Last week, Chicago lawyer Anton Valukas submitted to the court charged with supervising the bankruptcy of Lehman Brothers a 2,200 page report on just how Lehman failed on September 15, 2008.
In preparing the analysis, Valukas and his team examined some 34 million pages of documents (a fraction of the pages turned over by the company and a testimony to the use of the written word in modern business).
Highlighted by Valukas was Lehman’s use of legal formalism to delay its collapse.
In the first and second quarters of 2008, Lehman did not want to reveal the extent of its debt obligations – its true leverage ratio which was a significant measure of the risk it had assumed in its business model. Thus, the company entered into so-called “Repo 105” transactions.
It order to earn higher profits in trading, Lehman like other investment banks borrowed money with which to buy and sell securities. Billions of dollars were thus borrowed in over-night loans called “repo” loans. Lehman pledged securities that it had bought as collateral for the loans. Both the collateral and the loans stayed on Lehman’s books, showing assets offset by liabilities. Keeping the securities on its books, however, offset by huge amounts of debt showed that Lehman was heavily leveraged and subject to collapse if its Repo lenders ever questioned its credit-worthiness, or the value of its collateral.
Now, in a Repo 105 transaction, Lehman would turn over collateral valued at 105% of the money borrowed. Under UK law, such a transaction could be considered a “sale” of assets and not a “loan” supported by assets still owned but pledged as collateral.
With a “sale” on its books, Lehman could reduce its balance sheet by both assets sold and debt repaid with the cash received for the assets. Then, the company could turn around in a new “purchase” transaction, borrow money and “re-purchase” the assets, loading up its balance sheet again with assets on one side and debt on the other. Repo 105 deals allowed it to de-leverage for a few days and then quickly re-leverage.
The critical point is that on special days at the end of each quarter when it had to report its financial position, by using Repo 105 “sales” Lehman could lower the debt shown to the public on its books. This way, it could appear to be in a more sustainable position than was the fact given its business model of using high leverage to earn more trading profits.
In its last three quarters, Lehman moved US$50 billion off its balance sheets using Repo 105 and Repo 108 “sales”.
Thus, questionable risk management on the part of Lehman was hidden from regulators and the public. The market was conned and Lehman’s supercharged speculation in trading was facilitated when taxpayers and the public were left to carry its can.
The manipulative device was a legal formalism, so bent from a proper purpose that it could be considered as no more than a legal fiction. Repo 105 deals were sales that really weren’t sales. The intent of Lehman was not to “sell” assets, but only to disguise its ownership risks for a day or so. It misused the law and abused its actual legal status, which was as a debtor.
The same technique had been used before by ENRON in its creative financing. Both special purpose entities and so-called “sales” of energy supplies to banks with right of repurchase at a higher price – really an usurious interest charge - were used by ENRON to hide the amount of its borrowings from the public.
In addition, transactions suggested by Goldman Sachs to the Government of Greece had a similar effect: forms of transaction allowed the Greek Government to under-report its debt obligations.
Accountants for both ENRON and Lehman approved treating the transactions as “sales” and assisted ENRON and Lehman in their cover-ups of actual risks assumed, but only because legal formalities had been attended to. “T”’s had been crossed and “i”’s had been dotted by lawyers, very accomplished and very well paid lawyers in fact. You can’t turn debt into non-debt without the help of lawyers.
In ENRON’s case, it was the firm of Vincent & Elkins in Houston; for Lehman Brothers it was Linklaters in London.
Upon this revelation of one way in which Lehman was able to over indulge in risk and cause havoc to global credit markets upon its collapse from excessive debt and speculation, we need to drag lawyers into reform of financial markets.
So far, the lawyers have gotten off scot-free. With ENRON, Arthur Anderson failed, but Vincent & Elkins has paid no penalty that I am aware of for making possible misuse of accounting proprieties. With Lehman, Linklaters insists that, given the facts presented to it, it did nothing improper in opining that transactions were legitimate “sales.” And, though Lehman’s auditor – Ernst & Young – will not go down over this as Arthur Anderson did with ENRON, its reputation is now tarnished as it apparently knew of Lehman’s thirst for Repo 105 “sales” and did or said nothing.
The point of learning, I suggest, is shortcomings in taking only a “compliance” approach to disclosure and risk management. Compliance is the working of black letter law where, if you can fit the “thing” conceptually within a verbal definition, the “thing” then becomes for legal purposes what ever is defined. Thus, “black” becomes “white” in the famous rejection of legalisms and legalistic thinking. A bird that quacks may not, therefore, be a duck.
The old story about a lawyer when asked “how much is two plus two” has him reply: “how much do you want it to be?”
Compliance approaches to disclosure of truth are exercises in appearances. If you can make it look good, you can successfully pretend that you have complied with the rules.
The alternative is to go for substance: what walks like a duck and quacks like a duck is a duck, plain and simple.
Going for substance is an ethical stance; compliance may or may not support truly ethical outcomes, as the Lehman case proves.
The challenge, however, is how to get to the truth behind representations? Who owns reality when appearances are often all we see of reality?
Making businesses more responsible requires that we bring in the lawyers, not for consultation, but for remediation of their practices. Or, maybe, accountants should be told that they can’t rely on legal opinions but must determine for themselves what is fair value under the circumstances?