SEC Admits Flawed Oversight of Lehman Brothers

SEC Admits Flawed Oversight of Lehman Brothers

In the wake of a 2,200-page report on how “misleading” accounting techniques led to Lehman Brothers’ collapse, Securities and Exchange Commission (SEC) Chairman Mary Schapiro would not comment on whether an investigation would commence, but acknowledged that the agency’s oversight of Lehman was “terribly flawed in design and execution.”

“It was inadequately staffed almost from the very beginning. It was a bit insular and stove-piped,” she said.

In the report released last week, court-appointed examiner Anton Valukas said that while many of the decisions that led to Lehman’s collapse were “non-culpable errors of business judgment,” senior Lehman officials failed to disclose key actions that contributed to its financial failure. He mentioned individuals such as Chief Executive Richard Fuld, who he said was “at least grossly negligent in causing Lehman to file misleading periodic reports,” leading to Lehman’s bankruptcy.

More notably, the report said that Lehman’s external auditor, Ernst & Young, failed to meet “professional standards.” Enough evidence of its “failure to question and challenge improper or inadequate disclosures in those financial statements” exists to allow plaintiffs to file suit. Civil litigation could come from private plaintiffs or the SEC, and criminal charges from the Justice Department could even ensue.

The main issue was how Lehman used repurchase agreements, or repo. Investment banks don’t have large amounts of money at hand. Thus, when they need to pay operation costs, they go to a bank and get a short-term loan by putting up collateral – securities or bonds they possess – roughly equivalent to the amount of money they will receive. The investment bank gets this loan on the provision that it will buy back the collateral later, paying back the money and a small fee for the service.

Lehman realized that they only had to report these transactions as repos if the collateral was worth between 92 to 102 percent of the cash they received, due to a loophole. So, instead, Lehman supplied assets worth 105 cents to the dollar – hence the name Repo 105.

The banks still classified the transactions as loans. Lehman, however, could record them as sales, meaning the securities it put up for collateral disappeared from their balance sheets. It used this technique to hide billions of toxic assets by the end of the quarter in order to reduce doubts regarding its leverage, or debt problems, and appear more financially healthy than it really was.

The report said that though the Repo 105 transactions weren’t “inherently improper,” they were used purely to misleadingly manipulate their balance sheets. “Lehman’s own accounting personnel described Repo 105 transactions as an ‘accounting gimmick’ and a ‘lazy way of managing the balance sheet as opposed to legitimately meeting balance sheet targets at quarter end,'” it said.

In a speech in the Senate on Monday, Sen. Ted Kaufman (D-Delaware) said that “fraud and potential criminal conduct were at the heart of the financial crisis” and sharply criticized the financial industry, saying it was “high time that we return the rule of law to Wall Street.”

“We became enamored of the view that self-regulation was adequate, that ‘rational’ self-interest would motivate counterparties to undertake stronger and better forms of due diligence than any regulator could perform, and that market fundamentalism would lead to the best outcomes for the most people,” he said. “The allure of deregulation, instead, led to the biggest financial crisis since 1929. And now we’re learning, not surprisingly, that fraud and lawlessness were key ingredients in the collapse as well.”

Senator Kaufman also called for the Justice Department and the SEC to launch thorough civil and criminal investigations “to identify every last person who had knowledge that Lehman was misleading the public about its troubled balance sheet.”

Schapiro, who started her chairmanship one year ago, did not comment on whether the SEC would launch an investigation into Lehman or Ernst & Young, only saying, “Our review of activity during this period is taking us down a broad path, and we’re looking broadly.”

However, she did say that the SEC is trying to improve communication among its bureaus, review its operations and focus on staff integrity.

“The public appropriately holds the SEC to a very high standard for integrity and professionalism, and we must hold ourselves to that very high standard as well,” she said in a prepared statement.

Institutions abroad have also come under fire for Lehman’s actions. Though Lehman could not get its lawyers in the US to consider the Repo 105s actual “sales” instead of loans, the British law firm Linklaters gave the opinion that the repos could count as actual sales under British law. Lehman then ran the repos through its British subsidiary and foreign banks instead.

Lehman bankers seemed to manage these actions without its auditors, Ernst & Young, ever raising concerns about the legality of the operation.

The British financial watchdog organization Financial Reporting Council (FRC) said on Monday, after spending the weekend poring over the report, that it would begin to look into how Ernst & Young audited Lehman’s transactions in Britain.

“To that end, we have asked Ernst & Young to provide further information in relation to what happened in the UK,” the FRC said.

Ernst & Young has said that it will cooperate “fully with all relevant parties.” The firm has said that the report “made no findings in his report that Lehman’s assets or liabilities were improperly valued or accounted for incorrectly in Lehman’s November 30, 2007, financial statements.”

The report did say that the firm inadequately investigated Lehman Senior Vice President Matthew Lee’s claims that there were accounting improprieties and “took virtually no action” to investigate the use of Repo 105s or Lehman’s nondisclosure regarding their use.

Senator Kaufman emphasized the need to change not only the underlying behavior of Wall Street, but the regulatory system as well. He spoke about ensuring that the legal system treats financial crimes with the “same gravity” that it treats everything else, especially considering the resources that “Wall Street criminals” have to execute their plans and cover their tracks.

“At the end of the day, this is a test of whether we have one justice system in this country or two. If we don’t treat a Wall Street firm that defrauded investors of millions of dollars the same way we treat someone who stole 500 dollars from a cash register, then how can we expect our citizens to have faith in the rule of law?”