Lehman Brothers--the thin line between aggressive accounting and unethical behavior.

Author:Jeffers, Agatha E.
Position::Report
 
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1. INTRODUCTION

The failure of Lehman Brothers and the crisis that ensued in the subprime mortgage market has raised the question of the adequacy of the use of accounting practices by investment banking institutions to account for their mortgages and other transactions. An aggressive accounting technique, known as Repo 105, helped Lehman to temporarily appear less leveraged and healthier in the eyes of investors, creditors and other interested parties. These were material transactions and had the ability to affect the decisions of a prudent person. Nevertheless, Lehman failed to disclose these transactions in the notes to their financial statements and in their filings to the Securities & Exchange Commission (SEC). The two major questions are 1) Did Lehman follow proper accounting principles? 2) Did Lehman's management behave in an unethical manner? To answer these questions, an examination of the Generally Accepted Accounting Principles (GAAP)and disclosures with respect to these types of transactions is undertaken. In addition, an examination of Lehman's responsibilities to its investors, creditors and the general public is undertaken and a determination made of whether these responsibilities were met. Additionally, an examination is made of the responsibility of the executives in relation to the Sarbanes Oxley Act of 2002. Further, Lehman's behavior in relation to the SEC Act of 1933 & 1934 as well as the standards prescribed by the Institute of Management Accountants(IMA) are examined and a determination made of whether the Lehman's management behaved unethically. Furthermore, the implications are considered and suggestions are made for future research.

2. BACKGROUND

On September 15, 2008, Lehman Brothers, the fourth largest investment banking firm in the United States filed for Chapter 11 bankruptcy. This information is detailed in a 2200 page report filed by a bankruptcy court(United States Bankruptcy Court Southern District of New York In re Lehman Brothers Holdings Inc, et al. Debtors, Chapter 11 Case No. 08-13555 (JMP)--Report of Anton R. Valukas, Examiner, 2010). This was the largest bankruptcy filing in history and intensified the financial crisis that rocked the fabric of the global society. Soon after its demise, the news of Lehman's use of Repo 105 came to light. As a result, on April 29, 2008, a class action lawsuit was filed on behalf of the purchasers of the securities of Lehman Brothers against three members of the senior executives of Lehman Brothers, including the Chief Executive Officer, Richard Fuld. The suit alleges that the executives failed to disclose the controversial accounting technique known as Repo 105 and misrepresented Lehman's financial position which resulted in a falsely inflated market price of the firm's securities (New York Times, Reuters, June 4, 2010).

3. WHAT IS REPO 105?

Essentially, Repo 105 is an aggressive and deceitful accounting off-balance sheet device which was used to temporarily remove troubled securities from Lehman's balance sheet while reporting its financial results to the public.

Steps in Lehman's Repo 105 transactions

The steps involved the purchase of bonds through a Special Financing Unit and intercompany transactions with a London Affiliate. It worked as follows as adapted from Wilchins, Dan & DaSilva, Silvio (2010):

Step 1: Lehman Brothers bought a government bond from another bank using its Lehman Brothers Special Financing unit in the United States.

Step 2: Just before the end of the quarter, the U.S. unit transferred bonds to a London affiliate, known as Lehman Brothers International (Europe).

Step 3: The London affiliate gave assets to its counterparty and received cash and agreed to buy back the assets at the beginning of the next quarter at a higher price. Essentially, the assets given were at least 105 percent of the cash received.

Step 4: The monies received were then used to pay off a large amount of Lehman's liabilities.

Step 5: The reduction of assets and liabilities now showed healthier quarterly financial statements and the corresponding leverage and other risk ratios. These healthy ratios were then issued to the regulators, investors and the general public.

Step 6: At the beginning of the quarter and armed with these healthy financial statements, Lehman then went to banks and other lending institutions and obtained loans.

Step 7: A few days later, Lehman Brothers Holding would repurchase the securities from their London Affiliate at 105 percent of the values of the assets

Lehman's Repo 105 transactions usually occurred for a period of seven to ten days around the end of the quarter and created a materially misleading picture of the firm's financial condition. In this accounting maneuver, Lehman would obtain a short term cash loan from its counterparty in exchange for its assets. Lehman would then record this transaction as a sale, when in fact it was simply a secured financing arrangement. Since this was only borrowing money, Lehman should have kept the assets on its books. However, they did not follow proper accounting rules and instead they removed the troubled assets from their books and recorded the transaction as a sale. The proceeds obtained from these "alleged" sales were used to pay down liabilities. Hence, on the quarterly financial reporting date, Lehman would show a balance sheet composed of less risky assets, less debt and possibly more cash. To outsiders, it appeared as if Lehman was less leveraged and in really great condition. This resulted in the appearance of healthy financial statements and the related healthy leverage ratios. Armed with healthy financial statements, Lehman would go out and obtain loans from financial institutions. However, the obligation to buy back the collateral (troubled mortgage assets) remained with Lehman. Thus, immediately after the financial statements were issued, the company would use the cash obtained from the loans and buy back its original troubled assets at 105 percent of their value. This means that Lehman would pay a 5 percent interest rate rather than the industry norm of 2 percent (hence the classification by Lehman as Repo 105). After the repurchase of the troubled assets, Lehman's leverage would spike back up again and its balance sheet would be brought back to its true inferior position (less the 5 percent paid to repurchase their troubled assets).

3.1 Importance of Financial Leverage

A major goal in Lehman's Repo 105 transactions was to show favorable financial leverage. A favorable financial leverage means that the company is earning a return on borrowed funds that exceed the cost of borrowing the funds. The proportion of debt to shareholders equity in the capital structure of a company is of interest to shareholders...

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