Beware: SEC Fishing for Repo’s in Company 10-Ks
Whether or not you’ve heard about the tricky accounting technique Lehman Brothers allegedly used to mask huge losses before filing for bankruptcy protection in 2008, you may want to read this.
It is a so-called “Dear CFO” letter from the SEC’s Division of Corporation Finance. It could be the first step the SEC may take in a deep dive into your financial statements to look at how your CFO accounted for repurchase agreements, securities lending transactions and other transactions involving the transfer of financial assets.
The letter, which went out in March to certain companies, is in response to an examiner’s report on the bankrupt Lehman Brothers. That bank allegedly used an accounting treatment called Repo 105 that has proved to be somewhat controversial. In an interview with CNBC this week reported on in CFO magazine, SEC Chair Mary Schapiro spells out the SEC’s strategy behind the letter.
“We want to make sure their accounting and disclosures are accurate when it comes to characterizing repurchases,” Schapiro said.
While the SEC only posted the notice of the sample letter to its Web site on Monday, some people in the corporate governance area have some advice for all public companies.
“My two cents: even if you believe your company did not receive this ‘sample letter,’ or even if you see this letter referred to in the press or otherwise as directed at specific industries, I would suggest companies, auditors, legal counsel, and audit committees consider such ‘Dear CFO’ letters as illustrative of the SEC’s general view [on this matter],” Edith Orenstein wrote in her FEI Financial Reporting Blog Tuesday.
Terry Iannaconi, a partner in KPMG’s National Office and a former deputy chief accountant for the SEC, said she would be concerned if her company received such a letter.
“They are looking for a great deal of analysis,” she said during Tuesday’s KPMG Audit Committee Institute/National Association of Corporate Directors’ quarterly Webcast. “If you are in receipt of one of these letters, you can expect a deep dive process.”
Repo 105 had been utilized by Lehman Brothers since 2001. According to the examiner’s report in the Lehman bankruptcy case, the process allowed Lehman to overcollateralize repurchase transactions by pledging $105 million for $100 million in cash.
Knowledge@Wharton published an article, “Lehman’s Demise and Repo 105: No Accounting for Deception” that describes how Repo 105 works as well as how it benefited Lehman prior to its bankruptcy and ultimately led to its downfall. The article reads:
“Much of Lehman’s problem involved huge holdings of securities based on subprime mortgages and other risky debt. As the market for these securities deteriorated in 2008, Lehman began to suffer huge losses and a plunging stock price. Ratings firms downgraded many of its holdings, and other firms like JPMorgan Chase and Citigroup demanded more collateral on loans, making it harder for Lehman to borrow. The firm filed for bankruptcy on September 15, 2008.
“Prior to the bankruptcy, Lehman worked hard to make its financial condition look better than it was, the Valukas [examiner’s] report says. A key step was to move $50 billion of assets off its books to conceal its heavy borrowing, or leverage. The Repo 105 maneuver used to accomplish that was a twist on a standard financing method known as a repurchase agreement. Lehman first used Repo 105 in 2001 and became dependent on it in the months before the bankruptcy.”
As for the SEC letter itself, it is about three pages long, written by the senior assistant chief accountant and ends with the following ominous language:
“Finally, if you accounted for repurchase agreements, securities lending transactions, or other transactions involving the transfer of financial assets with an obligation to repurchase the transferred assets as sales and did not provide disclosure of those transactions in your Management’s Discussion and Analysis, please advise us of the basis for your conclusion that disclosure was not necessary and describe the process you undertook to reach that conclusion. We refer you to paragraphs (a)(1) and (a)(4) of Item 303 of Regulation S-K.”
What’s more, the SEC asks for a written response to the questions raised in the letter within 10 business days.
- Gary Larkin
What more can one say about the SEC, which has been too busy with tackling matters after the fact. Even this approach appears to be misplaced, as it will look to prosecute matters which until now may not have been illegal and for which many of these major financial institutions have taken internal actions to address so that they don’t have a situation similar to that of Lehman Brothers. This would appear to be another instance where the SEC will mismanage their limited resources, being late to the party and prosecute something that doesn’t require prosecution, simply because for public appearances it looks like they are doing their job. The SEC needs to focus its energies on real, substantive investigations that will protect public investors.