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.


  1. What is fraud?

    It seems to me that the legal definition of fraud is by nature complex and detail driven.  It could take 1000's of hours of legal education and case-by-case scrutiny to arrive at a specific legal outcome.

    But it seems to me that the fraudelence of an action is not dependant on the legal outcome, or even on the laws of the country in question.

    Here is my simpler definition of fraud:
    Any action taken with the purpose of misleading investors, the gov't, or customers (whether or not its technically illegal) is fraud.

    ...I have more to say, but no time right now.  I'll add a comment later.

  2. If you don't mind me jumping in before you respond...

    I completely disagree with your defintion of fraud. At least when it comes to punishing people under a court of law.

    Citizens and businesses need a well-defined, precise, defintion that they can live by. If the law is incorrect, it should be changed (but people should not be punished retroactively) but until then, I wouldn't consider it a crime.

    I think your defintion captures ethics more than law (yes I realize many equate the two and in an ideal world, the two should be the same.) It's highly unethical to mislead investors yet it may fall within the law.

    So-called "window dressing" appears to be legal but highly unethical. CEOs stacking the compensation comittee with their allies and paying themselves huge sums is unethical but appears to be legal. And so on.

    In the case of Lehman Brothers executives, they really shouldn't have used repo 105 (and who knows what other techinques that haven't come to light) but I wouldn't throw them in jail for that--especially when a law firm and an accounting firm say it is ok under British law (I am assuming it is not a mistake and that those two are correct with their opinion.)

    On top of all this, I think we should consider the notion of someone or some company doing something with the knowledge of their actions versus that aren't aware. Under common law in nearly all countries, ignorance of the law is not going to let you off the hook; but, I do think it makes a big difference if something was done maliciously with full knowledge or not.

  3. I defend the Lehman executives not because they are more vituous than others on Wall Street. Instead, it's partly because, I suspect, they are no different than many others on the Street. Punishing one party that was caught while others are left alone is totally unfair. For me, fairness is an important element of justice. If the US government is going to go after Lehman executives, they should dig through all the other investment and commercial banks too. I have no proof but I suspect other firms are engaged in similar behaviour.

  4. This is a huge and complex issue, so I'll touch on a few opinions of mine, without going in depth on any of them.

    I agree that I'm defining fraud in terms of ethics and not law.  It would take a lawyer to have a informed opinion on the legal issues in a complex case like this, so I have no real opinion on the legality here.

    Here is a question.  What is the purpose of a law against fraud?  It seems to me that the reason we have laws against fraud is to prevent and punish unethical and deceitful actions designed to take other's wealth.  So if the law is operating correctly, then unethical actions such as those at Enron (I'm not as certain on Lehman) should be punished.

    By the way, this goes for all abusers, not just those that are singled out by the political environment.
    Like you, I would bet that the same kinds of things would be found at other major financial institutions.

    There are also some things that I consider grey-areas - things that are borderline fraud.  For instance, I have noticed that many brokerages lure people in by reporting long term market returns in terms of the annual arithmetic mean, when the geometric mean is the accurate measurement.  For instance, suppose that over 5 years the market returns +19%, +19%, +19%, +19%, -50%.  The broker would report an average annual return of +5%, when the actual (geometric) return over the entire 5 years is +0%.

    This is an unethical activity designed to mislead people about market rewards and convince people to invest their money.  This is just a minor example, but I would love to see these institutions held accountable for these kinds of activities.

  5. I agree with you completely on one thing, which is that people are way too quick to both villianize a politically vulnerable target, and to assume that their knowledge is greater than it really is.

    As an example of this, I had a friend who watched a documentary about Enron, and came to me fired up and complaining about how Enron used 'Mark-to-market' and how 'Mark-to-market' should be banned!  It took me about 10 minutes to explain what mark-to-market is, and how ludicrous the idea of banning it was...

    This friend is a very smart person with similar political views to mine, but with little financial background.  Presented with an easy target, and a little data, they came to an absurd conclusion.  I'm guessing that a high number of likewise intelligent people would have come to the same absurd conclusion.  This is essentially an error in confidence - people assuming they have enough data to judge on a matter that they don't really understand.  That is what we have to guard against.

  6. If this is not a crime, then perhaps it should be:

  7. I am a student studying for a MBA. My legal professor is of the opinion that Lehman should burn. She wants us to write a legal paper pointing out 2 legal issues and 1 ethical issue. The ethical issue is easy but I am finding it to be a close to impossible task to find 1 strickly this is the law they broke legal issue.  I never agreed with the treatment of Lehman and to do this assignment is against my sense of justice but I need the grade so...Where can I find more information on possible laws that Lehman broke?

  8. Sivaram VelauthapillaiNovember 19, 2010 at 10:52 AM

    Just some ideas off the top of my head...

    (i) You may want to look into repo 105 transactions and see if they are indeed legal. I think they are but I'm not a lawyer, and you may find that Lehman didn't carry out the transaction properly.

    (ii) Look to see what David Einhorn, the short-seller who was critical of Lehman Brothers, said during that period (say 1Q08 to 4Q08). He was skeptical of Lehman's reported numbers and you may want to see if Lehman misled investors. You may want to look to see if the way Lehman booked earnings during that chaotic period was legal.

    Hope that helps.


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