CASE

ANALYSIS
(LEHMAN
BROTHERS)

Prepared by:

de la Cruz, Michaela Kowalski C.

Baldevia, Mary Ruth N.
Garcelaso, Lecil E.
(INFOACT 3:00 – 4:00 MWF)
 August 10, 2019
I. Company Background
The establishment of Lehman Brothers dates back to the 19th century. A
German immigrant named Henry Lehman established a small shop trading in
general merchandise including the sale and purchase of groceries, dry goods and
utensils. Upon the inclusion of Henry’s two brothers, Emmanuel Lehman and Mayer
Lehman in the business in 1850, it was renamed Lehman Brothers. The firm entered
into commodities brokerage by trading in cotton in the same year. Lehman Brothers
progressed and made significant strides in the securities market in the 19th century.
For instance, the Firm was mandated as Alabama government’s fiscal agent to assist
in the sale of the State’s bonds in 1867. Lehman Brothers played a key role in the
formation of commodities exchanges such as New York Cotton Exchange in 1870
and later the Coffee Exchange and Petroleum Exchange. It was also engaged to
service Alabama State’s debt, interest payments as well as other obligations. In
1887, the Firm changed its business line from commodities to merchant banking
upon becoming member of the New York Stock Exchange.
The Firm’s idea of supporting retail businesses became eminent in the early 20th
century. This was evidenced in the formation of an alliance with Goldman Sachs to
finance the emerging retail sector. It resulted in the joint underwriting of retail
businesses such Sears, Roebuck & Co., Woolworth Co., May Department store,
Gimbel Brother Inc., and R.H Macy & Co. by the two firms. The Firm also chalked
significant milestones in the areas of entertainment, communications, oil and gas
exploration and production, electronic and computer technology between the 1920s
and 1950s. Notable amongst them are financing of Paramount Pictures, 20th
Century Fox, Murphy Oil, Radio Corporation of America, as well as underwriting of
the first public offering of Digital Equipment Corporations.
Lehman Brothers was instrumental in the provision of innovative methods of
financing during the Great Depression in 1929 when the stock market crashed. Due
to the depreciation, capital raising on the stock market became practically
impossible. Consequently, Lehman Brothers introduced private placement as a new
method of raising capital from private individuals and companies.
Lehman Brothers embarked on a massive expansion programme by opening
offices in Europe and Asia in the 1960s and 1970s. In 1977, it merged with Kuhn,
Loeb & Co, a renowned investment banking firm located in New York which was
facing a capital crisis. The firm then became known as Kuhn Loeb Lehman Brothers
Inc., and at the time was the fourth largest investment bank. However, the business
romance was short-lived due to internal wrangling, resulting in its acquisition by
Shearson/America Express in 1984 for US$360 million. This merger resulted in the
creation of Shearson Lehman/America Express.
In 1988, the world witnessed another historical merger when E.F Hutton & Co.
agreed to merge with Shearson Lehman/America Express in a US$1 billion deal at
the time, to form Shearson Lehman Hutton Inc. The merger failed to achieve its
 expected objectives due to amongst other things high labor turnover at Hutton.
Consequently, the Hutton brand was abandoned and the business was renamed
Shearson Lehman Brothers in 1990. American Express began to break away from
banking and brokerage operations and consequently sold Shearson’s retail
brokerage and asset management business to Primerica. The remaining investment
banking and institutional businesses then became Lehman Brothers Holdings Inc.,
(LBHI), and it had its Initial Public Offer (IPO) in 1994.
LBHI witnessed steadily increased revenues and tremendous increase in human
resource base from 8,500 to 28,000 during the period after the IPO in 1994. For
three consecutive years (2000 – 2002), the Firm recorded a net income of US$1
billion. In order to boost its asset management business, the Company acquired
Neuberger Berman Inc. for a transaction value US$3.2 billion in 2003. In 2007, the
Firm also became the largest underwriter of mortgage backed securities

II. Fraud/Case Involved

The collapse of Lehman Brothers was not the result of a single lapse in ethical
judgment committed by one misguided employee. It would have been nearly
impossible for an isolated incident to bring the Wall Street giant to its knees,
especially after it successfully withstood so many historical trials.
Instead its demise was the cumulative effect of a number of missteps perpetrated
by several individuals and parties. These offenses can be categorized into three
acts: Lies told by Chief Executive Officer Richard Fuld; concealment endorsed by
Chief Financial Officer Erin Callan; and negligence on behalf of Ernst & Young.

1. Lies told by CEO Richard Fuld

When the housing marketing began faltering in 2007, Fuld was entrenched in a
highly aggressive and leveraged business model, not unlike many other Wall Street
players at the time. Unlike the competitors, a few of whom had the foresight to
identify the pending collapse and evaluate possible consequences of mortgage
defaults, Fuld did not rethink his strategy. Instead he proceeded into mortgage-
backed security investments, continuously increasing Lehman Brothers’ asset
portfolio to one of unreasonably high risk given market conditions. In short, he was
obstinate, but when the time came to recognize his error, he did not assume
responsibility or admit wrongdoing. Fuld had an opportunity in 2007 to voice
concerns about his bank’s short-term financial health and its heavy involvement in
risky loans, and he squandered it in favor of communicating to investors and Wall
Street that no foreseeable concerns existed. Had he been truthful, more competitive
solutions — along with the benefit of time — would have been available, likely
helping prevent or minimize the financial hemorrhage that loomed on the horizon.
For example, commercial banks, such as Barclays and Bank of America, which were
approached for a snap acquisition decision, would have had more time to evaluate
whether the move would complement their long-term strategies. They also would
have had more time and opportunity to resuscitate Lehman Brothers than they did a
few quarters down the road.
 Additionally, while the immediate effects of admitting a shaky outlook would have
been negative, two repercussions must be considered. First, large capital investors
would have been appreciative of the transparency, and after getting past the initial
shock, they would have taken action to get the bank back on track. Second, had the
general public — including the federal government — been aware of the situation
and the actionable measures being taken to rectify it, more intellectual and financial
aid would have been available to minimize losses and potentially avoid total collapse.
This was not the case, however, and by choosing to paint an unrealistically optimistic
picture of Lehman Brothers’ financial situation, Fuld forfeited the opportunity to take
advantage of various solutions that would have cut the company’s losses. Had he
acted more prudently, Lehman Brothers’ story may have ended differently.

2. Concealment endorsed by Chief Financial Officer Erin Callan

The second ethical lapse, which was perhaps the most premeditated and
fundamentally wrong, was Callan’s approval of siphoning assets away from Lehman
Brothers accounts and into Hudson Castle, the phantom subsidiary created for the
benefit of its parent company’s balance sheet. This blatant misrepresentation of
financial health, perpetrated through the employment of Repo 105, was an attempt to
grossly manipulate the bank’s many stakeholders and also clearly indicative of a
much bigger problem. Even more telling is the fact that this technique was used in
two consecutive quarters.
Various documents examining the collapse of Lehman Brothers, including
congressional testimonies and investigative reports, confirm that the purpose of
Repo 105 was not to diminish earnings for tax benefits or similar effects. Instead,
moving assets away from the balance sheet was intended to create the illusion of a
company that was stable and secure. Had Lehman Brothers’ executive team been
capable of managing the issue, this tactic would have been a temporary stay until
reorganizational measures were taken and accurate statement releases could be
resumed. Instead, for six consecutive months, the bank’s leverage was so
dangerously high that it had no choice but to intentionally mislead its shareholders if
it hoped to maintain any semblance of confidence in its operation. As with Fuld’s
decision to lie about the company’s state of affairs, Lehman Brothers would have
been better served by fully and accurately disclosing the details of its finances. With
the benefit of credibility and time to strategize, the likelihood of receiving much-
needed aid would have been far greater.

3. Negligence on behalf of Ernst & Young

Ernst & Young, the only third party privy to the happenings at Lehman Brothers,
failed to reveal the extensive steps taken by executive leadership to conceal financial
problems. As a firm of certified public accountants expected to honor and uphold an
industry-wide code of ethics, Ernst & Young may be accused of being responsible for
gross negligence and lack of corporate responsibility. Why would such a highly
respected organization risk its own reputation and turn a blind eye on behavior that is
clearly unethical? Obviously Lehman Brothers was a sizeable (and presumably
lucrative) client of the firm. But past scandals involving questionable accounting
observances, such as Enron, have demonstrated firsthand that inaction is as equally
 reprehensible as direct involvement in the scheme itself. More than just a paycheck
was at risk, and failure to act successfully discredited Ernst & Young on the basis of
ethical and industry standards.
As an accounting firm, Ernst & Young is charged with certifying that companies
deliver accurate and reliable information to shareholders. In this regard, Ernst &
Young failed completely, as executives were aware of behind-the-scenes
bookkeeping and the extent to which it was occurring. In this situation, concern for
ethical behavior was of minimal or nonexistent concern. Therefore, the company’s
shareholders were deliberately deceived for the purpose of preserving a paycheck,
and in that regard, the team of accountants who chose not to act disappointed more
than just their company; they let down the entire industry and each of the right-
minded professionals within it.

III. Analysis and Conclusion

The failure of Lehman Brothers had devastating effects on the international
banking system and the financial system at large. Huge sums of funds were lost by
companies and individuals as a result of their investments in Lehman Brothers and
their related businesses. While the event eroded investor confidence, well noted,
internationally acclaimed stock markets were adversely affected across the globe.
Top executives of Lehman Brothers at the time were partly blamed for the fate of the
Company due to decisions taken. Analysis of the events leading to the collapse of
the firm and post-bankruptcy exposed weaknesses in the risk management
implementation strategies of the Firm, and the accounting standard guiding the
accounting treatments of repurchase agreement transactions. It also revealed the
weaknesses in the monitoring and supervision of regulatory bodies as like investors
could not foresee this tragedy coming. Regulatory bodies displayed a lack of
capacity in effectively auditing the financial statements of Lehman Brothers.
Furthermore, the legal framework for rescuing companies in financial distress such
as Lehman Brothers was not available. The bankruptcy of Lehman Brothers also
brought into question the analytical capabilities of those hedge funds that invested
heavily in Lehman Brothers.
Lessons abound in Lehman Brothers’ collapse. The first lesson is that a small
bubble can bust just as a big one can, and to be “financially scientific”, a big ball and
a small ball will reach the ground at the same time when dropped at the same time in
a space. This is because mass has no effect on the acceleration of an object in a
free fall in a space. Big companies have the potential to fail just like small companies
if the right structures are not put in place and implemented. Secondly, the negative
effects of a failed big firm are many folds of that of a failed small firm. Thirdly, relying
wholly on an audited accounts of a company in taking investment decisions could be
very suicidal. The collapse of Lehman Brothers and the financial turmoil in 2008 at
large, exposed serious weaknesses. Risks inherent in certain banking activities such
as securitizations, trading and exposure to off-balance sheet were completely
ignored.
The story of Lehman Brothers’ demise is unfortunate, and not just because its
collapse meant the end of a Wall Street institution (Wall Street is the financial center
in the United States). The real tragedy lies in the lack of ethical behavior of its
executives and professional advisors. They made conscious decisions to deceive
and manipulate, and the consequences proved too dire to preserve the
historic investment bank’s existence. The perennial lesson of the Lehman Brothers
case is that no matter how dire the circumstances may appear, transparency and
accountability are paramount. Right action up front may sting initially, but as history
has repeatedly shown, gross unethical business practices rarely endure in the long
term. A global financial crisis such as that of 2008 may not be prevented from
happening again. What can be improved, in large measure through ethics education,
is how corporations behave. Wall Street should take note of the case of Lehman
Brothers to ensure history does not find a way to repeat itself