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Question: On September 15, 2008, Lehman Brothers Holdings

On September 15, 2008, Lehman Brothers Holdings Inc., one of the world’s most respected and profitable investment banks, filed for Chapter 11 bankruptcy protection in the United States Bankruptcy Court in the Southern District of New York.1 Although Lehman Brothers (LB) had reported record revenues of almost $60 billion and record earnings in excess of $4 billion for the fiscal year ended November 30, 2007, only ten months later, their bankruptcy proceeding became the largest ever filed.2 How and why this happened is a complex story, part of which involves financial statement manipulation using a technique that has come to be known as Lehman’s Repo 105 to modify information provided to investors and regulators about the extent to which LB was using other investors’ funds to leverage their own. Banks generate revenue and profit principally by investing funds borrowed from other investors, such as depositors or lenders. Although some of the funds they invest are their own, banks can increase their activity by attracting and using other investors’ funds—an approach that is known as “leverage” because it is using the bank’s own capital to attract investments from others to increase or lever revenue- and profit- generation investments beyond the capacity of the bank’s own limited resources. A bank’s profit from lending activities is generated by “the spread”—the higher rate of return at which a bank lends funds than it pays outside depositors and investors for the use of their funds. However, outside investors or depositors will invest with a bank only if they are convinced that the bank’s own capital is sufficient to provide an adequate cushion against loss of their investment in the event that the bank suf- fers losses. Consequently, outside investors want accurate information on the extent of leverage employed by the bank, which is usually provided as a ratio as follows: Leverage Ratio 5 Total Assets Shareholders’ Equity (the bank’s own capital) In its simplest form, the Repo 105 mechanism—a multiple-step technique3 combined with the failure to disclosure promises to reacquire assets—was used by LB to reduce the reported total assets and net assets included in the leverage ratio, thus showing a lower ratio or more conservative use of leverage than was actually the case. Consequently, bank investors were misled about LB’s ability to cushion losses with its own equity compared to banks that did not artificially depress their leverage ratios. Each of the steps in the Repo 105 technique represented a transaction under- taken near the end of a reporting period designed to reduce the leverage ratio, but the impact of this was essentially reversed just after the beginning of the next reporting period. This reduction and reversal pro- cess was repeated each quarterly reporting period from 2001 to 2008. Because most of these periods (those up to November 30, 2007) were subject to audit by Ernst & Young (E&Y), questions have been raised about what E&Y knew and thought about the Repo 105 technique and its impact and what they should have done and did do during their audit process. In addition, the role and responsibility of LB’s management and the Board of Directors has come into question. Why Did Lehman Brothers Fail? According to the Bankruptcy Examiner’s Report4 by Anton Valukas, LB failed for several reasons, including the following: • The poor economic climate caused by the subprime lending crisis leading to a degeneration of confidence and there- fore a disenchantment and devaluation of asset-backed commercial paper and other financial instruments in which LB and others had invested. • A very highly leveraged position prior to the onset of the subprime lending crisis—LB “maintained approximately $700 billion of assets … on capital of approximately $25 billion,”5 a ratio of 28:1. • Decisions involving excessive risk taking by LB executives. For example, as the subprime lending crisis unfolded, LB management decided to invest more or “double down”6 in depressed assets hoping for a quick gain when values rebounded. LB’s aggressive decisions resulted in it exceeding its own risk limits and controls.7 • A mismatch between longer-term assets and the shorter-term liabilities used to finance them, thus making LB vulnerable to shifts in the preferences of creditors or the cost of the credit needed to finance the assets. Because the assets were of a longer-term nature, they were not maturing in time to pay off creditors who were making reinvestment decisions on a much shorter time scale. LB had to have creditors who had sufficient confidence in LB to be willing to invest daily so that LB could be sustained. • A masking of the extent to which LB was leveraged through the use of repurchase transactions—otherwise known as repo transactions—including ordinary repo transactions, Repo 105 transactions, and Repo 108 transactions. (Repo transactions are explained more fully in the next section.) This masking prevented creditors and investors from understanding how leveraged LB was, thus permitting LB to expand. • In March 2008, Bear Stearns, a rival investment house, began to falter and nearly collapsed, putting the spotlight on LB, which was considered the next most vulnerable. • Investor confidence was further eroded when Lehman announced its first-ever loss of $2.8 billion for its second quarter of 2008. At this time, the SEC and the Federal Reserve Bank of New York sent personnel to take up residence on-site to monitor LB’s liquidity. • In fact, LB had masked approximately $50 billion in leverage in the first and second quarters of 2008, so their condition was worse than disclosed. Although LB raised $6 billion of new capital on June 12, 2008, “[U.S.] Treasury Secretary Henry M. Paulson, Jr., privately told [LB CEO] Fuld that if Lehman was forced to report further losses in the third quarter without having a buyer or a definitive survival plan in place, Lehman’s existence would be in jeopardy. On September 10, 2008 Lehman announced that it was projecting a $3.9 billion loss for the third quarter of 2008.”8 • On September 15, 2008, LB’s bankruptcy filing proved Paulson to be correct. The Repo 105 Mechanism and Impact There are three kinds of repo transactions: (1) ordinary, (2) Repo 105, and (3) Repo 108. All three are illustrated along with their impact on the balance sheet and leverage ratio in volume 3 of the Examiner’s Report.9 Most investment banks used ordinary repo transactions to borrow funds using securities as collateral, which they shortly repaid for a 2% fee (interest charge), or “haircut” as it became known. Because the cash received as well as the assets used as collateral and the liability for repurchase are all shown on the balance sheet, it and the leverage ratios are accurately stated.10 Schematically, an ordinary repo transaction sequence can be represented as follows:11 A Repo 105 transaction sequence is different in that prior to the reporting date, (1) the initial transaction is treated as a sale, not a borrowing; (2) the cash received is used to pay off liabilities; and then, after the reporting date; (3) LB borrows funds elsewhere to repurchase the securities sold
On September 15, 2008, Lehman Brothers Holdings Inc., one of the world’s most respected and profitable investment banks, filed for Chapter 11 bankruptcy protection in the United States Bankruptcy Court in the Southern District of New York.1 Although Lehman Brothers (LB) had reported record revenues of almost $60 billion and record earnings in excess of $4 billion for the fiscal year ended November 30, 2007, only ten months later, their bankruptcy proceeding became the largest ever filed.2 How and why this happened is a complex story, part of which involves financial statement manipulation using a technique that has come to be known as Lehman’s Repo 105 to modify information provided to investors and regulators about the extent to which LB was using other investors’ funds to leverage their own. Banks generate revenue and profit principally by investing funds borrowed from other investors, such as depositors or lenders. Although some of the funds they invest are their own, banks can increase their activity by attracting and using other investors’ funds—an approach that is known as “leverage” because it is using the bank’s own capital to attract investments from others to increase or lever revenue- and profit- generation investments beyond the capacity of the bank’s own limited resources. A bank’s profit from lending activities is generated by “the spread”—the higher rate of return at which a bank lends funds than it pays outside depositors and investors for the use of their funds. However, outside investors or depositors will invest with a bank only if they are convinced that the bank’s own capital is sufficient to provide an adequate cushion against loss of their investment in the event that the bank suf- fers losses. Consequently, outside investors want accurate information on the extent of leverage employed by the bank, which is usually provided as a ratio as follows: Leverage Ratio 5 Total Assets Shareholders’ Equity (the bank’s own capital) In its simplest form, the Repo 105 mechanism—a multiple-step technique3 combined with the failure to disclosure promises to reacquire assets—was used by LB to reduce the reported total assets and net assets included in the leverage ratio, thus showing a lower ratio or more conservative use of leverage than was actually the case. Consequently, bank investors were misled about LB’s ability to cushion losses with its own equity compared to banks that did not artificially depress their leverage ratios. Each of the steps in the Repo 105 technique represented a transaction under- taken near the end of a reporting period designed to reduce the leverage ratio, but the impact of this was essentially reversed just after the beginning of the next reporting period. This reduction and reversal pro- cess was repeated each quarterly reporting period from 2001 to 2008. Because most of these periods (those up to November 30, 2007) were subject to audit by Ernst & Young (E&Y), questions have been raised about what E&Y knew and thought about the Repo 105 technique and its impact and what they should have done and did do during their audit process. In addition, the role and responsibility of LB’s management and the Board of Directors has come into question. Why Did Lehman Brothers Fail? According to the Bankruptcy Examiner’s Report4 by Anton Valukas, LB failed for several reasons, including the following: • The poor economic climate caused by the subprime lending crisis leading to a degeneration of confidence and there- fore a disenchantment and devaluation of asset-backed commercial paper and other financial instruments in which LB and others had invested. • A very highly leveraged position prior to the onset of the subprime lending crisis—LB “maintained approximately $700 billion of assets … on capital of approximately $25 billion,”5 a ratio of 28:1. • Decisions involving excessive risk taking by LB executives. For example, as the subprime lending crisis unfolded, LB management decided to invest more or “double down”6 in depressed assets hoping for a quick gain when values rebounded. LB’s aggressive decisions resulted in it exceeding its own risk limits and controls.7 • A mismatch between longer-term assets and the shorter-term liabilities used to finance them, thus making LB vulnerable to shifts in the preferences of creditors or the cost of the credit needed to finance the assets. Because the assets were of a longer-term nature, they were not maturing in time to pay off creditors who were making reinvestment decisions on a much shorter time scale. LB had to have creditors who had sufficient confidence in LB to be willing to invest daily so that LB could be sustained. • A masking of the extent to which LB was leveraged through the use of repurchase transactions—otherwise known as repo transactions—including ordinary repo transactions, Repo 105 transactions, and Repo 108 transactions. (Repo transactions are explained more fully in the next section.) This masking prevented creditors and investors from understanding how leveraged LB was, thus permitting LB to expand. • In March 2008, Bear Stearns, a rival investment house, began to falter and nearly collapsed, putting the spotlight on LB, which was considered the next most vulnerable. • Investor confidence was further eroded when Lehman announced its first-ever loss of $2.8 billion for its second quarter of 2008. At this time, the SEC and the Federal Reserve Bank of New York sent personnel to take up residence on-site to monitor LB’s liquidity. • In fact, LB had masked approximately $50 billion in leverage in the first and second quarters of 2008, so their condition was worse than disclosed. Although LB raised $6 billion of new capital on June 12, 2008, “[U.S.] Treasury Secretary Henry M. Paulson, Jr., privately told [LB CEO] Fuld that if Lehman was forced to report further losses in the third quarter without having a buyer or a definitive survival plan in place, Lehman’s existence would be in jeopardy. On September 10, 2008 Lehman announced that it was projecting a $3.9 billion loss for the third quarter of 2008.”8 • On September 15, 2008, LB’s bankruptcy filing proved Paulson to be correct. The Repo 105 Mechanism and Impact There are three kinds of repo transactions: (1) ordinary, (2) Repo 105, and (3) Repo 108. All three are illustrated along with their impact on the balance sheet and leverage ratio in volume 3 of the Examiner’s Report.9 Most investment banks used ordinary repo transactions to borrow funds using securities as collateral, which they shortly repaid for a 2% fee (interest charge), or “haircut” as it became known. Because the cash received as well as the assets used as collateral and the liability for repurchase are all shown on the balance sheet, it and the leverage ratios are accurately stated.10 Schematically, an ordinary repo transaction sequence can be represented as follows:11 A Repo 105 transaction sequence is different in that prior to the reporting date, (1) the initial transaction is treated as a sale, not a borrowing; (2) the cash received is used to pay off liabilities; and then, after the reporting date; (3) LB borrows funds elsewhere to repurchase the securities sold including a 5% interest charge.12 The overall impact is to reduce the assets and the liabilities on the balance sheet at the reporting date, thus reducing the leverage ratio because the numerator and the denominator of that ratio are reduced by the same amount. The balance sheet and leverage impacts of ordinary repo transactions as well as Repo 105 or 108 transactions are shown in the following sequence of illustrations.13,14,15,16,17 Balance Sheet and Leverage Impacts of Lehman Repo Transactions In order to make the initial sale transaction credible, LB needed a letter from a law firm specifying that it constituted a “true sale.” Interestingly, LB could not obtain such an opinion under U.S. law from U.S. lawyers, but Lehman Brothers International (Europe) (LBIE), based in London, did obtain one from Linklaters, a U.K. firm.18 Consequently, when Repo 105 and Repo 108 transactions were needed, they were done via transfers to and from LBIE in London. Repo 105 transactions were used with highly liquid securities, whereas Repo 108 transactions involved nonliquid or equity securities. To make sure these transactions went according to protocol, LB created an Accounting Policy Manual Repo 105 and 108 to guide their personnel.19 LB employed ordinary repo transactions as well as Repo 105 and Repo 108 transactions. The interest charges or fees involved were 2%, 5%, and 8%, respectively. The higher interest rate charges on the Repo 105 and 108 transactions were to compensate for their higher level of risk. But, because ordinary repo transactions could have been used to raise cash20 at a cost of 2%, it has been argued that LB used the higher-cost Repo 105 and 108 transactions only because they provided a way to man- age LB’s balance sheet and leverage ratio. This was confirmed by LB employees who commented as follows: “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.”21 Other former Lehman employees characterized Repo 105 transactions as an “accounting gimmick” and a “lazy way of managing the balance sheet.”22 When queried about meeting internal leverage targets for the second quarter, an employee responded by email saying: “very] close … any- thing that moves is getting 105’d.”23 The reduction in leverage ratios achieved through the use of Repo 105 and 108 trans- actions are shown below:24 According to the Bankruptcy Examiner, E&Y noted that LB’s threshold for deter- mining material items requiring reopening a closed balance sheet for correction was “any item individually, or in the aggregate, that moves net leverage by 0.1 or more (typically $1.8 billion).”25 Consequently, the usage of Repo 105 transactions noted previously resulted in changes that were many times greater than LB’s standard of materiality, which should have been a red-flag indicator to management and the auditors. Ratings agencies, on whose ratings LB’s credibility with lenders depended, were queried as to what they knew of the Repo 105 usage and materiality of the impact involved. According to the Examiner’s Report, Eileen Fahey, an analyst at Fitch, said that she had never heard of repo trans- actions being accounted for as true sales on the basis of a true sale opin- ion letter or repo transactions known as Repo 105 transactions. Fahey stated that a transfer of $40 billion or $50 billion of securities inventory— regardless of the liquidity of that inventory—from Lehman’s balance sheet at quarter-end would be “material” in Fitch’s view, and upon having a standard Repo 105 transaction described, Fahey remarked that such a transaction “sounded like fraud.”26 Fahey likened this “manipulation” to an investment bank telling regulators that it did not own any mortgage-backed securities when, in fact, it owned them but had temporarily transferred them to a counter- party and was obligated to repurchase them shortly thereafter.27 (This was similar to the usage Enron made with its special purpose entities.) The timing of the use of Repo 105 trans- actions corroborates that the intention was to manipulate LB’s end-of-quarter balance sheets, as is shown in the following graph.28 At the end of each quarter, LB’s assets are significantly higher than at the end of the two previous months. Thus, as a result of these transactions, LB’s end-of-quarter balance sheet shows significantly less assets than would have been reported at any other time during the quarter. LB’s Accounting Analysis LB’s Repo 105 transactions were under- taken under paragraph 9 of the FASB’s Statement of Financial Accounting Standards (SFAS) 140, which reads as follows: Accounting for Transfers and Servicing of Financial Assets A transfer of financial assets (or all or a portion of a financial asset) in which the transferor surrenders control over those financial assets shall be accounted for as a sale to the extent that consideration other than beneficial interests in the transferred assets is received in exchange. The transferor has surrendered control over transferred assets if and only if all of the following conditions are met: a. The transferred assets have been isolated from the transferor—put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership (paragraphs 27 and 28). b. Each transferee (or, if the transferee is a qualifying special purpose entity (para- graph 35), each holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both constrains the transferee (or holder) from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor (paragraphs 29–34). c. The transferor does not maintain effective control over the transferred assets through either (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity (paragraphs 47–49) or (2) the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call (paragraphs 50–54).29 SFAS 140 comments further in paragraph 218 that control over the assets transferred is maintained (thus breaking condition b above) if repurchase arrangements cover as much as 98% collateralization or as little as 102% overcollateralization. LB interpreted this to mean that because the “haircut” or fee charged in Repo 105 transactions was 5% and therefore greater than the 2% col- lateralization limit, control could be considered to have been surrendered, thus allowing the transfer to be considered a sale. Essentially, based on the percentages, LB took the position that they did not have the funds available to fund substantially all of the repurchase cost.30 To further bolster the position that the transfer of assets was a sale, LB obtained a letter from a U.K. law firm, Linklaters of London, that the transaction was a “true sale.”31 Such an opinion was possible under U.K. law but not under U.S. law, but the opinion was addressed to LBIE, thus necessitating transfers to LBIE so that the trans- actions would qualify as sales under U.K. law. LB, however, did not observe this need for transfer entirely.32 According to the Examiner, LB had this treatment as a sale vetted by outside auditors (E&Y) and lawyers.33 However, on May 16, 2008, Matthew Lee, former LB senior vice president, Finance Division, who was in charge of Global Balance Sheet and Legal Entity Accounting, sent a whistleblower letter to senior LB management expressing concerns about possible LB Ethics Code violations34 about the balance sheet irregularities related to the $50 billion in Repo 105 transactions then under way. According to the examiner, Lee’s letter contained the following six allegations: (1) on the last day of each month, Lehman’s books and records contained approximately $5 billion of net assets in excess of what was managed on the last day of the month, thereby suggesting that the firm’s senior management was not in control of its assets to be able to present full, fair, and accurate financial statements to the public; (2) Lehman had “tens of billions of dollars of unsubstantiated balances, which may or may not be ‘bad’ or non-performing assets or real liabilities”; (3) Lehman had tens of billions of dollars of illiquid inventory and did not value its inventory in a “fully realistic or reasonable” way; (4) given Lehman’s rapid growth and increased number of accounts and entities, it had not invested sufficiently in financial systems and personnel to cope with the balance sheet; (5) the India Finance office lacked sufficient knowledgeable management, resulting in the real possibility of potential misstatements of material facts being distributed by that office; and (6) certain senior level audit personnel were not qualified to “properly exercise the audit functions they are entrusted to manage.”35 Lee was interviewed by E&Y representatives about his concerns on June 12, 2008.36 E&Y’s Reaction E&Y faced questions from the business press and their clients as soon as the Examiner’s Report was made public. In response, a letter was quickly issued to clients, which apparently found its way into the public domain by being published on the Web. That letter was originally published with- out the opening and closing paragraphs by Francine McKenna37 on March 20, 2010, at http://www.retheauditors.com. E&Y’s let- ter, which is shown below,38 was published in its entirety on March 23, 2010, on the Contrarian Pundit website at http://www.contrarianpundit.com. ERNST & YOUNG 23 March 2010 To: Recently, there have been extensive media reports about the release of the Bankruptcy Examiner’s Report relating to the September 2008 bankruptcy of Lehman Brothers. As you may have read, Ernst & Young was Lehman Brothers’ independent auditors. The concept of an examiner’s report is a feature of US bankruptcy law. It does not represent the views of a court or a regulatory body, nor is the Report the result of a legal process. Instead, an examiner’s report is intended to identify potential claims that, if pursued, may result in a recovery for the bankrupt company or its creditors. EY is confident we will prevail should any of the potential claims identified against us be pursued. We wanted to provide you with EY’s perspective on some of the potential claims in the Examiner’s Report. We also wanted to address certain media coverage and commentary on the Examiner’s Report that has at times been inaccurate, if not misleading. A few key points are set out below. General Comments ■ EY’s last audit was for the year ended November 30, 2007. Our opinion stated that Lehman’s financial statements for 2007 were fairly presented in accordance with US GAAP, and we remain of that view. We reviewed but did not audit the interim periods for Lehman’s first and second quarters of fiscal 2008. ■ Lehman’s bankruptcy was the result of a series of unprecedented adverse events in the financial markets. The months leading up to Lehman’s bankruptcy were among the most turbulent periods in our economic history. Lehman’s bankruptcy was caused by a collapse in its liquidity, which was in turn caused by declining asset values and loss of market confidence in Lehman. It was not caused by accounting issues or disclosure issues. ■ The Examiner identified no potential claims that the assets and liabilities reported on Lehman’s financial statements (approximately $691 billion and $669 billion, respectively, at November 30, 2007) were improperly valued or accounted for incorrectly. Accounting and Disclosure Issues Relating to Repo 105 Transactions ■ There has been significant media attention about potential claims identified by the Examiner related to what Lehman referred to as “Repo 105” transactions. What has not been reported in the media is that the Examiner did not challenge Lehman’s accounting for its Repo 105 transactions. ■ As recognized by the Examiner, all investment banks used repo transactions extensively to fund their operations on a daily basis; these banks all operated in a high-risk, high-leverage business model. Most repo transactions are accounted for as financings; some (the Repo 105 transactions) are accounted for as sales if they meet the requirements of SFAS 140. ■ The Repo 105 transactions involved the sale by Lehman of high quality liquid assets (generally government-backed securities), in return for which Lehman received cash. The media reports that these were “sham transactions” designed to off-load Lehman’s “bad assets” are inaccurate. ■ Because effective control of the securities was surrendered to the counterparty in the Repo 105 arrangements, the accounting literature (SFAS 140) required Lehman to account for Repo 105 transactions as sales rather than financings. ■ The potential claims against EY arise solely from the Examiner’s conclusion that these transactions ($38.6 billion at November 30, 2007) should have been specifically disclosed in the footnotes to Lehman’s financial statements, and that Lehman should have disclosed in its MD&A the impact these transactions would have had on its leverage ratios if they had been recorded as financing transactions. ■ While no specific disclosures around Repo 105 transactions were reflected in Lehman’s financial statement footnotes, the 2007 audited financial statements were presented in accordance with US GAAP, and clearly portrayed Lehman as a leveraged entity operating in a risky and volatile industry. Lehman’s 2007 audited financial statements included footnote disclosure of off balance sheet commitments of almost $1 trillion. ■ Lehman’s leverage ratios are not a GAAP financial measure; they were included in Lehman’s MD&A, not its audited financial statements. Lehman concluded no further MD&A disclosures were required; EY did not take exception to that judgment. ■ If the Repo 105 transactions were treated as if they were on the balance sheet for leverage ratio purposes, as the Examiner suggests, Lehman’s reported gross leverage would have been 32.4 instead of 30.7 at November 30, 2007. Also, contrary to media reports, the decline in Lehman’s reported leverage from its first to second quarters of 2008 was not a result of an increased use of Repo 105 transactions. Lehman’s Repo 105 transaction volumes were comparable at the end of its first and second quarters. Handling of the Whistleblower’s Issues ■ The media has inaccurately reported that EY concealed a May 2008 whistleblower letter from Lehman’s Audit Committee. The whistleblower letter, which raised various significant potential concerns about Lehman’s financial controls and reporting but did not mention Repo 105, was directed to Lehman’s management. When we learned of the letter, our lead partner promptly called the Audit Committee Chair; we also insisted that Lehman’s management inform the Securities & Exchange Commission and the Federal Reserve Bank of the letter. EY’s lead partner discussed the whistleblower letter with the Lehman Audit Committee on at least three occasions during June and July 2008. ■ In the investigations that ensued, the writer of the letter did briefly reference Repo 105 transactions in an interview with EY partners. He also confirmed to EY that he was unaware of any material financial reporting errors. Lehman’s senior executives did not advise us of any reservations they had about the company’s Repo 105 transactions. ■ Lehman’s September 2008 bankruptcy prevented EY from completing its assessment of the whistleblower’s allegations. The allegations would have been the subject of significant attention had EY completed its third quarter review and 2008 year-end audit. Should any of the potential claims be pursued, we are confident we will prevail. Thank you for your support in this matter. Please feel free to call me at anytime at With best regards, Lehman’s Risk Management LB was a major player in a field that involved many varieties of risk and had specifically identified that their risk appetite for Repo 105 transactions in July 2006 was “1x leverage … or $17 billion, [and] $5 billion for Repo 108 transactions.”39 Consequently, LB’s internal cap on repo transactions was breached by significant amounts beginning in 2007.40 Recognizing that the levels of $40 billion to 50 billion were unsustainable, LB made efforts to obtain outside financing to be used to cut the level of repo transactions in 2008. Unfortunately, that effort was too little, too late. On September 15, 2008, LB declared bankruptcy. Questions 1. What was the most important reason for the LB failure? 2. What is leverage and why is it so important? 3. Prepare the journal entries for a Repo 105 transaction sequence for $1 million in securities. 4. In your opinion, how large should a Repo 105 transaction be to be considered material and why? 5. Was LB’s interpretation of SFAS 140— Repo 105 transactions could be treated as sales—correct? Provide your reasons. 6. If, as the Examiner’s Report states,41 LB continued to collect the revenue from the securities involved in the Repo 105 transactions, how could LB say that they had given up ownership? 7. An emerging issue Interpretation Bulletin42 accompanying FAS 140 gives examples indicating that Repo 102 transactions would not qualify as sales but that Repo 110 would. Why do you think this Bulletin was issued? See Q&A 140—A Guide to Implementation of Statement 140 on Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities at http://www.fasb.org/cs /ContentServer?c=Document_C& pagename=FASB%2FDocument_C% 2FDocumentPage&cid=1175801856780 (accessed March 27, 2011). 8. Knowing that LB could not obtain a “true sale” opinion from a U.S. lawyer under U.S. law, should LB have tried to obtain the opinion from a U.K. law firm? Why and why not? 9. Do the Repo 105 arrangements constitute fraud? Why and why not? 10. What is the auditor’s responsibility if a fraud is suspected or discovered? What professional standards are most import- ant in such cases and why? 11. If you were the audit partner in charge in the United States, what would you have required be done in regard to the Linklater “true sale” letter? 12. Should consolidated financial statements of a U.S. parent company include (i.e., consolidate) foreign subsidiary accounts prepared on a basis not considered appropriate U.S. GAAP? 13. Would the adoption of IFRS have pre- vented the Repo 105 misrepresentations? 14. What should the following have done on learning of Matthew Lee’s whistleblower’s letter—LB’s management, Board of Directors, and the external auditors, E&Y? 15. Arthur Andersen tried to keep its Enron audit problems quiet, whereas E&Y spoke out in its own defense. Was it a good idea for E&Y to send a letter, such as the one reproduced previously, to their clients? Why and why not? 16. Based on the letter, should E&Y be in the clear of any wrongdoing related to the Repo 105 and 108 transactions and reporting? Provide your reasons for and against. 17. If an auditor explains a problem to the chair of an audit committee, is there any further obligation on the part of the auditor to ensure that the full board has been notified and why? 18. Organizations who use the Enterprise Risk Management (ERM) framework43 should work through the following stages: review on the internal environment, identification of the organization’s risk appetite or objectives, risk identification and measurement, risk assessment, risk response, providing risk information and communications, and risk monitoring. In which of these did LB fail? Who was to blame for the failure? 19. How should the U.S. Bankruptcy Examiner’s Report be regarded—as a neutral set of findings or as a signpost intended to point creditors in the direction of potential recoveries? What are the implications of each? 20. After the Enron and WorldCom fiascos, regulators sought to avoid future misrepresentation by enacting the Sarbanes-Oxley Act (SOX) in 2002. Why did SOX not prevent Lehman’s use of Repo 105 and 108 misrepresentations? Does that mean that SOX is a failure?
including a 5% interest charge.12 The overall impact is to reduce the assets and the liabilities on the balance sheet at the reporting date, thus reducing the leverage ratio because the numerator and the denominator of that ratio are reduced by the same amount. The balance sheet and leverage impacts of ordinary repo transactions as well as Repo 105 or 108 transactions are shown in the following sequence of illustrations.13,14,15,16,17 Balance Sheet and Leverage Impacts of Lehman Repo Transactions In order to make the initial sale transaction credible, LB needed a letter from a law firm specifying that it constituted a “true sale.” Interestingly, LB could not obtain such an opinion under U.S. law from U.S. lawyers, but Lehman Brothers International (Europe) (LBIE), based in London, did obtain one from Linklaters, a U.K. firm.18 Consequently, when Repo 105 and Repo 108 transactions were needed, they were done via transfers to and from LBIE in London. Repo 105 transactions were used with highly liquid securities, whereas Repo 108 transactions involved nonliquid or equity securities. To make sure these transactions went according to protocol, LB created an Accounting Policy Manual Repo 105 and 108 to guide their personnel.19 LB employed ordinary repo transactions as well as Repo 105 and Repo 108 transactions. The interest charges or fees involved were 2%, 5%, and 8%, respectively. The higher interest rate charges on the Repo 105 and 108 transactions were to compensate for their higher level of risk. But, because ordinary repo transactions could have been used to raise cash20 at a cost of 2%, it has been argued that LB used the higher-cost Repo 105 and 108 transactions
On September 15, 2008, Lehman Brothers Holdings Inc., one of the world’s most respected and profitable investment banks, filed for Chapter 11 bankruptcy protection in the United States Bankruptcy Court in the Southern District of New York.1 Although Lehman Brothers (LB) had reported record revenues of almost $60 billion and record earnings in excess of $4 billion for the fiscal year ended November 30, 2007, only ten months later, their bankruptcy proceeding became the largest ever filed.2 How and why this happened is a complex story, part of which involves financial statement manipulation using a technique that has come to be known as Lehman’s Repo 105 to modify information provided to investors and regulators about the extent to which LB was using other investors’ funds to leverage their own. Banks generate revenue and profit principally by investing funds borrowed from other investors, such as depositors or lenders. Although some of the funds they invest are their own, banks can increase their activity by attracting and using other investors’ funds—an approach that is known as “leverage” because it is using the bank’s own capital to attract investments from others to increase or lever revenue- and profit- generation investments beyond the capacity of the bank’s own limited resources. A bank’s profit from lending activities is generated by “the spread”—the higher rate of return at which a bank lends funds than it pays outside depositors and investors for the use of their funds. However, outside investors or depositors will invest with a bank only if they are convinced that the bank’s own capital is sufficient to provide an adequate cushion against loss of their investment in the event that the bank suf- fers losses. Consequently, outside investors want accurate information on the extent of leverage employed by the bank, which is usually provided as a ratio as follows: Leverage Ratio 5 Total Assets Shareholders’ Equity (the bank’s own capital) In its simplest form, the Repo 105 mechanism—a multiple-step technique3 combined with the failure to disclosure promises to reacquire assets—was used by LB to reduce the reported total assets and net assets included in the leverage ratio, thus showing a lower ratio or more conservative use of leverage than was actually the case. Consequently, bank investors were misled about LB’s ability to cushion losses with its own equity compared to banks that did not artificially depress their leverage ratios. Each of the steps in the Repo 105 technique represented a transaction under- taken near the end of a reporting period designed to reduce the leverage ratio, but the impact of this was essentially reversed just after the beginning of the next reporting period. This reduction and reversal pro- cess was repeated each quarterly reporting period from 2001 to 2008. Because most of these periods (those up to November 30, 2007) were subject to audit by Ernst & Young (E&Y), questions have been raised about what E&Y knew and thought about the Repo 105 technique and its impact and what they should have done and did do during their audit process. In addition, the role and responsibility of LB’s management and the Board of Directors has come into question. Why Did Lehman Brothers Fail? According to the Bankruptcy Examiner’s Report4 by Anton Valukas, LB failed for several reasons, including the following: • The poor economic climate caused by the subprime lending crisis leading to a degeneration of confidence and there- fore a disenchantment and devaluation of asset-backed commercial paper and other financial instruments in which LB and others had invested. • A very highly leveraged position prior to the onset of the subprime lending crisis—LB “maintained approximately $700 billion of assets … on capital of approximately $25 billion,”5 a ratio of 28:1. • Decisions involving excessive risk taking by LB executives. For example, as the subprime lending crisis unfolded, LB management decided to invest more or “double down”6 in depressed assets hoping for a quick gain when values rebounded. LB’s aggressive decisions resulted in it exceeding its own risk limits and controls.7 • A mismatch between longer-term assets and the shorter-term liabilities used to finance them, thus making LB vulnerable to shifts in the preferences of creditors or the cost of the credit needed to finance the assets. Because the assets were of a longer-term nature, they were not maturing in time to pay off creditors who were making reinvestment decisions on a much shorter time scale. LB had to have creditors who had sufficient confidence in LB to be willing to invest daily so that LB could be sustained. • A masking of the extent to which LB was leveraged through the use of repurchase transactions—otherwise known as repo transactions—including ordinary repo transactions, Repo 105 transactions, and Repo 108 transactions. (Repo transactions are explained more fully in the next section.) This masking prevented creditors and investors from understanding how leveraged LB was, thus permitting LB to expand. • In March 2008, Bear Stearns, a rival investment house, began to falter and nearly collapsed, putting the spotlight on LB, which was considered the next most vulnerable. • Investor confidence was further eroded when Lehman announced its first-ever loss of $2.8 billion for its second quarter of 2008. At this time, the SEC and the Federal Reserve Bank of New York sent personnel to take up residence on-site to monitor LB’s liquidity. • In fact, LB had masked approximately $50 billion in leverage in the first and second quarters of 2008, so their condition was worse than disclosed. Although LB raised $6 billion of new capital on June 12, 2008, “[U.S.] Treasury Secretary Henry M. Paulson, Jr., privately told [LB CEO] Fuld that if Lehman was forced to report further losses in the third quarter without having a buyer or a definitive survival plan in place, Lehman’s existence would be in jeopardy. On September 10, 2008 Lehman announced that it was projecting a $3.9 billion loss for the third quarter of 2008.”8 • On September 15, 2008, LB’s bankruptcy filing proved Paulson to be correct. The Repo 105 Mechanism and Impact There are three kinds of repo transactions: (1) ordinary, (2) Repo 105, and (3) Repo 108. All three are illustrated along with their impact on the balance sheet and leverage ratio in volume 3 of the Examiner’s Report.9 Most investment banks used ordinary repo transactions to borrow funds using securities as collateral, which they shortly repaid for a 2% fee (interest charge), or “haircut” as it became known. Because the cash received as well as the assets used as collateral and the liability for repurchase are all shown on the balance sheet, it and the leverage ratios are accurately stated.10 Schematically, an ordinary repo transaction sequence can be represented as follows:11 A Repo 105 transaction sequence is different in that prior to the reporting date, (1) the initial transaction is treated as a sale, not a borrowing; (2) the cash received is used to pay off liabilities; and then, after the reporting date; (3) LB borrows funds elsewhere to repurchase the securities sold including a 5% interest charge.12 The overall impact is to reduce the assets and the liabilities on the balance sheet at the reporting date, thus reducing the leverage ratio because the numerator and the denominator of that ratio are reduced by the same amount. The balance sheet and leverage impacts of ordinary repo transactions as well as Repo 105 or 108 transactions are shown in the following sequence of illustrations.13,14,15,16,17 Balance Sheet and Leverage Impacts of Lehman Repo Transactions In order to make the initial sale transaction credible, LB needed a letter from a law firm specifying that it constituted a “true sale.” Interestingly, LB could not obtain such an opinion under U.S. law from U.S. lawyers, but Lehman Brothers International (Europe) (LBIE), based in London, did obtain one from Linklaters, a U.K. firm.18 Consequently, when Repo 105 and Repo 108 transactions were needed, they were done via transfers to and from LBIE in London. Repo 105 transactions were used with highly liquid securities, whereas Repo 108 transactions involved nonliquid or equity securities. To make sure these transactions went according to protocol, LB created an Accounting Policy Manual Repo 105 and 108 to guide their personnel.19 LB employed ordinary repo transactions as well as Repo 105 and Repo 108 transactions. The interest charges or fees involved were 2%, 5%, and 8%, respectively. The higher interest rate charges on the Repo 105 and 108 transactions were to compensate for their higher level of risk. But, because ordinary repo transactions could have been used to raise cash20 at a cost of 2%, it has been argued that LB used the higher-cost Repo 105 and 108 transactions only because they provided a way to man- age LB’s balance sheet and leverage ratio. This was confirmed by LB employees who commented as follows: “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.”21 Other former Lehman employees characterized Repo 105 transactions as an “accounting gimmick” and a “lazy way of managing the balance sheet.”22 When queried about meeting internal leverage targets for the second quarter, an employee responded by email saying: “very] close … any- thing that moves is getting 105’d.”23 The reduction in leverage ratios achieved through the use of Repo 105 and 108 trans- actions are shown below:24 According to the Bankruptcy Examiner, E&Y noted that LB’s threshold for deter- mining material items requiring reopening a closed balance sheet for correction was “any item individually, or in the aggregate, that moves net leverage by 0.1 or more (typically $1.8 billion).”25 Consequently, the usage of Repo 105 transactions noted previously resulted in changes that were many times greater than LB’s standard of materiality, which should have been a red-flag indicator to management and the auditors. Ratings agencies, on whose ratings LB’s credibility with lenders depended, were queried as to what they knew of the Repo 105 usage and materiality of the impact involved. According to the Examiner’s Report, Eileen Fahey, an analyst at Fitch, said that she had never heard of repo trans- actions being accounted for as true sales on the basis of a true sale opin- ion letter or repo transactions known as Repo 105 transactions. Fahey stated that a transfer of $40 billion or $50 billion of securities inventory— regardless of the liquidity of that inventory—from Lehman’s balance sheet at quarter-end would be “material” in Fitch’s view, and upon having a standard Repo 105 transaction described, Fahey remarked that such a transaction “sounded like fraud.”26 Fahey likened this “manipulation” to an investment bank telling regulators that it did not own any mortgage-backed securities when, in fact, it owned them but had temporarily transferred them to a counter- party and was obligated to repurchase them shortly thereafter.27 (This was similar to the usage Enron made with its special purpose entities.) The timing of the use of Repo 105 trans- actions corroborates that the intention was to manipulate LB’s end-of-quarter balance sheets, as is shown in the following graph.28 At the end of each quarter, LB’s assets are significantly higher than at the end of the two previous months. Thus, as a result of these transactions, LB’s end-of-quarter balance sheet shows significantly less assets than would have been reported at any other time during the quarter. LB’s Accounting Analysis LB’s Repo 105 transactions were under- taken under paragraph 9 of the FASB’s Statement of Financial Accounting Standards (SFAS) 140, which reads as follows: Accounting for Transfers and Servicing of Financial Assets A transfer of financial assets (or all or a portion of a financial asset) in which the transferor surrenders control over those financial assets shall be accounted for as a sale to the extent that consideration other than beneficial interests in the transferred assets is received in exchange. The transferor has surrendered control over transferred assets if and only if all of the following conditions are met: a. The transferred assets have been isolated from the transferor—put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership (paragraphs 27 and 28). b. Each transferee (or, if the transferee is a qualifying special purpose entity (para- graph 35), each holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both constrains the transferee (or holder) from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor (paragraphs 29–34). c. The transferor does not maintain effective control over the transferred assets through either (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity (paragraphs 47–49) or (2) the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call (paragraphs 50–54).29 SFAS 140 comments further in paragraph 218 that control over the assets transferred is maintained (thus breaking condition b above) if repurchase arrangements cover as much as 98% collateralization or as little as 102% overcollateralization. LB interpreted this to mean that because the “haircut” or fee charged in Repo 105 transactions was 5% and therefore greater than the 2% col- lateralization limit, control could be considered to have been surrendered, thus allowing the transfer to be considered a sale. Essentially, based on the percentages, LB took the position that they did not have the funds available to fund substantially all of the repurchase cost.30 To further bolster the position that the transfer of assets was a sale, LB obtained a letter from a U.K. law firm, Linklaters of London, that the transaction was a “true sale.”31 Such an opinion was possible under U.K. law but not under U.S. law, but the opinion was addressed to LBIE, thus necessitating transfers to LBIE so that the trans- actions would qualify as sales under U.K. law. LB, however, did not observe this need for transfer entirely.32 According to the Examiner, LB had this treatment as a sale vetted by outside auditors (E&Y) and lawyers.33 However, on May 16, 2008, Matthew Lee, former LB senior vice president, Finance Division, who was in charge of Global Balance Sheet and Legal Entity Accounting, sent a whistleblower letter to senior LB management expressing concerns about possible LB Ethics Code violations34 about the balance sheet irregularities related to the $50 billion in Repo 105 transactions then under way. According to the examiner, Lee’s letter contained the following six allegations: (1) on the last day of each month, Lehman’s books and records contained approximately $5 billion of net assets in excess of what was managed on the last day of the month, thereby suggesting that the firm’s senior management was not in control of its assets to be able to present full, fair, and accurate financial statements to the public; (2) Lehman had “tens of billions of dollars of unsubstantiated balances, which may or may not be ‘bad’ or non-performing assets or real liabilities”; (3) Lehman had tens of billions of dollars of illiquid inventory and did not value its inventory in a “fully realistic or reasonable” way; (4) given Lehman’s rapid growth and increased number of accounts and entities, it had not invested sufficiently in financial systems and personnel to cope with the balance sheet; (5) the India Finance office lacked sufficient knowledgeable management, resulting in the real possibility of potential misstatements of material facts being distributed by that office; and (6) certain senior level audit personnel were not qualified to “properly exercise the audit functions they are entrusted to manage.”35 Lee was interviewed by E&Y representatives about his concerns on June 12, 2008.36 E&Y’s Reaction E&Y faced questions from the business press and their clients as soon as the Examiner’s Report was made public. In response, a letter was quickly issued to clients, which apparently found its way into the public domain by being published on the Web. That letter was originally published with- out the opening and closing paragraphs by Francine McKenna37 on March 20, 2010, at http://www.retheauditors.com. E&Y’s let- ter, which is shown below,38 was published in its entirety on March 23, 2010, on the Contrarian Pundit website at http://www.contrarianpundit.com. ERNST & YOUNG 23 March 2010 To: Recently, there have been extensive media reports about the release of the Bankruptcy Examiner’s Report relating to the September 2008 bankruptcy of Lehman Brothers. As you may have read, Ernst & Young was Lehman Brothers’ independent auditors. The concept of an examiner’s report is a feature of US bankruptcy law. It does not represent the views of a court or a regulatory body, nor is the Report the result of a legal process. Instead, an examiner’s report is intended to identify potential claims that, if pursued, may result in a recovery for the bankrupt company or its creditors. EY is confident we will prevail should any of the potential claims identified against us be pursued. We wanted to provide you with EY’s perspective on some of the potential claims in the Examiner’s Report. We also wanted to address certain media coverage and commentary on the Examiner’s Report that has at times been inaccurate, if not misleading. A few key points are set out below. General Comments ■ EY’s last audit was for the year ended November 30, 2007. Our opinion stated that Lehman’s financial statements for 2007 were fairly presented in accordance with US GAAP, and we remain of that view. We reviewed but did not audit the interim periods for Lehman’s first and second quarters of fiscal 2008. ■ Lehman’s bankruptcy was the result of a series of unprecedented adverse events in the financial markets. The months leading up to Lehman’s bankruptcy were among the most turbulent periods in our economic history. Lehman’s bankruptcy was caused by a collapse in its liquidity, which was in turn caused by declining asset values and loss of market confidence in Lehman. It was not caused by accounting issues or disclosure issues. ■ The Examiner identified no potential claims that the assets and liabilities reported on Lehman’s financial statements (approximately $691 billion and $669 billion, respectively, at November 30, 2007) were improperly valued or accounted for incorrectly. Accounting and Disclosure Issues Relating to Repo 105 Transactions ■ There has been significant media attention about potential claims identified by the Examiner related to what Lehman referred to as “Repo 105” transactions. What has not been reported in the media is that the Examiner did not challenge Lehman’s accounting for its Repo 105 transactions. ■ As recognized by the Examiner, all investment banks used repo transactions extensively to fund their operations on a daily basis; these banks all operated in a high-risk, high-leverage business model. Most repo transactions are accounted for as financings; some (the Repo 105 transactions) are accounted for as sales if they meet the requirements of SFAS 140. ■ The Repo 105 transactions involved the sale by Lehman of high quality liquid assets (generally government-backed securities), in return for which Lehman received cash. The media reports that these were “sham transactions” designed to off-load Lehman’s “bad assets” are inaccurate. ■ Because effective control of the securities was surrendered to the counterparty in the Repo 105 arrangements, the accounting literature (SFAS 140) required Lehman to account for Repo 105 transactions as sales rather than financings. ■ The potential claims against EY arise solely from the Examiner’s conclusion that these transactions ($38.6 billion at November 30, 2007) should have been specifically disclosed in the footnotes to Lehman’s financial statements, and that Lehman should have disclosed in its MD&A the impact these transactions would have had on its leverage ratios if they had been recorded as financing transactions. ■ While no specific disclosures around Repo 105 transactions were reflected in Lehman’s financial statement footnotes, the 2007 audited financial statements were presented in accordance with US GAAP, and clearly portrayed Lehman as a leveraged entity operating in a risky and volatile industry. Lehman’s 2007 audited financial statements included footnote disclosure of off balance sheet commitments of almost $1 trillion. ■ Lehman’s leverage ratios are not a GAAP financial measure; they were included in Lehman’s MD&A, not its audited financial statements. Lehman concluded no further MD&A disclosures were required; EY did not take exception to that judgment. ■ If the Repo 105 transactions were treated as if they were on the balance sheet for leverage ratio purposes, as the Examiner suggests, Lehman’s reported gross leverage would have been 32.4 instead of 30.7 at November 30, 2007. Also, contrary to media reports, the decline in Lehman’s reported leverage from its first to second quarters of 2008 was not a result of an increased use of Repo 105 transactions. Lehman’s Repo 105 transaction volumes were comparable at the end of its first and second quarters. Handling of the Whistleblower’s Issues ■ The media has inaccurately reported that EY concealed a May 2008 whistleblower letter from Lehman’s Audit Committee. The whistleblower letter, which raised various significant potential concerns about Lehman’s financial controls and reporting but did not mention Repo 105, was directed to Lehman’s management. When we learned of the letter, our lead partner promptly called the Audit Committee Chair; we also insisted that Lehman’s management inform the Securities & Exchange Commission and the Federal Reserve Bank of the letter. EY’s lead partner discussed the whistleblower letter with the Lehman Audit Committee on at least three occasions during June and July 2008. ■ In the investigations that ensued, the writer of the letter did briefly reference Repo 105 transactions in an interview with EY partners. He also confirmed to EY that he was unaware of any material financial reporting errors. Lehman’s senior executives did not advise us of any reservations they had about the company’s Repo 105 transactions. ■ Lehman’s September 2008 bankruptcy prevented EY from completing its assessment of the whistleblower’s allegations. The allegations would have been the subject of significant attention had EY completed its third quarter review and 2008 year-end audit. Should any of the potential claims be pursued, we are confident we will prevail. Thank you for your support in this matter. Please feel free to call me at anytime at With best regards, Lehman’s Risk Management LB was a major player in a field that involved many varieties of risk and had specifically identified that their risk appetite for Repo 105 transactions in July 2006 was “1x leverage … or $17 billion, [and] $5 billion for Repo 108 transactions.”39 Consequently, LB’s internal cap on repo transactions was breached by significant amounts beginning in 2007.40 Recognizing that the levels of $40 billion to 50 billion were unsustainable, LB made efforts to obtain outside financing to be used to cut the level of repo transactions in 2008. Unfortunately, that effort was too little, too late. On September 15, 2008, LB declared bankruptcy. Questions 1. What was the most important reason for the LB failure? 2. What is leverage and why is it so important? 3. Prepare the journal entries for a Repo 105 transaction sequence for $1 million in securities. 4. In your opinion, how large should a Repo 105 transaction be to be considered material and why? 5. Was LB’s interpretation of SFAS 140— Repo 105 transactions could be treated as sales—correct? Provide your reasons. 6. If, as the Examiner’s Report states,41 LB continued to collect the revenue from the securities involved in the Repo 105 transactions, how could LB say that they had given up ownership? 7. An emerging issue Interpretation Bulletin42 accompanying FAS 140 gives examples indicating that Repo 102 transactions would not qualify as sales but that Repo 110 would. Why do you think this Bulletin was issued? See Q&A 140—A Guide to Implementation of Statement 140 on Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities at http://www.fasb.org/cs /ContentServer?c=Document_C& pagename=FASB%2FDocument_C% 2FDocumentPage&cid=1175801856780 (accessed March 27, 2011). 8. Knowing that LB could not obtain a “true sale” opinion from a U.S. lawyer under U.S. law, should LB have tried to obtain the opinion from a U.K. law firm? Why and why not? 9. Do the Repo 105 arrangements constitute fraud? Why and why not? 10. What is the auditor’s responsibility if a fraud is suspected or discovered? What professional standards are most import- ant in such cases and why? 11. If you were the audit partner in charge in the United States, what would you have required be done in regard to the Linklater “true sale” letter? 12. Should consolidated financial statements of a U.S. parent company include (i.e., consolidate) foreign subsidiary accounts prepared on a basis not considered appropriate U.S. GAAP? 13. Would the adoption of IFRS have pre- vented the Repo 105 misrepresentations? 14. What should the following have done on learning of Matthew Lee’s whistleblower’s letter—LB’s management, Board of Directors, and the external auditors, E&Y? 15. Arthur Andersen tried to keep its Enron audit problems quiet, whereas E&Y spoke out in its own defense. Was it a good idea for E&Y to send a letter, such as the one reproduced previously, to their clients? Why and why not? 16. Based on the letter, should E&Y be in the clear of any wrongdoing related to the Repo 105 and 108 transactions and reporting? Provide your reasons for and against. 17. If an auditor explains a problem to the chair of an audit committee, is there any further obligation on the part of the auditor to ensure that the full board has been notified and why? 18. Organizations who use the Enterprise Risk Management (ERM) framework43 should work through the following stages: review on the internal environment, identification of the organization’s risk appetite or objectives, risk identification and measurement, risk assessment, risk response, providing risk information and communications, and risk monitoring. In which of these did LB fail? Who was to blame for the failure? 19. How should the U.S. Bankruptcy Examiner’s Report be regarded—as a neutral set of findings or as a signpost intended to point creditors in the direction of potential recoveries? What are the implications of each? 20. After the Enron and WorldCom fiascos, regulators sought to avoid future misrepresentation by enacting the Sarbanes-Oxley Act (SOX) in 2002. Why did SOX not prevent Lehman’s use of Repo 105 and 108 misrepresentations? Does that mean that SOX is a failure?

On September 15, 2008, Lehman Brothers Holdings Inc., one of the world’s most respected and profitable investment banks, filed for Chapter 11 bankruptcy protection in the United States Bankruptcy Court in the Southern District of New York.1 Although Lehman Brothers (LB) had reported record revenues of almost $60 billion and record earnings in excess of $4 billion for the fiscal year ended November 30, 2007, only ten months later, their bankruptcy proceeding became the largest ever filed.2 How and why this happened is a complex story, part of which involves financial statement manipulation using a technique that has come to be known as Lehman’s Repo 105 to modify information provided to investors and regulators about the extent to which LB was using other investors’ funds to leverage their own. Banks generate revenue and profit principally by investing funds borrowed from other investors, such as depositors or lenders. Although some of the funds they invest are their own, banks can increase their activity by attracting and using other investors’ funds—an approach that is known as “leverage” because it is using the bank’s own capital to attract investments from others to increase or lever revenue- and profit- generation investments beyond the capacity of the bank’s own limited resources. A bank’s profit from lending activities is generated by “the spread”—the higher rate of return at which a bank lends funds than it pays outside depositors and investors for the use of their funds. However, outside investors or depositors will invest with a bank only if they are convinced that the bank’s own capital is sufficient to provide an adequate cushion against loss of their investment in the event that the bank suf- fers losses. Consequently, outside investors want accurate information on the extent of leverage employed by the bank, which is usually provided as a ratio as follows: Leverage Ratio 5 Total Assets Shareholders’ Equity (the bank’s own capital) In its simplest form, the Repo 105 mechanism—a multiple-step technique3 combined with the failure to disclosure promises to reacquire assets—was used by LB to reduce the reported total assets and net assets included in the leverage ratio, thus showing a lower ratio or more conservative use of leverage than was actually the case. Consequently, bank investors were misled about LB’s ability to cushion losses with its own equity compared to banks that did not artificially depress their leverage ratios. Each of the steps in the Repo 105 technique represented a transaction under- taken near the end of a reporting period designed to reduce the leverage ratio, but the impact of this was essentially reversed just after the beginning of the next reporting period. This reduction and reversal pro- cess was repeated each quarterly reporting period from 2001 to 2008. Because most of these periods (those up to November 30, 2007) were subject to audit by Ernst & Young (E&Y), questions have been raised about what E&Y knew and thought about the Repo 105 technique and its impact and what they should have done and did do during their audit process. In addition, the role and responsibility of LB’s management and the Board of Directors has come into question. Why Did Lehman Brothers Fail? According to the Bankruptcy Examiner’s Report4 by Anton Valukas, LB failed for several reasons, including the following: • The poor economic climate caused by the subprime lending crisis leading to a degeneration of confidence and there- fore a disenchantment and devaluation of asset-backed commercial paper and other financial instruments in which LB and others had invested. • A very highly leveraged position prior to the onset of the subprime lending crisis—LB “maintained approximately $700 billion of assets … on capital of approximately $25 billion,”5 a ratio of 28:1. • Decisions involving excessive risk taking by LB executives. For example, as the subprime lending crisis unfolded, LB management decided to invest more or “double down”6 in depressed assets hoping for a quick gain when values rebounded. LB’s aggressive decisions resulted in it exceeding its own risk limits and controls.7 • A mismatch between longer-term assets and the shorter-term liabilities used to finance them, thus making LB vulnerable to shifts in the preferences of creditors or the cost of the credit needed to finance the assets. Because the assets were of a longer-term nature, they were not maturing in time to pay off creditors who were making reinvestment decisions on a much shorter time scale. LB had to have creditors who had sufficient confidence in LB to be willing to invest daily so that LB could be sustained. • A masking of the extent to which LB was leveraged through the use of repurchase transactions—otherwise known as repo transactions—including ordinary repo transactions, Repo 105 transactions, and Repo 108 transactions. (Repo transactions are explained more fully in the next section.) This masking prevented creditors and investors from understanding how leveraged LB was, thus permitting LB to expand. • In March 2008, Bear Stearns, a rival investment house, began to falter and nearly collapsed, putting the spotlight on LB, which was considered the next most vulnerable. • Investor confidence was further eroded when Lehman announced its first-ever loss of $2.8 billion for its second quarter of 2008. At this time, the SEC and the Federal Reserve Bank of New York sent personnel to take up residence on-site to monitor LB’s liquidity. • In fact, LB had masked approximately $50 billion in leverage in the first and second quarters of 2008, so their condition was worse than disclosed. Although LB raised $6 billion of new capital on June 12, 2008, “[U.S.] Treasury Secretary Henry M. Paulson, Jr., privately told [LB CEO] Fuld that if Lehman was forced to report further losses in the third quarter without having a buyer or a definitive survival plan in place, Lehman’s existence would be in jeopardy. On September 10, 2008 Lehman announced that it was projecting a $3.9 billion loss for the third quarter of 2008.”8 • On September 15, 2008, LB’s bankruptcy filing proved Paulson to be correct. The Repo 105 Mechanism and Impact There are three kinds of repo transactions: (1) ordinary, (2) Repo 105, and (3) Repo 108. All three are illustrated along with their impact on the balance sheet and leverage ratio in volume 3 of the Examiner’s Report.9 Most investment banks used ordinary repo transactions to borrow funds using securities as collateral, which they shortly repaid for a 2% fee (interest charge), or “haircut” as it became known. Because the cash received as well as the assets used as collateral and the liability for repurchase are all shown on the balance sheet, it and the leverage ratios are accurately stated.10 Schematically, an ordinary repo transaction sequence can be represented as follows:11 A Repo 105 transaction sequence is different in that prior to the reporting date, (1) the initial transaction is treated as a sale, not a borrowing; (2) the cash received is used to pay off liabilities; and then, after the reporting date; (3) LB borrows funds elsewhere to repurchase the securities sold including a 5% interest charge.12 The overall impact is to reduce the assets and the liabilities on the balance sheet at the reporting date, thus reducing the leverage ratio because the numerator and the denominator of that ratio are reduced by the same amount. The balance sheet and leverage impacts of ordinary repo transactions as well as Repo 105 or 108 transactions are shown in the following sequence of illustrations.13,14,15,16,17 Balance Sheet and Leverage Impacts of Lehman Repo Transactions In order to make the initial sale transaction credible, LB needed a letter from a law firm specifying that it constituted a “true sale.” Interestingly, LB could not obtain such an opinion under U.S. law from U.S. lawyers, but Lehman Brothers International (Europe) (LBIE), based in London, did obtain one from Linklaters, a U.K. firm.18 Consequently, when Repo 105 and Repo 108 transactions were needed, they were done via transfers to and from LBIE in London. Repo 105 transactions were used with highly liquid securities, whereas Repo 108 transactions involved nonliquid or equity securities. To make sure these transactions went according to protocol, LB created an Accounting Policy Manual Repo 105 and 108 to guide their personnel.19 LB employed ordinary repo transactions as well as Repo 105 and Repo 108 transactions. The interest charges or fees involved were 2%, 5%, and 8%, respectively. The higher interest rate charges on the Repo 105 and 108 transactions were to compensate for their higher level of risk. But, because ordinary repo transactions could have been used to raise cash20 at a cost of 2%, it has been argued that LB used the higher-cost Repo 105 and 108 transactions only because they provided a way to man- age LB’s balance sheet and leverage ratio. This was confirmed by LB employees who commented as follows: “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.”21 Other former Lehman employees characterized Repo 105 transactions as an “accounting gimmick” and a “lazy way of managing the balance sheet.”22 When queried about meeting internal leverage targets for the second quarter, an employee responded by email saying: “very] close … any- thing that moves is getting 105’d.”23 The reduction in leverage ratios achieved through the use of Repo 105 and 108 trans- actions are shown below:24 According to the Bankruptcy Examiner, E&Y noted that LB’s threshold for deter- mining material items requiring reopening a closed balance sheet for correction was “any item individually, or in the aggregate, that moves net leverage by 0.1 or more (typically $1.8 billion).”25 Consequently, the usage of Repo 105 transactions noted previously resulted in changes that were many times greater than LB’s standard of materiality, which should have been a red-flag indicator to management and the auditors. Ratings agencies, on whose ratings LB’s credibility with lenders depended, were queried as to what they knew of the Repo 105 usage and materiality of the impact involved. According to the Examiner’s Report, Eileen Fahey, an analyst at Fitch, said that she had never heard of repo trans- actions being accounted for as true sales on the basis of a true sale opin- ion letter or repo transactions known as Repo 105 transactions. Fahey stated that a transfer of $40 billion or $50 billion of securities inventory— regardless of the liquidity of that inventory—from Lehman’s balance sheet at quarter-end would be “material” in Fitch’s view, and upon having a standard Repo 105 transaction described, Fahey remarked that such a transaction “sounded like fraud.”26 Fahey likened this “manipulation” to an investment bank telling regulators that it did not own any mortgage-backed securities when, in fact, it owned them but had temporarily transferred them to a counter- party and was obligated to repurchase them shortly thereafter.27 (This was similar to the usage Enron made with its special purpose entities.) The timing of the use of Repo 105 trans- actions corroborates that the intention was to manipulate LB’s end-of-quarter balance sheets, as is shown in the following graph.28 At the end of each quarter, LB’s assets are significantly higher than at the end of the two previous months. Thus, as a result of these transactions, LB’s end-of-quarter balance sheet shows significantly less assets than would have been reported at any other time during the quarter. LB’s Accounting Analysis LB’s Repo 105 transactions were under- taken under paragraph 9 of the FASB’s Statement of Financial Accounting Standards (SFAS) 140, which reads as follows: Accounting for Transfers and Servicing of Financial Assets A transfer of financial assets (or all or a portion of a financial asset) in which the transferor surrenders control over those financial assets shall be accounted for as a sale to the extent that consideration other than beneficial interests in the transferred assets is received in exchange. The transferor has surrendered control over transferred assets if and only if all of the following conditions are met: a. The transferred assets have been isolated from the transferor—put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership (paragraphs 27 and 28). b. Each transferee (or, if the transferee is a qualifying special purpose entity (para- graph 35), each holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both constrains the transferee (or holder) from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor (paragraphs 29–34). c. The transferor does not maintain effective control over the transferred assets through either (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity (paragraphs 47–49) or (2) the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call (paragraphs 50–54).29 SFAS 140 comments further in paragraph 218 that control over the assets transferred is maintained (thus breaking condition b above) if repurchase arrangements cover as much as 98% collateralization or as little as 102% overcollateralization. LB interpreted this to mean that because the “haircut” or fee charged in Repo 105 transactions was 5% and therefore greater than the 2% col- lateralization limit, control could be considered to have been surrendered, thus allowing the transfer to be considered a sale. Essentially, based on the percentages, LB took the position that they did not have the funds available to fund substantially all of the repurchase cost.30 To further bolster the position that the transfer of assets was a sale, LB obtained a letter from a U.K. law firm, Linklaters of London, that the transaction was a “true sale.”31 Such an opinion was possible under U.K. law but not under U.S. law, but the opinion was addressed to LBIE, thus necessitating transfers to LBIE so that the trans- actions would qualify as sales under U.K. law. LB, however, did not observe this need for transfer entirely.32 According to the Examiner, LB had this treatment as a sale vetted by outside auditors (E&Y) and lawyers.33 However, on May 16, 2008, Matthew Lee, former LB senior vice president, Finance Division, who was in charge of Global Balance Sheet and Legal Entity Accounting, sent a whistleblower letter to senior LB management expressing concerns about possible LB Ethics Code violations34 about the balance sheet irregularities related to the $50 billion in Repo 105 transactions then under way. According to the examiner, Lee’s letter contained the following six allegations: (1) on the last day of each month, Lehman’s books and records contained approximately $5 billion of net assets in excess of what was managed on the last day of the month, thereby suggesting that the firm’s senior management was not in control of its assets to be able to present full, fair, and accurate financial statements to the public; (2) Lehman had “tens of billions of dollars of unsubstantiated balances, which may or may not be ‘bad’ or non-performing assets or real liabilities”; (3) Lehman had tens of billions of dollars of illiquid inventory and did not value its inventory in a “fully realistic or reasonable” way; (4) given Lehman’s rapid growth and increased number of accounts and entities, it had not invested sufficiently in financial systems and personnel to cope with the balance sheet; (5) the India Finance office lacked sufficient knowledgeable management, resulting in the real possibility of potential misstatements of material facts being distributed by that office; and (6) certain senior level audit personnel were not qualified to “properly exercise the audit functions they are entrusted to manage.”35 Lee was interviewed by E&Y representatives about his concerns on June 12, 2008.36 E&Y’s Reaction E&Y faced questions from the business press and their clients as soon as the Examiner’s Report was made public. In response, a letter was quickly issued to clients, which apparently found its way into the public domain by being published on the Web. That letter was originally published with- out the opening and closing paragraphs by Francine McKenna37 on March 20, 2010, at http://www.retheauditors.com. E&Y’s let- ter, which is shown below,38 was published in its entirety on March 23, 2010, on the Contrarian Pundit website at http://www.contrarianpundit.com. ERNST & YOUNG 23 March 2010 To: Recently, there have been extensive media reports about the release of the Bankruptcy Examiner’s Report relating to the September 2008 bankruptcy of Lehman Brothers. As you may have read, Ernst & Young was Lehman Brothers’ independent auditors. The concept of an examiner’s report is a feature of US bankruptcy law. It does not represent the views of a court or a regulatory body, nor is the Report the result of a legal process. Instead, an examiner’s report is intended to identify potential claims that, if pursued, may result in a recovery for the bankrupt company or its creditors. EY is confident we will prevail should any of the potential claims identified against us be pursued. We wanted to provide you with EY’s perspective on some of the potential claims in the Examiner’s Report. We also wanted to address certain media coverage and commentary on the Examiner’s Report that has at times been inaccurate, if not misleading. A few key points are set out below. General Comments ■ EY’s last audit was for the year ended November 30, 2007. Our opinion stated that Lehman’s financial statements for 2007 were fairly presented in accordance with US GAAP, and we remain of that view. We reviewed but did not audit the interim periods for Lehman’s first and second quarters of fiscal 2008. ■ Lehman’s bankruptcy was the result of a series of unprecedented adverse events in the financial markets. The months leading up to Lehman’s bankruptcy were among the most turbulent periods in our economic history. Lehman’s bankruptcy was caused by a collapse in its liquidity, which was in turn caused by declining asset values and loss of market confidence in Lehman. It was not caused by accounting issues or disclosure issues. ■ The Examiner identified no potential claims that the assets and liabilities reported on Lehman’s financial statements (approximately $691 billion and $669 billion, respectively, at November 30, 2007) were improperly valued or accounted for incorrectly. Accounting and Disclosure Issues Relating to Repo 105 Transactions ■ There has been significant media attention about potential claims identified by the Examiner related to what Lehman referred to as “Repo 105” transactions. What has not been reported in the media is that the Examiner did not challenge Lehman’s accounting for its Repo 105 transactions. ■ As recognized by the Examiner, all investment banks used repo transactions extensively to fund their operations on a daily basis; these banks all operated in a high-risk, high-leverage business model. Most repo transactions are accounted for as financings; some (the Repo 105 transactions) are accounted for as sales if they meet the requirements of SFAS 140. ■ The Repo 105 transactions involved the sale by Lehman of high quality liquid assets (generally government-backed securities), in return for which Lehman received cash. The media reports that these were “sham transactions” designed to off-load Lehman’s “bad assets” are inaccurate. ■ Because effective control of the securities was surrendered to the counterparty in the Repo 105 arrangements, the accounting literature (SFAS 140) required Lehman to account for Repo 105 transactions as sales rather than financings. ■ The potential claims against EY arise solely from the Examiner’s conclusion that these transactions ($38.6 billion at November 30, 2007) should have been specifically disclosed in the footnotes to Lehman’s financial statements, and that Lehman should have disclosed in its MD&A the impact these transactions would have had on its leverage ratios if they had been recorded as financing transactions. ■ While no specific disclosures around Repo 105 transactions were reflected in Lehman’s financial statement footnotes, the 2007 audited financial statements were presented in accordance with US GAAP, and clearly portrayed Lehman as a leveraged entity operating in a risky and volatile industry. Lehman’s 2007 audited financial statements included footnote disclosure of off balance sheet commitments of almost $1 trillion. ■ Lehman’s leverage ratios are not a GAAP financial measure; they were included in Lehman’s MD&A, not its audited financial statements. Lehman concluded no further MD&A disclosures were required; EY did not take exception to that judgment. ■ If the Repo 105 transactions were treated as if they were on the balance sheet for leverage ratio purposes, as the Examiner suggests, Lehman’s reported gross leverage would have been 32.4 instead of 30.7 at November 30, 2007. Also, contrary to media reports, the decline in Lehman’s reported leverage from its first to second quarters of 2008 was not a result of an increased use of Repo 105 transactions. Lehman’s Repo 105 transaction volumes were comparable at the end of its first and second quarters. Handling of the Whistleblower’s Issues ■ The media has inaccurately reported that EY concealed a May 2008 whistleblower letter from Lehman’s Audit Committee. The whistleblower letter, which raised various significant potential concerns about Lehman’s financial controls and reporting but did not mention Repo 105, was directed to Lehman’s management. When we learned of the letter, our lead partner promptly called the Audit Committee Chair; we also insisted that Lehman’s management inform the Securities & Exchange Commission and the Federal Reserve Bank of the letter. EY’s lead partner discussed the whistleblower letter with the Lehman Audit Committee on at least three occasions during June and July 2008. ■ In the investigations that ensued, the writer of the letter did briefly reference Repo 105 transactions in an interview with EY partners. He also confirmed to EY that he was unaware of any material financial reporting errors. Lehman’s senior executives did not advise us of any reservations they had about the company’s Repo 105 transactions. ■ Lehman’s September 2008 bankruptcy prevented EY from completing its assessment of the whistleblower’s allegations. The allegations would have been the subject of significant attention had EY completed its third quarter review and 2008 year-end audit. Should any of the potential claims be pursued, we are confident we will prevail. Thank you for your support in this matter. Please feel free to call me at anytime at With best regards, Lehman’s Risk Management LB was a major player in a field that involved many varieties of risk and had specifically identified that their risk appetite for Repo 105 transactions in July 2006 was “1x leverage … or $17 billion, [and] $5 billion for Repo 108 transactions.”39 Consequently, LB’s internal cap on repo transactions was breached by significant amounts beginning in 2007.40 Recognizing that the levels of $40 billion to 50 billion were unsustainable, LB made efforts to obtain outside financing to be used to cut the level of repo transactions in 2008. Unfortunately, that effort was too little, too late. On September 15, 2008, LB declared bankruptcy. Questions 1. What was the most important reason for the LB failure? 2. What is leverage and why is it so important? 3. Prepare the journal entries for a Repo 105 transaction sequence for $1 million in securities. 4. In your opinion, how large should a Repo 105 transaction be to be considered material and why? 5. Was LB’s interpretation of SFAS 140— Repo 105 transactions could be treated as sales—correct? Provide your reasons. 6. If, as the Examiner’s Report states,41 LB continued to collect the revenue from the securities involved in the Repo 105 transactions, how could LB say that they had given up ownership? 7. An emerging issue Interpretation Bulletin42 accompanying FAS 140 gives examples indicating that Repo 102 transactions would not qualify as sales but that Repo 110 would. Why do you think this Bulletin was issued? See Q&A 140—A Guide to Implementation of Statement 140 on Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities at http://www.fasb.org/cs /ContentServer?c=Document_C& pagename=FASB%2FDocument_C% 2FDocumentPage&cid=1175801856780 (accessed March 27, 2011). 8. Knowing that LB could not obtain a “true sale” opinion from a U.S. lawyer under U.S. law, should LB have tried to obtain the opinion from a U.K. law firm? Why and why not? 9. Do the Repo 105 arrangements constitute fraud? Why and why not? 10. What is the auditor’s responsibility if a fraud is suspected or discovered? What professional standards are most import- ant in such cases and why? 11. If you were the audit partner in charge in the United States, what would you have required be done in regard to the Linklater “true sale” letter? 12. Should consolidated financial statements of a U.S. parent company include (i.e., consolidate) foreign subsidiary accounts prepared on a basis not considered appropriate U.S. GAAP? 13. Would the adoption of IFRS have pre- vented the Repo 105 misrepresentations? 14. What should the following have done on learning of Matthew Lee’s whistleblower’s letter—LB’s management, Board of Directors, and the external auditors, E&Y? 15. Arthur Andersen tried to keep its Enron audit problems quiet, whereas E&Y spoke out in its own defense. Was it a good idea for E&Y to send a letter, such as the one reproduced previously, to their clients? Why and why not? 16. Based on the letter, should E&Y be in the clear of any wrongdoing related to the Repo 105 and 108 transactions and reporting? Provide your reasons for and against. 17. If an auditor explains a problem to the chair of an audit committee, is there any further obligation on the part of the auditor to ensure that the full board has been notified and why? 18. Organizations who use the Enterprise Risk Management (ERM) framework43 should work through the following stages: review on the internal environment, identification of the organization’s risk appetite or objectives, risk identification and measurement, risk assessment, risk response, providing risk information and communications, and risk monitoring. In which of these did LB fail? Who was to blame for the failure? 19. How should the U.S. Bankruptcy Examiner’s Report be regarded—as a neutral set of findings or as a signpost intended to point creditors in the direction of potential recoveries? What are the implications of each? 20. After the Enron and WorldCom fiascos, regulators sought to avoid future misrepresentation by enacting the Sarbanes-Oxley Act (SOX) in 2002. Why did SOX not prevent Lehman’s use of Repo 105 and 108 misrepresentations? Does that mean that SOX is a failure?

On September 15, 2008, Lehman Brothers Holdings Inc., one of the world’s most respected and profitable investment banks, filed for Chapter 11 bankruptcy protection in the United States Bankruptcy Court in the Southern District of New York.1 Although Lehman Brothers (LB) had reported record revenues of almost $60 billion and record earnings in excess of $4 billion for the fiscal year ended November 30, 2007, only ten months later, their bankruptcy proceeding became the largest ever filed.2 How and why this happened is a complex story, part of which involves financial statement manipulation using a technique that has come to be known as Lehman’s Repo 105 to modify information provided to investors and regulators about the extent to which LB was using other investors’ funds to leverage their own. Banks generate revenue and profit principally by investing funds borrowed from other investors, such as depositors or lenders. Although some of the funds they invest are their own, banks can increase their activity by attracting and using other investors’ funds—an approach that is known as “leverage” because it is using the bank’s own capital to attract investments from others to increase or lever revenue- and profit- generation investments beyond the capacity of the bank’s own limited resources. A bank’s profit from lending activities is generated by “the spread”—the higher rate of return at which a bank lends funds than it pays outside depositors and investors for the use of their funds. However, outside investors or depositors will invest with a bank only if they are convinced that the bank’s own capital is sufficient to provide an adequate cushion against loss of their investment in the event that the bank suf- fers losses. Consequently, outside investors want accurate information on the extent of leverage employed by the bank, which is usually provided as a ratio as follows: Leverage Ratio 5 Total Assets Shareholders’ Equity (the bank’s own capital) In its simplest form, the Repo 105 mechanism—a multiple-step technique3 combined with the failure to disclosure promises to reacquire assets—was used by LB to reduce the reported total assets and net assets included in the leverage ratio, thus showing a lower ratio or more conservative use of leverage than was actually the case. Consequently, bank investors were misled about LB’s ability to cushion losses with its own equity compared to banks that did not artificially depress their leverage ratios. Each of the steps in the Repo 105 technique represented a transaction under- taken near the end of a reporting period designed to reduce the leverage ratio, but the impact of this was essentially reversed just after the beginning of the next reporting period. This reduction and reversal pro- cess was repeated each quarterly reporting period from 2001 to 2008. Because most of these periods (those up to November 30, 2007) were subject to audit by Ernst & Young (E&Y), questions have been raised about what E&Y knew and thought about the Repo 105 technique and its impact and what they should have done and did do during their audit process. In addition, the role and responsibility of LB’s management and the Board of Directors has come into question. Why Did Lehman Brothers Fail? According to the Bankruptcy Examiner’s Report4 by Anton Valukas, LB failed for several reasons, including the following: • The poor economic climate caused by the subprime lending crisis leading to a degeneration of confidence and there- fore a disenchantment and devaluation of asset-backed commercial paper and other financial instruments in which LB and others had invested. • A very highly leveraged position prior to the onset of the subprime lending crisis—LB “maintained approximately $700 billion of assets … on capital of approximately $25 billion,”5 a ratio of 28:1. • Decisions involving excessive risk taking by LB executives. For example, as the subprime lending crisis unfolded, LB management decided to invest more or “double down”6 in depressed assets hoping for a quick gain when values rebounded. LB’s aggressive decisions resulted in it exceeding its own risk limits and controls.7 • A mismatch between longer-term assets and the shorter-term liabilities used to finance them, thus making LB vulnerable to shifts in the preferences of creditors or the cost of the credit needed to finance the assets. Because the assets were of a longer-term nature, they were not maturing in time to pay off creditors who were making reinvestment decisions on a much shorter time scale. LB had to have creditors who had sufficient confidence in LB to be willing to invest daily so that LB could be sustained. • A masking of the extent to which LB was leveraged through the use of repurchase transactions—otherwise known as repo transactions—including ordinary repo transactions, Repo 105 transactions, and Repo 108 transactions. (Repo transactions are explained more fully in the next section.) This masking prevented creditors and investors from understanding how leveraged LB was, thus permitting LB to expand. • In March 2008, Bear Stearns, a rival investment house, began to falter and nearly collapsed, putting the spotlight on LB, which was considered the next most vulnerable. • Investor confidence was further eroded when Lehman announced its first-ever loss of $2.8 billion for its second quarter of 2008. At this time, the SEC and the Federal Reserve Bank of New York sent personnel to take up residence on-site to monitor LB’s liquidity. • In fact, LB had masked approximately $50 billion in leverage in the first and second quarters of 2008, so their condition was worse than disclosed. Although LB raised $6 billion of new capital on June 12, 2008, “[U.S.] Treasury Secretary Henry M. Paulson, Jr., privately told [LB CEO] Fuld that if Lehman was forced to report further losses in the third quarter without having a buyer or a definitive survival plan in place, Lehman’s existence would be in jeopardy. On September 10, 2008 Lehman announced that it was projecting a $3.9 billion loss for the third quarter of 2008.”8 • On September 15, 2008, LB’s bankruptcy filing proved Paulson to be correct. The Repo 105 Mechanism and Impact There are three kinds of repo transactions: (1) ordinary, (2) Repo 105, and (3) Repo 108. All three are illustrated along with their impact on the balance sheet and leverage ratio in volume 3 of the Examiner’s Report.9 Most investment banks used ordinary repo transactions to borrow funds using securities as collateral, which they shortly repaid for a 2% fee (interest charge), or “haircut” as it became known. Because the cash received as well as the assets used as collateral and the liability for repurchase are all shown on the balance sheet, it and the leverage ratios are accurately stated.10 Schematically, an ordinary repo transaction sequence can be represented as follows:11 A Repo 105 transaction sequence is different in that prior to the reporting date, (1) the initial transaction is treated as a sale, not a borrowing; (2) the cash received is used to pay off liabilities; and then, after the reporting date; (3) LB borrows funds elsewhere to repurchase the securities sold including a 5% interest charge.12 The overall impact is to reduce the assets and the liabilities on the balance sheet at the reporting date, thus reducing the leverage ratio because the numerator and the denominator of that ratio are reduced by the same amount. The balance sheet and leverage impacts of ordinary repo transactions as well as Repo 105 or 108 transactions are shown in the following sequence of illustrations.13,14,15,16,17 Balance Sheet and Leverage Impacts of Lehman Repo Transactions In order to make the initial sale transaction credible, LB needed a letter from a law firm specifying that it constituted a “true sale.” Interestingly, LB could not obtain such an opinion under U.S. law from U.S. lawyers, but Lehman Brothers International (Europe) (LBIE), based in London, did obtain one from Linklaters, a U.K. firm.18 Consequently, when Repo 105 and Repo 108 transactions were needed, they were done via transfers to and from LBIE in London. Repo 105 transactions were used with highly liquid securities, whereas Repo 108 transactions involved nonliquid or equity securities. To make sure these transactions went according to protocol, LB created an Accounting Policy Manual Repo 105 and 108 to guide their personnel.19 LB employed ordinary repo transactions as well as Repo 105 and Repo 108 transactions. The interest charges or fees involved were 2%, 5%, and 8%, respectively. The higher interest rate charges on the Repo 105 and 108 transactions were to compensate for their higher level of risk. But, because ordinary repo transactions could have been used to raise cash20 at a cost of 2%, it has been argued that LB used the higher-cost Repo 105 and 108 transactions only because they provided a way to man- age LB’s balance sheet and leverage ratio. This was confirmed by LB employees who commented as follows: “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.”21 Other former Lehman employees characterized Repo 105 transactions as an “accounting gimmick” and a “lazy way of managing the balance sheet.”22 When queried about meeting internal leverage targets for the second quarter, an employee responded by email saying: “very] close … any- thing that moves is getting 105’d.”23 The reduction in leverage ratios achieved through the use of Repo 105 and 108 trans- actions are shown below:24 According to the Bankruptcy Examiner, E&Y noted that LB’s threshold for deter- mining material items requiring reopening a closed balance sheet for correction was “any item individually, or in the aggregate, that moves net leverage by 0.1 or more (typically $1.8 billion).”25 Consequently, the usage of Repo 105 transactions noted previously resulted in changes that were many times greater than LB’s standard of materiality, which should have been a red-flag indicator to management and the auditors. Ratings agencies, on whose ratings LB’s credibility with lenders depended, were queried as to what they knew of the Repo 105 usage and materiality of the impact involved. According to the Examiner’s Report, Eileen Fahey, an analyst at Fitch, said that she had never heard of repo trans- actions being accounted for as true sales on the basis of a true sale opin- ion letter or repo transactions known as Repo 105 transactions. Fahey stated that a transfer of $40 billion or $50 billion of securities inventory— regardless of the liquidity of that inventory—from Lehman’s balance sheet at quarter-end would be “material” in Fitch’s view, and upon having a standard Repo 105 transaction described, Fahey remarked that such a transaction “sounded like fraud.”26 Fahey likened this “manipulation” to an investment bank telling regulators that it did not own any mortgage-backed securities when, in fact, it owned them but had temporarily transferred them to a counter- party and was obligated to repurchase them shortly thereafter.27 (This was similar to the usage Enron made with its special purpose entities.) The timing of the use of Repo 105 trans- actions corroborates that the intention was to manipulate LB’s end-of-quarter balance sheets, as is shown in the following graph.28 At the end of each quarter, LB’s assets are significantly higher than at the end of the two previous months. Thus, as a result of these transactions, LB’s end-of-quarter balance sheet shows significantly less assets than would have been reported at any other time during the quarter. LB’s Accounting Analysis LB’s Repo 105 transactions were under- taken under paragraph 9 of the FASB’s Statement of Financial Accounting Standards (SFAS) 140, which reads as follows: Accounting for Transfers and Servicing of Financial Assets A transfer of financial assets (or all or a portion of a financial asset) in which the transferor surrenders control over those financial assets shall be accounted for as a sale to the extent that consideration other than beneficial interests in the transferred assets is received in exchange. The transferor has surrendered control over transferred assets if and only if all of the following conditions are met: a. The transferred assets have been isolated from the transferor—put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership (paragraphs 27 and 28). b. Each transferee (or, if the transferee is a qualifying special purpose entity (para- graph 35), each holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both constrains the transferee (or holder) from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor (paragraphs 29–34). c. The transferor does not maintain effective control over the transferred assets through either (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity (paragraphs 47–49) or (2) the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call (paragraphs 50–54).29 SFAS 140 comments further in paragraph 218 that control over the assets transferred is maintained (thus breaking condition b above) if repurchase arrangements cover as much as 98% collateralization or as little as 102% overcollateralization. LB interpreted this to mean that because the “haircut” or fee charged in Repo 105 transactions was 5% and therefore greater than the 2% col- lateralization limit, control could be considered to have been surrendered, thus allowing the transfer to be considered a sale. Essentially, based on the percentages, LB took the position that they did not have the funds available to fund substantially all of the repurchase cost.30 To further bolster the position that the transfer of assets was a sale, LB obtained a letter from a U.K. law firm, Linklaters of London, that the transaction was a “true sale.”31 Such an opinion was possible under U.K. law but not under U.S. law, but the opinion was addressed to LBIE, thus necessitating transfers to LBIE so that the trans- actions would qualify as sales under U.K. law. LB, however, did not observe this need for transfer entirely.32 According to the Examiner, LB had this treatment as a sale vetted by outside auditors (E&Y) and lawyers.33 However, on May 16, 2008, Matthew Lee, former LB senior vice president, Finance Division, who was in charge of Global Balance Sheet and Legal Entity Accounting, sent a whistleblower letter to senior LB management expressing concerns about possible LB Ethics Code violations34 about the balance sheet irregularities related to the $50 billion in Repo 105 transactions then under way. According to the examiner, Lee’s letter contained the following six allegations: (1) on the last day of each month, Lehman’s books and records contained approximately $5 billion of net assets in excess of what was managed on the last day of the month, thereby suggesting that the firm’s senior management was not in control of its assets to be able to present full, fair, and accurate financial statements to the public; (2) Lehman had “tens of billions of dollars of unsubstantiated balances, which may or may not be ‘bad’ or non-performing assets or real liabilities”; (3) Lehman had tens of billions of dollars of illiquid inventory and did not value its inventory in a “fully realistic or reasonable” way; (4) given Lehman’s rapid growth and increased number of accounts and entities, it had not invested sufficiently in financial systems and personnel to cope with the balance sheet; (5) the India Finance office lacked sufficient knowledgeable management, resulting in the real possibility of potential misstatements of material facts being distributed by that office; and (6) certain senior level audit personnel were not qualified to “properly exercise the audit functions they are entrusted to manage.”35 Lee was interviewed by E&Y representatives about his concerns on June 12, 2008.36 E&Y’s Reaction E&Y faced questions from the business press and their clients as soon as the Examiner’s Report was made public. In response, a letter was quickly issued to clients, which apparently found its way into the public domain by being published on the Web. That letter was originally published with- out the opening and closing paragraphs by Francine McKenna37 on March 20, 2010, at http://www.retheauditors.com. E&Y’s let- ter, which is shown below,38 was published in its entirety on March 23, 2010, on the Contrarian Pundit website at http://www.contrarianpundit.com. ERNST & YOUNG 23 March 2010 To: Recently, there have been extensive media reports about the release of the Bankruptcy Examiner’s Report relating to the September 2008 bankruptcy of Lehman Brothers. As you may have read, Ernst & Young was Lehman Brothers’ independent auditors. The concept of an examiner’s report is a feature of US bankruptcy law. It does not represent the views of a court or a regulatory body, nor is the Report the result of a legal process. Instead, an examiner’s report is intended to identify potential claims that, if pursued, may result in a recovery for the bankrupt company or its creditors. EY is confident we will prevail should any of the potential claims identified against us be pursued. We wanted to provide you with EY’s perspective on some of the potential claims in the Examiner’s Report. We also wanted to address certain media coverage and commentary on the Examiner’s Report that has at times been inaccurate, if not misleading. A few key points are set out below. General Comments ■ EY’s last audit was for the year ended November 30, 2007. Our opinion stated that Lehman’s financial statements for 2007 were fairly presented in accordance with US GAAP, and we remain of that view. We reviewed but did not audit the interim periods for Lehman’s first and second quarters of fiscal 2008. ■ Lehman’s bankruptcy was the result of a series of unprecedented adverse events in the financial markets. The months leading up to Lehman’s bankruptcy were among the most turbulent periods in our economic history. Lehman’s bankruptcy was caused by a collapse in its liquidity, which was in turn caused by declining asset values and loss of market confidence in Lehman. It was not caused by accounting issues or disclosure issues. ■ The Examiner identified no potential claims that the assets and liabilities reported on Lehman’s financial statements (approximately $691 billion and $669 billion, respectively, at November 30, 2007) were improperly valued or accounted for incorrectly. Accounting and Disclosure Issues Relating to Repo 105 Transactions ■ There has been significant media attention about potential claims identified by the Examiner related to what Lehman referred to as “Repo 105” transactions. What has not been reported in the media is that the Examiner did not challenge Lehman’s accounting for its Repo 105 transactions. ■ As recognized by the Examiner, all investment banks used repo transactions extensively to fund their operations on a daily basis; these banks all operated in a high-risk, high-leverage business model. Most repo transactions are accounted for as financings; some (the Repo 105 transactions) are accounted for as sales if they meet the requirements of SFAS 140. ■ The Repo 105 transactions involved the sale by Lehman of high quality liquid assets (generally government-backed securities), in return for which Lehman received cash. The media reports that these were “sham transactions” designed to off-load Lehman’s “bad assets” are inaccurate. ■ Because effective control of the securities was surrendered to the counterparty in the Repo 105 arrangements, the accounting literature (SFAS 140) required Lehman to account for Repo 105 transactions as sales rather than financings. ■ The potential claims against EY arise solely from the Examiner’s conclusion that these transactions ($38.6 billion at November 30, 2007) should have been specifically disclosed in the footnotes to Lehman’s financial statements, and that Lehman should have disclosed in its MD&A the impact these transactions would have had on its leverage ratios if they had been recorded as financing transactions. ■ While no specific disclosures around Repo 105 transactions were reflected in Lehman’s financial statement footnotes, the 2007 audited financial statements were presented in accordance with US GAAP, and clearly portrayed Lehman as a leveraged entity operating in a risky and volatile industry. Lehman’s 2007 audited financial statements included footnote disclosure of off balance sheet commitments of almost $1 trillion. ■ Lehman’s leverage ratios are not a GAAP financial measure; they were included in Lehman’s MD&A, not its audited financial statements. Lehman concluded no further MD&A disclosures were required; EY did not take exception to that judgment. ■ If the Repo 105 transactions were treated as if they were on the balance sheet for leverage ratio purposes, as the Examiner suggests, Lehman’s reported gross leverage would have been 32.4 instead of 30.7 at November 30, 2007. Also, contrary to media reports, the decline in Lehman’s reported leverage from its first to second quarters of 2008 was not a result of an increased use of Repo 105 transactions. Lehman’s Repo 105 transaction volumes were comparable at the end of its first and second quarters. Handling of the Whistleblower’s Issues ■ The media has inaccurately reported that EY concealed a May 2008 whistleblower letter from Lehman’s Audit Committee. The whistleblower letter, which raised various significant potential concerns about Lehman’s financial controls and reporting but did not mention Repo 105, was directed to Lehman’s management. When we learned of the letter, our lead partner promptly called the Audit Committee Chair; we also insisted that Lehman’s management inform the Securities & Exchange Commission and the Federal Reserve Bank of the letter. EY’s lead partner discussed the whistleblower letter with the Lehman Audit Committee on at least three occasions during June and July 2008. ■ In the investigations that ensued, the writer of the letter did briefly reference Repo 105 transactions in an interview with EY partners. He also confirmed to EY that he was unaware of any material financial reporting errors. Lehman’s senior executives did not advise us of any reservations they had about the company’s Repo 105 transactions. ■ Lehman’s September 2008 bankruptcy prevented EY from completing its assessment of the whistleblower’s allegations. The allegations would have been the subject of significant attention had EY completed its third quarter review and 2008 year-end audit. Should any of the potential claims be pursued, we are confident we will prevail. Thank you for your support in this matter. Please feel free to call me at anytime at With best regards, Lehman’s Risk Management LB was a major player in a field that involved many varieties of risk and had specifically identified that their risk appetite for Repo 105 transactions in July 2006 was “1x leverage … or $17 billion, [and] $5 billion for Repo 108 transactions.”39 Consequently, LB’s internal cap on repo transactions was breached by significant amounts beginning in 2007.40 Recognizing that the levels of $40 billion to 50 billion were unsustainable, LB made efforts to obtain outside financing to be used to cut the level of repo transactions in 2008. Unfortunately, that effort was too little, too late. On September 15, 2008, LB declared bankruptcy. Questions 1. What was the most important reason for the LB failure? 2. What is leverage and why is it so important? 3. Prepare the journal entries for a Repo 105 transaction sequence for $1 million in securities. 4. In your opinion, how large should a Repo 105 transaction be to be considered material and why? 5. Was LB’s interpretation of SFAS 140— Repo 105 transactions could be treated as sales—correct? Provide your reasons. 6. If, as the Examiner’s Report states,41 LB continued to collect the revenue from the securities involved in the Repo 105 transactions, how could LB say that they had given up ownership? 7. An emerging issue Interpretation Bulletin42 accompanying FAS 140 gives examples indicating that Repo 102 transactions would not qualify as sales but that Repo 110 would. Why do you think this Bulletin was issued? See Q&A 140—A Guide to Implementation of Statement 140 on Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities at http://www.fasb.org/cs /ContentServer?c=Document_C& pagename=FASB%2FDocument_C% 2FDocumentPage&cid=1175801856780 (accessed March 27, 2011). 8. Knowing that LB could not obtain a “true sale” opinion from a U.S. lawyer under U.S. law, should LB have tried to obtain the opinion from a U.K. law firm? Why and why not? 9. Do the Repo 105 arrangements constitute fraud? Why and why not? 10. What is the auditor’s responsibility if a fraud is suspected or discovered? What professional standards are most import- ant in such cases and why? 11. If you were the audit partner in charge in the United States, what would you have required be done in regard to the Linklater “true sale” letter? 12. Should consolidated financial statements of a U.S. parent company include (i.e., consolidate) foreign subsidiary accounts prepared on a basis not considered appropriate U.S. GAAP? 13. Would the adoption of IFRS have pre- vented the Repo 105 misrepresentations? 14. What should the following have done on learning of Matthew Lee’s whistleblower’s letter—LB’s management, Board of Directors, and the external auditors, E&Y? 15. Arthur Andersen tried to keep its Enron audit problems quiet, whereas E&Y spoke out in its own defense. Was it a good idea for E&Y to send a letter, such as the one reproduced previously, to their clients? Why and why not? 16. Based on the letter, should E&Y be in the clear of any wrongdoing related to the Repo 105 and 108 transactions and reporting? Provide your reasons for and against. 17. If an auditor explains a problem to the chair of an audit committee, is there any further obligation on the part of the auditor to ensure that the full board has been notified and why? 18. Organizations who use the Enterprise Risk Management (ERM) framework43 should work through the following stages: review on the internal environment, identification of the organization’s risk appetite or objectives, risk identification and measurement, risk assessment, risk response, providing risk information and communications, and risk monitoring. In which of these did LB fail? Who was to blame for the failure? 19. How should the U.S. Bankruptcy Examiner’s Report be regarded—as a neutral set of findings or as a signpost intended to point creditors in the direction of potential recoveries? What are the implications of each? 20. After the Enron and WorldCom fiascos, regulators sought to avoid future misrepresentation by enacting the Sarbanes-Oxley Act (SOX) in 2002. Why did SOX not prevent Lehman’s use of Repo 105 and 108 misrepresentations? Does that mean that SOX is a failure?

On September 15, 2008, Lehman Brothers Holdings Inc., one of the world’s most respected and profitable investment banks, filed for Chapter 11 bankruptcy protection in the United States Bankruptcy Court in the Southern District of New York.1 Although Lehman Brothers (LB) had reported record revenues of almost $60 billion and record earnings in excess of $4 billion for the fiscal year ended November 30, 2007, only ten months later, their bankruptcy proceeding became the largest ever filed.2 How and why this happened is a complex story, part of which involves financial statement manipulation using a technique that has come to be known as Lehman’s Repo 105 to modify information provided to investors and regulators about the extent to which LB was using other investors’ funds to leverage their own. Banks generate revenue and profit principally by investing funds borrowed from other investors, such as depositors or lenders. Although some of the funds they invest are their own, banks can increase their activity by attracting and using other investors’ funds—an approach that is known as “leverage” because it is using the bank’s own capital to attract investments from others to increase or lever revenue- and profit- generation investments beyond the capacity of the bank’s own limited resources. A bank’s profit from lending activities is generated by “the spread”—the higher rate of return at which a bank lends funds than it pays outside depositors and investors for the use of their funds. However, outside investors or depositors will invest with a bank only if they are convinced that the bank’s own capital is sufficient to provide an adequate cushion against loss of their investment in the event that the bank suf- fers losses. Consequently, outside investors want accurate information on the extent of leverage employed by the bank, which is usually provided as a ratio as follows: Leverage Ratio 5 Total Assets Shareholders’ Equity (the bank’s own capital) In its simplest form, the Repo 105 mechanism—a multiple-step technique3 combined with the failure to disclosure promises to reacquire assets—was used by LB to reduce the reported total assets and net assets included in the leverage ratio, thus showing a lower ratio or more conservative use of leverage than was actually the case. Consequently, bank investors were misled about LB’s ability to cushion losses with its own equity compared to banks that did not artificially depress their leverage ratios. Each of the steps in the Repo 105 technique represented a transaction under- taken near the end of a reporting period designed to reduce the leverage ratio, but the impact of this was essentially reversed just after the beginning of the next reporting period. This reduction and reversal pro- cess was repeated each quarterly reporting period from 2001 to 2008. Because most of these periods (those up to November 30, 2007) were subject to audit by Ernst & Young (E&Y), questions have been raised about what E&Y knew and thought about the Repo 105 technique and its impact and what they should have done and did do during their audit process. In addition, the role and responsibility of LB’s management and the Board of Directors has come into question. Why Did Lehman Brothers Fail? According to the Bankruptcy Examiner’s Report4 by Anton Valukas, LB failed for several reasons, including the following: • The poor economic climate caused by the subprime lending crisis leading to a degeneration of confidence and there- fore a disenchantment and devaluation of asset-backed commercial paper and other financial instruments in which LB and others had invested. • A very highly leveraged position prior to the onset of the subprime lending crisis—LB “maintained approximately $700 billion of assets … on capital of approximately $25 billion,”5 a ratio of 28:1. • Decisions involving excessive risk taking by LB executives. For example, as the subprime lending crisis unfolded, LB management decided to invest more or “double down”6 in depressed assets hoping for a quick gain when values rebounded. LB’s aggressive decisions resulted in it exceeding its own risk limits and controls.7 • A mismatch between longer-term assets and the shorter-term liabilities used to finance them, thus making LB vulnerable to shifts in the preferences of creditors or the cost of the credit needed to finance the assets. Because the assets were of a longer-term nature, they were not maturing in time to pay off creditors who were making reinvestment decisions on a much shorter time scale. LB had to have creditors who had sufficient confidence in LB to be willing to invest daily so that LB could be sustained. • A masking of the extent to which LB was leveraged through the use of repurchase transactions—otherwise known as repo transactions—including ordinary repo transactions, Repo 105 transactions, and Repo 108 transactions. (Repo transactions are explained more fully in the next section.) This masking prevented creditors and investors from understanding how leveraged LB was, thus permitting LB to expand. • In March 2008, Bear Stearns, a rival investment house, began to falter and nearly collapsed, putting the spotlight on LB, which was considered the next most vulnerable. • Investor confidence was further eroded when Lehman announced its first-ever loss of $2.8 billion for its second quarter of 2008. At this time, the SEC and the Federal Reserve Bank of New York sent personnel to take up residence on-site to monitor LB’s liquidity. • In fact, LB had masked approximately $50 billion in leverage in the first and second quarters of 2008, so their condition was worse than disclosed. Although LB raised $6 billion of new capital on June 12, 2008, “[U.S.] Treasury Secretary Henry M. Paulson, Jr., privately told [LB CEO] Fuld that if Lehman was forced to report further losses in the third quarter without having a buyer or a definitive survival plan in place, Lehman’s existence would be in jeopardy. On September 10, 2008 Lehman announced that it was projecting a $3.9 billion loss for the third quarter of 2008.”8 • On September 15, 2008, LB’s bankruptcy filing proved Paulson to be correct. The Repo 105 Mechanism and Impact There are three kinds of repo transactions: (1) ordinary, (2) Repo 105, and (3) Repo 108. All three are illustrated along with their impact on the balance sheet and leverage ratio in volume 3 of the Examiner’s Report.9 Most investment banks used ordinary repo transactions to borrow funds using securities as collateral, which they shortly repaid for a 2% fee (interest charge), or “haircut” as it became known. Because the cash received as well as the assets used as collateral and the liability for repurchase are all shown on the balance sheet, it and the leverage ratios are accurately stated.10 Schematically, an ordinary repo transaction sequence can be represented as follows:11 A Repo 105 transaction sequence is different in that prior to the reporting date, (1) the initial transaction is treated as a sale, not a borrowing; (2) the cash received is used to pay off liabilities; and then, after the reporting date; (3) LB borrows funds elsewhere to repurchase the securities sold including a 5% interest charge.12 The overall impact is to reduce the assets and the liabilities on the balance sheet at the reporting date, thus reducing the leverage ratio because the numerator and the denominator of that ratio are reduced by the same amount. The balance sheet and leverage impacts of ordinary repo transactions as well as Repo 105 or 108 transactions are shown in the following sequence of illustrations.13,14,15,16,17 Balance Sheet and Leverage Impacts of Lehman Repo Transactions In order to make the initial sale transaction credible, LB needed a letter from a law firm specifying that it constituted a “true sale.” Interestingly, LB could not obtain such an opinion under U.S. law from U.S. lawyers, but Lehman Brothers International (Europe) (LBIE), based in London, did obtain one from Linklaters, a U.K. firm.18 Consequently, when Repo 105 and Repo 108 transactions were needed, they were done via transfers to and from LBIE in London. Repo 105 transactions were used with highly liquid securities, whereas Repo 108 transactions involved nonliquid or equity securities. To make sure these transactions went according to protocol, LB created an Accounting Policy Manual Repo 105 and 108 to guide their personnel.19 LB employed ordinary repo transactions as well as Repo 105 and Repo 108 transactions. The interest charges or fees involved were 2%, 5%, and 8%, respectively. The higher interest rate charges on the Repo 105 and 108 transactions were to compensate for their higher level of risk. But, because ordinary repo transactions could have been used to raise cash20 at a cost of 2%, it has been argued that LB used the higher-cost Repo 105 and 108 transactions only because they provided a way to man- age LB’s balance sheet and leverage ratio. This was confirmed by LB employees who commented as follows: “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.”21 Other former Lehman employees characterized Repo 105 transactions as an “accounting gimmick” and a “lazy way of managing the balance sheet.”22 When queried about meeting internal leverage targets for the second quarter, an employee responded by email saying: “very] close … any- thing that moves is getting 105’d.”23 The reduction in leverage ratios achieved through the use of Repo 105 and 108 trans- actions are shown below:24 According to the Bankruptcy Examiner, E&Y noted that LB’s threshold for deter- mining material items requiring reopening a closed balance sheet for correction was “any item individually, or in the aggregate, that moves net leverage by 0.1 or more (typically $1.8 billion).”25 Consequently, the usage of Repo 105 transactions noted previously resulted in changes that were many times greater than LB’s standard of materiality, which should have been a red-flag indicator to management and the auditors. Ratings agencies, on whose ratings LB’s credibility with lenders depended, were queried as to what they knew of the Repo 105 usage and materiality of the impact involved. According to the Examiner’s Report, Eileen Fahey, an analyst at Fitch, said that she had never heard of repo trans- actions being accounted for as true sales on the basis of a true sale opin- ion letter or repo transactions known as Repo 105 transactions. Fahey stated that a transfer of $40 billion or $50 billion of securities inventory— regardless of the liquidity of that inventory—from Lehman’s balance sheet at quarter-end would be “material” in Fitch’s view, and upon having a standard Repo 105 transaction described, Fahey remarked that such a transaction “sounded like fraud.”26 Fahey likened this “manipulation” to an investment bank telling regulators that it did not own any mortgage-backed securities when, in fact, it owned them but had temporarily transferred them to a counter- party and was obligated to repurchase them shortly thereafter.27 (This was similar to the usage Enron made with its special purpose entities.) The timing of the use of Repo 105 trans- actions corroborates that the intention was to manipulate LB’s end-of-quarter balance sheets, as is shown in the following graph.28 At the end of each quarter, LB’s assets are significantly higher than at the end of the two previous months. Thus, as a result of these transactions, LB’s end-of-quarter balance sheet shows significantly less assets than would have been reported at any other time during the quarter. LB’s Accounting Analysis LB’s Repo 105 transactions were under- taken under paragraph 9 of the FASB’s Statement of Financial Accounting Standards (SFAS) 140, which reads as follows: Accounting for Transfers and Servicing of Financial Assets A transfer of financial assets (or all or a portion of a financial asset) in which the transferor surrenders control over those financial assets shall be accounted for as a sale to the extent that consideration other than beneficial interests in the transferred assets is received in exchange. The transferor has surrendered control over transferred assets if and only if all of the following conditions are met: a. The transferred assets have been isolated from the transferor—put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership (paragraphs 27 and 28). b. Each transferee (or, if the transferee is a qualifying special purpose entity (para- graph 35), each holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both constrains the transferee (or holder) from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor (paragraphs 29–34). c. The transferor does not maintain effective control over the transferred assets through either (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity (paragraphs 47–49) or (2) the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call (paragraphs 50–54).29 SFAS 140 comments further in paragraph 218 that control over the assets transferred is maintained (thus breaking condition b above) if repurchase arrangements cover as much as 98% collateralization or as little as 102% overcollateralization. LB interpreted this to mean that because the “haircut” or fee charged in Repo 105 transactions was 5% and therefore greater than the 2% col- lateralization limit, control could be considered to have been surrendered, thus allowing the transfer to be considered a sale. Essentially, based on the percentages, LB took the position that they did not have the funds available to fund substantially all of the repurchase cost.30 To further bolster the position that the transfer of assets was a sale, LB obtained a letter from a U.K. law firm, Linklaters of London, that the transaction was a “true sale.”31 Such an opinion was possible under U.K. law but not under U.S. law, but the opinion was addressed to LBIE, thus necessitating transfers to LBIE so that the trans- actions would qualify as sales under U.K. law. LB, however, did not observe this need for transfer entirely.32 According to the Examiner, LB had this treatment as a sale vetted by outside auditors (E&Y) and lawyers.33 However, on May 16, 2008, Matthew Lee, former LB senior vice president, Finance Division, who was in charge of Global Balance Sheet and Legal Entity Accounting, sent a whistleblower letter to senior LB management expressing concerns about possible LB Ethics Code violations34 about the balance sheet irregularities related to the $50 billion in Repo 105 transactions then under way. According to the examiner, Lee’s letter contained the following six allegations: (1) on the last day of each month, Lehman’s books and records contained approximately $5 billion of net assets in excess of what was managed on the last day of the month, thereby suggesting that the firm’s senior management was not in control of its assets to be able to present full, fair, and accurate financial statements to the public; (2) Lehman had “tens of billions of dollars of unsubstantiated balances, which may or may not be ‘bad’ or non-performing assets or real liabilities”; (3) Lehman had tens of billions of dollars of illiquid inventory and did not value its inventory in a “fully realistic or reasonable” way; (4) given Lehman’s rapid growth and increased number of accounts and entities, it had not invested sufficiently in financial systems and personnel to cope with the balance sheet; (5) the India Finance office lacked sufficient knowledgeable management, resulting in the real possibility of potential misstatements of material facts being distributed by that office; and (6) certain senior level audit personnel were not qualified to “properly exercise the audit functions they are entrusted to manage.”35 Lee was interviewed by E&Y representatives about his concerns on June 12, 2008.36 E&Y’s Reaction E&Y faced questions from the business press and their clients as soon as the Examiner’s Report was made public. In response, a letter was quickly issued to clients, which apparently found its way into the public domain by being published on the Web. That letter was originally published with- out the opening and closing paragraphs by Francine McKenna37 on March 20, 2010, at http://www.retheauditors.com. E&Y’s let- ter, which is shown below,38 was published in its entirety on March 23, 2010, on the Contrarian Pundit website at http://www.contrarianpundit.com. ERNST & YOUNG 23 March 2010 To: Recently, there have been extensive media reports about the release of the Bankruptcy Examiner’s Report relating to the September 2008 bankruptcy of Lehman Brothers. As you may have read, Ernst & Young was Lehman Brothers’ independent auditors. The concept of an examiner’s report is a feature of US bankruptcy law. It does not represent the views of a court or a regulatory body, nor is the Report the result of a legal process. Instead, an examiner’s report is intended to identify potential claims that, if pursued, may result in a recovery for the bankrupt company or its creditors. EY is confident we will prevail should any of the potential claims identified against us be pursued. We wanted to provide you with EY’s perspective on some of the potential claims in the Examiner’s Report. We also wanted to address certain media coverage and commentary on the Examiner’s Report that has at times been inaccurate, if not misleading. A few key points are set out below. General Comments ■ EY’s last audit was for the year ended November 30, 2007. Our opinion stated that Lehman’s financial statements for 2007 were fairly presented in accordance with US GAAP, and we remain of that view. We reviewed but did not audit the interim periods for Lehman’s first and second quarters of fiscal 2008. ■ Lehman’s bankruptcy was the result of a series of unprecedented adverse events in the financial markets. The months leading up to Lehman’s bankruptcy were among the most turbulent periods in our economic history. Lehman’s bankruptcy was caused by a collapse in its liquidity, which was in turn caused by declining asset values and loss of market confidence in Lehman. It was not caused by accounting issues or disclosure issues. ■ The Examiner identified no potential claims that the assets and liabilities reported on Lehman’s financial statements (approximately $691 billion and $669 billion, respectively, at November 30, 2007) were improperly valued or accounted for incorrectly. Accounting and Disclosure Issues Relating to Repo 105 Transactions ■ There has been significant media attention about potential claims identified by the Examiner related to what Lehman referred to as “Repo 105” transactions. What has not been reported in the media is that the Examiner did not challenge Lehman’s accounting for its Repo 105 transactions. ■ As recognized by the Examiner, all investment banks used repo transactions extensively to fund their operations on a daily basis; these banks all operated in a high-risk, high-leverage business model. Most repo transactions are accounted for as financings; some (the Repo 105 transactions) are accounted for as sales if they meet the requirements of SFAS 140. ■ The Repo 105 transactions involved the sale by Lehman of high quality liquid assets (generally government-backed securities), in return for which Lehman received cash. The media reports that these were “sham transactions” designed to off-load Lehman’s “bad assets” are inaccurate. ■ Because effective control of the securities was surrendered to the counterparty in the Repo 105 arrangements, the accounting literature (SFAS 140) required Lehman to account for Repo 105 transactions as sales rather than financings. ■ The potential claims against EY arise solely from the Examiner’s conclusion that these transactions ($38.6 billion at November 30, 2007) should have been specifically disclosed in the footnotes to Lehman’s financial statements, and that Lehman should have disclosed in its MD&A the impact these transactions would have had on its leverage ratios if they had been recorded as financing transactions. ■ While no specific disclosures around Repo 105 transactions were reflected in Lehman’s financial statement footnotes, the 2007 audited financial statements were presented in accordance with US GAAP, and clearly portrayed Lehman as a leveraged entity operating in a risky and volatile industry. Lehman’s 2007 audited financial statements included footnote disclosure of off balance sheet commitments of almost $1 trillion. ■ Lehman’s leverage ratios are not a GAAP financial measure; they were included in Lehman’s MD&A, not its audited financial statements. Lehman concluded no further MD&A disclosures were required; EY did not take exception to that judgment. ■ If the Repo 105 transactions were treated as if they were on the balance sheet for leverage ratio purposes, as the Examiner suggests, Lehman’s reported gross leverage would have been 32.4 instead of 30.7 at November 30, 2007. Also, contrary to media reports, the decline in Lehman’s reported leverage from its first to second quarters of 2008 was not a result of an increased use of Repo 105 transactions. Lehman’s Repo 105 transaction volumes were comparable at the end of its first and second quarters. Handling of the Whistleblower’s Issues ■ The media has inaccurately reported that EY concealed a May 2008 whistleblower letter from Lehman’s Audit Committee. The whistleblower letter, which raised various significant potential concerns about Lehman’s financial controls and reporting but did not mention Repo 105, was directed to Lehman’s management. When we learned of the letter, our lead partner promptly called the Audit Committee Chair; we also insisted that Lehman’s management inform the Securities & Exchange Commission and the Federal Reserve Bank of the letter. EY’s lead partner discussed the whistleblower letter with the Lehman Audit Committee on at least three occasions during June and July 2008. ■ In the investigations that ensued, the writer of the letter did briefly reference Repo 105 transactions in an interview with EY partners. He also confirmed to EY that he was unaware of any material financial reporting errors. Lehman’s senior executives did not advise us of any reservations they had about the company’s Repo 105 transactions. ■ Lehman’s September 2008 bankruptcy prevented EY from completing its assessment of the whistleblower’s allegations. The allegations would have been the subject of significant attention had EY completed its third quarter review and 2008 year-end audit. Should any of the potential claims be pursued, we are confident we will prevail. Thank you for your support in this matter. Please feel free to call me at anytime at With best regards, Lehman’s Risk Management LB was a major player in a field that involved many varieties of risk and had specifically identified that their risk appetite for Repo 105 transactions in July 2006 was “1x leverage … or $17 billion, [and] $5 billion for Repo 108 transactions.”39 Consequently, LB’s internal cap on repo transactions was breached by significant amounts beginning in 2007.40 Recognizing that the levels of $40 billion to 50 billion were unsustainable, LB made efforts to obtain outside financing to be used to cut the level of repo transactions in 2008. Unfortunately, that effort was too little, too late. On September 15, 2008, LB declared bankruptcy. Questions 1. What was the most important reason for the LB failure? 2. What is leverage and why is it so important? 3. Prepare the journal entries for a Repo 105 transaction sequence for $1 million in securities. 4. In your opinion, how large should a Repo 105 transaction be to be considered material and why? 5. Was LB’s interpretation of SFAS 140— Repo 105 transactions could be treated as sales—correct? Provide your reasons. 6. If, as the Examiner’s Report states,41 LB continued to collect the revenue from the securities involved in the Repo 105 transactions, how could LB say that they had given up ownership? 7. An emerging issue Interpretation Bulletin42 accompanying FAS 140 gives examples indicating that Repo 102 transactions would not qualify as sales but that Repo 110 would. Why do you think this Bulletin was issued? See Q&A 140—A Guide to Implementation of Statement 140 on Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities at http://www.fasb.org/cs /ContentServer?c=Document_C& pagename=FASB%2FDocument_C% 2FDocumentPage&cid=1175801856780 (accessed March 27, 2011). 8. Knowing that LB could not obtain a “true sale” opinion from a U.S. lawyer under U.S. law, should LB have tried to obtain the opinion from a U.K. law firm? Why and why not? 9. Do the Repo 105 arrangements constitute fraud? Why and why not? 10. What is the auditor’s responsibility if a fraud is suspected or discovered? What professional standards are most import- ant in such cases and why? 11. If you were the audit partner in charge in the United States, what would you have required be done in regard to the Linklater “true sale” letter? 12. Should consolidated financial statements of a U.S. parent company include (i.e., consolidate) foreign subsidiary accounts prepared on a basis not considered appropriate U.S. GAAP? 13. Would the adoption of IFRS have pre- vented the Repo 105 misrepresentations? 14. What should the following have done on learning of Matthew Lee’s whistleblower’s letter—LB’s management, Board of Directors, and the external auditors, E&Y? 15. Arthur Andersen tried to keep its Enron audit problems quiet, whereas E&Y spoke out in its own defense. Was it a good idea for E&Y to send a letter, such as the one reproduced previously, to their clients? Why and why not? 16. Based on the letter, should E&Y be in the clear of any wrongdoing related to the Repo 105 and 108 transactions and reporting? Provide your reasons for and against. 17. If an auditor explains a problem to the chair of an audit committee, is there any further obligation on the part of the auditor to ensure that the full board has been notified and why? 18. Organizations who use the Enterprise Risk Management (ERM) framework43 should work through the following stages: review on the internal environment, identification of the organization’s risk appetite or objectives, risk identification and measurement, risk assessment, risk response, providing risk information and communications, and risk monitoring. In which of these did LB fail? Who was to blame for the failure? 19. How should the U.S. Bankruptcy Examiner’s Report be regarded—as a neutral set of findings or as a signpost intended to point creditors in the direction of potential recoveries? What are the implications of each? 20. After the Enron and WorldCom fiascos, regulators sought to avoid future misrepresentation by enacting the Sarbanes-Oxley Act (SOX) in 2002. Why did SOX not prevent Lehman’s use of Repo 105 and 108 misrepresentations? Does that mean that SOX is a failure?

On September 15, 2008, Lehman Brothers Holdings Inc., one of the world’s most respected and profitable investment banks, filed for Chapter 11 bankruptcy protection in the United States Bankruptcy Court in the Southern District of New York.1 Although Lehman Brothers (LB) had reported record revenues of almost $60 billion and record earnings in excess of $4 billion for the fiscal year ended November 30, 2007, only ten months later, their bankruptcy proceeding became the largest ever filed.2 How and why this happened is a complex story, part of which involves financial statement manipulation using a technique that has come to be known as Lehman’s Repo 105 to modify information provided to investors and regulators about the extent to which LB was using other investors’ funds to leverage their own. Banks generate revenue and profit principally by investing funds borrowed from other investors, such as depositors or lenders. Although some of the funds they invest are their own, banks can increase their activity by attracting and using other investors’ funds—an approach that is known as “leverage” because it is using the bank’s own capital to attract investments from others to increase or lever revenue- and profit- generation investments beyond the capacity of the bank’s own limited resources. A bank’s profit from lending activities is generated by “the spread”—the higher rate of return at which a bank lends funds than it pays outside depositors and investors for the use of their funds. However, outside investors or depositors will invest with a bank only if they are convinced that the bank’s own capital is sufficient to provide an adequate cushion against loss of their investment in the event that the bank suf- fers losses. Consequently, outside investors want accurate information on the extent of leverage employed by the bank, which is usually provided as a ratio as follows: Leverage Ratio 5 Total Assets Shareholders’ Equity (the bank’s own capital) In its simplest form, the Repo 105 mechanism—a multiple-step technique3 combined with the failure to disclosure promises to reacquire assets—was used by LB to reduce the reported total assets and net assets included in the leverage ratio, thus showing a lower ratio or more conservative use of leverage than was actually the case. Consequently, bank investors were misled about LB’s ability to cushion losses with its own equity compared to banks that did not artificially depress their leverage ratios. Each of the steps in the Repo 105 technique represented a transaction under- taken near the end of a reporting period designed to reduce the leverage ratio, but the impact of this was essentially reversed just after the beginning of the next reporting period. This reduction and reversal pro- cess was repeated each quarterly reporting period from 2001 to 2008. Because most of these periods (those up to November 30, 2007) were subject to audit by Ernst & Young (E&Y), questions have been raised about what E&Y knew and thought about the Repo 105 technique and its impact and what they should have done and did do during their audit process. In addition, the role and responsibility of LB’s management and the Board of Directors has come into question. Why Did Lehman Brothers Fail? According to the Bankruptcy Examiner’s Report4 by Anton Valukas, LB failed for several reasons, including the following: • The poor economic climate caused by the subprime lending crisis leading to a degeneration of confidence and there- fore a disenchantment and devaluation of asset-backed commercial paper and other financial instruments in which LB and others had invested. • A very highly leveraged position prior to the onset of the subprime lending crisis—LB “maintained approximately $700 billion of assets … on capital of approximately $25 billion,”5 a ratio of 28:1. • Decisions involving excessive risk taking by LB executives. For example, as the subprime lending crisis unfolded, LB management decided to invest more or “double down”6 in depressed assets hoping for a quick gain when values rebounded. LB’s aggressive decisions resulted in it exceeding its own risk limits and controls.7 • A mismatch between longer-term assets and the shorter-term liabilities used to finance them, thus making LB vulnerable to shifts in the preferences of creditors or the cost of the credit needed to finance the assets. Because the assets were of a longer-term nature, they were not maturing in time to pay off creditors who were making reinvestment decisions on a much shorter time scale. LB had to have creditors who had sufficient confidence in LB to be willing to invest daily so that LB could be sustained. • A masking of the extent to which LB was leveraged through the use of repurchase transactions—otherwise known as repo transactions—including ordinary repo transactions, Repo 105 transactions, and Repo 108 transactions. (Repo transactions are explained more fully in the next section.) This masking prevented creditors and investors from understanding how leveraged LB was, thus permitting LB to expand. • In March 2008, Bear Stearns, a rival investment house, began to falter and nearly collapsed, putting the spotlight on LB, which was considered the next most vulnerable. • Investor confidence was further eroded when Lehman announced its first-ever loss of $2.8 billion for its second quarter of 2008. At this time, the SEC and the Federal Reserve Bank of New York sent personnel to take up residence on-site to monitor LB’s liquidity. • In fact, LB had masked approximately $50 billion in leverage in the first and second quarters of 2008, so their condition was worse than disclosed. Although LB raised $6 billion of new capital on June 12, 2008, “[U.S.] Treasury Secretary Henry M. Paulson, Jr., privately told [LB CEO] Fuld that if Lehman was forced to report further losses in the third quarter without having a buyer or a definitive survival plan in place, Lehman’s existence would be in jeopardy. On September 10, 2008 Lehman announced that it was projecting a $3.9 billion loss for the third quarter of 2008.”8 • On September 15, 2008, LB’s bankruptcy filing proved Paulson to be correct. The Repo 105 Mechanism and Impact There are three kinds of repo transactions: (1) ordinary, (2) Repo 105, and (3) Repo 108. All three are illustrated along with their impact on the balance sheet and leverage ratio in volume 3 of the Examiner’s Report.9 Most investment banks used ordinary repo transactions to borrow funds using securities as collateral, which they shortly repaid for a 2% fee (interest charge), or “haircut” as it became known. Because the cash received as well as the assets used as collateral and the liability for repurchase are all shown on the balance sheet, it and the leverage ratios are accurately stated.10 Schematically, an ordinary repo transaction sequence can be represented as follows:11 A Repo 105 transaction sequence is different in that prior to the reporting date, (1) the initial transaction is treated as a sale, not a borrowing; (2) the cash received is used to pay off liabilities; and then, after the reporting date; (3) LB borrows funds elsewhere to repurchase the securities sold including a 5% interest charge.12 The overall impact is to reduce the assets and the liabilities on the balance sheet at the reporting date, thus reducing the leverage ratio because the numerator and the denominator of that ratio are reduced by the same amount. The balance sheet and leverage impacts of ordinary repo transactions as well as Repo 105 or 108 transactions are shown in the following sequence of illustrations.13,14,15,16,17 Balance Sheet and Leverage Impacts of Lehman Repo Transactions In order to make the initial sale transaction credible, LB needed a letter from a law firm specifying that it constituted a “true sale.” Interestingly, LB could not obtain such an opinion under U.S. law from U.S. lawyers, but Lehman Brothers International (Europe) (LBIE), based in London, did obtain one from Linklaters, a U.K. firm.18 Consequently, when Repo 105 and Repo 108 transactions were needed, they were done via transfers to and from LBIE in London. Repo 105 transactions were used with highly liquid securities, whereas Repo 108 transactions involved nonliquid or equity securities. To make sure these transactions went according to protocol, LB created an Accounting Policy Manual Repo 105 and 108 to guide their personnel.19 LB employed ordinary repo transactions as well as Repo 105 and Repo 108 transactions. The interest charges or fees involved were 2%, 5%, and 8%, respectively. The higher interest rate charges on the Repo 105 and 108 transactions were to compensate for their higher level of risk. But, because ordinary repo transactions could have been used to raise cash20 at a cost of 2%, it has been argued that LB used the higher-cost Repo 105 and 108 transactions only because they provided a way to man- age LB’s balance sheet and leverage ratio. This was confirmed by LB employees who commented as follows: “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.”21 Other former Lehman employees characterized Repo 105 transactions as an “accounting gimmick” and a “lazy way of managing the balance sheet.”22 When queried about meeting internal leverage targets for the second quarter, an employee responded by email saying: “very] close … any- thing that moves is getting 105’d.”23 The reduction in leverage ratios achieved through the use of Repo 105 and 108 trans- actions are shown below:24 According to the Bankruptcy Examiner, E&Y noted that LB’s threshold for deter- mining material items requiring reopening a closed balance sheet for correction was “any item individually, or in the aggregate, that moves net leverage by 0.1 or more (typically $1.8 billion).”25 Consequently, the usage of Repo 105 transactions noted previously resulted in changes that were many times greater than LB’s standard of materiality, which should have been a red-flag indicator to management and the auditors. Ratings agencies, on whose ratings LB’s credibility with lenders depended, were queried as to what they knew of the Repo 105 usage and materiality of the impact involved. According to the Examiner’s Report, Eileen Fahey, an analyst at Fitch, said that she had never heard of repo trans- actions being accounted for as true sales on the basis of a true sale opin- ion letter or repo transactions known as Repo 105 transactions. Fahey stated that a transfer of $40 billion or $50 billion of securities inventory— regardless of the liquidity of that inventory—from Lehman’s balance sheet at quarter-end would be “material” in Fitch’s view, and upon having a standard Repo 105 transaction described, Fahey remarked that such a transaction “sounded like fraud.”26 Fahey likened this “manipulation” to an investment bank telling regulators that it did not own any mortgage-backed securities when, in fact, it owned them but had temporarily transferred them to a counter- party and was obligated to repurchase them shortly thereafter.27 (This was similar to the usage Enron made with its special purpose entities.) The timing of the use of Repo 105 trans- actions corroborates that the intention was to manipulate LB’s end-of-quarter balance sheets, as is shown in the following graph.28 At the end of each quarter, LB’s assets are significantly higher than at the end of the two previous months. Thus, as a result of these transactions, LB’s end-of-quarter balance sheet shows significantly less assets than would have been reported at any other time during the quarter. LB’s Accounting Analysis LB’s Repo 105 transactions were under- taken under paragraph 9 of the FASB’s Statement of Financial Accounting Standards (SFAS) 140, which reads as follows: Accounting for Transfers and Servicing of Financial Assets A transfer of financial assets (or all or a portion of a financial asset) in which the transferor surrenders control over those financial assets shall be accounted for as a sale to the extent that consideration other than beneficial interests in the transferred assets is received in exchange. The transferor has surrendered control over transferred assets if and only if all of the following conditions are met: a. The transferred assets have been isolated from the transferor—put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership (paragraphs 27 and 28). b. Each transferee (or, if the transferee is a qualifying special purpose entity (para- graph 35), each holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both constrains the transferee (or holder) from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor (paragraphs 29–34). c. The transferor does not maintain effective control over the transferred assets through either (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity (paragraphs 47–49) or (2) the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call (paragraphs 50–54).29 SFAS 140 comments further in paragraph 218 that control over the assets transferred is maintained (thus breaking condition b above) if repurchase arrangements cover as much as 98% collateralization or as little as 102% overcollateralization. LB interpreted this to mean that because the “haircut” or fee charged in Repo 105 transactions was 5% and therefore greater than the 2% col- lateralization limit, control could be considered to have been surrendered, thus allowing the transfer to be considered a sale. Essentially, based on the percentages, LB took the position that they did not have the funds available to fund substantially all of the repurchase cost.30 To further bolster the position that the transfer of assets was a sale, LB obtained a letter from a U.K. law firm, Linklaters of London, that the transaction was a “true sale.”31 Such an opinion was possible under U.K. law but not under U.S. law, but the opinion was addressed to LBIE, thus necessitating transfers to LBIE so that the trans- actions would qualify as sales under U.K. law. LB, however, did not observe this need for transfer entirely.32 According to the Examiner, LB had this treatment as a sale vetted by outside auditors (E&Y) and lawyers.33 However, on May 16, 2008, Matthew Lee, former LB senior vice president, Finance Division, who was in charge of Global Balance Sheet and Legal Entity Accounting, sent a whistleblower letter to senior LB management expressing concerns about possible LB Ethics Code violations34 about the balance sheet irregularities related to the $50 billion in Repo 105 transactions then under way. According to the examiner, Lee’s letter contained the following six allegations: (1) on the last day of each month, Lehman’s books and records contained approximately $5 billion of net assets in excess of what was managed on the last day of the month, thereby suggesting that the firm’s senior management was not in control of its assets to be able to present full, fair, and accurate financial statements to the public; (2) Lehman had “tens of billions of dollars of unsubstantiated balances, which may or may not be ‘bad’ or non-performing assets or real liabilities”; (3) Lehman had tens of billions of dollars of illiquid inventory and did not value its inventory in a “fully realistic or reasonable” way; (4) given Lehman’s rapid growth and increased number of accounts and entities, it had not invested sufficiently in financial systems and personnel to cope with the balance sheet; (5) the India Finance office lacked sufficient knowledgeable management, resulting in the real possibility of potential misstatements of material facts being distributed by that office; and (6) certain senior level audit personnel were not qualified to “properly exercise the audit functions they are entrusted to manage.”35 Lee was interviewed by E&Y representatives about his concerns on June 12, 2008.36 E&Y’s Reaction E&Y faced questions from the business press and their clients as soon as the Examiner’s Report was made public. In response, a letter was quickly issued to clients, which apparently found its way into the public domain by being published on the Web. That letter was originally published with- out the opening and closing paragraphs by Francine McKenna37 on March 20, 2010, at http://www.retheauditors.com. E&Y’s let- ter, which is shown below,38 was published in its entirety on March 23, 2010, on the Contrarian Pundit website at http://www.contrarianpundit.com. ERNST & YOUNG 23 March 2010 To: Recently, there have been extensive media reports about the release of the Bankruptcy Examiner’s Report relating to the September 2008 bankruptcy of Lehman Brothers. As you may have read, Ernst & Young was Lehman Brothers’ independent auditors. The concept of an examiner’s report is a feature of US bankruptcy law. It does not represent the views of a court or a regulatory body, nor is the Report the result of a legal process. Instead, an examiner’s report is intended to identify potential claims that, if pursued, may result in a recovery for the bankrupt company or its creditors. EY is confident we will prevail should any of the potential claims identified against us be pursued. We wanted to provide you with EY’s perspective on some of the potential claims in the Examiner’s Report. We also wanted to address certain media coverage and commentary on the Examiner’s Report that has at times been inaccurate, if not misleading. A few key points are set out below. General Comments ■ EY’s last audit was for the year ended November 30, 2007. Our opinion stated that Lehman’s financial statements for 2007 were fairly presented in accordance with US GAAP, and we remain of that view. We reviewed but did not audit the interim periods for Lehman’s first and second quarters of fiscal 2008. ■ Lehman’s bankruptcy was the result of a series of unprecedented adverse events in the financial markets. The months leading up to Lehman’s bankruptcy were among the most turbulent periods in our economic history. Lehman’s bankruptcy was caused by a collapse in its liquidity, which was in turn caused by declining asset values and loss of market confidence in Lehman. It was not caused by accounting issues or disclosure issues. ■ The Examiner identified no potential claims that the assets and liabilities reported on Lehman’s financial statements (approximately $691 billion and $669 billion, respectively, at November 30, 2007) were improperly valued or accounted for incorrectly. Accounting and Disclosure Issues Relating to Repo 105 Transactions ■ There has been significant media attention about potential claims identified by the Examiner related to what Lehman referred to as “Repo 105” transactions. What has not been reported in the media is that the Examiner did not challenge Lehman’s accounting for its Repo 105 transactions. ■ As recognized by the Examiner, all investment banks used repo transactions extensively to fund their operations on a daily basis; these banks all operated in a high-risk, high-leverage business model. Most repo transactions are accounted for as financings; some (the Repo 105 transactions) are accounted for as sales if they meet the requirements of SFAS 140. ■ The Repo 105 transactions involved the sale by Lehman of high quality liquid assets (generally government-backed securities), in return for which Lehman received cash. The media reports that these were “sham transactions” designed to off-load Lehman’s “bad assets” are inaccurate. ■ Because effective control of the securities was surrendered to the counterparty in the Repo 105 arrangements, the accounting literature (SFAS 140) required Lehman to account for Repo 105 transactions as sales rather than financings. ■ The potential claims against EY arise solely from the Examiner’s conclusion that these transactions ($38.6 billion at November 30, 2007) should have been specifically disclosed in the footnotes to Lehman’s financial statements, and that Lehman should have disclosed in its MD&A the impact these transactions would have had on its leverage ratios if they had been recorded as financing transactions. ■ While no specific disclosures around Repo 105 transactions were reflected in Lehman’s financial statement footnotes, the 2007 audited financial statements were presented in accordance with US GAAP, and clearly portrayed Lehman as a leveraged entity operating in a risky and volatile industry. Lehman’s 2007 audited financial statements included footnote disclosure of off balance sheet commitments of almost $1 trillion. ■ Lehman’s leverage ratios are not a GAAP financial measure; they were included in Lehman’s MD&A, not its audited financial statements. Lehman concluded no further MD&A disclosures were required; EY did not take exception to that judgment. ■ If the Repo 105 transactions were treated as if they were on the balance sheet for leverage ratio purposes, as the Examiner suggests, Lehman’s reported gross leverage would have been 32.4 instead of 30.7 at November 30, 2007. Also, contrary to media reports, the decline in Lehman’s reported leverage from its first to second quarters of 2008 was not a result of an increased use of Repo 105 transactions. Lehman’s Repo 105 transaction volumes were comparable at the end of its first and second quarters. Handling of the Whistleblower’s Issues ■ The media has inaccurately reported that EY concealed a May 2008 whistleblower letter from Lehman’s Audit Committee. The whistleblower letter, which raised various significant potential concerns about Lehman’s financial controls and reporting but did not mention Repo 105, was directed to Lehman’s management. When we learned of the letter, our lead partner promptly called the Audit Committee Chair; we also insisted that Lehman’s management inform the Securities & Exchange Commission and the Federal Reserve Bank of the letter. EY’s lead partner discussed the whistleblower letter with the Lehman Audit Committee on at least three occasions during June and July 2008. ■ In the investigations that ensued, the writer of the letter did briefly reference Repo 105 transactions in an interview with EY partners. He also confirmed to EY that he was unaware of any material financial reporting errors. Lehman’s senior executives did not advise us of any reservations they had about the company’s Repo 105 transactions. ■ Lehman’s September 2008 bankruptcy prevented EY from completing its assessment of the whistleblower’s allegations. The allegations would have been the subject of significant attention had EY completed its third quarter review and 2008 year-end audit. Should any of the potential claims be pursued, we are confident we will prevail. Thank you for your support in this matter. Please feel free to call me at anytime at With best regards, Lehman’s Risk Management LB was a major player in a field that involved many varieties of risk and had specifically identified that their risk appetite for Repo 105 transactions in July 2006 was “1x leverage … or $17 billion, [and] $5 billion for Repo 108 transactions.”39 Consequently, LB’s internal cap on repo transactions was breached by significant amounts beginning in 2007.40 Recognizing that the levels of $40 billion to 50 billion were unsustainable, LB made efforts to obtain outside financing to be used to cut the level of repo transactions in 2008. Unfortunately, that effort was too little, too late. On September 15, 2008, LB declared bankruptcy. Questions 1. What was the most important reason for the LB failure? 2. What is leverage and why is it so important? 3. Prepare the journal entries for a Repo 105 transaction sequence for $1 million in securities. 4. In your opinion, how large should a Repo 105 transaction be to be considered material and why? 5. Was LB’s interpretation of SFAS 140— Repo 105 transactions could be treated as sales—correct? Provide your reasons. 6. If, as the Examiner’s Report states,41 LB continued to collect the revenue from the securities involved in the Repo 105 transactions, how could LB say that they had given up ownership? 7. An emerging issue Interpretation Bulletin42 accompanying FAS 140 gives examples indicating that Repo 102 transactions would not qualify as sales but that Repo 110 would. Why do you think this Bulletin was issued? See Q&A 140—A Guide to Implementation of Statement 140 on Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities at http://www.fasb.org/cs /ContentServer?c=Document_C& pagename=FASB%2FDocument_C% 2FDocumentPage&cid=1175801856780 (accessed March 27, 2011). 8. Knowing that LB could not obtain a “true sale” opinion from a U.S. lawyer under U.S. law, should LB have tried to obtain the opinion from a U.K. law firm? Why and why not? 9. Do the Repo 105 arrangements constitute fraud? Why and why not? 10. What is the auditor’s responsibility if a fraud is suspected or discovered? What professional standards are most import- ant in such cases and why? 11. If you were the audit partner in charge in the United States, what would you have required be done in regard to the Linklater “true sale” letter? 12. Should consolidated financial statements of a U.S. parent company include (i.e., consolidate) foreign subsidiary accounts prepared on a basis not considered appropriate U.S. GAAP? 13. Would the adoption of IFRS have pre- vented the Repo 105 misrepresentations? 14. What should the following have done on learning of Matthew Lee’s whistleblower’s letter—LB’s management, Board of Directors, and the external auditors, E&Y? 15. Arthur Andersen tried to keep its Enron audit problems quiet, whereas E&Y spoke out in its own defense. Was it a good idea for E&Y to send a letter, such as the one reproduced previously, to their clients? Why and why not? 16. Based on the letter, should E&Y be in the clear of any wrongdoing related to the Repo 105 and 108 transactions and reporting? Provide your reasons for and against. 17. If an auditor explains a problem to the chair of an audit committee, is there any further obligation on the part of the auditor to ensure that the full board has been notified and why? 18. Organizations who use the Enterprise Risk Management (ERM) framework43 should work through the following stages: review on the internal environment, identification of the organization’s risk appetite or objectives, risk identification and measurement, risk assessment, risk response, providing risk information and communications, and risk monitoring. In which of these did LB fail? Who was to blame for the failure? 19. How should the U.S. Bankruptcy Examiner’s Report be regarded—as a neutral set of findings or as a signpost intended to point creditors in the direction of potential recoveries? What are the implications of each? 20. After the Enron and WorldCom fiascos, regulators sought to avoid future misrepresentation by enacting the Sarbanes-Oxley Act (SOX) in 2002. Why did SOX not prevent Lehman’s use of Repo 105 and 108 misrepresentations? Does that mean that SOX is a failure?
only because they provided a way to man- age LB’s balance sheet and leverage ratio. This was confirmed by LB employees who commented as follows: “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.”21 Other former Lehman employees characterized Repo 105 transactions as an “accounting gimmick” and a “lazy way of managing the balance sheet.”22 When queried about meeting internal leverage targets for the second quarter, an employee responded by email saying: “very] close … any- thing that moves is getting 105’d.”23 The reduction in leverage ratios achieved through the use of Repo 105 and 108 trans- actions are shown below:24
On September 15, 2008, Lehman Brothers Holdings Inc., one of the world’s most respected and profitable investment banks, filed for Chapter 11 bankruptcy protection in the United States Bankruptcy Court in the Southern District of New York.1 Although Lehman Brothers (LB) had reported record revenues of almost $60 billion and record earnings in excess of $4 billion for the fiscal year ended November 30, 2007, only ten months later, their bankruptcy proceeding became the largest ever filed.2 How and why this happened is a complex story, part of which involves financial statement manipulation using a technique that has come to be known as Lehman’s Repo 105 to modify information provided to investors and regulators about the extent to which LB was using other investors’ funds to leverage their own. Banks generate revenue and profit principally by investing funds borrowed from other investors, such as depositors or lenders. Although some of the funds they invest are their own, banks can increase their activity by attracting and using other investors’ funds—an approach that is known as “leverage” because it is using the bank’s own capital to attract investments from others to increase or lever revenue- and profit- generation investments beyond the capacity of the bank’s own limited resources. A bank’s profit from lending activities is generated by “the spread”—the higher rate of return at which a bank lends funds than it pays outside depositors and investors for the use of their funds. However, outside investors or depositors will invest with a bank only if they are convinced that the bank’s own capital is sufficient to provide an adequate cushion against loss of their investment in the event that the bank suf- fers losses. Consequently, outside investors want accurate information on the extent of leverage employed by the bank, which is usually provided as a ratio as follows: Leverage Ratio 5 Total Assets Shareholders’ Equity (the bank’s own capital) In its simplest form, the Repo 105 mechanism—a multiple-step technique3 combined with the failure to disclosure promises to reacquire assets—was used by LB to reduce the reported total assets and net assets included in the leverage ratio, thus showing a lower ratio or more conservative use of leverage than was actually the case. Consequently, bank investors were misled about LB’s ability to cushion losses with its own equity compared to banks that did not artificially depress their leverage ratios. Each of the steps in the Repo 105 technique represented a transaction under- taken near the end of a reporting period designed to reduce the leverage ratio, but the impact of this was essentially reversed just after the beginning of the next reporting period. This reduction and reversal pro- cess was repeated each quarterly reporting period from 2001 to 2008. Because most of these periods (those up to November 30, 2007) were subject to audit by Ernst & Young (E&Y), questions have been raised about what E&Y knew and thought about the Repo 105 technique and its impact and what they should have done and did do during their audit process. In addition, the role and responsibility of LB’s management and the Board of Directors has come into question. Why Did Lehman Brothers Fail? According to the Bankruptcy Examiner’s Report4 by Anton Valukas, LB failed for several reasons, including the following: • The poor economic climate caused by the subprime lending crisis leading to a degeneration of confidence and there- fore a disenchantment and devaluation of asset-backed commercial paper and other financial instruments in which LB and others had invested. • A very highly leveraged position prior to the onset of the subprime lending crisis—LB “maintained approximately $700 billion of assets … on capital of approximately $25 billion,”5 a ratio of 28:1. • Decisions involving excessive risk taking by LB executives. For example, as the subprime lending crisis unfolded, LB management decided to invest more or “double down”6 in depressed assets hoping for a quick gain when values rebounded. LB’s aggressive decisions resulted in it exceeding its own risk limits and controls.7 • A mismatch between longer-term assets and the shorter-term liabilities used to finance them, thus making LB vulnerable to shifts in the preferences of creditors or the cost of the credit needed to finance the assets. Because the assets were of a longer-term nature, they were not maturing in time to pay off creditors who were making reinvestment decisions on a much shorter time scale. LB had to have creditors who had sufficient confidence in LB to be willing to invest daily so that LB could be sustained. • A masking of the extent to which LB was leveraged through the use of repurchase transactions—otherwise known as repo transactions—including ordinary repo transactions, Repo 105 transactions, and Repo 108 transactions. (Repo transactions are explained more fully in the next section.) This masking prevented creditors and investors from understanding how leveraged LB was, thus permitting LB to expand. • In March 2008, Bear Stearns, a rival investment house, began to falter and nearly collapsed, putting the spotlight on LB, which was considered the next most vulnerable. • Investor confidence was further eroded when Lehman announced its first-ever loss of $2.8 billion for its second quarter of 2008. At this time, the SEC and the Federal Reserve Bank of New York sent personnel to take up residence on-site to monitor LB’s liquidity. • In fact, LB had masked approximately $50 billion in leverage in the first and second quarters of 2008, so their condition was worse than disclosed. Although LB raised $6 billion of new capital on June 12, 2008, “[U.S.] Treasury Secretary Henry M. Paulson, Jr., privately told [LB CEO] Fuld that if Lehman was forced to report further losses in the third quarter without having a buyer or a definitive survival plan in place, Lehman’s existence would be in jeopardy. On September 10, 2008 Lehman announced that it was projecting a $3.9 billion loss for the third quarter of 2008.”8 • On September 15, 2008, LB’s bankruptcy filing proved Paulson to be correct. The Repo 105 Mechanism and Impact There are three kinds of repo transactions: (1) ordinary, (2) Repo 105, and (3) Repo 108. All three are illustrated along with their impact on the balance sheet and leverage ratio in volume 3 of the Examiner’s Report.9 Most investment banks used ordinary repo transactions to borrow funds using securities as collateral, which they shortly repaid for a 2% fee (interest charge), or “haircut” as it became known. Because the cash received as well as the assets used as collateral and the liability for repurchase are all shown on the balance sheet, it and the leverage ratios are accurately stated.10 Schematically, an ordinary repo transaction sequence can be represented as follows:11 A Repo 105 transaction sequence is different in that prior to the reporting date, (1) the initial transaction is treated as a sale, not a borrowing; (2) the cash received is used to pay off liabilities; and then, after the reporting date; (3) LB borrows funds elsewhere to repurchase the securities sold including a 5% interest charge.12 The overall impact is to reduce the assets and the liabilities on the balance sheet at the reporting date, thus reducing the leverage ratio because the numerator and the denominator of that ratio are reduced by the same amount. The balance sheet and leverage impacts of ordinary repo transactions as well as Repo 105 or 108 transactions are shown in the following sequence of illustrations.13,14,15,16,17 Balance Sheet and Leverage Impacts of Lehman Repo Transactions In order to make the initial sale transaction credible, LB needed a letter from a law firm specifying that it constituted a “true sale.” Interestingly, LB could not obtain such an opinion under U.S. law from U.S. lawyers, but Lehman Brothers International (Europe) (LBIE), based in London, did obtain one from Linklaters, a U.K. firm.18 Consequently, when Repo 105 and Repo 108 transactions were needed, they were done via transfers to and from LBIE in London. Repo 105 transactions were used with highly liquid securities, whereas Repo 108 transactions involved nonliquid or equity securities. To make sure these transactions went according to protocol, LB created an Accounting Policy Manual Repo 105 and 108 to guide their personnel.19 LB employed ordinary repo transactions as well as Repo 105 and Repo 108 transactions. The interest charges or fees involved were 2%, 5%, and 8%, respectively. The higher interest rate charges on the Repo 105 and 108 transactions were to compensate for their higher level of risk. But, because ordinary repo transactions could have been used to raise cash20 at a cost of 2%, it has been argued that LB used the higher-cost Repo 105 and 108 transactions only because they provided a way to man- age LB’s balance sheet and leverage ratio. This was confirmed by LB employees who commented as follows: “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.”21 Other former Lehman employees characterized Repo 105 transactions as an “accounting gimmick” and a “lazy way of managing the balance sheet.”22 When queried about meeting internal leverage targets for the second quarter, an employee responded by email saying: “very] close … any- thing that moves is getting 105’d.”23 The reduction in leverage ratios achieved through the use of Repo 105 and 108 trans- actions are shown below:24 According to the Bankruptcy Examiner, E&Y noted that LB’s threshold for deter- mining material items requiring reopening a closed balance sheet for correction was “any item individually, or in the aggregate, that moves net leverage by 0.1 or more (typically $1.8 billion).”25 Consequently, the usage of Repo 105 transactions noted previously resulted in changes that were many times greater than LB’s standard of materiality, which should have been a red-flag indicator to management and the auditors. Ratings agencies, on whose ratings LB’s credibility with lenders depended, were queried as to what they knew of the Repo 105 usage and materiality of the impact involved. According to the Examiner’s Report, Eileen Fahey, an analyst at Fitch, said that she had never heard of repo trans- actions being accounted for as true sales on the basis of a true sale opin- ion letter or repo transactions known as Repo 105 transactions. Fahey stated that a transfer of $40 billion or $50 billion of securities inventory— regardless of the liquidity of that inventory—from Lehman’s balance sheet at quarter-end would be “material” in Fitch’s view, and upon having a standard Repo 105 transaction described, Fahey remarked that such a transaction “sounded like fraud.”26 Fahey likened this “manipulation” to an investment bank telling regulators that it did not own any mortgage-backed securities when, in fact, it owned them but had temporarily transferred them to a counter- party and was obligated to repurchase them shortly thereafter.27 (This was similar to the usage Enron made with its special purpose entities.) The timing of the use of Repo 105 trans- actions corroborates that the intention was to manipulate LB’s end-of-quarter balance sheets, as is shown in the following graph.28 At the end of each quarter, LB’s assets are significantly higher than at the end of the two previous months. Thus, as a result of these transactions, LB’s end-of-quarter balance sheet shows significantly less assets than would have been reported at any other time during the quarter. LB’s Accounting Analysis LB’s Repo 105 transactions were under- taken under paragraph 9 of the FASB’s Statement of Financial Accounting Standards (SFAS) 140, which reads as follows: Accounting for Transfers and Servicing of Financial Assets A transfer of financial assets (or all or a portion of a financial asset) in which the transferor surrenders control over those financial assets shall be accounted for as a sale to the extent that consideration other than beneficial interests in the transferred assets is received in exchange. The transferor has surrendered control over transferred assets if and only if all of the following conditions are met: a. The transferred assets have been isolated from the transferor—put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership (paragraphs 27 and 28). b. Each transferee (or, if the transferee is a qualifying special purpose entity (para- graph 35), each holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both constrains the transferee (or holder) from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor (paragraphs 29–34). c. The transferor does not maintain effective control over the transferred assets through either (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity (paragraphs 47–49) or (2) the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call (paragraphs 50–54).29 SFAS 140 comments further in paragraph 218 that control over the assets transferred is maintained (thus breaking condition b above) if repurchase arrangements cover as much as 98% collateralization or as little as 102% overcollateralization. LB interpreted this to mean that because the “haircut” or fee charged in Repo 105 transactions was 5% and therefore greater than the 2% col- lateralization limit, control could be considered to have been surrendered, thus allowing the transfer to be considered a sale. Essentially, based on the percentages, LB took the position that they did not have the funds available to fund substantially all of the repurchase cost.30 To further bolster the position that the transfer of assets was a sale, LB obtained a letter from a U.K. law firm, Linklaters of London, that the transaction was a “true sale.”31 Such an opinion was possible under U.K. law but not under U.S. law, but the opinion was addressed to LBIE, thus necessitating transfers to LBIE so that the trans- actions would qualify as sales under U.K. law. LB, however, did not observe this need for transfer entirely.32 According to the Examiner, LB had this treatment as a sale vetted by outside auditors (E&Y) and lawyers.33 However, on May 16, 2008, Matthew Lee, former LB senior vice president, Finance Division, who was in charge of Global Balance Sheet and Legal Entity Accounting, sent a whistleblower letter to senior LB management expressing concerns about possible LB Ethics Code violations34 about the balance sheet irregularities related to the $50 billion in Repo 105 transactions then under way. According to the examiner, Lee’s letter contained the following six allegations: (1) on the last day of each month, Lehman’s books and records contained approximately $5 billion of net assets in excess of what was managed on the last day of the month, thereby suggesting that the firm’s senior management was not in control of its assets to be able to present full, fair, and accurate financial statements to the public; (2) Lehman had “tens of billions of dollars of unsubstantiated balances, which may or may not be ‘bad’ or non-performing assets or real liabilities”; (3) Lehman had tens of billions of dollars of illiquid inventory and did not value its inventory in a “fully realistic or reasonable” way; (4) given Lehman’s rapid growth and increased number of accounts and entities, it had not invested sufficiently in financial systems and personnel to cope with the balance sheet; (5) the India Finance office lacked sufficient knowledgeable management, resulting in the real possibility of potential misstatements of material facts being distributed by that office; and (6) certain senior level audit personnel were not qualified to “properly exercise the audit functions they are entrusted to manage.”35 Lee was interviewed by E&Y representatives about his concerns on June 12, 2008.36 E&Y’s Reaction E&Y faced questions from the business press and their clients as soon as the Examiner’s Report was made public. In response, a letter was quickly issued to clients, which apparently found its way into the public domain by being published on the Web. That letter was originally published with- out the opening and closing paragraphs by Francine McKenna37 on March 20, 2010, at http://www.retheauditors.com. E&Y’s let- ter, which is shown below,38 was published in its entirety on March 23, 2010, on the Contrarian Pundit website at http://www.contrarianpundit.com. ERNST & YOUNG 23 March 2010 To: Recently, there have been extensive media reports about the release of the Bankruptcy Examiner’s Report relating to the September 2008 bankruptcy of Lehman Brothers. As you may have read, Ernst & Young was Lehman Brothers’ independent auditors. The concept of an examiner’s report is a feature of US bankruptcy law. It does not represent the views of a court or a regulatory body, nor is the Report the result of a legal process. Instead, an examiner’s report is intended to identify potential claims that, if pursued, may result in a recovery for the bankrupt company or its creditors. EY is confident we will prevail should any of the potential claims identified against us be pursued. We wanted to provide you with EY’s perspective on some of the potential claims in the Examiner’s Report. We also wanted to address certain media coverage and commentary on the Examiner’s Report that has at times been inaccurate, if not misleading. A few key points are set out below. General Comments ■ EY’s last audit was for the year ended November 30, 2007. Our opinion stated that Lehman’s financial statements for 2007 were fairly presented in accordance with US GAAP, and we remain of that view. We reviewed but did not audit the interim periods for Lehman’s first and second quarters of fiscal 2008. ■ Lehman’s bankruptcy was the result of a series of unprecedented adverse events in the financial markets. The months leading up to Lehman’s bankruptcy were among the most turbulent periods in our economic history. Lehman’s bankruptcy was caused by a collapse in its liquidity, which was in turn caused by declining asset values and loss of market confidence in Lehman. It was not caused by accounting issues or disclosure issues. ■ The Examiner identified no potential claims that the assets and liabilities reported on Lehman’s financial statements (approximately $691 billion and $669 billion, respectively, at November 30, 2007) were improperly valued or accounted for incorrectly. Accounting and Disclosure Issues Relating to Repo 105 Transactions ■ There has been significant media attention about potential claims identified by the Examiner related to what Lehman referred to as “Repo 105” transactions. What has not been reported in the media is that the Examiner did not challenge Lehman’s accounting for its Repo 105 transactions. ■ As recognized by the Examiner, all investment banks used repo transactions extensively to fund their operations on a daily basis; these banks all operated in a high-risk, high-leverage business model. Most repo transactions are accounted for as financings; some (the Repo 105 transactions) are accounted for as sales if they meet the requirements of SFAS 140. ■ The Repo 105 transactions involved the sale by Lehman of high quality liquid assets (generally government-backed securities), in return for which Lehman received cash. The media reports that these were “sham transactions” designed to off-load Lehman’s “bad assets” are inaccurate. ■ Because effective control of the securities was surrendered to the counterparty in the Repo 105 arrangements, the accounting literature (SFAS 140) required Lehman to account for Repo 105 transactions as sales rather than financings. ■ The potential claims against EY arise solely from the Examiner’s conclusion that these transactions ($38.6 billion at November 30, 2007) should have been specifically disclosed in the footnotes to Lehman’s financial statements, and that Lehman should have disclosed in its MD&A the impact these transactions would have had on its leverage ratios if they had been recorded as financing transactions. ■ While no specific disclosures around Repo 105 transactions were reflected in Lehman’s financial statement footnotes, the 2007 audited financial statements were presented in accordance with US GAAP, and clearly portrayed Lehman as a leveraged entity operating in a risky and volatile industry. Lehman’s 2007 audited financial statements included footnote disclosure of off balance sheet commitments of almost $1 trillion. ■ Lehman’s leverage ratios are not a GAAP financial measure; they were included in Lehman’s MD&A, not its audited financial statements. Lehman concluded no further MD&A disclosures were required; EY did not take exception to that judgment. ■ If the Repo 105 transactions were treated as if they were on the balance sheet for leverage ratio purposes, as the Examiner suggests, Lehman’s reported gross leverage would have been 32.4 instead of 30.7 at November 30, 2007. Also, contrary to media reports, the decline in Lehman’s reported leverage from its first to second quarters of 2008 was not a result of an increased use of Repo 105 transactions. Lehman’s Repo 105 transaction volumes were comparable at the end of its first and second quarters. Handling of the Whistleblower’s Issues ■ The media has inaccurately reported that EY concealed a May 2008 whistleblower letter from Lehman’s Audit Committee. The whistleblower letter, which raised various significant potential concerns about Lehman’s financial controls and reporting but did not mention Repo 105, was directed to Lehman’s management. When we learned of the letter, our lead partner promptly called the Audit Committee Chair; we also insisted that Lehman’s management inform the Securities & Exchange Commission and the Federal Reserve Bank of the letter. EY’s lead partner discussed the whistleblower letter with the Lehman Audit Committee on at least three occasions during June and July 2008. ■ In the investigations that ensued, the writer of the letter did briefly reference Repo 105 transactions in an interview with EY partners. He also confirmed to EY that he was unaware of any material financial reporting errors. Lehman’s senior executives did not advise us of any reservations they had about the company’s Repo 105 transactions. ■ Lehman’s September 2008 bankruptcy prevented EY from completing its assessment of the whistleblower’s allegations. The allegations would have been the subject of significant attention had EY completed its third quarter review and 2008 year-end audit. Should any of the potential claims be pursued, we are confident we will prevail. Thank you for your support in this matter. Please feel free to call me at anytime at With best regards, Lehman’s Risk Management LB was a major player in a field that involved many varieties of risk and had specifically identified that their risk appetite for Repo 105 transactions in July 2006 was “1x leverage … or $17 billion, [and] $5 billion for Repo 108 transactions.”39 Consequently, LB’s internal cap on repo transactions was breached by significant amounts beginning in 2007.40 Recognizing that the levels of $40 billion to 50 billion were unsustainable, LB made efforts to obtain outside financing to be used to cut the level of repo transactions in 2008. Unfortunately, that effort was too little, too late. On September 15, 2008, LB declared bankruptcy. Questions 1. What was the most important reason for the LB failure? 2. What is leverage and why is it so important? 3. Prepare the journal entries for a Repo 105 transaction sequence for $1 million in securities. 4. In your opinion, how large should a Repo 105 transaction be to be considered material and why? 5. Was LB’s interpretation of SFAS 140— Repo 105 transactions could be treated as sales—correct? Provide your reasons. 6. If, as the Examiner’s Report states,41 LB continued to collect the revenue from the securities involved in the Repo 105 transactions, how could LB say that they had given up ownership? 7. An emerging issue Interpretation Bulletin42 accompanying FAS 140 gives examples indicating that Repo 102 transactions would not qualify as sales but that Repo 110 would. Why do you think this Bulletin was issued? See Q&A 140—A Guide to Implementation of Statement 140 on Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities at http://www.fasb.org/cs /ContentServer?c=Document_C& pagename=FASB%2FDocument_C% 2FDocumentPage&cid=1175801856780 (accessed March 27, 2011). 8. Knowing that LB could not obtain a “true sale” opinion from a U.S. lawyer under U.S. law, should LB have tried to obtain the opinion from a U.K. law firm? Why and why not? 9. Do the Repo 105 arrangements constitute fraud? Why and why not? 10. What is the auditor’s responsibility if a fraud is suspected or discovered? What professional standards are most import- ant in such cases and why? 11. If you were the audit partner in charge in the United States, what would you have required be done in regard to the Linklater “true sale” letter? 12. Should consolidated financial statements of a U.S. parent company include (i.e., consolidate) foreign subsidiary accounts prepared on a basis not considered appropriate U.S. GAAP? 13. Would the adoption of IFRS have pre- vented the Repo 105 misrepresentations? 14. What should the following have done on learning of Matthew Lee’s whistleblower’s letter—LB’s management, Board of Directors, and the external auditors, E&Y? 15. Arthur Andersen tried to keep its Enron audit problems quiet, whereas E&Y spoke out in its own defense. Was it a good idea for E&Y to send a letter, such as the one reproduced previously, to their clients? Why and why not? 16. Based on the letter, should E&Y be in the clear of any wrongdoing related to the Repo 105 and 108 transactions and reporting? Provide your reasons for and against. 17. If an auditor explains a problem to the chair of an audit committee, is there any further obligation on the part of the auditor to ensure that the full board has been notified and why? 18. Organizations who use the Enterprise Risk Management (ERM) framework43 should work through the following stages: review on the internal environment, identification of the organization’s risk appetite or objectives, risk identification and measurement, risk assessment, risk response, providing risk information and communications, and risk monitoring. In which of these did LB fail? Who was to blame for the failure? 19. How should the U.S. Bankruptcy Examiner’s Report be regarded—as a neutral set of findings or as a signpost intended to point creditors in the direction of potential recoveries? What are the implications of each? 20. After the Enron and WorldCom fiascos, regulators sought to avoid future misrepresentation by enacting the Sarbanes-Oxley Act (SOX) in 2002. Why did SOX not prevent Lehman’s use of Repo 105 and 108 misrepresentations? Does that mean that SOX is a failure?
According to the Bankruptcy Examiner, E&Y noted that LB’s threshold for deter- mining material items requiring reopening a closed balance sheet for correction was “any item individually, or in the aggregate, that moves net leverage by 0.1 or more (typically $1.8 billion).”25 Consequently, the usage of Repo 105 transactions noted previously resulted in changes that were many times greater than LB’s standard of materiality, which should have been a red-flag indicator to management and the auditors. Ratings agencies, on whose ratings LB’s credibility with lenders depended, were queried as to what they knew of the Repo 105 usage and materiality of the impact involved. According to the Examiner’s Report, Eileen Fahey, an analyst at Fitch, said that she had never heard of repo trans- actions being accounted for as true sales on the basis of a true sale opin- ion letter or repo transactions known as Repo 105 transactions. Fahey stated that a transfer of $40 billion or $50 billion of securities inventory— regardless of the liquidity of that inventory—from Lehman’s balance sheet at quarter-end would be “material” in Fitch’s view, and upon having a standard Repo 105 transaction described, Fahey remarked that such a transaction “sounded like fraud.”26 Fahey likened this “manipulation” to an investment bank telling regulators that it did not own any mortgage-backed securities when, in fact, it owned them but had temporarily transferred them to a counter- party and was obligated to repurchase them shortly thereafter.27 (This was similar to the usage Enron made with its special purpose entities.) The timing of the use of Repo 105 trans- actions corroborates that the intention was to manipulate LB’s end-of-quarter balance sheets, as is shown in the following graph.28 At the end of each quarter, LB’s assets are significantly higher than at the end of the two previous months. Thus, as a result of these transactions, LB’s end-of-quarter balance sheet shows significantly less assets than would have been reported at any other time during the quarter. LB’s Accounting Analysis LB’s Repo 105 transactions were under- taken under paragraph 9 of the FASB’s Statement of Financial Accounting Standards (SFAS) 140, which reads as follows: Accounting for Transfers and Servicing of Financial Assets A transfer of financial assets (or all or a portion of a financial asset) in which the transferor surrenders control over those financial assets shall be accounted for as a sale to the extent that consideration other
On September 15, 2008, Lehman Brothers Holdings Inc., one of the world’s most respected and profitable investment banks, filed for Chapter 11 bankruptcy protection in the United States Bankruptcy Court in the Southern District of New York.1 Although Lehman Brothers (LB) had reported record revenues of almost $60 billion and record earnings in excess of $4 billion for the fiscal year ended November 30, 2007, only ten months later, their bankruptcy proceeding became the largest ever filed.2 How and why this happened is a complex story, part of which involves financial statement manipulation using a technique that has come to be known as Lehman’s Repo 105 to modify information provided to investors and regulators about the extent to which LB was using other investors’ funds to leverage their own. Banks generate revenue and profit principally by investing funds borrowed from other investors, such as depositors or lenders. Although some of the funds they invest are their own, banks can increase their activity by attracting and using other investors’ funds—an approach that is known as “leverage” because it is using the bank’s own capital to attract investments from others to increase or lever revenue- and profit- generation investments beyond the capacity of the bank’s own limited resources. A bank’s profit from lending activities is generated by “the spread”—the higher rate of return at which a bank lends funds than it pays outside depositors and investors for the use of their funds. However, outside investors or depositors will invest with a bank only if they are convinced that the bank’s own capital is sufficient to provide an adequate cushion against loss of their investment in the event that the bank suf- fers losses. Consequently, outside investors want accurate information on the extent of leverage employed by the bank, which is usually provided as a ratio as follows: Leverage Ratio 5 Total Assets Shareholders’ Equity (the bank’s own capital) In its simplest form, the Repo 105 mechanism—a multiple-step technique3 combined with the failure to disclosure promises to reacquire assets—was used by LB to reduce the reported total assets and net assets included in the leverage ratio, thus showing a lower ratio or more conservative use of leverage than was actually the case. Consequently, bank investors were misled about LB’s ability to cushion losses with its own equity compared to banks that did not artificially depress their leverage ratios. Each of the steps in the Repo 105 technique represented a transaction under- taken near the end of a reporting period designed to reduce the leverage ratio, but the impact of this was essentially reversed just after the beginning of the next reporting period. This reduction and reversal pro- cess was repeated each quarterly reporting period from 2001 to 2008. Because most of these periods (those up to November 30, 2007) were subject to audit by Ernst & Young (E&Y), questions have been raised about what E&Y knew and thought about the Repo 105 technique and its impact and what they should have done and did do during their audit process. In addition, the role and responsibility of LB’s management and the Board of Directors has come into question. Why Did Lehman Brothers Fail? According to the Bankruptcy Examiner’s Report4 by Anton Valukas, LB failed for several reasons, including the following: • The poor economic climate caused by the subprime lending crisis leading to a degeneration of confidence and there- fore a disenchantment and devaluation of asset-backed commercial paper and other financial instruments in which LB and others had invested. • A very highly leveraged position prior to the onset of the subprime lending crisis—LB “maintained approximately $700 billion of assets … on capital of approximately $25 billion,”5 a ratio of 28:1. • Decisions involving excessive risk taking by LB executives. For example, as the subprime lending crisis unfolded, LB management decided to invest more or “double down”6 in depressed assets hoping for a quick gain when values rebounded. LB’s aggressive decisions resulted in it exceeding its own risk limits and controls.7 • A mismatch between longer-term assets and the shorter-term liabilities used to finance them, thus making LB vulnerable to shifts in the preferences of creditors or the cost of the credit needed to finance the assets. Because the assets were of a longer-term nature, they were not maturing in time to pay off creditors who were making reinvestment decisions on a much shorter time scale. LB had to have creditors who had sufficient confidence in LB to be willing to invest daily so that LB could be sustained. • A masking of the extent to which LB was leveraged through the use of repurchase transactions—otherwise known as repo transactions—including ordinary repo transactions, Repo 105 transactions, and Repo 108 transactions. (Repo transactions are explained more fully in the next section.) This masking prevented creditors and investors from understanding how leveraged LB was, thus permitting LB to expand. • In March 2008, Bear Stearns, a rival investment house, began to falter and nearly collapsed, putting the spotlight on LB, which was considered the next most vulnerable. • Investor confidence was further eroded when Lehman announced its first-ever loss of $2.8 billion for its second quarter of 2008. At this time, the SEC and the Federal Reserve Bank of New York sent personnel to take up residence on-site to monitor LB’s liquidity. • In fact, LB had masked approximately $50 billion in leverage in the first and second quarters of 2008, so their condition was worse than disclosed. Although LB raised $6 billion of new capital on June 12, 2008, “[U.S.] Treasury Secretary Henry M. Paulson, Jr., privately told [LB CEO] Fuld that if Lehman was forced to report further losses in the third quarter without having a buyer or a definitive survival plan in place, Lehman’s existence would be in jeopardy. On September 10, 2008 Lehman announced that it was projecting a $3.9 billion loss for the third quarter of 2008.”8 • On September 15, 2008, LB’s bankruptcy filing proved Paulson to be correct. The Repo 105 Mechanism and Impact There are three kinds of repo transactions: (1) ordinary, (2) Repo 105, and (3) Repo 108. All three are illustrated along with their impact on the balance sheet and leverage ratio in volume 3 of the Examiner’s Report.9 Most investment banks used ordinary repo transactions to borrow funds using securities as collateral, which they shortly repaid for a 2% fee (interest charge), or “haircut” as it became known. Because the cash received as well as the assets used as collateral and the liability for repurchase are all shown on the balance sheet, it and the leverage ratios are accurately stated.10 Schematically, an ordinary repo transaction sequence can be represented as follows:11 A Repo 105 transaction sequence is different in that prior to the reporting date, (1) the initial transaction is treated as a sale, not a borrowing; (2) the cash received is used to pay off liabilities; and then, after the reporting date; (3) LB borrows funds elsewhere to repurchase the securities sold including a 5% interest charge.12 The overall impact is to reduce the assets and the liabilities on the balance sheet at the reporting date, thus reducing the leverage ratio because the numerator and the denominator of that ratio are reduced by the same amount. The balance sheet and leverage impacts of ordinary repo transactions as well as Repo 105 or 108 transactions are shown in the following sequence of illustrations.13,14,15,16,17 Balance Sheet and Leverage Impacts of Lehman Repo Transactions In order to make the initial sale transaction credible, LB needed a letter from a law firm specifying that it constituted a “true sale.” Interestingly, LB could not obtain such an opinion under U.S. law from U.S. lawyers, but Lehman Brothers International (Europe) (LBIE), based in London, did obtain one from Linklaters, a U.K. firm.18 Consequently, when Repo 105 and Repo 108 transactions were needed, they were done via transfers to and from LBIE in London. Repo 105 transactions were used with highly liquid securities, whereas Repo 108 transactions involved nonliquid or equity securities. To make sure these transactions went according to protocol, LB created an Accounting Policy Manual Repo 105 and 108 to guide their personnel.19 LB employed ordinary repo transactions as well as Repo 105 and Repo 108 transactions. The interest charges or fees involved were 2%, 5%, and 8%, respectively. The higher interest rate charges on the Repo 105 and 108 transactions were to compensate for their higher level of risk. But, because ordinary repo transactions could have been used to raise cash20 at a cost of 2%, it has been argued that LB used the higher-cost Repo 105 and 108 transactions only because they provided a way to man- age LB’s balance sheet and leverage ratio. This was confirmed by LB employees who commented as follows: “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.”21 Other former Lehman employees characterized Repo 105 transactions as an “accounting gimmick” and a “lazy way of managing the balance sheet.”22 When queried about meeting internal leverage targets for the second quarter, an employee responded by email saying: “very] close … any- thing that moves is getting 105’d.”23 The reduction in leverage ratios achieved through the use of Repo 105 and 108 trans- actions are shown below:24 According to the Bankruptcy Examiner, E&Y noted that LB’s threshold for deter- mining material items requiring reopening a closed balance sheet for correction was “any item individually, or in the aggregate, that moves net leverage by 0.1 or more (typically $1.8 billion).”25 Consequently, the usage of Repo 105 transactions noted previously resulted in changes that were many times greater than LB’s standard of materiality, which should have been a red-flag indicator to management and the auditors. Ratings agencies, on whose ratings LB’s credibility with lenders depended, were queried as to what they knew of the Repo 105 usage and materiality of the impact involved. According to the Examiner’s Report, Eileen Fahey, an analyst at Fitch, said that she had never heard of repo trans- actions being accounted for as true sales on the basis of a true sale opin- ion letter or repo transactions known as Repo 105 transactions. Fahey stated that a transfer of $40 billion or $50 billion of securities inventory— regardless of the liquidity of that inventory—from Lehman’s balance sheet at quarter-end would be “material” in Fitch’s view, and upon having a standard Repo 105 transaction described, Fahey remarked that such a transaction “sounded like fraud.”26 Fahey likened this “manipulation” to an investment bank telling regulators that it did not own any mortgage-backed securities when, in fact, it owned them but had temporarily transferred them to a counter- party and was obligated to repurchase them shortly thereafter.27 (This was similar to the usage Enron made with its special purpose entities.) The timing of the use of Repo 105 trans- actions corroborates that the intention was to manipulate LB’s end-of-quarter balance sheets, as is shown in the following graph.28 At the end of each quarter, LB’s assets are significantly higher than at the end of the two previous months. Thus, as a result of these transactions, LB’s end-of-quarter balance sheet shows significantly less assets than would have been reported at any other time during the quarter. LB’s Accounting Analysis LB’s Repo 105 transactions were under- taken under paragraph 9 of the FASB’s Statement of Financial Accounting Standards (SFAS) 140, which reads as follows: Accounting for Transfers and Servicing of Financial Assets A transfer of financial assets (or all or a portion of a financial asset) in which the transferor surrenders control over those financial assets shall be accounted for as a sale to the extent that consideration other than beneficial interests in the transferred assets is received in exchange. The transferor has surrendered control over transferred assets if and only if all of the following conditions are met: a. The transferred assets have been isolated from the transferor—put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership (paragraphs 27 and 28). b. Each transferee (or, if the transferee is a qualifying special purpose entity (para- graph 35), each holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both constrains the transferee (or holder) from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor (paragraphs 29–34). c. The transferor does not maintain effective control over the transferred assets through either (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity (paragraphs 47–49) or (2) the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call (paragraphs 50–54).29 SFAS 140 comments further in paragraph 218 that control over the assets transferred is maintained (thus breaking condition b above) if repurchase arrangements cover as much as 98% collateralization or as little as 102% overcollateralization. LB interpreted this to mean that because the “haircut” or fee charged in Repo 105 transactions was 5% and therefore greater than the 2% col- lateralization limit, control could be considered to have been surrendered, thus allowing the transfer to be considered a sale. Essentially, based on the percentages, LB took the position that they did not have the funds available to fund substantially all of the repurchase cost.30 To further bolster the position that the transfer of assets was a sale, LB obtained a letter from a U.K. law firm, Linklaters of London, that the transaction was a “true sale.”31 Such an opinion was possible under U.K. law but not under U.S. law, but the opinion was addressed to LBIE, thus necessitating transfers to LBIE so that the trans- actions would qualify as sales under U.K. law. LB, however, did not observe this need for transfer entirely.32 According to the Examiner, LB had this treatment as a sale vetted by outside auditors (E&Y) and lawyers.33 However, on May 16, 2008, Matthew Lee, former LB senior vice president, Finance Division, who was in charge of Global Balance Sheet and Legal Entity Accounting, sent a whistleblower letter to senior LB management expressing concerns about possible LB Ethics Code violations34 about the balance sheet irregularities related to the $50 billion in Repo 105 transactions then under way. According to the examiner, Lee’s letter contained the following six allegations: (1) on the last day of each month, Lehman’s books and records contained approximately $5 billion of net assets in excess of what was managed on the last day of the month, thereby suggesting that the firm’s senior management was not in control of its assets to be able to present full, fair, and accurate financial statements to the public; (2) Lehman had “tens of billions of dollars of unsubstantiated balances, which may or may not be ‘bad’ or non-performing assets or real liabilities”; (3) Lehman had tens of billions of dollars of illiquid inventory and did not value its inventory in a “fully realistic or reasonable” way; (4) given Lehman’s rapid growth and increased number of accounts and entities, it had not invested sufficiently in financial systems and personnel to cope with the balance sheet; (5) the India Finance office lacked sufficient knowledgeable management, resulting in the real possibility of potential misstatements of material facts being distributed by that office; and (6) certain senior level audit personnel were not qualified to “properly exercise the audit functions they are entrusted to manage.”35 Lee was interviewed by E&Y representatives about his concerns on June 12, 2008.36 E&Y’s Reaction E&Y faced questions from the business press and their clients as soon as the Examiner’s Report was made public. In response, a letter was quickly issued to clients, which apparently found its way into the public domain by being published on the Web. That letter was originally published with- out the opening and closing paragraphs by Francine McKenna37 on March 20, 2010, at http://www.retheauditors.com. E&Y’s let- ter, which is shown below,38 was published in its entirety on March 23, 2010, on the Contrarian Pundit website at http://www.contrarianpundit.com. ERNST & YOUNG 23 March 2010 To: Recently, there have been extensive media reports about the release of the Bankruptcy Examiner’s Report relating to the September 2008 bankruptcy of Lehman Brothers. As you may have read, Ernst & Young was Lehman Brothers’ independent auditors. The concept of an examiner’s report is a feature of US bankruptcy law. It does not represent the views of a court or a regulatory body, nor is the Report the result of a legal process. Instead, an examiner’s report is intended to identify potential claims that, if pursued, may result in a recovery for the bankrupt company or its creditors. EY is confident we will prevail should any of the potential claims identified against us be pursued. We wanted to provide you with EY’s perspective on some of the potential claims in the Examiner’s Report. We also wanted to address certain media coverage and commentary on the Examiner’s Report that has at times been inaccurate, if not misleading. A few key points are set out below. General Comments ■ EY’s last audit was for the year ended November 30, 2007. Our opinion stated that Lehman’s financial statements for 2007 were fairly presented in accordance with US GAAP, and we remain of that view. We reviewed but did not audit the interim periods for Lehman’s first and second quarters of fiscal 2008. ■ Lehman’s bankruptcy was the result of a series of unprecedented adverse events in the financial markets. The months leading up to Lehman’s bankruptcy were among the most turbulent periods in our economic history. Lehman’s bankruptcy was caused by a collapse in its liquidity, which was in turn caused by declining asset values and loss of market confidence in Lehman. It was not caused by accounting issues or disclosure issues. ■ The Examiner identified no potential claims that the assets and liabilities reported on Lehman’s financial statements (approximately $691 billion and $669 billion, respectively, at November 30, 2007) were improperly valued or accounted for incorrectly. Accounting and Disclosure Issues Relating to Repo 105 Transactions ■ There has been significant media attention about potential claims identified by the Examiner related to what Lehman referred to as “Repo 105” transactions. What has not been reported in the media is that the Examiner did not challenge Lehman’s accounting for its Repo 105 transactions. ■ As recognized by the Examiner, all investment banks used repo transactions extensively to fund their operations on a daily basis; these banks all operated in a high-risk, high-leverage business model. Most repo transactions are accounted for as financings; some (the Repo 105 transactions) are accounted for as sales if they meet the requirements of SFAS 140. ■ The Repo 105 transactions involved the sale by Lehman of high quality liquid assets (generally government-backed securities), in return for which Lehman received cash. The media reports that these were “sham transactions” designed to off-load Lehman’s “bad assets” are inaccurate. ■ Because effective control of the securities was surrendered to the counterparty in the Repo 105 arrangements, the accounting literature (SFAS 140) required Lehman to account for Repo 105 transactions as sales rather than financings. ■ The potential claims against EY arise solely from the Examiner’s conclusion that these transactions ($38.6 billion at November 30, 2007) should have been specifically disclosed in the footnotes to Lehman’s financial statements, and that Lehman should have disclosed in its MD&A the impact these transactions would have had on its leverage ratios if they had been recorded as financing transactions. ■ While no specific disclosures around Repo 105 transactions were reflected in Lehman’s financial statement footnotes, the 2007 audited financial statements were presented in accordance with US GAAP, and clearly portrayed Lehman as a leveraged entity operating in a risky and volatile industry. Lehman’s 2007 audited financial statements included footnote disclosure of off balance sheet commitments of almost $1 trillion. ■ Lehman’s leverage ratios are not a GAAP financial measure; they were included in Lehman’s MD&A, not its audited financial statements. Lehman concluded no further MD&A disclosures were required; EY did not take exception to that judgment. ■ If the Repo 105 transactions were treated as if they were on the balance sheet for leverage ratio purposes, as the Examiner suggests, Lehman’s reported gross leverage would have been 32.4 instead of 30.7 at November 30, 2007. Also, contrary to media reports, the decline in Lehman’s reported leverage from its first to second quarters of 2008 was not a result of an increased use of Repo 105 transactions. Lehman’s Repo 105 transaction volumes were comparable at the end of its first and second quarters. Handling of the Whistleblower’s Issues ■ The media has inaccurately reported that EY concealed a May 2008 whistleblower letter from Lehman’s Audit Committee. The whistleblower letter, which raised various significant potential concerns about Lehman’s financial controls and reporting but did not mention Repo 105, was directed to Lehman’s management. When we learned of the letter, our lead partner promptly called the Audit Committee Chair; we also insisted that Lehman’s management inform the Securities & Exchange Commission and the Federal Reserve Bank of the letter. EY’s lead partner discussed the whistleblower letter with the Lehman Audit Committee on at least three occasions during June and July 2008. ■ In the investigations that ensued, the writer of the letter did briefly reference Repo 105 transactions in an interview with EY partners. He also confirmed to EY that he was unaware of any material financial reporting errors. Lehman’s senior executives did not advise us of any reservations they had about the company’s Repo 105 transactions. ■ Lehman’s September 2008 bankruptcy prevented EY from completing its assessment of the whistleblower’s allegations. The allegations would have been the subject of significant attention had EY completed its third quarter review and 2008 year-end audit. Should any of the potential claims be pursued, we are confident we will prevail. Thank you for your support in this matter. Please feel free to call me at anytime at With best regards, Lehman’s Risk Management LB was a major player in a field that involved many varieties of risk and had specifically identified that their risk appetite for Repo 105 transactions in July 2006 was “1x leverage … or $17 billion, [and] $5 billion for Repo 108 transactions.”39 Consequently, LB’s internal cap on repo transactions was breached by significant amounts beginning in 2007.40 Recognizing that the levels of $40 billion to 50 billion were unsustainable, LB made efforts to obtain outside financing to be used to cut the level of repo transactions in 2008. Unfortunately, that effort was too little, too late. On September 15, 2008, LB declared bankruptcy. Questions 1. What was the most important reason for the LB failure? 2. What is leverage and why is it so important? 3. Prepare the journal entries for a Repo 105 transaction sequence for $1 million in securities. 4. In your opinion, how large should a Repo 105 transaction be to be considered material and why? 5. Was LB’s interpretation of SFAS 140— Repo 105 transactions could be treated as sales—correct? Provide your reasons. 6. If, as the Examiner’s Report states,41 LB continued to collect the revenue from the securities involved in the Repo 105 transactions, how could LB say that they had given up ownership? 7. An emerging issue Interpretation Bulletin42 accompanying FAS 140 gives examples indicating that Repo 102 transactions would not qualify as sales but that Repo 110 would. Why do you think this Bulletin was issued? See Q&A 140—A Guide to Implementation of Statement 140 on Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities at http://www.fasb.org/cs /ContentServer?c=Document_C& pagename=FASB%2FDocument_C% 2FDocumentPage&cid=1175801856780 (accessed March 27, 2011). 8. Knowing that LB could not obtain a “true sale” opinion from a U.S. lawyer under U.S. law, should LB have tried to obtain the opinion from a U.K. law firm? Why and why not? 9. Do the Repo 105 arrangements constitute fraud? Why and why not? 10. What is the auditor’s responsibility if a fraud is suspected or discovered? What professional standards are most import- ant in such cases and why? 11. If you were the audit partner in charge in the United States, what would you have required be done in regard to the Linklater “true sale” letter? 12. Should consolidated financial statements of a U.S. parent company include (i.e., consolidate) foreign subsidiary accounts prepared on a basis not considered appropriate U.S. GAAP? 13. Would the adoption of IFRS have pre- vented the Repo 105 misrepresentations? 14. What should the following have done on learning of Matthew Lee’s whistleblower’s letter—LB’s management, Board of Directors, and the external auditors, E&Y? 15. Arthur Andersen tried to keep its Enron audit problems quiet, whereas E&Y spoke out in its own defense. Was it a good idea for E&Y to send a letter, such as the one reproduced previously, to their clients? Why and why not? 16. Based on the letter, should E&Y be in the clear of any wrongdoing related to the Repo 105 and 108 transactions and reporting? Provide your reasons for and against. 17. If an auditor explains a problem to the chair of an audit committee, is there any further obligation on the part of the auditor to ensure that the full board has been notified and why? 18. Organizations who use the Enterprise Risk Management (ERM) framework43 should work through the following stages: review on the internal environment, identification of the organization’s risk appetite or objectives, risk identification and measurement, risk assessment, risk response, providing risk information and communications, and risk monitoring. In which of these did LB fail? Who was to blame for the failure? 19. How should the U.S. Bankruptcy Examiner’s Report be regarded—as a neutral set of findings or as a signpost intended to point creditors in the direction of potential recoveries? What are the implications of each? 20. After the Enron and WorldCom fiascos, regulators sought to avoid future misrepresentation by enacting the Sarbanes-Oxley Act (SOX) in 2002. Why did SOX not prevent Lehman’s use of Repo 105 and 108 misrepresentations? Does that mean that SOX is a failure?
than beneficial interests in the transferred assets is received in exchange. The transferor has surrendered control over transferred assets if and only if all of the following conditions are met: a. The transferred assets have been isolated from the transferor—put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership (paragraphs 27 and 28). b. Each transferee (or, if the transferee is a qualifying special purpose entity (para- graph 35), each holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both constrains the transferee (or holder) from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor (paragraphs 29–34). c. The transferor does not maintain effective control over the transferred assets through either (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity (paragraphs 47–49) or (2) the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call (paragraphs 50–54).29 SFAS 140 comments further in paragraph 218 that control over the assets transferred is maintained (thus breaking condition b above) if repurchase arrangements cover as much as 98% collateralization or as little as 102% overcollateralization. LB interpreted this to mean that because the “haircut” or fee charged in Repo 105 transactions was 5% and therefore greater than the 2% col- lateralization limit, control could be considered to have been surrendered, thus allowing the transfer to be considered a sale. Essentially, based on the percentages, LB took the position that they did not have the funds available to fund substantially all of the repurchase cost.30 To further bolster the position that the transfer of assets was a sale, LB obtained a letter from a U.K. law firm, Linklaters of London, that the transaction was a “true sale.”31 Such an opinion was possible under U.K. law but not under U.S. law, but the opinion was addressed to LBIE, thus necessitating transfers to LBIE so that the trans- actions would qualify as sales under U.K. law. LB, however, did not observe this need for transfer entirely.32 According to the Examiner, LB had this treatment as a sale vetted by outside auditors (E&Y) and lawyers.33 However, on May 16, 2008, Matthew Lee, former LB senior vice president, Finance Division, who was in charge of Global Balance Sheet and Legal Entity Accounting, sent a whistleblower letter to senior LB management expressing concerns about possible LB Ethics Code violations34 about the balance sheet irregularities related to the $50 billion in Repo 105 transactions then under way. According to the examiner, Lee’s letter contained the following six allegations: (1) on the last day of each month, Lehman’s books and records contained approximately $5 billion of net assets in excess of what was managed on the last day of the month, thereby suggesting that the firm’s senior management was not in control of its assets to be able to present full, fair, and accurate financial statements to the public; (2) Lehman had “tens of billions of dollars of unsubstantiated balances, which may or may not be ‘bad’ or non-performing assets or real liabilities”; (3) Lehman had tens of billions of dollars of illiquid inventory and did not value its inventory in a “fully realistic or reasonable” way; (4) given Lehman’s rapid growth and increased number of accounts and entities, it had not invested sufficiently in financial systems and personnel to cope with the balance sheet; (5) the India Finance office lacked sufficient knowledgeable management, resulting in the real possibility of potential misstatements of material facts being distributed by that office; and (6) certain senior level audit personnel were not qualified to “properly exercise the audit functions they are entrusted to manage.”35 Lee was interviewed by E&Y representatives about his concerns on June 12, 2008.36 E&Y’s Reaction E&Y faced questions from the business press and their clients as soon as the Examiner’s Report was made public. In response, a letter was quickly issued to clients, which apparently found its way into the public domain by being published on the Web. That letter was originally published with- out the opening and closing paragraphs by Francine McKenna37 on March 20, 2010, at http://www.retheauditors.com. E&Y’s let- ter, which is shown below,38 was published in its entirety on March 23, 2010, on the Contrarian Pundit website at http://www.contrarianpundit.com. ERNST & YOUNG 23 March 2010 To: Recently, there have been extensive media reports about the release of the Bankruptcy Examiner’s Report relating to the September 2008 bankruptcy of Lehman Brothers. As you may have read, Ernst & Young was Lehman Brothers’ independent auditors. The concept of an examiner’s report is a feature of US bankruptcy law. It does not represent the views of a court or a regulatory body, nor is the Report the result of a legal process. Instead, an examiner’s report is intended to identify potential claims that, if pursued, may result in a recovery for the bankrupt company or its creditors. EY is confident we will prevail should any of the potential claims identified against us be pursued. We wanted to provide you with EY’s perspective on some of the potential claims in the Examiner’s Report. We also wanted to address certain media coverage and commentary on the Examiner’s Report that has at times been inaccurate, if not misleading. A few key points are set out below. General Comments ■ EY’s last audit was for the year ended November 30, 2007. Our opinion stated that Lehman’s financial statements for 2007 were fairly presented in accordance with US GAAP, and we remain of that view. We reviewed but did not audit the interim periods for Lehman’s first and second quarters of fiscal 2008. ■ Lehman’s bankruptcy was the result of a series of unprecedented adverse events in the financial markets. The months leading up to Lehman’s bankruptcy were among the most turbulent periods in our economic history. Lehman’s bankruptcy was caused by a collapse in its liquidity, which was in turn caused by declining asset values and loss of market confidence in Lehman. It was not caused by accounting issues or disclosure issues. ■ The Examiner identified no potential claims that the assets and liabilities reported on Lehman’s financial statements (approximately $691 billion and $669 billion, respectively, at November 30, 2007) were improperly valued or accounted for incorrectly. Accounting and Disclosure Issues Relating to Repo 105 Transactions ■ There has been significant media attention about potential claims identified by the Examiner related to what Lehman referred to as “Repo 105” transactions. What has not been reported in the media is that the Examiner did not challenge Lehman’s accounting for its Repo 105 transactions. ■ As recognized by the Examiner, all investment banks used repo transactions extensively to fund their operations on a daily basis; these banks all operated in a high-risk, high-leverage business model. Most repo transactions are accounted for as financings; some (the Repo 105 transactions) are accounted for as sales if they meet the requirements of SFAS 140. ■ The Repo 105 transactions involved the sale by Lehman of high quality liquid assets (generally government-backed securities), in return for which Lehman received cash. The media reports that these were “sham transactions” designed to off-load Lehman’s “bad assets” are inaccurate. ■ Because effective control of the securities was surrendered to the counterparty in the Repo 105 arrangements, the accounting literature (SFAS 140) required Lehman to account for Repo 105 transactions as sales rather than financings. ■ The potential claims against EY arise solely from the Examiner’s conclusion that these transactions ($38.6 billion at November 30, 2007) should have been specifically disclosed in the footnotes to Lehman’s financial statements, and that Lehman should have disclosed in its MD&A the impact these transactions would have had on its leverage ratios if they had been recorded as financing transactions. ■ While no specific disclosures around Repo 105 transactions were reflected in Lehman’s financial statement footnotes, the 2007 audited financial statements were presented in accordance with US GAAP, and clearly portrayed Lehman as a leveraged entity operating in a risky and volatile industry. Lehman’s 2007 audited financial statements included footnote disclosure of off balance sheet commitments of almost $1 trillion. ■ Lehman’s leverage ratios are not a GAAP financial measure; they were included in Lehman’s MD&A, not its audited financial statements. Lehman concluded no further MD&A disclosures were required; EY did not take exception to that judgment. ■ If the Repo 105 transactions were treated as if they were on the balance sheet for leverage ratio purposes, as the Examiner suggests, Lehman’s reported gross leverage would have been 32.4 instead of 30.7 at November 30, 2007. Also, contrary to media reports, the decline in Lehman’s reported leverage from its first to second quarters of 2008 was not a result of an increased use of Repo 105 transactions. Lehman’s Repo 105 transaction volumes were comparable at the end of its first and second quarters. Handling of the Whistleblower’s Issues ■ The media has inaccurately reported that EY concealed a May 2008 whistleblower letter from Lehman’s Audit Committee. The whistleblower letter, which raised various significant potential concerns about Lehman’s financial controls and reporting but did not mention Repo 105, was directed to Lehman’s management. When we learned of the letter, our lead partner promptly called the Audit Committee Chair; we also insisted that Lehman’s management inform the Securities & Exchange Commission and the Federal Reserve Bank of the letter. EY’s lead partner discussed the whistleblower letter with the Lehman Audit Committee on at least three occasions during June and July 2008. ■ In the investigations that ensued, the writer of the letter did briefly reference Repo 105 transactions in an interview with EY partners. He also confirmed to EY that he was unaware of any material financial reporting errors. Lehman’s senior executives did not advise us of any reservations they had about the company’s Repo 105 transactions. ■ Lehman’s September 2008 bankruptcy prevented EY from completing its assessment of the whistleblower’s allegations. The allegations would have been the subject of significant attention had EY completed its third quarter review and 2008 year-end audit. Should any of the potential claims be pursued, we are confident we will prevail. Thank you for your support in this matter. Please feel free to call me at anytime at With best regards, Lehman’s Risk Management LB was a major player in a field that involved many varieties of risk and had specifically identified that their risk appetite for Repo 105 transactions in July 2006 was “1x leverage … or $17 billion, [and] $5 billion for Repo 108 transactions.”39 Consequently, LB’s internal cap on repo transactions was breached by significant amounts beginning in 2007.40 Recognizing that the levels of $40 billion to 50 billion were unsustainable, LB made efforts to obtain outside financing to be used to cut the level of repo transactions in 2008. Unfortunately, that effort was too little, too late. On September 15, 2008, LB declared bankruptcy. Questions 1. What was the most important reason for the LB failure? 2. What is leverage and why is it so important? 3. Prepare the journal entries for a Repo 105 transaction sequence for $1 million in securities. 4. In your opinion, how large should a Repo 105 transaction be to be considered material and why? 5. Was LB’s interpretation of SFAS 140— Repo 105 transactions could be treated as sales—correct? Provide your reasons. 6. If, as the Examiner’s Report states,41 LB continued to collect the revenue from the securities involved in the Repo 105 transactions, how could LB say that they had given up ownership? 7. An emerging issue Interpretation Bulletin42 accompanying FAS 140 gives examples indicating that Repo 102 transactions would not qualify as sales but that Repo 110 would. Why do you think this Bulletin was issued? See Q&A 140—A Guide to Implementation of Statement 140 on Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities at http://www.fasb.org/cs /ContentServer?c=Document_C& pagename=FASB%2FDocument_C% 2FDocumentPage&cid=1175801856780 (accessed March 27, 2011). 8. Knowing that LB could not obtain a “true sale” opinion from a U.S. lawyer under U.S. law, should LB have tried to obtain the opinion from a U.K. law firm? Why and why not? 9. Do the Repo 105 arrangements constitute fraud? Why and why not? 10. What is the auditor’s responsibility if a fraud is suspected or discovered? What professional standards are most import- ant in such cases and why? 11. If you were the audit partner in charge in the United States, what would you have required be done in regard to the Linklater “true sale” letter? 12. Should consolidated financial statements of a U.S. parent company include (i.e., consolidate) foreign subsidiary accounts prepared on a basis not considered appropriate U.S. GAAP? 13. Would the adoption of IFRS have pre- vented the Repo 105 misrepresentations? 14. What should the following have done on learning of Matthew Lee’s whistleblower’s letter—LB’s management, Board of Directors, and the external auditors, E&Y? 15. Arthur Andersen tried to keep its Enron audit problems quiet, whereas E&Y spoke out in its own defense. Was it a good idea for E&Y to send a letter, such as the one reproduced previously, to their clients? Why and why not? 16. Based on the letter, should E&Y be in the clear of any wrongdoing related to the Repo 105 and 108 transactions and reporting? Provide your reasons for and against. 17. If an auditor explains a problem to the chair of an audit committee, is there any further obligation on the part of the auditor to ensure that the full board has been notified and why? 18. Organizations who use the Enterprise Risk Management (ERM) framework43 should work through the following stages: review on the internal environment, identification of the organization’s risk appetite or objectives, risk identification and measurement, risk assessment, risk response, providing risk information and communications, and risk monitoring. In which of these did LB fail? Who was to blame for the failure? 19. How should the U.S. Bankruptcy Examiner’s Report be regarded—as a neutral set of findings or as a signpost intended to point creditors in the direction of potential recoveries? What are the implications of each? 20. After the Enron and WorldCom fiascos, regulators sought to avoid future misrepresentation by enacting the Sarbanes-Oxley Act (SOX) in 2002. Why did SOX not prevent Lehman’s use of Repo 105 and 108 misrepresentations? Does that mean that SOX is a failure?

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> Short selling occurs when a seller borrows shares from a brokerage house and then sells those shares. At a later date, the seller buys the shares and delivers them to the brokerage house. If the price falls during the shorting period, then the short sell

> Allegations of serious impropriety and perhaps illegality surrounding Goldman Sachs’s contribution to the 2008 financial crisis have been well publicized. Allegations included trading for their own benefit directly against the interests of its clients (e

> In 2007, Danske Bank, Denmark’s largest bank, bought Finland’s Sampo Bank, which had a tiny branch office in Tallinn, Estonia. From 2007 until 2015, €200 billion of suspicious money flowed through the Tallinn branch, approximately ten times the gross dom

> Headquartered in London, Barclays is an investment and financial services bank with operations throughout the world. In December 2015, Barclays hired Jes Staley as CEO. Previously, Staley had been a 30-year veteran with JP Morgan in its investment bankin

> Assume that you have just been placed in charge of the Claims Investigation Unit of a small insurance company based in Minneapolis. Your personnel department has provided the following details on your personnel. However, because your insurance company is

> On May 17, 2010, a federal jury in New York decided that Novartis, a Swiss- headquartered drug company, was guilty of discriminating against women and should pay the twelve women plaintiffs who testified in the trial $3.37 million in compensatory damages

> In October 2008, Jill Hubley, a former senior strategist in the Dell Americas human resource group, a Dell Inc. division located in Texas, filed a lawsuit against the world’s second-largest maker of personal computers. She alleged that Dell had systemati

> The bottled water industry is lucrative and expanding, especially in the United States, where it has been growing steadily since 2010, reaching 11 billion gallons in 2014.1 This upward trend is likely to continue as health conscious consumers opt for wat

> In March 1994, six African Americans employed at Texaco Inc.1 filed a class action lawsuit on behalf of 1,400 current and former African American employees. They alleged that Texaco had systematically discriminated against them in terms of promotions and

> In essence, cruise ships are floating small towns. They carry thousands of passengers on ships that often stand thirteen decks tall. The cruise ship industry that travels from Washington State to Alaska contributes billions of dollars into the economies

> Lynn James was in the vortex of a set of crises. Lynn, an entrepreneur and the president, CEO, and 75% owner of Wind River Energy Inc., was one week away from closing a deal to secure much-needed financing for existing and new operations via an independe

> Society is quite concerned about the level of greenhouse gases that are being emitted by various businesses. Many firms are responding by becoming more candid about the effects that their operations are having on the planet. Some are reporting this infor

> According to the Greenpeace Web page, On 16 February last year (1995), Greenpeace learned that the U.K. government had granted permission for Shell Oil to dump a huge, heavily contaminated oil installation, the 14,500 tonne Brent Spar, into the North Atl

> Shortly after midnight on March 24, 1989, the oil tanker Exxon Valdez ran aground on Bligh Reef in Alaska’s Prince William Sound, spilling 11 million gallons of crude oil. Ecological systems were threatened, and the lives and livelihood of area residents

> A two-month-old child was accidentally given a drug overdose at a Texas hospital despite the fact that seven health care professionals reviewed the prescription order before the drug was given to the baby. The following excerpts from a New York Times art

> In 2000,1 Toyota had a strong and growing reputation for quality. Its engineering excellence was peaking with the worldwide introduction of the first successful commercially available hybrid, the Prius, in 2001. But by 2010, over 10 million individual re

> BP has had a record of mishaps affecting life, the environment, and the property of the company and other stakeholders. On October 26, 2010, the Public Broadcasting System (PBS) in the United States aired a fifty-three-minute TV documentary titled The Sp

> In its own Internal Investigation,1 released on September 8, 2010, BP provided its analysis of why the Deepwater Horizon oil rig exploded, precipitating one of the largest oil spills the world has ever seen. Eleven oil rig crew members were killed and se

> On July 16, 2008, it was announced that several Chinese producers of baby milk powder had been adding melamine, a chemical usually used in countertops, to increase the “richness” of their milk powder and to increase the protein count. Shockingly, the mel

> South Africa and the drug companies have changed forever,” say David Pilling and Nicol degli Innocenti.1 South Africa is to the drug pharmaceutical industry what Vietnam was to the U.S. military. Nothing will be quite the same again. That, at least, is t

> Harold Johns found himself in jail in Germany. He was a vice president of Baranca Industries Inc., a U.S. firm that constructs and installs factory equipment. Unfortunately, he was the highest-ranking Baranca official in Germany while he was in Germany o

> Walt1 Pavlo joined MCI in 1992 and rapidly became second in command at the company’s finance or long-distance collections unit, as is documented in the ethics case “Manipulation of MCI’s Allowance for Doubtful Accounts” in Chapter 5. Walt left MCI in 199

> A cryptocurrency, such as a Bitcoin, is a digital commodity that can be used in financial transactions. Unlike the U.S. or Canadian dollar, cryptocurrencies have no government backing. It is worth only what another person will pay for it. A crypto- curre

> Harry Potter is known to tens of millions of readers as a figment of J. K. Rowling’s imagination. One of the good guys, he is a gifted apprentice magician and budding wizard. Harry and his pals have bested evil wizards in tale after tale and many movies,

> Assume that you are a professional accountant who is CFO of a medium-sized manufacturing company that plans to do the following: • Misrepresent products that come from environmentally irresponsible sources as environmentally friendly. • Bribe officials o

> In 1984, twenty-three-year-old Wanda Liczyk received her designation as a chartered accountant. The following year, she left Coopers & Lybrand (now part of PricewaterhouseCoopers) to become a budget analyst for the City of North York. By 1991, she had be

> Martin Pilzmaker was a young, aggressive lawyer from Montreal who was invited in 1985 to join the law firm Lang Michener in Toronto. It was expected that his immigration law practice “could enrich the (firm’s) coffers by $1 million a year catering to the

> Livent, once the world’s premier live entertainment companies, was sold in 1998 to buyers who soon found that the value they had paid for was an illusion. Livent had thrilled audiences with performances of Phantom of the Opera, Ragtime, Kiss of the Spide

> On July 1, 2013, Scott London, a former KPMG audit partner, pleaded guilty to securities fraud. He had been passing information to his friend, Bryan Shaw, over a two-year period ending in 2012. He told his friend about earnings announcements by Herbalife

> Google is the world’s largest search engine. In 2009, it had approximately 400 million Web users, of which 200 million are located in the United States. Its global revenue from advertising amounted to $23.6 billion. China is the world’s third-largest eco

> The Sarbanes-Oxley Act of 2002 created the Public Company Accounting Oversight Board (PCAOB). The PCAOB reports to the U.S. Securities and Exchange Commission (SEC). One of the PCAOB’s responsibilities is to audit the accounting firms through practice in

> At the firm, we’ve got a new way of looking at tax issues. It’s called ‘risk management,’ and, in your case, John, it means that we can be more aggressive than in the past. In the past, when there was an issue open to interpretation, we advised you to ad

> Sophia and Maya were having a quiet afterwork drink at the Purple Pheasant around the corner from their office. Both are professional accountants in their late twenties and were talking about their futures in public accounting. “I want to concentrate on

> Before 2002, accounting firms would provide multiple services to the same firm. Hired by the shareholders, they would audit the financial statements that were prepared by management while also pro- viding consulting services to those same managers. Some

> As Bill Adams packed his briefcase on Friday, March 15, he could never remember being so glad to see a weekend. As a senior tax manager with a major accounting firm, Hay & Hay, on the fast track for partnership, he was worried that the events of the week

> The Italian federal corporate tax system has an official, legal tax structure and tax rates just as the U.S. system does. However, all similarity between the two systems ends there. The Italian tax authorities assume that no Italian corporation would eve

> The leak of the Panama Papers in 2016 revealed the existence of hundreds of thou- sands of offshore shell companies used by the world’s wealthy to avoid paying taxes, raised the public’s awareness of advantaged treatment of the wealthy, and led to renewe

> Multinationals are headquartered in one country but have operations worldwide. Generally, each multinational pays income taxes in the jurisdiction in which it generates its profits. For example, a German company with operations in the United States and S

> Multidisciplinary practices are probably an inevitable development. Clients want “one- stop shopping,” at a professional firm where they can go for all their needs, and where the partner responsible for their work can keep them briefed on new services th

> Stan Jones was an investor who had recently lost money on his investment in Fine Line Hotels, Inc., and he was anxious to discuss the problem with Janet Todd, a qualified accountant who was his friend and occasional advisor. “How can they justify this, J

> In June 2002, Martha Stewart began to wrestle with allegations that she had improperly used inside information to sell a stock investment to an unsuspecting investing public. That was when her personal friend Sam Waksal was defending himself against SEC

> It’s legal, but is it ethical? For years, a nationally known doughnut chain only sold sugary drinks at its retail outlets on a prominent university campus. Sugar consumption is known to contribute to diseases such as heart disease, tooth decay, diabetes,

> At one time, a well-known communications firm measured all managers at all levels on return on net assets (RONA). Write a report to the firm’s CFO indicating why you believe that the use of a single performance measure for managers at all levels will not

> Consider the following jobs. Identify a nonfinancial performance measure that you would recommend. a. Flight attendant b. Hotel parking valet c. Sports venue ticket-taker d. Bank teller e. Restaurant wait-staff

> Kipling’s Taco Shop was the only establishment serving tacos and other quick bites in a small college town for more than 20 years. Service was limited to the walk-up window, with no delivery and no inside seating. The owner of Kipling’s focused on well-m

> Refer to the information in Exercise 17-43. Required Write a memo to the managers at Crescent Call Centers recommending which variances they should investigate this period along with your reasons. Exercise 17-43: The standard direct labor cost per call

> Refer to the information in Exercise 17-41. Required Write a memo to the senior manager of Oakman Accounting Partners recommending which variances from the past year the firm should investigate along with your reasons. Exercise 17-41:

> Gerisch Consolidated sold 21,150 units of its only product last period. It had budgeted sales of 24,300 units based on an expected market share of 25 percent. The sales activity variance for the period is $340,200 U. The industry volume variance was $194

> Refer to the information in Exercise 17-22. Assume that Fischer Fabrication had no beginning finished goods inventory and only produced one product. A count of inventory showed that 4,400 units remained in the warehouse. Required a. Assume Fischer writes

> The River Plant of Carlisle, Inc. produces a particular metal fixture used in aerospace and maritime industries. The following information is available for the last operating month: ∙ The plant produced and sold 27,600 fixtures for $72

> The (partial) cost sheet for the single product manufactured at Briarcliff Corporation follows: The master budget level of production is 45,000 direct labor-hours, which is also the production volume used to compute the fixed overhead application rate. O

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