Colorable Claims

The court handling the Lehman Brothers bankruptcy directed the court-appointed examiner to “file a statement of . . . any fact ascertained pertaining to fraud, dishonesty, incompetence, misconduct, mismanagement, or irregularity in the management of the affairs of the debtor, or to a cause of action available to the estate.”  Yesterday the examiner, Jenner & Block’s Anton Valukas, issued his 2,200-page report.  Responding to the question “Why did Lehman fail?” the report’s executive summary concludes

Lehman failed because it was unable to retain the confidence of its lenders and counterparties and because it did not have sufficient liquidity to meet its current obligations. Lehman was unable to maintain confidence because a series of business decisions had left it with heavy concentrations of illiquid assets with deteriorating values such as residential and commercial real estate . . . The business decisions that brought Lehman to its crisis of confidence may have been in error but were largely within the business judgment rule. But the decision not to disclose the effects of those judgments does give rise to colorable claims against the senior officers who oversaw and certified misleading financial statements – Lehman’s CEO Richard S. Fuld, Jr., and its CFOs Christopher O’Meara, Erin M. Callan and I an T. Lowitt. There are colorable claims against Lehman’s external auditor Ernst & Young for, among other things, its failure to question and challenge improper or inadequate disclosures in those financial statements.  (emphasis added)

Fuld responded through his lawyer:  “Mr. Fuld did not know what those transactions were-he didn’t structure or negotiate them, nor was he aware of their accounting treatment.”  Between 2000 and 2008 Lehman paid Fuld over $484 million in compensation–salary, bonuses, and stock options.  Some explain outlandish compensation packages like Fuld’s as the market price for the rare combination of talents required to run a major corporate enterprise.  Slash executive pay, they say, and the quality of corporate management will plummet.

Here’s my question: how could a manager worth over $484 million for nine year’s compensation not know the terms and accounting treatment of these transactions?  The examiner’s report is not talking about one-off deals entered into by middle management.  It focuses on what Lehman internally called “Repo 105” transactions that were accounted for as sales, not financings, thus removing the assets from Lehman’s balance sheet and lowering its net leverage ratio.  According to the Examiner’s report

Lehman used Repo 105 for no articulated business purpose except ‘to reduce balance sheet at the quarter?end.’ Rather than sell assets at a loss, ‘[a] Repo 105 increase would help avoid this without negatively impacting our leverage ratios.’ Lehman’s Global Financial Controller confirmed that “the only purpose or motive for [Repo 105] transactions was reduction in the balance sheet” and that ‘there was no substance to the transactions.’

Lehman accounting personnel also called Repo 105 transactions a “lazy way of managing the balance sheet as opposed to legitimately meeting balance sheet targets at quarter end.”  Lehman did not publicly disclose these transactions.

In 2007-08, Lehman knew that net leverage numbers were critical to the rating agencies and to counterparty confidence. Its ability to deleverage by selling assets was severely limited by the illiquidity and depressed prices of the assets it had accumulated. Against this backdrop, Lehman turned to Repo 105 transactions to temporarily remove $50 billion of assets from its balance sheet at first and second quarter ends in 2008 so that it could report significantly lower net leverage numbers than reality. Lehman did so despite its understanding that none of its peers used similar accounting at that time to arrive at their leverage numbers, to which Lehman would be compared;

Lehman defined materiality, for purposes of reopening a closed balance sheet, as “any item individually, or in the aggregate, that moves net leverage by 0.1 or more (typically $1.8 billion).” Lehman’s use of Repo 105 moved net leverage not by tenths but by whole points . . . Lehman’s failure to disclose the use of an accounting device to significantly and temporarily lower leverage, at the same time that it affirmatively represented those “low” leverage numbers to investors as positive news, created a misleading portrayal of Lehman’s true financial health.

I’ve read only the report’s executive summary and I’m outraged by the arrogance and greed it reveals.

Yahoo’s Grumpy Shareholders

Yahoo’s shareholders made clear their “discontent” and “disappointment” with Yahoo’s performance at the company’s annual meeting. The first rebuke that caught my eye concerned a proposal “to adopt a policy that opposes censorship on the Internet,” which only 15% of shareholders approved. That fared better than the proposal for a “committee to oversee Yahoo’s human rights practices,” favored by 4% of shareholders. While I was tempted to write a headline along the lines of “Yahoo to Chinese Political Dissidents: Kiss Off!”, I’m guessing these votes reflect disenchantment with Yahoo’s 10% decline in stock price over the last year more than a pro-political repression platform. After being approved by 97% or more of shareholders last year some of the directors received as few as 66% of the votes at this year’s meeting. According to The Wall Street Journal “approvals with only two-thirds of the vote could be considered a victory for shareholder activists who have condemned high executive pay at the company,” specifically Yahoo CEO Terry Semel’s $71.7 million 2006 compensation. Still, shareholders also rejected a pay-for-performance proposal that would have bestowed bonuses only when Yahoo outperformed its industry peers.

The shareholders also rejected the chicken a la king and chocolate cake served at lunch. A bad day for the board, all around.