Sunday, March 14, 2010

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.


  1. Professor Grant:

    In repeatedly violating "its own internal risk limits and controls," does the report indicate how heavily invested Lehman was in securitized subprime mortgage instruments? Without having read the report, I have to assume that reckless investment in both collateralized debt obligations and reckless reliance on credit default swaps is where Lehman repeatedly violated its own risk limits and controls.

  2. Valukas found that Repo 105 was not disclosed to government regulators ....

    Not true. It turns out that NY Fed may be "culpable in aiding and abetting Lehman in accounting fraud and Sarbox violations", according to Yves Smith at Naked Capitalism, who has read the report and has been following the reporting closely:

    “It also emerges that the NY Fed, and thus Timothy Geithner, were at a minimum massively derelict in the performance of their duties, and may well be culpable in aiding and abetting Lehman in accounting fraud and Sarbox violations.

    We need to demand an immediate release of the e-mails, phone records, and meeting notes from the NY Fed and key Lehman principals regarding the NY Fed’s review of Lehman’s solvency. If, as things appear now, Lehman was allowed by the Fed’s inaction to remain in business, when the Fed should have insisted on a wind-down (and the failed Barclay’s said this was not infeasible: even an orderly bankruptcy would have been preferrable, as Harvey Miller, who handled the Lehman BK filing has made clear; a good bank/bad bank structure, with a Fed backstop of the bad bank, would have been an option if the Fed’s justification for inaction was systemic risk), the NY Fed at a minimum helped perpetuate a fraud on investors and counterparties.”

    This pattern further suggests the Fed, which by its charter is tasked to promote the safety and soundness of the banking system, instead, via its collusion with Lehman management, operated to protect particular actors to the detriment of the public at large.

    And most important, it says that the NY Fed, and likely Geithner himself, undermined, perhaps even violated, laws designed to protect investors and markets. If so, he is not fit to be Treasury secretary or hold any office related to financial supervision and should resign immediately.

    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?

    Smith explains:

    ... even though Lehman dressed up its accounts for the great unwashed public, it did not try to fool the authorities. It's games playing was in full view to those charted with protecting investors and the financial system.

    So what transpired? The SEC (which in all fairness, has never had much expertise in credit markets, this is a major regulatory problem) handed assessing Lehman over to the Fed, which bent over backwards to give it a clean bill of health ...

    One thing is for certain, the civil lawsuits, and hopefully criminal charges and indictments, will flow shortly.

    Let's hope that those indictments include the names of the people at the SEC and the FED entrusted with protecting the public. Want to take any bets?

  3. anonymous:

    so, no culpability for the lehman executives that engaged in the fraud?

    agreed that if the regulators intentionally failed in their responsibility that indictments should include them as well.

    what motivation would valukas have to cover up this failure? he is supposed to be an independent (and prominent) lawyer appointed by the bankruptcy court.

  4. I worked in securities regulation for 13 years. I think the problem is the regulators don't understand the products and have to rely on the broker/dealers to explain it to them. These products have become very sophisticated, and firms are hiring M.I.T. mathematicians to come up with new products. I have a hard time believing more then a few people in the firm understand the product. So a regulator needs to fit the round peg of that product into the square hole of the regulation and try to ascertain whether or not it's compliant with rules, especially financial/operation rules of net capital requirements. I think management and regulators were equally bullied by the few people who understood the products into believing the firm was compliant. Another repeated lesson learned just like the Prudential limited partnership scandal, and on and on in the list of securities scandals that were suppose to change regulation.

  5. so, no culpability for the lehman executives that engaged in the fraud?

    Who suggested that?

    There are people being paid handsomely by the taxpayers to oversee the market and it's participants. If, in fact, they knowingly looked the other way or participated in the defrauding of Lehman's shareholders and counterparties, resulting in the loss of billions of shareholder and taxpayer dollars, then they should share the same fate as Lehman's executives. And no one is suggesting that Anton Valukas covered up anything.

    Try actually reading the post and it's supporting links before making your predictably ignorant comments.

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  7. Prior to Lehman Brother's collapse, $50 billion in troubled assets were converted from its balance sheet, in an effort - according to an internal email unearthed - described as "basically window dressing."

    The officers identified in the report included former CEO Richard Fuld and three chief financial executives.

    However, the report slammed Ernst & Young, for "its failure to question and challenge improper or inadequate disclosures" in Lehman Brother's financial statements.

    "Ernst & Young took no steps to question or challenge the non-disclosure by Lehman of its use of $50 billion of temporary, off-balance sheet transactions," the report stated.

    If Congress does not use this latest financial catastrophe as a wake-up call to pass meaningful regulatory reform, then the United States risks becoming completely desensitized to corrupt practices that have the ability to implode this country's economic stability.

  8. I agree that when Lehman Brothers filed bankruptcy, it had a large impact on our economy, and I too wonder how heavily invested Lehman Brother was in subprime mortgage instruments. Also if Ernst & Young were auditors, it does seem plausible that they would have detected any suspicious accounting practices. However, if Repo 105 was used to reduce liabilities on the balance sheet, but the use of Repo 105 is not in and of itself illegal, I'm not sure that, standing alone it would have threw up a red flag. Surely there were some red flags though. I also agree that more laws should be passed in order to prevent this type of abuse. However, I'm pessimistic in the sense that the someone will always find a way to lie, and cheat, no matter how many laws you have, no matter how many auditors you have. That's the brilliance of the human mind. It really comes down to ethics, and values. We really must get to a point, even in the corporate world where no amount of money is worth the unethical conduct displayed on an off of Wall Street. People just have to WANT to do the RIGHT thing.

  9. It is absolutely mind-boggling to see how history is truly repeating itself. Lehman Brothers definitely had something to do with the current economic crisis here in the United States. How have we created loophole systems that allow you the ability to move around and hide 50 billion dollars? And then to have the information be reviewed by Ernst & Young and for them to not report it, truly raises some questions for me. These individuals have experience, and an educational backing that would have allowed them to know that their current business practices were completely unacceptable. And now the country is in one of the worst positions in history because of the greed of a small number of individuals. We have the SOX act in place and all of these other regulations, but what good does it do when no one is taking the time to truly put them into practice. Some of the financial institutions are causing the general citizens and populations to lose faith and not trust them at all. There is going to be a long period of rebuilding, but our country is strong and will bounce back.
    -David H. Kenton

  10. The collapse of Lehman Brothers is very questionable for me. How is it that you can have one of the top auditor firms backing you and they not realize a problem exists when you move $50 billion dollars worth of assets from your balance sheet in an effort to lower leverage and generate a false indication of your financial health? I agree with some of the prior posts in that it boils down to doing the right thing, but when you have one inferior person who speaks out against a collection of individuals who are greedy and tricksters then there is a no win situation. The use of the repurchase agreements, although not entirely wrong, should have been thoroughly reviewed by Ernst & Young.

  11. In terms of financial failure and corruption, history will have to continue to repeat itself in order for regulations and changes to be made in our financial system. Sarbanes-Oxley and legislation such as that are reactive rather than proactive. It is rare to have proactive legislation because there is no money in being progressive and stopping and anticipating problems of the future. The notion of having banks which are "Too Big to Fail" will not be properly regulated until their collapse(s) effect millions of Americans on a long term basis. These issues will not be regulated until the public outcry leads to substantial change in the legislatures on both a local and national level.

  12. What more can one say about the SEC, which has been too busy with tackling matters after the fact. Even this approach appears to be misplaced, as it will look to prosecute matters which until now may not have been illegal and for which many of these major financial institutions have taken internal actions to address so that they don't have a situation similar to that of Lehman Brothers. This would appear to be another instance where the SEC will mismanage their limited resources, being late to the party and prosecute something that doesn't require prosecution, simply because for public appearances it looks like they are doing their job. The SEC needs to focus its energies on real, substantive investigations that will protect public investors.

  13. GERMAINE ANTHONY AUSTINApril 5, 2010 at 12:19 PM

    It's not hard to believe that history found a way to repeat itself in this situation. The Sarbanes Oxley Act was supposed to be a failsafe “manuscript” to prevent the use of intentional misguided information used on financial statements. The Securities and Exchange Commission serves as a protection for investors and prevents businesses/corporations from using false information involving the purchase and sale of securities. The Securities and Exchange Commission can't catch every in house act and I can't deny that they step in whenever businesses decide to get reckless. They are a good checks and balance system when it comes to securities and holding businesses/corporations accountable for securities fraud. However, when we allow gray areas to foster in the world of regulation what makes people think that the gray area won't be used.
    Additionally, isn't it the job of some to find the gray areas, loop holes and use them to get around situations? The article clearly states, "Through a loophole and gap, accounting rules allowed Lehman to treat Repo 105 transactions as sales instead of financings." If this type of accounting principle has such an affect why would we even allow others to use it, knowing that in tight situations its purpose would cause destruction? Furthermore, the article also states that Lehman's CEO was misguided on the true purpose of Repo 105. Actually, the truth is, he probably wasn't disclosed to the whole purpose of Repo 105. Lastly, Lehman created a dreadful situation for them, they saw their demise and instead of accepting it they decided to drag others in the whole with them, the individuals that count the most, investors. This type of practice is illegal, "Valukas indicated that Lehman Brother’s attempted to forestall its ultimate demise by misleading investors about its true financial picture." They are business minded individuals and they should know the consequences of engaging in corporate fraud. I am curious to know what type of charges and indictments will follow, please keep me posted.

  14. Now is a time for our government to be more pro-active and not reactive. Now is the time to establish new enforcement of reporting regulations and create a more responsible corporate climate. Clearly the officers and directors have breached their duty of care. But what about the vendors who are hired to ensure that such bad faith dealings are caught? They're supposed to serve as as a stop-gap filter, impose some checks and balances. What happens when they fall short? Shouldn't they be held accountable too?

  15. With the fresh corporate scandal wounds from the likes of Enron, WorldCom, and Tyco (TYC) still healing, an observer might expect the auditors to more responsibly monitor the behavior of questionable client behavior. The down fall of accounting giant Arthur Andersen (former Enron auditor) was supposed to serve as example of what can happen if irresponsible corporate behavior goes unchecked. Apparently Lehman Brothers’ “Big Four” auditor Ernst & Young didn’t learn a lesson from the mess left behind by its competitor. Not only did Ernst & Young sign-off on these transactions, but their neglect to commence investigations on whistle-blower allegations also serves to land them in very hot water. I believe the SEC and multiple state Attorney Generals should investigate Valukas’ findings further to see if civil or criminal charges against Lehman and Ernst and Young executives are appropriate.

  16. "Lehman Brothers Used 'Alter Ego' to Transfer Risks."

    If this case doesn't turn out to be our business and corporations law exam question hypothetical, I will eat my textbook. Their graphic even looks like one of our professor's pictures. Even the most complicated of relationships can be summarized as a diagram. I agree with the previous blog poster that it would be interesting to see where the regulators tried and failed (or simply failed) to regulate.

    Still - greed has managed to overwhelm legality as the overriding cardinal principle of corporate behavior. Can't wait to see the Michael Douglas follow up to Wall Street... Wonder who the heroes who will in that movie will be?

  17. -Anthony Gonzalez

    Definitely gives off the Enron scent. Sarbanes Oxley was created after the Enron scandal to prevent incidents like this one and yet, it went unnoticed. The examiner for Lehman, Valukas, will argue that the SEC just stood by without doing anything as the bank collapsed. He'll argue that the SEC did not even ask fundamental questions which could have led to the discovery of this matter a lot sooner. Who knows, if Valukas supports his argument with the fact that SEC employees watch porn while on the job, he might just be successful. (referring to the other article about SEC employees watching porn)