Lehman Brothers Repo 105 Balance-Sheet Transactions (2007-08)

Introduction

Lehman Brothers Holdings Inc. filed for Chapter 11 bankruptcy on 15 September 2008 — the largest bankruptcy in United States history at the time, with roughly $613 billion in debt. The collapse is widely regarded as the single most destabilising event of the 2008 global financial crisis. What emerged in the months and years afterward was a detailed picture of accounting practices that, in the view of the court-appointed bankruptcy examiner, left Lehman's reported leverage materially misleading to investors, rating agencies, and regulators in the lead-up to its collapse. Whether that conduct was legally fraud has never been decided by a court.

The central mechanism was a transaction type Lehman called "Repo 105." In standard repurchase agreements (repos), assets are transferred as collateral against short-term borrowing and recorded on the balance sheet as financing — as they should be, because the firm retains the risks and rewards of ownership. Lehman's Repo 105 transactions, by contrast, were booked as sales under the US accounting standard SFAS 140, relying on a Linklaters opinion under English law that they were true sales, allowing Lehman to remove assets from its balance sheet at quarter-end, repurchase them days later, and report leverage ratios that were lower than they would otherwise have been.

The Scheme: How Repo 105 Worked

At each quarterly reporting date, Lehman would execute large Repo 105 transactions — transferring securities to counterparties at a 5% or greater haircut (hence "105") and treating the transfers as sales rather than financing. This removed tens of billions of dollars in assets from the balance sheet. The cash received from the "sale" was then used to pay down other liabilities, further reducing apparent leverage. Shortly after the quarter-end reporting date, Lehman would repurchase the assets, restoring them to the balance sheet.

The Valukas Report — produced by Anton Valukas of Jenner & Block as court-appointed bankruptcy examiner and released in March 2010 — quantified the scale: Repo 105 usage grew from approximately $38.6 billion in Q4 2007 to $49.1 billion in Q1 2008 to $50.38 billion in Q2 2008. These sums temporarily removed leverage that, if reported, would have shown Lehman's net leverage ratio to be significantly higher than disclosed. The report did not find anyone liable. It concluded that there was sufficient evidence to support "colorable" claims, meaning claims that on appropriate proof would support a recovery in a civil court, that Lehman's CEO and three of its chief financial officers breached their fiduciary duties by exposing the firm to liability for filing materially misleading periodic reports that did not disclose Repo 105, and that Ernst & Young failed to meet professional standards in connection with that non-disclosure. It also said there was a colorable claim that the sole function of the transactions, as Lehman used them, was balance sheet manipulation, while noting that Repo 105 transactions "may not have been inherently improper."

The Linklaters Opinion and the US Counsel Refusal

Lehman could not execute Repo 105 transactions in the United States because, according to the Valukas Report, it was unable to find a US law firm that would provide an opinion that the transactions were true sales under US law. Lehman's own Repo 105 accounting policy stated: "Repos generally cannot be treated as sales in the United States because lawyers cannot provide a true sale opinion under U.S. law." Instead, Lehman routed the transactions through its London subsidiary, where UK law firm Linklaters LLP provided the necessary legal opinions under English law. The Linklaters opinions provided the transactional cover without which Repo 105 could not function under US accounting standards.

The documented point is narrow: because no US-law opinion was available, Lehman ran the transactions through its London broker-dealer, LBIE, under an English-law opinion. Linklaters said the examiner "does not criticise those opinions or say or suggest that they were wrong or improper," and that it was not aware of any facts or circumstances that would justify criticism of them.

Ernst & Young and the Audit

Ernst & Young (EY) was Lehman's external auditor and signed off on financial statements that incorporated Repo 105 balances. New York Attorney General Andrew Cuomo sued EY on 21 December 2010 under the state's Martin Act, alleging that EY had approved Lehman's accounting for the Repo 105 transactions and issued unqualified audit opinions despite knowing that Lehman was not disclosing them. EY settled that lawsuit for $10 million in April 2015; separately, it agreed to pay $99 million to settle a private investor class action. Both settlements are set out below. EY denied liability in the class action and said the New York settlement carried no findings of wrongdoing.

Neither settlement was a finding of liability against EY, which has said its work met all applicable professional standards. The examiner found colorable claims against EY for failing to meet professional standards in connection with the non-disclosure.

CEO Dick Fuld and the Absence of Criminal Charges

Dick Fuld told the House Financial Services Committee on 20 April 2010, about six weeks after the Valukas Report was released: "I have absolutely no recollection whatsoever of hearing anything about or seeing documents related to Repo 105 transactions while I was the CEO of Lehman." The examiner reported that Fuld likewise denied recalling any conversation about Repo 105 with other members of Lehman's Executive Committee, that a former senior Lehman executive told the examiner that "Fuld knew about the accounting of Repo 105," and that "[a] finder of fact will have to further evaluate Fuld's statements in light of other evidence of his knowledge of Repo 105 and his interest in reducing Lehman's net leverage." The examiner found sufficient evidence to support a colorable claim that Fuld was at least grossly negligent for failing to ensure that Lehman's second-quarter 2008 Form 10-Q fairly presented its financial condition. That is a civil claim the examiner assessed, not a finding of liability.

The SEC investigated Lehman for more than three years and brought no charges of any kind against its executives; the Department of Justice brought no criminal case. The SEC's reported decision not to proceed drew criticism in press commentary. No prosecutor or regulator has charged any Lehman executive over Repo 105; Fuld and other former officers were defendants in the private investor class action, in which the officer and director defendants settled for $90 million.

Verdict

The claim judged here is that Lehman used Repo 105 transactions at quarter-ends in 2007-08 to temporarily remove tens of billions of dollars from its balance sheet and so report lower leverage than it carried, without disclosing the practice. That is confirmed by the Valukas bankruptcy examiner report, which drew on Lehman's own records and on interviews with its staff. What is not established is that the conduct was legally fraud. The examiner found colorable civil claims, not liability; no court has ruled on the question; the two EY settlements ended without a finding of liability; and no regulator or prosecutor has charged any Lehman executive. The absence of charges is not a finding that the practice did not occur, but it does mean the "fraud" label rests on the examiner's and others' opinions rather than on any adjudication.

What Would Change Our Verdict

• New documentary evidence that Repo 105 usage was disclosed to and understood by all relevant investors at the time
• A judicial finding that the Linklaters opinions rendered the accounting treatment fully compliant and that no disclosure of Repo 105 was required

The Whistleblower Who Was Let Go: Matthew Lee

One of the clearest pieces of evidence that Lehman's own staff had concerns about its accounting, and about Repo 105 in particular, came from inside the firm's finance division. On 16 May 2008, Matthew Lee, a senior vice president in the Finance Division responsible for Lehman's global balance sheet and legal entity accounting, with 14 years at the firm, sent a letter to senior management identifying possible accounting improprieties, among them about $5 billion of net assets in excess of what was managed at month-end and "tens of billions of dollars of unsubstantiated balances." According to the Valukas Report, the letter did not mention Repo 105. Lee was let go six days after sending the letter, before the 12 June meeting. Lee raised Repo 105 separately on 12 June 2008, in a meeting with two Ernst & Young partners who were investigating his letter, telling them that at the end of the second quarter Lehman had moved $50 billion in assets off its balance sheet using Repo 105 transactions and moved them back a few days later. The next day, 13 June, E&Y met Lehman's board audit committee but did not tell it about Lee's Repo 105 assertion, despite the committee's express direction to advise it of all of Lee's allegations; Lehman filed its second-quarter 2008 Form 10-Q on 10 July 2008. The examiner's colorable claims against E&Y include its communications with the audit committee and its investigation of a whistleblower claim.

What Valukas Actually Found on Camera

When CBS's 60 Minutes interviewed Anton Valukas in 2012, two years after his report was published, he described Repo 105 in blunt terms: "They'd fudged the numbers... It was a shell game. It was a gimmick." Valukas told correspondent Steve Kroft that his investigators had read internal emails in which Lehman personnel discussed the transactions' purpose, then interviewed the authors of those emails directly. His account: "They told us they were doing it for purposes of affecting the numbers." On Ernst & Young's role, Valukas was equally direct: "Ernst and Young certainly knew it... and did nothing with it." Asked whether Lehman's quarterly reports gave investors a fair, accurate picture, Valukas said: "In our opinion, they did not." Asked whether that was against the law, he said: "It certainly, in our opinion, was against civil law if you will. There were colorable claims that this was a fraud, yes." The interview aired with no criminal charges having been filed against any Lehman executive or auditor, and none have been filed since.

Why the SEC Walked Away: The 2012 Internal Memo

The Securities and Exchange Commission investigated Lehman for more than three years. It never issued a public statement closing the case. Instead, according to reporting that drew on an internal SEC memo, the agency's staff quietly concluded its inquiry in the spring of 2012. The memo reportedly stated that "the staff has concluded its investigation and determined that charges will likely not be recommended." In September 2013, according to the ABA Journal's summary of a New York Times report that relied on anonymous sources, federal investigators had determined that the accounting practices the examiner focused on were legal and were not material to Lehman's failure, and top Lehman executives would face neither criminal prosecution nor civil charges from the SEC. An SEC spokesman declined to comment on the specifics. The reported decision drew criticism from commentators, among them a Yahoo Finance column headlined "SEC Dropping Lehman Case: Where’s the Outrage?" No SEC action followed, and the Department of Justice likewise brought no criminal case.

Two Different Ernst & Young Settlements — Not One

A precise accounting of Ernst & Young's legal exposure over Repo 105 requires separating two distinct cases that are sometimes conflated in summaries of the affair. The first was a private federal securities class action brought by investors in Lehman securities, consolidated before U.S. District Judge Lewis Kaplan in the Southern District of New York. Lead plaintiffs told the court on 11 October 2013 that E&Y had agreed to pay $99 million, and the settlement was disclosed in a filing in late November 2013 after more than three years of litigation that included more than 50 depositions and the review of 26 million pages of documents. Judge Kaplan approved the settlement as fair, reasonable and adequate after a fairness hearing on 16 April 2014. E&Y denied all liability. The second, separate case was a lawsuit brought under the state's Martin Act by the New York Attorney General's office, filed on 21 December 2010 by then-Attorney General Andrew Cuomo; his successor, Eric Schneiderman, announced the settlement. It alleged that E&Y approved Lehman's accounting for the Repo 105 transactions and issued unqualified audit opinions despite knowing Lehman was not disclosing them. The Attorney General's office described the settlement as resolving the first lawsuit brought against an auditor of a public company under New York's securities laws. It settled on 15 April 2015 for $10 million, most of which goes to investors in Lehman securities, with the remainder reimbursing the state for investigation and litigation costs. E&Y did not admit wrongdoing in either settlement.

The Legal Opinion That Never Failed a Court Test

A genuine open question in the historical record is whether Repo 105 was fraud or aggressive-but-technically-legal accounting, and the record does not resolve it cleanly in either direction. Linklaters' opinion that the transactions qualified as "true sales" under English law was never struck down by a court, and no US regulator or prosecutor obtained a ruling that the accounting treatment itself was unlawful. Academic and legal commentary on the episode has split on how to characterize it. The CPA Journal (August 2016) concluded that Lehman used a narrow test in FAS 140, the US accounting standard governing when a transferred asset can be treated as sold rather than financed, to structure transactions that could be booked as sales, and that Lehman "may not have violated the letter of the accounting standards, but it definitely violated their intent by materially misleading financial statement users." Others — including Wharton finance faculty interviewed shortly after the report's release — emphasized that legality of the mechanics did not settle the question of deception. Franklin Allen of Wharton called it "simply an artifice, to deceive people," while colleague Richard Herring argued the accounting firm's role was to "help the firm misrepresent its actual position." Jeremy Siegel, another Wharton finance professor, was reported as noting more neutrally that balance-sheet "window dressing" is a widespread practice that also can be perfectly legal, underscoring that Repo 105 sat closer to an extreme end of an existing spectrum of accepted practice rather than wholly outside it. The Valukas Report's own conclusion split the difference: it found that Lehman did not disclose Repo 105's use or scale to the government, rating agencies, investors or its own board, and that there was a colorable claim that this left its periodic reports materially misleading, while stating that it "does not reach the question of whether Lehman's Repo 105 transactions technically complied with the relevant financial accounting standard, SFAS 140," because the answer does not affect whether a colorable claim exists.

Standard-Setter Response

The Repo 105 disclosure also prompted a response from accounting rule-makers. In April 2011 the Financial Accounting Standards Board issued Accounting Standards Update 2011-03, which, according to The CPA Journal, was meant "to deal with the Repo 105/108 issue" by removing from the test for effective control the criterion of whether the transferor can repurchase the assets on the agreed-upon terms. A change to the rule is not a finding about what Lehman did under the old one, and whether Lehman's use of that rule, and its non-disclosure, was deceptive remains a separate question.

Why the Nuance Matters for the Verdict

None of the above changes the underlying, confirmed fact: Lehman Brothers used Repo 105 transactions, documented in detail by a court-appointed examiner working from the company's own records and email traffic, to temporarily remove tens of billions of dollars from its balance sheet at quarter-end reporting dates in order to present a lower leverage ratio than its actual financial position. That is settled by primary-source documentary evidence. The two Ernst & Young settlements arose from allegations about the same conduct, though neither was a finding of liability. What remains genuinely contested — and is presented here as legitimate limitation rather than as doubt about the core finding — is whether the specific legal characterization of "fraud" fits the conduct as opposed to an aggressive use of an accounting standard's wording, and why no charges followed: press reports attribute the federal decisions not to charge to findings that the practices were legal and not material to Lehman's failure.