Saturday, April 17, 2010

Lehman's Alter Ego: Hudson Castle and the Collapse of Lehman Brothers

A few weeks ago I discussed the Lehman Brothers collapse on this blog. Well, as we found out recently, the saga continues. In a April 12, 2010 New York Times story entitled "Lehman Channeled Risks Through 'Alter Ego' Firm " written by Louise Story and Eric Dash, Lehman's use of a small company named Hudson Castle as an "alter ego" was exposed.

Essentially, according to Lehman documents and interviews with former Lehman employees, the NY Times reporters highlighted the critical role Hudson Castle played in keeping a number of transactions off Lehman's balance sheet prior to the Lehman collapse in Septemeber 2008. On the surface Hudson Castle possessed all of the appearances and attributes of a stand-alone corporation. However, as noted, Hudson Castle was entwined and interconnected with Lehman Brothers in ways no one could imagine. For example, for a number of years Lehman owned 1/4 of Hudson Castle equity, controlled the Hudson Board of Directors, and stocked Hudson's ranks with former Lehman employees. Despite this entanglement Lehman did not disclose these facts to shareholders or regulators.

Lehman, and a host of other large banks, use corporations like Hudson Castle to exchange investments for cash--thereby making their cash position and finances look better to the outside world. Often, "off-balance sheet" transactions like the transactions that Lehman and Hudson Castle engaged in are mentioned in occasional financial statement footnotes, and at worst are never mentioned at all. Indeed, in the case of the relationship between Lehman and Hudson Castle, Lehman failed to inform their shareholders about the relationship and arrangement. Additionally, credit rating agency Moody's decided not to mention the Lehman and Hudson Castle relationship in credit ratings reports covering Hudson Castle vehicles.

Sadly, arrangements like the one between Lehman and Hudson Castle are legal. Federal securities disclosure laws require that publicly traded corporations like Lehman, are only obligated to disclose material investments or purchases of public companies. Unfortunately, Lehman's relationship with Hudson Castle did not meet either of these requirements.

In my last post on Lehman Brothers, I discussed Lehman's "Repo 105" program. Apparently, Hudson Castle was at the forefront of the Repo 105 program. Allegedly, "Hudson Castle created at least four separate legal entities to borrow money in the markets by issuing short-term i.o.u.'s to investors. It then used that money to make loans to Lehman and other financial companies, often via repurchase agreements, or repos." Under these repurchase or repo agreements, banks sell assets and promise to buy them back at a set price in the future. The transactions are made to look like arms-length transactions to shift "toxic" or "risky" assets off-balance sheet. The idea is to prevent these off-balance sheet risks from appearing as "headline risk" in the event of their failure or collapse on-balance sheet.

We are finding out more and more about the collapse of Lehman Brothers. I'm interested to find out what other skeletons we end up uncovering. What do you think about Hudson Castle? Are more regulations and tougher disclosure requirements necessary?


  1. Tiffany Smith

    Entities such as Hudson Castle are part of a vast financial system that operates in the shadows of Wall Street, largely beyond the reach of banking regulators. These entities enable banks to exchange investments for cash to finance their operations and, at times, make their finances look stronger than they are. Even now, a year and a half after Lehman's collapse, major banks still undertake such transactions with businesses whose names, like Hudson Castle's, are rarely mentioned outside of footnotes in financial statements, if at all. At several points, Lehman did transactions greater than $1 billion with Hudson vehicles, but it is unclear how much money was involved since 2001.Unfortunately, most of these deals were legal with the exception of a few

  2. I am truly not surprised to read this recent information regarding Lehman Brothers. As I continued to read this blog, I could only think of the remedies the shareholders and the creditors have. I would imagine that the creditors filed a claim to pierce the cooperate veil and retrieve their return from the shareholders. However, what remedies do the shareholders have? Lehman Brothers did not breach a fiduciary duty of not disclosing because it was a publicly traded corporation. However, since the material fact being disclosed by the corporation was misleading, a remedy should be given to the shareholders. I definitely believe that it is necessary to have more regulations on corporations and tougher disclosure requirements.

  3. It is interesting that Lehman is bankrupt while Hudson Castle is still dealing with other banks and deemed "independent" since 2004. With the numerous banks, firms, companies and individuals implicated in this fraud/misrepresentation, it was at least a comfort to read that there were no US attorneys that would support these deals – Lehman had to use English law and English attorneys. It is unfortunate that these transactions were permitted and can still be and currently are being used by other banks to defraud unsuspecting investors – in the name of greed. The May investigations are going to be very interesting. The following link is a copy of a NYT graphic which helps visualize what Lehman and Hudson were doing.

  4. I was also thinking about the duty of loyalty as I read this blog and the articles included in it. I took a look at Hudson Castle's website ( just to take a look at exactly what the company does generally and was suprised to read this in their company overview: "Hudson Castle was formed in 1996 and is a private, independent company based in the heart of the financial center in midtown Manhattan. We are predominantly employee-owned, are not part of a larger company and no outside party has a controlling interest in our firm." I thought that was kind of interesting in relation to the instant case. The overview goes on stating: "Our corporate independence is critical to our clients who rely upon us to provide objective, unbiased advice and to our other constituents who rely upon us to make business and risk management decisions free from conflicts of interest."

  5. It is not surprising that this information about the Lehman Brothers was discovered. This type of non-disclosure is very common because corporations are not required to disclose unless the information is about a material investment or purchase of a public company. It seems to me that stricter disclosure requirements should be in place to prevent this type of coverup. Unfortunately is unlikely that the shareholders will be able to recover any damages for their losses. I think that the harm done to the Lehman Brothers shareholders could have been prevented if there were harsher disclosure requirements in place.

  6. Wow. When will these investors get enough of making these mistakes. These high powered individuals have found so many loopholes and different provisions that have allowed them to makes fools out of the general public. Rules and regulations that were created to keep certain risky business ventures from happening, have now been used a safety net and a protection for those who have learned how to circumvent the problems. So many people question why are country is in the current position it is, and it has a lot do with all the “power players” making these irresponsible financial decisions that not only effect them, but the entire country. And now we implement these bailout plans, and all these other incentives to get these major corporations out of a “crunch” situation. Hopefully we can take this as an opportunity to examine leadership within this country and work towards building a better America.

    David H. Kenton

  7. I agree with everyone above that there definitely needs to be some stricter disclosure requirements. However, I think that these intelligent individuals will eventually find some loopholes to get around the tougher requirements. I think that it is terrible that the shareholders do no seem to have any recourse against the individuals who have taken advantage of everone involved here. Hopefully we can learn from all of these events and work towards preventing things like this from being able to happen in the future.

  8. where's the governance? We need cowboys to lasso these jerks in.

  9. -Anthony Gonzalez

    Using a small company to hide critical financial information so that you give off the appearance that you're much healthier than what you really are = ENRON. You'd think Lehman would've taken a few notes from that scandal. Non-disclosure is clearly a big deal, time and time again we see these very similar situations. Enron led to Sarbanes Oxley and as these corporations continue down this path there will be stricter regulations implemented.