Forum funnies

Repo 105: Lehman Brothers’ now notorious “Repo 105” scam depended on forum shopping. The investment bank was not able to persuade US lawyers that the relevant repurchase agreements constituted real sales. So it routed them through its UK subsidiary. That meant they came under the English legal system, and law firm Linklaters was able to opine that the transactions counted as sales. US accounting apparently did the rest, allowing Lehman to shuffle $50 billion of assets off its balance sheet. Regulators in different jurisdictions need to cooperate to close all such gaps they can.

Forum shopping, also known as regulatory arbitrage, is undesirable, but smart bankers are always going to do it. The Lehman case shows, for one thing, how they exploited weaknesses in US accounting standards — seemingly without objection from auditor Ernst & Young.

Although the transactions concerned came under English law, they were reported under U.S. generally accepted accounting principles. U.S. GAAP has lots of detailed rules, but it doesn't catch every eventuality. Things can slip through the cracks.

International accounting standards, by contrast, rely more heavily on broad principles. These can be better at ensuring compliance with the spirit of true and fair accounting. For example, one principle of the IAS 39 accounting standard is that if companies keep substantially all the risks and rewards of an asset, they can't keep it off their balance sheets. This would seem to mean that Lehman's sleight-of-hand with Repo 105 would not have been possible under international accounting standards.

Lehman's other regulatory arbitrage, of course, was to park the Repo 105 transactions in the UK. If Lehman had stayed entirely at home, using both U.S. law and accounting, it wouldn't have been able to hide assets. If the firm had hopped over the Atlantic and applied international accounting standards as well as English law, the scheme would equally have failed.

The crafty Lehman bankers found a fault in the system -- the intersection of English law and U.S. GAAP. But that's to be expected from highly-paid bankers, helped by expensive lawyers and accountants. It's a concrete reminder that those spearheading individual nations' reform of financial regulation need to keep thinking globally.