BA 297 Final Exam The Bankruptcy of Lehman Brothers

BA 297 Corporate Governance – Final Examination
The Bankruptcy of Lehman Brothers: Causes, Effects and Lessons Learnt
Background
Lehman Brothers Holdings Inc. filed for bankruptcy on September 15, 2008. Lehman’s
bankruptcy filing was the largest in history, as its assets far surpassed those of previous
bankrupt giants. Lehman was one of the largest US investment bank at the time of its
collapse, with around 25,000 employees worldwide.
Aspect of Corporate Governance in relation to Lehman Bros. (the “Firm”) failure
1. The firm has become dependent into subprime mortgage market. Subprime
mortgage market loans are loans available to customers with poor credit ratings.
The main justification on pursuing the subprime mortgage market is that the price
of mortgage can compensate for any loss through remortgaging in the event of
default and the firm took advantage when the mortgage prices are high. The key
feature of the subprime mortgages was the adjustable interest rates. This
indicates that the management had no idea that subprime mortgage market
could eventually crash due to not having long term projections and short &
medium projections are not done accurately. In addition, the Firm was unable to
make accurate projections and implement counter strategies when market
conditions changed.
2. The executives might have known the possible changes in the subprime
mortgage market condition but were pre-occupied with maximizing shareholders’
value and enriching themselves through payment of huge bonuses. For instance,
the CEO had received total of USD 484 million compensation since 2000. Also
in 2007, he received USD 70 million compensation and in 2009, they paid
themselves a total of USD 10 billion through year-end bonuses, stock buyouts
and dividends.
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3. The firm has incurred excessive borrowings resulting to high leverage ratio of
31:1 which is in violation of US regulation of not more than 15:1 leverage ratio.
4. The firm was accused of deceit and unethical behaviour due to accounting
treatment and timing of the repos transactions. Repos transaction consists of
dealing repos 105 and repos 108 which are traded with overcollateralized rates
of 5% and 8%, respectively. The firm was also accused of using repos to window
dress its financial statements to deceive investors, regulatory bodies and public.
The firm recognized the repos transactions as sales when it should be
recognized as liability.
5. The firm took advantage of the loophole as their independent auditor, Earnest
and Young, defended their accounting treatment in relation to the repos
transactions claiming that the International Accounting Standards as of the time
supported the treatment of such transaction.
6. The firm commits misrepresentation of the disclosure of the repos transactions.
The independent auditor failed to detect the frequency of the timing of the
transactions and that they should realize a breach in US Generally Accepted
Accounting Principles requirements of ensuring that all significant events such as
repos transactions should be disclosed at all times.
7. The firm misled the public to believe that all repos transactions were treated as
financing transactions and not sales.
8. The firm has failed to implement their risk management policies that lead to their
collapse and filing of bankruptcy. The firm’s risk management policies includes
having a Finance and Risk committee that should meet weekly to discuss all risk
exposure, position concentration and taking activities of the firm. However, this
was poorly implemented and the said committee has only met twice in a year.
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Recommendations
1. The firm should not have become dependent into subprime mortgage market.
The BOD should inspect the strategies of the CEO including its dependence with
subprime mortgage market and monitor the firm’s investment portfolio to identify
whether the firm is taking a high risk exposure in a certain investment such as
the subprime mortgage market.
2. The firm should have a remuneration scheme for the top executives regarding
the cash bonuses and equity sales that will be approved by the BOD and majority
of the stockholders. The remuneration scheme may apply a cap on the maximum
bonus to the top executives based on the overall performance of the firm
including proper implementation of risk management policies that will be
measure through scorecards and will be monitored by the Finance and Risk
Management committee.
3. The firm should review their risk management policies to identify the cause for
failure of implementation of said policies by the Finance and Risk Management
committee. The said committee must be strengthened by nominating qualified
directors to supervise the committee. Directors should be qualified by having vast
experience and knowledge with regard to the finance and risk management.
4. The firm’s annual report must include all required disclosures on significant
events that will materially affect the firm such as repos transactions, high risk
exposures, accounting policies and such. These will help the stakeholders of the
firm to understand the financial status of the firm and to prevent
misrepresentation in material transactions.
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BA 297 Corporate Governance – Final Examination

The Bankruptcy of Lehman Brothers: Causes, Effects and Lessons Learnt

Aspect of Corporate Governance in relation to Lehman Bros. (the “Firm”) failure

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