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BY JOE TYRRELL
NEWJERSEYNEWSROOM.COM
As their bad business decisions were pushing it toward collapse, top executives of failed investment bank Lehman Brothers Holdings Inc. repeatedly lied to investors and withheld information from their own board, according to a bankruptcy examiner.
Lehman's auditor, accounting giant Ernst & Young, was aware of the executives' manipulation of balance sheets, but chose to shield them from an internal inquiry, according to the report from court-appointed examiner Anton R. Valukas of the law firm Jenner & Block.
The corporate executives "who oversaw and certified misleading financial statements – Lehman's CEO Richard S. Fuld Jr., and its CFOs Christopher O'Meara, Erin Callan and Ian T. Lowitt," have left themselves open to legal claims, Valukas said.
He also found that "colorable" – that is, actionable – "claims exist that Ernst & Young did not meet professional standards."Following the Wall Street herd, Lehman plunged heavily into risky investments in recent years. As the housing bubble burst and the economy slumped in 2007-8, Lehman executives searched for a way to improve their bottom line. But they were stuck with overpriced assets whose market value was dropping.
So just before the end of the second quarter of 2008, Lehman management privately removed $50 billion in illiquid assets from the books, according to Valukas. The temporary move made it appear that instead of being further overextended in heavily leveraged, non-performing deals, the company was getting stronger.
Temporary sales and repurchases of assets, repossessions, are not unusual, Valukas said. But citing internal e-mails, he found Lehman's used the maneuver "for no articulated business purpose except 'to reduce the balance sheet at the quarter-end.' "
Lehman still reported an unprecedented $2.8 billion loss for the second quarter of 2008. Management "sought to cushion the bad news by trumpeting that it had significantly reduced its net leverage ratio to less than 12.5 percent, that it had reduced the next assets on its balance sheet by $60 billion, and that it had a strong and robust liquidity pool," Valukas wrote.
But even employees described "Repo 105," their name for the temporary removal of $50 billion of the $60 billion, as "an accounting gimmick" and the "lazy way" to improve the balance sheet without actually selling underperforming assets, the examiner said.
"Lehman did not disclose its use – or the magnitude of its use – of Repo 105 to the government, to the rating agencies, to its investors, or even to its Board of Directors," Valukas wrote. "Ernst & Young were aware but did not question Lehman's use and nondisclosure."
Even the post-bankruptcy sale of Lehman Brothers assets to UK-based Barclays Capital Inc. raised red flags for the examiner. But some were handled properly, he concluded a "limited amount... were improperly transferred to Barclays."
But the examiner did absolve Fuld and his team for their poor business judgment. He even found that although they withheld details of the $50 billion move from the board, they adequately informed the corporate directors about their high-risk strategy.
The examiner noted that not everyone at Lehman was caught up in the rush to high-risk, low-reward investings. Fuld removed some executives because of their opposition to management's growing accumulation of risky and illiquid investments," Valukas said.
At least one manager sounded the alarm about the $50 billion sleight-of-hand, according to the report. In May 3008, Matthew Lee, a senior vice president, complained to the board about irregularities. On June 12, he called Ernst & Young's attention to the $50 billion shift, Valukas said.
"The next day – on June 13, 2008 – Ernst & Young met with the Lehman Board Audit Committee but did not advise it about Lee's assertions, despite an express direction" to tell the committee everything, Valukas said.
Instead, the auditors "took virtually no action," and "no steps to question or challenge the non-disclosure" by the Lehman executives, the examiner said. "Colorable claims exist that Ernst & Young did not meet professional standards," he said.
While bungling and deception exacerbated Lehman's problems, an underlying cause of its failure was the culture of Wall Street, according to the report. The company's highly leverage business model "was not unique," Valukas said.
Lehman management were such enthusiastic high fliers that they "even intensified this high-risk strategy after the onset of the subprime residential mortgage crisis intensified in late 2006," the report said.
To generate greater revenues from the housing market, many lenders pushed borrowers into pricey "subprime" mortgages, relaxing eligibility standards for loans whose initial low interest rates were structure to balloon quickly.
Enticed by the prospects of higher fees, lenders even diverted some customers who qualified for standard loans into subprime loans. The banks expectation was that when borrowers failed to make payments, they could foreclose on them and resell the properties.
But as foreclosures became widespread in California and other formerly booming markets, the glut of available homes contributed to a decline in housing values, in turn sapping the portfolios of the banks themselves.
As other companies started to pull back, though, Lehman decided to "double down" on its risks, according to Valukas. Between December 2006 and June 2007, "Lehman participated in more than 11 leveraged buyout deals that each exceeded $5 billion," Valukas said.
As "Fuld later admitted, Lehman underestimated both the severity of the subprime crisis and the extent of the contagion to Lehman's other business lines," Valukas said.
On this issue, though, Valukas found that Fuld and the other top executives simply showed poor business judgment. Lehman Brothers Holding Inc. was incorporated in Delaware, where laws create "a high bar" to claims of a breach of fiduciary duty, the examiner said.
The report contains other bad news for investors wondering about the reliability of corporate governance.
Although management occasionally ignored Lehman's internal risk limits and stress tests to pursue risky investments, the rules "did not impose legal requirements on management or prevent management and the Board from exceeding those limits if they chose to do so," Valukas said.
While withholding Repo 105 details from the directors, the management team "did inform the Board, clearly and on more than one occasion, that it was taking increased business risk in order to grow the firm aggressively," Valukas noted.
Fuld and associates also told the directors "that market conditions after July 2007 were hampering the firms' liquidity," the report said. While a more alert group might have pressed for information, the directors "fully embraced" the riskier approach, according to the examiner.
Valukas cites an internal e-mail from a Lehman executive following a talk with board President Joseph Gregory before the March 20, 2007 board meeting.
"Board is not sophisticated around subprime market – Joe doesn't want too much detail," wrote Lana Frank Harber, chief administrative officer for the company's mortgage division.
While Gregory wanted to "candidly talk about the risks," he also wanted to be "optimistic and constructive," focusing on opportunities, Harber wrote.
During the period from November 2006 to August 2007, Lehman's illiquid holdings grew three times faster than its most secure ones, according to Valukas. This shift in the firm's equity position was the "dominant cause" of the firm's rapid decline, he said.
Although the directors apparently were unaware of the company's actual condition, they "did not breach their duty to monitor Lehman's risks," Valukas concluded.
Joe Tyrrell may be reached at This e-mail address is being protected from spambots. You need JavaScript enabled to view it
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