would not sign off on the Repo 105 accounting treatment. According to the report, Lehman had to turn to its UK-based European counsel to get an opinion letter.

“That seems to me to be an area where you have something quite deliberate going on,” Fritz says. “As opposed to just an aggressive use of an accounting practice, you have an actual effort to circumvent the advice you’re getting in order to be able to use this particular accounting mechanism in this particular way.”

Fritz expects a great deal of scrutiny from investigators on Lehman’s opinion shopping and says it could raise problems for the defunct company’s former in-house lawyers.

“There could be a whole separate message on how far can in-house counsel go in terms of getting approvals for aggressive accounting practices,” she says.

Ernst & Young, which signed off on all the transactions, is standing by its audits and blaming Lehman’s woes on the recession. But there’s no denying the accounting giant is in the hot seat, too.

The report shows one thing for certain: There’s more than enough blame to go around for Lehman Brothers’ demise. What looked mystifying at the time, at least from the outside, turned out to be the result of tactics that should not have passed the smell test.

“The guidance I give to boards of directors, in-house counsel and also other executives that I work with is to really pay attention to complex transactions, and if the accounting treatment sounds a little too good, you should start asking questions,” Brown says. “People just have to use some common sense and ask themselves, ‘Is it really too good? Are we doing the right thing here?’”