Repo 105 - What happened to Materiality and Substance over form?

Out-going New York Attorney General (AG) Andrew Cuomo recently brought civil charges against Lehman Brothers’ external auditors Ernst & Young (EY) for complicity in fraudulently misleading investors. The AG alleges that Lehman’s then-auditor (EY) assisted the bank to perpetrate financial fraud. In particular, Cuomo has charged the accounting giant with three counts of securities fraud under the Martin Act and a charge of persistent fraud and illegality brought under the Executive Law § 63(12) of New York. The AG claims that EY, by signing off on the controversial Repo 105 transactions worth about $US 50 billion on Lehman’s balance sheet just before it went bankrupt, aided the bank to mislead investors.

Repo 105 (Repo is short for repurchase agreements) involved what amounted to a short-term loan, exchanging collateral for cash up front, and then unwinding the trade as soon as overnight. It involved selling securities for 105% of their value to counterparties with the agreement to repurchase the securities later. Repo 105s have been around since 2001 but they proved particularly useful to Lehman during the subprime crisis in 2008. The underlying collateral that Lehman typically used for its Repo 105 transactions included A- to AAA-rated securities, Treasuries and Agency debt since many of Lehman’s counterparties to the Repo transactions preferred liquid investment grade assets. However during the 2008 crisis Lehman shifted some of its Commercial Mortgage Backed Securities (CMBS) and subprime mortgages — which were falling in value in a very illiquid market off its balance sheet through Repo 105. Merely selling off those assets to decrease leverage would have resulted in significant losses for the bank, therefore Repo 105 came in especially handy. The beauty of Repo 105, according to Lehman adviser Linklaters, was that the firm could book the transactions as a sale rather than a loan. That meant that for a few days Lehman could shuffle off tens of billions of dollars in assets to appear more financially healthy than it really was; in time for quarterly reports.

When Lehman first designed Repo 105 in 2001, however, there was one catch. The firm couldn’t get any American law firms to sign off on the aggressive accounting. American law firms thought the transactions were loans in reality veiled behind the legal appearance of a sale. Therefore they (Lehman) hired British law firm Linklaters who provided a sale opinion on the Repo transactions under British law. Incidentally, Lehman’s Repo 105 transactions were executed through its European arm Lehman Brothers International (Europe) or LBIE. This “opinion-shopping” provided Lehman with exactly what it needed to book its Repo 105 transactions as sales and is a key argument in Cuomo’s suit.

In response to the AG’s allegations Ernst & Young said:

“There is no factual or legal basis for a claim to be brought against an auditor in this context where the accounting for the underlying transaction is in accordance with the US Generally Accepted Accounting Principles (US GAAP). Lehman’s bankruptcy occurred in the midst of a global financial crisis triggered by dramatic increases in mortgage defaults, associated losses in mortgage and real estate portfolios, and a severe tightening of liquidity. Lehman’s bankruptcy was preceded and followed by other bankruptcies, distressed mergers, restructurings, and government bailouts of all of the other major investment banks, as well as other major financial institutions. In short, Lehman’s bankruptcy was not caused by any accounting issues.”

EY’s response is all true. The provision applicable to the Repo 105 transactions, called SFAS 140, is subject to interpretation, like most accounting rules. Taking a liberal view of its requirements would support the conclusion that Lehman complied with reporting standards and therefore would be difficult for the attorney general to establish that the accounting treatment violated GAAP. Secondly, I remember September 2008 all too well. It was two months after IndyMac Bank had suffered a bank run leading to its bankruptcy following Sen. Charles Schumer’s unrelenting public comments on the banks poor health. It was an era marked with fire sales of undervalued assets, panic, speculation arising from nervous markets and credit contagion.

But the fact of the matter is the AG is not charging E&Y for being responsible for Lehman’s bankruptcy, neither is he saying Repo 105’s violated GAAP or that they caused Lehman’s bankruptcy. At the core of Cuomo’s complaint is whether investors failed to comprehend the risks on Lehman’s balance sheet because the Repo 105 transactions (or their lack of disclosure) concealed the firm’s precarious position.

This brings me to the core accounting convention of Materiality and to a lesser extent full disclosure. Materiality means that accountants only record events that are significant enough to justify the usefulness of the information. Only items that are deemed significant for a given size of operation should be recorded. In other words information is deemed material if it’s inclusion or lack thereof can be significant enough to alter users' decisions or otherwise mislead users. On Lehman’s last balance sheet before it went bankrupt, there were US$ 50 billion worth of Repo 105 transactions. Is this material enough to be fully disclosed in the footnotes to the account? Let’s find out. Based on my audit experience, I would deem a transaction or account to be material if it was either 5 – 10% of pretax income (default for public companies), 0.5 –1% of revenue, 1 – 2% of Gross margin or 1 –5% of Equity. Lehman’s pretax income for the period ended November 30, 2007 (it’s last before it filed for bankruptcy was) was US$ 6 billion. So assuming Lehman was thought to be lower risk by its auditors they (E&Y) would set materiality at say 10% of 6 billion. Meaning any account with a value of at least US$600 million would be considered material. Clearly the volume and dollar value of the Repo 105 transactions for that period alone exceeded reasonable materiality thresholds. The question is was it material enough to require separate and full disclosure on the financial statements? These are difficult questions that have no easy answers.

The other issue is the accounting principle of substance over form. In accounting, real substance takes precedence over legal form. Meaning accountants must look beyond the legal form and consider the economic reality or financial substance of transactions. Repo 105s in all reality would appear to be a short term financing deal; rather than a sale. This would make it some type of collateralized short term loan. Of course recording the transaction as a loan would do nothing to improve the snapshot view of Lehman's deteriorating leverage position on its balance sheet at the cutoff date, which would appear to be the reason Lehman sought legal grounds in the UK to book the transactions as a sale. I mean who sells assets and buys them back after a few days, every quarter at the cutoff date for reporting? Obviously Lehman performed its actions with decent legal grounds but the financial substance was sketchy. Should Ernst & Young have insisted that Lehman separately disclose the volume of its Repo 105 transactions because of the extent of their materiality? Should they have invoked substance over form to restate the financial statements to reflect the Repos as a loan rather than a sale? I don’t know. I do know that the world of finance can be very complicated.

Ernst & Young is a solid reputable firm and this suit is not doing a lot of good to its image. Rather than risk the reputational cost of a prolonged legal battle if this case goes on trial, I would hope Ernst & Young will settle the case out of court. I worked at Ernst & Young prior to b-school and it is solid beacon among the world’s top four accounting firms. Needless to say, it will be interesting to see how this case unfolds.

KALEVOR: Global vertical integration personified – The China Model

China maybe ruled by the Communist party but there’s hardly anything communist about the way the country is run. China has become a global behemoth over the last few decades since Deng Xiaoping begun economic reforms in 1978. Their government is a well oiled machine that runs with blistering efficiency. Decisions are taken quickly and executed with just as much dispatch. The communist party runs the country like a corporation.

In the second quarter of 2010 China surpassed Japan to become the world’s second largest economy after posting a second quarter GDP of $1.337 trillion. Undoubtedly this caps China’s meteoric rise from rural communism to being a global economic force. But the story of China is just beginning. The reasons are simple. Over the past decade, China has been on a relentless mission to control the critical resources that drive its growth – steel, iron ore, oil, agriculture, technology and rare earth elements. At the same time, the artificially devalued renminbi (the Chinese currency) effectively ensures that China controls its export prices, making its export led growth a smooth sail - for now at least. A vertically integrated model that worked successfully for western business moguls such as John D. Rockefeller, Andrew Carnegie, US Steel, BP, Exxon Mobil, etc. Simple strategy, effective results.

BHP Billiton’s (the world’s largest mining conglomerate) $39 billion bid for Potash Corp in August 2010 was not the only time the Australian mining giant attracted China’s unwelcome attention. In November 2007, BHP’s bid for iron-ore giant Rio Tinto crumbled under China’s “dawn raid” on Rio Tinto. BHP had proposed a 3 for 1 share swap for the deal which Rio unequivocally rejected as undervaluing it. At the same time, China’s steel industry, the largest in the world was worried that a BHP-Rio merger would cause a monopoly in global iron-ore production. The combined enterprise would control at least 60% of global iron ore production. Such a monopoly could cause the price of steel to rise and effectively stifle China’s export led growth. China, eager to have control of a crucial ingredient to its expansion would stop at nothing to keep Rio Tinto out of BHP’s hands. BHP raised the bid for Rio to $147 billion on February 6, 2008 but it was too little too late. Just 5 days earlier, China Aluminum Company (Chalco), China’s state owned aluminum producer had launched a dawn raid and bought a 9.3% stake in Rio Tinto. Making it the biggest shareholder, China gained two advantages – they could acquire Rio at a depressed stock price or they could gain enough clout to outvote BHP’s bid. So with a simple strategic move, China now controls an essential ingredient to its growth. They played it beautifully!

It looks like BHP is going to get burned by China yet again. Sinochem Corp, China’s state owned chemicals company has been keenly following BHP’s bid for Potash Corp. (a Canadian mining giant and the world’s largest producer of fertilizer) Why is China so interested in Potash? Simple - agriculture! Potash is a key ingredient in fertilizer and as the world’s population expands and food security becomes important, whoever controls potash production is likely to be laughing to the bank. BHP knows this, but unfortunately for them, so does China. Secondly, as a top consumer of potash, China wants to keep prices for the vital crop nutrient low and does not want Potash in BHP's hands. That situation is still unraveling and it will be interesting to see how it plays out.

Needless to say, this strategy has been very successful for China. Buying foreign companies with the technology they need, moving production to China and eventually owning the technology. A few decades ago the best PC brands were made exclusively in the US. Today, superior brands such as Lenovo and Asus are manufactured in China. Lenovo bought IBM’s PC division a few years back, took production home and now Lenovo is a widely used brand in US markets.

China is getting its hands on everything. Last week state-owned oil refiner Sinopec paid $7.1 billion to the Spanish oil company Repsol for a 40% stake in its Brazilian unit. The new funds will allow Repsol to develop its discoveries in the Guara y Carioca blocks, both located in the Santos Basin off the Atlantic coast, where Petrobras is also actively exploiting one of the largest oil finds in recent history. Petrobras (Brazil’s state owned oil giant) raised $67 billion in a secondary stock offering – the largest such offering in history on September 24 2010. And China will be there, getting a piece of that wealth. It’s remarkable to say the least. But the most impressive story of China’s quest to “vertically integrate” is how it managed to control 97% of the world’s production of rare earth elements (REEs) – a key input needed for its military and technological expansion.

Rare earth elements are a group of 17 naturally occurring chemical elements on the periodic table. They represent a family of minerals found in commercial products ranging from TV displays, cell phones, superconductors to green technologies such as hybrid electric motors and wind turbines. For instance, the rare earth element neodymium is very magnetic and is used in everything from computer hard drives to Toyota's Prius hybrid car. Military technologies such as guided bombs and night vision goggles rely heavily upon rare earth elements. Promethium is a highly radioactive rare earth element and is used in making nuclear batteries.

Since the 1990s, China has been buying up mining companies that own rights to rare earth mines around the world. They gained global market share at an exponential rate by reducing the price of REEs and effectively controlling the market after a few years. Through learning effects and scale economies, China acquired the technology to mine REEs efficiently and the bulk of the 97% of global output comes from the Inner Mongolia region of China. The United States was once the main source of REEs. The Mountain Pass, CA rare earth mine is perhaps the largest non-Chinese source of REEs. In 2005, the China National Offshore Oil Corporation (CNOOC) made a bid to acquire Unocal Corp, the US oil company that owns the Mountain Pass, CA mine. Had the US Congress not blocked the deal, the mine would have slipped quietly into Chinese hands and they would be controlling a near 100% of global REE production.

An April 2010 report by the US Government Accountability Office (GAO) states that this situation poses a serious national security risk. "Defense systems will likely continue to depend on rare earth materials, based on their life cycles and lack of effective substitutes," the GAO reported. The report further stated that it could take at least 15 years for the US to wean itself of its dependence on REEs from China.

The Department of Defense (DOD) and military officials have stressed how rare earth elements form a currently irreplaceable part of devices such as lasers, radar, missile-guidance systems, satellites and aircraft electronics. And many military systems rely on commercial computer hard drives that use rare earth magnets. Even more specific examples of rare earth-driven technologies include the navigation system for the M1A2 Abrams battle tank, and a new hybrid electric drive in the works for the Navy's DDG-51 destroyers. According to the GAO report, rare earth elements might eventually become part of the US National Defense Stockpile. Again, China was one step ahead as they seem to be in recent decades. The rare earth unit of China's Baotou Iron & Steel Group gained official approval in February 2010 to begin building a strategic reserve of rare earth elements, China's official newspaper, People's Daily, recently reported.

Clearly with the amount of control China now holds on these key resources it will become a global superpower without much doubt. China is clearly attempting to backward-vertically integrate the inputs needed for its expansion. In some cases it has set quotas on REE exports to satisfy its own demand for the resource. They set quotas or outright bans for other reasons as well. And they do it because they can.

In September 2010, China imposed a ban on exports of REEs to force the release of a detained captain of a Chinese fishing trawler whose boat collided with two Japanese coast guard ships off the East China sea. Within days of the ban, Japan which was initially adamant, released the boat captain. Now this may seem like a minor diplomatic row, but if China can exercise such leverage, then what it can do with this power remains to be seen.

KALEVOR: The Role of Free Market Economics in the Future

With the U.S. economy spinning dangerously out of control and with G-20 leaders scrambling for options at their recent summit, several questions have been raised about the potency and viability of free market capitalism as a sustainable means of efficiently allocating resources and creating wealth.

Former Federal Reserve Chairman, Alan Greenspan, one of the most authoritative economists of the post WW II period, admitted that he was shocked at the scale and magnitude of this recession which was sparked off by frozen credit markets. At a speech prepared for delivery before a congressional committee in 2008, he said “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity—myself especially—are in a state of shocked-disbelief.”

This raises some pertinent questions, a few of which are: Are we going back to an era of nationalization of private enterprise—given the unprecedented scale of government intervention in the capital markets? Should it be so or should the market be allowed to perform its duty of “efficiently” allocating resources? Is the market really efficient? Or, the market is sometimes irrational? Was Citigroup Inc. really worth ninety-something cents a share when it broke the buck in March 2009? Is this the end of free market economics as we know it?

In the light of all this, I present below compelling anecdotal (the experience of my home country Ghana) and empirical evidence from Adam Smith’s book, Wealth of Nations, that point to all indications that free markets is still the most potent social system for creating wealth.

On December 31 1981, Lt. Jerry Rawlings and his team of air force officers overthrew the democratically elected government of Dr. Hilla Limann. This was the second time that Rawlings had staged a military coup in two years—the first was in 1979 when he led a group of renegade military officers to oust the Supreme Military Council. This marked the beginning of Ghana’s tumultuous slide towards centralized economic planning. Rawlings and his band of idealists were angry about, what they termed, the “greed and corruption” of wealthy politicians and businessmen; thus he promised a “revolution” with his 1981 comeback.

In hindsight, Rawlings genuinely sought to bring progressive change but was in need of proper direction as he led Ghana to find its identity. He seized money, property, and businesses of wealthy businessmen and promised to equitably distribute the nation’s resources to all citizens. His regime centralized all the major sectors of the economy, including agriculture which was its backbone. My mother tells me that she had to queue for hours to buy food from government warehouses in those days. By 1984, the drought that had hit most parts of sub-Saharan Africa had taken its toll on Ghana and millions of people were starving across the country. Rawlings had to turn to the same western liberalized economies that he so despised because of his leftist inclination, for food aid. The fact that Ghana couldn’t survive the drought without food aid leads me to conclude that while centralized economies may satisfy short term goals, over the long haul, they are not sustainable for economic prosperity.

Today, it’s a new Ghana, booming with the fastest growing financial markets in Africa, attracting foreign direct investment, and recording one of the highest GDP growth rates on the continent. By 1990, it was clear that the future of the country lay in free market economics. The state-owned telecommunications, postal, electricity, and agricultural sectors were divested to private entrepreneurs. Under the Financial Sector Adjustment Program (FINSAP), the banking sector was deregulated and a stock exchange was established in 1990.

Free market economics provides the incentives necessary to drive innovation, growth and economic prosperity. It removes the “tragedy of commons” that bedevils centrally planned economies. In his book, Wealth of Nations, Adam Smith (1776), noted that a group is collectively better off, if each individual in the group strives to achieve self interest. The incentives, derived from individual success, motivate everybody to innovate and create value leading to positive externalities that benefit all. This explains why companies especially in biotechnology, pharmaceuticals, aerospace/defense, and robotics deploy billions of dollars in research and development.

But for patent laws that protect their proprietary knowledge and processes, they would not profit from their research and we would gravitate to a Nash equilibrium where no one conducts research at all. With patent laws, these firms benefit the most (for instance, the huge rallies in their stock prices/windfall corporate profits when their patents are approved) from their research, but the community also benefits (positive externality) because of cutting edge cancer drugs, anti-retroviral drugs, etc that their research produces and which save lives. This incentive to innovate, that Adam Smith referred to 300 years ago, probably explains why some small biotech firms tend to be less innovative when they’re acquired by larger pharmaceutical firms. The potency of free market economics is as true today as it was 300 years ago, from this example.

William E. Simon (1978) (63rd United States Treasury Secretary and namesake of the William E. Simon Graduate School of Business – University of Rochester) in his book, A Time for Truth, recounts his experiences as the Chairman of the Oil Planning Committee in the 1970s. He notes how the Energy Planning Office centralized the distribution and allocation of oil resources. The lack of innovation in energy exploration that resulted from government regulation of the sector resulted in a heavy reliance on imported oil. By 1973, the U.S. was importing one-third of its oil, half of which came from the Middle East.

The 1973 oil embargo from Arab countries created a gaping hole in the U.S. oil supply chain. Again, central planning proved not to be sustainable in the face of this crisis. These experiences cemented William E. Simon’s beliefs in laissez-faire capitalism. He wrote that, “there is only one social system that reflects the sovereignty of the individual: the free market.”

These examples overwhelmingly demonstrate that free market economics is the best social system in the sense that it guarantees the primacy of the individual and it creates value as a consequence. The viability and applicability of free markets have no geographic boundaries as demonstrated by the Ghana and United States examples. Finally, the concept has stood the test of time; thus, history is the best argument in favor of free markets.

In the face of the 2007-2009 global recession and the unprecedented government intervention that we’re seeing, the efficacy of this argument remains to be seen going into the future. But that is a story for another day.

Delaena Kalevor is an MBA Graduate from the Simon Graduate School of Business, University of Rochester. Excerpts from this article were part of an award-winning essay he presented to the Simon School for which he was awarded The Prince Family Scholarship for his philosophical insights into free market capitalism.

Liberia - Africa’s oldest republic celebrates 162 years of nationhood on July 26 2009. What does the future hold for them?

On July 4 2009, Liberia’s Truth and Reconciliation Commission (TRC) recommended the prosecution and debarment of ex-warlords and their associates during the Liberian civil wars of the 1990s and early 2000s. It recommended that President Ellen Johnson-Sirleaf, and others be barred from public office for thirty years for their role in the dreadful war. Mrs. Johnson-Sirleaf became the first female head of state in Africa when she became Liberia’s president on January 16 2006.

Liberia became the first republic in Africa when freed slaves from the United States (who chose to return to Africa) founded the nation on July 26 1847 with Joseph Jenkins Roberts “originally” from Norfolk, VA becoming its first president. The freed slaves or Americo-Liberians (as they became known as) though just about 5% of the population formed an impregnable ruling elite in Liberian society virtually colonizing the natives. They ruled the country unchallenged till 1980 when Sgt. Samuel Doe (a native from the Krahn tribe) stormed the Executive Mansion, executed President Tolbert and his family and took over the country in a very bloody military coup. The natives were mainly made up of the following West African tribes: Dei, Bassa, Kru, Krahn, Grebo, Gios, Manos, Vai, Mende, Mandingos among others.

While Doe’s military coup ended 133 years of Americo-Liberian hegemony, his tumultuous regime was characterized by mass executions of many Americo-Liberians in apparent retribution for decades of their domination. By 1989, the Americo-Liberians were growing impatient with Doe and multiple insurgencies had begun in various parts of the country. The most notable rebel movements were led by Prince Yomi Johnson and Charles Taylor. Prince Johnson’s rebel faction captured and tortured President Doe before executing him in September 1990. After Doe was killed, a power struggle between Johnson and Taylor eventually led to the protracted civil war that ended in 1997 after the Akosombo Peace Accord was signed in Akosombo, Ghana. Taylor became president after elections in 1997 but was forced into exile in Nigeria in 2003 after another rebel insurgency led to the collapse of his government. A transitional government took over the country till elections in 2005 after which the current president was sworn in on January 16 2006.

What does the TRC’s recommendation mean for the future of Liberia and President Johnson-Sirleaf? First off, Mrs. Johnson-Sirleaf (a Harvard trained lawyer) has never lied about her support for Charles Taylor when he launched his insurgency from Ivory Coast in 1989. At the time, Samuel Doe was the common enemy. She claims Taylor convinced her under false pretenses. I believe it’s possible for anyone to be taken in given the circumstances – even the most astute politician. Obviously, Taylor is one wily dealmaker (from lay preacher to businessman to warlord to president and now war crimes defendant). He even has “breaking out of a maximum security prison in the United States” on his resume. Clearly, Taylor is the kind of guy who has no real cause. He was a mercenary by almost any measure.

But Mrs. Johnson did support an insurrection against a sitting president. Was she wrong? I don't think so. Doe's regime was illegal. He came to power in an extremely bloody military coup against a “democratically” elected president. His brutal reign was typified by ethnic politics, public executions of his enemies, among other atrocious crimes. In my view, Mrs. Johnson-Sirleaf is no less a patriot than the officers of Ghana’s AFRC revolt in 1979 or Washington, Jefferson and Adams. After all she withdrew support for Taylor after she could get a better read on him.

There are many lessons that can be drawn from Liberia’s story. In many ways, it’s very similar to the French, American, Cuban (Fidel Castro’s 1959 revolution), Libya (Gaddafi’s Al-Fatah revolution) and the Iranian (Islamic) revolution. Who would have thought that after 133 years of “democracy” Liberia could descend into such anarchy? The answer is there was no democracy to begin with. The Americo-Liberians “colonized” the natives and ruled them like subjects for over a century. During that period, they wielded all political and economic power and it was as if the natives lived in a different world. The fact that there was “peace” didn’t mean everything was OK. It was a time bomb waiting to explode. And it did explode in 1980 when Doe, a native and a sergeant in the Liberian military burst on the scene.

How can a sergeant (a non commissioned officer in the army) just storm a presidential residence and take over a country? He and his rebels must have been very angry. They had nothing to lose and so they were highly motivated. Harrison Ford (as U.S. president James Marshall) in the movie Air Force One said that “peace is not just the absence of conflict but the presence of justice.” The injustice of 133 years in Liberia is what culminated in Doe and the civil war. I do not intend to give any credit to Doe, but he changed the country significantly. The native people are now fairly represented in Liberian politics and play a bigger role in government. Doe may be a savage beast, but he changed the country even though at a very high price.

Jerry Rawlings (former president of Ghana) once said that “if you humiliate a human being for so long and to such a base extent; even when you offer him a Cadillac to appease him, he’ll kick it right back at you, he will demand your blood.” His views maybe a little extreme but it clearly explains what happened in Liberia. Social injustice ultimately leads to “class wars”, which is what all these revolutions have been about.

I'm only pleased that democratic institutions are working well in the new Liberia, such that they are willing to hang out their dirty laundry and deal with it. Whether the executive or the courts decide to implement the recommendations of the TRC remains to be seen. But Liberia, the oldest republic in Africa has come a very long way. And I believe a brighter future lies ahead of them. Long live Liberia.