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.