The Lehman bankruptcy examiner report: And Then There Were None……..

Posted by on 31 March 2010

 My objective in this article is to explore the broader implications of the new Lehman report issued by the bankruptcy examiner- the Valukas report. I will first briefly review the findings.  The Lehman details the massive effort to hide Lehman’s true debt levels – through the so-called “Repo 105” structure. The examiner’s report finds that the CEO and his CFOs were “grossly negligent” and that claims for breach of fiduciary duty could be made against all of them. There are potentially grounds as well for criminal charges. 

Further, as discussed in great detail in the examiner’s report, Lehman’s own Corporate Audit group, together with Ernst & Young, investigated allegations about balance sheet substantiation problems made in a May 16, 2008 “whistleblower” letter sent to senior management. During the investigation, Ernst & Young was informed about Lehman’s use of $50 billion of Repo 105 transactions in the second quarter of 2008.  At a June 13, 2008 meeting, Ernst & Young failed to disclose that allegation to the Board’s Audit Committee.   
Lehman Brothers’   Repo 105 scheme depended on as well on a legal opinion and the investment bank wasn’t able to persuade its lawyers in the United States that the relevant repurchase agreements constituted real sales. So it found a British law firm- Linklaters- that used the intersection of British law and American accounting standards to opine that the transactions counted as sales. Clearly the legal opinion is blatant case of forum shopping and intent to deceive. Therefore the examiner’s report suggests that there are grounds for civil action, i.e., people can sue for damages.  News reports give no indication of potential criminal charges, but this may change soon. It is strikingly reminiscent of how Enron’s balance sheet was disguised through fake asset “sales”. 
When crimes happened in the past, as in the case of Enron, when aided and abetted by the gatekeepers at Arthur Andersen, there were criminal convictions.    It is worth pointing out that The Enron fraud lead to the demise of Arthur Anderson and that might be a possibility in this case.
The intent of this article is to discuss the broader implications of this case. They are serious implications with lasting impact and no solution in sight. 
First, transparency is at the foundation of a well functioning system and it relies on multiple gatekeepers such as accountants, auditors, lawyers and rating agencies. But instead of developing a competitive transparent gatekeeper system, we are witnessing the shirking of the gatekeepers industry. 
Arthur Andersen was once one of the "Big Five" accounting firms among PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young and KPMG, providing auditing, tax, and consulting services to large corporations. In 2002, the firm voluntarily surrendered its licenses to practice as Certified Public Accountants in the United States after being found guilty of criminal charges relating to the firm's handling of the auditing of Enron. A similar situation exists with the three large U.S.-based credit rating agencies – Moody’s, Standard & Poor’s, and Fitch – that are provided extensive authority under the Basel II regime and play a central role in the financial system. 
Basically, we are witnessing increased concentration in a form of imperfect competition in which a large number of buyers face a very small number of sellers of "transparency" services. Clearly this market structure is prone to distortions. We are now down to four major national accounting firms and three ratings agencies that can potentially hold the system hostage in a classic prisoner dilemma.  The rating agencies and accounting firms have the regulators and financial industry over a barrel, because we don’t dare provoke their demise and the end of transparency. Clearly this situation is not conducive to reforms. 
A second and even more troublesome problem is the incoherence in international financial regulation that permitted a race to the bottom in a regulatory arbitrage process designed to maintain the hegemony of London as a financial center. We had a glimpse of this permissiveness in the case of Meddoff’s offshore operation, and AIG financial products that were both located in London. We have now further evidence in the “legal light” opinion provided by Linklaters when an American law firm refused to accommodate Lehman. As long as this global regulatory arbitrage continues, it is inevitable that the forces of competition will force the most “straight laced” financial firms, auditors, lawyers and rating agencies to compromise their sound judgment. 
The credit rating agencies and accounting firms have played a critical role in the debacle of the past two years. As a result we are witnessing recent efforts to heightened regulation of the rating agencies – such as the provisions in the financial regulatory reform legislation   that was passed by the House of Representatives in December, 2009. We have seen this movie before with the “velvet glove” treatment of the large “too big to fail” financial institutions in the aftermath of the “Great Recession” and the outcome. We can expect slap on the wrist of the now “big four” accounting firms and “big three” rating agencies with a similar outcome. Nevertheless, it is my hope that the authorities on both sides of the Atlantic investigate the culpability of Ernst & Young and Linklaters and pursue action to the full extent permissible by the law. Those efforts do nothing to alleviate the inherent distortions market. They only increase the distortions in those markets by raising barriers to entry; and codify rigid structures and procedures for accounting firms and rating agencies without the possibility of stringent sanctions because the firms know they are indispensable.   
Domestic regulators and international financial regulators better get on with real reforms. 
a revised version will appear in the FT Economists Forum