12 March 2010
One of the most stunning revelations to come out of the Court Appointed Examiner’s Report into the bankruptcy of Lehman Brothers, published last night, was that the collapsed New York-based investment bank was unable to find a US-based law firm that was prepared to sign off its deceptive and probably fraudulent approach to accounting.
The 2,292 page report lifts the lid on Lehman Brothers’ use, at the end of each quarter, of Repo 105, an accounting ruse that enabled it to hide up to $50 billion of toxic loans without any need to declare these on its balance sheet. Lehman Brothers relied on this and other Enron-esque kidology to deceive investors and counterparties about its financial health — and dress up the ‘sow’s ear’ of its own profligate recklessness as the ‘silk purse’ of a prudently-managed bank.
The report’s author, Chicago-lawyer Anton Valukas, wrote: “Unbeknownst to the investing public, rating agencies, government regulators, and Lehman’s board of directors, Lehman reverse engineered the firm’s net leverage ratio for public consumption.” But US-based lawyers refused to lend their name to the trickery. So where did the investment bank, led by CEO Dick Fuld go? Where could it be confident of finding a firm of lawyers willing to rubber stamp such underhand practises?
Naturally, it came to London where Linklaters was only too happy to oblige. One assumes that Linklaters’ hunger for fees dulled any ethical antennae. The “magic circle” law firm appears to have had fewer qualms about lending its name to sophisticated swindling along these lines than lawyers across the pond (it’s also worth remembering that Linklaters was principal legal adviser to Royal Bank of Scotland on its disastrous €71bn takeover of ABN Amro).
The same applied to Lehman’s use of Ernst & Young as its UK auditors. The London office of the surprisingly pliable “Big Four” accountancy firm was no less reluctant to lend its imprimatur to Lehman’s sleight-of-hand. No questions were asked, as long as the fees — $31 million in 2007 — were paid (for further analysis of the shamelessness of ‘Big Four’ audit firms click here).
Lehman’s choice of jurisdiction is telling.
The 2000 Financial Services & Markets Act helped institute a regulatory vacuum in the UK. It did this by, among other things, decreeing that the FSA “must consider the international mobility of the financial business” before taking enforcement action against financial institutions and “avoid damaging the UK’s competitiveness”. In other words, Tony Blair’s government created a regulator that was specifically asked to put the interests of the Square Mile above the rule of law. (I learnt about this from Nick Cohen’s excellent recent Observer article “Shock! City slickers are arrested“)
It was little wonder that in 2002-08 London became known as “Guantanamo Bay of finance” to US investment bankers. The FSMA ensured they were able to get away with things here that would never have got past regulators in America (in much the same way as the US perpetrated abuses in the Cuban enclave that wouldn’t have been carried out back home). The prospect of virtually zero oversight in the City of London, dubbed “light touch, limited touch” regulation by chancellor Gordon Brown, was hugely attractive to Wall Street firms and other US financial institutions, which flocked to locate their riskiest and most highly-leveraged activities in the Square Mile.
In the case of insurance company AIG, London became home to its epically disastrous “Financial Products Group”. Led by the trader Joe Cassano, this ended up playing a key part in precipitating the financial crisis of October 2008, and its activities have been brilliantly covered by Tim Rayment in a feature in the Sunday Times magazine on May 17 2009 (see “Joseph Cassano: The Man with the Trillion-Dollar Price on His Head“). Here is an excerpt: “Operating from the fifth floor of a polished white stone building in Mayfair, Cassano’s unit sold billions of pounds of derivatives called credit-default swaps (CDS), allowing banks to buy risky debt without attracting the attention of regulators. AIG took the fees, but did not have the money to pay up if the loans went bad. By the time the music stopped, European banks had protected more than $300 billion of debt with this bogus “insurance”.”
Senior Lehman executives — presumably including Fuld — and Ernst & Young were fully aware of the use of Repo 105 to misrepresent the bank’s figures, according to the Valukas report, which has detonated a series of timebombs that are likely to continue to reverberate across the financial landscape for months to come.
Valukas, senior partner of New York law firm Jenner & Block, suggested there are “colorable” claims (ones that would be plausible to a jury) against Fuld, Christopher O’Meara (Lehman’s head of risk), and two of Lehman’s former chief financial officers, Erin Callan and Ian Lowitt. He also said there could be “colorable” claims against E&Y, adding, “Colorable claims exist that E&Y did not meet professional standards, both in investigating [whistleblower Matthew] Lee’s allegations and in connection with its audit and review of Lehman’s financial statements.” If E&Y were to face claims for negligence and damages, there’s a chance it could implode as Arthur Anderson before it.
Lynn E Turner, a former SEC chief accountant, accused E&Y of abdicating responsibility by not presenting its concerns to Lehman’s audit committee. He (yes it is a man) told the New York Times: “This is pretty aggressive and pretty abusive. I don’t know how under GAAP this follows the rules whatsoever. It reeks of an auditor who is beholden to management.” Turner said he believes the SEC and Justice Department should follow up on Valukas’s findings.
Valukas’s also said there are “colorable” claims against investment banks JP Morgan Chase and Citigroup. Their demands for increased collateral and modification of agreements with Lehman sucked liquidity out of the weaker institution and precipitated its demise. The report, which cost $38m to produce, says the conduct of Lehman executives “ranged from serious but non-culpable errors of business judgment to actionable balance sheet manipulation.” Lehman chose to “disregard or overrule the firm’s risk controls on a regular basis,” even as the credit and property markets started to collapse.
Lehman used Repo 105 transactions from 2001 onwards to classify “repurchase” agreements as sales, keeping investors in the dark about its obligation to buy the assets back at a later date. Repo 105 enabled Lehman to remove problematic assets from its balance sheet, and provided cash with which it could temporarily pay down other liabilities. The ruse gave the impression Lehman was less dependent on leverage than it was.
In a string of emails cited by Valukas, one senior Lehman executive wrote of Repo 105: ”It’s basically window-dressing.” Another responded: ‘I see … so it’s legally do-able but doesn’t look good when we actually do it? Does the rest of the Street do it? Also is that why we have so much BS [balance sheet] to Rates Europe?” The first executive replies: ”Yes, No and yes.”
Fuld’s lawyer, Patricia Hynes, claimed Fuld: ”did not know what those transactions were — he didn’t structure or negotiate them, nor was he aware of their accounting treatment”. Valukas was appointed in January 2009 to examine the causes of Lehman’s collapse by the US Bankruptcy Court for the Southern District of New York.
Here’s my pick of the best of this morning’s coverage of the Valukas Report:-
- Examiner: Lehman Torpedoed Lehman Wall Street Journal
- The Genesis of Repo 105 FT Alphaville
- Repo 105 FT Alphaville
- Report escalates Lehman ineptitude to new level Breaking Views (via Daily Telegraph)
- Lehman Bosses Used Accounting Gimmick to Cover up Debts The Times
- Lehman’s Boesky, and why you can get away with anything in London Jeremy Warner’s blog
- Could Lehman’s Dick Fuld end up behind bars? The Guardian
- (Updated May 17th, 2010)