Saturday, March 13, 2010
It cost $36 million and a year to produce, so the logical question is what will result from Examiner Anton Valukas' Report (2,200 pages) on the causes of the Lehman Brothers collapse and whether there are colorable claims against individuals and entities relating to the collapse. Jenner & Block posted the complete report on its webite, and I am working my way through parts of it. The bankruptcy judge was right -- it is a fascinating read, better than most journalists' books on business scandals.
Here are some highlights from the introduction and executive summary. I have omitted footnotes, but otherwise the text is verbatim.
From the Introduction:
There are many reasons Lehman failed, and the responsibility is shared. Lehman was more the consequence than the cause of a deteriorating economic climate. Lehman’s financial plight, and the consequences to Lehman’s creditors and shareholders, was exacerbated by Lehman executives, whose conduct ranged from serious but non‐culpable errors of business judgment to actionable balance sheet
manipulation; by the investment bank business model, which rewarded excessive risk taking and leverage; and by Government agencies, who by their own admission might better have anticipated or mitigated the outcome.
On the importance of the repo transactions ("Repo 105"):
Lehman did not disclose, however, that it had been using an accounting device (known within Lehman as “Repo 105”) to manage its balance sheet – by temporarily removing approximately $50 billion of assets from the balance sheet at the end of the first and second quarters of 2008. In an ordinary repo, Lehman raised cash by selling assets with a simultaneous obligation to repurchase them the next day or several days later; such transactions were accounted for as financings, and the assets remained on Lehman’s balance sheet. In a Repo 105 transaction, Lehman did exactly the same thing, but because the assets were 105% or more of the cash received, accounting rules permitted the transactions to be treated as sales rather than financings, so that the assets could be removed from the 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.
On the nondisclosure of Repo 105:
Lehman did not disclose its use – or the significant magnitude of its use – of Repo 105 to the Government, to the rating agencies, to its investors, or to its own Board of Directors. Lehman’s auditors, Ernst & Young, were aware of but did not question Lehman’s use and nondisclosure of the Repo 105 accounting transactions.
From the executive summary on why Lehman failed:
Lehman failed because it was unable to retain the confidence of its lenders and counterparties and because it did not have sufficient liquidity to meet its current obligations. ...
As to whether there are colorable claims. First, the Examiner makes clear that by "colorable claim" he means more than simply an allegation that could survive a motion to dismiss. Instead, because of his extensive investigation, he means by "colorable claim" a higher standard -- sufficient credible evidence exists to support a finding of a trier of fact.
From the executive summary:
The business decisions that brought Lehman to its crisis of confidence may have been in error but were largely within the business judgment rule. But the decision not to disclose the effects of those judgments does give rise to colorable claims against the senior officers who oversaw and certified misleading financial statements – Lehman’s CEO Richard S. Fuld, Jr., and its CFOs Christopher O’Meara, Erin M. Callan and Ian T. Lowitt. 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.
Although Repo 105 transactions may not have been inherently improper, there is a colorable claim that their 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.” Lehman used Repo 105 “to reduce balance sheet at the quarter‐end.”
Colorable claims exist against the senior officers who were responsible for balance sheet management and financial disclosure, who signed and certified Lehman’s financial statements and who failed to disclose Lehman’s use and extent of Repo 105 transactions to manage its balance sheet.
And what about the independent auditors, Ernst & Young? Again from the executive summary:
In May 2008, a Lehman Senior Vice President, Matthew Lee, wrote a letter to management alleging accounting improprieties; in the course of investigating the allegations, Ernst & Young was advised by Lee on June 12, 2008 that Lehman used $50 billion of Repo 105 transactions to temporarily move assets off balance sheet and quarter end. The next day ‐ on June 13, 2008 ‐ 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. Colorable claims exist that Ernst & Young did not meet professional standards, both in investigating Lee’s allegations and in connection with its audit and review of Lehman’s financial statements.
The Examiner has done his job. Will the regulators and prosecutors do theirs?