'Repo 105' at the heart of Lehman report

By Sean Farrell

Published: 8:11PM GMT 12 Mar 2010

Mr Valukas finds what he calls "colorable claims" that could support
a court decision against the former executives and the accountancy firm.

At the heart of his findings is "Repo 105", an accounting ruse that
was instead used to try and keep the bank alive.

What is Repo 105?

Repo 105 was the name used at Lehman for what its own staff called an "accounting
gimmick". The bank had used the trick since 2001, but what started as "a
lazy way of managing the balance sheet" became crucial as the bank
tried to survive the credit crisis.

At the end of each quarter, Lehman sold some of its loans and investments
temporarily to other financial institutions for cash using short-term
repurchase (or "repo") agreements and then bought them back a few
days later. Ordinarily the assets would still be included on the bank's
balance sheet, but because they were valued at 105pc or more of the cash
received, the transactions counted as a "sale" under accounting
rules and Lehman was able to report a less risky balance sheet.

The bank stuck roughly to a limit of $25bn of Repo 105 until early 2007 but
increased its use so that in the first and second quarters of 2008 Lehman
was hiding $50bn of assets from investors, the government, rating agencies
and regulators. For the second quarter, Lehman reported a net leverage ratio
of 12.1 when the true figure was 13.9 - and a difference of 0.1 was regarded
as material.

In Mr Valukas's words, Lehman was "trumpeting" its reduced leverage
as it reported a massive $2.8bn second-quarter loss without revealing that
it had bought the assets back once its books were signed off.

The auditor's role

Ernst & Young knew about Repo 105 but did not keep a check on how much the
bank was using the accounting trick. E&Y's lead Lehman partner, William
Schlich, told Mr Valukas his firm did not "approve" Repo 105 but "became
comfortable with the policy for purposes of auditing financial statements".

Mr Valukas concluded that there was a potential case against E&Y for
malpractice for alleged "failure to question and challenge improper
disclosures" by Lehman and not acting when a Lehman whistleblower told
Mr Schlich about the $50bn of assets hidden from investors. Mr Schlich had
already been asked by Lehman's audit committee to investigate other claims
made in May 2008 by the whistleblower but did not report the new claims
about Repo 105 to the committee the following month. E&Y's tolerance of
Repo 105 for its powerful client may have echoes of Arthur Andersen's
complicity in Enron's off-balance-sheet accounting, which resulted in the
former big five accountancy firm imploding in 2002. However, Repo 105 is a
legitimate accounting tool.

The top executives

Mr Valukas says there are grounds for claims against Dick Fuld, the bank's
fearsome chief executive, and three of his former finance directors for
allowing the filing of financial statements that omitted or misrepresented
Lehman's Repo 105 activities and for failing to tell the bank's directors
about the accounting "gimmick".

The report said Mr Fuld was told in June 2008 by Bart McDade, Lehman's chief
operating officer, that the bank relied too heavily on Repo 105. "Fuld
took no action to determine whether Lehman's use of Repo 105 transactions
materially impacted its publicly filed statements and related disclosures"
and this action could be deemed grossly negligent, the report said.

Lehman went through a series of finance directors as the crisis unfolded.
Chris O'Meara, who served from 2004 to December 1, 2007, claimed little
knowledge of Repo 105 but was involved in targeting net leverage ratios and
knew Repo 105 was aimed at balance sheet reduction, the report said.

Erin Callan replaced Mr O'Meara and was warned in early 2008 by the bank's
global financial controller that Lehman was running risks with Repo 105
transactions that "lacked economic substance" and were not used by
its rivals. There was sufficient evidence that both Mr O'Meara and Ms Callan
had breached their fiduciary duties, and there was also enough evidence to
support a claim that Ian Lowitt, who took over in June 2008, was grossly
negligent, Mr Valukas said.

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