Publications

25 Aug 2010

Repurchase agreements draw heightened scrutiny from the SEC, FASB

Securities Litigation Alert

Perrie Michael Weiner
Patrick Hunnius

Earlier this year, a bankruptcy examiner concluded that Lehman’s financial accounting, in connection with its use of repurchase agreements (repos), created a “materially misleading picture of the firm’s financial condition.” 

Generally, repos are loan agreements that allow financial institutions to borrow money for a short term, offering securities held by the firms as collateral while simultaneously agreeing to repay the cash and take back the collateral at a specific point in time.  Lehman (according to the examiner) accounted for its repo transactions as sales, thereby reducing the debts on its balance sheet.  As a result, Lehman “in effect borrowed tens of billions of dollars in these transactions” without disclosing its borrowing.  

Recent developments confirm that, in the wake of the examiner’s report, the US Securities and Exchange Commission and other regulators have been closely examining accounting for repos and that they plan to intensify their scrutiny in this area.  Significantly, while many of the press accounts regarding the SEC’s focus on repos have centered on banks and other financial institutions, the SEC’s most recent public pronouncements make clear it is expanding its efforts to examine all “large and financially significant companies,” regardless of their industries.

The SEC’s recent “repo” inquiries

As the Wall Street Journal reported,[1] a recent AuditAnalytics.com study concluded that, since 2004, the SEC has questioned 115 transactions conducted by 102 separate companies “to assess if they accounted properly” for repos.[2]  The Journal further reported that some of the companies questioned recently disclosed they had “mistakenly booked some repo trades as sales when they should have been borrowings.”[3]

These recent disclosures are likely the result of an SEC initiative launched almost immediately after the issuance of the Lehman report.  The SEC, concerned that the “findings of the Examiner's Report … raise questions as to how widespread this practice may be,”[4] issued “letters to various public companies requesting detailed information about their use of repurchase agreements or similar transactions….”[5]  In all, nineteen “large public companies” received such a letter, which asked the companies to explain how they used repos and “how they accounted for them in their financial statements.”[6]  In particular, the SEC asked for “detailed information about the financial statement impact of these transactions throughout each quarter” and a description of “how that impact differed from that presented at each quarter end.”[7]  In many instances, the SEC then asked “several companies to enhance their disclosure about their accounting for repurchase and similar transactions and to expand their discussions of off-balance sheet arrangements.”[8] 

The SEC’s “repo” initiatives:  Potential new regulation and a new specialized unit

In recent public statements regarding repos, Chairman Schapiro has stated both that the SEC is evaluating “whether changes in accounting, disclosure, or to the underlying standards themselves, are needed to ensure that investors have accurate information about a firm's leverage and risk”; and that public companies can “expect more of these ‘Dear CFO’ letters, as [the SEC] reviews the filings of financially significant companies more deeply and consistently.”[9]

The chairman clearly meant what she said.  The SEC recently announced that the Division of Corporation Finance is creating three new specialized offices.[10]  One of these new offices[11] is a “disclosure review office that will expand the Division's enhanced reviews” of “large and financially significant companies.”[12]  Through the new disclosure review office, the Division plans to “increase the number of institutions subject to these reviews, concentrate staff expertise, and develop new review techniques to further strengthen its review program.”[13]

FASB considering new rules

The SEC is not alone in expanding the examination of repos.  During the July 28, 2010 meeting of FASB’s board of directors, FASB Chairman Robert Herz announced that, as a result of the Lehman report, the board has launched a project “to improve the accounting for repurchase agreements (repos) or other agreements that both entitle and obligate the transferor to repurchase or redeem financial assets before their maturity.”[14]  Once the project is complete, the board will consider how the new proposals compare to any similar standards promulgated by the IFRS.

The SEC’s demonstrated past interest in repos, coupled with its and the FASB’s current efforts to intensify their examination of this area, augur not just potential regulation, but also enforcement actions.  As Chairman Schapiro told Congress earlier this year, “Where we find that companies are engaging in financial transactions that are inconsistent with their publicly reported financial condition, we will take appropriate action.”[15] 

In light of the intensifying scrutiny of repos, any public company that has recently employed them or similar financing arrangements should review, with qualified counsel, its disclosures to determine whether they provide a fair presentation of the company’s finances.

For more information about this trend, please contact:

Perrie M. Weiner

Patrick O. Hunnius