Simona Tothova 1 Essay Corporate Governance failure in the Lehman Brothers case 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. 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 board’s accountability to the company and the shareholders”. Based on these principles, board members supposed to act on a fully Simona Tothova 2 Essay 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 Lehman’s 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 hasn’t been enough to Mr. Fuld who rewarded his self with nearly half a billion dollars between 1993 and 2007. Corporate risk management failure Since Lehman Brothers were a leading investment bank, it was inherent that risk is a part of their day-to- day 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 company’s Executive Committee. Apart from that, the Risk Committee (which consisted of the company’s 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 Simona Tothova 3 Essay 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 raport, 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. Repo operations Repo (“sale and repossession”) operations transform a financing transaction into an asset disposal. They started to be used in the 20th century for legitimate purpose. They were used for money making by lending, circulating and investing it. Usually financial institutions borrow funds using securities as collateral. Imagine that financial institution has securities for $ 102, it will borrow $ 100 from another institution presenting the securities as a guarantee for the short-term loan. The difference ($ 2) is a “haircut” – price for the liquidity and risk of the bond. In these operations collateral (treasuries) stays on the borrower’s books, cash increases the bank’s balance sheet (as if asset were duplicated) and liability arises from the borrowed amount. At the maturity of the repo, the borrower gets the securities back if he returns the cash plus interest. Another use of repo is as an asset disposal. Financial institution first sells a security for a price and then buys similar security and gets the returns on the cash invested during that period. However, this transaction is little bit problematic since the security can be sold at a discounted price (if nobody wants those assets or market is not liquid) and there is no guarantee that the security will be repurchased for the favorable price. On the other hand, financial institution may, by this method, raise capital which can be used to reduce its leverage. Simona Tothova 4 Essay “Repo 105”and 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 company’s 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. “Ernst & Young” position The last point of this essay is Ernst & Young position in this case. There is a lot of discussion on the role of Ernst & Young and its knowledge about the “Repo 105” transactions in Lehman Brothers. During the court process the company’s officers stated firstly that: “Ernst & Young did not approve the Accounting Policy” it rather “became comfortable with the Policy for purposes of auditing financial statements “. Secondly, they stipulates that they obey the principles laid down by America’s Financial Accounting Standards Board and one of the rules, FAS 140, allowed to certify Repo 105 the way it did.