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SEC Rebuked for Regulatory Failure With Lehman Brothers

Even as the Securities and Exchange Commission seeks to rehabilitate its reputation with its lawsuit against Goldman Sachs, the agency was sharply criticized today for its failure to intervene with Lehman Brothers--the failed financial firm that ultimately contributed to the financial crisis when it declared bankruptcy in 2008.

In a hearing before lawmakers today, Anton Valukas, the examiner who produced last month's stunning bankruptcy report on Lehman, criticized regulators--particularly the SEC (PDF)--for failing both to rein in Lehman's risks and to adequately protect investors.

According to Valukas, the SEC knew that Lehman was exceeding its own risk controls and did nothing about it. The examiner also faulted the regulator for its cluelessness about the firm's balance sheet manipulations known as Repo 105--an accounting gimmick Lehman used to hide its risks.

"The SEC did not know about the practice," said Valukas in prepared testimony. "But it is difficult to understand why not. In the post-Enron world, it would be logical, if not obvious, to ask public companies to explain their off-balance sheet transactions. I saw nothing in my investigation to suggest that the SEC asked even the most fundamental questions that might have uncovered this practice."

The SEC's chairman, Mary Schapiro, also testified before the House Committee on Financial Services, saying that while "it is not clear that anything the SEC could have done would have prevented Lehman’s bankruptcy," the SEC "did not do enough" to identify Lehman's risks.

On the Repo 105 issue, Schapiro said that the regulators "depended on the integrity of the balance sheet information provided by Lehman’s management which was audited or, in the case of quarterly reports, reviewed, by Lehman’s auditors." The SEC has since sent out letters to about two dozen other financial firms, asking if they employed similar accounting tactics to those of Lehman Brothers.

Schapiro, though she testified on the subject, was not the SEC chairman when Lehman fell. Christopher Cox, who was the chairman then, also submitted a statement to the Financial Services Committee, in which he noted that regulatory responsibilty for Lehman didn't fall solely on the SEC.

"Lehman was effectively outside of the regulatory jurisdiction of any individual federal department or agency," Cox said. "This was a fundamental flaw in the statutory scheme that had to be addressed -- but in the meantime, it was up to the SEC, the Fed, the Treasury and other regulators to improvise solutions."

Valukas also criticized the various financial regulatory agencies for failing to work together, comparing the lack of communication between regulatory agencies to the problems of intelligence agencies after 9/11:

Like most Americans, I was disturbed to learn after 9/11 that various intelligence agencies did not always share information with one another. I thought we learned something from that, but apparently not. Significantly, the SEC and the FRBNY failed to share information about Lehman’s liquidity and Lehman’s inclusion of encumbered collateral in its liquidity pool. ... What is clear is that the regulators were not fully engaged and did not direct Lehman to alter the conduct we know in retrospect led Lehman to ruin. Someone must be in charge. And the agency in charge must have the will to act.

We've reported in the past on the warring between regulators at the New York Federal Reserve and the SEC. On that issue, the SEC's Schapiro testified that the commission "will be seeking additional opportunities to coordinate more effectively with our fellow regulators."