Dear Chairman Reed, Ranking Member Crapo, and Members of the Committee:
I appreciate the opportunity to appear before you to address what role the accounting profession can play in helping to prevent another financial crisis. I address this question primarily from the perspective of my role as the Examiner in the Lehman Brothers bankruptcy proceeding. I want to emphasize at the outset that I did not make any finding as to whether regulators or auditors necessarily could have prevented Lehman’s collapse. Lehman failed in part because it was unable to retain the confidence of its lenders and counterparties and because it did not have sufficient liquidity. Lehman was unable to maintain confidence because it made a series of business decisions that left it with heavy concentrations of illiquid assets with deteriorating values, such as residential and commercial real estate. The extent to which Lehman’s demise was, in part, the function of any act or failure to act by the auditors is a question we must leave for the courts.
Lehman’s executives – not regulators or auditors – made the decision to load up on illiquid assets. Lehman’s executives – not regulators or auditors – were responsible in the first instance for preparing fair and accurate financial reports. I found that Lehman’s decision not to disclose to the public a fair and accurate picture of its financial condition gave rise to colorable claims against senior officers who oversaw and certified misleading financial statements.
Nevertheless, and wholly apart from the claims involving Lehman’s auditors, we must recognize the general principle that auditors serve a critical role in the proper functioning of public companies and financial markets. Boards of directors and audit committees are entitled to rely on external auditors to serve as watchdogs – to be important gatekeepers who provide an independent check on management. And the investing public is entitled to believe that a “clean” report from an independent auditor stands for something. The public has every right to conclude that auditors who hold themselves out as independent will stand up to management and not succumb to pressure to avoid rocking the boat.
I found that colorable claims exist against Lehman’s external auditor in connection with Lehman’s issuance of materially misleading financial reports. As I explained in my Report:
[I]n this Report a colorable claim is one for which the Examiner has found that there is sufficient credible evidence to support a finding by a trier of fact. The Examiner is not the ultimate decision-maker; whether claims are in fact valid will be for the triers of fact to whom claims are presented. The identification of a claim by the Examiner as colorable does not preclude the existence of defenses and is not a prediction as to how a court or a jury may resolve any untested legal, factual, or credibility issues.
If Lehman had earlier presented a fair and accurate picture of its financial condition, regulators and Lehman’s board may have had a fighting chance to make needed corrections or arrange for a smoother landing. As there is litigation pending against some of the individuals and entities covered by my findings, it would not be appropriate for me to comment directly on any issues that will have to be decided by the courts. There are, however, important lessons that can be gleaned as to how auditors can help prevent another financial crisis.
In Lehman’s final months, two issues were of critical importance: leverage and liquidity. In both instances the system broke down. Information given to the investing public was misleading or inaccurate, and opportunities to identify severe problems were missed.
Leverage: Lehman’s Balance Sheet Manipulation
Beginning in 2007, market observers began demanding that investment banks reduce their leverage. Lehman knew that if it did not reduce leverage it would suffer a ratings downgrade, which would have an immediate and tangible monetary impact. Paolo Tonucci, Lehman’s Global Treasurer, recognized in 2007 that ratings agencies were “most interested and focused on leverage.” In early 2008, Erin Callan, Lehman’s CFO, noted that reducing leverage was necessary to “win back the confidence of the market, lenders, and investors.”
Lehman’s CEO Richard Fuld knew that Lehman had to improve its net leverage ratio by selling inventory, but by mid-2007, much of Lehman’s inventory had become “sticky” – difficult to sell without incurring substantial losses. As detailed in my Report, Lehman opted to create a perception of reducing its net leverage ratio through increased use of a device known as “Repo 105.”
Lehman repeatedly and heavily relied on Repo 105 transactions to temporarily remove – and I emphasize temporarily – some $50 billion off of Lehman’s balance sheet right at quarter end. Lehman undertook $38.6 billion, $49.1 billion, and $50.38 billion of Repo 105 transactions at quarter-end fourth quarter 2007, first quarter 2008, and second quarter 2008, respectively. Lehman executives described this accounting device as a “gimmick,” “window dressing,” and a “drug we r on.” Martin Kelly, Lehman’s former Global Financial Controller, stated unequivocally that there was “no substance to the transactions.” $50 billion of transactions with no business purpose. I uncovered ample contemporaneous evidence that the sole purpose of these transactions was to make the published balance sheets look better than they actually were. To make matters worse, these transactions not only lacked any affirmative business purpose but required Lehman to pay a premium for the privilege of masking its true financial condition.