Lehman Brothers Audit Failure
Background
General
In 1844, Henry Lehman began the precursor to Lehman Brothers, a dry goods store in Alabama.
Several years later, after his brothers joined the business, it was renamed to Lehman Brothers and entered
the cotton trading industry. After moving its headquarters to NYC, the center of cotton trading, Lehman
Brothers joined the NYSE and underwrote its first IPO in the late 19th century. After expanding to include
nonfamily members, underwriting numerous IPOs, and surviving the Great Depression, the now
investment banking firm fell on hard times in the early 1970s. Tensions ensued between the firm’s
investment bankers and traders, leading many bankers to leave and causing CEO Glucksman to sell the
firm to American Express in 1984, where it remained for 10 years. After American Express divested
Lehman though an IPO, Richard Fuld became CEO and led Lehman Brothers to become the fourth largest
Investment Bank in the US, after Goldman Sachs, Morgan Stanley, and Merrill Lynch. After successfully
weathering the 1997 Asian financial crisis, the loss of its physical headquarters on 9/11, and SEC litigation
for associating analyst compensation with investment banking revenues (leading to biased analyst
reports), Lehman Brothers reported $680 billion in assets as of 2008.
Subprime Mortgage Exposure
Lehman was one of the first wall-street firms to enter the mortgage business. At the turn of the
21st century, Lehman bought Aurora Loan Services and BNC Mortgage LLC, both of which engaged in riskier
loans (Alt-A and subprime respectively). Lehman quickly became a leader in the subprime mortgage
market; it more than doubled its lending from 2003 to 2004 (18.2 billion to over 40 billion), and by 2006
it was lending almost $50 billion a month. By 2008, its $680 billion in assets were supported by only $22.5
billion of equity capital, making it’s debt-to-equity ratio over 29.
Accounting Scandal
Pressure
Lehman’s business model was high risk and high return. While its huge leverage made return on
equity high, the asset side of its balance sheet was long term while its liabilities were short term. As such,
Lehman required regular cash infusions to continue its operations, which meant keeping creditors and
rating agencies satisfied, particularly by maintaining a debt-to-equity ratio, or net leverage, below certain
levels. Furthermore, in mid-2007, real estate markets began to weaken, leading stakeholders to closely
scrutinize investment banks and the value of their real-estate holdings. Due to this pressure, its highly
leveraged position, and its inability to sell its mortgage backed securities at or near book value, Lehman
began relying more heavily on SFAS 140 to improve its balance sheet and reduce leverage.
SFAS 140 and Repo 105
In 2000, the FASB issued Standard 140, which allowed firms to characterize certain repurchase
(“repo”) transactions previously classified as borrowings as asset sales. A standard repo transaction
involves the temporary transfer of assets (often equity or fixed income securities) to another party for
cash accompanied by an agreement to repurchase the assets at a specified price later. The time is usually
short, between several days to two weeks. The lender returns the securities in exchange for the loan plus
interest in cash from the borrower. The form of this transaction is a loan.
In contrast, repo transactions characterized as asset sales, not loans, involved the “surrender of
control” over the financial assets. To qualify as having “surrendered control”, three criteria must be met:
1. The assets are beyond reach of the transferor and its creditors, even in bankruptcy
2. The lender can pledge or exchange the assets without any constraints imposed by the borrower
3. The borrower cannot require the return of the assets prior to the specified date.
Furthermore, the proceeds from the sale of the assets must be insufficient to fully fund their repurchase,
and firms must obtain a letter from a law firm attesting the transfer is a true sale in law.1
At first glance, a repo characterized as an asset sale has no impact on leverage. Securities are
replaced with cash, meaning assets and the balance sheet remain unchanged. However, a firm could use
the cash to pay down short-term debt, reducing its leverage. If done around the balance sheet date, this
could make a firm seem less leveraged than it was in reality. Furthermore, a few days later when the repo
matured, the firm would need to borrow more funds to buy back the assets with interest, increasing
assets, liabilities, and leverage.
Lehman’s Usage of Repo 105
Lehman called its “asset sale” repurchase agreements Repo 105 (for debt securities) and Repo
108 (for equity securities). The 105 & 108 refer to the 5% and 8% overcollateralization Lehman used to
demonstrate the proceeds from the sale were insufficient for the repurchase (i.e. Lehman would sell $105
of debt securities or $108 of equity securities for $100 cash). From 2001 to 2006, Lehman used both
financing repos and Repo 105s (and some Repo 108s) to varying degrees. However, as stakeholders
pressured banks to reduce their leverage, Lehman increasingly used Repo 105s to reduce its assets on the
balance sheet, with usage topping $50 billion in Q2 2008 with a commensurate reduction in assets
(reducing perceived leverage). Furthermore, while Lehman disclosed its use of repos in its annual and
quarterly filings, it only stated that it accounted for them as financings. At no point did it reference its use
of SFAS 140 to characterize some repos as asset sales, either in the notes to the financials or in MD&A.
The Bank Examiner’s Report noted that “an investor reviewing Lehman’s 2007 Form 10-K and two 2008
Forms 10-Q would not have been able to discern that Lehman was engaged in Repo 105 transactions.”2
1
2
Burke, pages 167-169
Quote taken from Wiggens, page 112
While using a sale repo is not inherently problematic under SFAS 140, Lehman Brother’s use of
the standard would be problematic even if it had correct disclosures. Firstly, it failed to obtain the
required letter from a US law firm. The UK law firm that issued the attestation letter, Linklaters, premised
its opinion on UK law. The difficulty obtaining a letter from a US law firm was likely due to the second
problem: the transactions lacked economic substance. The overcollateralization was unnecessary; the
Bankruptcy Examiner noted that Lehman “had the ability to conduct an ordinary repo transaction using
the same securities and with substantially the same counterparties as in Repo 105 transactions, at a lower
cost.”3 This, combined with the timing of a substantial volume of Repo 105 transactions (which often
occurred right before reporting dates in 2007 and 2008)4, demonstrated that there was no business
purpose to the transactions; their sole purpose was to soothe stakeholder concerns by reducing leverage
ratios and making the financials appear more stable.
Audit Failure
Background
EY was the auditor for Lehman Brothers from 2001 through the latter’s bankruptcy in 2008, giving
the desired unqualified opinion on the financials throughout this time. Its role went beyond merely
reviewing the financial statements, however. EY was Lehman’s trusted advisor and was consulted on
numerous accounting and financial matters relating to Lehman’s operations.
Role in Repo 105 Policy and Use
It is unclear what role EY played in the development of Lehman’s Repo 105 policy, but it became
aware of it at some point and had numerous discussions with management about it. In the course of the
engagement, EY reviewed the Repo 105 policy and related accounting treatment, transactions, and
affected ratios. William Schlich, the EY Partner covering the Lehman engagement, said his team never
3
4
Quote taken from Burke, page 172
See Exhibit 1
evaluated the policy to see if it was a correct interpretation of SFAS 140. He elaborated that EY didn’t
approve of the policy but became “comfortable with the policy for purposes of auditing the financial
statements.”5 In this case professional skepticism would dictate that EY issue at least an unmodified
opinion with emphasis of matter, but EY continued with its unqualified opinion. Finally, William claimed
that while EY was required to provide assurance on whether Repo 105 transactions were accounted for
correctly, it was not required to investigate the timing and volume of transactions. This again violated the
professional skepticism expected of auditors. Furthermore, auditors are supposed to inquire about
unusual situations and transactions, meaning it was within the scope of the engagement to ask about the
amounts and patterns of Repo 105 transactions.
There is a plethora of other examples of EY’s lack of professional skepticism and due diligence in
its audits of Lehman. EY never inquired how Lehman developed its Repo 105 policy from SFAS 140, and
it never asked to see the Linklater letter despite knowing of its existence. It never questioned the Repo
105 usage, even though it was an expensive way to raise funds (as mentioned earlier, Lehman
overcollateralized the loans and could have obtained the same financing at lower cost) and most
investment banks had ceased to use such transactions. Finally, it never questioned the sufficiency of
Lehman’s liquidity and liability disclosures in the MD&A section of the financials, even though billions of
dollars related to Repo 105 repurchase obligations were not discussed (while audit reports do not cover
MD&A, auditors are required to read the section and be satisfied that it is clear and complete).
How It Came To Light
The Whistleblower Letter
On May 16, 2008, Matthew Lee, SVP of Lehman’s Global Balance Sheet, send a letter to senior
management about accounting irregularities (the “Whistleblower Letter”). His responsibilities included
consolidating the financial and accounting information from Lehman’s various subsidiaries into one set of
5
Quote taken from Wiggens, page 109
statements for reporting purposes. Among other things, he alleged that many balance sheet accounts
were unsubstantiated, and that the firm needed to invest in additional systems and personal to deal with
the increased size of the balance sheet (recall that over time, Repo 105 transactions increase Total Assets
and Liabilities). Furthermore, he claimed that the internal audit department lacked the expertise to deal
with the increasingly complex situations Lehman faced. Unless the firm made drastic changes, it could
not comply with its policy of presenting financial statements in a “full, fair, accurate, and timely manner.”6
Handling the Letter
Senior management provided the letter to the audit committee, which asked to be informed of
all of Lee’s allegations, and to EY, which was charged with investigating the allegations. Schlich
interviewed Matthew on June 12, 2008, where he was told of Lehman’s escalating use of Repo 105 and
its balance sheet effects. The next day, senior management and Schlich met with the audit committee to
discuss Q2 financial reports, and Schlich met with them again on July 2. Notwithstanding the allegations
or investigation, EY once again issued an unqualified opinion on July 10 for the second quarter. On July
22, Schlich attended a board meeting where management delivered a presentation on the Whistleblower
Letter. The presentation failed to mention Repo 105. Regardless of its duty under SOX to inform the audit
committee of any observations that are significant to the financial reporting process, and its fiduciary duty
to shareholders, EY did not inform the audit committee or the board of Lee’s allegations regarding Repo
105 usage at any of these meetings (even thought the audit committee specifically requested this
information).
Bankruptcy and Impact
Bankruptcy Filing
On September 15, 2008, after suffering major losses due to its subprime mortgage holdings,
Lehman Brothers filed the largest bankruptcy filing in US history. Its bankruptcy shook the market and
6
Wiggens, pages 121-123
played a major role in the 2008 Financial Crisis. The liquidation of its mortgage securities caused a
precipitous decline in commercial real estate values. Many mutual funds and institutional investors had
significant exposure to Lehman and saw their values decline as well. Close to 100 hedge funds used
Lehman as their prime broker and relied on their firm for financing. Once it filed for bankruptcy, the hedge
funds positions were frozen, and they needed to reduce their leverage and hold large cash balances,
inhibiting growth.
Effect on EY
In his report, Bankruptcy Examiner Anthony Valukas concluded that EY had failed to adequately
perform its duty to assess whether the financial statements were materially misleading. As such, possible
claims existed against EY for professional negligence due to the following:
1. Failing to inform the audit committee of Lehman’s Repo 105 usage,
2. Poor handling of Lee’s Whistleblower Letter, and
3. Not challenging Lehman’s filing of financials that were materially misstated.
Nonetheless, the PCAOB and SEC both declined to initiate any proceedings against EY. The Accountancy
and Actuarial Disciplinary Board conducted an 18-month investigation but eventually concluded not to
take any disciplinary action against EY as well. EY itself denied any wrongdoing, claiming Lehman Brothers’
financials were in accordance with GAAP and the investigation into the Whistleblower Letter had been
cut short by the bankruptcy.
However, EY did not escape completely unscathed. It faced various lawsuits from Lehman
investors and in November 2013 announced it would pay $99 million to settle one such suit. It also settled
a lawsuit brought against it by the Attorney General of NY seeking disgorgement of the $150 million in
fees it received from Lehman (the settlement was only $10 million).
Impact
The Bankruptcy of Lehman would have far-reaching consequences. Firstly, in 2011, the FASB
amended SFAS 140 to state that the obligation to repurchase securities constitutes effective control,
meaning all repurchase agreements are required to be recorded and disclosed as borrowings, not asset
sales. Had this been in place earlier, Lehman could not have used Repo 105 to hide its leverage.
More importantly, the collapse of Lehman Brothers and the ensuing Financial Crisis led to the
enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The act had numerous
implications. Firstly, it created the Consumer Financial Protection Bureau, which was charged with
protecting consumers against abuses related to credit cards, mortgages, and other financial products.
Secondly, it created the Financial Stability Oversight Council and the Office of Financial Research to
identify threats to the financial stability of the US. Thirdly, it gave the Federal Reserve new powers to
regulate systemically important institutions. It also created the Orderly Liquidation Authority to handle
the liquidation of large firms. Finally, it created the Volcker Rule, which restricts banks from making
certain speculative investments.
Conclusion
Lehman Brothers’ bankruptcy caused tremendous damage to the economy. Had the independent
auditors upheld their responsibilities of professional skepticism and due diligence, their fiduciary duties
to shareholders, and their statutory obligations to communicate unusual situations to the audit
committee, perhaps its collapse could have been prevented. Alternatively, it would have gone bankrupt
without misleading stakeholders for so long, protecting the stability of the financial system. The case
highlights the crucial role auditors play as guardians of the public
Exhibit 17
7
Burke, page 173
Bibliography
Burke, John JA. “Deconstructing the Use of REPO 105 and Repo 108 Transactions Under SFAS 140: The Case of
Lehman Brothers Holding Inc. and the Liability of Ernst & Young.” Academicus International Scientific
Journal, no. 19, Entrepreneurship Training Center Albania, 2019, pp. 165–87.
Wiggins, Rosalind Z., et al. “The Lehman Brothers Bankruptcy D: The Role of Ernst & Young.” SSRN Electronic
Journal, 2014. DOI.org (Crossref), doi:10.2139/ssrn.2588551.