Opinion: In defense of Lehman Brothers

I don't like witch hunts—especially when one can't tell who the witch is, or even if they exist. Even worse is when you kill a human while witches are all around you.

Such is the case with Lehman Brothers.

Some may find this article a bit surprising and out of character for me. I'll state my position up front and say that I don't think the executives of Lehman Brothers have committed crimes anywhere near the degree that the mainstream media and the masses believe. It looks like very few share my view, other than Charlie Gasparino of all people (yikes, when Charlie and I are on similar pages, the world is probably coming to an end ;) ) Some of the blogs I read appear to believe they have found the witches who nearly caused the financial system in America to collapse, but I believe they are grossly mistaken.


The clueless masses are calling for the execution of someone—anyone!—and whoever is associated with Lehman Brothers seems like an easy target. Although I am critical of the Street at times, especially for their greed, I don't think the firms and their employes are as criminal as many claim. I certainly feel this way about Lehman Brothers. I have defended the company in the past—admittedly I was wrong about their financial condition—and I still have the feeling that they were not a total fraud like many claim. I also hate to see someone who has fallen being kicked and that's kind of what is happening.

As many of you are probably aware, the examiner hired by the Lehman Brothers Trustee released a report suggesting potential foul play and opening the door to lawsuits. Let's recap what the situation. I am neither a legal expert nor understand banking and finance so I'll be extensively quoting various sources below.



Examiner's Speculations

MarketWatch has a good, quick, summary of the Examiner's controversial conclusions:

In a 2,200-page report, examiner Anton Valukas said that while Lehman's directors at the time of the collapse weren't necessarily responsible, some of its top executive management might be held liable, according to reports of the findings.

...

Valukas mentioned ex-Chief Executive Dick Fuld and chief financial officers Chris O'Meara, Erin Callan and Ian Lowitt as possibly facing claims for negligence or breach of duty.


The report cited a practice known internally as "Repo 105," in which Lehman allegedly used repurchase agreements -- the temporary exchange of assets for cash -- that were structured as sales so that the leverage could be moved off the firm's balance sheet. See story on Lehman's accounting "drug" Repo 105.

As a result, the report says, Lehman may have already been insolvent on Sept. 2, 2008, almost two weeks before its Sept. 15 bankruptcy filing rocked the financial world and helped send the stock market into a nosedive.

"In this way, unbeknownst to the investing public, rating agencies, government regulators, and Lehman's board of directors, Lehman reverse engineered the firm's net leverage ratio for public consumption," the report said.

...

The Valukas report also said evidence exists to support a professional malpractice claim against Lehman auditor Ernst & Young, as the firm "took no steps to question or challenge the non-disclosure by Lehman of its use of $50 billion of temporary, off-balance sheet transactions," according to the Journal.

...

Valukas also suggested claims might be possible against some Lehman's competitors, including J.P. Morgan Chase & Co. and Citigroup Inc., particularly for demands of about $16 billion in collateral as Lehman began to fall apart.

The Examiner speculates on three key items:

1. Lehman Brothers senior executives may be liable but not the Board of Directors. The speculation here is that the 'repo 105' method that was used by Lehman Brothers was misleading.
2. Ernst & Young, Lehman's auditor, may be liable for not questioning some non-disclosure by Lehman Brothers
3. Damages against Citigroup and JP Morgan may succeed when these companies demanded collateral

I'm not a legal expert but the way I'm seeing this, I think we need to keep a few things in mind. First of all, the examiner, whose background appears to be as a government attorney, is probably someone who lives in a theoretical world where everyone follows the rules exactly, to the point. The reality is anything but. I have no proof but it wouldn't surprise me if more than half the major financial institutions were doing something that this examiner would find borderline criminal. Secondly, and most importantly, the examiner is attempting to come up with methods of recovering money for Lehman Brothers creditors. Throwing a million ideas out there and attempting to sue anyone and everyone is generally the strategy of lawyers everywhere.
 
Repo 105 — Doesn't Look So Criminal to Me
 
The main thrust of the accusations against Lehman senior management and the auditor appears to center on the use of the repo 105 transactions to window-dress the balance sheet. I'm not too knowledgeable about accounting but it appears to involve a very-short-term transaction to transfer liabilities and assets off the balance sheet in order to lower the leverage. Lehman Brothers would apparently pledge assets and get cash back as a loan. This would lower the leverage for a few days; but after a few days Lehman would pay back the loan and get back its assets (leverage would go up after this.)
 
Moving transactions off the balance sheet is always questionable but I don't get the feeling that this is as sinister as it seems. Lehman was pledging 105% of the cash (loan) it was receiving so it isn't as dubious as the Enron scheme (or various other schemes of yesteryear.) Lehman Brothers was dealing non-affiliated entities (unlike Enron and various other fraud cases in the past) and also paid back the loan with interest so this is definitely an economic transaction. From my layman view, it looks like a typical repo loan.
 
However, Lehman booked this transactions as a "sale," which clearly distorted the true nature of the financial state. Was the "sale" transaction illegal? The skeptics, bears, not to mention short-sellers and others, clearly think it is. But I'm not so sure.
 
Not as Illegal as it Seems
 
The repo 105 situation is more complicated than it seems because it was carried out, not by the US division, but the British subsidiary. Lehman Brothers did this because it wasn't a common practice in USA (it might not even be legal; no law firm was willing to support it) but its legal counsel in Britain said the deal was fine.
 
Lehman's law firm in Britain, Linklaters, appears to have said that the repo 105 transaction is legal and a "sale" under British law:
 

The firm explicitly said: “This opinion is limited to English law as applied by the English courts and is given on the basis that it will be governed by and construed in accordance with English law.”

Otherwise, Linklaters provided Lehman with exactly what it wanted to hear. The law firm decreed in its briefs, at least as outlined in the 2006 iteration obtained by Mr. Valukas, that intent matters. If two parties intend to exchange assets for cash, and then later the party receiving the assets decides to hand back “equivalent assets (such as securities of the same series and nominal value) rather than the very assets that were originally delivered,” that amounts to a sale.

 
There is a possibility that Linklaters is wrong or was doing something illegal but I don't suspect it is. If we assume that the repo 105 transaction was legal under British law, and if Lehman's British division was the one carrying out those transactions, I am not sure how liable the US company and its executives are. I don't know anything about the legal system and am not sure how the US courts look at situations like this but it'll be interesting to see what happens.
 
The government may still charge the executives and maybe even Linklaters, the British legal firm, but it isn't as clear-cut as it seems. There may also be political pressure for the SEC and the DOJ to charge anyone just because of their failure of late but I'm not sure how easy this case will be for them. As this excellent NYT DealBook article suggests, the government has several choices. If the government charges the CEO and CFOs (there were 3 of them during the period,) I hope they do it because the intent was malicious and not because they are on a fishing expedition. One of their recent fishing expeditions—one of the first cases from the financial crises—involving charges against two managers of Bear Stearns real-estate hedge funds went nowhere (court acquitted the accused.)
 
Can the Trustee (and others) Sue Ernst & Young?
 
The examiner's suggestion that Ernst & Young is somehow liable also seems fishy to me. Like I said, the legal opinion (on the repo 105 as a sale) was given by a British firm and if that transaction is actually legal in Britain, I'm not really sure what Ernst & Young has to do with that. The examiner is suggesting that the auditor ignored the non-disclosure but is that a big deal?
 
I have to double-check this (anyone know?) but I don't think quarterly statements in USA are audited (only annual statements.) So Ernst & Young's last audited statements were almost an year before the collapse and even if Ernst & Young were liable, damages seem limited. Unless, of course, someone accuses them of wrong-doing all the way back to 2001, when repo 105 seems to have been initiated (not sure if Ernst & Young was the auditor during the whole time.)
 
Lawsuit Against Citigroup & JP Morgan
 
Finally, we have a real stretch in attempting to recoup money from Citigroup and JP Morgan. The Financial Post says:
 

JPMorgan Chase & Co. and Citigroup Inc. helped cause the illiquidity that led to the collapse of Lehman Brothers Holding Inc., the bankrupt bank's examiner said yesterday in a report filed in Manhattan federal court. Lehman tumbled into its US$639-billion bankruptcy, the biggest in U.S. history, because it didn't have enough liquidity and lost the confidence of its counterparties, according to a 2,200-page report from Anton Valukas, the U.S. Trustee-appointed examiner. "The examiner has determined that there are a limited number of colourable claims for avoidance actions against JPMorgan and Citibank," Mr. Valukas said in the report. Mr. Valukas defined a colourable claim in the report as sufficient credible evidence to persuade a jury to award damages at trial.

Seems like a bizarre suggestion but obviously the examiner believes that money could be recouped from JP Morgan and Citigroup (I'm not sure why several other European banks apparently doing the same thing were left out.) Citigroup and JP Morgan, as creditors of the repo 105s, acted in their own interest. It seems kind of ludicrous to expect them to act in the interest of Lehman Brothers.

Clutching at Straws

It looks to me like the examiner, acting on behalf of the trustee, is reaching for ways to sue anyone involved in the Lehman saga. Some of the speculations seem bizarre but it remains to be seen what comes of any of this. The masses are looking for a scapegoat and the failed government agencies are probably looking to round up anyone they could get their hands on.

The problem with situations like this is that what the public perceives as reality is often nowhere near the truth. If you want to see how uncertain everything is, consider what I am about to say about Enron.


Enron - Not Quite What You Thought

It is pretty much a given that everyone out there, let alone investors and those interested in business, pretty much know that massive fraud was committed at Enron. Books have been written; documentaries have been made; and courses are taught as schools purporting to show fraud on a massive scale.

What if someone came along and said that the illegal activities at Enron wasn't as bad as it is widely believed? Well, some of you are going to lose respect for me, and probably delete this blog from your bookmark ;), but that's actually my belief.

There was clearly illegal actions that occurred at Enron—I'm not talking about the post-arrest issues such shredding evidence but, rather, the dubious off-balance-sheet transactions involving those barges—but how sinister were those transactions that apparently brought down Enron?

Arthur Andersen Case Overturned

Well, before I present a radical view (it's actually not my view but I'm influenced by it,) do note a very important outcome that points towards my stance: the US Supreme Court reversed the (conviction) judgement against Arthur Andersen, Enron's accounting firm. Arthur Andersen collapsed and was bought out by IBM—Supreme Court decision happened years later—but that never should have happened. It's truly unfortunate that Arthur Andersen was dismantled.

Now, just to be clear, I believe Aruthur Andersen committed illegal acts. They were clearly instrumental in helping Enron carry out the dodgy accounting strategies. However, the severity of the crime was totally blown out of proportion. My point is about the severity of the crime, not the crime itself.

Life Is Always Murkier Than It Seems

Long-time readers of this blog may know that I'm a fan of American author, Malcolm Gladwell. He is a best-selling author who always seems surrounded by (minor) controversies. Many don't agree with his views and some even claim he can't back up his arguments with facts. Since he writes about social science issues, particularly to do with human behaviour, the disagreements and attacks shouldn't be surprising to anyone. You just can't prove anything to absolute certainty. Some of the criticism also appears to be based on jealousy more than anything.

I like his writing because, Gladwell thinks outside the box and isn't shy about tackling controversial topics. A lot of scientific or fact-minded people often criticize essays that are not precise and backed 100% with facts but I am not in that camp. I am of the opinion that liberal arts writers should be given some lee-way to challenge conventional thinking.

For a guy who claims he is a fan of Gladwell, I have to say that I haven't read any of his books—yet. But I have certainly read most, if not all, of his New Yorker essays in the last 5 to 10 years, as well as a few other odd pieces, speeches, and the like. One of the best essays by Malcolm Gladwell was his "In the Air" piece I highlighted last year. But there is another essay which I don't believe I mentioned before. It has to do with Enron.

In another one of his controversial essays, "Enron, intelligence, and the perils of too much information," Gladwell implies that the crimes committed by Enron executives aren't as sinister as the popular press would have you believe.

When Weil had finished his reporting, he called Enron for comment. "They had their chief accounting officer and six or seven people fly up to Dallas," Weil says. They met in a conference room at the Journal's offices. The Enron officials acknowledged that the money they said they earned was virtually all money that they hoped to earn. Weil and the Enron officials then had a long conversation about how certain Enron was about its estimates of future earnings. "They were telling me how brilliant the people who put together their mathematical models were," Weil says. "These were M.I.T. Ph.D.s. I said, 'Were your mathematical models last year telling you that the California electricity markets would be going berserk this year? No? Why not?' They said, 'Well, this is one of those crazy events.' It was late September, 2000, so I said, 'Who do you think is going to win? Bush or Gore?' They said, 'We don't know.' I said, 'Don't you think it will make a difference to the market whether you have an environmentalist Democrat in the White House or a Texas oil man?" It was all very civil. "There was no dispute about the numbers," Weil went on. "There was only a difference in how you should interpret them."


Of all the moments in the Enron unravelling, this meeting is surely the strangest. The prosecutor in the Enron case told the jury to send Jeffrey Skilling to prison because Enron had hidden the truth: You're "entitled to be told what the financial condition of the company is," the prosecutor had said. But what truth was Enron hiding here? Everything Weil learned for his Enron exposé came from Enron, and when he wanted to confirm his numbers the company's executives got on a plane and sat down with him in a conference room in Dallas.

If you never read this essay and thought you knew all there is to know about Enron, read it and see if it changes your opinion. Just like how Arthur Andersen was perceived to have committed a company-destroying crime, the executives of Enron was convicted of crimes way beyond what actually happened. I'm not arguing that Enron executives should not have been charged; my point is that the punishment and charges were totally out of line with what happened.

What happened to the Enron executives was a miscarriage of justice. They should still have been charged and spend some time in jail but, as a layperson sitting on the sidelines, 24 years in jail seems excessive for the use of (mostly) publicly disclosed accounting techniques. I believe the main reason for the harsh punishment was simply due to public sentiment.

What is happening with Lehman Brothers appears to be similar to the Enron situation. Lehman Brothers went bankrupt so the masses, who believe the bankruptcy was the root of all evil while conveniently ignoring how many other firms were kept alive with huge taxpayer bailouts (companies ranging from Morgan Stanley, Goldman Sacs, GE, Wells Fargo, Citigroup, and AIG would have gone bankrupt as well and done even more damage,) appear to hold that view.


If the Department of Justice is going to charge Lehman Brothers for manipulating its balance sheet using repo 105 (so far no indication of what is going on behind the scenes) then all the other firms using misleading accounting should be charged too. I mean, some say almost all the mutual fund companies window dress their performance at the end of each quarter. Why not charge the whole Street? Otherwise, what is unraveling here appears to be unjust!

There is one other thing to note. The public tends to believe that executives know every single detail of their company but that is never the case. This is especially true for large companies. Even Warren Buffett, who is very virtuous and knows quite a bit about his companies, was embroiled in the AIG fraud, which was facilitated by a Berkshire Hathaway subsidiary, Gen Re.