It just keeps getting more twisted.
Last week, I disparaged the reprehensible conduct of the key players in the tragic demise of Lehman Brothers. An investigative report prepared for the bankruptcy judge overseeing the liquidation of the former Wall Street icon confirmed what many of us always suspected but had no facts to prove.
Top management at Lehman along with its shady cadre of paid auditors at Ernst & Young were as crooked as a dog’s hind leg. What we didn’t know until now was the corrupt complicity of federal regulators in concealing Lehman’s true financial condition from the investing public.
They Had a Responsibility
The primary mission of the Securities and Exchange Commission (SEC) is to protect the investors from fraud. To accomplish this objective, the SEC monitors publicly traded companies like Lehman to certify that they make a full disclosure of all facts that may affect individual investment decisions.
This latest installment of the Lehman Brothers’ post- mortem shows that the SEC and the New York branch of the Federal Reserve Bank either failed to discover the accounting fraud at the legendary investment house or simply turned a blind eye. In either case, it amounts to a grave failure by regulators.
In one instance cited by the bankruptcy examiner, Lehman counted a $2 billion deposit at Citigroup among cash-like assets available in an emergency, even though withdrawing the money could have impaired the firm’s continued ability to trade. Instead of intervening or disclosing this irregularity, the SEC simply viewed the asset’s designation as “problematic.”
As Lehman’s cash crisis deepened, regulators at the SEC and New York Fed – under the direction of current Treasury Secretary Tim Geithner – remained mum. Consequently, in the months before the company filed the biggest bankruptcy ever, investors only got Lehman’s version of its financial health.
While the New York Fed may have had a confidential relationship with banks like Lehman, the SEC did not. Although it is arguable that the Fed charter mandated it work behind the scenes to avert a public banking panic, the SEC was not similarly constrained. Findings by the bankruptcy investigator Anton Valukas confirm that SEC officials knew the sorry state of Lehman’s books, but appeared to elevate the firm’s orchestrated illusion of stability over the public’s need to know.
Even if current and former SEC officials argue otherwise, they can’t ignore the red flag that was raised by former Lehman employee Matt Lee.
The Route of His Claims
Lee was fired after he blew the whistle on the irregularities surrounding now infamous “Repo 105,” an accounting ruse devised by Lehman executives and endorsed by company auditors Ernst & Young to hide the actual size of the firm’s bloated balance sheet. Accounting maneuvers like “Repo 105” allowed the firm to shrink the size of its reported liabilities to the tune of nearly $50 billion. As a result of these accounting tricks, Lehman was able to pretend in its quarterly reports to shareholders that it was less leveraged than was actually true.
In May 2008, nearly four months before Lehman went belly up, Lee raised serious concerns about the company’s suspect accounting practices. Lee’s claims allegedly were investigated and subsequently dismissed by Ernst & Young.
Under SEC rules, the regulators had unfettered access to everything provided to the auditors, including Lee’s alarming memo. Rather than acting independently to protect the public, SEC officials relied on Ernst & Young to tell them whether Lee’s concerns were credible.
There is no question that Lehman’s vast army of highly paid lawyers and accountants exploited weaknesses in the law and U.S. accounting standards to conceal the dismal state of the company’s finances. For example, when its own lawyers became convinced that the repurchase agreements under “Repo 105” would not withstand scrutiny under U.S. regulations as actual sales, it routed the transactions through its British subsidiary.
This reshuffling of $50 billion in liabilities was pulled off with the tacit endorsement of Ernst & Young and the apparent full knowledge of the SEC.
Debacles like the Lehman saga and the Madoff scandal underscore the danger of regulators becoming too chummy with their charges. The SEC was in position to call investors’ attention to the gaping irregularities at Lehman’s, but instead chose to stay silent.
As Congress and the President gird themselves to tackle a revamping of federal fiscal oversight, they need to consider the Lehman case. While stricter regulations may be the order of the day, unless they take a hard look at the corrupt culture of American financial regulation, scofflaws like Lehman and Madoff will continue to hoodwink the investing public.
John Cohn is a senior partner in the Globe West Financial Group based in West Los Angeles. He may be contacted at www.globewestfinancial.com
