Tiểu luận analysis of lehman brothers

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GIẢI THƯỞNG
ĐỀ TÀI MƠN HỌC XUẤT SẮC UEH500 - NĂM 2019

TÊN CƠNG TRÌNH: ANALYSIS OF LEHMAN BROTHERS
FRAUD
THUỘC KHOA: Viẹn đao tao Quôc tê ISB

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TP. HỒ CHÍ MINH - 2019

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I. ABSTRACT
The world has witnessed several corporate accounting scandals over the years
and one of the worst ones was caused by Lehman Brothers corporation. Therefore,
our report will focus on the analysis of its fraud through introducing about the
company, stating economic background in this period, clarifying the reasons of its
bankruptcy as well as investigating the role and responsibility of auditor (EY).
Moreover, we also indicate the severe consequences in together with the remedial
actions of expertise. Based on our analysis, we hope that we can provide an
overview as well as a deep insight into the mistakes of both the corporation and
auditing firm to help other corporations and auditors in choosing appropriate
solutions to prevent the similar frauds happening again in the future.

Keywords: Lehman Brothers, EY, fraud, Repo 105, auditor

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II
TABLE OF CONTENTS
I. ABSTRACT.......................................................................................................................... I
1. INTRODUCTION......................................................................................................... 1
2. COMPANY’S INTRODUCTION............................................................................. 1
3. ANALYSIS OF LEHMAN BROTHERS FRAUD............................................... 7
3.1 ECONOMIC BACKGROUND........................................................................ 7
3.2 METHOD OF FRAUD ON FINANCIAL STATEMENT…….……....9
3.3 ROLES OF AUDITOR (EY)…………………………………………16
4. CONSEQUENCES – RESPONSIBILITIES……………………………..18

4.1 ASSESS THE CONSEQUENCES OF THE LEHMAN BROTHERS
FAILURE ON THE GLOBAL FINANCIAL MARKETS……………….18
4.2

THE

RESPONSIBILITIES

OF

LEHMAN

BROTHERS’S

BANKRUPTCY…………………………………………………………..20
5. IMPLICATIONS AND CONCLUSION………………………………….22

5.1 IMPLICATIONS.………………………………………………….….22
5.2 CONCLUSION...………………………………………………….….22
AI. REFERENCES……………………………………..…………………………III

III.APPENDICES……………………………………..……….………………….V

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1. INTRODUCTION
The global financial crisis is one of the serious issues, the central point of the world
economy in 2008. This crisis is "triggered" by lacking subprime mortgage lending in the
US easily and uncontrollably. The number of loans of this type boomed during the
bubble period in the US real estate market because borrowers had high hopes of
getting the high return and making a massive profit from buying properties, besides,
the banks realized that the profits are too lucrative. Since then, many companies have
made great efforts in the market to not meet the brink of bankruptcy, including Lehman
Brothers. However, Lehman used fraud to improve financial reporting and attract
investors in the financial market, faced a tragic outcome of bankruptcy and has left
potential risks for America's economy in particular and the world in general. In this
report, we choose Lehman Brothers case since Lehman used to be the fourth-biggest
venture bank in the United States (Goldman Sachs, Morgan Stanley, and Merrill Lynch
were first, second and third, individually). In addition, it was the one which declared
bankruptcy with fraud rates of up to $50 billions, much larger in comparison with the

other cases such as Enron, WorldCom. Moreover, in one report, one of the most
important findings regarding Lehman's use of an accounting "trick" with internal bank
names is Repo 105 and Repo 108 to temporarily hide the system. the debt is too high
at the end of every quarter since 2001 until the time of bankruptcy. Therefore, we
decided to choose Lehman Brothers to analyze their causes, mistakes, the role of the
auditor, the consequences as well as responsibilities of the parties involved in this
bankruptcy in order to make conclusions, experience and give out recommendations
for other companies. Especially supplementing the shortcomings in the law as well as
more closely review the audit process later to avoid similar bankruptcy.

2. COMPANY’S INTRODUCTION
Lehman Brother – a global financial services firm with more than 25,000 employees
worldwide – announced to bankruptcy on 15

th

September 2008. Founded in the mid-

nineteenth century, a German immigrant Henry Lehman and his brother, Emanuel and
Mayer advanced from a general store to become the fourth-biggest investment banking
house in the United State. The firm made due through the Civil War (1861-1865), the

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railroad insolvencies of the 1800s, World War I & II, the Great Depression
(1930s), mergers, a lack of capital when it was spun off by American Express
Co. in 1994, and the Long Term Capital Management breakdown and Russian

obligation default of 1998—making the progress from a family-run private
organization enduring more than one hundred years to be a public company.

The Lehman frequently got the installment for merchandise in their general store as
cotton—a course of action that offered stimulus to their entrance into the matter of
purchasing and selling cotton for grower in the nearby Montgomery zone. It was to a
great extent a bargain understanding. The farmers would come in with their cotton and
exchange it for shirts and shoes and compost, seed, and all of the necessities.
Because of Lehman Brothers made the change from general merchandisers to cotton
item representatives, they opened an office in New York in 1858, the focal point of the
wares exchanging business. The firm filled in as dealers between farmers selling
cotton and industrialists and exporters getting it. Mayer Lehman dealt with the store in
Montgomery and worked with nearby grower and farmers, while Emanuel met with
cotton producers and exporters in New York. Positive credit provides details regarding
Lehman Brothers issued by the nation's first business credit organization R. G. Dun
and Co. built up the notoriety of the new undertaking and encourage its growth.
Through an association with John Wesley Durr in 1862, the siblings extended their
capacity limit and exchanging business, and Lehman, Durr and Co. before long
positioned among the top cotton firms in the zone.

Unfortunately, when the Civil War began, president Lincoln forced a barricade keeping the
shipment of cotton from the South to material makers in the North. Lehman Brothers
conceived a few methodologies to evade the bar, including sending cotton from the South
to England and after that from England to New York. During the war, the economy of the
Southern was destructive, although that the growth of Lehman kept continuing after 1865.
In 1868, Mayer left the South and joined Emanuel in New York City. The firm moved from
Liberty Street to Pearl Street, close Wall Street and Hanover

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Square, where the cotton representatives involved workplaces. The two siblings, who
looked somewhat like each other, were outstanding figures in the city of New York.

In 1870, Lehman Brothers helped found the New York Cotton Exchange, a wares fates
exchanging adventure, which beyond what one hundred cotton dealers could exchange a
focal area. The Cotton Exchange spoke to a fate showcase in which purchasers and
merchants made arrangements before the cotton was reaped or brought to the processing
plants. Afterward, Lehman Brothers stretched out into different commodities and joined the
Coffee, Sugar, and Cocoa Exchange, and the New York Petroleum Exchange. The firm
kept on structure its notoriety and mastery, while extending its customer base.

During this period, Lehman Brothers was designated the Fiscal Agent of Alabama. In this
limit, its first endeavor into city financing, the firm sold state bonds as approach to support
the state's obligations, intrigue installments, and other budgetary commitments. Lehman
Brothers exercises as of now likewise focused on the industrialization of the South,
including railroad, material, mining, and land undertakings. Nonetheless, in spite of its
capacity to survive in the past, the breakdown of the U.S. lodging market at last pushed
Lehman to the edge of total collapse, as its fast hurry into the subprime home loan market
demonstrated to be a tragic advance.

The housing boom of the early to mid-2000s saw Lehman and other Wall Street
firms saw Lehman and other Wall Street firms become vigorously associated
with debt obligations and mortgage-backed securities. Lehman's acquisitions
from the start appeared to be farsighted; record incomes from Lehman's land
organizations empowered incomes in the capital markets unit to flood 56% from
2004 to 2006, a quicker pace of development than different organizations in
speculation banking or resource the executives. The firm securitized $146
billions of home loans in 2006, a 10% expansion from 2005. Lehman revealed

record benefits each year from 2005 to 2007. In 2007, the firm revealed net
gain of a record $4.2 billion on incomes of $19.3 billion.

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In February 2007, the stock arrived at a record $86.18, giving Lehman a market
capitalization of near $60 billion. In any case, by the primary quarter of 2007,
splits in the U.S. lodging business sector were at that point getting to be evident
as defaults on subprime home loans rose to a seven-year high. On March 14,
2007, multi day after the stock had its greatest one-day drop in five years on
worries that rising defaults would affect Lehman's benefit, the firm detailed
record incomes and benefit for its monetary first quarter.

As the credit crisis emitted in August 2007 with the disappointment of two Bear Stearns
multifaceted investments, Lehman's stock fell forcefully. During that month, the
organization wiped out 2,500 home loan related employments and shut down its BNC
unit. Likewise, it additionally shut workplaces of Alt- a loan specialist Aurora in three
states. Indeed, even as a remedy in the U.S. lodging business sector picked up force,
Lehman kept on being a noteworthy player in the home loan advertise. In 2007,
Lehman endorsed more home loan supported securities than some other firm,
collecting a $85 billion portfolio, or multiple times its investors' value. In the final
quarter of 2007, Lehman's stock bounced back, as worldwide value markets arrived at
new highs and costs for fixed-salary resources organized a transitory bounce back.
Nonetheless, the firm did not accept the open door to trim its monstrous home loan
portfolio, which by and large, would end up being its last shot.

Because of the debilitating real estate market, as speculators and appraisals

offices communicated genuine questions about these kinds of advantages,
because of their absence of liquidity in the market, they started to lose trust in
Lehman and its venture banking peers. Bear Stearns, perhaps the nearest
contender, was the first to go under, barely keeping away from bankruptcy with
a deal to J.P. Morgan Chase on March 16, 2008. In the result of Bear's abrupt
breakdown, bits of gossip flowed that Lehman Brothers would be beside fall.

Like Bear and other speculation banks, Lehman's dependence on momentary financing
arrangements known as repurchase understandings, or "repos," to raise billions of

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dollars it expected to run business tasks everyday made it particularly helpless
against any emergency in speculator and market certainty. Lehman looked to
console its financial specialists, bringing $6 billion up in value in June 2008,
regardless of announcing its first misfortune since opening up to the world in 1994.

At that point on September 10, the firm reported that it expected $5.6 billion in
composing downs for its "dangerous" resources and a $3.93 billion misfortune
for the second from last quarter. Also, Lehman said it wanted to turn off $50
billion of harmful resources into a different openly held organization.

In response to the declaration, the significant appraisals office Moody's taken steps
to downsize Lehman's obligation evaluations, and on September 12, Federal
Reserve Chairman Timothy Geithner, Treasury Secretary Henry Paulson and
others met at the Fed in New York to talk about the company's destiny.

Lehman's high level of leverage—the proportion of all out advantages for investors

value—was 31 out of 2007, and its tremendous arrangement of home loan
protections made it progressively defenseless against falling apart economic
situations. On March 17, 2008, after the close breakdown of Bear Stearns – the
second-biggest financier of home loan upheld protections—Lehman offers fell as
much as 48% on concern it would be the following Wall Street firm to fizzle.

Trust in the organization came back somewhat in April, after it raised $4 billion through an
issue of favored stock that was convertible into Lehman shares at a 32% premium to its
cost at the time. In any case, the stock continued its decay as support investments
supervisors started scrutinizing the valuation of Lehman's home loan portfolio.

On June 9, Lehman declared a second-quarter loss of $2.8 billion, its first misfortune
since being spun off by American Express, and detailed that it had raised another $6
billion from financial specialists. The firm likewise said that it had helped its liquidity
pool to an expected $45 billion, diminished gross resources by $147 billion, decreased

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its introduction to private and business contracts by 20%, and chop down
influence from a factor of 32 to around 25.

Be that as it may, these measures were seen as being short of what was expected. Over
the mid-year, Lehman's administration made fruitless suggestions to various potential
accomplices. The stock dove 77% in primary seven dates stretch of September 2008, in
the midst of diving value markets around the world, as financial specialists addressed CEO
Richard Fuld's arrangement to keep the firm autonomous by selling some portion of its
advantage the board unit and turning off business land resources. Expectations that the

Korea Development Bank would take a stake in Lehman were dashed on Sept. 9, as the
state-claimed South Korean bank put chats on hold.

The news was a final knockout to Lehman, prompting a 45% dive in the stock and a
66% spike in credit-default swaps on the organization's obligation. The organization's
fence investments customers started hauling out, while its transient loan bosses cut
credit lines. On Sept. 10, Lehman pre-reported troubling monetary second from last
quarter results that underscored the delicacy of its money related position.

The firm revealed lost $3.9 billion, including a record of $5.6 billion, and
furthermore declared a broad vital rebuilding of its organizations. That day,
Moody's Investor Service declared that it was investigating Lehman's FICO
assessments, and furthermore said that Lehman would need to sell a greater
part stake to a key accomplice so as to dodge a rating minimize. These
advancements prompted a 42% dive in the stock on Sept.

With just $1 billion remaining in real money before that week's over, Lehman
was rapidly coming up short on schedule. Final desperate attempts throughout
the few days of Sept. 13 between Lehman, Barclays PLC and Bank of America
Corp., planned for encouraging a takeover of Lehman, were fruitless. On
Monday, Sept. 15, Lehman looked into going to bankruptcy, bringing about the
stock diving 93% from its past close on Sept.

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In spite of worries about the collapse of Lehman Brothers breakdown would bring,
the central government and delegates of the organization of President George W.

Shrub at last would not rescue another venture bank. Any expectations of a deal to
another bank missed the mark too: One imminent purchaser, Bank of America,
chose to purchase Merrill Lynch rather, while British controllers hindered a lastdump arrangement to sell Lehman to Barclays of London.

Out of alternatives, Lehman Brothers looked into going to bankruptcy from the getgo the morning of September 15. The firm pronounced $639 billion in resources
and $613 billion in obligations, making it the biggest insolvency documenting in
U.S. history. That day, the Dow Jones Industrial Average dove in excess of 500
points, its steepest decay since reviving after the 9/11 fear-based oppressor
assaults. Lehman's breakdown sent monetary markets into strife for a considerable
length of time, driving numerous to scrutinize the national government's choice to
allow to the bank come up short. After Lehman's bankruptcy recording, Barclays
consented to buy the company's North American speculation banking and capital
markets organizations, sparing nearly 10,000 occupations.

Lehman Brothers turned into an injured individual, as a result the main genuine symbol to
fall in a tidal wave that has come to pass for the credit markets. This is the most earthshattering insolvency hearing I've at any point endured. It can never be esteemed point of
reference for future cases. It's difficult for me to envision a comparable crisis.

3. ANALYSIS OF LEHMAN BROTHERS FRAUD
3.1. ECONOMIC
BACKGROUND The Financial Crisis of 2008
The evolution of the financial marketplace in the United States during the early twentyfirst century has been considered as the crucial foundation of the buildup to the
economic crisis of 2008. According to Prager (2013), the main reasons to this crisis
are the rise of the “shadow banking system” with relatively high leverage ratio; the

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expansion of the housing market into a real estate bubble; the low interest rate
environment; a reduction in the quality of mortgages and the immerse size of
the derivatives market. Since much of the lending involved short-term loans, a
potential liquidity risk existed.

The initial signs for the global financial market collapse were the decline in housing
prices in 2005 that was followed by a downturn in the middle of 2006. However, both
speculators in housing and subprime borrowers who expected continued rise in
housing prices to refinance their mortgages reacted to the price fall by delaying loan
repayments or defaulting entirely (Prager, 2013). Starting in the second quarter and
continuing through the second half of 2007 are the widespread decline in the value of
mortgage-backed securities and as a consequence, the bankruptcy of two Bear
Stearns funds concentrating in mortgage-backed securities which made values of
mortgage-backed securities continue to fall, weakening the portfolios of most of the
shadow banks as well as the largest of the commercial banks. The financial markets
experienced the worst condition ever in September 2008 with the continuous failures of
Fannie Mae and Freddie Mac, Lehman Brothers, Merrill, Lynch, AIG, Morgan Stanley,
and Goldman Sachs. This event affected both interest rates and commercial paper
market volume; a pervasive flight to safety occurs as lenders seek to avoid short-term
lending to financial institutions (Prager, 2013).

Lehman Brothers Financial Difficulties
The investment bank Lehman Brothers filed for bankruptcy in September 2008. Lehman
Brothers was a company having the largest amount of assets for a firm filing for
bankruptcy. According to Jones and Presley (2013), at the time of the filing, it appeared
that Lehman Brothers had $600 billion of assets with $30 billion in equity. The company
stock price had fallen continuously several months before its bankruptcy. At that time, there
were a lot of financial entities experiencing financial trouble as the housing bubble burst
and mortgage-backed securities lost significant value. However, Lehman’s bankruptcy was
mainly resulted in the company business strategy to follow increasing risks in order to

maximize their revenue. Lehman Brothers’ balance sheet

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started to grow rapidly at the beginning of 2006 and included many long-term
investments financed through short-term borrowing. According to Hines,
Kreuze, and Langsam (2011), these assets included substantial amounts of
residential and commercial mortgage-backed securities, the same type of
securities that precipitated the 2008 financial crisis.

During 2007, despite the fact that some signs of trouble were foreseen in the market
for residential mortgage-backed securities, Lehman continued its aggressive growth
expecting to benefit from the countercyclical crisis. During this time, Lehman
executives took on more risk by ignoring its own risk models and excluding some
assets from their risk analyses (Hines et al., 2011). These assets and other
investments became increasingly difficult to sell without incurring significant losses.
Furthermore, a sale of some of these securities at a loss may have indicated to
potential partners of the company that the remaining assets were overvalued. This
would have to lead a loss of confidence by counterparties at the very time Lehman
needed their confidence to keep its heavily leveraged operations afloat. These
counterparties evaluated Lehman by review of its leverage ratios. Therefore, it was in
Lehman’s interest to have low leverage ratios compared to its competition. The
intention of Lehman Brothers’ management in using Repo 105 transactions was
initially to bolster the financial condition of the company to maintained acceptable debt
ratios in order to allegedly mislead investors and in later periods to avert bankruptcy.

3.2. METHOD OF FRAUD ON FINANCIAL STATEMENT

To handle the financial crisis, Lehman Brothers intended to “window dressing”
its financial statement with the aim of deceiving investors and analysts by
taking advantages of Repo 105.
Ordinary Repo versus Repo 105
A repurchase agreement (Repo) is a financing tool commonly used by investment banks.
Under a Repo transaction, a party transfers its securities as collateral for a short-term cash
funding. At the maturity date, which occurs within seven or ten days, the

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transferor will pay back the borrowing plus interest as a repurchase of its highly
liquid assets. Normally, the total amount of assets and liabilities remain
unchanged during the transaction occurrence since both the collateralized
investments and related obligations are not excluded from the balance sheet.
Hence, leverage ratios of the company stay constant.

A Repo 105 is quite similar to a usual Repo except for the recognition of several
typical transactions as sales. The Statement of Financial Accounting Standards
(SFAS) No. 140 issued by the Financial Accounting Standards Board (FASB) has
enabled Lehman Brothers to record its Repo 105 transactions as sales. The bank
then removed the securities and related interest off the balance sheet and used the
temporary fund to settle its other debts. As a result, the bank’s leverage ratios
reduced making it more attractive to investors.

Apparently, the cash inflow from collateralization contributing to the firm’s retirement of
short-term liabilities had benefited its debt status. However, if the repurchase
happened after the financial statements had been filed, accounting standards would

ordinarily require the company to recognize a liability on its balance sheet. Therefore,
the debt position even got worsen (Jones, B., & Presley, T., 2013, p.60). For example,
a $100,000 cash received from collateralizing an investment would increase the firm’s
liquidity. The firm subsequently used the amount to pay off current obligations, leading
to a reduction in debt portions in its capital structure. Nevertheless, if the repurchase
arrangements take place after financial statement disclosure, a liability was regulated
to acknowledge before the financial statement date. Due to the interest implied in the
arrangement, the amount of liability would exceed $100,000 cash borrowed, thus,
raised leverage ratios. Had it not been recognized as sales transactions; Lehman
would have been no longer benefited from the agreement. Accordingly, the issuance of
Repo 105 created an opportunity for Lehman to make up the financial position thanks
to means of escape in the accounting standards (Jones, B., & Presley, T., 2013, p.61).

Requirements satisfying sales transactions under Repo 105

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As stated in Appendix 17 of Examiner’s report by Valukas in 2010, SFAS No.
140 regulates that a sales transaction under Repo 105 must meet the following
three conditions:
“(1) the transaction is a true sale at law (SFAS No. 140.9a)
(2) the transferee has the ability to pledge or exchange the

transferred assets (SFAS No. 140.9b);
(3) the transferor is considered to relinquish control of the securities transferred

(SFAS No. 140.9c).”

Lehman had fulfilled the first criterion of a “true sale” by acquiring a lawyer’s
confirmation on qualifying a true sales transaction. It was impossible for the bank to
take the action under US regulations since it was out of attorneys’ reach (Valukas
et al., 2010, Appendix 7, p.4). In contrast to US law, London law allowed the
attorney to offer such an opinion, which was applied to “Repurchase Transactions
under a Global Master Repurchase Agreement” (Valukas et al., 2010, Appendix 7,
p.4). Consequently, Repo 105 transactions were conducted by Lehman Brothers
International Europe (LBIE). However, a majority of collateralized assets under
Repo 105 were possessed by Lehman Brothers in the US.

In response to the second requirement: “the transferee has the ability to pledge
or exchange the transferred assets”, the company solely used “readily
obtainable” investments such government or treasury securities to exchange
for borrowing. These assets, afterward, could be pledged or traded and
supplanted by similar alternatives at the maturity of the repo.

The final condition of “the transferor is considered to relinquish control of the securities
transferred” was met as the firm utilized the difference in the value of transferred
securities and the money received (normally known as “haircut”). Because Lehman’s
secured loans could not surpass 95% of the value of the assets, it was incapable of
financing other equivalent assets during the agreement period. Thus, Lehman claimed

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itself to have relinquished the authorization on the collateralized investments
(Hines et al., 2011, p.43).

Usage of Repo 105 at Lehman Brothers
According to Examiner’s Report by Valukas, 2010, the number of Repo 105 activities
taken by Lehman Brothers significantly increased on quarterly publishing dates to the
SEC (the Securities and Exchange Commission), which signaled a suspicious action
as a “window dressing” to decrease leverage ratios at that time. Since fiscal 2001,
when SFAS No.140 became effective, Lehman Brothers initiated Repo 105 activities
(Valukas, 2010, p.765) but the firm’s reliance on those transactions virtually boomed
from 2007 to 2008. By treating the agreement as sales, the firm could recognize an
increase in liquidity by the cash borrowings, subtract collateralized securities from the
financial statement as well as acknowledge the “haircut” as a derivative asset.
Additionally, such treatment enabled the bank to ignore the financing loan and its
obligation on reporting the financial records. For instance, a $100 million debt with 5%
“haircut” only affected the constitution of assets, but not the total assets. The bank
witnessed a rise of $105 million, which included $100 million in cash and a $5 million
derivative asset as well as a fall of $105 million in securities. Later, to lower leverage
ratios (which essentially the assets to equity ratio), Lehman had to use the amount
received through collateralization to pay back other obligations. Because the payment
only impacted on the total assets and total liabilities but not the owner’s equity, gross
and net leverage ratios reduced. A few days after reporting the financial statement to
the SEC and new quarter commenced, Lehman borrowed a loan to cover Repo 105
debt and liabilities, buy back the securities and return the former position of total assets
on its balance sheet (Valukas, 2010, Vol. 3, p. 734). Figure 1 illustrates how Lehman’s
balance sheet changed during the Repo 105 activities.

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Figure 1: Changes in Lehman’s Balance sheet under Repo 105.

Unlike Repo 105, the ordinary Repo has no effect on leverage ratios even a
retirement on liabilities happens due to financing borrowings as the increase in
total assets and liabilities equally subtracted the additional payback. Figure 2
describes the difference in accounting treatments for ordinary Repo and Repo 105.

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Figure 2: Difference between ordinary Repo and Repo 105 (Hines et al., 2011, p.45).

The Examiner’s Report by Valukas in 2010 pointed out that from mid-2007 to the
first quarter of 2008, Lehman increased its use of Repo 105 transactions on the
global system. At a time, Lehman's asset value was "disappearing" from the
balance sheet by nearly $50 billion to reduce the debt ratio. Figure 3 shows how
the net leverage ratio of Lehman Brothers changed under the effect of Repo 105.

Time

Q4/2007

38.6

Q1/2008

49.1

Q2/2008

50.38

Figure 3: Impact of Repo 105 on Lehman Brothers’ leverage ratio (Valukas et
al., 2010).

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Since Lehman Brothers determined materiality as “any item individually, or in the
aggregate, that moves net leverage by 0.1 or more (typically $1.8 billion)” (Valukas,
2010, Vol. 3, p. 889), the variance in leverage ratio due to Repo 105 was considered to
be material. Furthermore, these transactions were eliminated from the balance sheet
which is reported to the SEC, which hid the company's true financial condition. Using
Repo 105 helped Lehman not only to decrease the number of assets under the
subprime mortgage crisis but also to maintain the credit rating by S&P as Lehman
argued that S&P's approach focuses on assessing the impact of debt ratios of banks.

The implication of Repo 105 only brought temporary advantages to Lehman’s
by decreasing leverage ratios which made the firm seemed to be less risky to
investors. However, it provided no incentives for economic growth. Using Repo
105 increased financial costs of borrowing and restrained profitability. The
arrangement just improved the company’s performance on paper, yet, in reality,
created negative economic influence on financial position. Eventually, the bank
could not save itself from bankruptcy under the liquidity crisis.
Remedial Actions
Lehman Brothers were not the only bank that removed debt off the balance sheet.
As reported by the Wall Street Journal (Rapoport and McGinty, 2010), there were

18 financial companies experiencing current liabilities reduction for ten consecutive
quarters in 2010, such as Bank of America Corp., Citigroup, and Deutsche Bank
AG. They also classified an enormous number of short-term obligations as sales
rather than liabilities, just like the way Lehman used Repo 105.

In order to cover the loophole in the accounting standards after Lehman's bankruptcy,
the SEC required more information regarding Repo transactions from large banks.
Additionally, a stricter and clearer disclosure of quarter-end transactions has been
demanded by the SEC and applied for all companies (Wall Street Journal, 2010).

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Moreover, an exposure draft (ED), issued on 3 November 2010 by the FASB,
asked for further explanations from stakeholders on Transfers and Servicing
(Topic 860): Reconsideration of Effective Control for Repurchase Agreements.
The aim of the ED is to enhance the accounting treatments for repo
transactions as well as other arrangements.
3.3. ROLES OF AUDITOR (EY)
One of the mistakes leading to the collapse of Lehman Brothers is the auditor’s
violations in auditing process. Ernst & Young Global Limited (EY) served as
Lehman Brothers’ independent auditing firm from 2001 until it went bankruptcy
in 2008. The later investigation conducted by Anton Valukas, the Lehman
bankruptcy examiner, brought the role and responsibility of EY auditors into
question. The Valukas report stated three EY’s auditing malpractices including:
(1) failure to communicate with Lehman’s Audit Committee about the
company’s use of Repo 105,
(2) lack of professional standard of care in investigating the Whistleblower

Letter and Lee’s complaint about Repo 105, and
(3) negligence in auditing and evaluating Lehman’s public financial reports
filings. Additionally, a long period of auditing for Lehman can increase the
efficiency of the auditor’s work, however, it also increases risk that the auditor’s
independence and objectivity might reduce.

To examine its failure to report to Lehman’s Audit Committee, EY’s awareness of Repo
105 is considered. When the examiner interviewed William Schlich, lead partner of EY
on the Lehman audit team, he said that EY had been aware of Repo 105 policy and
transactions used in Lehman for years (Valukas, A., 2010, Vol. 3, p. 948) but they
“became comfortable with the Policy for purposes of auditing financial statements.”
(Valukas, A., 2010, Vol. 3, p. 949). It proves that although Lehman’s wrong usage of
Repo 105 lasted from 2001 to 2008, EY did not report this violation or any risks related
to use this type of mechanism to Audit Committee during that period.

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To examine the violation in professional care of EY in handling the Whistleblower
Letter (Appendix A), our group reviews the process of solving the allegations
related to Lehman’s accounting mistakes of EY which is listed below:
•

On May 16, 2008, a letter (“Whistleblower Letter”) was sent by Matthew Lee
(Senior Vice President, Global Balance Sheet of Lehman) to several senior
Lehman officers to allege accounting errors and other irregularities. It is
provided to Lehman’s Audit Committee to inform of all of Lee’s allegations,
and to EY, to conduct an investigation into these allegations.

•

On the next month, June 12, 2018, Schlich interviewed Lee and at this
meeting, Lee also told EY about the escalating use of Repo 105 of
Lehman and its effect to the company’s balance sheet.

•

On June 13, 2008, Lehman management and Schlich organized a meeting with the
Audit Committee to discuss second quarter financial reports of the company.

•

On July 2, 2008, Schlich again met the audit committee to review and
evaluate the final statements.

•

On July 10, 2008, EY issued an unqualified report for the second quarter
Form 10-Q, despite having the Whistleblower Letter.

•

On July 22, 2008, Schlich attended a full board meeting at which the
Whistleblower Letter was delivered by a Lehman officer’s presentation,
but this presentation did not mention the wrong use of Repo 105.

Although having several meetings, EY did not communicate with the Lehman’s
Audit Committee about the wrong use of Repo 105 which went against the
statutory obligations under Sarbanes-Oxley Act (SOX) and the request of Audit

Committee to be informed all of allegations made by Lee. Hence, this action
was considered as negligence (Valukas, A., 2010, Vol. 3, p. 1032) and seriously
violated due care rule in principles of professional conduct in auditing.

To examine the negligence in evaluating and reviewing Lehman’s financial statements,
EY’s responsibilities should be analyzed carefully. In particular, in 2007, when Lehman
used high volume of Repo 105 to report more attractive balance sheet and material

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reductions in its net leverage ratio, EY did not request any additional information
about how it attained Linklaters opinion letter and the explanation of the company
for the escalating amounts and pattern of Repo 105 in that year after auditing the
numerous documents, analyzing Lehman’s various balance sheet netting
mechanisms including Repo 105 and reviewing its accounting policy and
transactions. With the responsibility to apply professional skepticism and to inquire
about unusual situations and transactions, EY did not raise a question about
Lehman’s use of Repo 105 despite the fact that this is an unusual way to raise
funds and Lehman’s peer investment banks had ceased to utilize this mechanism
(Wiggins, R., Bennett, R. L., & Metrick, A., 2014). In addition, its evaluation that
Lehman’s financial statements remained free from material misstatements and
fairly presented in conformity with GAAP (Appendix B) which resulted in its
issuance of unqualified and clean audit reports for 2007 is the verified evidence to
show the negligence of EY in evaluating Lehman’s public financial reports filings.

4. CONSEQUENCES – RESPONSIBILITIES
4.1. ASSESS THE CONSEQUENCES OF THE LEHMAN
BROTHERS FAILURE ON THE GLOBAL FINANCIAL MARKETS

On September 15, 2008, a financial event has shocked the economy, Lehman
Brothers officially filed for bankruptcy protection. This has shocked both the US
and the financial market in general. So, the 150-year-old-financial-institution, the
fourth largest investment bank of the United States, has been removed from the
world financial map, leaving many losses to the world financial economy. Many "If"
questions have been asked, many lessons are mentioned then... But no matter
what, the most serious consequence is that 25,000 employees were unemployed,
a huge amount of assets evaporated, and 5 investment banks of the biggest Wall
Street is now only existing two (Goldman Sachs and Morgan Stanley).

Before Lehman Brothers declared financial bankruptcy in September 2008, it was the
fourth-biggest venture bank in the United States (Goldman Sachs, Morgan Stanley,
and Merrill Lynch were first, second and third, individually). Lehman was a noteworthy

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player in the sub-prime mortgage market, endorsing more US home credits than some
other bank in 2006 and 2007. At its pinnacle, the bank was, at last, endorsing one of
every 10 US home loans. The breakdown in the US lodging business sector cost it
$830m (£469m) a year ago. The destruction of Lehman was its enormous presentation
to subprime contracts through owning organizations that guaranteed the home loans
and furthermore in issuing MBSs that contained subprime contracts. The liquidation
documenting in September 2008 is viewed as the tipping point in the financial crisis. It
dissolved trust in budgetary establishments and caused a keep running on currency to
advertise common assets. This absence of certainty spread crosswise over business
sectors and nations, bringing about banks holding money, along these lines enhancing
misfortunes in the subprime home loan advertise.

In another aspect, The Street newspaper said that “The fallout from Lehman Brothers'
collapse was nothing short of disastrous.” While a big deal of factors definitely added
to the monetary strife that resulted, Lehman Brothers bankruptcy appeared to be the
activating component that released the conduits of across the board retreat. According
to ABC News estimates, economies in some countries such as Latvia and Hungary
have been affected after this crisis, in particular, there has been a decline up to 6
million people losing jobs. Even Pakistan must seek help from the International
Monetary Fund (IMF). Moreover, Iceland had to face a crisis when officials declared
that the national government had no funds to support major banks in this country which
made it fall into a wide-range crisis. "Lehman's bankruptcy will forever be synonymous
with the financial crisis and (resulting) wealth destruction," Paul Hickey, the founder of
Bespoke Investment Group, disclosed to ABC News.

The collapse of Lehman Brothers also had a significant impact on the United States’
economy. To save the remain financial sectors of the nation, President George Bush
spent $700 billion for bail-out plan to relieve the US economy. In addition, as a
consequence of the financial crisis in 208, the Dodd-Frank Act was executed to help
increment financial regulation. Meanwhile, in England, Lloyds Bank has to save HBOS,
the British government also sponsors Lloyds itself and the Royal Bank of Scotland.

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Furthermore, the collapse of Lehman Brothers is synonymous with the collapse of faith
in the financial market. Along with the distrust, a vast number of questions had been
marked following the bankruptcy. In particular, the public who have previously put a lot
of faith (and also money) in such "too big to fail" companies like Lehman, they
suddenly found themselves skeptical of the global economy. Lehman was an example
which demonstrated a defining moment in money to a noteworthy degree. The trust

that once went with enormous financial foundations is never again certain. Additionally,
Lehman Brothers went bankrupt, causing nearly 250,000 employees to lose their jobs.
A woman who gave up her position as the top and honorable chief executive at HSBC
to move to work for Lehman Brothers just for a year before the bank dissipated with
her savings. A lawyer who was currently working for a start-up company still misses the
atmosphere when he was in Lehman. An executive assistant who works at the bank for
10 years has not been able to find another job. He moved from one company to
another, stuck in uncertainty. Many people lose trust after Lehman's collapse and
bankruptcy. After only one night, the failure of Lehman Brother in 2008 abruptly put an
end to the beautiful times of thousands of employees and contributed to sparking a
dark financial crisis that left many people unbelieved in the future of American
capitalism. By September 15, 2008, the bank went bankrupt and pushed about 25,000
employees into unemployment. Renee Spero, a former assistant of vice president at
Lehman said her life was completely deflected after the collapse of Lehman. "I
remember the full-time position in the financial sector in New York City. Sometimes, I
wanted to wear a shirt with the words:" I used to have a great job. ", Renee said.

4.2. THE RESPONSIBILITIES OF LEHMAN
BROTHERS’S BANKRUPTCY
After many years of witnessing Lehman's collapse and bankruptcy, thousands of
questions were raised about the responsibility but there was no official answer.

Lehman's Executive Duo
First of all, we must mention the responsibility of Lehman's core managers and how
they said and commented about one of the biggest bankruptcies in United Stated and

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over the world in general. They are comprised of Dick Fuld -CEO of Lehman Brothers
(2008) and Erin Callan - Chief Financial Officer of Lehman Brothers in 2008 (but she
was fired immediately before the collapse). Fuld ran Lehman 14 years ago before the
bank declared bankruptcy and received remuneration of up to $ 500 million in eight
years when he was working in Lehman. With the nickname "chimpanzee", he
constantly blamed the US government, lawmakers and unfounded rumors that led to
Lehman's "death." Fuld only recognized a very small part of the responsibility for what
happened. Lehman employees repeatedly blamed "chimpanzee", especially, the
climax in a US parliamentary hearing, a congressman called Fuld "a scammer". About
Erin Callan, she used to be a former lawyer, Callan had a fast-growing career on Wall
Street. She joined Lehmann in 1995 and became the bank's CFO at the end of 2007.
In a very short time, with a flexible and active way in working, she helped reassure
investors, but Fuld decided to fire her just two months before Lehman collapsed.
Callan was criticized a lot after being fired. She was accused of not being able to run
financial affairs at Lehman because of a lack of basic accounting knowledge. Callan
was also harshly criticized in the court's indictment that she had ignored the increasing
warning signals and used tricks to falsify Lehman's financial balance sheet with a big
amount of money up to 50 billion USD.

Managers of the US Government
The first "named" in the list of managers who were criticized after Lehman's
demise is Ben Bernanke - President of the US Federal Reserve (Fed) in 2008.
Bernanke ignored the significant signs of a financial crisis that was gradually
existing. However, he was the one who had been through a great recession
with a lot of lessons left, he took very dominant actions after the failure of
Lehman. He directed the Fed to cut interest rates to 0% and coordinate with
central banks, launching a series of eased methods, injecting money into the
economy to prevent the worst post-war crisis into the second great recession.

Henry 'Hank' Paulson is the US Treasury Secretary in 2008. While Lehman was moving

toward the brink of bankruptcy, Paulson has been tough on the US not to rescue the

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bank. He claimed that he did not want to be "the savior" even though the US Treasury
was criticized for supporting the bankruptcy of a series of financial institutions.

The last one had been mentioned on the list is Tim Geithner who was the
Former President of Fed in New York (2008). On behalf of the core leader of
Fed New York, Geithner was the one in many decision-makers decided to let
Lehman go bankrupt, although he was the one who criticized Paulson for
revealing the plan. When Barack Obama officially became US president in
November 2008, Geithner was appointed as the Secretary of the US Treasury.
4 years here, he was criticized for his overly close relationship with firms in Wall
Street and setting a target to cut the deficit to reduce unemployment.
5. IMPLICATIONS AND CONCLUSION
5.1 IMPLICATIONS
The collapse of the investment bank, Lehman Brothers, has raised notable concerns
to the financial system. The transparency of providing informative financial statement
must be preserved to avoid allegedly misleading both foreseen and foreseeable
potentials. The concept “substance over form” should be prioritized when choosing
accounting principles. Only if all companies record their financial situation in a
transparent manner, investors and creditors will have a comprehensive picture of the
financial market in considering investment options to make rational decisions.
Moreover, not only entities but also auditors are responsible for ensuring that financial
information is fairly presented. Whenever there are inconsistencies between what the
public expects from the auditors’ work and what the auditors actually do in accordance
with auditing standards and GAAP, Lehman Brothers-similar cases may still occur.

5.2 CONCLUSION
The collapse of Lehman Brothers caused a huge shock to the economy as one of the top 5
largest investment banks in the U.S and for over 150 years of history. The cause of this
failure mainly started from the lack of financial statement transparency, which had been
actually practiced since 2001. However, Ernst and Young Company (E&Y) - the

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