Law and Accounting: Did Lehman Brothers Use of Repo 105 Transactions Violate Accounting and Legal Rules?

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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. …