On September 15, 2008, Lehman Brothers filed for Chapter 11––the largest such bankruptcy in American history. The move stunned global financial markets and, many argue, triggered the ensuing financial crisis. Founded in 1850, Lehman had weathered many financial panics and recessions (including the Great Depression) to grow into the nation’s fourth largest investment bank. The firm was also a major player in subprime mortgages; therein lay its doom. From 2000 to 2008, U.S. investment banks borrowed heavily to grow, and Lehman was no exception. In February 2008, Lehman held $786 billion in assets with only $24.8 billion in stockholder equity––a debt-to equity ratio of nearly 32-to-1. With that much leverage, it would take only a small drop in asset values to wipe out the firm, and the meltdown of the subprime-mortgage market obliged. During the preceding housing boom, lenders scrambled to give mortgages to applicants with less than “prime” credit––such borrowers accounted for nearly one-third of 2005 origination's. Many qualified only because of low “teaser” interest rates and expected home-price appreciation. When teaser rates expired and housing prices peaked, defaults on subprime mortgages began to climb. And firms top-heavy with securities backed by those mortgages–– like Lehman Brothers–– found themselves in trouble. As its finances deteriorated, Lehman turned to “Repo 105s” to mask its leverage (and vulnerability to the falling prices of subprime backed securities). Financial institutions commonly use repurchase agreements, or repos, to borrow short-term––a firm wanting cash sells securities with a promise to buy them back a short time later at a higher price. Lehman had something else in mind––executing repos just prior to releasing quarterly financial statements, using the cash to temporarily pay down debt, and then unwinding everything shortly after the statements were public. To the public, these transactions made Lehman’s leverage ratio appear much smaller than it really was. Securities were repurchased at 105% of initial sales price because of an accounting rule requiring repos at 102% or less to be reported as loans on the balance sheet. Through Repo 105s, Lehman “removed” between $39 and $50 billion in assets and debt from its reported balance sheets the last three quarters before bankruptcy. No reputable American law firm would bless the legality of these transactions, so the firm found one in the U.K. and did the deals through its London office. The fallout continued long after Lehman Brothers’ demise. In 2013, the firm’s auditors, Ernst & Young (E&Y), agreed to pay $99 million to investors and in 2015 another $10 million to the State of New York for not blowing the whistle on the shady repos. Allegedly, E&Y kept mum because Lehman was its eighth largest U.S. auditing client, forgetting Warren Buffett’s wise counsel: “It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.”

Because the Repo 105 deals took place in London, Lehman executives hid behind the legal blessing from a U.K. law firm to escape U.S. prosecution. Does “legal” make the transactions ethical? What ethical duty did E&Y have as Lehman’s auditor to go public with the intent of the Repo 105 transactions?