It can be argued that the Lehman Brothers did engage in forum shopping, particularly when it came to the Repo 105 transactions. Given that they could not get US attorneys to agree on and approve repurchase agreements as real sales, Lehman Brothers used a UK subsidiary Lehman Brothers International, to shift assets through the Hudson Castle Group Inc., which was tightly controlled by Lehman Brothers’ board. This was done since, under British law, the intention of outright transfer is considered a true sale, as was certified by British law firm Linklaters LLP (Kakani et al., 2012).
Lehman took advantage of the weak accounting standards in the United States at the time, with little objection from their auditors, Ernst & Young. If Lehman had used the repo transactions in the US, they would not have been able to disguise the assets. Generally, international accounting standards are based on broad principles with the purpose of driving compliance with the concept of true and fair accounting to establish mutual trust. One of these standards indicates that if companies keep both the risks and rewards of an asset, it cannot be kept off the balance sheet (Dixon & Winkler, 2010). However, Lehman found a loophole in the intersection of British law and American accounting standards favorable to its interests.
Forum shopping is also known as “regulatory arbitrage, or a corporate practice of utilizing more favorable laws in one jurisdiction to circumvent less favorable legislation elsewhere” (Hayes, 2021, para.3). In part, it can be argued that Lehman Brothers received indirect help from regulators both in the US and in the UK. The US regulatory standards were intentionally lax, favoring big banking and allowing these well-known practices of forum shopping for repo alongside the subprime mortgage practices, which sparked the financial crisis. Meanwhile, the UK law, which evidently ignored international accounting standards if convenient, served as a loophole for Lehman. Similarly, this was likely intended to make the UK an attractive financial hub for such big corporate and banking companies. However, it was also the involvement of several other firms to help Lehman Brothers. As mentioned, the Hudson Castle Group had to serve as a UK-based firm to fulfill the repo 105 obligations, while the law firm Linklaters had to certify them. It is without a doubt that these UK firms were well aware of the purpose of the repo 105 scheme but chose to quietly benefit from it in order to help Lehman circumvent regulations.
The primary lesson that was derived for regulators from this debacle was that the global financial system is highly interconnected. Therefore, when attempting to establish financial regulation in the respective countries, such as the US, which later passed the Dodd-Frank Act, it is absolutely crucial to think globally and identify the loopholes in the international system (Dixon & Winkler, 2010). Furthermore, as discussed by Kakani et al. (2012), the case encouraged regulators to put various locks and safeguards in the financial system. The first was for regulators to work together internationally with major markets to standardize accounting and reporting standards to avoid cases where repo assets could be hidden to legislative loopholes. The U.S. Financial Accounting Standards Board amended the narrow guidelines for repo accounting.
Furthermore, the SEC sought to significantly widen disclosure requirements. The lesson essentially was to leave no stone unturned when it comes to accounting and reporting, greatly pressuring firms to avoid such circumstances again. Finally, it was determined that banks should not be given absolute free will on how they invest their assets and utilize such key financial instruments as the repo, mortgage lending, and others. The Dodd-Frank Act went on to highly limit which operations could be conducted to avoid such drastic manipulation of the markets for financial gain by the banks.
Dixon, H., & Winkler, R. (2010). Lehman hid money with the help of global rules. The New York Times.
Hayes, A. (2021). Regulatory arbitrage.
Kakani, R.K., Singhania, V., & Stack, M. (2012). Lehman Brothers’ fall. Richard Ivey School of Business Foundation.