The Lehman Report

Beancounters in a bind

Mar 18th 2010 | NEW YORK
From The Economist print edition

Banks’ professional advisers come under scrutiny

IF SUNSHINE really is the best disinfectant, the 2,200-page report into Lehman Brothers’ downfall by its court-appointed bankruptcy examiner may do more to clean up finance than any number of new regulations. It paints a remarkably detailed, and damning, picture of Dick Fuld, Lehman’s ex-boss, and the executives around him. Their spectacularly ill-advised strategy was to take on oodles more risk in property just as everyone else was running the other way. Risk management was risible, with risk limits raised whenever they were breached and dodgy investments excluded from stress tests.

Lehman’s former leaders are not the only ones squirming in the glare. Some of its counterparty banks get a slap on the wrist for changing the terms of their collateral demands, for instance. But the strongest criticism of those who interacted with the flailing firm is reserved for Lehman’s auditor, Ernst & Young (E&Y), for failing to “question and challenge improper or inadequate disclosures”. The main “accounting gimmick” hidden from investors, but apparently known to the auditor, was called Repo 105. This technique helped the firm flatter its numbers by temporarily moving assets off its balance-sheet at the end of each quarter. Lawyers are also in the spotlight: unable to find an American law firm to approve the transaction as a “true sale” of assets, Lehman got the nod from Linklaters in London. Both E&Y and Linklaters deny any wrongdoing.

Although Repo 105 appears to have been in line with American accounting standards, its effect was to deceive. The technique allowed Lehman to reduce its reported leverage substantially and thus avoid ruinous ratings downgrades as it fought for survival. Investors would like to think that auditors consider not just the letter of the rules but their spirit, too. The examiner concluded that there was enough evidence to support a case for malpractice against E&Y.

The report identifies two other aspects to E&Y’s involvement. Lehman used subjective, inconsistent methods to value its illiquid assets. The examiner raises numerous questions about the auditor’s scrutiny of those “marks”, though he finds no evidence of deliberate misvaluation. Secondly, he accuses E&Y of failing properly to investigate claims about Repo 105 by a whistleblower, or to report these to the company’s audit committee (a claim which E&Y disputes).

All of which threatens to dent E&Y’s credibility and, perhaps, lighten its pockets. Class-action suits may follow. Lehman’s trustee could sue to recover losses suffered by creditors, who are seeking more than $800 billion in (at the last count) 64,000 separate claims. Nobody expects E&Y to suffer the same fate as Andersen, whose work for Enron led to its break-up in 2002, reducing the Big Five global accounting firms to four. But the industry, which had to swallow a raft of reforms, including Sarbanes-Oxley, after that scandal, could face calls for further tightening if similar tactics are exposed elsewhere.

Lehman is unlikely to be an isolated case, argues Prem Sikka, an accounting professor at the University of Essex, because “the guards are in bed with the prisoners.” Like rating agencies, auditors suffer from a potential conflict of interest because they are paid by those they judge (and can still tout for other work from them, despite post-Enron restrictions). E&Y’s annual bill for Lehman was $31m. With such big fees on the line, there may be a temptation to wave through practices that meet the rules but present a misleading picture of a client’s financial health.

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