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Linklaters, one of Britain’s leading law firms, approved controversial accounting practices that allowed Lehman Brothers to shift billions of dollars of debt off its balance sheet and mask the perilous state of the bank’s finances before its catastrophic collapse in 2008.
A 2,200-page report into the collapse of the 158-year old institution has uncovered evidence that Lehman used “balance sheet manipulation” in the form of an accounting practice known as “Repo 105”, without telling investors or regulators, that made the business appear healthier.
Lehman initially had sought legal clearance from an American law firm to permit Repo 105 transactions but was denied. It then sought advice from Linklaters in London, which said that the deals were possible under English law.
The Repo 105 practice had been in use by Lehmans since 2001 but in the bank’s final two years it was regularly used to alter public perceptions of the bank’s balance sheet.
In the run-up to a reporting period, Lehman would enter an arrangement to sell and then repurchase financial assets. Normally, such deals are accounted as “transactions”, but by adding a cash element Lehman was able to call them “sales”.
The bank’s balance sheet, therefore, could be pumped up with cash from the sale and would also reduce its borrowings. At the beginning of a new quarter, Lehman would borrow more money and repurchase the assets to put them back on its balance sheet.
The assets were transferred through Lehman’s London operations so that the Repo 105 deals could be conducted under English law.
Anton Valukas, of Jenner & Block, who was appointed as examiner by the judge handling Lehman’s bankruptcy, said: “Unable to find a United States law firm that would provide it with an opinion letter permitting the true sale accounting treatment under United States law, Lehman conducted its Repo105 programme under the aegis of an opinion letter the Linklaters law firm in London.”
In 2008, just before Lehman filed for bankruptcy, it transferred $50.38 billion in a Repo 105 arrangement, reducing its leverage from 13.9 per cent to 12.1 per cent.
“Lehman’s failure to disclose the use of an accounting device to significantly and temporarily lower leverage, at the same time that it affirmatively represented those 'low' leverage numbers to investors as positive news, created a misleading portrayal of Lehman’s true financial health,” Mr Valukas said.
Linklaters is part of Britain’s “magic circle” of leading law firms, which includes Clifford Chance, Allen & Overy, Slaughter and May and Freshfields Bruckhaus Deringer, and is one of the biggest practices in the world.
Linklaters said that it had not been contacted by the examiner during his investigation and stood by its advice to Lehman Brothers. In a statement, the firm said that Mr Valukas had not criticised the opinions provided to Lehman Brothers or found that they were improper. "We have reviewed those opinions and are not aware of any facts or circumstances which would justify any criticism," Linklaters added.
Mr Valukas’s report also accuses Ernst & Young of professional negligence over a number of years before the catastrophic downfall Lehman and warns the British accountancy firm that it could face legal action for signing off the Repo 105 arrangements.
Mr Valukas criticises Ernst & Young “for among other things its failure to question and challenge improper or inadequate disclosure in those financial statements."
He said the accountancy firm “was professionally negligent in allowing those [Repo 105] reports to go unchallenged.” He added that there could be a colourable claim for professional malpractice against the accountancy giant.
Ernst & Young was appointed as Lehman's auditor in 1994, the same year that Christopher O'Meara left the accountancy firm, where he was a senior manager in the financial services practice, to join the US bank. Mr O'Meara eventually became Lehman's global head of risk.
The report also detailed that Matthew Lee, a senior vice-president of Lehman, wrote a letter to management "alleging accounting improprieties". Ernst & Young investigated the claims and was advised by Mr Lee on June 12, 2008, that Lehman had used $50 billion of Repo 105 transactions to temporarily move assets off balance sheet.
The report states that on the next day, at a meeting with the bank's audit committee, Ernst & Young "did not advise [the committee] about Lee’s assertions".
Mr Valukas concludes that Ernst & Young "took virtually no action to investigate the Repo 105 allegations" and "took no steps to question or challenge the non-disclosure by Lehman of its use of $50 billion of temporary, off-balance sheet transactions".
He adds: "Colorable claims exist that Ernst & Young did not meet professional standards, both in investigating Lee’s allegations and in connection with its audit and review of Lehman’s financial statements."
Dick Fuld, the former chairman and chief executive of Lehman, and some of his closest lieutenants are also facing legal claims for breach of fiduciary duty after using the “lazy accounting gimmick” to hide the fact that the bank was insolvent.
The Valukas report paints a damning picture of the bank’s final two years, branding it as a hothouse institution so obsessed with growth that senior executives said openly they did not want to hear “too much detail” about the risks they might face in case it held them back.
The examiner concluded that although Lehman’s top management had chosen to disregard or overrule the firm’s risk controls on a regular basis and while certain of their risk decisions were “unwise” and represented poor “judgment”, this did not amount to a breach of fiduciary duty.
He noted that the sole function of the Repo 105 transactions was “balance sheet manipulation”, adding that even Lehman’s own accounting personnel described them as an “accounting gimmick” and a “lazy way of managing the balance sheet”.
Mr Valukas concluded that there were “colourable claims” against Mr Fuld, Mr O’Meara, Lehman’s head of risk, Erin Callan, the chief financial officer and Ian Lowitt, who replaced Ms Callan as chief financial officer.
He described a “colourable claim” as one for which “there is sufficient credible evidence” to support a finding in a court.
Mr Fuld’s lawyer said last night that the former Lehman boss did not know what the Repo 105 transactions were or their accounting treatment.
Ernst & Young said: “Our opinion indicated that Lehman’s financial statements for that year were fairly presented in accordance with Generally Accepted Accounting Principles [GAAP], and we remain of that view.”
When Lehman filed for bankruptcy on September 15, 2008, with about $600 billion in debt, its collapse contributed to the freezing of credit markets worldwide and to increasing the depth of the global recession.
Judge James Peck, who is handling the Lehman bankruptcy in the Bankruptcy Court of the Southern District of New York, appointed Mr Valukas a year ago to investigate the events that led to Lehman’s collapse, including any possible “fraud, dishonesty, incompetence, misconduct, mismanagement or irregularity”.
On Thursday, Judge Peck unsealed Mr Vulakas’s report, which had been presented to him last month.
The meticulously researched document describes Lehman’s aggressive growth strategy, which, Mr Vulakas said, was intended to take advantage of the sub-prime mortgage crisis that broke in 2006 by increasing its exposure to real estate at a time when others were cutting back.
While Mr Vulakas concluded that Mr Fuld and other senior executives may have a case to answer in the use of Repo 105 arrangements, their management of Lehman’s aggressive expansion and attitude to risk were not so “reckless and irrational” as to give rise to a breach of fiduciary duty.
Mr Valukas also concluded that after Lehman’s collapse Barclays may have received “a limited amount of assets” improperly when it took control of Lehman’s core US brokerage.
He added that Lehman could have potential claims against JPMorgan Chase and Citibank in connection with demands for collateral and certain changes made to guarantee agreements in Lehman’s final days.
The long-awaited report, which cost $38 million to produce, is likely to give ammunition to shareholders suing Lehman as well as to government prosecutors.
Compiled with the help of a team of 70 lawyers, it is based on more than 250 interviews, five million documents and 26 million pages of company e-mails.
Hector Sants, chief executive of the Financial Services Authority (FSA), was the only person to decline to be interviewed.
However, the FSA did provide detailed, written answers to specific questions regarding the FSA’s involvement in the weekend before Lehman’s collapse and in the Barclays transaction that would have been posed to Mr Sants.
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