Ethical Issue in Financial Market:

Ethical Issue in Financial Market: Lehmann Brothers and Repo 105

In 2007 and 2008 Lehmann Brothers employed an accounting method called Repo 105 which enabled the firm to hide billions of dollars in unprofitable assets from public scrutiny. The financial institution was able to accomplish this sleight of hand by selling packages of Treasury bonds, Eurobonds, mortgages, and other bad investments at the end of an accounting quarter to offshore financial institutions in the Cayman Islands with the understanding that within a few weeks they would reacquire them. Basically it worked this way, imagine you want a loan to buy a car but you've maxed out several credit cards. On the day before a loan examiner checks your credit, you hide all of your credit card debt under a fictitious person's name, making your credit report look good to the loan examiner. Once you have secured approval for the loan you reassume your debts (Sharp).

This accounting practice enabled Lehmann Brothers to report financial statements that enhanced the company's appearance of solvency while simultaneously concealing approximately $38.6 billion in the fourth quarter of 2007, $49.1 billion in the first quarter of 2008, and $50.3 billion in the second quarter of 2008 of toxic assets. In September of 2008 the company declared bankruptcy.

Firms move transactions off their balance sheet for legitimate reasons all the time. This business practice is commonly employed by banks who record these off-balance-sheet transactions as loans in their books. However, when a company moves a transaction off their balance sheet accounting regulations need to be followed in order to make clear where and why the entry was moved to investors and other interested parties. By recording these transactions as sales on their books Lehmann Brothers created the misconception that the company held more cash assets and was exposed to less liability. This made the company's balance sheet look better to investors and more importantly rating agencies. Many speculate the company felt if word of their true financial position became public and the company was downgraded the possibility of securing new investors or loans would be gravely impaired. It appears Lehmann Brothers hid this accounting practice not only from the investing public, rating agencies, and government regulators, but also from their own board of directors (Ahrens).

Discussion

During Lehman's 2008 earnings calls, in which it touted its leverage reduction, analysts questioned the means by which the firm was accomplishing this achievement. Company officials reported Lehmann was reducing its leverage through the sale of less liquid asset categories and simultaneously claimed they were trying to give the group a great amount of transparency on the balance sheet. They said nothing about the firm's use of Repo 105 transactions.

One could make a serious argument that Lehman Brothers actions were both unethical and unprofessional. According to the CFA Institute Code of Ethics and Standards of Professional Conduct members must "act with integrity, competence diligence respect, and in an ethical manner with the public, clients, prospective clients, employers, employees, colleagues in the investment profession, and other participants in global markets."

While moving transactions off their balance sheets was not illegal, the intent of this action, to deceive investor's and rating agencies is clearly unethical. Standard C. Of the CFA Institute Code, Misrepresentation, states that members and candidates "must not knowingly make any misrepresentations relating to investment analysis, recommendations, actions, or other professional activities." Furthermore, Standard D, Misconduct says, "Members and Candidates must not engage in any professional conduct involving dishonesty, fraud, or deceit or commit any act that reflects adversely on their professional reputation, integrity, or competence." The code also states when communicating investment information care must be taken to ensure that it is fair, accurate and complete as well as make full and fair disclosure of all matters that could reasonably be expected to impair their independence and objectivity or interfere with respective duties to their clients, prospective clients, and employer.

Evidence indicates Lehman's senior financial executives knew of the Repo 105 transactions and certified the accuracy of Lehman's financial statements and disclosures despite having full knowledge that the company had engaged in the use of these transactions to hide their toxic assets and make their financial statements appear to be in good health when, in reality, they were not. These executives were fully aware that the financial statements were misleading and did not fairly present the true position of the company.

Hiding toxic assets and releasing favorable financial statements to investors each quarter clearly was intended to deceive investors and the public in general. This practice showed a favorable and healthy Lehman Brothers when in fact this was not the case. This action clearly misrepresented the financial position of Lehman and resulted in an inflation of the market price of the firm's securities.

Additionally, the Lehman executives received compensation that was based on the favorable financial statements produced by the company. Many of these senior executives benefited greatly by receiving huge compensation, bonuses, and stock grants (Jeffers). Information was manipulated by Lehman's executives in their own favor and for their personal benefit to the detriment of their investors and other principals. Lehmann's accounting practices constituted a conflict of interest and a serious breach of ethical conduct.

In June of 1012 the Accountability and Actuarial Board (AADB) concluded that no action should be taken against accountant Ernst and Young (E & Y) or any individuals in connection with the auditing of Lehmann Brother's before the September 2008 collapse. The AADB announced there is no realistic prospect of an adverse finding against E & Y or members within that firm and the investigation was closed (Treanor).