The Securities and Exchange Commission is asking public-company CFOs for additional information about repurchase agreements, or repos, the transactions Lehman Brothers used to make its balance sheet look healthier before the investment bank collapsed into bankruptcy.
The SEC wants companies to help it “better understand” the accounting treatment used to record repos, and to provide details about how management determines whether to record a repo as a sale or a collateralized financing. The commission would like to know, for example, how many repos qualified for sales-accounting treatment each quarter for the past three years, whether those sales were concentrated with certain counterparties or countries, the business reason for structuring such transactions as sales, and whether a company has changed its original accounting treatment for any of the repos.
Issued in March in the form of a “Dear CFO” letter, the SEC’s request for additional information seems “granular and broad at the same time,” says Wallace Enman, a vice president and senior accounting analyst with Moody’s Investors Service. He says that if companies were to use the letter as a guide, they would create “relatively robust” disclosures about repos. A sample letter was posted on the SEC’s Website on Monday.
While SEC comment letters are usually directed at a single company, Dear CFO letters cover issues that affect a large swath of companies. But the repo letter “is not a typical Dear CFO letter where we provide companies with our views on accounting and disclosure matters they should consider,” says commission spokesman John Nester. “In this case, we are seeking very specific information from companies about repurchase agreements and similar transactions.”
Nester says that based on company responses, the SEC could ask issuers to amend their filings or modify disclosures in future filings. But so far the commission has not concluded that any company has failed to comply with generally accepted accounting principles, violated any SEC rules, or failed to provide appropriate disclosures.
This isn’t the first time the SEC has questioned companies about the way they apply asset-transfer accounting rules. Since 2004 the SEC has exchanged 171 comment letters with 93 different companies about whether agreements to transfer financial assets are treated as a sale or a temporary transaction under U.S. GAAP, according to research firm Audit Analytics.
For his part, Enman says the questions are the SEC’s way of making sure Lehman’s so-called Repo 105 technique doesn’t go unnoticed. Indeed, in an interview with CNBC this week, SEC chairman Mary Schapiro said the commission is looking at all the issues surrounding Repo 105, both at Lehman and other financial institutions. “We want to make sure their accounting and disclosures are accurate when it comes to characterizing repurchases,” she said.
One for the Books
Far from going unnoticed, Lehman’s Repo 105 transactions are destined to take a prominent place in the annals of accounting scandals — somewhere between Enron’s infamous special-purpose entities and AIG’s booby-trapped credit-default swaps.
Earlier this month, Anton Valukas, the court-appointed examiner in the Lehman bankruptcy case, released a 2,200-page report on the collapse of the investment bank, devoting more than 300 pages to Repo 105. While the report did not find that Lehman violated asset-transfer accounting rules, it said the investment bank was not as forthcoming as it should have been in its financial-statement disclosures.
Valukas faulted Lehman for not revealing enough to investors about the purpose of Repo 105 transactions and how they affected the bank’s leverage ratios. However, internal Lehman e-mail messages made public in the report quoted Lehman executives as describing the repos as balance-sheet “window dressing” and an “accounting gimmick.”
In general, repos are used to buy and sell groups of securities, usually Treasury securities, in short-term transactions, typically overnight. The securities are put up as collateral by a borrower, and in exchange the borrower receives cash from counterparties that charge interest. Since the securities are treated as collateral and the agreement stipulates that the borrower has an obligation to pay back the cash in short order, the transaction is considered a financing for accounting purposes, and the transaction remains on the balance sheet.
In the case of Repo 105, however, Lehman overcollateralized the transactions by pledging $105 million for $100 million in cash. As a result, the investment bank — with the blessing of a legal opinion from U.K. law firm Linklaters — categorized Repo 105 as a sale for accounting purposes. The sales-accounting treatment enabled Lehman to remove the securities from its balance sheet and use the cash from the “sale” to pay down other debt and improve its overall leverage ratios.
Lehman repeated the transaction again and again, including at the end of the last three quarters the bank was solvent. According to the Valukas report, “Lehman employed off-balance sheet devices…to temporarily remove securities inventory from its balance sheet, usually for a period of seven to ten days, and to create a materially misleading picture of the firm’s financial condition in late 2007 and 2008.” Then, a few days into the new quarter, Lehman would borrow funds to repay the repo borrowing plus interest, repurchase the securities, and restore the assets to its balance sheet.
Valukas chastised Lehman for “never publicly” disclosing its use of Repo 105 transactions, its accounting treatment for these deals, the considerable escalation of its total repo usage in late 2007 and into 2008, and the material impact the transactions had on the firm’s publicly reported net leverage ratio.