A New Issue of Moral Cents is Out!
April 23rd, 2013We are close to the five-year anniversary of the global financial crisis, if we take ...
Lehman Brothers and Repo Accounting
(Analyzed using a virtue ethics framework)
Background
Prior to its collapse in 2008, investment banking giant Lehman Brothers Holdings Inc., actively participated in, what is widely considered, trickery in order to mislead the investing public. Repurchase agreements (repos) are a commonly used method of borrowing for many financial institutions across the nation. These agreements should be (according to financial standards) classified as a liability on an institution’s balance sheet. An increase in liabilities equates to an increase in leverage (debt). Lehman Brothers (at some point) found a loophole in the financial accounting standards, which allowed it to move its repurchase agreements (liabilities) off its balance sheet. The intent of the accounting standard was not to facilitate investor deception, but Lehman Brothers apparently exploited the loophole in that way. As asset quality deterioration began to accelerate during the subprime crisis and the public (belatedly) began to focus their concern on leverage, Lehman Brothers relied on this loophole to decrease leverage and maintain investor confidence (and their stock price).[1]
Facts about the case
Applicable facts (assumptions are noted as such) surrounding the case include the following:
- Lehman Brothers commonly used repurchase agreements as a source of financing.
- Repurchase agreements are considered a liability and increase an institution’s leverage ratios.
- Loopholes in financial accounting standards allowed for repurchase agreements to be moved off-balance sheet in the event that certain requirements are met.
- Lehman Brothers would (legally) move repurchase agreement debts off of their balance sheet during reporting periods in order to mislead investors by decreasing leverage (assumption).
- Investors were unaware of Lehman Brothers’ repurchase agreement shell games. Had they known, it may have negatively impacted Lehman Brothers’ stock price (assumption).
- No other financial institutions were employing this deceptive practice (assumption).
Ethical issue
Would persons of high moral character purposefully contradict the spirit of the law in order to mislead others?
Stakeholders
Primary and secondary stakeholders (and why they are considered such) of this case include the following:
Primary Stakeholders:
- Lehman Brothers (and its employees) – primary decision maker in this case, misled investors.
- Lehman Brothers’ debt and equity holders whose financial wellbeing is directly tied to Lehman Brothers financial performance as reported in the financial statements, as well as to Lehman Brothers reputation.
- Repurchase agreement counterparties – direct party to the transaction, facilitated Lehman Brothers misleading practices.
Secondary Stakeholders:
- Lehman Brothers’ employees’ families – if deception was uncovered then employees could lose their jobs, which would affect the wellbeing of their families.
- Stock market – Lehman Bros. was a major investment bank – any negative news regarding them could have an adverse affect on the market.
- Financial Accounting Standards Board (FASB) – must now consider making changes to the current accounting standards in order to close the loophole.
Identifying what a “person of integrity” would do in this situation
In this situation, persons of integrity would likely consider their relevant moral community in order to determine (at least in part) what actions a virtuous person would take. Lehman’s relevant moral community would likely include other financial institutions, regulatory bodies, and the greater investing public. Empathetically considering each of these community members would subsequently provide Lehman with a comprehensive virtuous decision making tool. For example, the investing public would likely consider an individual (or institution) of integrity as one who provides full and transparent disclosures. Regulatory bodies would expect individuals (or institutions) of integrity to abide not only by the letter of the law, but also by the spirit of the law. Lehman’s relevant community members would not consider its subsequent actions on repurchase agreements to be virtuous or moral.
Identifying the specific virtues involved
The primary virtues that are probably most relevant (e.g., lacking) to this case are integrity, compassion, prudence, and self-discipline. The common thread amongst these four virtues is doing the right thing not because you have to, but because you should. Just because an action is legal does not always mean that it is ethical (or virtuous). Lehman clearly lacked these virtues and consequently was punished because of it.
Cognitive barriers/biases
Lehman’s actions were likely supported by the confirmation trap. The institution found facts (read: loopholes) in the accounting guidance that supported its preferred choice (shifting debt off the balance sheet) and it made that choice. Additionally, it is also likely that the use of euphemistic language (i.e., off-balance sheet vs. deception) in the accounting guidance allowed Lehman to morally disengage and partake in unethical behavior.
Decision and proposed solution
Overall, after considering the relevant moral community to determine what a person of integrity would do, Lehman should not have exploited the accounting standard’s loopholes and misled the investing public. Utilizing a virtue ethics framework, we can conclude that Lehman’s actions are unethical because a virtuous person would not have done the same. An alternative solution for Lehman would have been to fully disclose the transactions in their filings.
Contributed by: Phil Whalen
[1] Floyd Norris, “Demystify the Lehman Shell Game,” The New York Times, 01 April 2010, www.nyt.com
