By Joseph Neu
In an April 19 letter to the House Financial Services Committee, in advance of their hearing on the Lehman Bankruptcy Examiner’s Report, FASB Chairman Robert Herz responded to the potential accounting inadequacies indicated therein. Mr. Herz focused on repo and related true sale accounting. But he also touched on accounting for consolidation of special-purpose entities (SPEs) found in the Lehman case. SPEs have been 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.
Fortunately for Mr. Herz, accounting guidance implemented since Lehman’s demise makes it very difficult to conduct Wall Street business from off-balance-sheet entities. This may have put one nightmare to rest. But, unfortunately, the Lehman bankruptcy report sheds light on another nightmare: where institutions continue to work around “bright-line” accounting rules that auditors continue to insist upon to everyone’s detriment and which clearly violate the principles upon which accounting seeks to be based.
Working around the rules
Mr. Herz did not say that Lehman violated GAAP, citing insufficient information requiring further investigation by the FASB and the SEC. However, he did shed light on one thing Lehman clearly did, and that is work around the accounting rules to win a desired outcome, moving its debt temporarily off-balance sheet over quarter-end, rather than sticking to principles.
Example: True sale on the repos. Mr. Herz pointed to two principles for determining if a repo is a sale or a secured borrowing:
a) The transferred financial assets must be legally isolated from the company that transferred the assets, meaning 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; and
b) The company that transferred the assets does not maintain effective control over those assets.
With its Repo 105 and Repo 108 transactions, Lehman clearly structured them to a) get them classified as sales by promoting the fact pattern that they were legally isolated (based on a true sale opinion from a UK law firm) and b) that their collateralization levels 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 US, the case law is apparently varied enough, as Mr. Herz noted based on discussions with attorneys, that most generally would not provide a true sale opinion. It is not so clear in the UK. Plus, as he also noted, the English law firm’s legal opinion may have limited applicability to Lehman’s UK sub. Thus, the question of legal isolation is an open one.
With regard to b) Mr. Herz noted how Lehman purposely discounted the transferred assets relative to the collateral received: 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). This supported the idea that there was insufficient collateral to ensure the repurchase of the securities in a default scenario, allowing Lehman to make the case for true sale under the so-called “collateral maintenance requirement.”
As is often the case with accounting-driven structures, Lehman made a rule out of an example in the accounting guidance provided to help illuminate the collateral maintenance concept: “Arrangements to repurchase securities typically with as much as 98–102 percent collateralization, valued daily and adjusted up or down frequently for changes in market prices, and with clear powers to use that collateral quickly in the event of the counterparty’s default, typically fall clearly within that guideline.”
Add 3 percent, or 5 percent just to be safe, to the example threshold for securities to collateral value and you help make your case for Repo 105 and 108 to be true sales—but only if you cling to a rules or “bright-line” mindset. “That example,” Mr. Herz said, “was not intended to, nor does it, create a ‘bright-line’ for making that determination.”
The real nightmare for Herz —and no doubt his FASB colleagues— is that any effort toward clarity in their accounting guidance will eventually be used against them.