Case Study - Kelompok 1

CASE 1.
Lehman Brothers Holdings, Inc.

Debt is a prolific mother of folly and crime.
Benjamin Disraeli
Thursday, October 24, 1929, easily ranks as the most dramatic day that Wall Street has ever
seen.1 That day witnessed the beginning of the Great Stock Market Crash that over the fol-
lowing few years would result in an almost 90 percent decline in the Dow Jones Industrial
Average (DJIA). Although not nearly as dramatic as “Black Thursday,” September 15,
2008, is a date that modern day Wall Street insiders will not soon forget. On that day, one
of Wall Street’s iconic investment banking firms, Lehman Brothers, filed for bankruptcy.
That bankruptcy filing ended the proud history of a firm that had played a major role in
shaping the nation’s securities markets and economy for more than a century.
Lehman Brothers had approximately $700 billion in assets when it failed, which
makes it the largest corporate bankruptcy in U.S. history, easily surpassing the previ-
ous headline-grabbing bankruptcies of Enron, General Motors, and WorldCom. By
comparison, the telecommunications giant WorldCom, which temporarily held the
title of the nation’s largest business failure after collapsing in 2002, had less than one-
sixth the total assets claimed by Lehman Brothers.
The shocking announcement that Lehman had filed for bankruptcy caused the DJIA to
plunge more than 500 points within a few hours. That large loss was only a harbinger of
things to come. Within six months, the DJIA had declined by more than 50 percent from
its all-time high of 14,164.53 that it had reached on October 9, 2007. That market decline
wiped out nearly 10 trillion dollars of “paper” wealth for stock market investors and
plunged the U.S. and world economies into what became known as the Great Recession.
In the spring of 2010, the Lehman bankruptcy once again captured the nation’s
attention when the company’s court-appointed bankruptcy examiner released his
2,200-page report. In preparing the highly anticipated report, the bankruptcy exam-
iner and his staff reviewed 20 million documents and 10 million emails and spent
$38 million. The massive report documented the circumstances and events that
had contributed to Lehman’s collapse and the parties that the bankruptcy examiner
believed could be held civilly liable for it.
The release of the bankruptcy report prompted a public outcry because it
revealed that Lehman’s executives had routinely used multibillion-dollar “account-
ing-motivated” transactions to embellish their company’s financial data. Allegedly,
those transactions had been executed for the express purpose of enhancing a finan-
cial ratio that regulatory authorities, stock market analysts, and investors consid-
ered to be a key indicator of the company’s overall financial condition.
As the company’s financial health was rapidly deteriorating in 2007 and 2008,
Lehman’s executives had ramped up their use of the controversial transactions,
resulting in the company’s liabilities being understated by as much as $50 billion.
Arguably most shocking was that Lehman never disclosed or referred to those trans-
actions in the 10-K and 10-Q registration statements it filed periodically with the
Securities and Exchange Commission (SEC).
1. I would like to thank Glen McLaughlin for his generous and continuing support of efforts to integrate
ethics into business curricula. I would also like to thank T. J. Gillette for his excellent research that was
instrumental in the development of this case.
23
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24 SECTION ONE Comprehensive Cases
Another revelation in the bankruptcy report that stunned the public was the fact
that Lehman’s audit firm had been aware of the billion-dollar transactions the com-
pany had used to window-dress its financial statements. According to the bank-
ruptcy examiner, the Big Four audit firm had discussed those transactions on many
occasions with company officials but had not insisted or, apparently, even sug-
gested that the company disclose them in their financial statements or the accom-
panying notes.
The bankruptcy examiner also maintained that the audit firm had not properly
informed Lehman’s management and audit committee of an internal whistleblower’s
allegations that management was intentionally misrepresenting the company’s
financial statements. Because of alleged professional malpractice, Lehman’s audit
firm was among the parties the bankruptcy examiner suggested could be held
civilly liable for the enormous losses suffered by the company’s stockholders and
creditors.
The Cotton Kings

Political unrest and poor economic conditions in their homeland prompted six mil-
lion Germans to immigrate to the United States during the nineteenth century. Those
immigrants included three brothers from Bavaria, the beautiful mountainous region
of southeastern Germany. In 1844, 23-year-old Henry Lehman arrived in Montgomery,
Alabama, a small city with fewer than 5,000 inhabitants in south central Alabama.
Over the next few years, Henry’s two brothers, Emanuel and Mayer, joined him in
Montgomery.
The three brothers established a small retail store that stocked a wide range of
merchandise including groceries, clothing, and hardware. Among the brothers’
principal customers were cotton farmers from nearby rural areas who often paid for
the merchandise they purchased with cotton bales. The brothers soon realized that
there were more profits to be made in buying and selling cotton than operating a
retail store so they became cotton merchants.
By 1860, “King Cotton” ruled the South. The southern states accounted for three-
fourths of the cotton produced worldwide. Cotton was also the nation’s largest
export, accounting for 60 percent of the United States’ total annual exports. In 1858,
the huge demand for cotton in New England’s booming textiles industry had con-
vinced the Lehman brothers to establish an office in lower Manhattan, just a few
blocks from the Wall Street financial district. But the outbreak of the Civil War in 1861
forced the Lehmans, who supported the Confederacy, to close that office.
The economic embargo imposed by President Lincoln on the South during the
Civil War meant that cotton merchants such as the Lehman brothers lost their biggest
market. Because the Lehmans realized that the demand for cotton would spike dra-
matically following the war, they bought large quantities of cotton produced during
the war years and stored it in well-hidden warehouses scattered across the South.
The postwar profits the brothers realized from selling that cotton helped them rees-
tablish their firm as one of the South’s largest cotton merchants following the war.
By 1870, the Lehman brothers had reopened their New York City office; a short time
later, they made that office the headquarters of their business.
In the latter decades of the nineteenth century, the Lehman brothers gradually
expanded their business to include the trading of other commodities such as coffee,
sugar, wheat, and petroleum products. The three brothers also decided to purchase
a seat on the New York Stock Exchange. They realized that there was a need for
financial intermediaries to funnel private investment capital to the large companies
that were fueling the nation’s rapid economic growth. Because of the nature of their
CASE 1.2 L ehman Brothers Holdings, Inc. 25
business, the three brothers were well acquainted with the banking and credit indus-
tries and believed they could use that experience to easily segue into the emerging
and lucrative investment banking industry.
By the early years of the twentieth century, the Lehman firm, which by then was being
managed by the second generation of the Lehman family, had cut its ties to the cotton
industry and focused its attention almost exclusively on investment banking. During
that time frame, the firm served as the underwriter for several companies that would
become stalwarts of the U.S. economy. These companies included B.F. Goodrich;
Campbell Soup; F.W. Woolworth; R.H. Macy & Co.; and Sears, Roebuck & Co.
Investment banks facilitate the flow of investment capital in a free market economy
by effectively “pricing risk.” That is, investment bankers help buyers and sellers deter-
mine the appropriate relationship between the risk posed by given securities and the
price at which those securities should be initially sold. This pricing process helps
ensure that scarce investment capital is allocated in an efficient manner to corpora-
tions, other business organizations, and governmental agencies that need external
funds to finance their operations.
Investment banking firms face a wide range of business risks. For example, invest-
ment banks sometimes absorb large losses on new client securities that they acquire
during the underwriting process and are unable to sell to third parties. The most
important factor contributing to the risk profile of investment banks is the degree of
financial leverage they utilize. Similar to commercial banks, investment banks rely
heavily on debt capital rather than invested capital. This high degree of financial
leverage typically results in significant profits accruing to the firms’ stockholders in
a strong economic environment when the investment banking industry prospers.
On the other hand, during economic downturns, investment banks often incur large
losses that wipe out much of their stockholders’ equity.
Throughout its history, Lehman Brothers experienced the highs and lows of the
volatile business cycle common to the investment banking industry. The intensity of
that cycle was magnified by a new line of investment products that Lehman and its
competitors made popular on Wall Street during the 1990s.
Playing with Fire

Lehman Brothers and the other large investment banks became major players in
the financial derivatives markets that emerged in the final decade of the twentieth
century. Investopedia (www.investopedia.com) defines a financial “derivative” as
follows:
A security whose price is dependent upon or derived from one or more underlying
assets. The derivative itself is merely a contract between two or more parties. Its value
is determined by fluctuations in the underlying asset. The most common underly-
ing assets include stocks, bonds, commodities, currencies, interest rates and market
indexes. Most derivatives are characterized by high leverage.
Many types of financial derivatives have existed for decades, including the most
generic, namely, put and call options on common stocks. In the mid-1990s, however,
a new genre of exotic financial derivatives became increasingly prevalent. These
new derivatives included collateralized debt obligations, credit default swaps, and
interest rate swaps, among many others. Institutional investors accounted for the
bulk of the trading volume in these new securities because they were poorly under-
stood and thus shunned by most individual investors.
The new breed of derivatives produced large and profitable revenue streams for
the investment banking industry. On the downside, the risks posed by these new
securities were often difficult to assess, which, in turn, made those risks difficult, if
not impossible, to manage. Some economists and Wall Street experts suggested that
the risks posed by many of these derivatives were, in fact, disproportionately high
compared to the rates of return they generated. Further enhancing the risk profile
of these investments was the fact that they were subject to only minimal regulatory
oversight.
In a 2009 retrospective overview of the securities markets, President Barack
Obama observed that over the prior two decades those markets had been character-
ized by “wild risk-taking.”2 The president added that many of the new securities that
became popular during that time frame were so complex and multifaceted that the
“old regulatory schemes” developed for the securities markets in the 1930s did not
provide adequate oversight for them.
Lehman flourished financially as the derivatives markets mushroomed in size
and prominence during the 1990s and beyond. The firm was particularly active in
the market for residential mortgage-backed securities or RMBS. By the turn of the
century, government agencies, brokerage firms, and investment banks were pro-
ducing a huge volume of RMBS each year. This “securitization” process involved
purchasing residential mortgages from the banks, mortgage companies, and other
entities that originated them, bundling or “pooling” these mortgages together, and
then selling ownership interests (securities) in these pools. The purchasers of RMBS
were actually purchasing a claim on the cash flows generated by the mortgages that
“backed” those securities. By 2004, Lehman produced more RMBS annually than
any other entity.3
The high yields on RMBS created a surging demand for these new hybrid securities.
In turn, the increasing demand for RMBS caused mortgage originators to become
increasingly aggressive in extending loans to individuals who in years past had not
been able to qualify for a home mortgage because of an insufficient income, a poor
credit history, or other issues. These mostly first-time home buyers were referred to
as “subprime” borrowers. Mortgage originators were not concerned by the sizable
default risk posed by subprime borrowers since they intended to sell their loans
“downstream” and thereby transfer that risk to the purchasers of RMBS.
The critical factor that influenced the riskiness of RMBS was the underlying health
of the housing market in the United States. Steadily rising housing prices during the
decade from 1995 through 2005 made the default risk on residential mortgages mini-
mal. Wall Street analysts warned, however, that a downturn in housing prices would
trigger a rise in mortgage defaults that would be problematic for parties having sig-
nificant investments in RMBS. On the other hand, a sudden and sharp downturn in
housing prices could prove to be catastrophic for those investors. Sadly, the latter
doomsday scenario took place.
Housing prices peaked in the United States in 2006. By late 2007, housing prices
had begun to tumble, declining in many residential markets by 20 percent or more
by mid-2008. In some of the residential markets that had seen the sharpest increases
over the previous several years, such as Las Vegas and south Florida, housing prices
plunged by 50 percent.
2. S. Labaton, “Obama Sought a Range of Views on Finance Rules,” New York Times (online),
17 June 2009.
3. Lehman purchased a large portion of the residential mortgages that it securitized from New Century
Financial Corporation, one of the nation’s major subprime mortgage companies. Case 1.11 documents
New Century’s brief and turbulent history.
Falling housing prices caused a growing number of U.S. homeowners to be “upside

down,” meaning that the market values of their homes were lower than the unpaid
balances of their mortgages. By early 2008, an estimated nine million Americans had
a negative equity in their homes, which caused a rapid rise in mortgage defaults
and foreclosures. It was only a matter of time before the sharp decline in housing
prices undercut the market for RMBS.
Government agencies, large institutional investors, and investment banks having
an ownership interest in RMBS suddenly found the value of those securities spiraling
downward when it became obvious that housing prices would continue their free
fall. In some cases, the markets for mortgage-backed securities simply “froze,” mean-
ing that the securities could not be sold at any price. Lehman was among those
entities that held a large inventory of mortgage-backed securities when the housing
market crumbled. At the end of 2007, the company owned nearly $90 billion of those
“toxic” assets. By comparison, Lehman’s total stockholders’ equity at the time was
only $22.5 billion.
Prior to the collapse of the housing market, Lehman’s high-risk business model
had produced a string of record-breaking years. Exhibit 1 presents a financial high-
lights table for Lehman for the five-year period 2003 through 2007 that is a con-
densed version of a similar table included in the company’s 2007 annual report.
Notice that during that time period the company reported record revenues and net
income each successive year. Lehman’s string of impressive operating results con-
tinued in early 2008. When the company posted stronger-than-expected results for
the first quarter of 2008, the price of its common stock soared by nearly 50 percent
in one day.
Lehman’s top executives profited enormously from the consistently strong financial
performance of their company. Richard Fuld served as Lehman’s chief executive offi-
cer (CEO) from 1994 through 2008. Over that time, Fuld earned nearly $500 million in
compensation. In addition to monetary rewards, Lehman’s executives were lavished
with praise and accolades. Just as Lehman’s financial empire was beginning to buckle
EXHIBIT 1
2007 2006 2005 2004 2003
Lehman Brothers
Revenues $ 19.3 $ 17.6 $ 14.6 $ 11.6 $ 8.7 Financial
Net Income 4.2 4.0 3.3 2.4 1.7 Highlights,
2003–2007*
Total Assets 691.1 503.6 410.1 357.2 312.1
Total Stockholders’
Equity 22.5 19.2 16.8 14.9 13.2
Earnings per Share 7.26 6.81 5.43 3.95 3.17
Dividends per Share .60 .48 .40 .32 .24
Year-end Stock Price 62.63 73.67 63.00 41.89 36.11
Return on Equity 20.8% 23.4% 21.6% 17.9% 18.2%
Leverage Ratio 30.7 26.2 24.4 23.9 23.7
Net Leverage Ratio 16.1 14.5 13.6 13.9 15.3
*In billions of dollars except for per share amounts.

Source: Lehman Brothers’ 2007 Annual Report.
in 2008, Barron’s included Fuld in its list of the top 30 CEOs nationwide and tagged
him with the title of “Mr. Wall Street.”
Despite the glowing operating results for fiscal 2007 and the first quarter of 2008,
Lehman’s management recognized that the company faced daunting challenges.
“Lehman was publicly presenting a rosy outlook about its future while it was pri-
vately scrambling for a solution to its deepening problems.”4 Complicating matters
for Lehman’s management was the fact that financial analysts and other parties
closely monitoring the investment banking industry had begun raising serious ques-
tions regarding the company’s financial health. Those questions stemmed primarily
from two issues facing Lehman, one of which was the mayhem taking place within
the housing market. The second and more important issue facing the large invest-
ment banking firm was the fact that it was “wildly overleveraged.”5 This issue was
critical because by this time there was a general consensus on Wall Street that an
investment bank’s degree of financial leverage was the most important metric to use
in evaluating its financial health.
Lehman’s financial highlights table in Exhibit 1 presents two measures of financial
leverage. The company’s conventional leverage ratio was computed by dividing total
assets by total stockholders’ equity. At fiscal year-end 2007, this ratio was 30.7 for
Lehman, meaning that the company had only $1 of stockholders’ equity for every
$30.70 of assets that it held. In the company’s 2007 annual report, Lehman’s manage-
ment suggested that the “net leverage ratio” was a much better measure of the com-
pany’s financial leverage than the conventional leverage ratio. In computing the net
leverage ratio, the company excluded from total assets a large volume of “low-risk”
assets. Notice that Lehman’s 2007 net leverage ratio was nearly 50 percent lower than
its conventional leverage ratio.
The importance being ascribed to Lehman’s leverage ratios, in particular its
net leverage ratio, by financial analysts in late 2007 prompted Richard Fuld to
order a company-wide “deleveraging strategy.” In an intercompany communi-
cation during this time frame, one of Fuld’s subordinates noted that “reducing
leverage is necessary to … win back the confidence of the market, lenders, and
investors.”6 Another of Fuld’s subordinates subsequently testified that beginning
in late 2007 “Lehman set balance sheet targets with an eye to reaching [reducing]
certain leverage ratios that rating agencies used to measure and gauge Lehman’s
performance.”
Lehman’s management chose an unconventional method to reduce the compa-
ny’s net leverage ratio. This improvised tactic involved engaging in a large volume
of “accounting-motivated” transactions, known internally as Repo 105 transactions,
near the end of each quarterly reporting period. Because the Repo 105 transactions
were not disclosed in Lehman’s SEC filings, third-party financial statement users were
unaware that the company’s net leverage ratio was being intentionally sculpted by
management. “Lehman never disclosed that its net leverage ratio—which Lehman
publicly touted as evidence of its discipline and financial health—depended upon
the Repo 105 practice.”
4. L. Story and B. White, “The Road to Lehman’s Failure Was Littered with Lost Chances,” New York
Times (online), 6 October 2008.
5. D. Leonard, “How Lehman Brothers Got Its Real Estate Fix,” New York Times (online), 3 May 2009.
6. This and all subsequent quotes, unless indicated otherwise, were taken from the following source:
In re: Lehman Brothers Holdings, Inc., et al., Debtors, “Report of Anton R. Valukas, Examiner,” U.S.
Bankruptcy Court for the Southern District of New York, Chapter 11 Case No. 08-13555, 11 March 2010.
Repo Central
In a repurchase or “repo” agreement, one party sells securities to another party while
making a contractual commitment to repurchase those securities at a later date. The
agreed-upon repurchase price for the given securities is nominally greater than the
original selling price. In substance, the original “seller” of the securities is actually bor-
rowing money from the original “purchaser” and using the securities transferred to the
purchaser as collateral for the loan. The difference between the original selling price
and the repurchase price is the interest earned on the loan by the original purchaser.
Another feature of repo transactions is what is known as the “haircut.” The bor-
rowing party (seller) transfers more than the face value of the securities involved
in the transaction as collateral to the lender (purchaser). For example, if Lehman
borrowed $100 million from another party under a conventional repo agreement, it
would transfer more than $100 million of securities to the lender to serve as collateral
for the loan. The haircut for Lehman’s normal repos was typically 2 percent. So, in
the example just provided, Lehman would have transferred $102 million of securities
to the lender even though the actual amount of the loan was only $100 million.
Repos are a common financing tool used by large companies that need to raise a
significant amount of funds for a short period of time. Repo lenders, on the other hand,
view these transactions as a relatively safe way to invest excess cash at a modest rate
of return without tying up those funds for an extended period of time. Similar to other
investment banks, Lehman used repos as a major source of short-term financing.
For accounting purposes, repo agreements are nearly always treated as financing
(borrowing) transactions by the borrower rather than as true sales of securities—
Lehman recorded all of its normal repos as financing transactions. At the time, this
accounting treatment was dictated by Statement of Financial Accounting Standards
(SFAS) No. 140, “Accounting for Transfers and Servicing of Financial Assets and
Extinguishment of Liabilities.” When certain unusual conditions were met, however,
SFAS No. 140 provided for an exception to this general rule, meaning that repo bor-
rowers could record the transactions as sales of securities.7
Lehman’s executives realized that the SFAS No. 140 exception could be used to their
advantage, namely, to reduce their company’s net leverage ratio. The lynchpin of this strat-
egy was engaging in a large volume of “Repo 105s” that were repurchase agreements
that the company recorded as sales rather than as financing transactions. The company’s
justification for treating a Repo 105 as a sale was the size of the “haircut” involved in the
transaction. For Repo 105s, the amount of the haircut was 5 percent—which explained
the label applied to them by the company. Lehman’s accounting staff maintained that the
larger haircut for the Repo 105s allowed them to be treated as sales under the exception
included in SFAS No. 140.8,9 Because this interpretation of SFAS No. 140 was controver-
sial, prior to engaging in any Repo 105s, company management decided to obtain a legal
opinion confirming that the transactions could be considered “true sales” of securities.
7. SFAS No. 140 has been revised in recent years, principally by SFAS No. 166, “Accounting for Transfers
of Financial Assets.”
8. Lehman Brothers’ detailed justification for this accounting treatment is documented in several sources
including a lengthy explanation in the bankruptcy examiner’s report. For a more concise discussion of
Lehman Brothers’ defense of this accounting treatment, see the following source: S. K. Dutta, D. Caplan, and
R. Lawson, “Poor Risk Management,” Strategic Finance, August 2010, 23–29. Essentially, Lehman maintained
that the larger haircut involved in a Repo 105 was evidence that it had surrendered control over the securities
transferred to the other party, a condition required for a repo to be treated as a sale under SFAS No. 140.
9. Recognize that the “haircut” is not equal to the amount of interest paid by the borrower to the lender in a
repo transaction. Since repos tend to be for a short period of time, the amount of interest paid by the borrower
is typically a fraction of 1 percent, although the annualized interest rate might be, for example, 8 percent.
Lehman’s management could not find a law firm in the United States willing to
issue a legal opinion that Repo 105s were true sales. Undeterred, the company’s
executives began searching for a foreign law firm that would issue such an opinion.
The law firm that the company eventually retained for that purpose was Linklaters, a
large British firm.
Unable to find a United States law firm that would provide it with an opinion letter permit-
ting the true sale accounting treatment under United States law, Lehman conducted its
Repo 105 program under the aegis of an opinion letter the Linklaters law firm in London
wrote for LBIE, Lehman’s European broker-dealer in London, under English law.
Because the Repo 105s had to be consummated in Great Britain, Lehman trans-
ferred securities that would be involved in those transactions from a U.S. division of
the firm to a British-based division, namely, Lehman Brothers International Europe
(LBIE), its London-based brokerage. Although these transactions were consum-
mated in Great Britain, they were ultimately included in Lehman’s consolidated
financial statements issued in the United States.
There were actually two “legs” to each Repo 105 transaction. The first leg involved
the “sale” of the securities to a third party; in the second leg of these transactions,
Lehman used the proceeds from the sale to pay off a portion of its outstanding liabili-
ties. When taken together, the two legs of Repo 105 transactions allowed Lehman to
reduce its net leverage ratio and thereby strengthen its apparent financial condition.
Recognize that the impact of the first leg of a Repo 105 on net assets was zero.
When securities were sold in a Repo 105, the journal entry to record the transac-
tion included a “debit” to a cash account that was offset by an equal “credit” to the
appropriate investments account.10 However, the second leg of the transaction, that
is, the use of Repo 105 cash proceeds to pay down liabilities, resulted in Lehman’s
total assets being reduced, which, in turn, reduced Lehman’s net leverage ratio. The
accounting treatment applied to conventional repos, which were simply recorded as
short-term loans, did not yield this “leverage-reduction” benefit.11
Lehman’s bankruptcy examiner documented the fact that the volume of Lehman’s
Repo 105s spiked dramatically at the end of each quarterly reporting period. This
opportunistic timing of the transactions allowed the company to significantly reduce
its net leverage ratio just days or even hours before its accounting staff closed the
accounting records to prepare the company’s quarterly or annual financial state-
ments. A few days later, Lehman would reverse or unwind the Repo 105s by reacquir-
ing the given securities with newly borrowed funds. At the end of fiscal 2007, Lehman
had $39 billion of “open” Repo 105 transactions; three months later, that figure had
risen to $50 billion.
Lehman’s use of Repo 105s to strengthen its reported financial condition in 2007
and 2008 was the major focus of the 2,200-page report that was filed by the com-
pany’s bankruptcy examiner with a federal court. Particularly appalling to the
bankruptcy examiner were the efforts of Lehman’s management to draw attention
to the company’s declining leverage while concealing the fact that Repo 105s were
10. This is a brief and simplified summary of the accounting treatment applied to Repo 105s by Lehman.
Examples of hypothetical accounting entries used by Lehman to record its Repo 105 transactions are
presented in the following article: S. K. Dutta, D. Caplan, and R. Lawson, “Poor Risk Management,”
Strategic Finance, August 2010, 23–29.
11. The conventional strategy for reducing the net leverage ratio would have been to simply sell assets
and then use the proceeds to pay down liabilities. Lehman could not avail itself of that strategy since
the markets for the assets (investments) that it had available for sale were highly illiquid. To sell those
assets, Lehman would have been forced to absorb large losses, losses that would have reduced its
stockholders’ equity and thus largely negated the intended reduction of its net leverage ratio.
responsible for much of that improvement. In “earnings calls” with financial ana-
lysts tracking Lehman’s stock, for example, the company’s chief financial officer
(CFO) stressed the fact that the company’s financial leverage was being reduced,
however, she “said nothing about the firm’s use of Repo 105 transactions.” At the
same time, the CFO told those analysts that her company was committed to pro-
viding them “a great amount of transparency” regarding the company’s balance
sheet.
The bankruptcy examiner maintained that even if the accounting treatment
applied to the Repo 105s technically complied with SFAS No. 140, that accounting
treatment violated Generally Accepted Accounting Principles (GAAP) by causing
Lehman’s financial statements to be misleading. To support his position, the bank-
ruptcy examiner referred to a ruling handed down by a federal district court in a
case involving an accounting matter. “GAAP itself recognizes that technical compli-
ance with particular GAAP rules may lead to misleading financial statements, and
imposes an overall requirement that the statements taken as a whole accurately
reflect the financial status of the company.”
According to the bankruptcy examiner, there had been no underlying business
purpose for the Repo 105s. Instead, the sole purpose of the transactions had been
to make Lehman’s “balance sheet appear stronger than it actually was.” In sum, the
transactions had been “accounting-motivated.” The bankruptcy examiner referred to
a prior SEC release to define that term.
“Accounting-motivated structured transactions” are “transactions that are structured
in an attempt to achieve reporting results that are not consistent with the economics of
the transaction, and thereby impair the transparency of financial reports.” [Attempts]
to portray the transactions differently from their substance do not operate in the inter-
ests of investors, and may be in violation of the securities laws.
The bankruptcy examiner uncovered numerous instances of intercompany com-
munications that suggested the Repo 105s had been accounting-driven. In respond-
ing to an inquiry regarding why Lehman was engaging in a large volume of Repo
105s at the end of each quarter, one company executive had told another, “It’s basi-
cally window-dressing. We are calling repos true sales based on legal technicalities.”
Another company executive testified that “It was universally accepted throughout
the entire institution [company] that Repo 105 was used for balance sheet relief
at quarter end.” A lower-level Lehman employee had referred to Repo 105s as an
“accounting gimmick” and a “lazy way of managing the balance sheet.” Finally, a
high-ranking accounting officer admitted to the bankruptcy examiner that “there
was no substance to these transactions” and that their only “purpose or motive was
reduction [of assets] in the balance sheet.”
Further validating the bankruptcy examiner’s argument that the Repo 105s had
been purely accounting-driven was the fact that they had been more expensive than
Lehman’s normal repo transactions. That is, the company could have secured the
short-term financing provided by the several hundred billions of dollars of its Repo
105s at a lower cost by using conventional repo agreements. “Lehman could have
obtained the same financing at a lower cost by engaging in ordinary repo transac-
tions with substantially the same counterparties using the same assets involved in
the Repo 105 transactions.”
When considering the issue of whether the accounting treatment applied to the
Repo 105s made Lehman’s financial statements materially misleading, the bank-
ruptcy examiner effectively invoked the definition of that construct found in
Statement of Financial Accounting Concepts No. 2, “Qualitative Characteristics of
Accounting Information.”
The magnitude of an omission or misstatement of accounting information that, in

light of the surrounding circumstances, makes it probable that the judgment of a rea-
sonable person relying on the information would have been changed or influenced by
the omission or misstatement.
The bankruptcy examiner surveyed a wide range of “reasonable” parties that had
relied on Lehman’s financial statements. Nearly all of these parties insisted that
they would have wanted to know that the company was using the Repo 105 trans-
actions to distort its balance sheet and key financial ratios. “Lehman’s directors,
the rating agencies, and government regulators—all of whom were unaware of
Lehman’s use of Repo 105 transactions—have advised the Examiner that Lehman’s
Repo 105 usage was material or significant information that they would have
wanted to know.” In fact, in 2008, the controller of Lehman’s European opera-
tions had emailed a Lehman colleague in the United States and warned him that
the Repo 105s “are understating what we have at risk by a material amount espe-
cially around quarter ends.” The bankruptcy examiner relied on such statements
in arriving at his decision that a “trier of fact,” that is, a court, would likely find
that the Repo 105s had resulted in Lehman’s financial statements being materially
misleading.
To bolster this conclusion, the bankruptcy examiner referred to a discussion of
materiality included in the 2007 workpapers of Lehman’s independent audit firm,
Ernst & Young (E&Y). “Indeed, audit walk-through papers prepared by Lehman’s
outside auditor, Ernst & Young, regarding the process for reopening or adjusting a
closed balance sheet stated: ‘Materially is usually defined as any item individually, or
in the aggregate, that moves net leverage by 0.1 or more (typically $1.8 billion). Repo
105 moved net leverage not by tenths, but by whole points.’ ” As shown in Exhibit 1,
Lehman’s reported net leverage ratio as of the end of fiscal 2007 was 16.1. According
to the bankruptcy examiner, the actual ratio would have been 17.8 if the company
had accounted for the Repo 105s as financing transactions.
During his investigation, the bankruptcy examiner spent considerable time review-
ing the Ernst & Young audit workpapers. The prominent accounting firm ultimately
became a major focus of that investigation and the target of scathing criticism by the
bankruptcy examiner.
Auditors on the Firing Line

E&Y served as Lehman’s independent audit firm from 1994 through 2008. For the
2007 audit, the final audit of the company prior to its collapse, Lehman paid E&Y
approximately $29.5 million. That figure included the fee for the 2007 audit, fees
for tax services provided to the company, and miscellaneous fees. William Schlich
served as the engagement audit partner for the 2007 audit of Lehman. In July 2008,
Schlich, a longtime E&Y partner, was named the head of E&Y’s “Global Banking &
Capital Markets” practice, the firm’s largest individual industry practice.
Lehman’s bankruptcy examiner interviewed Schlich extensively during his investi-
gation. Schlich told the bankruptcy examiner that E&Y had been aware of the Repo
105 transactions and was also aware that Lehman had not disclosed the transac-
tions in financial statements filed with the SEC. Schlich also revealed that Lehman
officials had consulted with E&Y while they were developing the company’s Repo
105 accounting policy, although he reported that his firm had not been directly
involved in that process and had not formally approved the accounting policy.
Martin Kelly, Lehman’s former financial controller, testified that he discussed the
Repo 105 transactions with Schlich in late 2007. Kelly told the bankruptcy examiner
that he had a certain degree of “discomfort” with the Repo 105s, ostensibly because
Lehman had been unable to obtain a legal opinion from a U.S. law firm that sup-
ported the company’s decision to record those transactions as sales of securities.
Kelly specifically recalled raising the latter issue with the E&Y auditors.
Surprisingly, Schlich told the examiner that he did not know whether anyone
on the E&Y engagement team had actually reviewed the legal opinion on the
Repo 105 transactions issued by Linklaters, the British law firm. Schlich sug-
gested that the responsibility for reviewing that letter would have rested with his
firm’s British affiliate, E&Y United Kingdom, which had audited the accounting
records of LBIE, the British arm of Lehman Brothers that had executed the Repo
105 transactions.
Throughout his investigation and in his report, the bankruptcy examiner repeat-
edly characterized the Repo 105s as “accounting-motivated” transactions without an
underlying business purpose that had been intended to embellish Lehman’s financial
statements and its net leverage ratio. While being interviewed by the examiner, how-
ever, Schlich staunchly defended the accounting treatment that had been applied to
those transactions. The E&Y partner insisted that the “off-balance sheet treatment”
of the Repo 105s was purely a “consequence of the accounting rules” rather than the
underlying “motive for the transactions.” When the examiner asked Schlich whether
“technical adherence” to SFAS No. 140 or any other specific accounting rule could
have resulted in Lehman’s financial statements being misstated, “Schlich refrained
from comment.” On two occasions, the examiner “offered Ernst & Young the oppor-
tunity” to explain or identify the “business purpose of Lehman’s Repo 105 transac-
tions.” On each occasion, the E&Y representative (apparently Schlich) “declined that
invitation.”
The bankruptcy examiner subsequently criticized E&Y for not addressing the pos-
sibility that Lehman’s “Repo 105 transactions were accounting-motivated transac-
tions that lacked a business purpose.” According to the examiner, E&Y should have
recognized, or at least considered the possibility, that the Repo 105s were simply
intended to improve Lehman’s apparent financial condition, in particular, its net
leverage ratio. The examiner stated that there was “no question that Ernst & Young
had a full understanding of the net leverage ratio” and that the auditors understood
the importance of that ratio to third-party financial statement users.
The bankruptcy examiner focused considerable attention on the materiality of the
Repo 105 transactions while he was interviewing Schlich. At one point, the examiner
asked Schlich what volume of Repo 105 transactions would have been considered
“material” by E&Y. “Schlich replied that Ernst & Young did not have a hard and fast
rule defining materiality in the balance sheet context, and that, with respect to bal-
ance sheet issues, ‘materiality’ depends upon the facts and circumstances.” In his
report, the bankruptcy examiner juxtaposed this statement of Schlich with the fact
that E&Y’s 2007 Lehman workpapers had identified the following precise materiality
threshold for the company’s net leverage ratio: “Materiality is usually defined as any
item individually, or in the aggregate, that moves net leverage by 0.1 or more (typi-
cally $1.8 billion).”
When questioned further regarding the materiality of the Repo 105s, Schlich told
the bankruptcy examiner that E&Y’s audit plan had not required the Lehman engage-
ment team to “review the volume or timing of Repo 105 transactions.” Consequently,
“as part of its year-end 2007 audit, E&Y did not ask Lehman about any directional
trends, such as whether its Repo 105 activity was increasing during fiscal year 2007.”
The bankruptcy examiner reported that Schlich was unable to “confirm or deny
that Lehman’s use of Repo 105 transactions was increasing in late 2007 and into
mid-2008.”
A final major issue raised with William Schlich by the bankruptcy examiner was
E&Y’s response to the whistleblower letter sent to company management in May 2008
by a senior member of Lehman’s accounting staff. Lehman’s management had asked
E&Y to be involved in investigating the allegations in that letter.12 Among other allega-
tions, the whistleblower suggested that Lehman’s assets and liabilities were routinely
misstated by “tens of billions of dollars” in the company’s periodic balance sheets. To
remind his superiors of their responsibilities related to financial reporting, the whistle-
blower had included in his letter the following excerpt from Lehman’s Code of Ethics.13
All employees … must endeavor to ensure that information in documents that Lehman
Brothers files with or submits to the SEC, or otherwise discloses to the public, is pre-
sented in a full, fair, accurate, timely and understandable manner. Additionally, each
individual involved in the preparation of the Firm’s financial statements must prepare
those statements in accordance with Generally Accepted Accounting Principles, con-
sistently applied, and any other applicable accounting standards and rules so that
the financial statements present fairly, in all material respects, the financial position,
results of operations and cash flows of the Firm.
Approximately four weeks passed before E&Y interviewed the author of the whis-
tleblower letter. Schlich and Hillary Hansen, another E&Y partner, conducted that
interview. Hansen’s handwritten notes compiled during the interview indicated that
the whistleblower alleged that Lehman had used tens of billions of dollars of Repo
105 transactions to strengthen its quarter-ending balance sheets. According to the
examiner, E&Y never interviewed the whistleblower a second time and never “fol-
lowed up” on his allegation regarding Lehman’s improper use of Repo 105s.
The day after interviewing the whistleblower, E&Y auditors met with Lehman’s
audit committee but, according to the bankruptcy examiner, did not inform the com-
mittee members of the whistleblower’s Repo 105 allegation. Three weeks later, E&Y
auditors met once more with Lehman’s audit committee and again reportedly failed
to mention that allegation. The bankruptcy examiner subsequently reviewed E&Y’s
workpapers for the 2007 audit and the 2008 quarterly reviews and “found no refer-
ence to any communication with the audit committee about Repo 105.”
During his interview with the bankruptcy examiner, Schlich indicated that he did
not recall the whistleblower mentioning the Repo 105 transactions when he and
Hansen met with him. When informed that Hansen’s handwritten notes of that meet-
ing indicated that the whistleblower had referred to those transactions, Schlich “did
not dispute the authenticity” of those notes.
In summarizing his investigation of E&Y’s role as Lehman’s auditor, the bankruptcy
examiner reported that there was “sufficient evidence to support at least three col-
orable claims that could be asserted against Ernst & Young relating to Lehman’s
Repo 105 activities and reporting.”14 The first colorable claim involved E&Y’s alleged
failure to “conduct an adequate inquiry” into the whistleblower’s allegations and
failing “to properly inform management and the audit committee” of those allega-
tions. Second, the bankruptcy examiner charged that E&Y had failed to “take proper
action” to investigate whether Lehman’s financial statements for the first two quarters
12. After reading the whistleblower letter, Schlich confided to two colleagues in an email that the letter
was “pretty ugly” and that it “will take us a significant amount of time to get through.”
13. The whistleblower was dismissed approximately one month after sending his letter to Lehman’s top
management. He was reportedly dismissed as a result of a corporate-wide “downsizing” campaign.
14. “Colorable claim” is a legal term. A colorable claim is generally a “plausible legal claim,” that is, a
claim “strong enough to have a reasonable chance of being valid if the legal basis is generally correct
and the facts can be proven in court.” (http://topics.law.cornell.edu)
of 2008 were materially misleading due to the company’s failure to disclose its Repo
105 transactions. The final colorable claim involved E&Y’s alleged failure to “take
proper action” to investigate whether Lehman’s financial statements for fiscal 2007
were materially misleading due to the Repo 105s.15
The allegations that the bankruptcy examiner filed against E&Y spawned wide-
spread discussion and debate within the accounting profession. One accounting pro-
fessor defended the accounting treatment that Lehman applied to its Repo 105s and,
by implication, E&Y’s tacit approval of that treatment. In responding to the question
of whether Lehman was entitled to account for those transactions as sales of securi-
ties, the professor responded, “Absolutely. Even if intended to influence (or deceit-
fully change) the numbers reported? Yes, intent doesn’t matter. It [Lehman] found
a rule it could utilize to its advantage and followed it.”16 The professor went on to
explain that the given “rule” was a bad one that should be amended.
Three other accounting professors expressed a very different point of view. These
professors noted that “a fundamental financial reporting objective that overrides the
application of any specific rule is that the accounting of a transaction should not obfus-
cate its economic substance.”17 The professors then noted that “parties with meaningful
roles in the financial reporting process” shouldn’t be involved in applying “account-
ing rules with the intent to obfuscate the economic substance”18 of given transactions.
Finally, the professors made the following observation regarding the professional
responsibilities of the accountants and auditors involved in the Lehman debacle:
External auditors, internal auditors, and management accountants all have profes-
sional standards that are aspirational in nature, and, regardless of whether Lehman’s
auditors and accountants met the minimum standards that might shield them from
legal liability and formal professional sanction, it seems clear that they fell short of the
higher standards to which all management accountants and auditors should aspire.19
EPILOGUE
The revelations and allegations included in the results of that survey or identified the spe-
the report issued by Lehman’s bankruptcy cific firms that were contacted.
examiner evoked an immediate response from Lehman’s bankruptcy report served as an
the SEC. In March 2010, an SEC spokesperson “open invitation”20 to file civil lawsuits against
reported that the federal agency had been E&Y. And that is exactly what happened.
unaware that Wall Street firms were using Repo Throughout 2010, numerous lawsuits that named
105-type transactions to enhance their appar- E&Y as a defendant or codefendant were filed
ent financial condition. The SEC revealed that on behalf of parties that suffered losses due to
it was contacting 20 major financial institu- Lehman’s collapse. Among these lawsuits, the
tions to determine if they had used similar one with arguably the highest profile was a civil
tactics to “manage” their balance sheets. The fraud lawsuit filed against E&Y in late December
federal agency never publicly commented on 2010 by Andrew Cuomo, New York’s Attorney
15. The bankruptcy examiner noted that E&Y “may have valid defenses” to the colorable claims that he
asserted against the firm. The examiner discussed some of these defenses including the fact that many
auditing standards do not impose “bright line rules” but instead provide only “general guidance” to auditors.
16. D. Albrecht, “Repo 105 Explained with Numbers and Detail,” 24 April 2010, http://profalbrecht
.wordpress.com/2010/04/24.
17. S. K. Dutta, D. Caplan, and R. Lawson, “Poor Risk Management,” Strategic Finance, August 2010, 29.
18. Ibid.
19. Ibid.
20. Texas Society of Certified Public Accountants, “Accounting Web—April 2, 2010,” http://www.tscpa.org.
General and Governor-elect. In commenting on mandated such disclosure, which, from the
the lawsuit, Cuomo noted that Lehman had been attorneys’ perspective, reinforced their argu-
a “house-of-cards” and that E&Y had “helped ment that such disclosure was not required in
hide” this fact “from the investing public.”21 2007.25
Shortly after the release of the Lehman Considerable attention was focused by
bankruptcy report, E&Y issued the following the bankruptcy examiner on the impact that
statement defending its unqualified opinion Lehman’s Repo 105 transactions had on the
on Lehman’s 2007 financial statements: “Our company’s reported net leverage ratio. E&Y,
opinion stated that Lehman’s financial state- however, pointed out that the ratio was not
ments for 2007 were fairly presented in accor- included in the company’s audited financial
dance with U.S. GAAP, and we remain of that statements and thus was not a “GAAP financial
view.” 22 E&Y’s statement went on to observe measure” subject to being audited.26 E&Y also
that “Lehman’s bankruptcy was the result of strongly contested the assertion that the Lehman
a series of unprecedented adverse events in auditors failed to properly inform the company’s
the financial markets. . . . It was not caused by audit committee of the allegations included in
accounting issues or disclosures issues.”23 the infamous whistleblower letter received by
E&Y’s responses to Lehman-related lawsuits Lehman’s management in May 2008.
typically included rebuttals of allegations ini- The media has inaccurately reported that
tially made by the company’s bankruptcy exam- E&Y concealed a May 2008 whistleblower
iner. For example, E&Y repeatedly insisted that letter from Lehman’s Audit Committee. The
the accounting treatment applied by Lehman whistleblower letter, which raised significant
to its Repo 105 transactions was GAAP com- potential concerns about Lehman’s financial
pliant. In a legal document filed with a federal controls and reporting but did not mention
court, E&Y’s defense counsel maintained that Repo 105, was directed to Lehman’s manage-
Lehman’s Repo 105s were properly recorded ment. When we learned of the letter, our lead
partner promptly called the Audit Committee
as true sales of securities under SFAS No. 140.24
Chair; we also insisted that Lehman’s man-
Likewise, E&Y maintained that at the time
agement inform the Securities & Exchange
Lehman was not required to disclose the Repo Commission and the Federal Reserve Bank
105 transactions in its financial statements. of the letter. E&Y’s lead partner discussed the
E&Y’s attorneys pointed out that SFAS No. 166, whistleblower letter with the Lehman Audit
“Accounting for Transfers of Financial Assets,” Committee on at least three occasions during
which was issued in June 2009, subsequently June and July 2008.27,28
21. P. Lattman, “Cuomo Sues Ernst & Young Over Lehman,” New York Times (online), 21 December 2010.
22. M. Cohn, “Ernst & Young Defends Lehman Audits,” WebCPA, 25 March 2010. (http://www
.accountingtoday.com)
23. Ibid.
24. In Re Lehman Brothers Equity/Debt Securities Litigation, No. 08 Civ. 5523 (LAK), “Civil Action No. 09
MD 2017 (LAK), U.S. District Court for the Southern District of New York.” E&Y’s legal counsel contended
that Lehman had relinquished “effective control” of the securities involved in the Repo 105 transactions
and, as a result, was permitted to record those transactions as sales of securities under SFAS No. 140.
Not surprisingly, the plaintiff attorneys disagreed with that interpretation of SFAS No. 140.
25. Ibid.
26. Texas Society of Certified Public Accountants, “Accounting Web—April 2, 2010.” Recall that
Lehman’s net leverage ratio was included in a financial highlights table in its 2007 annual report. That
ratio was also referred to in the Management’s Discussion & Analysis (MD&A) section of that report.
27. Texas Society of Certified Public Accountants, “Accounting Web—April 2, 2010.”
28. Notice that E&Y asserted that it discussed the whistleblower letter with Lehman’s audit committee.
The bankruptcy examiner, however, alleged that E&Y did not bring the Repo 105s to the attention of
the audit committee members. E&Y is correct that the Repo 105s were not specifically identified in the
whistleblower letter, although they were apparently alluded to in the letter and were referred to by the
whistleblower during his subsequent interview with Schlich and Hansen.
In 2013, E&Y agreed to pay $99 million to transactions. In fact, the Financial Accounting
settle a class-action lawsuit filed against it Standards Board attempted to do just that by
by Lehman’s former stockholders. Two years issuing multiple amendments to SFAS No. 140
later, in April 2015, E&Y made a $10 million in the aftermath of Lehman’s collapse.
payment to settle the lawsuit filed against it The authors of an article in a practice-
by Andrew Cuomo. E&Y did not admit any oriented accounting periodical, however,
wrongdoing in either settlement. Instead, the suggested that promulgating new, more pre-
accounting firm maintained that it agreed to cise accounting rules was unlikely to prevent
the settlements to end the costly litigation in Lehman-type accounting scandals in the future.
each case. To date, the largest settlement In their view, the most effective way to prevent
received by Lehman’s former stockholders was the recurrence of such scandals is to develop
a $500 million payment made by other named a more robust “ethical culture” within the
defendants, including Lehman’s former execu- accounting profession, a culture that encour-
tives, in the class-action lawsuit filed by those ages accountants and auditors to embrace the
stockholders. profession’s core values such as integrity, objec-
Similar to the Enron and WorldCom fiascoes tivity, and commitment to public service.
in the past, the Lehman debacle prompted Ethical behavior is not about abiding by the
widespread calls for accounting, auditing, and law. Individuals and organizations can act
financial reporting reforms. In particular, many legally and still be acting unethically. Ethical
parties critical of Lehman’s accountants and behavior is driven by compliance with a set
auditors urged rule-making bodies to clarify of values that act as the touchstone for situ-
the accounting and financial reporting rules for ational decisions where rules may not exist to
complex transactions, such as Repo 105-type cover every alternative.29
Questions
1. When Lehman was developing its Repo 105 accounting policy, did E&Y have
a responsibility to be involved in that process? In general, what role should an
audit firm have when a client develops an important new accounting policy?
Comment on an audit firm’s responsibilities during and following that process.
2. Do you agree with the assertion that “intent doesn’t matter” when applying
accounting rules? That is, should reporting entities be allowed to apply
accounting rules or approved exceptions to accounting rules for the express
purpose of intentionally embellishing their financial statements or related
financial data? Defend your answer.
3. Do auditors have a responsibility to determine whether important transactions of
a client are “accounting-motivated”? Defend your answer.
4. William Schlich implied that E&Y’s British affiliate had the responsibility for
reviewing the legal opinion issued by a British law firm regarding the treatment
of Repo 105s as sales of securities. Do you believe that Schlich or one of his
subordinates should have reviewed that letter? Why or why not? In general, how
should the responsibility for different facets of a multinational audit be allocated
between or among the individual practice offices involved in the engagement?
29. Dutta et al., “Poor Risk Management.”
5. Lehman’s net leverage ratio was not reported within the company’s audited
financial statements but rather in the company’s financial highlights table and
MD&A section of its annual report. What responsibility, if any, do auditors have
to assess the material accuracy of financial data included in those two sections
of a client’s annual report?
6. The Repo 105 transactions reduced Lehman’s net leverage ratio from 17.8 to 16.1
at the end of fiscal 2007. Do you believe that was a “material difference”? Why or
why not?
7. In general, what responsibility do auditors have to investigate whistleblower
allegations that relate to the material accuracy of an audit client’s financial
statements?
8. E&Y was a defendant in Lehman-related lawsuits filed in both state and federal
courts. Identify the factors that influenced E&Y’s legal exposure between
lawsuits filed in state courts versus those filed in federal courts.

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CASE 1.

Lehman Brothers Holdings, Inc.

The Cotton Kings

Playing with Fire

Falling housing prices caused a growing number of U.S. homeowners to be “upside

*In billions of dollars except for per share amounts.

The magnitude of an omission or misstatement of accounting information that, in

Auditors on the Firing Line

29. Dutta et al., “Poor Risk Management.”

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