Examining The Lehman Brothers Failure: Is This Enron All Over Again?

What led to the demise and failure of Lehman Brothers? This is the precise question that Anton Valukas, a partner in the New York office of the venerable law firm Jenner & Block, was appointed in January 2009 by the U.S. Bankruptcy Court for the Southern District of New York to answer. Indeed, Lehman Brother’s bankruptcy, which was filed on September 15, 2008, is the largest Chapter 11 bankruptcy filing in history. Many would argue that the Lehman collapse has contributed greatly to our current financial crisis—The Great Recession—one of the worst since The Great Depression. Yesterday, Valukas issued a 2,200-plus page Report detailing the failure of Lehman Brothers.

Valukas indentified a number of failures in corporate governance and auditing and financial controls. Valukas observed that Lehman Brothers “repeatedly exceeded its own internal risk limits and controls.” According to Valukas, Lehman’s management made a number of terrible decisions that ultimately led to Lehman’s collapse. Commenting on Lehman’s executives, Valukas noted that conduct “ranged from serious but non-culpable errors of business judgment to actionable balance sheet manipulation.” Valukas indicated that Lehman Brother’s attempted to forestall its ultimate demise by misleading investors about its true financial picture.

Perhaps most damning, Valukas discloses Lehman’s use of “Repo 105” a financial accounting device to “cook” or alter its balance sheet. Using Repo 105, Lehman shifted $50 billion of toxic assets off its balance sheet during the first and second quarters of 2008, instead of selling and reporting these toxic assets at a loss. Through a loophole and gap, accounting rules allowed Lehman to treat Repo 105 transactions as sales instead of financings. Lehman’s chief financial officer was implicated in emails that indicated that Repo 105’s chief purpose was to reduce liabilities on the balance sheet.

Valukas found that Repo 105 was not disclosed to government regulators, rating agencies, investors, or to Lehman’s board of directors. Lehman apparently did not act alone. Valukas discovered that Ernst & Young, Lehman’s auditor, was made aware of Repo 105 and did not challenge the use of this questionable accounting practice. Repo 105 led to the repossession of billions of taxpayer dollars and investment and retirement funds!!!

We passed Sarbanes-Oxley in the wake of the Enron scandal to try to root out financial and accounting irregularities. How could similar irregularities occur at Lehman Brothers? History has a way of constantly repeating itself. One thing is for certain, the civil lawsuits, and hopefully criminal charges and indictments, will flow shortly. I will do my best to keep you posted in the coming weeks and months.

Financial Crisis Symposium: A Progressive Analysis

I would like to thank my colleagues here at the Corporate Justice Blog for an absolutely wonderful conference at the University of Utah S.J. Quinney College of Law entitled, Financial Crisis Symposium that offered a progressive exploration of the cause of the current financial crisis.

Unfortunately due to a prior family obligation, I was unable to physically attend. However, I did watch the conference via web stream and participated via email. The marvels of modern technology truly are a wonderful thing.

The morning panel consisting of Professors Cheryl Wade, Steven Ramirez, Regina Burch and moderated by Todd J. Clark was absolutely superb. I was intrigued that each of the morning panelist thought that Sarbanes-Oxley (SOX) has been a failure. I believe that SOX is a powerful piece of legislation that has been under-utilized and watered-down by the incessant lobbying that the “cost” of SOX compliance outweighs the “benefit” of SOX compliance. As a result, the application of SOX has not done the job that it was designed to do. I suppose then in that respect I would agree that SOX has failed to keep the proverbial barbarians at the gate from storming the citadel and has left the investing public and average Americans to the tender mercy of American corporate hospitality.

The afternoon panel consisting of Professors Timothy A. Canova, andré douglas pond cummings, Joseph Grant, Christian Johnson and moderated by Jena Martin-Amerson was equally superb. Professors Canova, cummings, and Grant each provided a unique perspective as to how the Financial Modernization Act of 1999, also known as the "Gramm-Leach-Bliley Act," opened the door and set the stage for the current financial crisis. Deregulation of the financial services sector was lauded as necessary to provide synergy and to maintain American corporate competitiveness. The reality has been that the Financial Modernization Act of 1999, weakened the authority of the American central bank, the Federal Reserve, weakened the ability of the federal regulators to regulate the markets and left the American public unprotected from corporate mismanagement, greed, and fraud.

On behalf of the viewing public, thank you for a job well done.

Lydie Nadia Cabrera Pierre-Louis
St. Thomas University School of Law

A Sweet Securities and Exchange Commission Settlement Deal for VeriFone

The Securities and Exchange Commission (SEC) settled charges against VeriFone Holdings Inc. (VeriFone) and a former finance department employee, Paul Periolat, regarding allegations that VeriFone, a provider of electronic pay services, filed false accounting records which boosted the company’s gross margins and income reported to shareholders for three consecutive quarters in 2007. The falsification resulted in an overstatement of earnings by more than $37 million.

VeriFone settled with the SEC without admitting or denying the allegations. VeriFone consented to a permanent injunction against violations of the reporting, internal controls, and other provisions of the federal securities laws. Periolat, now an ex-employee, consented to a permanent injunction against further violations of certain antifraud, reporting, internal controls, and other provisions of the federal securities laws, and Periolat has to pay a $25,000 civil penalty fine. There were no other charges or any monetary penalty assessed against VeriFone.

This is perhaps one of the sweetest settlements for a public company who has breached its fiduciary duty of care to shareholders and presumptively violated Sarbanes-Oxley (SOX) Section 302. The facts concerning VeriFone’s wrongdoing are not unusual but the speed and the terms under which the SEC settled the investigation are unusual. The SEC sued VeriFone on Tuesday, September 1st and the case was settled on the same day.

The SEC alleged that VeriFone made unsupportable alterations to its records to compensate for an unexpected decline in gross margins, overstating VeriFone’s operating income by a total of 129 percent. The SEC further alleged that when internal VeriFone reports showed that gross margins would be markedly lower than previously released guidance to analysts, senior management "was convinced that previously released guidance to analysts were correct and directed finance employees to figure out and fix the problem” so VeriFone could report results in line with forecasts and thereby avoid “an 'unmitigated disaster." The SEC specifically alleged that VeriFone’s former supply chain controller, Periolat, made large manual adjustments to inventory balances on VeriFone’s books each quarter, dramatically increasing both gross margins and operating income. The accounting irregularities came to light during a routine annual audit in November 2007. A few weeks later, VeriFone announced it would restate earnings for the first three quarters of fiscal 2007. VeriFone’s stock fell by 46 percent to $26.03 the day of the announcement, wiping out $1.8 billion from VeriFone’s market capitalization. It is this type of corporate misconduct which encouraged Congress back in 2002 in the wake of historical corporate scandals to adopt comprehensive legislation to increase the accuracy, level of disclosure, and ultimately the accountability for corporate financial mis-reporting.

In 2002, with the seemingly endless financial and management scandals that were then coming to light, including the collapse of Enron and, even more dramatic, the collapse of WorldCom, Congress adopted SOX to remedy the damage that had been caused to investor confidence in the markets. SOX has set the requisite standard for public companies regarding financial transparency and accuracy. The responsibility is on companies’ chief executive officers (CEOs) and chief financial officers (CFOs) to ensure that their financial reporting is transparent and accountable. As such, VeriFone is under a federal statutory duty to implement long-term strategies to establish and evaluate internal control over its financial reporting. It is not enough for CEOs and CFOs to merely sign off on the financials. CEOs and CFOs must certify as to the financial accuracy and effective internal controls currently in place and must to attest to the transparency and accountability of company’s financials. This duty to implement and maintain effective internal controls has long existed under a corporation’s common law fiduciary duty of care. In re Caremark is the seminal case regarding a corporation’s fiduciary duty to implement and maintain effective internal controls. Professor William Gregory’s law review article in the Akron Law Review entitled, The Fiduciary Duty of Care: A Perversion of Words, is an excellent discussion of the confusion that often exist between the duty of loyalty and the duty of care.

SOX Section 302 entitled “Corporate Responsibility for Financial Reports” requires CEOs and CFOs of public companies to certify the information in the company's annual and quarterly reports to the SEC, as well as the company's internal controls are effective. Marc J. Fagel, director of the SEC’s San Francisco regional office stated that through poor oversight and controls, VeriFone senior management allowed an employee to make millions of dollars of unsubstantiated accounting adjustments that enabled the company to meet its guidance to Wall Street. VeriFone maintains that Periolat acted without scrutiny or authorization from more senior management. This means that VeriFone’s internal controls failed and three quarterly reports filed with the SEC in 2007 were inaccurate which violated SOX Section 302 and was a breach of VeriFone’s fiduciary duty of care to its shareholders.

Marc J. Fagel further stated that public companies need to ensure that their financial statements give an accurate assessment of their financial results, and are not improperly adjusted to meet analyst expectations. It is this “tough” language of necessary compliance with federal regulations and, yet “soft” settlement for breach of those regulations which is so perplexing. Perhaps the answer turns on intent. The SEC complaint did not accuse VeriFone of intending to misstate its financial results or to mislead anyone. However, VeriFone’s internal controls were not effective. It is this lack of effective internal controls which should have triggered SOX liability and a breach of VeriFone’s duty of care to its shareholders. These are not issues of intent. These are issues of negligence. VeriFone’s CEO Douglass Bergeron recently stated that “over the past 18 months, the company has substantially improved its governance and internal controls in order to prevent a recurrence of this type of event." Perhaps such sweet reassurances will bring comfort to regulators and shareholders.