Judge Lewis A. Kaplan of the United States District Court for the Southern District of New York recently granted in part and denied in part a motion to dismiss federal securities law claims brought on behalf of a putative class of purchasers of securities issued by Lehman Brothers Holdings Inc. (“Lehman”) prior to its September 2008 collapse. In re Lehman Bros. Sec. Litig. and ERISA Litig., Case No. 09-MD-2017, 2011 U.S. Dist. LEXIS 82119 (S.D.N.Y. 2011). The district court concluded that the complaint stated claims arising from alleged misstatements concerning Lehman’s net leverage ratio, which had allegedly been “reduced artificially,” thereby misleading investors concerning Lehman’s “ability to absorb any losses sustained by its riskiest assets.”


Plaintiffs are a putative class of individuals, pension funds and companies that purchased the more than $31 billion in Lehman debt and equity securities issued pursuant to a shelf registration statement and base prospectus dated May 30, 2006, and various supplements thereto. Plaintiffs seek to recover for their losses from Lehman’s former officers and directors, Lehman’s outside auditor, and the 51 entities that underwrote the offerings in which the securities at issue were purchased. Plaintiffs’ complaint, as amended April 23, 2010, in the wake of the issuance of a nine-volume report by the court-appointed examiner in the Lehman bankruptcy proceeding, alleges violations of the Securities Act of 1933 and Section 10(b)(5) and other provisions of the Securities Exchange Act of 1934 arising from false and misleading statements allegedly contained in Lehman’s offering materials and financial statements. The complaint alleges that those misleading statements concerned, among other things, Lehman’s accounting treatment of so-called “Repo 105” transactions and their effect on Lehman’s reported net leverage (i.e., the ratio of its net assets to tangible equity capital).

A repurchase agreement (also known as a “repo”) is a two-step transaction used to obtain short term funding. In the first step, the borrower transfers specified securities to the counter-party in exchange for a cash payment, with an agreement to later reacquire the transferred securities. In the second step, the borrower repays the original cash payment plus interest and the counter party returns the securities. According to the complaint, Lehman would ordinarily account for repo transactions as financings, with the collateral (i.e., the transferred securities) remaining on Lehman’s balance sheet as assets.

Repo 105 was a type of repo transaction that, according to the complaint, Lehman repeatedly used “near the ends of its quarterly reporting periods solely to lower its net leverage” to “present Lehman as being in a stronger financial position than it actually was.” Unlike with respect to an “ordinary” repo transaction, the collateral transferred by Lehman in a Repo 105 transaction was treated for accounting purposes “as though it actually had been sold and therefore removed from Lehman’s balance sheet.” This treatment allegedly artificially decreased Lehman’s net leverage ratio because “it reduced net assets by the ‘sale’ of the ‘collateral’” and, moreover, the cash received from a Repo 105 transaction was used to pay down other liabilities. Lehman allegedly would execute the second step of the Repo 105 transaction within days after the quarter closed, reacquiring the collateral and thereby “returning its net leverage to the pre-Repo 105 level.” Plaintiffs allege that, as a result of this process, Lehman’s statements of its quarter-ending net leverage ratios were “false and materially misleading” because they failed to disclose that “the ratio had been reduced artificially by the Repo 105 transactions.”

Defendants moved to dismiss the complaint in its entirety for failure to stay a claim upon which relief may be granted.

Complaint States Claims of Material Misstatements

To survive a motion to dismiss, plaintiffs claims under Section 10(b)(5) of the Exchange Act needed to allege adequately that the defendants “in connection with the purchase or sale of securities, made a materially false statement or omitted a material fact, with scienter, and that the [plaintiffs’] reliance on the [defendants’] action caused injury to the plaintiff.” The district court concluded that the allegations in the complaint were sufficient to state a claim against Lehman’s former officers under this standard.

The district court found that the complaint adequately alleged misstatements including, among others, misstatements based on Lehman’s “use of and accounting for Repo 105 transactions and their effect on net leverage.” Lehman’s offering materials and financial statements stated “(1) Lehman’s net leverage and amount of securities it sold under agreements to repurchase as of the end of each quarter, (2) that Lehman prepared its financial statements in accordance with GAAP, and (3) that Lehman treated securities sold under repurchase agreements as financings.” Moreover, during investor conference calls certain of Lehman’s executives allegedly represented that its net leverage reduction came in large part from a “reduction of assets across the Firm.” According to plaintiffs, these statements were false and misleading because Lehman “failed to disclose its use of Repo 105 transactions and its temporary effect of reducing Lehman’s net leverage” and thereby “presented a misleading picture of the company in violation of GAAP.”

The district court concluded that the “repetitive, temporary, and undisclosed reduction of net leverage at the end of each quarter is sufficient to make out a claim that the Offering Materials and oral statements about net leverage violated the overriding GAAP requirement to present the financial condition of the company accurately, assuming the changes in net leverage that resulted from the Repo 105 transactions were material.” Moreover, whether the changes in net leverage were material is a “fact-specific inquiry” that should not be decided at this stage of the litigation “unless they are so obviously unimportant to a reasonable investor that reasonable minds could not differ on the question of their importance.” This was not such a case. The district court rejected defendants’ contention that the changes in net leverage due to the Repo 105 transactions were immaterial as a matter of law because Lehman’s offering materials contained cautionary language that the overall size of Lehman’s balance sheet would “fluctuate from time to time and might be higher than the year-end or quarter-end amounts.” Though this was, in the district court’s view, the defendants’ “strongest argument” concerning materiality, it was unavailing because the cautionary language “was not sufficiently specific or prominent to support a conclusion as a matter of law that no reasonable investor would have found it important to know that Lehman engaged in transactions, the effect of which was to reduce temporarily its net leverage at the end of each reporting period.”

The complaint also gave rise to an inference of scienter (i.e., an intent to deceive, manipulate, or defraud) with respect to its alleged material misstatements. Specifically, the complaint’s allegations that Repo 105 transactions “were used at the end of each reporting period, in amounts that increased as the economic crisis intensified, to affect a financial metric that allegedly was material to investors, credit rating agencies, and analysts support a strong inference that [Lehman’s officers] knew, or were reckless in not knowing, that use of the Repo 105 transactions and the manner in which they were accounted for painted a misleading picture of the company’s finances.”

Finally, the plaintiffs adequately alleged an injury caused by these misrepresentations. The district court rejected defendants’ argument that the decline in Lehman’s stock price and its ultimate collapse were caused not by any of the misrepresentations alleged in the complaint but instead by “market-wide phenomenon,” namely the “crisis in the subprime market that spread to the rest of the real estate market” and led to the “collapse of the financial markets generally.” As an initial matter, plaintiffs were not required to allege that their entire loss was caused by the defendants’ misstatements. Furthermore, even though it could “be said with some assurance that Lehman, given the assets it held, would have been in trouble in any case, it is entirely plausible to conclude . . . from the facts alleged in the [complaint] that the misleading picture that Lehman portrayed played a material part in keeping its stock higher during the class period than it otherwise would have been.” As such, “plaintiffs are entitled to an opportunity to attempt to prove that some ascertainable amount of the losses they suffered was attributable to th[is] allegedly false picture of relative security.”

The complaint’s related claims under the Security Act against the former officers and directors of Lehman and the underwriters were also deemed adequate to survive the motion to dismiss. The Securities Act claims were “based principally on the same categories of alleged misstatements and omissions” relied upon in support of the complaint’s Exchange Act claims and, accordingly, the complaint “alleges misstatements and omissions sufficiently under the Securities Act to the same extent that it does so under the Exchange Act.”

Complaint also States Claims Against Auditors

The district court also found the allegations in the complaint adequate to state a claim under Section 10(b)(5) of the Exchange Act against Ernst & Young, Lehman’s outside auditor during the relevant period. The complaint alleged in part that opinions issued by Ernst & Young that Lehman’s financial statements were in compliance with U.S. generally accepted accounting principles (“GAAP”) were materially false and misleading because those financial statements in fact did not comply with GAAP.

The district court first clarified that Ernst & Young’s opinions indicated only its belief that Lehman’s financial statements were in compliance with GAAP and, accordingly, allegations that Lehman “violated GAAP in preparing its financial statements are not sufficient, in and of themselves, to state a claim that an auditor’s opinion of GAAP compliance is a factual misstatement.” The complaint must also “set forth facts sufficient to warrant a finding that the auditor did not actually hold the opinion it expressed or that it knew that it had no reasonable basis for holding it.” Here, the district court found that plaintiffs had “sufficiently alleged that [Ernst & Young] knew enough about Lehman’s use of Repo 105s to ‘window-dress’ its period-end balance sheets to permit a finding that [Ernst & Young] had no reasonable basis for believing that those balance sheets fairly presented the financial condition of Lehman.”

This finding relied in large part on allegations concerning an interview that Ernst & Young had conducted with Matthew Lee, a Lehman senior vice president, on June 12, 2008. According to the complaint, Lee told Ernst & Young during that interview “that Lehman moved $50 billion of inventory off its balance sheet at quarter-end through Repo 105 transactions and that these assets returned to the balance sheet about a week later.” If these allegations are true, then Ernst & Young “arguably was on notice by June 2008 that Lehman had used Repo 105s to portray its net leverage more favorably than its financial position warranted, a circumstance that could well have resulted in the published balance sheet for that quarter being inconsistent with GAAP’s overall requirement of fair presentation.”


Judge Kaplan’s recent decision to allow several federal securities claims to move forward in the sprawling, multi-district In re Lehman Bros. Securities Litigation and ERISA Litigation is a reminder of the continued potential exposure of financial institutions and their auditors to liability for losses suffered by investors in the wake of the 2008 financial crisis (and any future financial crises). With the added benefit of hindsight, investors may in some circumstances be able to allege sufficient facts to survive a motion to dismiss, even under the heightened pleading standards that govern federal securities claims.