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By Ronald Fink
The financial engineering that masked Lehman Brothers' true financial condition violated Securities and Exchange Commission disclosure requirements, according to a report released Thursday by the examiner appointed by the bankruptcy court to look into the investment bank's failure.
The report by Anton Valukas did not offer an opinion as to whether the repurchase agreements Lehman used to temporarily take $50 billion in assets off of its balance sheet in the months before it collapsed in September 2008 adhered to the accounting rule known as SFAS 140.
But Valukas, chairman of the law firm of Jenner & Block, strongly suggested that the deals were fraudulent anyway, because the company failed to adequately disclose the true nature and extent of the transactions, which were designed to make it seem as if Lehman was much less heavily leveraged than it really was.
SFAS 140 required Lehman to pay a market rate for the cash it borrowed through such repos in order for them to be considered sales instead of short-term financings, even though the bank promised to repay the money within days. The terms of such deals must be reviewed by a law firm for the deals to be certified as "true sales" and thus qualify for off-balance sheet treatment.
Lehman paid 105 cents on the dollar for the repos in question, which were known as Repo105 deals as a result, and got a legal opinion from the law firm of Linklaters in London saying they were true sales.
But the examiner's report found that the Repo105 transactions may have been fraudulent nonetheless, because Lehman's public disclosure concerning them fell well short of SEC standards.
"There is sufficient evidence to support a determination … that the notes to the financial statements and other written disclosures presented a misleading picture of Lehman's financial condition," the report concluded.
In a statement to the New York Times Thursday, a spokesman for Lehman's auditor, Ernst & Young, insisted that the transactions conformed to the accounting rules, but did not address the question of SEC disclosure.
One critical issue concerns Valukas' finding that Lehman could not attain a legal opinion that the deal constituted a sale for purposes of SFAS 140 in the US, and thus arranged it in the UK, where the laws regarding off-balance-sheet financing are more lenient. But Lehman did not disclose this fact to anyone but E&Y.
"I think that the 105 percent was arbitrarily selected to get the sale treatment and they probably didn't have the back-up to support the valuation," said Jack Ciesielski, an analyst who publishes the Analyst's Accounting Observer. "It certainly sounded fraudulent."
Because of the lack of disclosure concerning the deals, the examiner's report lambasted former Lehman executives, including CEO Richard Fuld and CFO Erin Callan. Valukas wrote that Fuld was "at least grossly negligent" in meeting his fiduciary duty and that Callan had "breached" her duty by certifying Lehman's financial results despite the failure to disclose the true nature of its Repo105 deals.
A lawyer for Fuld told the Times Thursday that his client had nothing to do with the transactions and was unaware of their accounting treatment. A lawyer for Callan could not be reached by CFOZone for comment before this was posted (update to follow).
The report's findings could influence the criminal and civil investigations into the role played by Lehman's executives before its bankruptcy, the largest in corporate history.
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