In a pattern that would be amusing if it was not so disturbing, we are again witnessing the spectacle of lawyers for a disgraced CEO who claim that their client was “unaware” of key risks that led to the downfall of their firm. The Lehman Brothers bankruptcy examiners report has been widely covered in the business media over the past few days and, at a minimum, paints a picture of shocking incompetence and an intent to mislead among Lehman’s senior management team. It is the type of scenario in which a former CEO’s only defense appears to rest on claims that he was incompetent rather than criminally negligent.
Repo 105 Transactions
The Wall Street Journal reports that Lehman management routinely engaged in “Repo 105” transactions in an attempt to dress up the balance sheet prior to the end of financial reporting periods. In a normal repurchase agreement, a borrower uses a financial security as collateral for a cash loan. The agreement generally involves the sale of the collateral combined with a commitment to repurchase the same security at a point in the future at a higher price. In a “Repo 105” transaction, Lehman was able to book the transaction as if it was an outright sale rather than an ordinary repo transaction because the assets the firm moved were worth 105% or more of the cash it received in return.
Through this accounting maneuver, Lehman was able to appear less leveraged than it really was. According to the Wall Street Journal, no United States based law firm would sanction this accounting treatment so Lehman secured an opinion letter from a London law firm named Linklaters. If a U.S. based Lehman entity needed to engage in a Repo 105 transaction, it would have to move the security to a European division to execute the transaction.
Lehman executives are on record acknowledging the necessity of such transactions as the following quote from a Wall Street Journal article clearly demonstrates:
Four days prior to the close of the 2007 fiscal year, Jerry Rizzieri, a member of Lehman’s fixed-income division, was searching for a way to meet his balance-sheet target, according to the report. He wrote in an email: “Can you imagine what this would be like without 105?”
A day before the close of Lehman’s first quarter in 2008, other employees scrambled to make balance-sheet reductions, the report said. Kaushik Amin, then-head of Liquid Markets, wrote to a colleague: “We have a desperate situation, and I need another 2 billion from you, either through Repo 105 or outright sales. Cost is irrelevant, we need to do it.”
Grossly Negligent, Criminally Responsible, or Merely Incompetent?
Lehman’s CEO Dick Fuld is cited in the bankruptcy examiner’s report as being “at least grossly negligent” regarding the Repo 105 transactions:
The examiner wrote there was “sufficient evidence” to support a legal claim that Mr. Fuld was “at least grossly negligent for failing to ensure” Lehman filed proper financial statements about its accounting for the transactions, and that a key former executive of the firm, the chief operating officer, personally briefed him on the matter.
Of course, Mr. Fuld’s attorneys have decided to pursue the “incompetent” defense as opposed to taking any responsibility for the situation:
Mr. Fuld’s lawyer said on Thursday that Mr. Fuld “did not know what those transactions were” and wasn’t “aware of their accounting treatment.”
It is unclear what is more shocking: The prospect of a CEO of a major financial institution willfully pursuing financial transactions designed specifically to mislead investors and counterparties into thinking that the firm was less leveraged than it really was or the idea that the CEO really had no idea that these maneuvers were taking place at all.
Buffett’s Decision on a Lehman Investment
The bankruptcy report also contains some interesting information regarding Lehman’s attempts to have Warren Buffett invest $2 billion in the company as a “stamp of approval”. Of course, Mr. Buffett decided against doing so when he found problems in Lehman’s 10-K as well as negative signals from Lehman executives who were unwilling to invest in the firm on the same terms he was offered.
As is often the case, we can also look at Mr. Buffett’s statements regarding corporate governance to understand what went wrong at Lehman:
“In my view a board of directors of a huge financial institution is derelict if it does not insist that its CEO bear full responsibility for risk control. If he’s incapable of handling that job, he should look for other employment. And if he fails at it – with the government thereupon required to step in with funds or guarantees – the financial consequences for him and his board should be severe.”
— Warren Buffett’s 2009 Letter to Shareholders.
If Lehman’s story can be distilled down to its core problem, it seems to be that the company’s CEO did not regard himself as the Chief Risk Officer. Based on Mr. Fuld’s own admission (if we are to believe him), he was not aware of critical accounting policies that misled investors and counterparties who were using Lehman’s financial statements to judge the health of the business. Of course, the Repo 105 maneuver was only necessary because of other failures to control risk at the firm.
It would be a refreshing change if at least one CEO involved in the demise of a major financial institution would step up and admit that the responsibility was his rather than hiding behind the “incompetence” defense.