Need the Lehman report lead to a slew of new accounting guidance, or just sticking to principles?
In letter to the House Financial Services Committee on Monday, FASB Chairman Robert Herz responded to the Lehman bankruptcy report and the potential accounting inadequacies indicated therein. This came in advance of a Committee hearing on April 20, “Public Policy Issues Raised by the Report of the Lehman Bankruptcy Examiner.” Mr. Herz focused on the major issues of the Lehman report (repo and related true sale accounting) as well as accounting guidance related to consolidation of special-purpose entities (SPEs) which pertain to the Lehman case, but are also the subject of a recurring Herz nightmare, where all of Wall Street becomes the domain of off-balance sheet SPEs and no more real institutions conduct business there anymore.
The ramifications of a regulatory-induced scramble by Wall Street firms to create SPEs are clearly not lost on everyone, but in his letter Mr. Herz sticks with the accounting. Here the nightmare is how institutions continue to work around accounting rules, which auditors continue insist upon, rather than abiding by accounting principles.
WORKING AROUND THE RULES
. Herz prefaced his remarks by saying, “we do not have sufficient information to assess whether Lehman complied with or violated particular standards relating to accounting for repurchase agreements or consolidation of special-purpose entities.” The FASB is, of course, working with the SEC to help determine this, but for now he can only shed light on the current accounting guidance to help put what Lehman did into context. What does seem clear, however, is that Lehman was working around the accounting rules, rather than sticking to principles.
Example: True sale on the repos. Take the repos for example. Mr. Herz pointed to two criteria that are key to determining if a repo is a sale versus a secured borrowing:
(a) The transferred financial assets must be legally isolated from the company that transferred the assets. In other words, Lehman or its creditors would not be able to reclaim the transferred securities during the term of the repo, even in the event of Lehman’s bankruptcy.2
(b) The company that transferred the assets does not maintain effective control over those assets. Specific tests relate to whether the company has maintained effective control, which he described in his letter.
With its Repo 105 and Repo 108 transactions, Lehman apparently structured them around the accounting to get them classified as sales rather than secured borrowings by promoting the following fact pattern:
(a) That the transferred securities had been legally isolated from Lehman (based on a true sale opinion from a U.K. law firm), and
(b) That the collateralization in the transactions did not provide Lehman with effective control over the transferred securities.
With regard to (a), Mr. Herz suggested that Lehman was exploiting differences between US and UK law concerning the treatment of repos in bankruptcy. “In the United States,” Mr. Herz noted based on discussions with attorneys, “case law related to repurchase transactions has been varied enough that most attorneys generally would not provide a true sale opinion.” It is not so clear in the UK. Plus, as Mr. Herz noted, “we understand that the opinion prepared by the English law firm may have limited applicability and pertains only to the portion of the transaction executed by the U.K. subsidiary with the repo counterparty.” Thus, the question of legal isolation is an open one.
With regard to (b) Mr. Herz noted how Lehman apparently took a haircut on the face value of the transferred assets offered to the counterparty, i.e., instead of transferring approximately $100 worth of securities for every $100 of cash received, it transferred $105 worth of debt securities or $108 of equity securities for every $100 in cash received (hence, the names Repo 105 and Repo 108). Such discounting supported the idea that there was insufficient cash collateral to ensure the repurchase of the securities in a default scenario and thus these were sales transactions for accounting purposes.
Essentially, Lehman sought to exploit accounting guidance for determining whether a company maintains effective control over securities transferred in a repo transaction, especially where it has elements of both a sale and a secured borrowing.