Repo 105: the examiner, the officers and Ernst & Young

analysisAccording to a 2014 court declaration by the investors' lead counsel, a Repo 105 was a repurchase agreement that Lehman accounted for as a sale instead of a financing, removing the assets from its balance sheet. Lehman used the cash it received to pay down other liabilities, which reduced both its balance sheet and its net leverage ratio. The name refers to the 5% overcollateralization Lehman provided; Repo 108 transactions were the same with 8%. ¹

analysisThe court-appointed examiner in LBHI's Chapter 11 case, Anton R. Valukas, reported on March 11, 2010 that Lehman turned to Repo 105 to remove $50 billion of assets temporarily at the first and second quarter ends of 2008, so that it could report significantly lower net leverage at a time when it knew that figure mattered to rating agencies and counterparties. He found that the transactions may not have been inherently improper but that there is a colorable claim that their sole function as Lehman employed them was balance-sheet manipulation, and he quoted Lehman accounting staff calling them an "accounting gimmick". His table, based on Lehman spreadsheets, gives quarter-end Repo 105 usage of $38.6 billion in the fourth quarter of 2007, $49.1 billion in the first quarter of 2008 and $50.4 billion in the second; Lehman reported net leverage of 16.1, 15.4 and 12.1 for those quarters, against 17.8, 17.3 and 13.9 without Repo 105, while its own threshold for reopening a closed balance sheet was any item that moved net leverage by 0.1 or more. The examiner defined a colorable claim as one supported by sufficient credible evidence for a finding by a trier of fact; he stated that he was not the ultimate decision-maker and that identifying a colorable claim neither precludes defenses nor predicts how a court would rule. His findings were not adjudicated as such. In July 2011, ruling on motions to dismiss in the investor class action, the district court held, as a securities class action clearinghouse reported, that the investors had sufficiently alleged their securities claims, among them that Lehman's use of Repo 105 "paint[ed] a misleading picture of the company's financial position at the end of each quarter"; that was a ruling on the pleadings, not a finding of fact. The investors' lead counsel later quoted a September 2013 newspaper report that the SEC and the Justice Department decided against asserting claims after finding that Repo 105 "had nothing to do with Lehman's failure and was technically allowed under an obscure accounting rule". ^{1 2 3}

analysisThe examiner concluded that Lehman's business decisions were within the business judgment rule, but that the decision not to disclose the effects of Repo 105 gave rise to colorable claims against the senior officers who oversaw and certified misleading financial statements: chief executive Richard S. Fuld, Jr. and chief financial officers Christopher O'Meara, Erin M. Callan and Ian T. Lowitt. He also found colorable claims against Ernst & Young for failing to meet professional standards in connection with the lack of disclosure. Before finalising, he told counsel for each officer and for Ernst & Young the basis of the potential findings and met them; he wrote that he was directed to credible facts and arguments that might support successful defenses, but that they did not change his conclusion. These findings rest on the same colorable-claim standard: sufficient credible evidence for a trier of fact to find for the claim, with the examiner not the ultimate decision-maker and the finding neither precluding defenses nor predicting a ruling. They were not themselves adjudicated. In July 2011, ruling on motions to dismiss, the court hearing the investor class action held that the investors had sufficiently alleged securities claims against former officers and directors, Ernst & Young and underwriters, though according to lead counsel the claims against Ernst & Young survived only in part; those claims were settled for $90 million by the former officers and nine former directors (approved May 24, 2012) and $99 million by Ernst & Young (2013-2014). ^{1 3 2}

analysisErnst & Young LLP was LBHI's independent auditor. The 2002 proxy statement proposed its reappointment for fiscal 2002 and gave its fiscal 2001 fees as $5,750,000 for the audit and $7,700,000 for other services; the Audit Committee was then chaired by Roger S. Berlind, with Michael L. Ainslie and Thomas H. Cruikshank as members. Its consent of May 2006 refers to its reports on the 2005 financial statements, and a consent of January 28, 2008 covers the reports on fiscal 2007; the retained copy of the latter does not show the firm's name, which the investors' complaint identifies as Ernst & Young. ^{1 2 3}

analysisAccording to the examiner, a Lehman senior vice president alleged accounting improprieties to management in May 2008 and on June 12, 2008 told Ernst & Young that Lehman had used $50 billion of Repo 105 to move assets off its balance sheet temporarily at quarter end. The next day Ernst & Young met the Audit Committee but did not tell it of these assertions, despite the committee's direction to report on all of his allegations, and in the examiner's words took virtually no action to investigate them. This too is an examiner's finding under his colorable-claim standard (sufficient credible evidence for a trier of fact; not the ultimate decision-maker; no prediction of how a court would rule). As with the officers, he told Ernst & Young's counsel the basis of the potential findings and met them; he wrote that he was directed to credible facts and arguments that might support successful defenses but that they did not change his conclusion. The finding was not adjudicated; the Attorney General's December 2010 suit, below, repeated the allegation about the Audit Committee, and Ernst & Young settled that suit for $10 million in 2015 and the investor class action for $99 million. ^{4 5 6 7}

analysisOn December 21, 2010 the New York Attorney General filed a Martin Act suit charging Ernst & Young with helping Lehman engage in an accounting fraud. The complaint alleged that Ernst & Young explicitly approved Repo 105 transactions used for more than seven years to park securities with European banks at quarter ends without disclosing the obligation to repurchase them, gave unqualified opinions from 2001 to 2007 and did not tell the Audit Committee of the whistleblower's concerns; the Attorney General sought return of more than $150 million in fees plus investor damages. These were the Attorney General's allegations and the case was settled without a trial. In the parallel investor class action Ernst & Young argued that the Repo 105 accounting complied with generally accepted accounting principles and that no disclosure was necessary. On April 15, 2015 the Attorney General announced a $10 million settlement, most of it restitution to Lehman investors, alongside about $99 million Ernst & Young was paying to settle the private class action; he stated that no other law enforcement authority had brought an enforcement action over Lehman's collapse and that an appellate decision in the case had confirmed his power to seek disgorgement of professional fees. ^{1 2 3}

analysisIn the class action In re Lehman Brothers Equity/Debt Securities Litigation, the third amended complaint of April 23, 2010 added Ernst & Young as a defendant, alleging that its statements in Lehman's 2007 and 2008 quarterly reports and 2007 annual report were misleading about its knowledge of undisclosed Repo 105 transactions. According to lead counsel, the court dismissed the Securities Act section 11 claims and the section 10(b) claims for purchases before July 10, 2008 but sustained section 10(b) claims over the review report for the second quarter of 2008; this account of the rulings is lead counsel's, given in a declaration supporting the settlement. Ernst & Young had moved to dismiss, arguing among other things that the accounting complied with GAAP, that no disclosure was needed and that the statements could not have caused the losses. It settled for $99 million in cash under a stipulation of November 20, 2013, bringing the action's total recovery to $615,218,000; lead counsel's declaration states that the Department of Justice and the SEC declined to bring charges or claims against Ernst & Young. ²