LEHMAN BROTHERS | ARTIKAH

CONTENT

INTRODUCTION
CAUSE OF LEHMAN BROTHER FAILURE:
CORPORATE GOVERNANCE

Corporate Risk Management Failure

Board of Director
Remuneration Scheme
Nomination Committees

TECHNICAL CAUSES
MISLEADING
CAUSES OF FINANCIAL CRISIS
CONCLUSION
REFERENCE

LEHMAN BROTHERS | ARTIKAH

INTRODUCTION
Lehman Brothers Holdings Inc. has filed for bankruptcy protection in the U.S.
The statement above is a current headline on the Lehman Brothers internet page - the fourth
largest investment bank in USA in 2007. It was surely a big surprise for a lot of company
stakeholders and shareholders, but when we look closer to this case, it was not unpredictable.
We will discuss in this work the reasons why Lehman Brothers had to file for Chapter 11, what
happened inside of the company, how corporate governance failed in this case and specifically
we will analyze their creative accounting issue REPO 105.
Lehman Brothers started in 1844 as a small grocery and dry goods store established by Henry
Lehman. Two decades later they traded cotton, moved to New York and established New York
Cotton Exchange. After this events Lehman continued on the road of success and became the
fourth-largest American investment bank. They survived the World wars and the Great
Depression, however, the collapse on the U.S. housing market brought Lehman Brothers to its
knees.
Objectively, there are many reasons why Lehman Brothers failed, but we could divide them to
two main groups technical issues and corporate governance failures. Lehman Brothers had
very weak corporate governance arrangements, no wonder when the turnover chief expressed
his opinion towards corporate governance as follows: Corporate governance is a joke. The
main areas of weakness were board of directors, corporate risk management, remuneration
scheme and nomination committees. In this work we will discuss mainly first two of them with
attention to REPO 105 operation what was the key creative accounting maneuver used by
Lehman Brothers.

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CAUSE OF LEHMAN BROTHER FAILURE: CORPORATE GOVERNANCE
Corporate Risk Management Failure
Since Lehman Brothers were a leading investment bank, it was inherent that risk is a part of
their day-today business. Financial markets are, by the principles, uncertain and face variety of
risks credit market, liquidity, legal, reputation and operational risk. Therefore, good risk
management is considered to be a base of all operations in the company, as well as risks
should be appropriately measured and analyzed.
In Lehman Brothers, overall risk limits and risk management policies were established by the
companys Executive Committee. Apart from that, the Risk Committee (which consisted of the
companys Executive Committee, the CRO and CFO) should meets weekly to discuss all
potential threats and risk taking activities. Sad is, that these facts are only pure statements in
Lehman Brothers policy manual of quantitative risk management. In reality, this committee met
only twice in the year 2006 and 2007. Besides that, Lehman started high- risk business years
before its bankruptcy. It was a period of aggressive growth strategy to overcome their problems.
During this period they developed exposures to risky subprime lending, structured products,
commercial real estate and high-risk lending for leveraged buyouts, but they have not
considered enough that these loans were less liquid that its usual investments and had more
vague prospects. Further, according to the Valukas report, they exceeded internal risk limits and
controls to pursuit higher earnings, what was the start of the end.
Valukas report (report composed by court-appointed investigator of bankruptcy of Lehman
Brothers, Anton Valukas) further stipulates that there is evidence that top officers of Lehman
Brothers Company (including the Chief Executive) violated their duties by exposing the
company to potential liability by filling misleading reports and financial statements. The specialty
of Lehman Brothers misleading transactions was Repo 105 through which company could
remove billions of liabilities off the balance sheet. The existence and misuse of the Repo 105
is very questionable and goes beyond corporate governance, concerning from accounting to
legal issues of its use. In following sections we will explore Repo transactions, their advantages,
disadvantages and ways of misuse.
Timothy Geithner (Secretary Of The Treasury), said in his report, Lehmans plunge into highrisk businesses in the years before its bankruptcy has become a familiar story. During this
period of aggressive growth, Lehman developed significant exposures to risky subprime
lending, commercial real estate, structured products, and high-risk lending for leveraged buyout.

LEHMAN BROTHERS | ARTIKAH

Importantly, the Valukas Report indicates that Lehman repeatedly breached its own risk
concentration limits in pursuit of higher earnings.

Repo 105and the Lehman Brothers

According to the report, Lehman Brothers used repo operations purportedly for financing
reason, though they reported them as asset disposal in the financial statements. They removed
securities inventory from the balance sheet for seven to ten days and made misleading
appearance of the companys overall situation in 2007 and 2008. To be concrete, they
accounted for Repo 105 transactions as sales, by which they removed the inventory from the
balance sheet. The number of the Repo 105 transactions regularly raised before the closure of
the reporting period. That way Lehman Brothers borrowed billions of dollars and used them to
pay other liabilities. Few days later, they repaid the cash borrowings plus interest, repurchased
the securities and restored the assets on its financial statement. Main reasons for these
creative accounting procedures were mainly lowering the publicly reported net leverage and
balance sheet. Namely, the net leverage had become an important indicator for the rating
agencies and of bank risk. However, the Repo 105 operations were not completely legal under
the U.S. law, and therefore Lehman Brother had to do all of these transactions in the UK under
their London unit. In this situation, the most important question is who knew about these
operations and who is responsible for them. Mr. Fuld claims that he did not know about those
transactions, in spite of the fact that Bart McDade stated, that he had a discussion about the
Repo 105 with Dick Fuld in 2008. Valukas report also stipulates the evidence against three
Lehman Brothers CFOs. But, they defended their selves with statements, that almost all
financial firms practice the window-dressing to adjust their balance sheet at the end of the
accounting period.

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Board of directors in the Lehman Brothers

According to the OECD principles, the corporate governance should ensure the strategic
guidance of the company, the effective monitoring of management by the board, and the boards
accountability to the company and the shareholders. Based on these principles, board
members supposed to act on a fully informed basis, in best interest and fairly to the company
and shareholders. They should apply high ethical standards and should be able to exercise
objective independent judgment on corporate affairs. Moreover, they supposed to fulfill several
functions including reviewing and guiding corporate strategy, risk policy budgets and business
plans. Board should also monitor the effectiveness and manage potential conflicts of interest as
well as oversee the process of disclosure.
Lehman Brothers Board of Directors was composed of ten members. The Chairman and CEO
was Richard S. Fuld, Jr. and included eight independent directors according to NYSE. However,
behind all of that there was a fact, that nine out of 10 directors were retired. Moreover, their
average age were 68.4 years (four of them were over 75 years), only two of them have direct
experience in financial service industry and only one of them had current financial sector
knowledge. In addition, one was U.S. Navy officer, another theatrical producer. Pointless is also
the fact, that indeed board members should be independent and suppose to take care of the
corporation, they cannot do it very precisely. Especially not, when they are for instance director
of Weight Watchers International, as well as chairman of Lehmans governance and nominating
committee and a member of the compensation, finance and risk committee at the same time
(e.g. Marsha Johnsons Evans). At the end of this section, we also cannot forget to mention, that
Lehman Brothers board members were paid for their services extremely well, since the range
was from $325 000 to $397 000 plus very high every year bonuses. However, this hasnt been
enough to Mr. Fuld who rewarded his self with nearly half a billion dollars between 1993 and
2007.

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Remuneration scheme and Nomination

A study from researchers at Harvard University, The Wages of Failure: Executive
Compensation at Bear Stearns and Lehman 2000-2008, shows that the top executive
managers of Lehman Brothers received about $1 billion respectively from cash bonuses and
equity sales between 2000 and 2008.
The Board at Lehman Brothers awarded total remuneration of close to $500 million to Chairman
Fuld, just four days before its collapse and following an announcement that the firm lost almost
$4 billion in the third quarter, Fuld told the media that the Boards been wonderfully supportive.
CEO received nearly half a billion dollars in total compensation between 1993 and 2007.
The staff received a disproportionately high percentage of their pay in Lehman stock and option.
When the firm went public, employees owned 4 percent of the firm, worth $60m. By 2006, they
owned around 30 percent, equivalent to $11 billion, at least on paper.
In nomination cause of four of the ten member board at Lehman Brothers were over 75 years of
age and only one had current financial sector knowledge.

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Technical causes of Lehman Brothers Failure

One of the main failure cases in Lehman Brothers was the misbehavior of top executives and
the inaction of both of the board and the auditing firm (Ernst & Young)
There are many similarities between the collapses of Enron in 2001 and Lehman Brothers in
2008, that they managed to reduce leverage on the right-hand side of balance sheet and at the
same time reduce assets on the left-hand side. In Lehman Brothers, Repo 105 transactions
double between late 2006 and May 2008, were known inside the corporation, exceeded the
firms self-imposed limits and typically happened at the end of each quarter, when financial
information had to be released.
Lehman in the last year was unable to retain the confident of its lenders and clients, because it
did not have sufficient liquidity to meet its current obligations and on two consecutive quarters
with huge reported losses, $2.8 billion in second quarter 2008 and $3.9 billion in third quarter
2008, without news of any definitive survival plan.

Misleading
The Wall Street equivalent of a coroners report, mention that Richard S.Fuld Jr, Lehmans
former chief executive, certified the misleading accounts, the report said. Mr. Valukas (one of
the examiner) wrote in the report Unbeknownst to the investing public, rating agencies,
government regulators, and Lehmans board of directors, Lehman reverse engineered the firms
net leverage ratio for public consumption, The report state that Mr. Fuld was at least grossly
negligent. Henry M. Paulson Jr., who was then the Treasury secretary, warned Mr. Fuld that
Lehman might fail unless it stabilized its finances or found a buyer.

LEHMAN BROTHERS | ARTIKAH

CAUSES OF FINANCIAL CRISIS

During much of the late 1990s and into the early 2000s many emerging-markets and
commodity-rich countries experienced large current account surpluses and sought safe assets
to invest in, traditionally sovereign and government agency debt. At the same time, there was
significant growth in institutional cash pools, such as pensions, money market funds, and hedge
funds, which also demanded these safe assets. As demand for these safe assets outstripped
supply, a global savings glut resulted. During the same period, booming U.S. housing prices and
low interest rates combined to create an exuberant mortgage market. Mortgage-backed
securities (MBS), whereby investors purchased the right to a stream of payments fuelled by a
pool of underlying mortgages, became very popular. As U.S. housing and mortgages had
traditionally been considered stable investments, and because at this time mostly lower risk
prime mortgages were used, many of these MBS received high investment-grade ratings. Prior
to 2003, the market in MBS had been dominated by the government-sponsored entities, the
Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage
Corporation (Freddie Mac), and also enjoyed an implied governmental guarantee.
In response to the savings glut, banks became more involved in producing MBS. As demand
continued, banks combined MBS with other types of asset-backed securities (ABS), such as
those based on credit card receivables, auto loans and student loans, to sell them as a new
type of bond-like security called collateralized debt obligations (CDOs). Payments under the
CDOs were to be made out of the flow of repayment from the underlying MBS and ABS making
up the CDO. Again, because of the mortgages underlying the CDOs, many received investmentgrade ratings.
CDOs proved very popular and were aggressively sold to investors in all the worlds major
markets. By 2007, CDOs had become a significant portion of the ABS market. To meet the
demand for MBS and CDOs, banks began pooling not just prime mortgages but also riskier
subprime loans and a greater portion of the securities underlying CDOs became MBS, and then
subprime MBS. Over time, lenders loosened underwriting standards in order to increase the
quantity of subprime mortgages that could be pooled. As they became common, CDOs and
other structured debt were routinely used as collateral for repo transactions.
CDOs were termed structured instruments because they were divided into different tranches
based on the timing of payments and the payment priority given the holder of a particular

LEHMAN BROTHERS | ARTIKAH

tranche (higher-rated tranches were guaranteed payment before lower rated tranches). Creating
tranches allowed investors to choose at what level of risk to invest and allowed investment firms
to create investment-grade tranches from even sub-prime mortgages. Lehmans troubles were
due in part to the fact that it retained some of the low-rated tranches of the CDOs it generated,
and these tranches were the first to get into trouble when the housing market cooled.

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CONCLUSION
The fact is that on September 15, 2008, Lehman Brothers filed for bankruptcy. And it wasnt the
first big international company (also not the last one) who ended under the Chapter 11. We can
for example point out the Enron bankruptcy from 2001, which is (maybe) accidently very similar
to Lehman Brothers case. But why we have the old pattern here again? My personal opinion is
that the reason is in the weak corporate governance arrangements in the company and in the
fact that corporate governance principles are not under the root of law. In the Lehman Brothers
weak corporate governance arrangements allowed officers to find the way how to accumulate
unearned profit and specifically increase their personal wealth.
In my opinion, there is no problem in the context of OECD principles since they arch over all
problems discussed in this work. OECD principles specifically say that the corporate
governance framework should ensure:
1. The strategic guidance of the company, the effective monitoring of management by the
board, and the boards accountability to the company and the shareholders
2. That timely and accurate disclosure is made on all material matters regarding the
corporation, including the financial situation, performance, ownership, and governance of
the company
3. That an annual audit is conducted by an independent, competent and qualified auditor in
order to provide an external and objective assurance to the board and shareholders that
the financial statements fairly represent the financial position and performance of the
company in all material respects.
As you can see above, if all of these points were fulfilled as is stated in the principles, the
Lehman Brothers company would probably not have to be under the Chapter 11. However,
there are several problems. First of all, Lehman Brothers had very weak corporate governance
arrangements and officers were not forced to fulfill the principles. Good instance is a situation in
their board of directors. Secondly, the most important issue is why companies should abide the
OECD principles, if there are no consequences of breaking them. I think that until the corporate
governance framework will not be under the law, these cases will arise. Moreover, problems are
also in the matter, that there are crucial differences between the law systems. As we could see,

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Lehman Brothers could not use Repo 105 in the U.S., but they were allowed to do it in UK and
manipulate their financial situation.
From nature, people are very inventive and they always look for means how to increase their
personal wealth. There will always be a group of people which goes beyond the principles as far
as the law permits and who will look for the opportunities to overpass the law. To conclude, I
would see the key issue in setting the system in the way, in which it will minimize opportunities
of these speculators and therefore minimize the failures of corporate governance.

LEHMAN BROTHERS | ARTIKAH

REFERENCE
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bear-stearns-and-lehman/
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