Securities Law Prof Blog

Editor: Eric C. Chaffee
Univ. of Toledo College of Law

Saturday, March 13, 2010

The Short Story on Lehman and Repo 105

What is Repo 105 (from Examiner Report's executive summary, footnotes omitted):

Lehman employed off‐balance sheet devices, known within Lehman as “Repo 105” and “Repo 108” transactions, to temporarily remove securities inventory from its balance sheet, usually for a period of seven to ten days, and to create a materially misleading picture of the firm’s financial condition in late 2007 and 2008. Repo 105 transactions were nearly identical to standard repurchase and resale (“repo”) transactions that Lehman (and other investment banks) used to secure short‐term financing, with a critical difference: Lehman accounted for Repo 105 transactions as “sales” as opposed to financing transactions based upon the overcollateralization or higher than normal haircut in a Repo 105 transaction.  By recharacterizing the Repo 105 transaction as a “sale,” Lehman removed the inventory from its balance sheet.

Lehman regularly increased its use of Repo 105 transactions in the days prior to reporting periods to reduce its publicly reported net leverage and balance sheet.  ...

Lehman never publicly disclosed its use of Repo 105 transactions, its accounting treatment for these transactions, the considerable escalation of its total Repo 105 usage in late 2007 and into 2008, or the material impact these transactions had on the firm’s publicly reported net leverage ratio. According to former Global Financial Controller Martin Kelly, a careful review of Lehman’s Forms 10‐K and 10‐Q would not reveal Lehman’s use of Repo 105 transactions. Lehman failed to disclose its Repo 105 practice even though Kelly believed “that the only purpose or motive for the transactions was reduction in balance sheet;” felt that “there was no substance to the transactions;” and expressed concerns with Lehman’s Repo 105 program to two consecutive Lehman Chief Financial Officers – Erin Callan and Ian Lowitt – advising them that the lack of economic substance to Repo 105 transactions meant “reputational risk” to Lehman if the firm’s use of the transactions became known to the public.  In addition to its material omissions, Lehman affirmatively misrepresented in its financial statements that the firm treated all repo transactions as financing transactions – i.e., not sales – for financial reporting purposes.

The Examiner's Report describes that no U.S. law firm would opine that the accounting treatment for Repo 105 was appropriate.  Accordingly, Lehman moved these transactions abroad:

Lehman first introduced its Repo 105 program in approximately 2001. Unable to find a United States law firm that would provide it with an opinion letter permitting the true sale accounting treatment under United States law, Lehman conducted its Repo 105 program under the aegis of an opinion letter the Linklaters law firm in London wrote for LBIE, Lehman’s European broker‐dealer in London, under English law. Accordingly, if United States‐based Lehman entities such as LBI and LBSF wished to engage in a Repo 105 transaction, they transferred their securities inventory to LBIE in order for LBIE to conduct the transaction on their behalf.

Lehman increased its reliance on Repo 105 to improve its reported performance:

Lehman dramatically ramped up its use of Repo 105 transactions in late 2007 and early 2008 despite concerns about the practice expressed by Lehman officers and personnel. In an April 2008 e‐mail asking if he was familiar with the use of Repo 105 transactions to reduce net balance sheet, Bart McDade, Lehman’s former Head of Equities (2005–2008) and President and Chief Operating Officer (June–September 2008), replied: “I am very aware . . . it is another drug we r on.” A week earlier, McDade had recommended to Lehman’s Executive Committee that the firm set a cap on the use of Repo 105 transactions. A senior member of Lehman’s Finance Group considered Lehman’s Repo 105 program to be balance sheet “window‐dressing” that was “based on legal technicalities.”* Other former Lehman employees characterized Repo 105 transactions as an “accounting gimmick” and a “lazy way of managing the balance sheet.

* Why do lawyers get blamed for accounting technicalities? (editorial comment)

The Examiner concludes that:

a fact finder could find that Lehman’s failure to disclose its use of Repo 105 transactions to impact its balance sheet at a time when both the market and senior Lehman management were keenly focused on the reduction of Lehman’s firm‐wide net leverage and balance sheet, and particularly in light of the specific volumes at which Lehman undertook Repo 105 transactions at quarter‐end in fourth quarter 2007, first quarter 2008, and second quarter 2008, materially misrepresented Lehman’s true financial condition.

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Students in ACCT 201, the basic principles course, are taught that such an accounting classification is unethical and does not comply with the principle of full disclosure.

Professor Emeritus
Christopher Newport University

Posted by: Leland Jordan | Mar 13, 2010 4:58:37 PM

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