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The Importance Of Financial Leverage Finance Essay

The purpose of this dissertation is to address questions that have arisen from the observation that the use of off-balance transactions in the last decades has risen rapidly and some financial institutions in their use on off-balance sheet financing seem to have deviated from its legitimate purposes. Lehman Brothers’ Repo 105 transactions are the blazing example of the author’s observations. This paper will examine aggressive and misleading financial reporting practices. The case of Lehman gave the author an opportunity to discuss both financial and legal concepts in equal amounts.

The topic is relevant because the lack of transparency in the financial reporting creates obstacles for professional and unsophisticated investors. Importance of disclosures is important now more than ever. Materiality of the Repo 105 transaction had the ability to impact the decisions of prudent investors. But what is the most troubling that even after Sarbanes-Oxley act passage and corporate governance scandals such as Enron, the history repeats itself. The Lehman bankruptcy produced a worst financial crisis and economic downturn in 70 years. It’s been 4 years since the collapse of Lehman brothers, and no one has been charge for misleading investors.

The author thinks that there are lessons to be learned from

Dissertation consists of 4 sections. We start with a short background for Lehman Brothers and the role the property market boom has played in its rise and fall. In the first section we introduce the reader to the world of off-balance finance and look at the role it is playing in the modern financial reporting. Off-balance finance is looked upon differently from the regulators and users point of view. In the second section we briefly discuss ordinary repurchase agreements and analyse the anatomy of the Repo 105 transactions in detail. It is argued that Repo 105 has been designed to reverse engineer the leverage ratio. In the second section we discuss the importance of financial leverage in financial markets and in Lehman balance sheets. Next, we discuss the role mark-to-market accounting and the issues an investment bank faces when deleveraging. For comprehension purposes the Repo 105 effect on the balance sheet will be illustrated step by step.

After getting all the pieces of the puzzle together we move to discussing legal technicalities that enabled the Repo 105 transaction to happen. In the fifth section we will stress the importance of disclosures and highlight the problems when defining materiality. We discuss the anti-fraud provisions of SEC act, which in the author’s opinion, were violated. We examine Generally Accepted Accounting Principles, Sarbanes Oxley Act, Securities Exchange Act of 1933 & 34 as well as SEC rule 10b-5 will be examined. In the sixth section we will touch upon corporate governance issues. Then to test the author’s ideas we will look at legal opinion on litigation between former Lehman Brothers executives and misled investors. Finally

In conclusion

Background for Lehman Brothers

2007 was a record breaking year for Lehman. A reason for this success – bricks and mortar. Both President Bill Clinton and George W. Bush championed home ownership. American house prices were rising steadily since 1950s, but rocketed after 2001 when interest rates were slashed. The boom was fuelled by loans with tempting introductory rates being offered to risky clients. The real money came to Wall Street came not from selling individual mortgages to homeowners but from selling bundles of these loans among themselves and other institutional investors. These bundles were labelled as low risk assets by the banks. By 2007 Lehman was the largest underwriter of real estate loan in U.S. A general view in the marketplace was that sophistication of 21 century financial markets has enabled to eradicate risk.

That false sense of confidence led Lehman to borrow heavily to invest in real estate. It borrowed $44 for every $1 it had in the bank to finance their investment deals. By 2007 it was investing $60 billion dollars in commercial property, hotels, shopping centers and residential developments around the world. While leverage multiplies profits when the prices go up, it also multiply losses when prices fall. And that is what happened in 2007. A growing number of people who have been “seduced” with cheap introductory mortgage rates could not keep up with the payments when the rates increased. Repositions rocketed and house prices slumped. The subprime crisis exploded on the world.

It was the decision to invest in commercial developments that was a tipping point. The bank invested aggressively at the property market at its peak. But could not get out before the crash. In essence Lehman … sell the syndicated loans globally. And when you can’t sell it and share the risk it become a led weight on the balance sheet over time. Lehman executives manipulated balance sheets and financial reports when investors began losing confidence in the firm and competitors closed in.

On September 15, 2008, Lehman Brothers, a global financial services firm and the fourth largest investment bank in the world declared bankruptcy sparkling chaos in financial markets and playing a major role in the global financial crisis. Twenty six thousand employees lost their jobs, millions of investors lost all or a part of their money. It has been called the largest bankruptcy in history. Larger than General Motors, Washington Mutual, Enron and Worldcom combined.

The federal bankruptcy court appointed Anton Valukas, a former United States attorney to conduct an investigation to determine what happened. Included in the 9 volume, 2200 page report was the finding that there enough evidence for a prosecutor to bring a case against top Lehman officials and the company’s accounting firm Ernst & Young for misleading government regulators and investors.

But what was most apparent and damaging was Lehman’s misuse of an accounting trick called Repo 105. Lehman would move approximately $50 billion of assets from the U.S. to the U.K. just before they printed their quarterly financial statements. And about a week after the financial statements had been distributed to the public, the $50 billion dollars would reappear back on the books in the U.S. By temporarily removing this money from its ledgers it looked like it though Lehman was reducing its dependency on borrowed money and was paying down its debt. Lehman never told investors or regulators about this tactic. It truly was the highest form of deception.

Off-balance sheet finance

‘Off-balance sheet’ transactions can be difficult to define, and this poses the first problem in discussing the object. The term implies that certain things belong on the balance sheet and that those which escape the net are deviations from this form. The practical effect of off-balance sheet transactions is that the financial statements do not fully represent the underlying activities of the reporting entity. The items in question may be excluded from the balance sheet altogether on the basis that they do not represent assets and liabilities. Examples include operating lease commitments and certain contingent liabilities.

Off-balance sheet financing is a form of borrowing in which the obligation is not recorded on the borrower's financial statements. Off-balance sheet financing can employ several different techniques, which include development arrangements, leasing, product financing arrangements or recourse sales of receivables. Off-balance sheet financing will raise concerns regarding the lenders' overall risk, but it improves their debt to equity ratio, which enhances their borrowing capacity. As a result, loans are often easy to arrange and are given lower interest rates because of the improved debt structure on the balance sheet. For example, loans issued by a bank are typically kept on the bank's books. If those loans are securitized and sold off as investments, the securitized debt is not kept on the bank's books.

Depending on their roles, different people react differently to the term ‘off-balance sheet finance’. To an accounting standard setter, or other financial regulator, the expression carries the connotation of devious accounting, intended to mislead the reader of financial statements. Off-balance sheet transactions are those which are designed to allow an entity to avoid reflecting certain types of its activities in its financial statements. The term is therefore pejorative and carries the slightly self-righteous inference that those who indulge in such transactions are up to no good and need to be stopped.

It is argued by Mizen (2008) that off-balance-sheet vehicles had emerged as a known and tolerated way for banks to get round the capital adequacy required by the Basle I regime for bank regulation: by transferring debt and risk to a wholly-owned subsidiary, the beneficial owners of banks were able to continue to take on risk. [1] . ‘Hiding’ the debt in special purposes vehicles is a fascinating topic, which deserves a separate paper, will not be considered in this dissertation.

Off-balance financing allows not showing assets and liabilities on the balance sheet. However, it is still a requirement to disclose the transactions in financial statements’ footnotes. But key financial ratios and, most importantly, regulatory capital is calculated using balance sheet positions alone. Because off-balance sheet liabilities are not included in the financial statements, banks can take positions almost impossible for the regulator to assess. It can be argued that nowadays, the footnotes are a more important source of information than the balance sheet itself. In case of AIG off-balance sheet items have grown more than the actual balance sheet.

Leverage exacerbates the problem further – instead of taking a position in the underlying, banks can use derivatives, thus multiplying both profits and losses. When a big financial institution fails, not only its shareholders, but a general public and the whole economy share the loss. It is also difficult for the market to discipline banks for excessive risk taking. In the author’s opinion such extensive risk taking practices can develop a feeling of impunity.

However, there is also room for a more honourable use of the term ‘off-balance sheet finance’. Entities may wish, for sound commercial reasons, to engage in transactions which share with the other parties the risks and benefits associated with certain assets and liabilities. Increasingly sophisticated financial markets allow businesses to protect themselves from selected risks, or to take limited ownership interests which carry the entitlement to restricted rewards of particular assets.

Benefits of off-balance sheet finance:

Part of financial innovation

Enables to share risk

Makes it easier to raise capital

Improves B/S from the firm perspective

Dangers of off-balance sheet finance:

Lack of transparency

Promotes increased leverage

Promotes risk taking

Concentration in illiquid assets

Difficult to regulate

In theory, it should be possible to determine what items belong in the balance sheet by reference to general principles such as those in the IASB’s Framework and similar concepts statements. In practice, however, such principles on their own have proved a less than adequate response to the increasingly indigenous and aggressive structures being developed for what would generally be regarded as the less-honourable forms of off-balance sheet finance. [2] 

The Conceptual Framework for Financial Reporting, developed by the International Standards Committee (IASC), sets out the principles that should underlie the preparation and presentation of financial statements. The Framework was adopted in 1999 by the International Accounting Standards Board (IASB) as the foundation for its work in developing new International Reporting Standards (IFRS’s). Under the framework company’s balance sheets are required to show a ‘true and fair view’ of the company's financial position. What is ‘true and fair view’ has not yet been defined, but could be explained as follows; True, i.e. free from all relative material error and Fair, i.e. fair from bias.

Another import qualitative characteristic of financial statements for our discussion is materiality. Materiality is a threshold quality and only material information needs to be considered further. Information is material if it could influence user’s decisions or where its misstatement or omission could result in the information being misinterpreted. There is no general definition of materiality, as a high degree of experience human judgement is needed to make a decision on the subject.

Let’s consider a simplified example to make the problem clear. It is common for the companies to look for additional funding towards the end of financial year or the reporting quarter. The company A obtains a secured loan, using its assets as collateral. The company shows the loan under its liabilities, and users of financial statements take it into account when making investment decisions.

The company B, instead of borrowing the funds, arranges a sale of its assets, agreeing to repurchase the asset at a later date. Users of financial statements believe that this company is in a better financial position and is less leveraged, because it does not report the loan under its liabilities. The result will be that the balance sheet suggests less exposure to assets and liabilities than really exists, with a consequential flattering effect on certain ratios, such as gearing and return on assets employed This may lead to different investment decisions.

As company balance sheets are required to show a true and fair view of the company's financial position, many accountants are naturally reluctant to approve balance sheets which they consider misleading. This reluctance is increased when, as is usual, the balance sheet omission was deliberately contrived, rather than accidental.

To conclude: Off-balance item is an asset or liability that does not appear on the company’s balance sheet, which is used by investors and supervisors to evaluate a company's financial health. Companies will often use off-balance-sheet financing to keep their debt to equity and leverage ratios low. These types of transactions and agreements were often used to try and show improved performance with a higher ROCE, together with keeping debt off the balance sheet to show lower 'gearing', and therefore lower risk, resulting in lower cost of borrowings.

The case of Lehman Brothers has showed how dangerous off-balance sheet transactions, combined with leverage and illiquid markets can be. The Lehman Brother used Repo off-balance sheet device, known as Repo 105.

What are Repo 105s?

Sale and repurchase agreements (“repos”) are agreements in which one party temporary transfers assets (often fixed income or equity securities) to another party as collateral for a short‐term borrowing of cash, while simultaneously agreeing to repay the cash and take back the collateral at a later date (often as short as a week or ten days). When the repo transaction matures, the borrower repays the funds plus an agreed upon interest rate or other charge and takes back its collateral. [3] A haircut in a repo transaction is the difference between the value of the collateral used to secure a borrowing and the amount of cash that is borrowed. Repurchase agreements involve minimal risk for the lender if structured carefully, having no market risk but only a credit risk. To reduce the repayment risk, the borrower transfers liquid assets to the lender as collateral. The collateral protects the lending party if the borrowing party defaults on the loan.

Repos are wholesale funding instrument within the banking industry. Repo transactions are widely used by financial institutions and are a legitimate tool for raising short‐term funding to pay for operating expenses, to meet reserve requirements and manage liquidity. Banks often need short term cash and have assets they cannot liquidate immediately. In repo market liquidity is high and rates are competitive. Published reports indicate that overall size of the repo market is large, estimated at close to $12 trillion.(source?)

The ordinary repurchase agreements are usually not and off-balance sheet item. The substance of the transaction is to provide a short term loan. It is difficult to argue that the financial institution is actually selling the assets to the counterparty. However, for our discussion we are interested in the specific accounting treatment of repurchase agreements.

According to the SFAS 140 paragraph 100 repo transactions are considered financing or borrowing transactions. In a typical repo transaction temporary transferred assets remain on the firm’s balance sheet, along with a liability for the provided cash from the financial transaction. Repo 105 transactions are nearly identical to a typical repo transactions, which are used by the most Investment banks to obtain short-term cash, with a key difference: Lehman accounted for these transactions as a sale, when in fact it was simply a secured borrowing arrangement.

The number 105 (or in many instances 108) was appended to the term Repo to describe the amount of loan collateral and reflects the use of the transaction as a vehicle to achieve an accounting result. [4] 105 per cent collateralization was used for the fixed income assets and 108 per cent was the amount used for equity. For example, to secure a 100$ cash loan, a borrower would provide a collateral of liquid securities equivalent to $105 million. On the surface such overcollateralization was puzzling, as lender did not request it to be so high. The usual collateralization amount at that time was 102 per cent (2 per cent haircut). It made no economic sense to put up to $105 million of collateral to obtain a $100 million short-term cash loan, when the same could be done using a lesser amount. By using overcollateralization or a higher than normal haircut Lehman was able to recharacterise the Repo 105 transactions as a sale and to remove them from the balance sheet. In the later chapters we discuss legal technicalities that allowed for the recharacterization.

Lehman’s Repo 105 transactions occurred around the end of the reporting quarter and lasted for a period of seven to ten days, creating a materially misleading picture of its financial position in late 2007 and 2008. Murtaza Bhallo, the former Business/Risk Manager for PTG Liquid Markets, described that Repo 105 was “an accounting gimmick”. [5] Marie Stewart, the former Global Head of Lehman’s Accounting, described Repo 105 transactions as “a lazy way of managing the balance sheet…” [6] 

As described by Hallman (2010), a typical Repo 105 would begin with Lehman’s European unit transferring $105 million or $108 million worth of securities to a counterparty in exchange for $100 million in cash. Lehman would then use the money to pay down other short-term liabilities, so that it could report quarterly leverage numbers low enough to satisfy the ratings agencies, and thus investors. A few days after the quarter ended, Lehman would repay the cash, plus interest, and get its collateral back.

The transaction worked as follows:

Step 1: Original purchase. Lehman Brothers, using its subsidiary Lehman Brothers Special Financing Inc. (U.S.) purchased from the street a government bond worth $105.

Step 2: Intercompany repo (no haircut). Before the end of the quarter, the U.S. based entity transferred these securities valued at $105 via an intercompany repo transaction to the Lehman Brothers International Europe (U.K).

Step 3: Repo 105. Upon receiving the securities worth $105, London affiliate LBIE would execute Repo 105 transaction with a European counterparty. The minimum haircut of 5 per cent is applied to the transaction, thus LBIE receives $100 cash and agrees to buy back the securities at a higher price.

Step 4: Add $5 derivative asset. Lehman Brothers Holdings Inc (LBHI) provides $5 to its London counterpart LBIE to then transfer the total of $105 to the United States based entity.

Step 5: Reduction of liabilities. The United States‐based Lehman entity used the $105 in cash either to pay for the repoed securities inventory or, more likely, to pay down its short‐term liabilities, thereby reducing leverage.

Step 6: Borrow cash. A few day after the reporting date, armed with seemingly healthy financial statements, Lehman would borrow the $105 needed to buy back the securities

Step 7: Repurchase the security. When the term of the repo expired, LBIE repurchased the securities from the Repo 105 counterparty at 105 percent of the values and then returned the securities to the United States‐based Lehman entity through an intercompany repo. [7] 

Lehman dramatically increased its usage of Repo 105 transactions in late 2007 and early 2008. There was concern expressed by Lehman personnel and officers. Bart McDade, Lehman’s former Head of Equities (2005–2008) and President and Chief Operating Officer, in an April 2008 e‐mail asking if he was familiar with the use of Repo 105 transactions to reduce net balance sheet, replied: “I am very aware . . . it is another drug we r on.”

Lehman had to set limits on itself as the temptation to employ more of Repo 105 was too great. If spikes in the trading volume are extreme just before the reporting date, there is a risk of attracting the attention of regulators. Lehman senior management set limit on how the firm can reduce its leverage using Repo 105. In 2006 the limit was $17 billion. Along with the $5 billion limit for the Repo 108 the total was $22 billion. As January 2008 the total cap for Repo 105/108 transactions was increased to $25 billion. There were other internal rules to make sure the transactions have a legitimate business purpose or that the amount of the transactions do not spike more than 120% near the reporting period. [8] 

But Lehman did not follow these self-imposed rules. Beginning in mid‐2007 - the very time that the market began to particularly focus on investment banks’ leverage – Lehman breached its internal limit on Repo 105 activity at every quarter‐end, temporarily removing as much as $50.38 billion in securities inventory from its balance sheet in second quarter 2008. Thus, Repo 105 volume in fact was increased twice above the cap in the second quarter of 2008

Firstly, If there was an economical benefit of using Repo 105/108 transaction it makes no sense to limit the use of this device. Secondly, a secured short-term financing could not been a business purpose of the transaction because the financing received in exchange for collateral was not reflected in Lehman’s periodic reports as a liability. A Repo 105 was a more expensive way to obtain financing compared to the ordinary repo, which Lehman could conduct using the same counterparties at a lower cost. Hence, another proof that Lehman officers were fully aware of the pure “window dressing” effect of the device.

Did the Examiner find any legitimate possible use of Repo 105 other than affect balance sheet? The examiner asked that question repeatedly to the persons who were involved but did not find an answer. Why to use Repo 105 when the firm can do a regular repo and pay less money to get the same financing. Why to move everything to London, pay a premium to get exactly the same borrowings as gotten here without paying the premium. Thus the true purpose of the Repo 105 was the balance sheet manipulation, specifically the reduction of the net asset component (the numerator) of the financial leverage calculation. There is no evidence of any other business purpose.

The result: Lehman wildly inflated the value of their company in the days before and after they issued their quarterly reports. In the Q4 of 2007 they had $39 billion of troubled assets using this technique, in the Q1 of 2008 they had $49 billion and finally in Q2 of 2008 $50 bililon dollars. It was the end of the next quarter when Citibank and JPMorgan called Lehman to pay up on all that money that the entire house of cards ultimately collapsed.

In the next chapter we discuss why the leverage plays such a crucial part in modern finance.

Q3 2006

4 2006

Q1 2007

Q2 2007

Q3 2007

Q4 2007

Q1 2008

Q2 2008

Repo 105









Repo 108

















$50.383 [9] 

Never disclosing that they have to pay back 50 billion dollars they have borrowed for those assets.

The proceeds obtained from these "alleged" sales were used to pay down liabilities. Hence, on the quarterly financial reporting date, Lehman would show a balance sheet composed of less risky assets, less debt and possibly more cash. To outsiders, it appeared as if Lehman was less leveraged and in really great condition. This resulted in the appearance of healthy financial statements and the related healthy leverage ratios. Armed with healthy financial statements, Lehman would go out and obtain loans from financial institutions. However, the obligation to buy back the collateral remained with Lehman. Thus, immediately after the financial statements were issued, the company would use the cash obtained from the loans and buy back its original troubled assets at 105 percent of their value. This means that Lehman would pay a 5 percent interest rate rather than the industry norm of 2 percent (hence the classification by Lehman as Repo 105). After the repurchase of the troubled assets, Lehman's leverage would spike back up again and its balance sheet would be brought back to its true inferior position (less the 5 percent paid to repurchase their troubled assets).

Importance of Financial Leverage

To fully understand the cause of off-balance sheet device usage it is vital to explain the importance of financial leverage in the business cycle and the market dynamics beneath it.

From the accounting perspective, leverage is the measure of the proportion of loan capital, and other borrowings in total capital employed. An entity is considered to be highly leveraged where there is a greater proportion of debt within the capital employed, as compared with other companies, or industry average. The effect of leverage is that there is a potentially greater rewards, but also greater risk for the equity shareholders. This is because the loan capital will generally carry a fixed rate of return. Thus, if the return on capital employed is greater that the interest rate on loan capital the shareholders will obtain financial leverage with a greater rate of return. The proportion of debt to equity is of paramount interest to shareholders. Therefore, a major goal in Lehman's Repo 105 transactions was to show favourable financial leverage. A favourable financial leverage means that the company is earning a return on borrowed funds that exceed the cost of borrowing the funds.

The economic perspective gives an additional dimension to leverage. During the bull market, banks believe that the markets will continue to increase and that all of their competitors will be maximally leveraged to take advantage of the expected rise. If a bank decreases its leverage, it means it will lose money in the future (or lose opportunities with respect to competitors, since performance is relative to benchmarks and to the industry), so, guided by the practice of maximizing short-term profits by any means necessary, banks increase their leverage in order to get more return in the future. [10] How large they will increase their leverage depends on their expectation of the future market.

Leverage – measure of risk. In the bull market leverage multiplies profits, but in the bear market it multiplies the loss.

Investment banks have traditionally been highly leveraged and lowly capitalized institutions relative to other industries. However, the collapse of securitization market brought the danger of over-leveraging to light. Before the mid-2007 public, analysts and media were concerned with the profit and loss of the firm. Starting in mid‐2007, credit agencies began to more carefully scrutinize the leverage of investment banks.

One of the purposes of balance sheet management is credit rating upgrade. In a September 2007 e‐mail comparing Lehman’s net leverage ratio to Bear Stearns’, Paolo Tonucci, Lehman’s Global Treasurer, wrote that Lehman’s net leverage calculation “was intended to reflect the methodology employed by S&P who were most interested and focused on leverage.

The reduction of financial leverage was crucial to maintaining the favourable credit ratings. The inability to forestall rating downgrade could have a direct monetary impact on Lehman. For example, A rating downgrade could also lead to higher cost of financing for Lehman through counterparties demanding to post more collateral.

Lehman real estate and mortgages portfolio was a primary obstacle to for the upgrade. It was argued by the media that Repo 105 is was used to temporarily remove these troubled assets from the Lehman balance sheet. However, it is important to note, that Lehman was not able to remove commercial and residential mortgage backed securities from its balance sheet using its Repo 105/108 programme. The effect of having sticky assets [11] (like commercial real estate and leveraged loans) was mitigated by the use of Repo 105 program. Removing more than $50.38 of liquid assets was enough to offset the $52.12 billion of illiquid real estate securities, which was a lead weight to a balance sheet.

The author strongly agrees with that sharp observation: At the top of a credit cycle, the income statement for a financial institution shows "the best of times", but buried in the balance sheet is "the worst of times" to come. [12] In the bull markets analysts are concerned with the income statements of the firm as its revenues, profit and loss entries show can the peak performance. In the bear markets it is the balance sheets that ultimately matter. Careful scrutiny of the quality of the company’s assets and amount of capital will show if it is able to take the hit from the decrease of the market value of its assets.

In light of these dynamics, Lehman increasingly relied on its Repo 105 transactions at each publicly reported quarter in late 2007 and 2008 to affect the balance sheet.

However shadowy and evil these transactions do appear to the detached onlooker it is important to understand that it was a product of public consumption. Government regulators, rating agencies and Lehman managements reverse engineered leverage ratios for public consumption.

In the author’s opinion it is interesting to draw a parallel between Lehman bankruptcy and sovereign debt crisis as both had the same cause – too much leverage. The crisis of 2006 was a problem of too much debt and leverage of the private sector, banks, financial institutions and corporates. Now is the result of the response to the crisis – fiscal stimulus, bailing out banks and other who had a massive surge in public debt and deficits. Now there is a risk of countries as opposed to individuals and investment banks like Lehman going belly up. Countries having sovereign risk and defaulting as already happened in Greece. And unfortunately when you have too much private and public debt it takes long time, up to a decade, to do deleveraging, which means to spend less to save more to reduce debts over time. That implies low economic growth, high unemployment rate and some degree of social and political instability and unhappiness. This slow economic growth or recession or a risk of default by government may stay with us for a number of years.

Mark to market accounting and the cost of deleveraging

Probably, the most important reason why off-balance sheet transactions are so widely used is mark to market accounting or fair value accounting. For Lehman selling the assets was not a viable option and off-balance sheet devices were employed. To understand why we need to look at the accounting side of the equation and specifically the role that mark-to-market accounting is playing

Fundamentally, under any balance sheet measurement system, changes in asset and liability values drive performance measurement. The current IASB definition of fair value as incorporated in its standards is “the amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction”. Market prices are most comprehensive method of identifying fair value.

Many of the losses the investment bank was taking came not from the actual realised losses from selling securities at a loss in financial markets but from the write downs in the value of assets they still actually hold. Accounting rules require that banks mark financial instruments to market or in other words carry them on their books and reflect any gain or loss in the value of these instruments in the tradable market as if it was the actual realised gain or loss even if the banks continues to hold the instrument.

This is the important point to understand for several reasons. In order for investment firms mark-to-market, there need to be an actual market where these instruments are trading. The problem now is that there been so many issues with mortgage-backed securities and other asset-backed securities and so many buyers have gone into trouble that no one wants to touch it. This creates a situation when the market is very illiquid or in other words there are very few buyers, so if a firm wants to sell these instruments it going to take a substantial hit in value. Lehman would have significant difficulty exiting its real estate/mortgage positions.

For this reason Lehman was trying to hold on to these instruments, hoping that order and liquidity would return to the market. And hoping when it does, these instruments would begin to trade at a price, which the investment bank feels more directly reflects their true value. The problem with this is many firms are got into trouble and had to sell these instruments even at distress prices, which all they would fetch because they needed to raise capital at almost any cost and when this happened it created a chain reaction throughout financial system as everyone else who held similar types of debt had to mark the value of that debt down to new level, taking a hit to their balance sheet as a result.

This is a big problem for two reasons. First, as the author has mentioned above, investment banks are required to hold a certain amount of capital on their books at all times to meet their reserve requirements. When they take write downs on the value of their positions this is the direct hit to their capital base, putting many of these banks in a positions, where they have to go out and raise additional capital to meet their reserve requirement. Secondly, these banks rely on the soundness of their balance sheet to borrow money at low interest rates and on a short term and fund their operations and fund their longer term investments, such as real estate developments. So when they write down the value of these instruments it is a direct hit to their balance sheet, putting them in a position when they have to go out and raise capital like Merrill Lynch and Citigroup did in 2008, when they had to sell off some of these instruments at distress prices further exacerbating the problem. Moreover, a fire sale could lead to a loss of confidence of valuation of the remaining assets of the firm.

In 2007 Richard Fuld, Lehman former CEO, stated that “Exiting large commercial mortgage-backed securities (CMBS) positions in Real Estate and sub-prime loans in Mortgages before quarter end would incur large losses due to the steep discounts that they would have to be offered at and carry substantial reputation risk in the market… A Repo 105 increase would help avoid this without negatively impacting our leverage ratios.”

An early 2007 document from Lehman’s archives concluding that “Repo 105 offers a low cost way to offset the balance sheet and leverage impact of current market conditions,”

A Repo 105 increase would help avoid this without negatively impacting our leverage ratios.” While Lehman did not utilize Repo 105 transactions for selling sticky inventory, the firm’s expanded use of Repo 105 transactions at quarter‐end impacted Lehman’s publicly reported net leverage ratio.

In order to reduce its leverage Lehman could decrease (net assets (the numerator) or increase the equity (denominator) in the net leverage calculation. Raising equity appeared not to be a viable option to the Lehman executives, possibly because of the signalling effect and it would not fix the problem of having illiquid assets. The sale of inventory comprised mostly of mortgages and loans would result to substantial losses to Lehman. Potential losses of moving $22 billion of illiquid assets would cost Lehman $750 million as for the time mid-2008.

In the reply to the analysts inquires about the means on how Lehman is reducing its leverage, CFO Callan told analysts that the company is reducing its leverage through the sale of less liquid assets. However, nothing was said about the use of Repo 105. The has to add, that the CFO was not honest when giving this answer, as we already know, selling the assets was not a viable option.

In the author opinion any time earlier in 2006 or 2007 deleveraging would not cost nearly as much as $750. It is the belief that the markets will change its course and inability to cut the losses that ultimately led to the worst outcome.

There are many arguments relating to how aggressive at marking illiquid assets to market we should be On the one side of the isle, supporting the efficient markets, is that we need to be even more aggressive that we have been. The argument on the other side of that is that if we are too aggressive than we are in danger in collapsing the whole financial system.

On October 1 2008, two weeks after Lehman filed for bankruptcy the U.S. Senate, as plan of its rescue plan, approved legislation that gave SEC the right to suspend mark-to-market accounting. The SEC ruled that if an active market does not exist for a security, it is permissible to rely on models. Of course it is questionable broker quote represent the fair economic value, but still reports based on observations are more truthful then the ones that are based on assumptions and predictions. The author can only guess which big financial institutions this political interference prevented from failing.

Misleading financial statements

As we saw from the discussions in the previous chapters leverage is important because measure of risk and is highly monitored investors, credit rating agencies and analysts. Inability to decrease the leverage can lead to a credit rating downgrade.

According to the Report, “Lehman’s failure to disclose the use of an accounting device to significantly and temporarily lower leverage, at the same time that it affirmatively represented those “low” leverage numbers to investors as positive news, created a misleading portrayal of Lehman’s true financial health.” [13] 

Under Lehman’s definition of net leverage ratio, Lehman divided net assets by tangible equity. In the author opinion the Net Leverage is rather crude way of measuring leverage as it does not take into account quality of the assets, which in case of Lehman were illiquid mortgage backed securities.

The impact of the Repo 105 transactions allowed the firm to temporarily remove approximately $50 billion of bad assets from its balance sheet at the end of its first and second quarters of 2008. These amounts are extremely material and allowed Lehman to present a superior balance sheet to the public and appear to be extremely healthy at a time when the financial markets were extremely nervous. Anton R. Valukas, the bankruptcy examiner stated that Lehman's failure to disclose the use of (their) accounting device to significantly and temporarily lower their leverage, at the same time that it affirmatively represented those "low leverage" numbers to investors as positive news, created a misleading portrayal of Lehman's true financial health (Valukas, 2010).These deceitful window dressing practices deceived investors, creditors, and other interested parties and led to huge losses to these people who put their faith as well as their wealth in Lehman. These practices also ultimately led to the downfall of Lehman Brothers and huge losses to investors, creditors and others.

Adopted from the examiner report are four illustrations below . Assume a simplified balance sheet of Lehman at the end of reporting period:

Illustration 1:

Assets (in millions $)




Short Term Borrowings


Financial Instruments


Collaterized Financing


Collaterized Agreements


Long Term Borrowings








Stockholders' Equity





Operating Income


Gross Leverage


(total assets divided by stockholders’ equity)

Net Leverage


(total assets - collaterized agreements) divided by stockholder equity

Return on assets


(operating income divided by total assets)

Ordinary repurchase agreements are accounted as

If Lehman executes a typical repurchase agreement, for example, at amount of $50,000 we will see an increase of both cash position and collaterized financing liabilities:

Illustration 2:

Assets (in millions $)




Short Term Borrowings


Financial Instruments


Collaterized Financing


Collaterized Agreements


Long Term Borrowings








Stockholders' Equity





Operating Income


Gross Leverage


(total assets divided by stockholders’ equity)

Net Leverage


(total assets - colaterized agreements) divided by stockholder equity

Return on assets


(operating income divided by total assets)

Because the instruments remain on the balance sheet we see the increase in the leverage ratios and decrease in the returns on assets (not a good news for the investors. Assuming, the Lehman uses cash to pay down its liabilities the net effect would be neutral. We are back to where we started: cash will fall by $50,000 and liabilities will decrease by the same amount. Our key financial ratios will be the same as on Illustration 1.

Now comes the most interesting part. The recharacterization of a repo transaction from financing to a sale, pursuant to the SFAS 140 in effect at 2007-2008, leads the following consequences:

Even though transferor is required to repurchase the securities, the inventory is derecognized, i.e. removed from the balance sheet.

The obligation to repay the funds is not recorded in the liabilities part of the balance sheet. The “borrowing” is not recorded on the balance sheet, thus the liabilities part does not increase.

Total assets remain unchanged at the moment of transaction, because transferor receives cash funds in exchange of financial instruments

Illustration 3 shows the effect on the balance sheet:

Assets (in millions $)




Short Term Borrowings


Financial Instruments


Collaterized Financing


Colaterized Agreements


Long Term Borrowings








Stockholders' Equity





Operating Income


Gross Leverage


Net Leverage


Return on assets


At the time of transaction financial leverage is unaffected. As a last step, Lehman used borrowed funds to pay down its short-term liabilities. By doing so, Lehman was able to reduce leverage ratios and increase its return on assets, as in illustration 4 below:

Illustration 4:

Assets (in millions $)




Short Term Borrowings


Financial Instruments


Collaterized Financing


Colaterized Agreements


Long Term Borrowings








Stockholders' Equity





Operating Income


Gross Leverage


Net Leverage


Return on assets


Lehman leverage and financial health depended heavily on its Repo 105 practice.

When the Repo 105 matured, Lehman borrowed funds in to repay the borrowing and transferred the assets back to the securities inventory. [14] Total assets and liabilities increased accordingly.

It is obvious that these transactions had no economic substance as the same funding could have been obtained at the lower cost with the same counterparties. The examiner concludes that the motive for undertaking Repo 105 was to manage the balance sheet and to affect the publicly disclosed leverage. [15] 

These leverage numbers

The Materiality of Lehman’s Repo 105 Practice

Defining the materiality will allow the author to make confident conclusions. Accountants are to judge all aspects of transactions to decide whether to disclose information or not in the financial statements.

Preparation of financial statements requires a high degree of judgement. Materiality cannot be defined using strict numerical guidelines. No general definition of materiality can take into account a high degree of experienced human judgement. According to SFAS 2 “A decision not to disclose certain information may be made, say, because investors have no need for that kind of information (it is not relevant) or because the amounts involved are too small to make a difference (they are not material). …. [16] Thus, materiality is a disclosure matter.

According to the SFAS paragraph 132 “The essence of the materiality concept is clear. The omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item”

IASB puts emphasis on the term “relevance” instead. According to the IASB framework “Relevant financial information is capable of making a difference in the decisions made by users. Materiality is an entity-specific aspect of relevance…”

U.S Supreme Court in TSC Industries defines materiality: “… material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote” [17] Lehman case reasserts the need to base materiality upon user’s perspectives.

All definitions put emphasis on investment decision of a reasonable investor. As was discussed in previous chapters, inability to reduce leverage could result in a credit rating downgrade for the Lehman. In the author’s opinion such information clearly makes a difference in decision making of investors.

According to the examiner report, Lehman’s Repo 105 practice at quarter‐end in late 2007 and for the first two quarters 2008 had a material impact on Lehman’s publicly‐reported net leverage ratio - and Lehman management knew it.

A proof to it is a walk‐through document related to Ernst & Young’s 2007 fiscal year‐end audit of Lehman, which defines “materiality”, as “any item individually, or in the aggregate, that moves net leverage by 0.1 or more (typically $1.8 billion).” [18] It represents Lehman’s determination of a “materiality threshold” in connection with Lehman’s own criteria for when to consider reopening and adjusting the closed balance sheet.

Looking at the table below we can observe the ratios using Repo 105 and using correct accounting. As a result of its quarter‐end Repo 105 practice from late 2007 through the second quarter 2008, Lehman publicly reported a net leverage ratio that was 1.7 to 1.9 points lower than what its net leverage ratio would have been if Lehman had used ordinary repo transactions instead of Repo 105 transactions. It is difficult to argue that the $50 billion transactions , even if broken down to many small amounts, are not material, as there was one purpose.

It is true that the case of Lehman emphasises that information is material if it could influence user’s decisions. But it is not necessary to assert that the investors would acted differently if knew about the actual leverage ratio. However, we should not forget the possible credit rating downgrade had very tangible consequences. Author is strongly convinced that this is material information and had to properly disclosed in the notes to financial statements and to the filings to SEC. The reported ratios are false and give a misleading picture about Lehman financial position.

($ in Millions)

May 31, 2008

Feb 29, 2008

Nov 30, 2007

Aug 31, 2007

May 31, 2007

Feb 28, 2007

Nov 30, 2006

Repo 105/108 Usage








Leverage Ratio

24.3 x

31.7 x

30.7 x

30.3 x

28.7 x

28.1 x

26.2 x

Net Leverage Ratio

12.1 x

15.4 x

16.1 x

16.1 x

15.4 x

15.4 x

14.5 x

If repos were used in place of repo 105s:

Leverage Ratio

26.3 x

33.6 x

32.4 x

32.0 x

30.2 x

29.5 x

27.5 x

Net Leverage Ratio

13.9 x

17.3 x

17.8 x

17.8 x

16.9 x

16.8 x

15.8 x

Principles vs. Rules

Lehman use of Repo 105 opens a principles vs. rules discussion that compares U.S. Generally Accepted Accounting Principles (GAAP) to International Financial Reporting Standards (IFRS). Lehman entities around the world maintained their books using U.S. GAAP. The Repo 105 transactions were designed to meet the GAAP provisions for financial reporting as a sale. However, as David Tweedie, former chair of the International Accounting Standards Board observed, “International Financial Reporting Standards does not provide for so-called Repo 105 transactions…We don’t allow it. That’s why we have principles, not rules, so you can’t do it. They find ways to get around rules.” 6 In fact,

Did Lehman violate Generally Accepted Accounting Principles?

This chapter will help to discuss the legal technicalities that enabled to recharactarize Repo 105 transaction as a true sale.

Despite the identical structure of ordinary repo, Repo 105 received a different accounting treatment: Lehman treated these transactions as “sales”, which enabled to remove the securities inventory off balance sheet. Statements of Financial Accounting Standards (SFAS) No. 140 provides accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities.

Under the SFAs No. 140, paragraph 9 “A transfer of financial assets in which the transferor surrenders control over those assets is accounted for as a sale…” A transferor surrenders control over a transferred asset – and therefore may treat the transaction as a sale – only if:

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.

Each transferee … 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 rig ht to pledge or exchange and provides more than a trivial benefit to the transferor.

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 or (2) the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call. [19] 

Therefore, if repo transaction satisfies all three conditions the transferor is said to have surrendered control over the asset and SFAS 140 paragraph 98 permit the transaction to be accounted as a sale of the asset and forward purchase commitment.

SFAS 140.98 states: “If the criteria in paragraph 9 are met… the transferor shall account for the repurchase agreement as a sale of financial assets and a forward repurchase commitment, and the transferee shall account for the agreement as a purchase of financial assets and a forward resale commitment.”

Lehman decided that transactions met SFAS 140 criteria and accounted for them accordingly. The previous chapter had showed the immediate effect on the balance sheet as a result. Excerpt from the Lehman internal Accounting Policy for Repo 105 acknowledge typical repo transaction as “secured financing transactions” but Repo 105 “as sales of inventory and forward agreements to repurchase”.

However, question on how Lehman was able to demonstrate that they have relinquished control of the transferred assets remains. A five per cent minimum haircut for repo 105 transaction was greater than the haircut in typical repo transactions. However this premium was essential to profit from the SFAS 140 accounting treatment.

Relevant discussion of control is contained in the paragraph 217 and 218 of SFAS 140: “to maintain effective control, the transferor must … reacquire securities that are identical to or substantially the same as those concurrently transferred.” and “the transferor's right to repurchase is not assured unless it is protected by obtaining collateral sufficient to fund substantially all of the cost of purchasing identical replacement securities during the term of the contract”

Paragraph 218 of SFAS 140 further provided: Judgment is needed to interpret the term “substantially all” … that the terms of a repurchase agreement do not maintain effective “control” over the transferred asset.

However, arrangements to repurchase or lend readily obtainable securities, typically with as much as 98 per cent collateralization … or as little as 102 per cent overcollateralization …, valued daily and adjusted up or down frequently for changes in the market price of the security transferred and with clear powers to use that collateral quickly in the event of default, typically fall clearly within that guideline. The Board believes that other collateral arrangements typically fall well outside that guideline.”

In other words the criteria above would only be met only if the cost of the pledged security would be between 98 and 102 per cent. Repo 105 and Repo 108 refer to securities sold at minimum of 105 for equity and 108 per cent for fixed income respectively. These percentages fall outside the SFAS guidelines.

As Anton Valukas, the Examiner puts it: Specifically, if Lehman had the ability to “fund substantially all of the cost of purchasing the same or substantially the same replacement assets,” Lehman would be “viewed as having the means to replace the assets” and was therefore “considered not to have relinquished control of the assets.

Thus, Lehman determined that because of the higher haircut they may not have enough cash to buy back the exact assets or similar assets. As we know they received only $100 for something worth $105. Lehman posted more collateral in order achieve off-balance sheet treatment. It is important to note that there is no rule that allows 105 per cent overcollateralization to be qualified as a “sale”. The 98 and 102 per cent guideline was a loophole on which Lehman not failed to capitalize upon.

As noted in a letter from Robert H. Herz (then FASB Chairman) to the House Financial Services Committee, (Re: Discussion of Selected Accounting Guidance Relevant to Lehman Accounting Policies, April 19, 2010):

It appears that Lehman structured the transactions in an attempt to support a conclusion that there was inadequate cash collateral to ensure the repurchase of the securities in the event of a default by the counterparty, and, on that basis, Lehman determined that sale accounting was appropriate.

Now FASB Update 2011-03 specifically marks out the controversial 98 and 102 per cent guidelines for treatment for repo agreements. It may be argued by principal-based standard supported that rule-based standards open too many loophole to be exploited. The author does not agree with that opinion as the rationale behind this rather arbitrary guideline remains unknown. Is it just a typical arrangement example? Why exactly 102 per cent?

In the author opinion it is the contractual obligations and not the value of collateral that must dictate the waiver of control. Transaction also lacked any business purpose as was argued in the previous chapters. However, author doubts that these allegations are sufficient to violate SFAS. If litigation is under rule-based system such as GAAP, it may be difficult for a plaintiff to prove that the violation of the abovementioned principles. It is well-documented legal technicality which is likely to prevail.

More to add, as the later chapter will show it is increasingly hard to support a claim which is based only on principles-based standards.

A major standard was introduced in UK accounting FRS 5 - 'Reporting the substance of transactions', which dealt with Sale and repurchase agreements, Sale and leasebacks, Factoring of receivables, Consignment inventory, etc. These types of transactions and agreements were often used to try and show improved performance with a higher Rate on capital employed ROCE, together with keeping debt off the balance sheet to show lower 'gearing', and therefore lower risk, resulting in lower cost of borrowings. There is no specific standard yet in international financial reporting standards, but there is a general requirement to reflect the commercial substance of transactions even where this conflicts with the legal form.

Linklaters True Sale Opinion Letter

In addition to the required overcollateralization, Lehman had to make an additional steps to qualify for a “sale”. To achieve a “true sale” treatment under SFAS 140 assets needs to be isolated – put beyond the reach of transferor and its creditors in the event of default of the transferor. To meet this requirement a transferor must obtain a true sale opinion letter.

Under the United States case law the treatment of repurchase agreement varies and there is a risk that the transferor’s creditors may have a claim on the collateral. Lawyers in the U.S. could not provide Lehman with the required opinion letter. Under English law there is apparently much less uncertainty about the how transfer would be viewed by the court in the event of insolvency of the transferor. Lehman was able to get the “true sale” legal opinion from the Linklaters firm based in London.. Nothing calls into question, that the transactions, were, in fact, a true sale under UK law. The law firm provided a letter for exclusive benefit of the LBIE without any reference to GAAP or SFAS 140

Conducting transaction through its London affiliate LBIE was the result of its inability to obtain a true sale opinion letter from the U.S. law firm. In the author’s opinion Linklaters failed to identify who was the true beneficiary of the transaction, as the significant amount of the transactions was conducted for the benefit of the U.S. based Lehman entity.

Would Repo 105 be possible under IFRS?

The author believes that it is intesting to ask. U.S. Generally Accepted Accounting principles are rule-based and IFRS is principle based. Under the latter the debate on the Repo 105 would not exist, since the substance of the transaction would dominate over its legal form to decide proper accounting treatment. It would be difficult under IFRS to structure a transaction to meet a certain accounting treatment. In the author’s opinion it is the clear case of accounting arbitrage and the use of one set of accounting standards such as IFRS may close the gap. However, there is no evidence that Americans would be willing to part with GAAp in the foreseen future.

In the author’s opinion if the single transaction complies with the certain accounting rules, it does not mean that the whole statement complies with the accounting standards.

Importance of Disclosures- Did Lehman properly disclose the Repo 105 transactions?

The objectives of securities regulation is ensure that all relevant information is made available to investors so that they make an informed judgement about the securities they are being invited to invest in. Modern regulatory regimes therefore require that investors should be provided with full, timely and accurate disclosure of current and reliable information which is material to investment decisions. Disclosure requirements promote transparency, which is an important prerequisite to well-functioning capital markets

On May 30 2006 Lehman issued debt and equity securities worth $31 billion. [20] It is required for the issuing company to publish various disclosure documents – registration statements, prospectuses and various pricing supplements (offering materials). All authorised persons who have signed the offering materials are obliged to state that they accept responsibility for the information in the offering materials and it is true to their best knowledge. Underwriters also share the same responsibility.

Probably, the biggest concern in case of Lehman brother are the financial statements incorporated in the offering materials.

Even if these transaction are technically compliant with the accounting standards, this accounting policy

Disclosure requirements

Regardless of being characterized as a “sale” or “borrow”, transactions occurred very close to the financial statement date, and given the size of the amounts involved, would be of interest to investors. However, according to the BER (page 973), Lehman made no disclosures in its Statement of Income, Statement of Financial Condition, Statement of Cash Flows, or MD&A sections (including its section on liquidity) from which an investor could infer that Lehman treated a certain volume of Repo transactions as sales under SFAS 140, thereby decreasing its net assets and its net leverage ratio. Even if one grants Lehman that the accounting sale treatment for its repo transactions may have technically complied with GAAP, it is difficult to understand why disclosure of such an important accounting policy was absent.

The Repo 105 transactions should have been properly disclosed by Lehman in the notes to their financial statements. They were required to state the terms of the transfer with respect to rights or interests and obligations of the sales of the receivables and the fact that they had been appropriately accounted for and removed from the balance sheet. However, Lehman failed to disclose any information regarding the sale or transfer of their receivables in the Repo 105 transactions.

Did Lehman Violate The Securities Exchange Act of 1934?

Lehman failed to disclose their use of the Repo 105 transactions to investors, creditors and the general public. The question here is whether the failure to disclose is an omission of a material fact.

This also leads to additional questions. Had investors known of Lehman's Repo 105 transactions, would they have continued to conduct business with Lehman? Did the investors in fact rely upon omissions and affirmative untrue statements to their obvious detriment? Did the statements and course of conduct of the defendants represent half-truths or were they patently false?

7.1 Anti-Fraud Provisions of the SEC Act of 1933 & 1934.

U.S. Securities and Exchange Commission is responsible for protecting investors and maintaining the integrity of securities markets. The Securities Exchange Act of 1933 is the first major federal legislation on securities. It has been enacted in response to the Stock Crash of 1929 and the ensuing Great Depression. Among its objectives the Act prohibits deceit, misrepresentations, and other fraud in the sale of securities.

The Act governs the trading of securities in the secondary market and also empowers the SEC to require periodic reporting of information by companies with publicly traded securities. The key disclosure forms that are of interest to our case are 10-K and 10-Q, where Lehman had to disclose its accounting treatment for Repo 105 transactions.

Section 11 and 12 of the Act prescribe civil liabilities for false offering materials. It gives a right to any person who acquired such security to sue any person who certified the offering materials, including auditors and underwriters.

According to Section 17(a) of the Securities Act of 1933, ‘‘It shall be unlawful for any person in the offer or sale of any securities by the use of any means or instruments of transportation or communication in interstate commerce or by the use of the mails, directly or indirectly

(1) to employ any device, scheme, or artifice to defraud, or

(2) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(3) to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.’’

In the author opinion, Repo 105 transactions fall under this section. It can be alleged by plaintiffs in a civil suit that Lehman engaged in these transactions in order to deceit them. Plaintiffs would then have to base their claims on the omissions in the information contained in the offering materials and periodic reports.

Another topical regulation is SEC Rule 10b-5, also formally known as the “Employment of Manipulative and Deceptive Practices” that was created under the Securities Exchange Act of 1934. Under the SEC Act Rule 10-b5, “it shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.” [21] 

In order to state a claim under the Rule 10b-5, plaintiffs must allege that deceit was intentional, i.e. scienter and that a damage has been done to the plaintiff. Misstatements and omissions, mentioned in the part (b) are illegal only if “material”.

These statutes are referred to collectively as the anti-fraud provisions of the securities laws. These statutes specifically make reference to ‘omissions’, ‘material facts’ and ‘untrue statements’. They can be enforced against Lehman executives as well as auditors, who failed to meet their duties to disclose material facts regarding the Repo 105 transactions in the notes of financial statements. Civil liability is de

In the author’s opinion

Did Lehman Violate the Sarbanes-Oxley Act?

Like the SEC Act of 1933 & 1934 was the reaction to the Great depression. The Sarbanes-Oxley Act of 2002 was enacted in reaction to management and accounting scandals including the collapse of Enron and WorldCom that cost investors billions of dollars. The rationale of SOX is to enhance corporate responsibility, improve disclosure and financial reporting, strengthen enforcement of the security laws, combat corporate and accounting fraud.

The SOX consist of 11 titles

The Sarbanes-Oxley Act Section 302 is entitled “Corporate Responsibility for Financial Reports” and requires chief executive officers and chief financial officers of public companies to certify the information in the company's annual and quarterly reports to the SEC. In addition to the civil liabilities arising from the Section 302, the Section 906 requires similar certification but carries criminal penalties for CEO/CFO financial statement certification of fully compliance with the requirements of section 13(a) or 15(d) of the Securities exchange Act of 1934.

A strong focus of the SOX is to restore confidence in the accounting profession, through enhancing reliability of auditing reports. According to the Section 401 of the Sarbanes-Oxley act financial statements are required to be presented in a manner that does not contain incorrect statements or fails to disclose any material information. These financial statements shall also include all material off-balance sheet transactions, obligations and relationships with other persons, that may have a material effect on financial condition.

The SOX requires Securities and Exchange Commission to implement the Act’s provisions. The SEC rules -- Rules 13a-14 and 15d-14 under the Exchange Act -- implement Section 302(a) of SOX by requiring that CEOs and CFOs certify in each “report” filed with the SEC that effective “disclosure controls and procedures” have been established and are being maintained. [22] 

Therefore, financial executives may be subject to severe penalties if the statements are found to contain material misrepresentations. Lehman executives are claiming ignorance that they were not aware of the misleading statements and the malpractices taking place, otherwise they may even face criminal charges under the Sarbanes-Oxley Act.

Examiner also finds that there is evidence to support a colourable claim that the executive responsible for certifying Lehman’s financial statements, by failed to report material information within the scope of their agency.

Several additional contemporaneous e‐mails retrieved from Lehman archives

succinctly set forth Lehman’s purpose for undertaking Repo 105 transactions:

● “[T]he firm has a function called repo 105 whereby you can repo a position

for a week and it is regarded as a true sale to get rid of net balance sheet.” 2893

● “We have been using Repo 105 in the past to reduce balance sheet at the

quarter‐end.” 2894

From the Examiner’s Report it appears that the Lehman executives knew of the true use of Repo 105 transactions. Allegedly, executives were fully aware that the statements were misleading and did not represent the true postion of the company. Despite having the knowledge of these transactions they certified the accuracy of financial reports making the company to be in good financial condition. Hence, the Lehman executives may be subject to criminal penalty and financial liability.

Lehman Brothers Securities and ERISA Litigation

The current chapter is of interest to the reader as it shows the significance of the author findings by comparing them to the actual legal opinion.

In a 106 page opinion dated July 27, 2011 the US District Court in Manhattan rejected a motion of former Lehman executives and their auditors Ernst & Young to dismiss a class lawsuit brought to them by investors, who allege they been misled by Lehman’s financial reports. The motion was in part dismissed and in part granted. This is not a formal ruling, but a rejection to dismiss a case.

The court ruling identifies which claims proceed to the next legal stage and which are to be dismissed. In each case court looks for evidence of “scienter”. Scienter is a full awareness of the consequences of punishment, the severity of the crime before it occurs. Therefore, the matter before the court was to dismiss the class action complaint on the motion of defendants

The plaintiffs of the case are pension funds, companies and individuals who purchased Lehman debt and equity securities. They sue are Lehman’s former officials, directors, auditors and underwriters under Sections 10(b), 20(a), and 20A of the Securities Exchange Act of 1934 and Rule 10b-5. The complaint claims that Offering Materials were false and misleading, because they incorporated financial statements, which, in turn, contained various omissions and misrepresentation. It alleges that Lehman and its officers made misleading statements with respect to Lehman’s, risk practices, liquidity management, credit risk and of course accounting for Repo 105 transaction and their effect on reported net leverage numbers.

U.S. District Judge Lewis A. Kaplan summarises plaintiffs’ allegations:

(1) accounted for the Repo 105 transactions as sales rather than financings in violation of GAAP,

(2) failed to disclose its use of Repo 105 transactions and its temporary effect of reducing Lehman’s net leverage, and

(3) presented a misleading picture of the company in violation of GAAP

On the other hand, defendants argue that these motions are to be dismissed because

(1) the financial statements complied with GAAP, and

(2) any alleged misstatements were immaterial

The judge ruled that there are not sufficient evidence to support a first part of the claim, backing up the author’s own thoughts in the chapter on GAAP. The Judge ruled that nothing in the SFAS suggests that there must be business purpose to the transaction or that true sale opinion letter must be from a U.S. based law firm. Therefore, the transaction was formally compliant with the GAAP.

Regarding the second point, probably, the strongest point of the defendants was that Lehman Offering materials “bespoke caution” and disclosed that overall size of the balance sheet may fluctuate time to time. The defendant maintained that these fluctuations were immaterial and that no reasonable investor would consider them important. However, the Judge Kaplan ruled that these disclosures about balance sheet size were not enough. And that a reasonable investor would like to know about the Repo 105 transactions that affected the leverage ratios of the company.

The Judge comments on the third point: “The fact that Lehman’s accounting for the Repo 105 transactions technically complied with SFAS 140 does not mean that Lehman’s financial statements complied with GAAP.” With respect to Repo 105 transactions Judge Kaplan concluded: “This repetitive, temporary, and undisclosed reduction of net leverage at the end of each quarter is sufficient to make out a claim…” [23] It can be concluded that the general requirement to present financial condition of the company accurately is overriding in this case.

According to the opinion, a state of mind needed to make inference about scienter is intent to “deceive, manipulate, defraud”. But on this legal stage allegation of recklessness sufficient. The Judge finds that that the Defendant knew, or were reckless of not knowing, that Repo 105 transactions affected financial metrics, so important to credit rating agencies, investors and analysts. Officials must have known that the financial health of the company was misleading.

The Judge rejected most allegations against Lehman auditing firm Ernst & Young. Still few remain. The strongest allegation is that the auditors did not properly respond to the “red flags” with all due professional care and scepticism. Firstly, Matthew Lee, the former senior vice president in charge of Lehman’s accounting practices, told the auditing firm about Repo 105 transactions described my him as “unlawful and unethical”. Secondly, about Lehman’s inability to obtain a true sale under U.S. jurisdiction. The auditor brought none of this before the board of directors.

As a result of Judge Kaplan’s rulings the one of the highest profile security suits will go forward. It will be very interesting to see how this challenging case due to its complexity on legal matters unravels. It is fascinating to know whether the defendants will fight for the ultimate vindication or work for a settlement.

Failure of corporate governance.

Corporate governance is a set of mechanisms, through which a companies are directed and controlled. It is a distribution of power in the corporation, first of all - between managers and shareholders.

In the author’s opinion, the fall of Lehman brother is a clear case of failure of corporate governance, not the market failure.

According to the Examiner’s report Lehman repeatedly exceeded its own internal risk limits and controls.

There was concern expressed by some senior executive at Lehman Brothers whether their accounting practices were appropriate. One of those executives was Matthew Lee. He was the senior executive at Lehman and the main accountant responsible for its global balance sheet. Lee was the first to raise objections inside Lehman about the accounting trick known as Repo 105. Lee’s position required him to sign off on the accuracy of the firm’s accounting practices every quarter. But in November 2007, ten months before the Lehman Brothers went bankrupt he declined to do so. Just four months before the Lehman collapsed.

Mathew sent a letter to Lehman’s top executives about his concerns. Six days later he was fired after a 14 years of employment. Upon his removal, Lehman executives asked their accountants from Ernst&Young to conduct an accent interview with Matthew. In those interviews Lee disclosed Repo 105 transaction to the accounting firm. Ernst and Young was legally bound to make sure the Lehman’s audit committee and its board of directors knew about these allegations of unethical and unlawful accounting practices, but they never did.

The Repo 105 Program Exposed Lehman to Potential “Reputational Risk”

Kelly recalled raising the following topics in his Repo 105 conversations with both Callan and Lowitt: (1) Kelly’s discomfort with the possible “reputational risk” Lehman would suffer if the investing public and analysts learned that Lehman used Repo 105 transactions solely to reduce its balance sheet; (2) the size of Lehman’s Repo 105 program, that is, the volume of Repo 105 transactions that Lehman undertook at quarter‐end to reduce its balance sheet; (3) the “technical basis,” from an accounting perspective, by which Lehman was authorized to engage in Repo 105 transactions; (4) Kelly’s belief that none ofLehman’s peer investment banks used Repo 105 transactions; and (5) the fact that Lehman’s Repo 105 activity was “skewed at quarter‐end,” in other words, that the firm’s Repo 105 usage spiked at quarter‐end, during Lehman’s reporting periods

8.3 Did Lehman Violate the Notions of Fairness, Fraud and Conflicts of Interest?

Jeffers & Mogielnicki (2010) noted that in order to examine whether behavior is ethical, it is also necessary to examine the traditional notions of fairness, fraud and conflicts of interest.

8.3.1 Fairness or Equity

First, individuals are entitled to be treated fairly and not to be harmed by the operation of markets through the denial of certain rights. Obviously, due to the risk aspect of investing, some persons will make money and others will not, and that is as it is meant to be. However, fairness suggests that there is a level playing field for all similarly situated investors with respect to such matters as the information available through which investors make informed rational decisions. A full analysis of what fairness means requires looking at concepts of fraud and manipulation, and unbalanced access to relevant information. False and misleading information fed to investors upon which they may base their decisions constitute unethical fraud. Self-dealing by not divulging material information to others is lying, and those in the financial business sector should demonstrate a moral responsibility that does not allow such conduct (Jeffers & Mogielnicki, 2010). It is evident that the Lehman executives failed to exercise fairness or equity with respect to their investors.


Lehman misused an accounting trick called repo 105 to temporarily remove assets from its ledgers to make it look as though it was reducing its dependency on borrowed money and was drawing down its debt.

Repo 105 transactions were not used for a business purpose, but instead for an accounting purpose: to reduce Lehman’s publicly reported net leverage and net balance sheet.

Repo 105 is an instrument for reverse engineering financial leverage for public consumption. Executed by management, incentivised by the regulators and rating agencies.

Lehman deleveraging policy relied on Repo 105

There is no credibility to financial reporting. It is very hard for a unsophisticated investor to orientate.

Regulation arbitrage still possible even between developed countries such as U.S. and U.K.

Use of IFRS globally may stop the accounting arbitrage

Congress should mandate that companies base disclosure decisions on the substance of their transactions. If a company is financing assets, those as-sets and the related liabilities should remain on the balance sheet, regardless of the form the company uses to construct these financings.(paraphrase!!!)

There is no culture of ethics in financial statements

Balance sheets of the investment firms are supposed to give important metrics for regulators and investors to assessr risk. Footnotes are more important repository of information than the balance sheet itself.

The ordinary individual will generally have neither the expertise nor the time to assess standing, riskiness and reputation of the banks. It is difficult for banks to obtain information about the creditworthiness of other banks (AIG and Lehman were rated AAA and AA minutes before the collapse).

Unlike most other companies, financial institutions are heavily regulated. Governments throughout the world want a stable financial sector. It is important that companies and private individuals have confidence in banks and insurance companies when they transact business. The regulations are designed to ensure that the probability of a bank or an insurance company experiencing severe financial difficulties is low.

What is the most troubling about this is that we went through Enron, we went through AIG accounting scandals, we passed Sarbanes Oxley, we thought people believed and wanted to believe or we wanted to believe the lesson was clear that schemes like these wouldn’t be accepted. And yet here we right back at the, sort of, inception. These transactions serve one purpose only, that was to mislead the market, they serve no economic purpose. Unfortunately, only criminal actions and saying to people it is not simply tolerable any longer.

Lehman's executives relied on the use of several accounting techniques that were used by Lehman's British affiliate that were not used in the U.S. Will the use of one set of accounting standards (IFRS) close this gap?

Various e-mails suggest that Lehman's executives knew that they were the only ones using the aggressive accounting technique but were content to use innovative techniques to mislead financial statement users. This raises the question of the appropriateness of the use of non-traditional accounting techniques and the disclosures that are required. Subsequent to Lehman's failure, FASB attempted to address this cloudiness by issuing a new statement. However, this is reactive. The question is how can FASB and other standard setters and regulators be more proactive?

Another area that needs further investigation is the responsibility of auditors when they are faced with unusual transactions. A suit filed by Andrew Cuomo on behalf of the People of the State of New York against Lehman's Auditors, Ernst & Young, LLP stated that E&Y assisted Lehman to engage in the massive accounting fraud. It is clear that the auditors had a duty to conduct more tests to assess the impact of these transactions on Lehman's financial statements. The question is will the outcome of this lawsuit lead to an increase in the responsibility as well as the expectations of auditors?

There are many cases of violations of the Sarbanes Oxley Act. Will executives be required to disgorge their unearned bonuses and other compensation and will they be held accountable and sent to jail for their role in the global financial meltdown when it is found that their companies sustained losses?

The use of Repo 105 by Lehman Brothers to hide their toxic mortgages from the public and show a favorable financial position has raised the question of the legal and ethical duties of fiduciaries to their clients and the public. It also indicates that the doctrines of fairness and conflict of interest may apply to all aspects of business. The use of Repo 105 constituted a conflict of interest and a serious breach of ethical conduct. In this paper, an examination is made of the use of Repo 105 and the difference between aggressive accounting and unethical behavior. Our findings suggest that Lehman's management acted unethically by violating the Integrity and Credibility standards of the IMAs Code of Conduct in its actions with the use of Repo 105. They also violated the requirements of the Sarbanes-Oxley Act of 2002 by stating that the financial statements were fairly stated when indeed they were misleading. We also find that Lehman engaged in conflict of interest activities and failed to adequately protect their investors. It is clear that there exists a thin line between aggressive accounting and unethical behavior. The ultimate decision regarding Lehman's liability and possible criminal culpability with respect to the alleged abuses in their use of Repo 105 and the eventual bankruptcy will be decided by the U.S. Courts.


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