Peter J. Henning follows issues related to white-collar crime for DealBook’s White Collar Watch.
The bankruptcy examiner’s report filed by Anton R. Valukas on the 2008 demise of Lehman Brothers discusses some accounting gimmicks that are eerily reminiscent of how Enron tried to prop up its balance sheet back in 2001 before it collapsed.
Both companies appear to have played right along the edge of properly accounting for transactions designed to make them appear much stronger than they turned out to be, becoming steadily more aggressive as they teetered on the brink of ruin.
The examiner’s report discusses potential claims that the bankruptcy trustee can bring against Lehman’s former officers and outside advisers and does not mention potential government law enforcement action. Reading his report, however, gives strong indications that at a minimum the Securities and Exchange Commission is likely to pursue civil charges for securities fraud, and that criminal charges are certainly possible against Lehman’s former top executives.
The examiner’s report gives us a new term for hiding problems on a corporate balance sheet that may become common parlance: “Repo 105.” Starting in 2001, Lehman Brothers engaged in repurchase agreements, called “repos,” which were described by DealBook as “what amounts to a short-term loan, exchanging collateral for cash up front, and then unwinding the trade as soon as overnight.” Repos are a common method for investment banks to finance their operations and are neither illegal nor questionable, at least when clearly accounted for.
Lehman Brothers went a step further by having the collateral exchange under the agreement worth 105 percent of the cash it received — hence, the “105” in the firm’s nomenclature. By doing so, that turned it into a sale for accounting purposes, so that the firm could move the assets it exchanged in the deal off of its balance sheet, at least for a short while.
As explained by DealBook, “That meant that for a few days — and by the fourth quarter of 2007 that meant end-of-quarter — Lehman could shuffle off tens of billions of dollars in assets to appear more financially healthy than it really was.” By timing Repo 105 transactions to the end of a quarter, the reports filed with the S.E.C. and reviewed by investors looked much better than what was going to be the case just a short time later. Enron did much the same thing with some of its assets, such as its notorious Nigerian barge deal.
The examiner’s report goes into great detail in describing how the Repo 105 transactions allowed Lehman Brothers to portray itself much more favorably to investors and analysts by proclaiming that it was reducing its leverage, something very important as the real estate bubble was bursting in 2007. The report determines that Lehman Brothers ramped up its use of Repo 105 deals to reduce its leverage by $38.6 billion in the fourth quarter of 2007, by $49.1 billion in the first quarter of 2008 and $50.4 billion in the second quarter of 2008. The firm did not quite get to the end of the third quarter, filing for bankruptcy in September 2008.
And there is the root of the potential civil and criminal liability of Lehman’s executives. The report describes the use of Repo 105 transactions as a “material misrepresentation” of Lehman’s financial statements.
A second issue involves the firm’s claims that it had adequate liquidity to deal with the collapsing market in 2008. According to Mr. Valukas, that purported liquidity included assets that Lehman could not easily tap and investments that were far from liquid. Once again, the statements by corporate executives about the firm’s strength may well have been misleading.
The examiner’s report says Lehman’s three chief financial officers during 2007 and 2008 (the firm played musical chairs with its C.F.O.’s during the period) and its former chief executive, Richard S. Fuld Jr., most likely knew of the effect of the Repo 105 transactions. If the financial statements were false, then each could be prosecuted under a provision adopted in 2002 as part of the Sarbanes-Oxley Act (18 U.S.C. § 1350), which requires the chief executive and the chief financial officer to certify that the financial statements comply with all applicable statutes and rules.
Public statements about the liquidity issue and the leverage on the balance sheet could be the basis of a securities fraud violation, along with potential charges related to properly maintaining the company’s books and records and providing false information to the S.E.C.
The examiner’s report notes that each of the senior executives denied having any detailed knowledge of the Repo 105 transactions or their effect on the financial statements. It also identifies one potentially important witness, Lehman’s former chief operating officer, as stating that he spoke with Mr. Fuld about the transactions and that he understood the accounting treatment of them.
As in any securities case, the key issue would be intent if the government pursues charges against former Lehman executives. No one will dispute that the Repo 105 transactions occurred, or that public statements about the firm’s balance sheet and liquidity were made. Much as during the Watergate investigation, the issue will be what the executives knew and when they knew it.
The examiner’s report goes into great detail regarding e-mail messages exchanged by various Lehman executives about the nature and effect of the Repo 105 transactions, with one describing them as “window dressing.” But e-mail alone does not make either a civil or criminal case. The recent prosecution in Brooklyn of two former Bear Stearns hedge fund managers, with a trial ending in their acquittal, showed how difficult it was for the government to prove a case based only on what the defendants wrote or received electronically. Words are rarely precise, and inferring knowledge from e-mail traffic can be difficult.
The Repo 105 transactions were not objected to by Lehman’s outside auditor, Ernst & Young, and the British law firm Linklaters provided an opinion letter under British law that they were sales and not mere financing arrangements. For a criminal prosecution especially, a defense of reliance on experts can undermine the government’s proof of intent to defraud or knowledge that statements were false or misleading.
As in the Enron prosecution, to make a securities fraud case against any Lehman executives the S.E.C. and Justice Department will need cooperating witnesses who can explain the underlying transactions and provide testimony about what was said and understood at the time. In the Enron and WorldCom prosecutions, the chief financial officers of the two companies — Andrew Fastow and Scott Sullivan, respectively — were crucial witnesses against the chief executives, Jeffrey K. Skilling and Kenneth L. Lay of Enron, and Bernard Ebbers of WorldCom.
The offices of the United States attorneys for the Southern and Eastern Districts of New York have been investigating the collapse of Lehman Brothers for months, along with the S.E.C. The government has access to the same documents as those discussed in the examiner’s report. As a former United States attorney, Mr. Valukas must have been keenly aware that his conclusions about the Repo 105 transactions being materially misleading and discussions about the basis for finding the executives were knowledgeable about Lehman’s financial difficulties would serve as a type of road map for potential government enforcement proceedings in addition to private lawsuits.
Will the government take action against any Lehman Brothers executives? I think a civil action by the S.E.C. is likely because of the importance of the Repo 105 transactions and the effect of the statements about liquidity on the market. The burden of proof in the civil case is much lower, requiring a preponderance of the evidence. And the commission may well bring a case against the outside auditors in addition to individuals at Lehman Brothers.
The canary in the coal mine for whether there will be a criminal case is if we see any executives from just below the executive suite agreeing to plead guilty and cooperate. Prosecutors work from the lower levels of management and then work their way up the chain. A criminal case will need cooperating witnesses to flesh out what happened because the documents and e-mail alone will not be enough to prove intent.
Accounting fraud cases generally take at least 18 to 24 months to develop, at which point the government will decide to proceed or allow the investigation to lapse. We are almost to that point, so the next few months will be crucial to seeing whether any criminal charges emerge from the collapse of Lehman Brothers. As the TV announcer says, “Stay tuned.”
– Peter J. Henning
“Peter J. Henning, writing for DealBook’s White Collar Watch, is a commentator on white-collar crime and litigation. A former lawyer at the Securities and Exchange Commission’s enforcement division and then a prosecutor at the Justice Department, he is a professor at the Wayne State University Law School. He is currently working on a book, “The Prosecution and Defense of Publc Corruption: The Law & Legal Strategies,” to be published by Oxford University Press.”
http://dealbook.blogs.nytimes.com/2010/03/12/in-lehmans-demise-some-shades-of-enron/
