February 26, 2021

High & Low Finance: Lehman Case Hints at Need to Stiffen Audit Rules

That, anyway, is the conclusion a federal judge has reached regarding Lehman Brothers. The judge said this week that it appeared Lehman had violated Generally Accepted Accounting Principles, or GAAP, even if it was in technical compliance with accounting rules. But he threw out a claim against Ernst Young, whose 2007 audit certified that Lehman had followed GAAP.

The ruling ought to raise a few eyebrows at the Public Company Accounting Oversight Board, which sets auditing standards and regulates auditing firms. If the Lehman audit was in compliance with the auditing rules, it is time to review the rules.

A little history: As the financial position of Lehman Brothers grew more and more perilous in 2007 and 2008, the company assured investors it was reducing its leverage by selling assets. That was, to put it ever so gently, a lie.

Without that lie, Lehman probably would have failed anyway. But regulators and investors might have seen the disaster coming a little earlier.

As always happens when a company collapses, class-action suits were filed by suffering investors. They sued Lehman’s executives and its outside directors. They sued Ernst. They sued all the investment banks — 51 of them — that underwrote securities issued by Lehman.

As always happens, the defendants tried to get the suit thrown out before any evidence could be collected.

This week the judge, Lewis A. Kaplan, refused to dismiss most of the suit. But Ernst came close to getting off entirely. The judge ruled that although there was evidence that Ernst should have done something differently in the final weeks of Lehman’s existence, there would be no trial on whether the firm’s audit of the 2007 financial statements was bad.

Lehman managed to hide as much as $50 billion of borrowing — and reduce its assets by the same amount — through something that has become immortalized as “Repo 105” transactions. Those transactions, completely hidden from investors while Lehman was heading to disaster, were disclosed last year in a blistering report by Lehman’s bankruptcy trustee. The fiddling did not affect profits, but it did make the company appear to be taking fewer risks than it was.

Judge Kaplan’s decision, it should be noted, was on a motion to dismiss and was not a finding that anyone had acted wrongly. In reaching his decision, he was required to assume that facts in the complaint were accurate and could be proven.

But the current state of class-action litigation makes the dismissal ruling very important. The law lets companies essentially tell the judge that “the plaintiff has no evidence we misbehaved, so you have to throw the case out before discovery lets the plaintiff find out if there is any evidence.” It is not unusual for a suit to be settled once a judge lets a case proceed.

At the heart of the Lehman case are repurchase agreements, commonly called repos, which are a common form of financing on Wall Street. The borrower “sells” securities for cash and agrees to repurchase them at a set price in a brief period.

Normally, repos are accounted for as borrowings, which is what they are. The borrower retains all the upside and downside of the securities in question. The lender gets an interest rate.

But Lehman found a loophole in an accounting rule, and concluded that if it put up $105 in collateral for every $100 borrowed, it could claim it really was a sale. At the end of each quarter, the company would decide just how much it needed to beautify its balance sheet, and would do repos to produce the desired result. They would be reversed a few days later.

The judge concluded that Lehman did not violate the accounting rule.

But, he added, “the fact that Lehman’s accounting for the Repo 105 transactions technically complied” with the rule “does not mean that Lehman’s financial statements complied with GAAP.”

Although companies hate it, that is the law. The United States Court of Appeals for the Second Circuit, in refusing to throw out the conviction of Bernie Ebbers, the former chief executive of WorldCom, said in 2006 that “GAAP itself recognizes that technical compliance with particular GAAP rules may lead to misleading financial statements, and imposes an overall requirement that the statements as a whole accurately reflect the financial status of the company.”

In the Lehman case, Judge Kaplan focused on the lack of evidence that Ernst had noticed what was going on.

Floyd Norris comments on finance and the economy at nytimes.com/norris.

Article source: http://feeds.nytimes.com/click.phdo?i=3206d59fbc61042e2505cac24f606c10

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