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How an accounting loophole helped enable Lehman Brothers demise 10 years ago

This year marks 10 years since financial services firm Lehman Brothers filed for bankruptcy in the US on Monday morning 15 September 2008. The date and event is now synonymous with the global financial crisis and the loss of 6 million jobs in the US, collapse of the housing market and consequences further afield such as the Euro-zone crisis and the bail-out of many key financial institutions that followed.

While corporate greed and de-regulated financial markets played a big role in what led to the crash, an accounting loophole called Repo 105 played a major role in enabling Lehman Brothers to misrepresent its sales and the financial fitness of the company.

It has however taken years to unravel the misuse and to determine if auditors, EY, knew about the scale of the problem.

 

What is Repo 105?

Accounting standards are not the most exciting sounding and usually only make sense to people trained to read and interpret financial statements. However, as was seen with Repo 105 a small re-interpretation of an accounting standard can have disastrous consequences in combination with other corporate failures.

Back in 2001 a new US accounting standard SFAS 140 first enabled Lehman Brothers to use Repo 105, which allowed Lehman’s to book repurchase agreements as sales rather than temporary transactions. While the practice was being used from 2001, it was only in 2007 that Lehman’s executives started to use the practice more regularly removing over $50bn of assets from the balance sheet.

 

How was this possible?

An investigation by a court appointed investigator Anton R. Valukas  in 2010 found that while under  SFAS 140 every sale had to fall under the true sale criteria- hence many other financial institutions misused this accounting standard – and US law firms would not approve repurchase agreements as sales.

However, Lehman Brothers found a way around it and went to London-based law firm Linklaters and used the international operations of Lehman Brothers for most of the Repo 105 transactions.

Linklaters was then the firm advising on the Lehman Brothers administration in the UK, which is 10 years latter still handled by PwC and has returned £41bn creditors so far, with £3bn still remaining to be distributed this year.

 

Were the auditors to blame?

Following the Valukas report legal claims fallowed from all over the world with some suits naming the auditors EY as also responsible for the bankruptcy and loss of assets.  In 2013 EY agreed to pay $99m to Lehman’s investors, but as the case was settled EY denied liability.
In the same year the UK regulator for the accounting profession decided to take no action towards EY in the case of Lehman Brothers. Equally the US Securities and Exchange Commission closed its investigation into the matter in 2012.

No one was ever jailed or prosecuted for their use of Repo 105.

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