In response to the release of the examiner’s report on the Lehman bankruptcy, and one that could lead to multiple SEC enforcement investigations, the SEC’s Division of Corporation Finance recently sent out a “Dear CFO letter” to various financial institutions. In the letter, the Staff has asked for information regarding the accounting and disclosure for their transfers of financial assets with an obligation to repurchase the transferred assets. It is clear that the Staff is trying to see if some financial institutions may have misinterpreted or abused the accounting literature to window dress or otherwise misrepresent their financial statements. 

The relevant accounting standard, ASC 860 (which now includes the provisions of FAS 140 (pdf), generally allows a transferor to obtain “sale” accounting treatment if the transferor effectively relinquishes control of the asset. If, however, the transferor maintains a right to repurchase or require the asset, the accounting rules require the transferor to account for the transfer as a secured borrowing because it still has control over the asset. The accounting consequences between the two scenarios are significant, for sale accounting allows a company to record revenue on the income statement and positive cash flow from operations, while accounting for a transfer as a secured borrowing means more debt on the balance sheet and no operational cash flow.

The SEC’s Division of Enforcement will certainly pay close attention to the responses received, as the misapplication of FAS 140 was a prevalent theme throughout the Enron investigation. In one particular case, the SEC settled a fraud action against CIBC for helping Enron meet the technical requirements of FAS 140 and thus achieve sale accounting in connection with multiple Enron asset “sales” to a CIBC financed special purpose entity. In reality, though, the SEC found that the transactions were not real sales but instead were “disguised loans,” as Enron always had control over the transferred assets because it always had the right (and the obligation) to reacquire them.

As such, financial institutions that do have similar Lehman-like transactions need to be prepared for the investigative scrutiny that will undoubtedly follow -- and not just from the SEC but also from criminal, banking and other regulators. In addition, third parties to such transactions such as syndicated lending agents and accounting firms should expect to be participants in what could be significant enforcement activity.