Business and Risk Management

Business and Risk Management

Executive Summary

¶In 2006, Lehman adopted a more aggressive business strategy by expanding its investments in potentially highly profitable lines of business that also carried much more risk than Lehman's traditional investment banking activities. Through the first half of 2007, Lehman focused on making "principal" investments – committing its own capital in commercial real estate ("CRE"), leveraged lending, and private equity‐like investments. These investments were considerably riskier for Lehman than its other business lines because Lehman was acquiring potentially illiquid assets that it might be unable to sell in a downturn.¹¹⁴¹¹⁴ See Tobias Adrian, Federal Reserve Bank of New York, and Hyun Song Shin, Princeton University, Financial Intermediaries, Financial Stability and Monetary Policy (Aug. 5, 2008), at p. 13.

¶Lehman continued and even intensified this high‐risk strategy after the onset of the subprime residential mortgage crisis in late 2006. As some Lehman officers described it, Lehman shifted from focusing almost exclusively on the "moving" business – a business strategy of originating assets primarily for securitization or syndication and distribution to others – to the "storage" business – which entailed making longer‐term investments using Lehman's own balance sheet.¹¹⁵¹¹⁵ See Section III.A.1.b of this Report. Lehman continued to pursue commercial real estate and leveraged loan transactions aggressively until July 2007.¹¹⁶¹¹⁶ See Section III.A.1.b of this Report.

44

¶While the decision to shift into long‐term investments was voluntary, market events pushed Lehman ever further from moving to storage. Lehman's primary mortgage origination subsidiaries, BNC Mortgage Inc. ("BNC") and Aurora Loan Services, LLC ("Aurora"), continued to originate subprime and other non‐prime mortgages to a greater extent than other mortgage originators, many of whom had recently gone out of business, or would soon do so.¹¹⁷¹¹⁷ Lehman, Update on Lehman Brothers' Subprime Mortgage Origination Business Presentation to Lehman Board of Directors (Mar. 20, 2007), at p. 5 [LBHI_SEC07940_025839]. BNC's and Aurora's continued mortgage originations increased the volume of illiquid assets on Lehman's balance sheet – albeit unintentionally – because Lehman became unable to securitize and distribute these mortgages to third parties.¹¹⁸¹¹⁸ Lehman, Securitized Products, MBS: Non Investment Grade Retained Interests (Jan. 16, 2007), at p. 1 [LBEX‐DOCID 839039]; Lehman, Update on Lehman Brothers' Subprime Mortgage Origination Business Presentation to Lehman Board of Directors [Draft] (Mar. 18, 2007), at p. 14 [LBEX‐DOCID 610173] ("Limited ability to sell below Investment Grade risk profitably in current environment"); Examiner's Interview of Matthew Miller, Sept. 24, 2009, at p. 2.Show full note

¶Lehman's continued pursuit of this aggressive growth strategy, even in the face of the subprime crisis, was based on two important calculations by Lehman's management. First, like some other market participants, not to mention governmental officials, Lehman's management believed that the subprime crisis would not spread to other markets and to the economy generally.¹¹⁹¹¹⁹ E.g., Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at pp. 16, 24; Examiner's Interview of Joseph Gregory, Nov. 13, 2009, at p. 7; Examiner's Interview of Treasury Secretary Timothy F. Geithner, Nov. 24, 2009, at p. 3. Second, Lehman's management believed that while other financial institutions were retrenching and reducing their risk profile, Lehman had the opportunity to pick up ground and improve its competitive position. Lehman had benefited from a similar "countercyclical growth strategy" during prior market dislocations, and its management believed it could similarly benefit from the subprime lending crisis.¹²⁰¹²⁰ See Section III.A.1.b of this Report. Lehman miscalculated. As Lehman's Chief Executive Officer ("CEO") Richard S. Fuld, Jr. later admitted, Lehman underestimated both the severity of the subprime crisis and the extent of the contagion to Lehman's other business lines.¹²¹¹²¹ Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at pp. 16, 24; Examiner's Interview of Richard McKinney, Aug. 27, 2009, at pp. 2, 9; Richard S. Fuld, Jr., Lehman, Notes for Senior Management Speech (June 16, 2008), at pp. 5‐6 [LBEX‐DOCID 529241], attached to e‐mail from Taimur Hyat, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (June 25, 2008) [LBEX‐DOCID 556064].

45

¶The Examiner investigated Lehman's adoption and implementation of this aggressive countercyclical business strategy for several reasons. First, the potentially illiquid assets Lehman acquired played a significant role in Lehman's ultimate financial failure. Lehman's losses were largely concentrated in its commercial real estate portfolio and in certain less liquid aspects of its residential mortgage origination and securitization business. Similarly, Lehman's liquidity was compromised by its accumulation of assets that it could not sell, including not only the commercial and residential real estate assets, but also, to a lesser extent, the leveraged loan positions.

46

¶Second, e‐mails written by Lehman risk management personnel suggest that Lehman senior management disregarded its risk managers, its risk policies, and its risk limits.¹²²¹²² See, e.g., e‐mail from Kentaro Umezaki, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (Sept. 10, 2008) [LBEX‐DOCID 1718043] (noting "history of `end arounds' on risk decisions," risk management's lack of authority and lack of authority over balance sheet and inability to enforce risk limits); e‐mail from Vincent DiMassimo, Lehman, to Christopher M. O'Meara, Lehman (Sept. 1, 2008) [LBEX‐DOCID 203219] ("whatever risk governance process we had in place was ultimately not effective in protecting the firm [.] Risk Appetite measures were not effective in establishing clear enough warning signals that the Firm was taking on too much risk relative to capital. . . . The [Risk Management] function lacked sufficient authority within the Firm. Decision‐making was dominated by the business. . . ."); e‐mail from Satu Parikh, Lehman, to Michael Gelband, Lehman, Sept. 15, 2008 [LBEX‐DOCID 882447] ("I am shocked at the poor risk mgmt at the highest levels, and I don't think it started with Archstone. It is all unbelievable and I think there needs to be an investigation into the broader issue of malfeasance. Mgmt gambled recklessly with thousands of jobs and shareholder wealth. . . .").Show full note Press reports prior to Lehman's bankruptcy stated that in 2007 Lehman had removed Madelyn Antoncic, Lehman's Chief Risk Officer ("CRO"), and Michael Gelband, head of its Fixed Income Division ("FID"), because of their opposition to management's growing accumulation of risky and illiquid investments.¹²³¹²³ See, e.g., Yalman Onaran, Lehman Fault‐Finding Points to Last Man Fuld as Shares Languish, Bloomberg.com, July 22, 2008. And external monitors of Lehman's affairs, such as the Office of Thrift Supervision ("OTS") and Moody's Investor Services ("Moody's"), also raised serious questions about Lehman's risk management, particularly with respect to its commercial real estate investments.¹²⁴¹²⁴ See Office of Thrift Supervision, Report of Examination, Lehman Brothers Holdings Inc. (as of May 31, 2008), at p. 2 [LBEX‐OTS 000392] (finding that Lehman did not employ sound risk management practices in its commercial real estate business); e‐mail from Stephen Lax, Lehman, to Erin M. Callan, Lehman, et al. (June 9, 2008) [LBEX‐DOCID 017840] (forwarding text of Moody's release announcing downgrade of Lehman ratings outlook: "The rating action also reflects Moody's concerns over risk management decisions that resulted in elevated real estate exposures and the subsequent ineffectiveness of hedges to mitigate these exposures").Show full note

47

¶Accordingly, the Examiner investigated (1) whether there are colorable claims for breach of the duty of care against Lehman's officers for the manner in which they administered Lehman's risk management system in connection with the acquisition of these illiquid assets; (2) whether there are colorable claims for breach of the duty of good faith and candor against Lehman's officers for failing fully to inform the Board of Directors (the "Board")¹²⁵¹²⁵ References to the "Board" in this Section of the Report refer to Lehman's outside directors, not to Fuld, who was CEO and Chairman of the Board. of the extent of the risk and illiquidity that Lehman assumed through the new strategy; and (3) whether there are colorable claims against Lehman's directors for breach of their duty to monitor Lehman's risk management.

¶The Examiner concludes that the conduct of Lehman's officers, while subject to question in retrospect, falls within the business judgment rule and does not give rise to colorable claims. The Examiner concludes that Lehman's directors did not breach their duty to monitor Lehman's risks.

The Examiner Does Not Find Colorable Claims That Lehman's Senior Officers Breached Their Fiduciary Duty of Care by Failing to Observe Lehman's Risk Management Policies and Procedures

¶Delaware law, which governs a Delaware corporation such as Lehman, sets a high bar for establishing a breach of the fiduciary duty of care.¹²⁶¹²⁶ For a detailed discussion of Delaware corporate fiduciary law, see Appendix 1. Officers' and directors' business decisions are generally protected from personal liability by the business judgment rule, and even if the business judgment rule does not apply, there is no liability unless the officer or director was grossly negligent. "In the duty of care context gross negligence has been defined as 'reckless indifference to or a deliberate disregard of the whole body of stockholders or actions which are without the bounds of reason.'"¹²⁷¹²⁷ McPadden v. Sidhu, 964 A.2d 1262, 1274 (Del. Ch. 2008) (quoting Benihana of Tokyo, Inc. v. Benihana, Inc., 891 A.2d 150, 192 (Del. Ch. 2005)).

48

¶The proof necessary to defeat the business judgment rule and establish gross negligence is particularly high with respect to risk management and financial transactions. Banking is inherently risky and prone to financial losses caused by unforeseen changes in the markets.¹²⁸¹²⁸ See In re Citigroup Inc. S'holder Derivative Litig., 964 A.2d 106, 126 (Del. Ch. 2009). Profitability depends largely on the firm's ability to evaluate the risks of potential investments and balance them against their potential gains.¹²⁹¹²⁹ See id. Consequently, to establish a colorable claim that Lehman officers breached their fiduciary duty by mismanaging business risk, the evidence must show that Lehman's senior management was reckless or irrational in managing the risks associated with the principal investment strategy that Lehman pursued during 2006 and 2007.¹³⁰¹³⁰ See Appendix 1, Legal Issues.

¶Lehman had sophisticated policies, procedures, and metrics in place to estimate the risk that the firm could assume without jeopardizing its ability to achieve a target rate of return, and to apprise management and the Board whether Lehman was within various risk limits.¹³¹¹³¹ See generally Appendix 1, Legal Issues. Lehman also used an array of stress tests to determine the potential financial consequences of an economic shock to its portfolio of assets and investments.¹³²¹³² Appendix No. 8, Risk Management Organization and Controls. Lehman had an extensive staff that was devoted solely to risk management.¹³³¹³³ Id.

49

¶These risk limits and stress tests, however, did not impose legal requirements on management or prevent management and the Board from exceeding those limits if they chose to do so.¹³⁴¹³⁴ Id. The role of the risk limits and stress tests was to cause management to consider whether a particular investment or a broad business strategy was worth the risk it carried.¹³⁵¹³⁵ See id. In addition, Lehman used its risk management system to promote its capabilities to investors, rating agencies, and regulators.¹³⁶¹³⁶ Id. Lehman's management always retained the discretion to use its judgment to decide whether to pursue particular strategies or transactions.¹³⁷¹³⁷ See id.

¶The Examiner did find that in pursuing its aggressive growth strategy, Lehman's management chose to disregard or overrule the firm's risk controls on a regular basis. The question whether there is a colorable claim that Lehman's senior officers breached their fiduciary duty of care focuses on facts relating to Lehman's acquisition of potentially illiquid investments in 2007 and the manner in which management used Lehman's risk management system as part of its process of making investment decisions:

50

● Lehman's management decided to exceed risk limits with respect to Lehman's principal investments, namely, the "concentration limits" on Lehman's leveraged loan and commercial real estate businesses, including the "single transaction limits" on the leveraged loans. These limits were designed to ensure that Lehman's investments were properly limited and diversified by business line and by counterparty. Lehman took highly concentrated risks in these two business lines, and, partly as a result of market conditions, ultimately exceeded its risk limits by margins of 70% as to commercial real estate and by 100% as to leveraged loans.¹³⁸¹³⁸ Appendix No. 9, comparing risk appetite and VaR usage versus limits.

● Lehman's management excluded certain risky principal investments from its stress tests. Although Lehman conducted stress tests on a monthly basis and reported the results of these stress tests periodically to regulators and to its Board of Directors, the stress tests excluded Lehman's commercial real estate investments, its private equity investments, and, for a time, its leveraged loan commitments. Thus, Lehman's management did not have a regular and systematic means of analyzing the amount of catastrophic loss that the firm could suffer from these increasingly large and illiquid investments.¹³⁹¹³⁹ See Section III.A.1.b of this Report.

● Lehman did not strictly apply its balance sheet limits, which were designed to contain the overall risk of the firm and maintain the firm's leverage ratio within the range required by the credit rating agencies, but instead decided to exceed those limits. To mitigate the apparent effect of these overages, Lehman used Repo 105 transactions to take assets temporarily off the balance sheet before the ends of reporting periods. (The Repo 105 transactions are discussed in Section III.A.4 of this Report.)¹⁴⁰¹⁴⁰ See id.

● Lehman's management decided to treat primary firm‐wide risk limit – the risk appetite limit – as a "soft" guideline, notwithstanding Lehman's representations to the Securities Exchange Commission ("SEC") and the Board that the risk appetite limit was a meaningful constraint on Lehman's risk‐taking.¹⁴¹¹⁴¹ E.g., SEC, Lehman Monthly Risk Review Meeting Notes (July 19, 2007), at p. 5 [LBEX‐SEC 007363] ("Jeff [Goodman] told us that . . . VaR is just one measure that Lehman uses, and is more of a speed bump/warning sign that a true, hard limit ‐‐ that role falls to RA [(i.e. risk appetite)]. [….] He said that Madelyn [Antoncic], Dave [Goldfarb], and the executive committee tend to look more at RA. As an aside, Madelyn came in after Jeff's explanation and gave virtually the same speech"); see also Section III.A.1.b of this Report.Show full note Lehman management's decision not to enforce the risk appetite limit was apparent in several ways:

51

○ Between December 2006 and December 2007, Lehman raised its firm‐ wide risk appetite limit three times, going from $2.3 to $4.0 billion.¹⁴²¹⁴² See Section III.A.1.b of this Report.

○ Between May and August 2007, Lehman omitted some of its largest risks from its risk usage calculation. The primary omitted risk was a $2.3 billion bridge equity position in the Archstone‐Smith Real Estate Investment Trust ("Archstone" or "Archstone REIT") real estate transaction, an extraordinarily large and risky commitment. Had Lehman's management promptly included that risk in its usage calculation, it would have been immediately apparent that Lehman was over its risk limits.¹⁴³¹⁴³ See id.

○ After Lehman did include the Archstone risk in the firm's risk appetite usage, Lehman continued to exceed the limit for several more months. Rather than aggressively reduce Lehman's balance sheet in response to these indicators of excessive risk‐taking, Lehman raised its firm‐wide risk limit again.¹⁴⁴¹⁴⁴ See id.

¶Although these decisions by Lehman's management ultimately proved to be unwise, the Examiner finds insufficient evidence to support a determination that Lehman's senior officers' conduct with respect to risk management was outside the business judgment rule or reckless or irrational.¹⁴⁵¹⁴⁵ See Section III.A.1.c of this Report.

52

¶Based upon their considerable business experience and successful track record, Lehman's senior managers decided to place a higher priority on increasing profits than on keeping the firm's risk level within the limits arising from its risk management policies and metrics. Lehman's senior managers were confident making business judgments based on their understanding of the markets, and did not feel constrained by the quantitative metrics generated by Lehman's risk management system. These decisions raise questions about the role of risk management in a complex financial institution, but they do not give rise to a colorable claim of the breach of the fiduciary duty of care given the high bar to liability established by Delaware law.

The Examiner Does Not Find Colorable Claims That Lehman's Senior Officers Breached Their Fiduciary Duty to Inform the Board of Directors Concerning the Level of Risk Lehman Had Assumed

¶The Examiner finds insufficient evidence to support a determination that Lehman's senior managers breached their fiduciary duty of candor, which required them to provide the Board with material reports concerning Lehman's risk and liquidity.¹⁴⁶¹⁴⁶ Appendix No. 1, Legal Issues; In re Amer. Int'l Group, Inc., 965 A.2d 763, 806‐07 (Del. Ch. 2009) ("In colloquial terms, a fraud on the board has long been a fiduciary violation under our law and typically involves the failure of insiders to come clean to the independent directors about . . . information that the insiders fear will be used by the independent directors to take actions contrary to the insidersʹ wishes").Show full note

¶The factual issues relevant to the duty of candor are the same risk management issues relevant to the duty of care. Lehman's officers did not disclose certain information concerning the amount or duration of the firm‐wide risk limit overages, their decisions to exceed certain concentration limits, or the limitations in the firm's stress testing. Nor did Lehman's officers disclose that Lehman's originations of Alt‐A mortgages – mortgages that were considered riskier than typical prime mortgages but not so risky as to be categorized as "subprime" – were exposing the firm to subprime mortgage risk, even as Lehman was curtailing originations of loans actually denominated as "subprime." Lehman's directors generally said that if such risk management issues were significant and long‐lasting, they would have liked to have received more information about them, but would not necessarily have taken action as a result.¹⁴⁷¹⁴⁷ Examiner's Interview of Roger S. Berlind, May 8, 2009, at p. 4; Examiner's Interview of Marsha Johnson Evans, May 22, 2009, at p. 6; Examiner's Interview of Roland A. Hernandez, Oct. 2, 2009, at p. 10; Examiner's Interview of John D. Macomber, Sept. 25, 2009, at p. 17; Examiner's Interview of Henry Kaufman, May 19, 2009, at p. 17; Examiner's Interview of Sir Christopher Gent, Oct. 21, 2009, at pp. 14‐16; Examiner's Interview of Michael Ainslie, Sept. 22, 2009, at pp. 3‐4. For information concerning the Board meetings where these general topics were discussed, the directors' statements to the Examiner about those meetings, and the directors' statements about the materiality of these facts, see Section III.A.1.b of this Report.Show full note

53

¶However, the Examiner found that Lehman's management did inform the Board, clearly and on more than one occasion, that it was taking increased business risk in order to grow the firm aggressively; that the increased business risk resulted in higher risk usage metrics and ultimately firm‐wide risk limit overages; and that market conditions after July 2007 were hampering the firm's liquidity.¹⁴⁸¹⁴⁸ Sections III.A.1.b of this Report. Lehman's management also informed the Board, accurately, that the subprime mortgage crisis was constricting profitability and that management was tightening origination standards and taking other steps to address that crisis.¹⁴⁹¹⁴⁹ Section III.A.1.b of this Report.

54

¶These disclosures were not so incomplete as to lead to the conclusion that Lehman's management misled the Board of Directors. Nor did Lehman's officers have a legal duty to disclose additional details to the Board. Lehman's risk limits and controls were designed primarily for management's internal use in making business decisions concerning the core issue faced by any financial institution: what business risks to take and what business risks to decline.¹⁵⁰¹⁵⁰ See Appendix No. 8, Risk Management Organization and Controls. While the overall risk management of the firm is an appropriate topic for board consideration, the day‐to‐day decisions are primarily the responsibility of officers, not directors.¹⁵¹¹⁵¹ See 17 C.F.R. §§ 240.15c3‐1e & 15c3‐4 (2007) (requiring Lehman to submit a comprehensive description of its internal risk management control system to the SEC); NYSE, Inc., Listed Company Manual §303A(7)(c)(iii)(D) & cmt. (2010) (requiring audit committee of board to "discuss policies with respect to risk assessment and risk management" while noting that "it is the job of the CEO and senior management to assess and manage the company's exposure to risk").Show full note

The Examiner Does Not Find Colorable Claims That Lehman's Directors Breached Their Fiduciary Duty by Failing to Monitor Lehman's Risk‐Taking Activities

¶Lehman's corporate charter and related aspects of Delaware law protect its directors from personal liability based upon their business decisions. As a result, the directors cannot be held liable for a breach of the duty of care; rather the directors can be liable for inadequately monitoring Lehman's affairs only if their failure to monitor was so egregious as to rise to the level of a breach of the duty of loyalty or the duty of good faith. The Delaware courts have called this type of claim – referred to as a Caremark claim – "possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment."¹⁵²¹⁵² In re Caremark Int'l Inc. Derivative Litig., 698 A.2d 959, 967 (Del. Ch. 1996).

55

¶The conduct typically evaluated in Caremark claims has been the failure to monitor managers' unlawful conduct. In contrast here, a claim that the directors failed to satisfy their duty to monitor the extent of risk assumed by management and its compliance with corporate risk policies would require proof that the directors failed to monitor managers' judgment as to internal procedures that were not legally binding. The business judgment rule applies with particular force to such a claim because the question of how much risk an investment bank can reasonably assume goes to the core of its business.¹⁵³¹⁵³ In re Citigroup Inc. S'holder Litig., 964 A.2d 106, 126 (Del. Ch. 2009).

¶The Examiner finds insufficient evidence of a breach of fiduciary duty by any Lehman director. The directors received reports concerning Lehman's business and the level and nature of its risk‐taking at every Board meeting. Although these reports noted the elevated levels of risk to Lehman's business beginning in late 2006, management informed the directors that the increased risk‐taking was part of a deliberate strategy to grow the firm. The directors continued to receive such reports throughout 2007, and were repeatedly informed about developments in the subprime markets and the credit markets generally. Management assured the directors that it was taking prudent steps to address these risks but that management saw the unfolding crisis as an opportunity to pursue a countercyclical growth strategy. Management's reports to the directors did not contain "red flags" imposing on the directors a duty to inquire further.¹⁵⁴¹⁵⁴ See, e.g., Lehman Brothers Holdings Inc., Minutes of Meeting of the Board of Directors (June 19, 2007) [LBHI_SEC07940_026267]; Lehman, Lehman Board of Directors Materials for June 19, 2007 Board Meeting (June 19, 2007) [LBHI_SEC07940_026214]; Lehman Brothers Holdings Inc., Minutes of Meeting of Board of Directors (Sept. 11, 2007) [LBHI_SEC07940_026364]; Lehman, Lehman Board of Directors Materials for Sept. 11, 2007 Board Meeting (Sept. 7, 2007) [LBHI_SEC07940_026282]; Lehman Brothers Holdings Inc., Minutes of Meeting of Board of Directors (Oct. 15, 2007), at p. 6 [LBHI_SEC07940_026407]; Lehman, Lehman Board of Directors Materials for Oct. 15, 2007 Board Meeting (Oct. 11, 2007) [LBHI_SEC07940_026371].Show full note

56

¶Delaware law permits directors to rely on management's reports and immunizes the directors from personal liability when they do so.¹⁵⁵¹⁵⁵ See DEL. CODE ANN. tit. 8, § 141(e) (2009). Consequently, there is insufficient evidence to establish a colorable claim that Lehman's directors breached their duty to monitor Lehman's management of its risks.

---

¶Although the Examiner does not find colorable claims against Lehman's senior officers or directors concerning Lehman's risk management, a complete discussion of the facts discovered by the Examiner's investigation of risk management is important in two fundamental respects. First, the Examiner sets out the facts in detail so that the Court and the parties have the basis for the Examiner's conclusion that Lehman management's decisions with respect to risk and its countercyclical growth strategy do not give rise to colorable claims.

57

¶Second, these facts show how Lehman's approach to risk ultimately created the conditions that led Lehman's top managers to use Repo 105 transactions as discussed in Section III.A.4 of this Report. Lehman's aggressive growth strategy also provides context for several other issues discussed in this Report, including issues concerning Lehman's liquidity pool and asset valuations. Lehman's growth strategy resulted in a dramatic growth of Lehman's balance sheet: All figures in ($ Billions) Q4 06 Q1 07 Q2 07 Q3 07 Q4 07 Q1 08 Q2 08 Reported Net Assets¹⁵⁶¹⁵⁶ Lehman defined net assets as total assets excluding: (1) cash and securities segregated and on deposit for regulatory and other purposes; (2) securities received as collateral; (3) securities purchases under agreements to resell; (4) securities borrowed; and (5) identifiable intangible assets and goodwill. Lehman Brothers Holdings Inc., Annual Report for 2007 10‐K as of Nov. 30, 2007 (Form 10‐K) (filed on Jan. 29, 2008), at p. 63.Show full note 268.936 300.797 337.667 357.102 372.959 396.673 327.774 Lehman's net assets increased by almost $128 billion or 48% in a little over a year – from the fourth quarter of 2006 through the first quarter of 2008.

¶This increase in Lehman's net assets was primarily attributable to the accumulation of potentially illiquid assets that could not easily be sold in a downturn. By one measure, Lehman's holdings of "less liquid assets" more than doubled during the same time period – increasing from $86.9 billion at the end of the fourth quarter of 2006 to $174.6 billion at the end of the first quarter of 2008.¹⁵⁷¹⁵⁷ Lehman Brothers Holdings Inc., Lehman Brothers Fact Book Q2 2008 (June 13, 2009), at p. 16 [LBHI_SEC07940_593047]. Lehman's public filings include a different quantification of Lehman's less liquid assets. According to these sources, Lehman's less liquid asset holdings almost quadrupled from the third quarter of 2006 until the first quarter of 2008, with a particularly sudden spike in the fourth quarter of 2007. Lehman Brothers Holdings Inc., Quarterly Report as of Aug. 31, 2006 (Form 10‐Q) (filed on Oct. 10, 2006), at pp. 16, 71‐72 ("LBHI 10‐Q (filed Oct 10, 2006)"); Lehman Brothers Holdings Inc.,Show full note

58

¶To explain the business and risk decisions that led Lehman management down this path, the following portions of this Section of the Report describe:

1. Lehman's decision in 2006 to take more principal risk;

2. The dramatic growth in Lehman's principal investments and in its balance sheet during the first half of Lehman's fiscal 2007, culminating in the acquisition of Archstone, to which Lehman committed in May 2007;

3. It became apparent during 2007 that Lehman's balance sheet had grown too large, and that Lehman had taken on too much risk;

4. How, even after it became apparent that Lehman's growth strategy had exposed the firm to financial peril, Lehman still acted without sufficient urgency to deleverage.

Facts

From Moving to Storage: Lehman Expands Its Principal Investments

¶During the course of 2006, Lehman's management and Board made the deliberate business decision to increase the firm's risk profile generally, and to take more risk specifically with respect to principal investments with the firm's capital. This new strategy was directed by Lehman's highest officers – primarily Fuld, Joseph Gregory (Lehman's President and Chief Operating Officer), and Hugh E. (Skip) McGee III (Global Head of Investment Banking) – after significant internal debate.

¶Annual Report for 2006 as of Nov. 30, 2006 (Form 10‐K) (filed on Feb. 13, 2007), at pp. 66‐67 ("LBHI 2006 10‐K"); Lehman Brothers Holdings Inc., Quarterly Report as of Feb. 28, 2007 (Form 10‐Q) (filed on Apr. 9, 2007), at pp. 15, 19, 60 ("LBHI 10‐Q (filed Apr. 9, 2007)"); Lehman Brothers Holdings Inc., Quarterly Report as of May 31, 2007 (Form 10‐Q) (filed on July 10, 2007) , at pp. 17, 22, 64 ("LBHI 10‐Q (filed July 10, 2007)"); Lehman Brothers Holdings Inc., Quarterly Report as of Aug. 31, 2007 (Form 10‐Q) (filed on Oct. 10, 2007), at pp. 18, 23, 67 ("LBHI 10‐Q (filed Oct. 10, 2007)"); Lehman Brothers Holdings Inc., Annual Report for 2007 as of Nov. 30, 2007 (Form 10‐K) (filed on Jan. 29, 2008), at pp. 61‐62, 104 ("LBHI 2007 10‐ K"); Lehman Brothers Holdings Inc., Quarterly Report as of Feb. 29, 2008 (Form 10‐Q) (filed on Apr. 9, 2008), at pp. 21, 27, 55, 71 ("LBHI 10‐Q (filed Apr. 9, 2008)"); Lehman Brothers Holdings Inc., Quarterly Report as of May 31, 2008 (Form 10‐Q) (filed on July 10, 2008), at pp. 26, 29 ("LBHI 10‐Q (filed July 10, 2008)"); see also Section III.A.1.b.4 of this Report.

59

¶This Section of the Report describes the principal investment strategy adopted by Lehman in 2006; explains the risks that this strategy posed to the firm; describes how Lehman's risk controls were applied (or not) to the new strategy; and explains the Board's understanding of, and agreement with, the new strategy.

Lehman's Changed Business Strategy

¶In 2006, Lehman made a significant change in its business strategy from a lower risk brokerage model to a higher risk, capital‐intensive banking model. Historically, Lehman described itself as being primarily in the moving business, not the storage business.¹⁵⁸¹⁵⁸ Examiner's Interview of Paul Shotton, June 5, 2009, at p. 12. Lehman, for the most part, did not use its balance sheet to acquire assets for its own investment; rather, Lehman acquired assets – such as commercial and residential real estate mortgages – primarily to move them by securitization or syndication and distribution to third parties.

¶During 2006, Lehman's management decided to emphasize the storage business – using Lehman's balance sheet to acquire assets for longer‐term investment.¹⁵⁹¹⁵⁹ Id. at p. 2. Fuld believed that other banks were using their balance sheets to make more proprietary investments, that these investments were highly profitable relative to their risk in the then‐buoyant economic environment, and that Lehman was missing out on significant opportunities to do the same.¹⁶⁰¹⁶⁰ Examiner's Interview of Richard S. Fuld Jr., Sept. 25, 2009, at pp. 10‐12 (Fuld said that Lehman expanded into the leveraged lending, bridge equity and principal investing to gain "wallet share." Fuld wanted to use the "80‐20 rule" to get the wallet share of Lehman's top clients. The 80‐20 rule says that the top 20% of the firm's clients will provide 80% of the firm's earnings.); Examiner's Interview of Jeremy M. Isaacs, Oct. 1, 2009, at p. 6.Show full note

60

¶Lehman's management primarily focused on expanding three specific areas of principal investment: commercial real estate; leveraged loans; and private equity.

¶Commercial real estate investments were considered a strong candidate for expansion because those investments had historically been a strength of the firm.¹⁶¹¹⁶¹ Examiner's Interview of Paul A. Hughson, Oct. 28, 2009, at p. 3. Mark A. Walsh, Lehman's head of the Global Real Estate Group ("GREG"), was one of the most successful and trusted operators at the firm; management believed that Walsh could invest Lehman's capital wisely and could distribute any excess risk to other investors.¹⁶²¹⁶² Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at p. 14; Examiner's Interview of Mark Walsh, Oct. 21, 2009, at pp. 4‐5; e‐mail from Jeffrey Goodman, Lehman, to Mark A. Walsh, Lehman (Sept. 19, 2006) [LBEX‐DOCID 1368068]. The firm was even willing to make commercial real estate bridge equity investments – taking potentially riskier equity pieces of real estate investments – on the theory that the bridge equity, though riskier than the debt, could quickly be resold to third parties at a profit.¹⁶³¹⁶³ Examiner's Interview of Mark A. Walsh, Oct. 21, 2009, at p. 6. Lehman was well paid for bridge equity in the commercial real estate business, and management believed that Walsh's distribution network minimized the risk that the firm would be unable to sell it.¹⁶⁴¹⁶⁴ Lehman, FID Offsite Presentation and Notes (Sept. 28, 2006), at p. 10 [LBEX‐DOCID 2042292, 2068495], attached to e‐mail from Michael Gelband, Lehman, to Richard S. Fuld, Jr., Lehman, et al. (Sept. 26, 2006) [LBEX‐DOCID 2384245].

61

¶The business strategy to expand the leveraged loan business was somewhat different. Lehman's management recognized that leveraged loans in their own right, including the bridge equity components of those transactions, were risky relative to their profitability.¹⁶⁵¹⁶⁵ Examiner's Interview of Kentaro Umezaki, June 25, 2009, at pp. 10, 13; Examiner's Interview of Michael Gelband, Aug. 12, 2009, at p. 6; Examiner's Interview of Alex Kirk, Jan. 12, 2010, at p. 6. But Fuld, Gregory, and McGee in particular believed that if Lehman made loans to private equity sponsors as part of major M&A transactions, Lehman would build long‐term client relationships with the sponsors and perhaps with other institutions involved in the transaction.¹⁶⁶¹⁶⁶ Examiner's Interview of Hugh E (Skip) McGee III, Aug. 12, 2009, at pp. 7‐8; Examiner's Interview of Joseph Gregory, Nov. 13, 2009, at p. 3; accord Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at p. 12. Fuld, Gregory, and McGee believed that every dollar that Lehman made from a leveraged loan would lead to five dollars of follow‐on profits in the future.¹⁶⁷¹⁶⁷ Examiner's Interview of Joseph Gregory, Nov. 13, 2009, at p. 3; Examiner's Interview of Alex Kirk, Jan. 12, 2010, at p. 7.

¶The firm's aggressive growth strategy was apparent in various firm‐wide presentations given by senior management and in certain high‐level business and risk‐ taking decisions made during 2006 and at the outset of the 2007 fiscal year. As David Goldfarb (then Lehman's Global Head of Strategic Partnerships, Principal Investing, and Risk) put it, Lehman was pursuing "13% annual growth" in revenues, and "to support this revenue growth [Lehman was] targeting an even faster increase in the firm's balance sheet, total capital base and risk appetite – each of which [was] projected to increase by 15% per year."¹⁶⁸¹⁶⁸ David Goldfarb, Lehman, Global Strategy Offsite Presentation (Mar. 2006), at pp. 30‐31 [LBEX‐DOCID 1342496], attached to e‐mail from Christopher M. O'Meara, Lehman, to Jacqueline Roncagliolo, Lehman (Apr. 3, 2006) [LBEX‐DOCID 1357100]. Goldfarb noted that Lehman had been "pedal to the metal in growth mode" for the previous two years, but planned to continue that going forward.¹⁶⁹¹⁶⁹ Id. at p. 10. That year, Fuld and Gelband (then head of FID) also gave presentations in which they discussed Lehman's aggressive growth strategy.¹⁷⁰¹⁷⁰ Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at p. 11; Lehman, FID Offsite Presentation and Notes (Sept. 28, 2006) [LBEX‐DOCID 2042292, 2068495], attached to e‐mail from Michael Gelband, Lehman, to Richard S. Fuld, Jr., Lehman, et al. (Sept. 26, 2006) [LBEX‐DOCID 2384245].

62

The Increased Risk From Lehman's Changed Business Strategy

¶The business strategy that Lehman pursued beginning in 2006 was risky in light of the firm's high leverage and small equity base. Commercial real estate investments, leveraged loans and other principal investments consumed more capital, entailed more risk, and were less liquid than Lehman's traditional lines of business.¹⁷¹¹⁷¹ Less liquid investments were "Level 3." Level 1 assets have readily available markets to provide prices and liquidity, such as exchange‐traded equities. Level 2 assets have observable events to provide pricing, such as comparable sales. Level 3 assets have no readily available pricing mechanism and therefore are less liquid than Level 1 and 2 assets.

¶The lack of liquidity increased the risk to the firm in several ways. Having a large volume of illiquid assets made it much more difficult for the firm to accomplish three important goals in a difficult financial environment: to raise cash; to hedge risks; or to sell assets to reduce the leverage in its balance sheet.

63

¶When a financial institution suffers losses, it often needs to raise cash to fund itself.¹⁷²¹⁷² See Lehman, Capital Adequacy Review (Sept. 11, 2008), at p. 1 [LBEX‐DOCID 012124]. But illiquid investments are difficult to use for that purpose because they cannot be sold quickly.¹⁷³¹⁷³ See Tobias Adrian, Federal Reserve Bank of New York, and Hyun Song Shin, Princeton University, Financial Intermediaries, Financial Stability and Monetary Policy (Aug. 5, 2008), at p. 13. When illiquid investments are sold in a difficult market, the seller often takes a much larger loss on the sale than on a liquid asset.¹⁷⁴¹⁷⁴ Martin Oehmke, Putting the Brakes on Collateral Liquidations, Columbia Business School Ideas at Work, July 28, 2009, http://www4.gsb.columbia.edu/ideasatwork/feature/731624/Putting+the+Brakes+on+Collateral+Liquidati ons (last visited on Feb. 1, 2010). Similarly, illiquid assets are more difficult to use as collateral for borrowing.¹⁷⁵¹⁷⁵ Id.; see also Moody's Investor Services, Press Release: Moody's Text: Changes Lehman Outlook From Stable To Negative (June 9, 2008). They often cannot be used in the repo market, which was a crucial source of funding for investment banks such as Lehman.¹⁷⁶¹⁷⁶ Examiner's Interview of Anuraj Bismal, Sept. 16, 2009, at p. 10; Lehman, Accounting Policy Manual (Sept. 9, 2006) [LBEX‐DOCID 3213287], attached to e‐mail from Marie Stewart, Lehman, to Martin Kelly, Lehman, et al. (Dec. 5, 2007) [LBEX‐DOCID 3223385]. If a borrower pledges illiquid assets as collateral, there will be a larger "haircut," that is, a discount from the market value of the pledged collateral, than for liquid assets.¹⁷⁷¹⁷⁷ See Lehman, Update on Risk, Liquidity and Capital Adequacy Presentation (Aug. 17, 2007), at p. 48 [LBEX‐DOCID 2031705] (Lehman's funding framework took account of the inability to fund illiquid assets through the repo market; therefore the firm always funded illiquid holdings with long‐term assets and liabilities).

64

¶Financial institutions generally engage in transactions designed to hedge their risks.¹⁷⁸¹⁷⁸ Cf. Examiner's Interview of Alex Kirk, Jan. 12, 2010, at p. 9; Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at pp. 3, 13. But illiquid investments are typically more difficult to hedge.¹⁷⁹¹⁷⁹ Cf. Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at pp. 3, 13. In fact, Lehman decided not to try to hedge its principal investment risks to the same extent as its other exposures for precisely this reason – its senior officers believed that hedges on these investments would not work and could even backfire, aggravating instead of mitigating Lehman's losses in a downturn.¹⁸⁰¹⁸⁰ Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at pp. 3, 13; Examiner's Interview of Roger Berlind, May 8, 2009, at p. 7; Examiner's Interview of Fred S. Orlan, Sept. 21, 2009, at p. 6; Examiner's Interview of Paul Shotton, June 5, 2009, at pp. 7‐8; Examiner's Interview of Kentaro Umezaki, June 25, 2009, at p. 17; Lehman, 2nd Quarter 2007 Review: Credit Facilitation Group (June 2007), at pp. 1‐2 [LBEX‐ DOCID 514908]; Lehman, Leveraged Finance Risk Presentation (June 2007), at p. 12 [LBEX‐DOCID 3283752]; e‐mail from Christopher M. O'Meara, Lehman, to Ian T. Lowitt, Lehman (Sept. 27, 2007) [LBEX‐ DOCID 193218]; e‐mail from Jeffrey Goodman, Lehman, to Christopher M. O'Meara, Lehman (Oct. 1, 2007) [LBEX‐DOCID 201866]; e‐mail from Jeffrey Goodman, Lehman, to Paul Shotton, Lehman, et al. (Mar. 19, 2008) [LBEX‐DOCID 335666]; Andrew J. Morton, Lehman, Hedging Fixed Income's Portfolio Presentation (Aug. 8, 2008), at pp. 2, 3, 8, 11 [LBEX‐DOCID 011869], attached to e‐mail from Thomas Odenthal, Lehman, to Andrew J. Morton, Lehman, et al. (Aug. 6, 2008) [LBEX‐DOCID 069824].Show full note As a result, Lehman acquired a large volume of unhedged assets that ultimately caused Lehman significant losses.¹⁸¹¹⁸¹ Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at pp. 3, 13; Examiner's Interview of Paul Shotton, June 5, 2009, at pp. 7‐8.

¶In a difficult financial environment, it also is important for financial institutions to be able to reduce their leverage and risk profile.¹⁸²¹⁸² Cf. Examiner's Interview of Treasury Secretary Timothy F. Geithner, Nov. 24, 2009, at pp. 7‐8. The more highly leveraged the institution is, the more important it is for the institution to begin reducing leverage as soon as market conditions turn against it. But if the need to reduce leverage forces the sale of illiquid assets at a loss, it has a double impact; in addition to the loss, the perception can be that there is "air" in the valuation of the other illiquid assets that remain on the balance sheet, exacerbating the risk of a loss of confidence in the firm's future.¹⁸³¹⁸³ Id.; see Moody's Investor Services, Press Release: Moody's Text: Changes Lehman Outlook From Stable To Negative (June 9, 2008).

65

¶During the declining market of 2007‐08, Lehman suffered from all these problems. Lehman had difficulty selling "sticky" assets and was unable to reduce its balance sheet quickly through typical means. Instead, Lehman expanded the volume of Repo 105 transactions that misleadingly and temporarily reduced its balance sheet solely for the purpose of the firm's public financial reports.¹⁸⁴¹⁸⁴ See Section III.A.4 of this Report.

Application of Risk Controls to Changed Business Strategy

¶Lehman's principal investments in illiquid assets presented new and increased forms of risk to the firm, but Lehman's management did not recalibrate the firm's pre‐ existing risk controls to ensure that its new investments were properly evaluated, monitored and limited. If anything, to facilitate the new investment strategy, Lehman's management relaxed its controls in several ultimately fateful ways, discussed below. Lehman's senior officers took this tack notwithstanding their periodic statements to Lehman's Board, the rating agencies, and the SEC that its risk management system was a rigorous independent check on the risks undertaken by its business lines.¹⁸⁵¹⁸⁵ Madelyn Antoncic, Risk Management Presentation to Standard & Poor's [Draft] (Aug. 17, 2007), at p. 5 [LBEX‐DOCID 342851] ("Global Risk Management Division is independent of the trading areas"), attached to e‐mail from Lisa Rathgeber, Lehman, to Jeffrey Goodman, Lehman, et al. (Aug. 15, 2007) [LBEX‐DOCID 305205]; SEC Division of Market Regulation, Lehman Brothers ‐ Consolidated Supervised Entity Market and Credit Risk Review (June 2005), at pp. 3‐4 [LBEX‐DOCID 2125011] (saying Risk Management was "independent of Lehman's business units"), attached to e‐mail from Michelle Danis, SEC, to David Oman, Lehman, et al. (Apr. 21, 2006) [LBEX‐DOCID 2068428]; Lehman, Risk Update Presentation to Lehman Board of Directors (July 18, 2006), at pp. 5, 8 [LBEX‐DOCID 2125293] (saying Lehmanʹs risk approach "applie[d] analytical rigor overlaid with sound practical judgment"; Lehman, Risk Management Update Presentation to Lehman Board of Directors (Apr. 15, 2008), at pp. 1‐2 [LBHI_SEC07940_027909‐29] (saying Lehman "provided an independent view of risk").Show full note

66

Stress Testing Exclusions

¶One of Lehman's major risk controls was stress testing. Historically, Lehman's stress testing had not been designed to encompass the risks posed to the firm by principal investments in real estate and private equity, because those positions previously made up a small portion of Lehman's portfolio.¹⁸⁶¹⁸⁶ Examiner's Interview of Paul Shotton, Oct. 16, 2009, at p. 2. Lehman did not revise its stress testing to address its evolving business strategy.

¶Lehman was required by the SEC¹⁸⁷¹⁸⁷ See infra, Section III.A.6. to conduct some form of regular stress testing on its portfolio to quantify the catastrophic loss it could suffer over a defined period of time.¹⁸⁸¹⁸⁸ Examiner's Interview of the Securities and Exchange Commission, Aug. 24, 2009, at p. 13. Lehman ran a series of stress tests based on 13 or 14 different scenarios.¹⁸⁹¹⁸⁹ See, e.g., Lehman, Stress Test Report for March 31, 2006 [LBEX‐DOCID 2078161], attached to e‐mail from Sandeep Garg, Lehman, to Patrick Whalen, Lehman, et al. (Apr. 24, 2006) [LBEX‐DOCID 2118206]; Lehman, Stress Test Report for February 28, 2007 [LBEX‐DOCID 632363], attached to e‐mail from Melda Elagoz, Lehman, to Paul Shotton, Lehman, et al. (Mar. 9, 2007) [LBEX‐DOCID 630356]; Stress Test Report for October 31, 2007 [LBEX‐DOCID 632432], attached to e‐mail from Jeffrey Goodman, Lehman, to Cherie Gooley, Lehman (Dec. 19, 2007) [LBEX‐DOCID 665513]; Stress Test Report for Apr. 30, 2008 [LBEX‐ DOCID 3296803], attached to e‐mail from Mark Weber, Lehman, to Cherie Gooley, Lehman, et al. (May 28, 2008) [LBEX‐DOCID 3302270].Show full note Some of the scenarios were historical events, such as the 1987 stock market crash or the 1998 Russian financial crisis, while other scenarios were hypothesized by Lehman's risk managers.¹⁹⁰¹⁹⁰ Lehman, Risk Management Presentation to Fitch (Apr. 7, 2006), at p. 47 [LBEX‐DOCID 691768]; Lehman, Risk, Liquidity, Capital, and Balance Sheet Update Presentation to Finance and Risk Committee of Lehman Board of Directors (Sept. 11, 2007), at p. 28 [LBEX‐AM 067167]. Lehman's management represented to its external constituents that regular and comprehensive stress tests "were performed to evaluate the potential P&L impact on the Firm's portfolio of abnormal yet plausible market conditions."¹⁹¹¹⁹¹ E.g., Madelyn Antoncic, Lehman, Risk Management Presentation to Standard & Poor's [Draft] (Aug. 17, 2007), at pp. 38‐39 [LBEX‐DOCID 342851], attached to e‐mail from Lisa Rathgeber, Lehman, to Jeffrey Goodman, Lehman, et al. (Aug. 15, 2007) [LBEX‐DOCID 305205]. Stress testing was designed to measure "tail risk" – a one in ten year type event.

67

¶When Lehman first adopted stress testing in about 2005, it applied the testing only to its tradable instruments such as stocks, bonds, and other securities; it did not include its un‐traded assets such as its commercial real estate or private equity investments.¹⁹²¹⁹² Examiner's Interview of Paul Shotton, Oct. 16, 2009, at pp. 5‐6; Examiner's Interview of Jeffrey Goodman, Aug. 28, 2009. Because these assets did not trade freely, they were not considered susceptible to stress testing over a short‐term scenario.¹⁹³¹⁹³ Examiner's Interview of Jeffrey Goodman, Aug. 28, 2009. And since Lehman did not then have significant investments in these areas, excluding them from the stress testing did not undermine the usefulness of the results.¹⁹⁴¹⁹⁴ Examiner's Interview of Paul Shotton, Oct. 16, 2009, at pp. 5‐6. The SEC was aware of this exclusion.¹⁹⁵¹⁹⁵ Examiner's Interview of Matthew Eichner, Nov. 23, 2009, at p. 12; Examiner's Interview of Paul Shotton, Oct. 16, 2009, at p. 6.

68

¶At various points in 2006 and 2007, Lehman's risk managers considered whether to include principal investments in Lehman's stress testing.¹⁹⁶¹⁹⁶ E‐mail from Marc Henn, Lehman, to Maria Turner, Lehman, (Mar. 2, 2007) [LBEX‐DOCID 264992]; e‐ mail from Melda Elagoz, Lehman, to Jeffrey Goodman, Lehman, et al. (June 11, 2007) [LBEX‐DOCID 384503]; Lehman, 2006 Competitor Analysis ‐ Key Considerations (Dec. 1, 2006) [LBEX‐DOCID 2110930], attached to e‐mail from Mirey Nadler, Lehman, to Fred Steinberg, Lehman (Dec. 1, 2006) [LBEX‐DOCID 2042308]; e‐mail from Gerard Reilly, Lehman, to Christopher M. O'Meara, Lehman (May 17, 2006) [LBEX‐ DOCID 1342418]; e‐mail from James Ballentine, Lehman, to Michael Gelband, Lehman, et al. (Jan. 4, 2007) [LBEX‐DOCID 384818].Show full note An internal audit advised that Lehman "address the main risks in the Firm's portfolio," including "illiquidity" and "concentration risk."¹⁹⁷¹⁹⁷ Lehman, Internal VaR Audit Report [Draft] (Feb. 26, 2007), at p. 3 [LBEX‐DOCID 232917], attached to e‐mail from Lisa Rathgeber, Lehman, to Paul Shotton, Lehman (Feb. 26, 2007) [LBEX‐DOCID 232916]. But Lehman did not take significant steps to include these private equity positions in the stress testing until 2008, even though these investments became an increasingly large portion of Lehman's risk profile.¹⁹⁸¹⁹⁸ Examiner's Interview of Christopher M. O'Meara, Aug. 14, 2009, at p. 25.

¶Until late 2007, Lehman's stress testing also excluded its leveraged loan commitments – i.e., the leveraged loans that Lehman had committed to fund in the future, but had not yet closed.¹⁹⁹¹⁹⁹ Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at pp. 10‐11; Examiner's Interview of Paul Shotton, Oct. 16, 2009, at p. 4; e‐mail from Melda Elagoz, Lehman, to Jeffery Goodman, Lehman (July 16, 2007) [LBEX‐DOCID 385103]; e‐mail from Jeffery Goodman, Lehman, to Stephen Lax, Lehman, et al. (Nov. 14, 2007) [LBEX‐DOCID 297400]. This exclusion appears to have been inadvertent.²⁰⁰²⁰⁰ Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at pp. 10‐11; Examiner's Interview of Paul Shotton, Oct. 16, 2009, at p. 4.

69

¶Because Lehman's stress testing did not include its real estate investments, its private equity investments or, during a crucial time period, its leveraged loan commitments, Lehman's management pursued its transition from the moving business to the storage business without the benefit of regular stress testing on the primary business lines that were the subject of this strategic change. For example, as described below, Lehman entered into a series of large and risky commercial real estate transactions in the first half of 2007 without stress testing the particular transactions and without conducting regular stress testing on Lehman's aggregate commercial real estate book.²⁰¹²⁰¹ See Section III.A.1.b of this Report.

¶This exclusion was significant. Experimental stress tests conducted in 2008 showed that a large proportion of Lehman's tail risk – perhaps even a large majority of its overall tail risk – lay with the businesses that were previously excluded from the stress testing. One stress test posited maximum potential losses of $9.4 billion, including $7.4 billion in losses on the previously excluded real estate and private equity positions, and only $2 billion on the previously included trading positions.²⁰²²⁰² Lehman, Stress Test Report (June 30, 2008), at p. 3 [LBEX‐DOCID 3326829], attached to e‐mail from Nancy Malik, Lehman, to Paul Shotton, Lehman, et al. (June 30, 2008) [LBEX‐DOCID 3301915]; Lehman, Private Equity and Real Estate Stresses, Global Market Risk Management presentation (June 30, 2008), at pp. 3‐4 [LBEX‐DOCID 3301916] attached to e‐mail from Nancy Malik, Lehman, to Paul Shotton, Lehman, et al. (June 30, 2008) [LBEX‐DOCID 3301915].Show full note Another stress test showed total losses of $13.4 billion, of which $2.5 billion was attributable to the firm's included positions, and $10.9 billion was attributable to the excluded positions.²⁰³²⁰³ Lehman, Stress Test Report (June 30, 2008), at p. 1 [LBEX‐DOCID 384227] attached to e‐mail from Nancy Malik, Lehman, to Paul Shotton, Lehman, et al. (Sept. 2, 2008) [LBEX‐DOCID 385413].

70

¶But these stress tests were conducted long after these assets had been acquired, and they were never shared with Lehman's senior management.²⁰⁴²⁰⁴ Examiner's Interview of Mark Weber, Aug. 11, 2009, at p. 14; Examiner's Interview of Christopher M. O'Meara, Sept. 23, 2009, at p. 19. For a more detailed discussion of Lehman's stress testing, see Appendix 8, Risk Management Organization and Controls.

Risk Appetite Limit Increase For Fiscal 2007

¶Lehman had a series of "risk appetite limits" that it considered the "center of its approach to risk."²⁰⁵²⁰⁵ See, e.g., Jared Pedowitz, BMRM‐Market Risk Management Walkthrough Template (Nov. 30, 2007), at p. 9 [EY‐LE‐LBHI‐KEYPERS 1015089]; Madelyn Antoncic, Lehman, Risk Management Presentation to Standard & Poor's [Draft] (Aug. 17, 2007), at p. 23 [LBEX‐DOCID 342851], attached to e‐mail from Lisa Rathgeber, Lehman, to Jeffrey Goodman, Lehman, et al. (Aug. 15, 2007) [LBEX‐DOCID 305205]. Risk appetite was a measure that aggregated the market risk, credit risk, and event risk faced by Lehman.²⁰⁶²⁰⁶ Madelyn Antoncic, Lehman, Risk Management Presentation to Standard & Poor's [Draft] (Aug. 17, 2007), at p. 21 [LBEX‐DOCID 342851], attached to e‐mail from Lisa Rathgeber, Lehman, to Jeffrey Goodman, Lehman, et al. (Aug. 15, 2007) [LBEX‐DOCID 305205]. Lehman had an elaborate set of procedures designed to calculate the "risk appetite usage" in each of its business lines, each of its divisions, and for the firm as a whole.²⁰⁷²⁰⁷ SEC Division of Market Regulation, Lehman Brothers ‐ Consolidated Supervised Entity Market and Credit Risk Review (2005), at pp. 4‐5 [LBEX‐DOCID 2125011]. These risk appetite usage figures were calculated every day.²⁰⁸²⁰⁸ See, e.g., e‐mail from Jenny Peng, Lehman, to David Goldfarb, Lehman, et al. (Oct. 12, 2007) [LBEX‐ DOCID 152049] (containing summary "Daily Risk Appetite and VaR Report" for Oct. 10, 2007), and attached spreadsheet (Oct. 12, 2007) [LBEX‐DOCID 150128] (containing daily risk appetite report, global risk appetite report organized by risk type, and daily VaR report).

71

¶At the beginning of each year, Lehman set numerical limits on the risk appetite usage it was willing to take for each such business unit and for the firm as a whole.²⁰⁹²⁰⁹ SEC Division of Market Regulation, Lehman Brothers ‐ Consolidated Supervised Entity Market and Credit Risk Review (2005), at pp. 4‐5 [LBEX‐DOCID 2125011]. See Appendix 8, Risk Management Organization and Controls (discussing risk appetite limits). Risk appetite measured the amount Lehman could lose in a give year and still achieve an acceptable level of net profit. Management presented the firm‐wide limit to the Board.²¹⁰²¹⁰ It is not clear whether the presentation was for ratification and approval or simply for information. See e.g., Lehman, 2008 Financial Plan Summary Presentation to Lehman Board of Directors (June 29, 2008), at p. 11 [LBHI_SEC07940_027374].

¶Under Lehman's limit policy, lower‐level limits applicable to a single business line or geographic area were relatively "soft" and could be exceeded based on appropriate authority.²¹¹²¹¹ Lehman, Market Risk Management Limit Policy Manual (Oct. 2006), at p. 2 [LBHI_SEC07940_767665), attached to e‐mail from Christopher M. O'Meara to Kristi Michelle Reynolds (Apr. 7, 2008) [LBHI_SEC07940_767661]. Lehman's higher‐level limits were "harder" and required greater authorization if they were exceeded.²¹²²¹² Lehman Brothers Global Risk Management, Second Quarter 2008 Report (July 21, 2008), at p. 29 [LBEX‐DOCID 738522], attached to e‐mail from Elizabeth Agosto, Lehman, to Jeffrey Goodman, Lehman, et al. (July 21, 2008) [LBEX‐DOCID 670132]. The firm‐wide risk appetite limit was the "hardest" of all, and if it was exceeded, the "Risk Committee" of the firm was required to consider the proper course of action to take.²¹³²¹³ E.g., SEC, Lehman Monthly Risk Review Meeting Notes (July 19, 2007), at p. 5 [LBEX‐SEC 007363]; SEC Division of Market Regulation, Lehman Brothers ‐ Consolidated Supervised Entity Market and Credit Risk Review (2005), at p. 6 [LBEX‐DOCID 2125011]. The Risk Committee was composed of the Executive Committee of the firm, the Chief Risk Officer ("CRO"), and the Chief Financial Officer ("CFO"). While one witness said that the only permissible reaction to exceeding the firm‐wide limit was immediately reducing the risk faced by the firm,²¹⁴²¹⁴ Examiner's Interview of Kentaro Umezaki, June 25, 2009, at p. 5. most Lehman personnel said that senior management could cure a limit excess by granting a temporary reprieve from the limit or by increasing the limit.²¹⁵²¹⁵ E.g., Examiner's Interview of Madelyn Antoncic, Oct. 6, 2009, at p. 7; Examiner's Interview with David Goldfarb, Sept. 21, 2009, at p. 5; Examiner's Interview of Paul Shotton, June 5, 2009, at pp. 10‐11 (saying that the firm‐wide risk appetite limit was a "hard" limit, the breach of which had to be cured by either reducing the firm's overall risk or raising the limit). As with the stress tests, management described the risk appetite limits to regulators, rating agencies and the Board as a meaningful control that Lehman used to manage its risk‐taking.²¹⁶²¹⁶ Madelyn Antoncic, Risk Management Presentation to Standard & Poor's [Draft] (Aug. 17, 2007), at p. 23 [LBEX‐DOCID 342851], attached to e‐mail from Lisa Rathgeber, Lehman, to Jeffrey Goodman, Lehman, et al. (Aug. 15, 2007) [LBEX‐DOCID 305205]; SEC Division of Market Regulation, Lehman Brothers ‐ Consolidated Supervised Entity Market and Credit Risk Review (June 2005), at pp. 4‐5 [LBEX‐ DOCID 2125011], attached to e‐mail from Michelle Danis, SEC, to David Oman, Lehman, et al. (Apr. 21, 2006) [LBEX‐DOCID 2068428]; Lehman, Risk Update Presentation to Lehman Board of Directors (July 18, 2007), at pp. 11‐12 [LBEX‐DOCID 2125293].Show full note

72

¶At the end of 2006, Lehman dramatically increased its risk appetite limits applicable to fiscal 2007. The firm‐wide limit increased from $2.3 billion to $3.3 billion, and subsidiary limits also increased significantly, particularly insofar as the principal investing businesses were concerned.²¹⁷²¹⁷ Lehman Brothers, 2007 Risk Appetite Limit (Jan. 7, 2007), at p. 1 [LBEX‐DOCID 158938], attachment to e‐mail from Robert Azerad, Lehman, to Madelyn Antoncic, Lehman (Jan. 11, 2007) [LBEX‐DOCID 158331].

¶These increases in the risk appetite limits were somewhat controversial. The CRO at the time, Madelyn Antoncic, argued for a significantly lower increase to $2.6 or $2.7 billion, and the much higher $3.3 billion figure was apparently the result of a compromise with other senior managers.²¹⁸²¹⁸ Examiner's Interview of Madelyn Antoncic, Mar. 27, 2009, at p. 13; e‐mail from David Goldfarb, Lehman, to Madelyn Antoncic, Lehman, et al. (Nov. 2, 2006) [LBEX‐DOCID 2125677]; e‐mail from Madelyn Antoncic, Lehman, to Christopher M. O'Meara, Lehman (Nov. 2, 2006) [LBEX‐DOCID 2125679]; e‐mail from Christopher M. O'Meara, Lehman, to Madelyn Antoncic, Lehman (Nov. 2, 2006) [LBEX‐ DOCID 2125680]. Moreover, to justify the increased limit amount, Lehman changed the way that it calculated the limit; had Lehman used the same method to calculate the 2007 limit that it had used to calculate the 2006 limit, the 2007 limit would have been several hundred million dollars lower.²¹⁹²¹⁹ Lehman, 2007 Financial Plan Presentation to Finance and Risk Committee of the Board of Directors (Jan. 30, 2007), at pp. 21‐22 [LBEX‐AM 067099].

73

¶Increasing the firm‐wide limit to $3.3 billion facilitated a rapid expansion of the firm's risk profile between 2006 and 2007. As described below, within the first few months of fiscal 2007, Lehman quickly used the full amount of the new $3.3 billion risk appetite limit – and then some. In late 2007 and early 2008, Lehman relaxed its risk appetite limits in several other ways, which are described below. For a more detailed discussion of Lehman's risk appetite limits, see Appendix 8, Risk Management Organization and Controls.

Decision Not To Enforce Single Transaction Limit

¶In 2006, to facilitate the planned expansion of the leveraged loan business, Lehman's Executive Committee decided to be more flexible with respect to the firm's single transaction limit.²²⁰²²⁰ Examiner's Interview of Alex Kirk, Jan. 12, 2010, at pp. 7‐8. The single transaction limit was actually two limits – one limit applicable to the notional amount of the expected leveraged loan and a second limit applicable to a calculated amount that Lehman was at risk of losing on the leveraged loan. The limits were partly a function of Lehman's equity. Lehman had previously agreed with the rating agencies that it would adopt a single transaction limit akin to limits previously adopted by commercial banks.²²¹²²¹ Appendix 8, Risk Management Organization and Controls.

74

¶Although Lehman's Executive Committee always retained the freedom to waive the single transaction limit as to any individual transaction, Lehman informed its external constituents that this prerogative would be exercised only in "rare circumstances."²²²²²² Madelyn Antoncic, Lehman, "Standard" Risk Management Presentation (Undated), at p. 21 [LBEX‐ DOCID 194031], attached to e‐mail from Paul Shotton, Lehman, to Christopher M. O'Meara, Lehman (Feb. 20, 2008) [LBEX‐DOCID 214223]; Madelyn Antoncic, Lehman, "Standard" Risk Management Presentation, at p. 21 [LBEX‐DOCID 194031].

¶In late 2006, Lehman's management decided not to enforce the single transaction limit because it had cost Lehman significant opportunities.²²³²²³ Examiner's Interview of Alex Kirk, Jan. 12, 2010, at pp. 7‐8; Lehman, Appendix to Financial Sponsors Strategies (Including Lending Capacity Solutions) Presentation to the Executive Committee (Aug. 3, 2006), at p. 6 [LBEX‐DOCID 1343776], attached to e‐mail from Blair Sieff, Lehman, to Madelyn Antoncic, Lehman, et al. (Aug. 2, 2006) [LBEX‐DOCID 1360977]. Because Lehman had a dramatically smaller equity base than its commercial banking competitors, and a somewhat smaller equity base even than its investment banking competitors, Lehman had a lower single transaction limit than its competitors, which forced it to forgo or limit its participation in a number of big deals.²²⁴²²⁴ Lehman, Appendix to Financial Sponsors Strategies (including Lending Capacity Solutions) Presentation to the Executive Committee (Aug. 3, 2006), at pp. 3, 6 [LBEX‐DOCID 1343776], attached to e‐ mail from Blair Sieff, Lehman, to Madelyn Antoncic, Lehman, et al. (Aug. 2, 2006) [LBEX‐DOCID 1360977]; Lehman, Financial Sponsors Strategies (including Lending Capacity Solutions) Presentation to the Executive Committee (Aug. 3, 2006), at pp. 10‐11 (LBEX‐DOCID 1343775], attached to e‐mail from Blair Sieff, Lehman, to Madelyn Antoncic, Lehman, et al. (Aug. 2, 2006) ([LBEX‐DOICD 1360977].Show full note Lehman's management decided that in the future, it would participate in such deals without regard to the single transaction limit.²²⁵²²⁵ E‐mail from Joe Li, Lehman, to Paul Mitrokostas, Lehman (Aug. 30, 2007) [LBEX‐DOCID 2547330]; Joe Li, Lehman, STL Backtesting Excel Spreadsheet (July 25, 2007) [LBEX‐DOCID 2506462], attached to e‐mail from Joe Li, Lehman, to Fred S. Orlan, Lehman, et al. (July 25, 2007) [LBEX‐DOCID 2563167]; accord Examiner's Interview of Alex Kirk, Jan. 12, 2010, at pp. 7‐8. Moreover, Lehman did not apply the single transaction limit to its commercial real estate deals, even though some of its risk managers advocated for this broader application of the limit.²²⁶²²⁶ Cf. Examiner's Interview of Madelyn Antoncic, Oct. 6, 2009, at p. 12; e‐mail from Jeffrey Goodman, Lehman, to Zev Klasewitz, Lehman (Jan. 17, 2007) [LBEX‐DOCID 794864]; e‐mail from Jeffrey Goodman, Lehman, to Zev Klasewitz, Lehman (Feb. 12, 2007) [LBEX‐DOCID 794879].

75

¶Like the decision to increase the firm‐wide risk appetite limit, the decision not to enforce the single transaction limit was controversial within Lehman's management. Alex Kirk, then head of Lehman's Credit Business, had primary responsibility for the leveraged loan business, thought that the single transaction limit was an important method of limiting the firm's risk on its leveraged loans.²²⁷²²⁷ Examiner's Interview of Alex Kirk, Jan. 12, 2010, at pp. 7‐8. Antoncic also thought that the firm should continue to abide by the single transaction limit in part because the substantive terms of the leveraged loans were increasingly lopsided in favor of the private equity sponsors and unfavorable for the lending banks.²²⁸²²⁸ Examiner's Interview of Madelyn Antoncic, Mar. 27, 2009, at p. 9. Although Antoncic thought the firm should abide by the single transaction limit,²²⁹²²⁹ Id.; Examiner's Interview of Alex Kirk, Jan. 12, 2010, at pp. 6‐8. Kirk and Antoncic were overruled by Fuld, Gregory, and McGee.²³⁰²³⁰ Examiner's Interview of Alex Kirk, Jan. 12, 2010, at pp. 7‐8; Examiner's Interview of Madelyn Antoncic, Mar. 27, 2009, at p. 9.

76

The Board's Approval of Lehman's Growth Strategy

¶Lehman's Board fully embraced Lehman's growth strategy. In a January 2007 Board meeting, the directors were informed of the large increase in the risk appetite limit for fiscal 2007, and of the firm's intention to expand its footprint in principal investments, and they agreed with Lehman's senior officers that Lehman needed to take more risk in order to compete.²³¹²³¹ Examiner's Interview of Sir. Christopher Gent, Oct. 21, 2009, at pp. 7‐8; Examiner's Interview of Thomas Cruikshank, Oct. 8, 2009, at pp. 2‐3; Examiner's Interview of Roland A. Hernandez, Oct. 2, 2009; Examiner's Interview of John D. Macomber, Sept. 28, 2009, at p. 12; Examiner's Interview of Michael L. Ainslie, Sept. 22, 2009, at p. 8; Examiner's Interview of Marsha Johnson Evans, May 22, 2009, at p. 12; Examiner's Interview of Dr. Henry Kaufman, May 19, 2009, at pp. 7‐8, 14; Examiner's Interview of Roger Berlind, May 8, 2009, at pp. 6‐7; Examiner's Interview of John F. Akers, Apr. 22, 2009, at p. 9.Show full note All of the directors told the Examiner that they agreed with Lehman's growth strategy at the time it was undertaken.²³²²³² Id..

¶Although the periodic materials that the Finance and Risk Committee²³³²³³ The Board had a Finance and Risk Committee that generally met twice a year and received more detailed information than the full Board on these topics. Dr. Henry Kaufman, former managing director of Salmon Brothers, was the head of the Finance and Risk Committee. received about the firm's stress testing disclosed that tests were conducted on the firm's "trading portfolio" and "We subject both our trading and our counterparty portfolio to stress tests,"²³⁴²³⁴ Lehman Brothers Holdings Inc., Risk, Liquidity, Capital and Balance Sheet Update Presentation to Finance and Risk Committee of Lehman Board of Directors (Sept. 11, 2007), at p. 28 [LBEX‐AM 067167‐ 233]. management did not inform the Finance and Risk Committee that many of the firm's commercial real estate and private equity investments were excluded from the firm's stress tests.²³⁵²³⁵ Examiner's Interview of Paul Shotton, Oct. 16, 2009, at p. 5; see also Lehman Brothers Holdings Inc., Risk, Liquidity, Capital and Balance Sheet Update Presentation to Finance and Risk Committee of Lehman Board of Directors (Sept. 11, 2007), at p. 29 [LBEX‐AM 067167‐233].

77

¶The omission was noted on January 29, 2008, when the Finance and Risk Committee received materials stating that "real estate owned and private equity" were excluded from the stress testing.²³⁶²³⁶ Lehman, 2008 Financial Plan Presentation to Lehman Finance and Risk Committee of the Board of Directors (Jan. 29, 2008), at p. 19 [LBHI_SEC 07940_068559]. No member of the Board who was asked by the Examiner about the issue recalled noticing this revised disclosure, and no member recalled Lehman's officers explaining it or otherwise bringing it to the attention of the Board.²³⁷²³⁷ Cf. Examiner's Interview of Jerry A. Grundhofer, Sept. 16, 2009, at p. 7; Examiner's Interview of Roland A. Hernandez, Oct. 2, 2009; Examiner's Interview of John D. Macomber, Sept. 25, 2009, at p. 4; Examiner's Interview of Dr. Henry Kaufman, Sept. 2, 2009, at p. 11; contra Examiner's Interview of Christopher M. O'Meara, Sept. 23, 2009, at p. 18. Some directors were not concerned about the exclusion of these investments from the stress testing, saying that the exclusions appeared reasonable at the time.²³⁸²³⁸ Examiner's Interview of Dr. Henry Kaufman, Sept. 2, 2009, at pp. 2‐3, 10‐11 ("Despite [these] exclusions, [Kaufman] was not concerned with the result to the stress tests."); Examiner's Interview of Jerry A. Grundhofer, Sept. 16, 2009, at p. 7 (saying the exclusion "looked reasonable and that it would be hard for [Grundhofer] to believe Lehman was not following the standard for conducting stress tests."); see Examiner's Interview of Sir Christopher Gent, Oct. 21, 2009, at pp. 13‐14 (saying he did not find stress tests helpful and thought some assets might be excluded).Show full note However, one director said that if the exclusion was material, he would have wanted to know about it.²³⁹²³⁹ Examiner's Interview of John D. Macomber, Sept. 25, 2009, at p. 11.

78

¶The Board also was not told that Lehman's management had decided not to apply the single transaction limits to its leveraged loans. Although the Examiner has found no evidence that before 2008, Lehman's management had represented to the Board that any single transaction limit had been adopted,²⁴⁰²⁴⁰ See, e.g., Lehman, Risk Update Presentation to Lehman Board of Directors (July 18, 2006) [LBEX‐WGM 986315] (not mentioning single transaction limit); but see Lehman, Risk Management Update Presentation to Lehman Board of Directors (Apr. 15, 2008), at p. 1 [LBHI_SEC07940_027909] ("We have an overall Risk Appetite limit which is supplemented by . . . single transaction, country and other concentration limits.").Show full note some directors said that concentration limits were important protections for the firm, and they would have wanted to know about significant excesses above concentration limits.²⁴¹²⁴¹ Examiner's Interview of Dr. Henry Kaufman, Sept. 2, 2009, at p. 6; Examiner's Interview of John Macomber, Sept. 25, 2009, at pp. 6, 17.

¶In sum, during the second half of 2006, Lehman began to pursue a more aggressive principal investment strategy, and it relaxed several risk limits to facilitate that strategy.

Lehman Doubles Down: Lehman Continues Its Growth Strategy Despite the Onset of the Subprime Crisis

¶Late in the second half of 2006, the first signs of weakness in the subprime residential mortgage market were apparent.²⁴²²⁴² Bank for International Settlements, 77th Annual Report (June 24, 2007), at p. 109. For example, delinquency rates on subprime loans, which had hovered near 10% in 2004 and 2005, reached 13% by the end of 2006.²⁴³²⁴³ Id. In addition, after peaking in mid‐2006, housing prices began to decline steeply.²⁴⁴²⁴⁴ Standard & Poor's, Press Release: Home Price Declines Worsen As We Enter the Fourth Quarter of 2008 According to the S&P/Case‐Shiller Home Price Indices (Dec. 30, 2008), at p. 1 (available at http://www2.standardandpoors.com/spf/pdf/index/CSHomePrice_Release_123062.pdf); see also Vikas Bajaj, Home Prices Fall in More Than Half of Nation's Biggest Markets, N.Y. Times, Feb. 16, 2007, at p. C1. This decline in prices threatened the subprime mortgage market because the market's health depended on continued price appreciation in housing.²⁴⁵²⁴⁵ Gary Gorton, Information, Liquidity and the (Ongoing) Panic of 2007 2 (NIBR Working Paper No. w14649, 2009); see also Gary Gorton & Andrew Metrick, Securitized Banking and the Run on Repo 5 (Yale Int'l Center for Finance, Working Paper No. 09‐14, 2009). As a result, beginning in November 2006, significant widening of spreads on non‐investment grade tranches of home equity loans was evident.²⁴⁶²⁴⁶ Bank for International Settlements, 77th Annual Report (June 24, 2007), at p. 109. By the spring of 2007, the crisis had advanced to the point that several major subprime lenders had gone bankrupt or been acquired by stronger partners.²⁴⁷²⁴⁷ Id. at pp. 109‐10.

79

¶Lehman's management saw the subprime crisis as an opportunity to pick up ground on its competitors.²⁴⁸²⁴⁸ Lehman, 2008 Financial Plan Summary Presentation to Lehman Board of Directors (Jan. 24, 2008), at p. 5 [LBHI_SEC07940_027374] ("Current environment presents a unique long‐term growth opportunity for the Firm. . . . The Firm's competitors, with the notable exceptions of Goldman Sachs and JP Morgan Chase, have sustained large losses, weakening their competitive positions. . . . This presents an opportunity for the Firm to pursue a countercyclical growth strategy, similar to what it did during the 2001‐2002 downturn, to improve its competitive position and, over time, generate superior returns for our shareholders."); see also Lehman, Update on Lehman Brothers' Subprime Mortgage Origination Business Presentation to Lehman Board of Directors (Mar. 20, 2007), at p. 10 [LBHI_SEC07940_025834] ("Most of large subprime independents have gone out of business, have been sold or are selling. . . . Current distressed environment provides substantial opportunities, as in late 1990's"); Lehman, Notes for Presentation for the Fixed Income Division Offsite Meeting (Sept. 26, 2006), at pp. 10‐12 [LBEX‐DOCID 1715601] (stating that Lehman viewed the 2006 growth strategy as a countercyclical opportunity to grow business), attached to e‐mail from Lesley Oramas‐Scala, Lehman, to Michael Gelband, Lehman (Sept. 26, 2006) [LBEX‐DOCID 1945744].Show full note Lehman's management adopted a "countercyclical growth strategy."²⁴⁹²⁴⁹ Id. Lehman's management believed that the subprime crisis would not spread to the economy generally, or even to the commercial real estate market, where Lehman was a major player.²⁵⁰²⁵⁰ Id. In past recessions and financial crises, Lehman had successfully taken on more risk while its competitors retrenched.²⁵¹²⁵¹ Id.

80

¶During the first half of 2007, Lehman continued its growth strategy. Although Lehman's management decided to curtail its residential mortgage origination business, it did so less dramatically than many of its competitors in that business, several of which went out of business.²⁵²²⁵² Lehman, Update on Lehman Brothers' Subprime Mortgage Origination Business Presentation to Lehman Board of Directors (Mar. 20, 2007), at pp. 5, 10 [LBHI_SEC07940_025834]; e‐mail from Dimitrios Kritikos, Lehman, to Jeffrey Goodman, Lehman (Feb. 2, 2007) [LBEX‐DOCID 566140] ("While the rest of the industry is tightening credit and increasing prices in these areas, we are moving in the opposite direction.").Show full note

¶Lehman, along with other market participants and government regulators, underestimated the severity of the subprime mortgage crisis;²⁵³²⁵³ Examiner's Interview of Treasury Secretary Timothy F. Geithner, Nov. 24, 2009, at p. 3; Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at pp. 16, 24; Examiner's Interview of Richard McKinney, Aug. 27, 2009, at pp. 2, 9; Richard S. Fuld, Jr., Lehman, Notes for Senior Management Speech (June 16, 2008), at pp. 5‐6 [LBEX‐DOCID 529241], attached to e‐mail from Taimur Hyat, Lehman, to Herbert H. McDade III, Lehman, et al. (June 25, 2008) [LBEX‐DOCID 556064].Show full note the subprime crisis impaired Lehman's ability to securitize and sell residential mortgages and forced the firm to retain an increasingly large volume of residential mortgage‐related risk on its own balance sheet.²⁵⁴²⁵⁴ Lehman, Securitized Products, MBS: Non Investment Grade Retained Interests (Jan. 16, 2007), at pp. 1, 3 [LBEX‐DOCID 839039], attached to e‐mail from James Guarino, Lehman, to Richard McKinney, Lehman, et al. (Jan. 16, 2007) [LBEX‐DOCID 865925]. At the same time, during the first two quarters of 2007, Lehman continued to grow its leveraged loan, commercial real estate, energy, and principal investments businesses.²⁵⁵²⁵⁵ See Section III.A.1.b.1 of this Report. Lehman's growth strategy culminated in the acquisition of the Archstone REIT in late May 2007.²⁵⁶²⁵⁶ See Section III.A.1.b.2.d of this Report. Together, these transactions continued the ongoing increase in the size of Lehman's balance sheet, with a particularly strong concentration in assets that could not easily be sold in a crisis. Beginning in the fourth quarter of 2006, FID's businesses consistently exceeded their limits even though returns on assets and earnings were decreasing.²⁵⁷²⁵⁷ Lehman, Fixed Income Division Balance Sheet Management (Apr. 2007), at p. 2 [LBEX‐DOCID 787297], attached to e‐mail from Kieron Keating, Lehman, to David N. Sherr, Lehman, et al. (June 6, 2007) [LBEX‐ DOCID 808850]; Lehman Balance Sheet and Disclosure Scorecard For Trade Date Apr. 21, 2008 (Apr. 22, 2008), at p. 3 [LBEX‐DOCID 3187588], attached to e‐mail from Tal Litvin, Lehman, to Herbert H. McDade III, Lehman, et al. (Apr. 22, 2008) [LBEX‐DOCID 3187333].Show full note By February 2007, FID had a "serious balance sheet issue."²⁵⁸²⁵⁸ E‐mail from Joseph Gentile, Lehman, to Michael Gelband, Lehman, et al. (Feb. 21, 2007) [LBEX‐DOCID 810934].

81

¶This Section of the Examiner's Report discusses Lehman's actions with respect to each of these business lines separately below. This Section also discusses the major personnel move during the first half of 2007 – the replacement of Michael Gelband with Roger Nagioff as the head of FID. Finally, this section discusses the extent to which Lehman's officers informed the Board of Directors of the continuing expansion of Lehman's balance sheet and risk‐taking.

82

Lehman's Residential Mortgage Business

Lehman Decides to Curtail Subprime Originations but Continue to Pursue "Alt‐A" Originations

¶In the second half of 2006, Lehman began to see the first cracks in the subprime mortgage market.²⁵⁹²⁵⁹ Examiner's Interview of Thomas L. Wind, Apr. 21, 2009, at p. 8; Examiner's Interview of Susan Harrison, Apr. 28, 2009, at pp. 2, 5; Examinerʹs Interview of Marie Jean Burruel, Apr. 28, 2009, at p. 5; Dimitrios Kritikos, Lehman, BNC Risk Review December 2006 (Jan. 20, 2007), at p. 50 [LBEX‐DOCID 251077]; Dimitrios Kritikos, Lehman, Risk Review: Aurora and BNC February 2007 (Mar. 19, 2007), at p. 10 [LBEX‐DOCID 188325].Show full note Lehman reacted to these signs by tightening its origination standards, particularly with respect to subprime mortgages,²⁶⁰²⁶⁰ Dimitrios Kritikos, Lehman, BNC Risk Review December 2006 (Jan. 20, 2007), at p. 6 [LBEX‐DOCID 251077]; Lehman, Materials Prepared for Office of Thrift Supervision Safety and Soundness/Compliance Examination 2007 (Aug. 13, 2007), at pp. 13‐15 [LBEX‐DOCID 538654]; Lehman, Presentation to Moody's [Draft] (Oct. 16, 2007), at pp. 12‐15 [LEH‐FINRA‐E‐MAIL00088455]; Lehman, Presentation to Radian: Mortgage Operations Review (July 24, 2007), at pp. 15‐17 [LBEX‐DOCID 839141]; Examiner's Interview of Marie Jean Burruel, Apr. 28, 2009, at pp. 8‐10; Examiner's Interview of Dimitrios Kritikos, Apr. 16, 2009, at p. 8.Show full note but Lehman continued to pursue growth in its mortgage origination business generally, particularly through its Alt‐A originator, Aurora.²⁶¹²⁶¹ Dimitrios Kritikos, Lehman, Aurora Loan Services Risk Review January 2008 (Feb. 7, 2008), at pp. 10, 12 [LBEX‐DOCID 394711]. Alt‐A loans are a "somewhat loosely defined category between prime and subprime" that are "designed for borrowers with good credit records who do not meet standard guidelines for documentation requirements."²⁶²²⁶² Saundra F. Braunstein, Director of Division of Consumer and Community Affairs, Board of Governors of the Federal Reserve, Testimony Before U.S. House of Representatives Committee on Financial Services, Subcommittee on Financial Institutions and Consumer Credit (Mar. 27, 2007); see also Lehman, Product Definitions of Alt‐A, Mortgage Maker, and Subprime (Oct. 17, 2007), at p. 1 [LBEX‐DOCID 537902]; Cynthia Angell & Clare D. Rowley, Federal Deposit Insurance Corp., FDIC Outlook (Second Quarter 2006) (last updated Mar. 21, 2007) (http://www.fdic.gov/bank/analytical/regional/ro20062q/na/2006_summer04.html)Show full note Although Lehman's Alt‐A mortgages were never as risky as subprime mortgages, its Alt‐A mortgages became increasingly risky towards the end of 2006 and the beginning of 2007.²⁶³²⁶³ E‐mail from Dimitrios Kritikos, Lehman, to Jeffrey Goodman, Lehman (Jan. 31, 2007) [LBEX‐DOCID 380035]; Dimitrios Kritikos, Lehman, Selected trends from Aurora Risk Review (Feb. 2, 2007), at p. 2 [LBEX‐DOCID 537846]; Examiner's Interview of Dimitrios Kritikos, July 29 & 30, 2009, at pp. 12, 14‐15. This portion of the Report describes those events.

83

¶Lehman considered its residential mortgage securitization business to be a distribution business.²⁶⁴²⁶⁴ Madelyn Antoncic, Lehman, 2007 Bondholder Meeting Presentation (Oct. 18, 2007), at p. 6 [LBEX‐ DOCID 244792]; Lehman, Presentation to Standard and Poor's, Lehman Brothers Securitized Products Business (Oct. 7, 2005), at p. 2 [LBEX‐DOCID 095356]; Lehman, Strategic and Financial Review (Jan. 18, 2008), at p. 9 [LBEX‐DOCID 1412341]; Examiner's Interview of Richard McKinney, Aug. 27, 2009, at p. 5. Lehman had a vertically integrated residential mortgage business in which BNC originated subprime loans and Aurora originated Alt‐A loans, and Lehman itself securitized pools of those mortgages into residential mortgage‐ backed securities ("RMBS").²⁶⁵²⁶⁵ Vikas Shilpiekandula, Lehman, An Overview of the Residential Mortgage Market (Oct. 25, 2007), at p. 2 [LBEX‐DOCID 894664]. BNC and Aurora were part of Lehman's Mortgage Capital Division, which originated residential mortgages, while FID was responsible for securitizing the mortgages.²⁶⁶²⁶⁶ Examiner's Interview of David N. Sherr, May 6, 2009, at p. 4. By selling the RMBS to investors, Lehman shifted the risks of the underlying mortgages to the investors.²⁶⁷²⁶⁷ Lehman, Securitized Products, MBS: Non Investment Grade Retained Interests (Jan. 16, 2007), at p. 1 [LBEX‐DOCID 839039]. Lehman, however, bore the risk that it would not be able to securitize the mortgages or sell the RMBS.²⁶⁸²⁶⁸ Id.; Lehman, Presentation to Standard and Poor's, Lehman Brothers Securitized Products Business (Oct. 7, 2005), at pp. 9, 10 [LBEX‐DOCID 095356]. The mortgages that Lehman could not shift to third‐party investors through securitization were known as "retained interests."²⁶⁹²⁶⁹ Lehman, Securitized Products, MBS: Non Investment Grade Retained Interests (Jan. 16, 2007), at p. 25 [LBEX‐DOCID 839039]; see also LBHI_SEC07940_581174 10‐Q (filed Apr. 9, 2008), at pp. 20, 55.

84

¶By late 2006, Lehman's non‐investment grade retained interests began to increase sharply; investors were growing increasingly cautious about purchasing RMBS bonds backed by subprime mortgages, "and as a result the [Lehman residential mortgage trading] desk [was] struggling to sell residuals and [non‐investment grade] bonds."²⁷⁰²⁷⁰ Lehman, Securitized Products, MBS: Non Investment Grade Retained Interests (Jan. 16, 2007), at p. 13 [LBEX‐DOCID 839039]. Lehman's diminished ability to shift the mortgage‐based risk to investors meant that the formerly profitable moving business could become a money‐losing storage business.²⁷¹²⁷¹ Id. at p. 1.

¶At the same time, Lehman's mortgage business experienced other troubling trends, including sharp increases in repurchase requests, rises in delinquency rates and a spike in first‐payment defaults.²⁷²²⁷² Examiner's Interview of Susan Harrison, Apr. 28, 2009, at pp. 2, 5; Dimitrios Kritikos, Lehman, BNC Risk Review December 2006 (Jan. 20, 2007), at p. 50 [LBEX‐DOCID 251077]; Dimitrios Kritikos, Lehman, Risk Review: Aurora and BNC February 2007 (Mar. 19, 2007), at p. 10 [LBEX‐DOCID 188325]. By the fourth quarter of 2006, Lehman's internal research reports were suggesting that investors in RMBS bonds, and particularly those backed by subprime mortgages, would become increasingly risk‐averse, and subprime‐ backed RMBS bonds would be at heightened risk of a rating agency downgrade.²⁷³²⁷³ Srinivas Modukuri, Lehman, Securitized Products Outlook for 2007: Bracing for a Credit Downturn (Dec. 2006), at pp. 8, 19 [LBEX‐DOCID 245013].

85

¶Because of these trends, Lehman tightened its subprime lending operations. In about August 2006, Lehman replaced BNC's CEO and also created a new executive position (filled by Thomas L. Wind) to oversee both BNC and Aurora operations.²⁷⁴²⁷⁴ Examiner's Interview of Thomas L. Wind, Apr. 21, 2009, at pp. 3, 8; Examiner's Interview of Dimitrios Kritikos, July 29‐30, 2009, at pp. 8‐9; Examiner's Interview of Richard McKinney, Aug. 27, 2009, at pp. 5‐6; Examiner's Interview of Lana Franks Harber, Sept. 23, 2009, at p. 6; Lehman, Presentation to the Office of Thrift Supervision, Lehman Brothers Bank, FSB: Safety & Soundness/Compliance Examination 2007 (Aug. 7, 2007), at p. 5 [LBEX‐DOCID 1693347]; Lehman, Update on Lehman Brothers' Subprime Mortgage Origination Business Presentation to Lehman Board of Directors (Mar. 20, 2007), at p. 6 [LBHI_SEC07940_025834].Show full note Wind and new BNC CEO Steven Skolnik initiated changes to BNC's underwriting guidelines and product mix.²⁷⁵²⁷⁵ Examiner's Interview of Thomas L. Wind, Apr. 21, 2009, at pp. 6, 7‐8. These changes included reduction in the size of one of BNC's leading lending programs, known as "80/20," in which BNC extended two separate loans to bring the borrower's loan‐to‐value ratio to 100% based only on income data as stated by the borrower.²⁷⁶²⁷⁶ Dimitrios Kritikos, Lehman, BNC Risk Review December 2006 (Jan. 20, 2007), at p. 6 [LBEX‐DOCID 251077]; Examiner's Interview of Marie Jean Burruel, Apr. 28, 2009, at pp. 8‐10. Production under the 80/20 program dropped by two thirds from 2005 to 2006, and BNC discontinued the program entirely in late March 2007.²⁷⁷²⁷⁷ Lehman, Materials Prepared for Office of Thrift Supervision Safety and Soundness/Compliance Examination 2007 (Aug. 13, 2007), at p. 13 [LBEX‐DOCID 538654]; Lehman, Presentation to Moody's [Draft] (Oct. 16, 2007), at p. 12 [LEH‐FINRA‐E‐MAIL00088444]; Lehman, Presentation to Radian: Mortgage Operations Review (July 24, 2007), at p. 14 [LBEX‐DOCID 839141]; Examiner's Interview of Marie Jean Burruel, Apr. 28, 2009, at pp. 8‐10; Examiner's Interview of Dimitrios Kritikos, Apr. 16, 2009, at p. 8.Show full note Yet even in early 2007, BNC was originating a substantial quantity of subprime mortgages (about $750 million worth during the month of February 2007, for example).²⁷⁸²⁷⁸ Dimitrios Kritikos, Lehman, Risk Review: Aurora and BNC February 2007 (Mar. 19, 2007), at p. 6 [LBEX‐DOCID 188325]. Lehman did not discontinue subprime lending (as Lehman defined it) through BNC until its closure of BNC on August 22, 2007.²⁷⁹²⁷⁹ Examiner's Interview of Lana Franks Harber, Sept. 23, 2009, at p. 12; Examiner's Interview of Theodore P. Janulis, Sept. 25, 2009, at p. 3; Examiner's Interview of Marie Jean Burruel, Apr. 28, 2009, at p. 10; Lehman Brothers Holdings Inc., Press Release: Lehman Brothers Announces Closure of BNC Mortgage (Aug. 22, 2007) [LBEX‐DOCID 880148]; Lehman, Subprime(r) (Sept. 4, 2007), at p. 14 [LBEX‐DOCID 894656]; e‐mail from Edward Grieb, Lehman, to Christopher M. O'Meara, Lehman (Aug. 22, 2007) [LBEX‐ DOCID 197143]; e‐mail from Tasha Pelio, Lehman, to Jasjit (Jesse) Bhattal, Lehman, et al. (Aug. 22, 2007) [LBEX‐DOCID 176893].Show full note

86

¶Lehman executives had different recollections concerning whether managers within FID had advocated an earlier and more rapid reduction in Lehman's subprime mortgage originations.²⁸⁰²⁸⁰ Examiner's Interview of Kentaro Umezaki, June 25, 2009, at pp. 2, 15; Examiner's Interview of Michael Gelband, Aug. 12, 2009, at pp. 2, 10‐12; Examiner's Interview of Lana Franks Harber, Sept. 23, 2009, at pp. 4, 6; Examiner's Interview of Theodore P. Janulis, Sept. 25, 2009, at pp. 3, 5. Certain FID executives noted that Lehman managers from the Mortgage Capital Division wished to continue aggressive origination and that Mortgage Capital's view prevailed, while others in Mortgage Capital did not recall the disagreement or maintained that FID could have reduced originations itself if it wished.²⁸¹²⁸¹ Compare Examiner's Interview of Kentaro Umezaki, June 25, 2009, at pp. 2, 15 (stating that he, Gelband and Sherr, wanted to scale back originations while Janulis did not); Examiner's Interview of Michael Gelband, Aug. 12, 2009, at p. 11; (recalling that as late as 2007, he recommended managing the residential real estate business more conservatively, and that in general, MCD had an incentive to continue to push for originations because it was rewarded when its origination volumes were high and the risk was shifted to the Securitized Products Group after the mortgages were originated.), with Examiner's Interview of David N. Sherr, Sept. 25, 2009, at pp. 2‐3, 4‐5 (stating that he did not recall a dispute between MCD and FID over any proposed scaling back of originations, but that there was tension between FID and MCD over the control of the residential mortgage origination business,); Examiner's Interview of Theodore P. Janulis, Sept. 25, 2009, at pp. 3, 5 (stating that he did not recall a disagreement about whether originations should be slowed and that FID could have slowed origination volumes if it wished to do so); Examiner's Interview of Lana Franks Harber, Sept. 23, 2009, at p. 6. (stating that she did not recall internal presentations by Gelband questioning the continued viability of subprime residential lending); see also Examiner's Interview of Joseph Gregory, Nov. 13, 2009, at p. 10 (suggesting that he agreed with MCD's view and approved a strategy of continuing to originate residential mortgages aggressively).Show full note

87

¶Even as Lehman was tightening standards on its subprime originations through BNC, Lehman was also using its Aurora subsidiary to expand its Alt‐A lending.²⁸²²⁸² Examiner's Interview of Carl Peterson, May 27, 2009, at pp. 6‐8. Moreover, Aurora's Alt‐A lending reached borrowers of lesser credit quality than those who historically had been considered Alt‐A borrowers.²⁸³²⁸³ Id. at pp. 5‐7. The vehicle for that aspect of the Aurora business plan was the Mortgage Maker product.²⁸⁴²⁸⁴ Id. at p. 5; Examiner's Interview of Diane May, Apr. 16, 2009, at p. 5; Aurora Loan Services, Presentation to Securities and Exchange Commission (Feb. 6‐7, 2007), at p. 2 [LBEX‐DOCID 357348]. As Mortgage Maker expanded to more than half of Aurora's Alt‐A production by February 2007, many of Aurora's loans denominated as Alt‐A came more and more to resemble the subprime loans that Lehman was supposedly exiting by tightening origination standards at BNC.²⁸⁵²⁸⁵ Examiner's Interview of David N. Sherr, May 6, 2009, at p. 8; Examiner's Interview of John Vedra, Apr. 15, 2009, at p. 8; Examiner's Interview of Diane May, Apr. 16, 2009, at p. 5; Dimitrios Kritikos, Lehman, Risk Review: Aurora and BNC February 2007 (Mar. 19, 2007), at p. 4 [LBEX‐DOCID 188325]; see also e‐ mail from Dimitrios Kritikos, Lehman, to Ken Linton, Lehman, et al. (Mar. 30, 2007) [LBEX‐DOCID 286265] (noting that the riskier segments of Mortgage Maker performed three to five times worse than the rest of Auroraʹs loans); Russell V. Brady, Aurora, Response to LXS Performance Issues (Jan. 24, 2007), at p. 1 [LBEX‐DOCID 885450] (suggesting that Aurora needed to "[d]etermine whether a segment of the [Mortgage] Maker population should be serviced similar to subprime"); e‐mail from Richard McKinney, Lehman, to Thomas L. Wind, Aurora, et al. (Feb. 12, 2007) [LBEX‐DOCID 1369758] (noting that the performance of Lehman's LXS securitizations that consisted mostly of Mortgage Maker had worsened versus its largest competitor for 2006 production, and stating "Expected subordination levels are 11.7% to AAA loss coverage. This compares with 20‐25% for a typical subprime deal. That is, we are creating worse performance than subprime, while the rating agencies assume our performance should be substantially better").Show full note

¶By late January 2007, Lehman's residential mortgage analyst began to notice disturbing trends with respect to Aurora's Mortgage Maker program:

88

Looking at the trends on originations and linking them to first payment defaults, the story is ugly: The last four months Aurora has originated the riskiest loans ever, with every month being riskier than the one before ‐ the industry meanwhile has pulled back during that time.²⁸⁶²⁸⁶ E‐mail from Dimitrios Kritikos, Lehman, to Jeffrey Goodman, Lehman (Jan. 31, 2007) [LBEX‐DOCID 380035].

¶At the same time, other participants in the Alt‐A industry were reporting default rates and late payment data that indicated that "[t]he credit deterioration [in Alt‐A] has been almost parallel to the one of the subprime market."²⁸⁷²⁸⁷ Dimitrios Kritikos, Lehman, Risk Review: Aurora and BNC February 2007 [Draft] (Mar. 9, 2007), at p. 1 [LBEX‐DOCID 538518]. Thus, while Aurora's mortgages were not as risky as subprime mortgages, Aurora's risk profile was increasing in much the same way as the risk in subprime mortgages.

¶As a result of all these factors, Lehman's risk managers sometimes considered the Mortgage Maker loans to be distinct from Alt‐A mortgages, and described Mortgage Maker as Alt‐B.²⁸⁸²⁸⁸ E‐mail from Dimitrios Kritikos, Lehman, to Jeffery Goodman, Lehman (Mar. 12, 2007) [LBEX‐DOCID 307101] ("Aurora's product is far from Alt‐A anymore. The traditional Alt‐A program is only 40% of Aurora's production"); e‐mail from Dimitrios Kritikos, Lehman, to Charlie Lu, Lehman (Apr. 12, 2007) [LBEX‐DOCID 566105] ("MortgageMaker is NOT Alt‐A"); Dimitrios Kritikos, Lehman, Selected trends from Aurora Risk Review February 2007 (Feb. 2, 2007), at p. 2 [LBEX‐DOCID 537846] ("The product mix of Aurora production has shifted substantially in the last 6 months from Alt‐A to MortgageMaker (Alt‐ B)").Show full note While the term Alt‐B was not an accepted term or categorization in the business, Lehman's managers occasionally used it as a way of differentiating the riskier mortgages in the Mortgage Maker program from what had more traditionally been considered Alt‐A mortgages, though not so risky as to merit the label subprime.²⁸⁹²⁸⁹ Dimitrios Kritikos, Lehman, Selected trends from Aurora Risk Review February 2007 (Feb. 2, 2007), at p. 2 [LBEX‐DOCID 537846]; Examiner's Interview of Dimitrios Kritikos, July 29‐30, 2009, at pp. 3, 18 (stating that Mortgage Maker loans were neither Alt‐A nor subprime).

89

¶To make matters worse, Lehman's risk managers saw indications that Lehman would not be able to distribute the risk on the mortgages it was originating. By January 2007, it was apparent that Lehman's holding of non‐investment grade retained interests in securitizations had been increasing.²⁹⁰²⁹⁰ Lehman, Securitized Products, MBS: Non Investment Grade Retained Interests (Jan. 16, 2007), at p. 3 [LBEX‐DOCID 839039]. And by March 2007, Lehman was noting sharp declines in securitization revenue,²⁹¹²⁹¹ Lehman, Mortgage Update 1Q 07, at p. 9 [LBHI_SEC07940_845984]. causing the Securitized Products Group within FID to exceed its risk appetite and VaR limits.²⁹²²⁹² See, e.g.,George Hansman, Lehman, Securitized Products Risk Appetite and VaR limit and overage graphs (May 17, 2007) [LBEX‐DOCID 861260]; e‐mail from Lehman Risk, to Lehman Risk Limit Excess e‐ mail group (Mar. 8, 2007) [LBEX‐DOCID 229930]; e‐mail from Lehman Risk, to Lehman Risk Limit Excess e‐mail group (Mar. 19, 2007) [LBEX‐DOCID 229944]; e‐mail from Lehman Risk, to Lehman Risk Limit Excess e‐mail group (Mar. 22, 2007) [LBEX‐DOCID 229954]; e‐mail from Lehman Risk, to Lehman Risk Limit Excess e‐mail group (Apr. 9, 2007) [LBEX‐DOCID 790039]; e‐mail from Lehman Risk, to Lehman Risk Limit Excess e‐mail group (Apr.16, 2007) [LBEX‐DOCID 790029]; e‐mail from Lehman Risk, to Lehman Risk Limit Excess e‐mail group (May 29, 2007) [LBEX‐DOCID 790059]; e‐mail from Lehman Risk, to Lehman Risk Limit Excess e‐mail group (May 30, 2007) [LBEX‐DOCID 790060]; e‐mail from Lehman Risk, to Lehman Risk Limit Excess e‐mail group (Sept. 5, 2007) [LBEX‐DOCID 230188]; e‐mail from Lehman Risk, to Lehman Risk Limit Excess e‐mail group (Oct. 12, 2007) [LBEX‐DOCID 230789903]; e‐mail from Lehman Risk, to Lehman Risk Limit Excess e‐mail group (Oct. 17, 2007) [LBEX‐DOCID 789908]; e‐ mail from Lehman Risk, to Lehman Risk Limit Excess e‐mail group (Oct. 18, 2007) [LBEX‐DOCID 789910]; e‐mail from Lehman Risk, to Lehman Risk Limit Excess e‐mail group (Oct. 19, 2007) [LBEX‐DOCID 789909]; e‐mail from Lehman Risk, to Lehman Risk Limit Excess e‐mail group (Oct. 22, 2007) [LBEX‐ DOCID 790089]; e‐mail from Lehman Risk, to Lehman Risk Limit Excess e‐mail group (Oct. 30, 2007) [LBEX‐DOCID 789916].Show full note

¶To respond to these risks in its Alt‐A portfolio, in March 2007 Lehman undertook a series of changes designed to make Mortgage Maker loans less available to borrowers with lower credit scores, or to borrowers who wished to take out loans at 100% of a home's value.²⁹³²⁹³ Dimitrios Kritikos, Lehman, Risk Review: Aurora and BNC February 2007 (Mar. 19, 2007), at p. 3 [LBEX‐DOCID 188325] (summarizing underwriting guideline changes at BNC and Aurora). Although the volume of Mortgage Maker loans originated by Lehman declined following implementation of the March 2007 guideline changes, Lehman continued to originate significant volumes of Alt‐A mortgages until August 2007.²⁹⁴²⁹⁴ Dimitrios Kritikos, Lehman, Aurora Loan Services Risk Review January 2008 (Feb. 7, 2008), at p. 12 [LBEX‐DOCID 394711].

90

The March 20, 2007 Board Meeting

¶On March 20, 2007, the Mortgage Capital and Fixed Income Divisions gave a presentation to Lehman's Board of Directors about the state of Lehman's residential mortgage origination and securitization business in light of the deepening subprime crisis.²⁹⁵²⁹⁵ Lehman Brothers Holdings Inc., Minutes of Meeting of Board of Directors (Mar. 20, 2007), at pp. 6‐7 [LBHI_SEC07940_025779]; Lehman, Update on Lehman Brothers' Subprime Mortgage Origination Business Presentation to Lehman Board of Directors (Mar. 20, 2007) [LBHI_SEC07940_025834]. The presentation was given by David N. Sherr, the head of Lehman's Securitized Products Group; Theodore P. Janulis, the head of the Mortgage Capital Division; and Lana Franks Harber, Chief Administrative Officer ("CAO") of the Mortgage Capital Division.²⁹⁶²⁹⁶ Lehman, Update on Lehman Brothers' Subprime Mortgage Origination Business Presentation to Lehman Board of Directors (Mar. 20, 2007) [LBHI_SEC07940_025834]; Examiner's Interview of Lana Franks Harber, Sept. 23, 2009, at p. 2; Examiner's Interview of Theodore P. Janulis, Sept. 25, 2009, at p. 2; Examiner's Interview of David N. Sherr, Sept. 25, 2009, at p. 9.

¶While preparing to give this presentation, Harber e‐mailed one of her colleagues to inform him about a conversation that she had with Lehman's President, Joseph Gregory, about the presentation:

Board is not sophisticated around subprime market – Joe doesn't want too much detail. He wants to candidly talk about the risks to Lehman but be optimistic and constructive – talk about the opportunities that this market creates and how we are uniquely positioned to take advantage of them.²⁹⁷²⁹⁷ E‐mail from Lana Franks Harber, Lehman, to Steven Skolnik, BNC Mortgage, et al. (Mar. 9, 2007) [LBEX‐DOCID 306198]; accord Examiner's Interview of Lana Franks Harber, Sept. 23, 2009, at pp. 9‐10; Examiner's Interview of Theodore P. Janulis, Sept. 25, 2009, at p. 6.

91

¶Consistent with this direction, the Board presentation emphasized that Lehman's management considered the crisis an opportunity to pursue a countercyclical strategy.²⁹⁸²⁹⁸ Lehman, Update on Lehman Brothers' Subprime Mortgage Origination Business Presentation to Lehman Board of Directors (Mar. 20, 2007), at pp. 1, 10 [LBHI_SEC07940_025834]. The March 2007 Board presentation first noted the difficulties in the subprime market, including the fact that seven of the top twenty subprime originators had already been sold to stronger partners or gone bankrupt and that the business was significantly less profitable than in past years because of lower origination volumes, lower sale and securitization margins, and increased loan loss reserves.²⁹⁹²⁹⁹ Id. at pp. 4‐5. The presentation further noted that in response to these market events, Lehman had improved BNC's risk and credit profile, tightened its lending criteria, retained new management, and significantly reduced headcount.³⁰⁰³⁰⁰ Id. at pp. 6‐7.

¶The presentation concluded by highlighting management's belief that Lehman had "substantial opportunities, as in late 1990's" to improve its competitive position.³⁰¹³⁰¹ Id. at p. 10. This countercyclical strategy was based on several stated premises. Most important, Lehman's management believed that the subprime crisis would present only a "Limited Contagion To Other Markets" – in particular, Lehman's management did not expect the subprime crisis to have a significant impact on the "[b]roader credit markets."³⁰²³⁰² Id. at p. 9. Lehman's management also believed that a "substantial part of [the] subprime market is here to stay" and that "[p]rofitability will return when environment improves."³⁰³³⁰³ Id. at p. 10. In sum, Lehman management thought that the market was nearing the bottom of the cycle in spring and summer of 2007, and that Lehman would benefit from preserving the option to expand the business in the future.³⁰⁴³⁰⁴ Examiner's Interview of Lana Franks Harber, Sept. 23, 2009, at p. 2; Examiner's Interview of Theodore P. Janulis, Sept. 25, 2009, at p. 8; Examiner's Interview of David N. Sherr, Sept. 25, 2009, at p. 6. Management informed the Board that the down cycle in subprime presented "substantial opportunities" for Lehman, and that management expected Lehman to be better positioned for profitable growth once the industry cycle turned.³⁰⁵³⁰⁵ Lehman, Update on Lehman Brothers' Subprime Origination Business Presentation to Lehman Board of Directors (Mar. 20, 2007), at pp. 1, 10 [LBHI_SEC07940_025834].

92

¶The presentation did not discuss Aurora's Alt‐A mortgage originations at all, notwithstanding the significant concerns that Lehman's residential mortgage analyst had recently raised about that group of mortgages.³⁰⁶³⁰⁶ Id. at pp. 1‐10. Instead, the presentation grouped the Alt‐A category of mortgages with prime and described "Prime/Alt‐A Mortgages" as follows: "credit performance not problematic ‐ delinquencies are within expected range."³⁰⁷³⁰⁷ Id. at p. 9. An earlier draft of the slideshow presented to the Board had used the term "Alt‐A/Alt‐B Mortgages" above the words "credit performance not problematic – delinquencies are within expected range,"³⁰⁸³⁰⁸ Lehman, State of Lehman Brothers' Subprime Mortgage Origination Business Presentation to Lehman Board of Directors [Draft] (Mar. 15, 2007), at p. 12 [LBEX‐DOCID 2485576]. but this reference to Alt‐B was deleted from the final version of the materials in favor of "Prime/Alt‐A Mortgages."³⁰⁹³⁰⁹ Lehman, Update on Lehman Brothers' Subprime Origination Business Presentation to Lehman Board of Directors (Mar. 20, 2007), at p. 9 [LBHI_SEC07940_025834].

93

¶Sherr, Janulis, and Harber told the Examiner that they did not include a specific reference to Mortgage Maker or Alt‐B in their presentation because they believed that the loans in the Mortgage Maker program were distinct from subprime mortgages, which were the subject of the presentation.³¹⁰³¹⁰ Examiner's Interview of Lana Franks Harber, Sept. 23, 2009, at p. 3; Examiner's Interview of Theodore P. Janulis, Sept. 25, 2009, at pp. 2, 7; Examiner's Interview of David N. Sherr, Sept. 25, 2009, at p. 7. The Lehman risk analyst who had studied the performance issues in Mortgage Maker told the Examiner that leaving Mortgage Maker out of a presentation on subprime was proper given the differences between what Lehman considered subprime (FICO scores below 620) and Mortgage Maker (average FICO score of 691).³¹¹³¹¹ Examiner's Interview of Dimitrios Kritikos, July 29‐30, 2009, at p. 19.

¶After the Board presentation, Lehman continued to originate subprime and especially Alt‐A/Alt‐B mortgage loans, thereby pursuing its countercyclical strategy, and likely exacerbating Lehman's residential mortgage losses. The Examiner's financial advisors have estimated the losses from residential mortgage positions from the first quarter of 2007 through the third quarter of 2008 at $7.4 billion.³¹²³¹² Lehman, Mortgage Update ‐ 1Q 07 (Apr. 9, 2007) [LBEX‐DOCID 540069]; Lehman, Mortgage Update ‐ 2Q 07 (June 8, 2007) [LBEX‐DOCID 505835]; Lehman, Mortgage Update ‐ June 07 (Aug. 9, 2007) [LBEX‐ DOCID 611902]; Lehman, Mortgage Update ‐ August 07 (Sept. 25, 2007) [LBEX‐DOCID 505889]; Lehman, Flash ‐ Mortgage Update ‐ November 07 (Dec. 21, 2007) [LBEX‐DOCID 505890]; Lehman, Flash ‐ Mortgage Update ‐ January 07 (Feb. 15, 2008) [LBEX‐DOCID 3237972]; Lehman, Flash ‐ Mortgage Update ‐ March 07 (Apr. 23, 2008) [LBEX‐DOCID 2432630]; Lehman, Flash ‐ Mortgage Update ‐ Apr. 07 (May 15, 2008) [LBEX‐DOCID 1362958]; Lehman, Flash ‐ Mortgage Update ‐ May 07 (June 11, 2008) [LBEX‐ DOCID 3238001]; Lehman, Securitized Products P&L ‐ June 2008 (July 11, 2008) [LBEX‐DOCID 505776]; Lehman, Securitized Products P&L ‐ July 2008 (Aug. 14, 2008) [LBEX‐DOCID 505778].Show full note

94

¶These losses were tempered by effective hedging strategies through at least 2007 and into early 2008.³¹³³¹³ Examiner's Interview of Kentaro Umezaki, June 25, 2009, at p. 17; Lehman, Minutes of Meeting of the Board of Directors (Sept. 11. 2007), at p. 6 [LBHI_SEC07940_263264]. Between the first quarter of 2007 and the third quarter of 2008, Lehman had a gain of $2.96 billion on its residential mortgage credit hedges.³¹⁴³¹⁴ Lehman, Mortgage Update ‐ 1Q 07 (Apr. 9, 2007) [LBEX‐DOCID 540069]; Lehman, Mortgage Update ‐ 2Q 07 (June 8, 2007) [LBEX‐DOCID 505835]; Lehman, Mortgage Update ‐ June 07 (Aug. 9, 2007) [LBEX‐ DOCID 611902]; Lehman, Mortgage Update ‐ August 07 (Sept. 25, 2007) [LBEX‐DOCID 505889]; Lehman, Flash ‐ Mortgage Update ‐ November 07 (Dec. 21, 2007) [LBEX‐DOCID 505890]; Lehman, Flash ‐ Mortgage Update ‐ January 07 (Feb. 15, 2008) [LBEX‐DOCID 3237972]; Lehman, Flash ‐ Mortgage Update ‐ March 07 (Apr. 23, 2008) [LBEX‐DOCID 2432630]; Lehman, Flash ‐ Mortgage Update ‐ Apr. 07 (May 15, 2008) [LBEX‐DOCID 1362958]; Lehman, Flash ‐ Mortgage Update ‐ May 07 (June 11, 2008) [LBEX‐ DOCID 3238001]; Lehman, Securitized Products P&L ‐ June 2008 (July 11, 2008) [LBEX‐DOCID 505776]; Lehman, Securitized Products P&L ‐ July 2008 (Aug. 14, 2008) [LBEX‐DOCID 505778].Show full note Of this $2.96 billion gain, $2.623 billion was gained between the first quarter of 2007 and the end of the first quarter of 2008.³¹⁵³¹⁵ Id. For the second and third quarters of 2008, however, Lehman had essentially no gains on its hedges.³¹⁶³¹⁶ LBHI 10‐Q (July 10, 2008), at p. 67. As a result, during those quarters, Lehman suffered very substantial losses on its residential mortgage business.³¹⁷³¹⁷ The Examiner's financial advisors estimate that Lehman's secured losses from residential mortgages exceeded $1 billion in the second quarter and in excess of $3.5 billion in the third quarter of 2008.

95

The Explosion in Lehman's Leveraged Loan Business

¶During the first half of fiscal 2007, the high yield market was active, notwithstanding the onset of the crisis in the subprime residential mortgage market.³¹⁸³¹⁸ E‐mail from Roopali Hall, Lehman (Jan. 4, 2008) [LBHI_SEC07940_066187]; Lehman Loan Syndicate, Year‐End Recap (Jan. 7, 2008), at p. 1 [LBHI_SEC07940_066190]. Like other market actors during this period, Lehman participated in more leveraged finance deals than ever before and entered into deals that were generally bigger than the leveraged finance deals it had done in the past.³¹⁹³¹⁹ E‐mail from Evette Saldana, Lehman, to HYCC members, Lehman, et al. (June 15, 2007) [LBEX‐DOCID 494525]; Lehman Credit Facilitation Group, 2nd Quarter 2007 Review (June 2007), at p. 1 [LBEX‐DOCID 514908], attachment to e‐mail from Evette Saldana, Lehman, to HYCC members, Lehman, et al. (June 15, 2007) [LBEX‐DOCID 494525]. Compared to its competitors, Lehman was the most aggressive lender per dollar of shareholder equity in the first half of 2007.³²⁰³²⁰ E‐mail from Evette Saldana, Lehman, to HYCC members, Lehman, et al. (June 15, 2007) [LBEX‐DOCID 494525]; Lehman Credit Facilitation Group, 2nd Quarter 2007 Review (June 2007), at p. 6 [LBEX‐DOCID 514908], attached to e‐mail from Evette Saldana, Lehman, to HYCC members, Lehman, et al. (June 15, 2007) [LBEX‐DOCID 494525].

¶Lehman continued down this path despite the fact that the terms of these deals became less and less favorable over time from an investment banking perspective. Because there was so much competition to finance these loans, sponsors were able to negotiate terms that significantly increased the risk to the banks. For example, according to some estimates, covenant light loans – loans that did not include previously standard covenants requiring the borrower to maintain certain levels of collateral, cash flow, and payment terms – increased from less than 1% of all leveraged loans in 2004 to over 18% by 2007 industry‐wide.³²¹³²¹ Eric Felder, Lehman, Credit Outlook Presentation (Apr. 16, 2008), at p. 48 [LBHI_SEC07940_393578], attached to e‐mail from Christopher Wichenbaugn, Lehman, to DCMNY, Lehman (Apr. 16, 2008) [LBHI_SEC07940_393578]; Standard & Poor's and LSTA, Leveraged Loan Index, August 2008 Review (Sept. 3, 2008), at p. 84 [LBEX‐DOCID 4404712], attached to e‐mail from Kristen Vigletta, Lehman (Sept. 3, 2008) [LBEX‐DOCID 4326914].Show full note Lenders such as Lehman also abandoned certain contractual protections (e.g., material adverse change provisions ("MACs"), up‐front syndication, and joint liability) that were previously standard in the leveraged loan industry.³²²³²² Examiner's Interview of Madelyn Antoncic, Feb. 25, 2009, at p. 4. In some deals, Lehman was the only party to sign the legal documents, even though other banks were intended to commit to the loans; thus, Lehman initially bore all the risk.³²³³²³ Id. As of March 2007, the rating agencies "perceived loosening of [Lehman's] risk standards – particularly in leveraged lending. . . ."³²⁴³²⁴ Lehman, Credit Ratings Strategy Presentation (Mar. 1, 2007), at p. 13 [LBEX‐DOCID 618355]; e‐mail from Stephen Lax, Lehman, to James P. Seery, Jr. Lehman, et al. (Apr. 11, 2008) [LBEX‐DOCID 444768]. The Examiner has not investigated whether the contractual terms of Lehman's leveraged lending transactions were more aggressive than those of its competitors.

96

¶Between December 2006 and June 2007, Lehman participated in more than 11 leveraged buyout deals that each exceeded $5 billion.³²⁵³²⁵ E‐mail from Miriam Oh, Lehman, to Paul Parker, Lehman, et al. (July 5, 2007) [LBEX‐DOCID 3197652]; Lehman, Big LBO Update (July 3, 2007), at p. 2 [LBEX‐DOCID 3183564]. By April 2007, Lehman had approximately 70 high yield contingent commitments in its pipeline – a record number for it.³²⁶³²⁶ E‐mail from Stephen Lax, Lehman, to Alex Kirk, Lehman, et al. (Apr. 26, 2007) [LBEX‐DOCID 259369]. In June 2007, Lehman's lending pace had already doubled Lehman's 2006 record‐setting year for high grade and high yield combined.³²⁷³²⁷ Lehman Credit Facilitation Group, 2nd Quarter 2007 Review (June 2007), at p. 13 [LBEX‐DOCID 514908], attached to e‐mail from Evette Saldana, Lehman, to HYCC members, Lehman, et al. (June 15, 2007) [LBEX‐DOCID 494525].

97

¶When the market started to slow, Lehman suddenly found itself with a huge volume of commitments on its books and a risk profile that was well above its high yield business's risk appetite limits. At the end of the second quarter of 2007, approximately $36 billion of contingent commitments remained on Lehman's books.³²⁸³²⁸ Alex Kirk, Lehman, Leveraged Finance Risk Presentation (June 2007) [LBEX‐DOCID 158975], attached to e‐mail from Olivia Lua, Lehman, to Christopher M. O'Meara, Lehman (June 21, 2007) [LBEX‐DOCID 158975]. FID was almost $20 billion over its net balance sheet limit for the quarter.³²⁹³²⁹ Lehman Brothers, Balance Sheet Trend Presentation (Apr. 2007), at pp. 4‐6 [LBEX‐DOCID 251418], attached to e‐mail from Kentaro Umezaki, Lehman, to Rebecca Miller, Lehman (May 3, 2007) [LBEX‐ DOCID 346520]. Relatedly, as described below, Lehman soon vastly exceeded its risk appetite limits for the high yield business.

Relaxation of Risk Controls to Accommodate Growth of Lehman's Leveraged Loans Business

¶To accommodate the growth of Lehman's high yield lending activities, Lehman's management decided to loosen several of the firm's risk controls that otherwise would have limited the firm's ability to engage in many of these deals. Most significantly, as discussed above, Lehman's senior management approved a number of deals that exceeded the firm's single transaction limit.

98

¶Many of the leveraged loans that Lehman funded in 2006 and 2007 were "way over the limit."³³⁰³³⁰ E‐mail from Joe Li, Lehman, to Paul Mitrokostas, Lehman (Aug. 30, 2007) [LBEX‐DOCID 2547330]. By July 2007, Lehman had committed to approximately 30 deals that exceeded the pre‐existing $250 million loss threshold, nine deals that would have exceeded a newly proposed loss threshold of $400 million,³³¹³³¹ Joe Li, Lehman, STL Backtesting Excel Spreadsheet (July 25, 2007) [LBEX‐DOCID 2506462], attached to e‐mail from Joe Li, Lehman, to Fred S. Orlan, Lehman, et al. (July 25, 2007) [LBEX‐DOCID 2563167]. five deals that violated the notional limit of $3.6 billion, and four deals that would have violated the notional limit of $4.5 billion that was proposed during the fourth quarter of 2007.³³²³³² Id. Some of Lehman's commitments exceeded the loss threshold limit by a factor of six.³³³³³³ Id. With respect to 24 of the largest high yield deals in which Lehman participated, Lehman committed roughly $10 billion more than the single transaction limit, if enforced, would have allowed.³³⁴³³⁴ Lehman, Fixed Income Business Strategy, Single Transaction Limit Policy Proposed Improvements (Sept. 2007), at p. 3 [LBEX‐DOCID 2563444]. These figures arguably understate the extent to which Lehman's leveraged loans exceeded the single transaction limit, since Lehman applied the single transaction limit only to the amount of the leveraged loan that Lehman "expected to fund," not the full amount of Lehman's commitment.³³⁵³³⁵ Lehman, Presentation to Lehman Executive Committee on Leveraged Finance Risk (Oct. 16, 2007), at p. 12 [LBEX‐DOCID 506033], attached to e‐mail from Blair Sieff, Lehman, to Steven Berkenfeld, Lehman, et al. (Oct. 16, 2007) [LBEX‐DOCID 569915].

¶To accommodate the growth of the high yield business, Lehman's management also relaxed the high yield business's risk appetite limits. Despite having increased the high yield business's risk appetite limit at the beginning of 2006 and again in early 2007, Lehman's increasing level of high yield commitments caused it to exceed the high yield business's risk appetite limit by significant amounts in 2007 and 2008.³³⁶³³⁶ Appendix: 9, comparing risk appetite and VaR usage versus limits. By late April 2007, Lehman had exceeded its newly increased high yield risk appetite limit,³³⁷³³⁷ Id. at p. 3. and starting in late July, the high yield business' usage consistently exceeded its limits.³³⁸³³⁸ Id. at p. 4. As Lehman funded more of its commitments, the leveraged loan exposure soon doubled the limit amount.³³⁹³³⁹ Id. at p. 4‐9.

99

¶Lehman's management made a conscious decision to exceed the risk appetite limits on leveraged loans.³⁴⁰³⁴⁰ Examiner's Interview of Kentaro Umezaki, June 25, 2009, at p. 13; Examiner's Interview of Jeffrey Goodman, Aug. 28, 2009. Even though the risk appetite limits were divided into subsidiary limits for the business lines of each division, the limits for each business line were flexible as long as the aggregate numbers "rolled‐up" within the divisional limit.³⁴¹³⁴¹ Examiner's Interview of Madelyn Antoncic, Mar. 27, 2009, at p. 12; Examiner's Interview of Madelyn Antoncic, Oct. 6, 2009, at p. 7. One Lehman executive questioned whether the firm even had a high yield limit. In April 2007, Kentaro Umezaki, Head of Fixed Income Strategy, e‐mailed Christopher M. O'Meara, Lehman CFO at the time, and several others, expressing concern that in a recent firm‐wide meeting, Fuld sent "inconsistent messages" by encouraging growth at the same time Lehman was near its risk limits.³⁴²³⁴² E‐mail from Kentaro Umezaki, Lehman, to Scott J. Freidheim, Lehman, et al. (Apr. 19, 2007) [LBEX‐ DOCID 210193]. Umezaki noted to O'Meara and others:

100

the majority of the trading businesses focus is on revenues, with balance sheet, risk limit, capital or cost implications being a secondary concern. The fact that they haven't heard that those items matter [in] public forums from senior management recently reinforces this revenue oriented behavior implicitly. . . . Example which we've debated for years: was even a topic in [the Turnberry meeting in] FLA: Do we or don't we have a limit on how much HY LBO related lending/commitment exposure we can have at any given time? There has been no real "one firm" outcome to date in my opinion. I'm not the only one who has this view in FID.³⁴³³⁴³ Id. (emphasis added); e‐mail from Kentaro Umezaki, Lehman, to Ian T. Lowitt, Lehman (Apr. 18, 2007) [LBEX‐DOCID 743931].

Internal Opposition to Growth of Leveraged Loans Business

¶Lehman's FID, including Gelband, Kirk, and Umezaki, opposed a number of the leveraged loan deals to which Lehman committed during this period, because they believed that these individual deals were too risky to justify their limited returns.³⁴⁴³⁴⁴ Examiner's Interview of Kentaro Umezaki, June 25, 2009, at p. 10; Examiner's Interview of Michael Gelband, Aug. 12, 2009, at pp. 6‐9; Examiner's Interview of Alex Kirk, Jan. 12, 2010, at p. 2; e‐mail from Eric Felder, Lehman, to Michael Gelband, Lehman, et al. (Aug. 28, 2008) [LBEX‐DOCID 822513]; see also e‐ mail from Steven Berkenfeld, Lehman, to Scott J. Freidheim, Lehman (May 11, 2007) [LBEX‐DOCID 1379290]; e‐mail from Bertrand Kan, Lehman, to Richard Atterbury, Lehman (Jan. 30, 2008) [LBEX‐ DOCID 1379129].Show full note Despite the opposition, the Executive Committee decided to proceed with many of the deals.³⁴⁵³⁴⁵ Examiner's Interview of Kentaro Umezaki, June 25, 2009, at p. 3; Examiner's Interview of Michael Gelband, Aug. 12, 2009, at pp. 7‐9; Examiner's Interview of Alex Kirk, Jan. 12, 2010, at pp. 2, 7; Examiner's Interview of Paul Shotton, June 5, 2009, at pp. 2, 6‐7; Examiner's Interview of Hugh E. (Skip) McGee III, Aug. 12, 2009, at p. 9; Examiner's Interview of Fred S. Orlan, Sept. 21, 2009, at p. 4; e‐mail from Eric Felder, Lehman, to Michael Gelband, Lehman, et al. (Aug. 28, 2008) [LBEX‐DOCID 822513]; see also e‐mail from Steven Berkenfeld, Lehman, to LBEC Member, Lehman, et al. (May 11, 2007) [LBEX‐DOCID 1379290]; e‐mail from Larry Wieseneck, Lehman, to Alex Kirk, Lehman (Jan. 30, 2008) [LBEX‐DOCID 1379129].Show full note

101

¶Some of the opposition to Lehman's increase in leveraged lending was focused on the bridge equity component of those deals.³⁴⁶³⁴⁶ E‐mail from Roger Nagioff, Lehman, to Madelyn Antoncic, Lehman, et al. (June 29, 2007) [LBEX‐ DOCID 1467654); Examiner's Interview of Fred S. Orlan, Sept. 21, 2009, at p. 7. Several former members of Lehman's senior management, including Nagioff, Antoncic, and Berkenfeld, expressed reservations regarding the firm's level of engagement in leveraged loan bridge equity activities.³⁴⁷³⁴⁷ E‐mail from Roger Nagioff, Lehman, to David Goldfarb, Lehman (June 1, 2007) [LBEX‐DOCID 1581523]; e‐mail from Madelyn Antoncic, Lehman, to David Goldfarb, Lehman, et al. (June 1, 2007). The Examiner, however, also found that sponsors were aggressive in demanding equity bridge components to financing³⁴⁸³⁴⁸ E‐mail from Steven Berkenfeld, Lehman, to Robert D. Redmond, Lehman (Sept. 23, 2007) [LBEX‐ DOCID 1387569]; e‐mail from Alex Kirk, Lehman, to [xxxxxxx]@archwireless.net (May 15, 2007) [LBEX‐ DOCID 1379297] (phone number redacted); e‐mail from Steven Berkenfeld, Lehman, to LBEC Member, Lehman, et al. (May 11, 2007) [LBEX‐DOCID 1379291]. and that the Investment Banking Division ("IBD") was in favor of providing bridge equity because it believed that Lehman needed to do so to stay competitive in the industry.³⁴⁹³⁴⁹ Examiner's Interview of Fred S. Orlan, Sept. 21, 2009, at p. 7. Despite various discussions among Lehman's management regarding whether the level of leveraged loan bridge equity was acceptable and sustainable, Lehman's management never put any limit on the business's leveraged loan bridge equity commitments.³⁵⁰³⁵⁰ Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at p. 13; Examiner's Interview of Alex Kirk, Jan. 12, 2010, at p. 8; e‐mail from Robert D. Redmond, Lehman, to Steven Berkenfeld, Lehman, et al. (May 19, 2007) [LBEX‐DOCID 264270]; e‐mail from Alex Kirk, Lehman, to Robert D. Redmond, Lehman, et al. (May 21, 2007) [LBEX‐DOCID 174236]; e‐mail from Steven Berkenfeld, Lehman, to David Goldfarb, Lehman, et al. (June 15, 2007) [LBEX‐DOCID 859026].Show full note

102

¶By April 2007, the overall size of the firm's leveraged loan commitments became controversial.³⁵¹³⁵¹ Examiner's Interview of Kentaro Umezaki, June 25, 2009, at p. 10. Kirk and Gelband became concerned about Lehman's overall exposure. In April 2007, Kirk e‐mailed Gelband:

As a heads up our risk of mandated commits is up to 6mm a bp triple our previous high. Also the commits are coming in fast and furious I expect us to be well north of 30B this quarter. This is also unprecedented. In addition we are now seeing commitments that have crossed the risk tolerance so we may need your help with the bank in saying no to some key clients.³⁵²³⁵² E‐mail from Alex Kirk, Lehman, to Michael Gelband, Lehman (Apr. 20, 2007) [LBEX‐DOCID 2763976].

¶At about the same time, Berkenfeld, who was head of the Commitment Committee that was charged with evaluating individual leveraged loans, noted in an e‐mail: "The frenzy of the last month or so concerns me and I don't like being brought in at the very end and expected to make these decisions in less than 48 hours."³⁵³³⁵³ E‐mail from Steven Berkenfeld, Lehman, to Jean‐Francois Astier, Lehman, et. al. (Mar. 30, 2007) [LBEX‐ DOCID 351370].

¶Antoncic, the CRO, also opposed many of the transactions and the overall size of the business. She recalled a conversation in which she told Berkenfeld and Goldfarb that the firm's leveraged loan exposure was getting too large and that limits had to be imposed.³⁵⁴³⁵⁴ Examiner's Interview of Madelyn Antoncic, Mar. 27, 2009, at p. 10. When Berkenfeld replied that he liked all of the deals that Lehman was considering, Antoncic responded that he could like one deal or another, but not all of them at once.³⁵⁵³⁵⁵ Id.

103

¶Fuld believed that FID and Gelband were not opposed to Lehman expanding its leveraged loan business.³⁵⁶³⁵⁶ Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at pp. 5, 12, 13. Fuld believed that FID simply did not want the leveraged loans on its own balance sheet, because it received credit for only half of the income.³⁵⁷³⁵⁷ Id. at p. 19. In contrast, IBD received credit for half of the income but bore no risk.³⁵⁸³⁵⁸ Examiner's Interview of Kentaro Umezaki, June 25, 2009, at p. 10. Fuld considered Gelband's concerns an "intramural P+L grab," which concerned him.³⁵⁹³⁵⁹ Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at p. 19.

Growth of Lehman's Commercial Real Estate Business at The Start of the Subprime Crisis

¶At the same time that Lehman was rapidly growing its leveraged loan business, Lehman also dramatically increased its commercial real estate transactions. Lehman almost doubled GREG's balance sheet limit from $36.5 billion in the first quarter 2007 to $60.5 billion in the first quarter 2008, with GREG regularly exceeding its balance sheet limits.³⁶⁰³⁶⁰ Lehman, FID‐Balance Sheet Management Presentation (Sept. 2007), at p. 3 [LBEX‐DOCID 4553137], attached to e‐mail from Janet Marrero, Lehman, to Gerard Reilly, Lehman (Oct. 8, 2007) [LBEX‐DOCID 4552976]; Lehman, FID‐Balance Sheet Presentation (Jan. 17, 2008), at p. 3 [LBEX‐DOCID 3363221], attached to e‐mail from Sigrid Stabenow, Lehman, to Erik Addington, Lehman (Jan. 31, 2008) [LBEX‐ DOCID 3384762]; Lehman, Fixed Income Q3 Balance Sheet Targets [LBEX‐DOCID 1742006], attached to e‐ mail from Kevin Horan, Lehman, to Clement Bernard, Lehman (June 27, 2009) [LBEX‐DOCID 1698861].Show full note For instance, GREG exceeded its balance sheet limit by approximately $600 million in the third quarter 2007 ($56.6 billion balance sheet usage); by approximately $3.8 billion in the fourth quarter 2007 ($64.3 billion balance sheet usage); and by approximately $5.2 billion in the first quarter 2008 ($65.7 billion balance sheet usage).³⁶¹³⁶¹ Id. In addition, between the second quarter of 2006 and the second quarter of 2007, Lehman's real estate bridge equity positions in the United States increased ten‐fold, from $116 million to $1.33 billion, and then doubled to more than $3 billion by the end of the second quarter of 2008.³⁶²³⁶² Ari Koutouvides, Lehman, Global Real Estate Group America's Portfolio Summary re the Second Quarter of 2007 (Oct. 24, 2007), at p. 2 [LBEX‐DOCID 2501404], attached to e‐mail from Jonathan Cohen, Lehman, to Paul Higham, Lehman (Oct. 24, 2007) [LBEX‐DOCID 2558146]; Global Real Estate Group Americas Portfolio as of June 30, 2008, at p. 15 [LBEX‐DOCID 1419825].

104

¶GREG's balance sheet growth was largely the result of a series of large transactions that Lehman concluded between May 2007 and November 2007. Each of the following deals increased the balance sheet by over $1 billion in the respective months:³⁶³³⁶³ The amounts listed were labeled as "[m]ovements onto the balance sheet" for the respective months. Unless otherwise noted in the source, these amounts are presumed to be amounts funded in that period. See Quarterly Real Estate Recap Third Quarter and Year‐To‐Date Presentation (Nov. 29, 2007), at pp. 118‐ 25 [LBEX‐DOCID 3504242], attached to e‐mail from Paul Higham, Lehman, to Donald E. Petrow, Lehman (Nov. 29, 2007) [LBEX‐DOCID 3625043].Show full note

● May 2007, $2.0 billion – Lehman financing to Broadway Partners to acquire a sub‐portfolio of Beacon Capital Strategic Partners III, LP.³⁶⁴³⁶⁴ Id.

● May 2007, $1.3 billion – Lehman financing to Broadway Real Estate Partners to acquire 237 Park Avenue.³⁶⁵³⁶⁵ Id.

● June 2007, $1.2 billion – Lehman financing to Apollo Investment Corp. for a take private of Innkeepers USA Trust;³⁶⁶³⁶⁶ Id.

● June 2007, $1.1 billion – Lehman financing to Thomas Properties Group to acquire the EOP Austin portfolio;³⁶⁷³⁶⁷ Id.

105

● June 2007, $1.7 billion – Lehman financing for the acquisition of Northern Rock's commercial real estate portfolio;³⁶⁸³⁶⁸ Id.

● July 2007, $1.5 billion – Lehman financing to ProLogis to acquire the Dermody industrial portfolio;³⁶⁹³⁶⁹ Id.

● July 2007, $2.9 billion – Lehman financing for the acquisition of the Coeur Defense office building;³⁷⁰³⁷⁰ Id.

● August 2007, $1.0 billion – Lehman financing for the acquisition of Northern Rock's commercial real estate portfolio;³⁷¹³⁷¹ Id.

● October 2007, $1.5 billion – Lehman financing to Blackstone for its acquisition of Hilton Hotels;³⁷²³⁷² Lehman, Commercial mortgages – Q2 2008 (Aug. 6, 2008), at pp. 5‐14 [LBEX‐DOCID 018868], attached to e‐mail from Gerard Reilly, Lehman, to Ian T. Lowitt, Lehman (Aug. 7, 2008) [LBEX‐DOCID 011867]. and

● October 2007, $5.4 billion – Lehman financing for the acquisition of the Archstone Smith Trust.³⁷³³⁷³ Id.

¶Because Lehman encountered subsequent difficulties in selling or securitizing portions of these deals, many of the above transactions remained among the largest exposures on Lehman's balance sheet as Lehman's financial condition deteriorated well into 2008.³⁷⁴³⁷⁴ Lehman, Global Real Estate Group Update, at pp. 2‐11 [LBEX‐DOCID 019080] (listing top 10 risks as of May 31, 2008).

Relaxation of Risk Controls to Accommodate Growth of Lehman's Commercial Real Estate Business

¶As with the growth of the leveraged loan business, the growth of the commercial real estate business was facilitated first by an increase in the risk limits and then by a decision to exceed those limits. In a May 9, 2006 e‐mail to Umezaki, Paul A. Hughson, GREG's Head of Credit Distribution, inquired as to how risk limits meshed with GREG's plans to "expand our business in Asia, Europe and our bridge equity business globally. I specifically wanted to focus on how we can grow Asia and bridge equity, given the risk limits . . . ."³⁷⁵³⁷⁵ E‐mail from Kentaro Umezaki, Lehman, to Paul A. Hughson, Lehman (May 9, 2006) [LBEX‐DOCID 1776281]. Several months later, in September 2006, in an e‐mail to Walsh, Jeffrey Goodman, (senior‐most risk manager for FID directly responsible for GREG) stated that he "wanted to followup on a conversation I had with [G]elband a while back concerning a push (from Goldfarb et al) to take on more risk in RE (double your size?) and get your view on what is realistic to expect and where you see this in the approval process internally."³⁷⁶³⁷⁶ E‐mail from Jeffrey Goodman, Lehman, to Mark A. Walsh, Lehman (Sept. 19, 2006) [LBEX‐DOCID 1368068].

106

¶Lehman's risk appetite limit for the real estate business increased from $600 million in 2006 to $720 million in 2007.³⁷⁷³⁷⁷ E‐mail from Paul A. Hughson, Lehman, to Thomas Pearson, Lehman, et al. (May 23, 2006) [LBEX‐ DOCID 1776282]; Lehman, Real Estate >> Risk Appetite / VaR >> Summary ‐ COB 27 Aug 2007 Monday [LBEX‐DOCID 2912096], attached to e‐mail from Patricia Luken, Lehman, to Paul Higham, Lehman, et al. [LBEX‐DOCID 2880146]. But the real estate business quickly felt pressure from management to exceed its recently increased limit. In a June 2007 e‐mail, Goodman told Antoncic that Hughson felt "trapped in that Roger [Nagioff] and other senior folks want[ed] them to keep growing the biz and hitting p/l budgets but on the other hand they [were] over [balance sheet] limits and risk limits."³⁷⁸³⁷⁸ E‐mail from Jeffrey Goodman, Lehman, to Madelyn Antoncic, Lehman (June 29, 2007) [LBEX‐DOCID 155724]. Goodman advised Hughson that Lehman's commercial real estate group "[could not] keep adding deals without a plan to reduce the risk somehow," and that there needed to be a discussion with Nagioff "as [to ask whether he could] cut risk in other areas (HY?) to free up some room or [whether he would] be willing to sit out some opportunities."³⁷⁹³⁷⁹ Id. Management ultimately decided that GREG would not be held to any risk appetite limits.³⁸⁰³⁸⁰ Examiner's Interview of Mark Walsh, Oct. 21, 2009, at pp. 4‐5. Walsh told the Examiner that he was told to double the commercial real estate risk. Id. at p. 5.

107

Internal Opposition to Growth of Commercial Real Estate Business

¶As with the leveraged loan business, some Lehman executives voiced concerns about the risk associated with Lehman's large concentration of commercial real estate positions on its balance sheet. But, again as with the leveraged loan business, Lehman's management decided to continue to grow the commercial real estate business notwithstanding those warnings, "because that was the strategic imperative of the firm."³⁸¹³⁸¹ Examiner's Interview of Paul A. Hughson, Oct. 28, 2009, at p. 3. For example, on May 7, 2007, Goodman e‐mailed Antoncic about the Archstone transaction discussed below and said that O'Meara, then the CFO, "ha[d] significant concerns regarding overall size of [the real estate] book and how much of the firm's equity [was] tied up in such bridge equity deals."³⁸²³⁸² E‐mail from Jeffrey Goodman, Lehman, to Madelyn Antoncic, Lehman (May 7, 2007) [LBEX‐DOCID 154953]. Lehman's risk managers were also concerned with the real estate bridge equity deals in which Lehman was participating.³⁸³³⁸³ Id.; Examiner's Interview of Madelyn Antoncic, Mar. 27, 2009, at pp. 8‐9; e‐mail from Madelyn Antoncic, Lehman, to Roger Nagioff, Lehman, et al. (June 29 , 2007) [LBEX‐DOCID 1478403]; e‐mail from Paul A. Hughson, Lehman, to Thomas Pearson, Lehman, et al. (May 23, 2006) [LBEX‐DOCID 1776282]. The bridge equity positions were considered particularly risky because Lehman's balance sheet would be directly affected by the declining market values of the underlying real estate if the firm failed to sell its bridge equity positions as planned.³⁸⁴³⁸⁴ Examiner's Interview of Madelyn Antoncic, Mar. 27, 2009, at pp. 8‐9.

108

¶Nevertheless, by late 2007, Lehman acquired a number of substantial bridge equity positions, both in the United States and overseas, including: $2.3 billion in Archstone;³⁸⁵³⁸⁵ Global Real Estate Group, Lehman, Updated Commitment Committee Memorandum for Archstone (May 22, 2007) [LBEX‐DOCID 1350952]; Lehman, Lehman Brothers Bridge Equity Pipeline (July 3, 2007) [LBEX‐DOCID 638275], attached to e‐mail from Jeffrey Goodman, Lehman, to Donald E. Petrow, Lehman, et al. (July 11, 2007) [LBEX‐DOCID 670845]. $574 million in ProLogis/Dermody portfolio;³⁸⁶³⁸⁶ Lehman, Top Real Estate Risk Summary (Dec. 12, 2007), at p. 2 [LBEX‐DOCID 789172]. €475 million ($655 million) in Coeur Defense;³⁸⁷³⁸⁷ Id.; Quarterly Real Estate Recap Third Quarter and Year‐To‐Date Presentation (Nov. 29, 2007), at p. 124 [LBEX‐DOCID 3504242], attached to e‐mail from Paul Higham, Lehman, to Donald E. Petrow, Lehman (Nov. 29, 2007) [LBEX‐DOCID 3625043]. $221 million in EOP Austin;³⁸⁸³⁸⁸ Id. at p. 3. and $195 million in the acquisition of the 200 Fifth Avenue building.³⁸⁹³⁸⁹ Id. at p. 4. As a result of these acquisitions, real estate bridge equity went from a negligible business to a multi‐billion dollar exposure in approximately 18 months.

Archstone

Lehman's Commitment

¶The enormous growth of Lehman's commercial real estate balance sheet culminated in Lehman's commitment to participate in an approximately $22 billion joint venture with Tishman Speyer for the acquisition of the publicly‐held Archstone REIT.³⁹⁰³⁹⁰ Lehman, Archstone Q2 2008 Update, at p. 14 [LBEX‐DOCID 2929329], attached to e‐mail from Leonard Cohen, Lehman, to Paul A. Hughson, Lehman (June 12, 2008) [LBEX‐DOCID 2820780]. Including units under construction, Archstone owned over 88,000 apartments, which were spread across more than 340 communities within the United States.³⁹¹³⁹¹ Archstone‐Smith Operating Trust, Annual Report for 2006 as of December 31, 2006 (Form 10‐K) (filed on Mar. 1, 2007), at p. 6. Mark Walsh was the driving force behind this deal, but Fuld and Gregory strongly supported it as well.³⁹²³⁹² Examiner's Interview of Mark A. Walsh, Oct. 21, 2009, at pp. 8‐10; Examiner's Interview of Joseph Gregory, Nov. 13, 2009, at pp. 7‐8; Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at pp. 3‐4.

109

¶On May 2, 2007, Lehman and Tishman Speyer provided a non‐binding letter to acquire all outstanding shares of Archstone for $64 per share, subject to confirmatory due diligence.³⁹³³⁹³ James L. Dixson, Lehman, Archstone Transaction Timeline (June 20, 2007), at. p. 2 [LBEX‐DOCID 2139993], attached to e‐mail from James L. Dixson, Lehman, to Robert Ashmun, Lehman, et al. (June 20, 2007) [LBEX‐DOCID 2139994]. After negotiating a price of $60.75 per share and executing a plan of merger,³⁹⁴³⁹⁴ Id. at p. 5; Agreement and Plan of Merger Among Archstone‐Smith Trust, Archstone‐Smith Operating Trust, River Holding, LP, River Acquisition (MD), LP, and River Trust Acquisition, LP (May 28, 2007) [TSREV00000460‐554]. the parties announced the deal publicly on May 29, 2007.³⁹⁵³⁹⁵ James L. Dixson, Lehman, Archstone Transaction Timeline (June 20, 2007), at. pp. 5, 6 [LBEX‐DOCID 2139993], attached to e‐mail from James L. Dixson, Lehman, to Robert Ashmun, Lehman, et al. (June 20, 2007) [LBEX‐DOCID 2139994]; Agreement and Plan of Merger for Archstone‐Smith and River Holding (May 28, 2007) [LBEX‐DOCID 1759937], attached to e‐mail from Kyle Krpata, Weil, Gotshal & Manges LLP, to David E. Shapiro, Wachtell, Lipton, Rosen & Katz, et al. (May 29, 2007) [LBEX‐DOCID 1870993].Show full note The deal was originally scheduled to close before August 31.³⁹⁶³⁹⁶ E‐mail from Chip Heflin, Lehman, to Loan Sales, Lehman (May 29, 2007) [LBEX‐DOCID 1488757].

¶Lehman's Executive Committee required Walsh to find partners to reduce Lehman's risk in the deal. Bank of America Corporation ("BofA") agreed to fund half of the floating rate bank loan and junior mezzanine loan, and to purchase half the bridge equity.³⁹⁷³⁹⁷ Compare Memorandum from Mark A. Walsh, Lehman, to Executive Committee of Lehman Board of Directors, Re: Project Easy Living (May 22, 2007) [LBEX‐DOCID 1350952], attached to e‐mail from Julia Atwood, Lehman, to HYCC Members, Lehman, et al. [LBEX‐DOCID 1341648] with Memorandum from Mark A. Walsh, Lehman, to Exec. Committee of LBHI Board of Directors, re: Project Easy Living (May 7, 2007), at pp. 1, 3 [LBEX‐DOCID 147230], attached to e‐mail from Mark A. Walsh, Lehman, to Steven Berkenfeld, Lehman, et al. (May 8, 2007) [LBEX‐DOCID 141217]; Letter from Scott M. Weiner, Barclays Investment Holdings, Inc., to Lehman, et al., Red‐line Commitment Letter for Archstone (June 11, 2007) [LBEX‐DOCID 2073685]; Letter from Scott M. Weiner, Barclays Investment Holdings, Inc., to Lehman, et al., Execution Copy of Commitment Letter for Archstone (June 11, 2007) [LBEX‐DOCID 1451573].Show full note Barclays Capital Inc. ("Barclays") signed a participation agreement to take 15% of the bridge equity and 15% of the debt in the Archstone deal, and then, on July 2, 2007, amended the agreement to take 25% of the debt.³⁹⁸³⁹⁸ Id. Barclays' commitments came out of BofA's share of the debt and equity, and thus did not affect Lehman's exposure to Archstone.³⁹⁹³⁹⁹ Examiner's Interview of Mark A. Walsh, Oct. 21, 2009.

110

¶The Archstone deal was an enormous commitment by Lehman, both in terms of debt financing and equity. After bringing in BofA and Barclays, Lehman agreed to make a permanent equity investment of $250 million; agreed to purchase bridge equity of approximately $2.3 billion; and also agreed to fund various debt tranches totaling $8.5 billion.⁴⁰⁰⁴⁰⁰ Project Easy Living, Term Sheet (Sponsor) (May 28, 2007), at p. 1 [LBEX‐DOCID 1624529], attached to e‐mail from David Herman, Weil, Gotshal & Manges LLP, to Andrew Dady, Schulte Roth & Zabel LLP, et al. [LBEX‐DOCID 1383842]; Project Easy Living, Term Sheet (Bridge Equity) (May 28, 2007), at p. 1 [LBEX‐ DOCID 1324526], attached to e‐mail from David Herman, Weil, Gotshal & Manges LLP, to Andrew Dady, Schulte Roth & Zabel LLP, et al. [LBEX‐DOCID 1383842]; River Holdings LP Senior Secured Facilities Commitment Letter (May 28, 2007), at p. 1 [LBEX‐DOCID 2395952], attached to e‐mail from Julian Chung, Cadwalader, Wickersham & Taft LLP, et al. (May 29, 2007) [LBEX‐DOCID 2268458].Show full note

111

¶At the time the deal was presented to the Executive Committee, Lehman intended to sell all Archstone debt at closing.⁴⁰¹⁴⁰¹ Lehman, Easy Living Talking Points for Executive Committee and Rating Agencies (May 18, 2007), at p. 2 [LBEX‐DOCID 200792], attached to e‐mail from Paolo R. Tonucci, Lehman, to Christopher M. O'Meara, Lehman, et al. (May 18, 2007) [LBEX‐DOCID 215761]. Because Lehman had price flex on the Archstone debt, Lehman management was reasonably confident that it could distribute the debt without suffering a loss.⁴⁰²⁴⁰² Id. Price flex is a mechanism that facilitates syndication or sale of a loan by the initial lender without taking a loss.⁴⁰³⁴⁰³ Standard & Poor's, Guide to the Loan Market (Sept. 2009), at p. 8, http://www2.standardandpoors.com/spf/pdf/fixedincome/LoanMarketGuide_2009_Final.pdf (last visited (last visited on Feb. 1, 2010); Alicia Taylor & Alicia Sansone, THE HANDBOOK OF LOAN SYNDICATIONS AND TRADING 175 (McGraw‐Hill 2007); Steven M. Vavaria, Standard & Poor's, Syndicated Loans‐‐A Rated Market, at Last! (Feb. 12, 2002), http://leeds‐ faculty.colorado.edu/madigan/3020/Readings/Syndicated_Loans‐‐A_Rated_Market_At_Last.pdf (last visited on Feb. 1, 2010).Show full note As a mechanical matter, price flex may permit the initial lender to increase the interest rate to attract other lenders (in which case the borrower is required to pay its lenders a higher interest rate), or require the borrower to reimburse the debt holders for any loss they may suffer as a result of syndicating or selling the debt to a third party at a price less than par.⁴⁰⁴⁴⁰⁴ Id. Because of the price flex on the Archstone debt, the risk in the Archstone commitment was heavily concentrated in Lehman's equity and bridge equity commitments.

¶Lehman planned to sell 50% of its remaining mezzanine debt and bridge equity positions within two to three weeks of closing (Lehman had already had two large financial institutions express an interest), and the rest would be sold off over the six months following closing.⁴⁰⁵⁴⁰⁵ Lehman, Easy Living Talking Points for Executive Committee and Rating Agencies (May 18, 2007), at p. 2 [LBEX‐DOCID 200792], attached to e‐mail from Paolo R. Tonucci, Lehman, to Christopher M. O'Meara, Lehman, et al. (May 18, 2007) [LBEX‐DOCID 215761]. Insofar as Lehman's potential profits were concerned, Lehman forecast earning more than $1.3 billion over a ten‐year period, including nearly $1 billion on Lehman's investment and substantial origination and asset management fees.⁴⁰⁶⁴⁰⁶ Memorandum from Mark A. Walsh, Lehman, to Executive Committee, Lehman, re Project Easy Living (May 7, 2007), at p. 3 [LBEX‐DOCID 147230], attached to e‐mail from Mark A. Walsh, Lehman, to Steven Berkenfeld, Lehman, et al. (May 8, 2007) [LBEX‐DOCID 141217].

112

Risk Management of Lehman's Archstone Commitment

¶Archstone was repeatedly considered by both the Commitment Committee and Executive Committee.⁴⁰⁷⁴⁰⁷ Examiner's Interview of David S. Lazarus, Nov. 18, 2009, at pp. 6‐7; Examiner's Interview of Paul A. Hughson, Oct. 28, 2009, at p. 2; Examiner's Interview of Lisa Beeson, Oct. 23, 2009, at p. 4; Examiner's Interview of Kenneth Cohen, Oct. 20, 2009, at pp. 5‐6. These committees mandated significant alterations to the deal structure, including, most importantly, requiring Walsh to bring in at least one partner – ultimately BofA – to reduce the size of Lehman's commitment.⁴⁰⁸⁴⁰⁸ Examiner's Interview of Steven Berkenfeld, Oct. 5 & 7, 2009, at pp. 14‐15; Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at pp. 22‐23.

¶Notwithstanding Archstone's consideration by the senior management of the firm, Lehman's risk managers said that they had minimal input in the decision to acquire Archstone.⁴⁰⁹⁴⁰⁹ Examiner's Interview of Jeffrey Goodman, Aug. 28, 2009; Examiner's Interview of Kentaro Umezaki, June 25, 2009, at p. 17; Examiner's Interview of Madelyn Antoncic, Feb. 25, 2009, at p. 5. As a result, despite the extraordinary size and risk of Lehman's commitment to the transaction, Lehman's management did not conduct quantitative analyses of Lehman's exposure in advance of the risk Lehman was undertaking.⁴¹⁰⁴¹⁰ Examiner's Interview of Jeffrey Goodman, Aug. 28, 2009; Examiner's Interview of Madelyn Antoncic, Mar. 27, 2009, at p. 11. For example, it does not appear that Lehman systematically analyzed the effect that the commitment would have on the firm's risk appetite levels, or conducted stress testing on the firm's burgeoning commercial real estate exposures, in advance of committing to the transaction. Because of the extraordinary size of the transaction, however – including especially an unprecedented bridge equity commitment – it was clear from the beginning that the Archstone commitment would cause Lehman to exceed its risk appetite limits.⁴¹¹⁴¹¹ Examiner's Interview of Jeffrey Goodman, Aug. 28, 2009.

113

¶The Office of Thrift Supervision ("OTS") criticized Lehman's decision to enter into the Archstone transaction in excess of its risk appetite limits.⁴¹²⁴¹² Office of Thrift Supervision, Report of Examination, Lehman Brothers Holdings Inc. (Exam starting July 7, 2008), at p. 2 [LBEX‐OTS 000392]. During OTS's yearly review of Lehman in 2007, the OTS noticed that Lehman had exceeded its risk appetite limits and that the Archstone deal was largely responsible for that overage.⁴¹³⁴¹³ Examiner's Interview of Ronald Marcus, Nov. 4, 2009, at pp. 7‐8. As a result, in 2008, OTS decided to conduct a targeted review of Lehman's commercial real estate business. After that targeted review, OTS issued a "negative" report, criticizing Lehman for being "materially overexposed" in the commercial real estate market and for entering into the Archstone deal without sound risk management practices.⁴¹⁴⁴¹⁴ Examiner's Interview of Ronald S. Marcus, Nov. 4, 2009, at pp. 7‐8; accord Office of Thrift Supervision, Report of Examination, Lehman Brothers Holdings Inc. (Exam starting July 7, 2008), at p. 2 [LBEX‐OTS 000392]. The report concluded that Lehman's breach of risk limits, caused largely by the Archstone deal, contributed to "major failings in the risk management process."⁴¹⁵⁴¹⁵ Office of Thrift Supervision, Report of Examination, Lehman Brothers Holdings Inc. (Exam starting July 7, 2008), at p. 2 [LBEX‐OTS 000392].

114

¶By contrast, the SEC told the Examiner that it was aware of the risk appetite limit excesses, and that it did not second‐guess Lehman's business decisions so long as the limit excesses were properly escalated within Lehman's management.⁴¹⁶⁴¹⁶ Examiner's Interview of the Securities and Exchange Commission, Aug. 24, 2009, at p. 8.

Nagioff's Replacement of Gelband as Head of FID

¶On May 1, 2007, Lehman announced that Gelband, the then‐acting Global Head of FID, had "decided to leave the Firm to pursue other interests," and that Roger Nagioff would assume the top FID position at Lehman.⁴¹⁷⁴¹⁷ Lehman Brothers Holdings Inc., Press Release: Lehman Brothers Names Roger B. Nagioff Global Head of Fixed Income (May 2, 2007), at p. 1 [LBEX‐DOCID 1470086], attached to e‐mail from Monique Wise, Lehman, to Jasjit (Jesse) Bhattal, Lehman, et al. (May 1, 2007) [LBEX‐DOCID 1605828]. Internally, Lehman announced that the change was based on "philosophical differences" among Fuld, Gregory, and Gelband as to the direction to take to grow the business.⁴¹⁸⁴¹⁸ Lehman Brothers, Talking Points & FAQs (May 1, 2007) [LBEX‐DOCID 1470087], attached to e‐mail from Monique Wise, Lehman, to Jasjit (Jesse) Bhattal, Lehman, et al. (May 1, 2007) [LBEX‐DOCID 1605828].

¶Gelband was removed from the position for several reasons, including that he was not aggressive enough in growing the business in accordance with Fuld's longterm revenue targets.⁴¹⁹⁴¹⁹ Examiner's Interview of Joseph Gregory, Nov. 5, 2009; Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at pp. 5‐6 (stating that Gregory informed him that Gelband was forced out because he was not willing to think creatively about growing Lehman's business and sharing his belief that Gelband's opposition to the Eagle Energy deal was the "last straw"); Examiner's Interview of Michael Gelband, Aug. 12, 2009, at pp. 15‐16; contra Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at p. 18; Examiner's Interview of Herbert H. (Bart) McDade III, Jan. 28, 2010, at p. 9.Show full note Fuld and Gregory also clashed with Gelband with respect to growing the firm's energy business and its leveraged loan business.⁴²⁰⁴²⁰ Examiner's Interview of Michael Gelband, Aug. 12, 2009, at pp. 2, 7, 15‐16; Examiner's Interview of Joseph Gregory, Nov. 5, 2009; Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at pp. 5‐6; Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at p. 18; e‐mail from Michael Gelband, Lehman to Richard S. Fuld, Jr., Lehman (Mar. 6, 2007) [LBEX‐DOCID 2762454] ("[R]isk/reward is not good here so I'm trying to get out of as much illiquid risk as possible. . . . That is the strategy at the moment that all my managers are following. I need to have them be in a position to be able to operate and capitalize if we go through a period of stress.").Show full note

115

¶Fuld and Gregory chose Nagioff, then the CEO of Lehman Europe, to succeed Gelband, even though he had no direct experience in the fixed income business, and he lived in London, not New York.⁴²¹⁴²¹ Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at pp. 5‐6; Examiner's Interview of Hugh E. (Skip) McGee, Aug. 12, 2009, at p. 27 (McGee indicated that replacing Gelband with Nagioff was an unusual idea because Nagioff's experience was with European equities and McDade would have been a more logical choice to replace Gelband.); Examiner's Interview of Kentaro Umezaki, June 25, 2009, at p. 15 (Umezaki stated that many people, himself included, were surprised at Nagioff's promotion because Nagioff had no background in fixed income and was not located in the United States at a time when Lehman was dealing with an economic crisis located primarily within the United States and further that Alex Kirk or Andrew J. Morton would have been more logical selections but that Gregory had indicated that Nagioff would be good for the job because of his abundance of business experience and a willingness to take risks.).Show full note Nagioff decided to commute from London for a portion of each month.⁴²²⁴²² Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at p. 6 (Nagioff's commute would ultimately prove to be an unsustainable arrangement, as the strain it created on Nagioff's family caused him to leave the company in February 2008.).

116

The Board of Directors' Awareness of Lehman's Increasing Risk Profile

¶In a June 19, 2007 Board meeting, O'Meara presented the second quarter results to the Board.⁴²³⁴²³ Lehman Brothers Holdings Inc., Minutes of Meeting of Board of Directors (June 19, 2007), at p. 3 [LBHI_SEC07940_026267]. Lehman's management generally disclosed the firm's increased risk profile as well as the recently concluded Archstone deal. For example, O'Meara reported that the firm‐wide quarterly average risk appetite usage for the second quarter of 2007 was $2.6 billion against a limit of $3.3 billion,⁴²⁴⁴²⁴ Id.; Lehman, Second Quarter 2007 Financial Information Presentation to Lehman Board of Directors (June 19, 2007), at p. 6 [LBHI_SEC07940_026226]. and the Board had an extended discussion concerning the fact that the increased risk usage was spread across the firm.⁴²⁵⁴²⁵ Lehman, Second Quarter 2007 Financial Information Presentation to Lehman Board of Directors with Welikson's notes (June 19, 2007), at p. 6 [WGM_LBEX_01165]. In June 2007, however, Lehman's daily risk systems reflected that the firm was almost at the $3.3 billion risk appetite limit, not including the Archstone transaction – well above the $2.6 billion quarterly average.⁴²⁶⁴²⁶ See, e.g., Lehman, Daily Risk Appetite Report (June 19, 2007), at p. 1 [LBEX‐DOCID 3296221], attached to e‐mail from Rui Li, Lehman, to Manhua Leng, Lehman, et al. (June 19, 2007) [LBEX‐DOCID 3295251].

¶The inclusion of the Archstone transaction was certain to put Lehman well over both its firm‐wide risk appetite limit and its limit applicable to the real estate business.⁴²⁷⁴²⁷ See, e.g., id.; Mark Weber, Lehman, Chart Showing Risk Appetite Adjustment for Archstone (July 24, 2008) [LBEX‐DOCID 425705], attached to e‐mail from Mark Weber, Lehman, to PortfolioRisk Support, Lehman, et al. (July 24, 2008) [LBEX‐DOCID 265567]. While the Archstone transaction was discussed at the June meeting,⁴²⁸⁴²⁸ Lehman's Board did not consider or approve the Archstone transaction in advance of the commitment. Examiner's Interview of Sir Christopher Gent, Oct. 22, 2009, at p. 3; but cf. Examiner's Interview of Michael L. Ainslie, Sept. 22, 2009, at p. 8 (stating that the Board never formally approved the Archstone acquisition or even discussed the transaction prior to Lehman's commitment to the deal); Examiner's Interview of John F. Akers, Apr. 22, 2009 (same); Examiner's Interview of Roger Berlind, May 8, 2009, at p. 10 (same); Examiner's Interview of Thomas Cruikshank, Oct. 8, 2009, at p. 3 (same); Examiner's Interview of Marsha Johnson Evans, May 22, 2009, at p. 14 (same); Examiner's Interview of Sir Christopher Gent, Oct. 22, 2009, at pp. 12‐13 (same); Examiner's Interview of Roland A. Hernandez, Oct. 2, 2009 (same); Examiner's Interview of Dr. Henry Kaufman, May 19, 2009, at p. 15 (same); Examiner's Interview of John D. Macomber, Sept. 25, 2009, at p. 13 (same).Show full note Lehman's management did not inform the Board until October 15, 2007 that Lehman had exceeded the firm‐wide risk appetite limit for more than four months.

117

Early Warnings: Risk Limit Overages, Funding Concerns, and the Deepening Subprime Crisis

¶From May to August 2007, the financial crisis that had previously been contained to the subprime residential mortgage market began to spread to other markets, including the commercial real estate and credit markets, where Lehman was particularly active. These concerns escalated in June and July 2007, when two Bear Stearns hedge funds imploded, leading to panic in the credit markets and concerns more generally that the subprime crisis would spill into the broader economy.⁴²⁹⁴²⁹ Mark Pittman, Bear Stearns Mortgage Fund Collapse Sends Shock Through CDOs (Update 2), Bloomberg, June 21, 2007. SEC Chairman Christopher Cox commented that "[o]ur concerns are with any potential systemic fallout."⁴³⁰⁴³⁰ Id.

¶As a consequence of this gathering storm, in the first two weeks of July 2007, S&P placed $7.3 billion of residential mortgage related securities on negative ratings watch and announced a review of collateralized debt obligations ("CDOs") exposed to residential collateral; Moody's downgraded $5 billion of subprime mortgage bonds and placed 184 mortgage backed CDO tranches on downgrade review; and Fitch placed 33 classes of structured finance CDOs on credit watch negative.⁴³¹⁴³¹ Bank for International Settlements, 78th Annual Report (June 30, 2008), at p. 95. By the first week of August 2007, Germany's IKB announced major subprime‐related losses and required a bailout, American Home Mortgage filed for Chapter 11 bankruptcy, and the French bank BNP Paribas froze redemptions on three of its funds, citing an inability to value them in the current market.⁴³²⁴³² Id.

118

¶Despite these events, Lehman went forward with a number of large investments, some previously committed, some new, until August 2007, when it drastically cut back on its leveraged lending, and later in 2007, when it stopped doing new commercial real estate deals.

¶This Section discusses the concerns of Lehman's managers about the state of the markets as early as April and May 2007 and management's actions with respect to the scale of its leveraged loan business. This Section also discusses the concerns among some Lehman managers in July and August 2007 that Lehman might be unable to fund all of its leveraged loan and real estate commitments, including Archstone, and Lehman managers' decision during this period not to increase the magnitude of Lehman's "macro hedges" on its leveraged loan and commercial real estate portfolio. Finally, this Section discusses management's decision to terminate its residential mortgage originations through BNC and Aurora.

119

Nagioff and Kirk Try to Limit Lehman's High Yield Business

¶Nagioff began to discuss rolling back the growth of the firm's leveraged loan business as soon as he became head of FID on May 2, 2007, but this decision was not fully effectuated until August 2007, by which time Lehman's leveraged loan exposure had grown to $35.8 billion as a result of $25.4 billion in new commitments.⁴³³⁴³³ Lehman, Business and Financial Review Q2 2008 (Aug. 5, 2008), at p. 14 [LBHI_SEC07940_659768]; Lehman, Loan Portfolio Group Weekly Review (June 8, 2007), at pp. 3‐8 [LBEX‐DOCID 146379]; Lehman, Loan Portfolio Group Weekly Review (June 15, 2007), at pp. 3‐8 [LBEX‐DOCID 146375]; Lehman, Loan Portfolio Group Weekly Review (June 22, 2007), at pp. 3‐8 [LBEX‐DOCID 146376]; Lehman, Loan Portfolio Group Weekly Review (June 29, 2007), at pp. 3‐8 [LBEX‐DOCID 146377]; Lehman, Loan Portfolio Group Weekly Review (July 6, 2007), at pp. 3‐8 [LBEX‐DOCID 146348]; Lehman, Loan Portfolio Group Weekly Review (July 13, 2007), at pp. 3‐8 [LBEX‐DOCID 146358]; Lehman, Loan Portfolio Group Weekly Review (July 20, 2007), at p. 7 [LBEX‐DOCID 146339]; Lehman, Loan Portfolio Group Weekly Review (July 27, 2007), at pp. 3‐8 [LBEX‐DOCID 146350]; Lehman, Loan Portfolio Group Weekly Review (Aug. 10, 2007), at pp. 3‐8 [LBEX‐DOCID 146341]; e‐mail from Jeffrey Goodman, Lehman, to David N. Sherr, Lehman, et al. (June 22, 2007) [LBEX‐DOCID 237094]. There is some evidence of inaccuracies in the LPG reports. See, e.g., Gary J. Fox, Lehman, Lehman Brothers Top Exposure Report Lehman Papers Compared to LPG Data (June 25, 2007) [LBEX‐DOCID 2461202], attached to e‐mail from Gary J. Fox, Lehman, to Greg L. Smith, Lehman, et al. (June 26, 2009) [LBEX‐DOCID 2461203]. The calculation excludes the commitment to TXU.Show full note

¶Nagioff learned about the size of Lehman's leveraged loan exposures from Kirk, then Head of Global Credit Products.⁴³⁴⁴³⁴ Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at p. 8. Lehman's leveraged loan business was "so gargantuan – the exposures jumped out at [him]."⁴³⁵⁴³⁵ Id. at p. 7. Nagioff and Kirk believed that this was "banker business, not broker business," which Lehman did not have the balance sheet to support.⁴³⁶⁴³⁶ Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at p. 7. Nagioff also thought that the chance of a sudden market downturn was high, and that Lehman was making relatively small profits for taking increasingly large and illiquid risks.⁴³⁷⁴³⁷ Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at p. 8; e‐mail from Gary Mandelblatt, Lehman, to Roger Nagioff, Lehman, et al. (Nov. 27, 2007) [LBEX‐DOCID 156264]. Nagioff was concerned because the tail risk of Lehman's leveraged loan business totaled billions of dollars.⁴³⁸⁴³⁸ Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at p. 10.

120

¶Nagioff also had broader concerns about the state of the credit markets. These concerns were shared by others outside Lehman and by several of Nagioff's senior colleagues, who believed that Lehman was operating in a "credit bubble."⁴³⁹⁴³⁹ E‐mail from Steven Berkenfeld, Lehman, to Roger Nagioff, Lehman (May 10, 2007) [LBEX‐DOCID 140669]; e‐mail from Roger Nagioff, Lehman, to Ian T. Lowitt, Lehman (May 10, 2007) [LBEX‐DOCID 140666]; e‐mail from Christopher M. O'Meara, Lehman, to Paulo R. Tonucci, Lehman (Apr. 6, 2007) [LBEX‐DOCID 1349076]; e‐mail from Christopher M. O'Meara, Lehman, to Ian T. Lowitt, Lehman (July 21, 2007) [LBEX‐DOCID 211149].Show full note Months later, Antoncic, for example, reflected back on the general consensus that the markets were in trouble: "every one saw the train wreck coming. 64k question is why didn't anyone get out of the way???"⁴⁴⁰⁴⁴⁰ E‐mail from Madelyn Antoncic, Lehman, to Jack Malvey, Lehman (Apr. 8, 2008) [LBHI_SEC07940_212356].

¶Although Nagioff's concerns were shared by several others, Nagioff believed that it would be difficult to curtail Lehman's leveraged loan business, because McGee's IBD, which had championed expansion of this business from the start, had to authorize the change.⁴⁴¹⁴⁴¹ Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at p. 10. Moreover, Lehman had many deals in the pipeline, and those deals were supporting "100 bankers."⁴⁴²⁴⁴² Id. To make matters worse, Kirk believed that Gelband had been relieved of his position partly as a result of his opposition to the leveraged loan business; Nagioff believed that he would only get one chance to convince Fuld that this business had to be stopped.⁴⁴³⁴⁴³ E‐mail from Roger Nagioff, Lehman, to Alex Kirk, Lehman (May 31, 2007) [LBEX‐DOCID 173414]; Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at p. 11; Examiner's Interview of Alex Kirk, Jan. 12, 2010, at p. 11 (Kirk stated that Nagioff thought that Gelband had been fired in part for opposing the leveraged loans business; thus, they had to move very slowly in obtaining authority to halt the business).Show full note

121

¶Nagioff spoke to Fuld on May 31, 2007. Nagioff told Fuld that Lehman was too big in the leveraged lending business and could lose a lot of money in the tail risk.⁴⁴⁴⁴⁴⁴ Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at p. 11; e‐mail from Jormen Vallecillo, Lehman, to Roger Nagioff, Lehman, et al. (June 8, 2007) [LBEX‐DOCID 1620669]; Alex Kirk, Lehman, Leveraged Finance Risk Presentation (June 8, 2007) [LBEX‐DOCID 1416503]. Nagioff showed Fuld the numbers, which reflected a possible $3.2 billion loss under a stress scenario that was computed specifically for the purpose of this meeting.⁴⁴⁵⁴⁴⁵ Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at pp. 11‐12; e‐mail from Jormen Vallecillo, Lehman, to Roger Nagioff, Lehman, et al. (June 8, 2007) [LBEX‐DOCID 1620669]; Alex Kirk, Lehman, Leveraged Finance Risk Presentation (June 8, 2007), at p. 10 [LBEX‐DOCID 1416503]. Nagioff told Fuld that Lehman needed to reduce its forward commitments from $36 billion to $20 billion, impose rules on the amount of leverage in the deals, and develop a framework for limiting and evaluating this business.⁴⁴⁶⁴⁴⁶ Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at p. 12.

¶Fuld was surprised and concerned by the tail risk in the leveraged loan positions and authorized Nagioff to present his analysis to the Executive Committee to get authorization to move forward with a plan to limit the firm's leveraged loan exposures.⁴⁴⁷⁴⁴⁷ Id.

122

¶Several weeks later, Nagioff discussed the leveraged loan exposure with the Executive Committee. After that conversation, on June 28, 2007, Nagioff was authorized by Fuld, Gregory, and McGee to conduct a "cross‐firm initiative" to reduce commitments to $20 billion by the end of 2007.⁴⁴⁸⁴⁴⁸ E‐mail from Steven Berkenfeld, Lehman, to Scott J. Freidheim, Lehman (June 26, 2007) [LBEX‐DOCID 1819424]; Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at p. 13. The cross‐firm initiative entailed developing more specific and effective limits on Lehman's high yield business (including single transaction limits) and bridge equity, and developing a plan for reducing the existing exposures.⁴⁴⁹⁴⁴⁹ Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at p. 13.

¶In the two months between Nagioff's conversation with Fuld on May 31 and the slowdown of Lehman's leveraged loan commitments in August 2007, the firm entered into another $25.4 billion in commitments.⁴⁵⁰⁴⁵⁰ Lehman, Loan Portfolio Group Weekly Review (June 8, 2007), at pp. 3‐8 [LBEX‐DOCID 146379]; Lehman, Loan Portfolio Group Weekly Review (June 15, 2007), at pp. 3‐8 [LBEX‐DOCID 146375]; Lehman, Loan Portfolio Group Weekly Review (June 22, 2007), at pp. 3‐8 [LBEX‐DOCID 146376]; Lehman, Loan Portfolio Group Weekly Review (July 6, 2007), at pp. 3‐8 [LBEX‐DOCID 146348]; Lehman, Loan Portfolio Group Weekly Review (July 13, 2007), at pp. 3‐8 [LBEX‐DOCID 146358]; Lehman, Loan Portfolio Group Weekly Review (July 27, 2007), at pp. 3‐8 [LBEX‐DOCID 146350]; Lehman, Loan Portfolio Group Weekly Review (Aug. 10, 2007), at pp. 3‐8 [LBEX‐DOCID 146341]. The calculation excludes Lehman's commitment to TXU.Show full note For example, Lehman agreed on June 18, 2007 to commit $2.05 billion to the Sequa Corp deal; to commit $3.3 billion to the Home Depot Supply deal on July 19, 2007; to commit $2.4 billion to finance the Houghton Mifflin deal; and to commit $2.14 billion to finance the Applebee's deal on July 16,

123

¶2007.⁴⁵¹⁴⁵¹ E‐mail from Lehman Risk, Lehman, to Risk Limit Excess, Lehman (July 16, 2007) [LBEX‐DOCID 230109]; Lehman, Loan Portfolio Group Weekly Review (July 20, 2007), at p. 7 [LBEX‐DOCID 146339]; Lehman, Loan Portfolio Group Weekly Review (July 27, 2007), at pp. 6‐7 [LBEX‐DOCID 146350]; Appendix: 9, comparing risk appetite and VaR usage versus limits. As a result, FID ended the quarter roughly $2 billion over its net balance sheet limit.⁴⁵²⁴⁵² Lehman, 2007 Balance Sheet Targets and Usage ‐ Global (Oct. 17, 2007) [LBEX‐DOCID 278229]. As Nagioff put it, it took time to "stop the machine;" a lot of deals were in the pipeline or under negotiation, and Lehman did not believe that it could abruptly terminate those deals.⁴⁵³⁴⁵³ Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at p. 10; Examiner's Interview of Alex Kirk, Jan. 12, 2009, at pp. 2‐3; accord Examiner's Interview of Richard S. Fuld, Jr., Dec. 9, 2009, at pp. 10‐11, 16‐17.

¶Nagioff was concerned that his efforts were too little too late: "Sadly in spite of killing BCE which was a 5!bn 'KKR disaster I am probably 3 months too late in the job….a big deal got pulled today and others are being restructured down….we are probably going to get punished for our stupidity."⁴⁵⁴⁴⁵⁴ E‐mail from Roger Nagioff, Lehman, to David Goldfarb, Lehman (June 26, 2007) [LBEX‐DOCID 1585157]. For a fuller discussion of the effort to reduce the firm's high yield exposure, see Sections III.A.1.b.3 and III.A.1.b.4 of this Report. Two days later, Nagioff also wrote: "I now have the thing under control . . . if I had the job 6 months earlier we would not be where we are . . . let's hope it is only scratches."⁴⁵⁵⁴⁵⁵ E‐mail from Roger Nagioff, Lehman, to David Goldfarb, Lehman (June 28, 2007) [LBEX‐DOCID 1585167].

July‐August 2007 Concerns Regarding Lehman's Ability to Fund Its Commitments

¶By July 2007, after the Bear Stearns' funds' implosion, some Lehman executives were concerned that Lehman might not be able to fund all of its commitments.⁴⁵⁶⁴⁵⁶ See, e.g., e‐mail from Paolo R. Tonucci, Lehman, to Sigrid M. Stabenow, Lehman (Mar. 14, 2007) [LBEX‐ DOCID 1342697]; e‐mail from Christopher M. O'Meara, Lehman, to Paolo R. Tonucci, Lehman (Apr. 6, 2007) [LBEX‐DOCID 1349076]; Lehman, Chart Showing High Grade and High Yield Loan Commitments (July 19, 2007) [LBEX‐DOCID 375444], attached to e‐mail from Nahill Younis, Lehman, to Kentaro Umezaki, Lehman (July 19, 2007) [LBEX‐DOCID 297877]; e‐mail from Kentaro Umezaki, Lehman, to Ian Lowitt, Lehman (July 20, 2007) [LBEX‐DOCID 717108]; e‐mail from Ian T. Lowitt, Lehman, to Kentaro Umezaki, Lehman (July 20, 2007) [LBEX‐DOCID 717108]; e‐mail from Ian T. Lowitt, Lehman, to Paolo Tonucci, Lehman, et al. (July 11, 2007) [LBEX‐DOCID 1901826].Show full note For example, Lehman had a maximum cumulative outflow funding model designed to ensure that Lehman had sufficient cash sources to meet the expected cash outflows in a stressed market environment.⁴⁵⁷⁴⁵⁷ Lehman, Liquidity Management At Lehman Brothers (July 2008), at p. 13 [LBEX‐DOCID 009007], attached to e‐mail from Rowena T. Carreon, Lehman, to Robert Azerad, Lehman, et. al. (July 31, 2008) [LBEX‐DOCID 067762]. Under that model, in July 2007, the firm's "[L]iquidity Pool one year forward position [was] short $(0.4) billion."⁴⁵⁸⁴⁵⁸ 3rd Quarter‐to‐Date MCO and Cumulative Outflow Analysis (July 11, 2007), at p. 1 [LBEX‐DOCID 1681748], attached to e‐mail from Nahill Younis, Lehman, to Paolo R. Tonucci, Lehman (July 11, 2007) [LBEX‐DOCID 1901826].

124

¶The liquidity concerns were the result of several factors. First, as the credit markets froze, Lehman was unable to distribute its risk in certain leveraged loan and commercial real estate deals, including Archstone, leaving it with more exposure than it had previously anticipated.⁴⁵⁹⁴⁵⁹ Examiner's Interview of Kentaro Umezaki, June 25, 2009, at p. 16; Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at p. 9; Examiner's Interview of Alex Kirk, Jan. 12, 2010, at p. 12. In addition, the firm had "effectively been locked out of the capital markets."⁴⁶⁰⁴⁶⁰ E‐mail from Nahill Younis, Lehman, to Paolo R. Tonucci, Lehman (July 11, 2007) [LBEX‐DOCID 1901826].

¶When Nagioff learned about these concerns, he wrote Ian T. Lowitt, Lehman's then Co‐CAO: "Kirk and Ken [Umezaki] are panicky…. Are they over reacting."⁴⁶¹⁴⁶¹ E‐mail from Roger Nagioff, Lehman, to Ian T. Lowitt, Lehman (July 20, 2007) [LBEX‐DOCID 175649]. Lowitt responded with a detailed explanation of the problem and his view of the root of the problem:

125

If everything goes as badly as it could simultaneously it will be awful, but at least at the moment a lot of people have money they are willing to [l]end to us and if we close them quickly it will make a difference. I do think we need to get on a `war footing.' [James] Merli and the guys on the desk are panicky and that is feeding back into fid and outside the firm. Need people to be confident. I would describe my position based on what I know today as anxious but not panicky. Also the discipline we had post 1998 about funding completely dissipated which adds to the alarm.⁴⁶²⁴⁶² E‐mail from Ian T. Lowitt, Lehman, to Roger Nagioff, Lehman (July 20, 2007) [LBEX‐DOCID 175646] (emphasis supplied).

¶Nagioff responded: "Last paragraph applies to firm broadly."⁴⁶³⁴⁶³ E‐mail from Roger Nagioff, Lehman, to Ian T. Lowitt, Lehman (July 20, 2007) [LBEX‐DOCID 175646].

¶Lowitt traced Lehman's difficulty in funding its commitments directly to its failure to abide by its risk limits, as Lowitt wrote to O'Meara in a later e‐mail on July 20, 2007: "In case we ever forget; this is why one has concentration limits and overall portfolio limits. Markets do seize up."⁴⁶⁴⁴⁶⁴ E‐mail from Ian Lowitt, Lehman, to Christopher M. O'Meara, Lehman (July 20, 2007) [LBEX‐DOCID 194066].

¶To deal with these concerns on a "war footing," Lowitt, O'Meara, Kirk, Umezaki, and Paolo R. Tonucci, (Lehman's Global Treasurer), set up an Asset‐Liability Committee ("ALCO") so that FID and Lehman's Treasury Department could "manage [the firm's] liquidity on a daily basis."⁴⁶⁵⁴⁶⁵ E‐mail from Ian Lowitt, Lehman, to Roger Nagioff, Lehman (July 20, 2007) [LBEX‐DOCID 175646]; e‐ mail from Ian Lowitt, Lehman, to Herbert H. McDade III, Lehman, et al. (July 20, 2007) [LBEX‐DOCID 175646]. Prior to the formation of ALCO, Lehman's Treasury Department relied on pipeline reports from the businesses.⁴⁶⁶⁴⁶⁶ Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at p. 9. ALCO convened frequent meetings from August 2007 through February 2008,⁴⁶⁷⁴⁶⁷ See e.g., Lehman, LBHI CC Projections (July 30, 2007) [LBEX‐DOCID 214312], attached to e‐mail from Paolo R. Tonucci, Lehman, to Christopher M. O'Meara, Lehman (July 30, 2007) [LBEX‐DOCID 187182]; ALCO Summary Package (Aug. 2, 2007) [LBEX‐DOCID 514844]; ALCO Summary Package (Aug. 7, 2007) [LBEX‐DOCID 514847]; ALCO Summary Package (Aug. 16, 2007) [LBEX‐DOCID 514851]; ALCO Summary Package (Sept. 4, 2007) [LBEX‐DOCID 514862]; ALCO Summary Package (Sept. 5, 2007) [LBEX‐ DOCID 514863]; ALCO Summary Package (Sept. 6, 2007) [LBEX‐DOCID 514865]; ALCO Summary Package (Sept. 7, 2007) [LBEX‐DOCID 514866]; ALCO Summary Package (Sept. 10, 2007) [LBEX‐DOCID 514867]; ALCO Summary Package (Sept. 12, 2007) [LBEX‐DOCID 514869]; ALCO Summary Package (Sept. 13, 2007) [LBEX‐DOCID 514870]; ALCO Summary Package (Sept. 14, 2007) [LBEX‐DOCID 514871]; ALCO Summary Package (Sept. 18, 2007) [LBEX‐DOCID 514873]; ALCO Summary Package (Sept. 21, 2007) [LBEX‐DOCID 514875]; ALCO Summary Package (Oct. 25, 2007) [LBEX‐DOCID 514887]; ALCO Summary Package (Dec. 4, 2007) [LBEX‐DOCID 104102]; ALCO Summary Package (Feb. 12, 2008) [LBEX‐ DOCID 104040].Show full note and began to track and monitor more closely the firm's monthly projections for cash capital and maximum cumulative outflow.

126

¶The cash capital model was a pillar of the firm's funding framework.⁴⁶⁸⁴⁶⁸ Lehman, Implications for the Funding Framework (Aug. 6, 2007), at p. 2 [LBEX‐DOCID 601971], attached to e‐mail from Angelo Bello, Lehman, to Kentaro Umezaki, Lehman (Aug. 6, 2007) [LBEX‐ DOCID 720559]. The sources of cash capital were equity and debt with a remaining life of greater than one year.⁴⁶⁹⁴⁶⁹ Lehman, Update on Risk, Liquidity, and Capital Adequacy Presentation to Standard and Poor's (Aug. 17, 2007), at p. 72 [LBEX‐DOCID 2031705], attached to e‐mail from Shaun K. Butler, Lehman, to Elizabeth R. Besen, Lehman (Aug. 28, 2007) [LBEX‐DOCID 2374876]. The firm always funded leveraged loans and commercial real estate with cash capital.⁴⁷⁰⁴⁷⁰ Id. at p. 67. Although the firm could fund loans and commercial real estate on a secured basis, it assumed that secured finance would not be available under stressed market conditions.⁴⁷¹⁴⁷¹ Id. It was the firm's policy always to have a cash capital surplus of at least $2 billion.⁴⁷²⁴⁷² Lehman, Risk, Liquidity, Capital and Balance Sheet Update Presentation to the Finance and Risk Committee of Lehman Board of Directors on (Sept. 11, 2007), at p. 31 [LBEX‐DOCID 505941], attached to e‐mail from Paolo R. Tonucci, Lehman, to Christopher M. O'Meara, Lehman, et al. (Sept. 9, 2007) [LBEX‐ DOCID 552383].

127

¶On July 30, 2007, ALCO members exchanged an analysis showing that Lehman did not project having the usual surplus, and in fact projected large deficits of cash capital.⁴⁷³⁴⁷³ LBHI CC Projections (July 30, 2007), at p. 2 [LBEX‐DOCID 214312], attached to e‐mail from Paolo Tonucci, Lehman, to Christopher M. O'Meara, Lehman (July 30, 2007) [LBEX‐DOCID 187182]. More specifically, Lehman's month end cash capital estimates for September, October, and November of the same year were ‐$11.4 billion, ‐$14.5 billion and ‐$9.4 billion.⁴⁷⁴⁴⁷⁴ Id. This meant that Lehman did not anticipate being able to fund its long‐term obligations with long‐term assets.

¶Faced with this prospect, in early August 2007, Kirk, Lowitt and Nagioff decided to shut down the leveraged loan and commercial real estate businesses until the end of the third quarter of 2007. They convinced McGee and Berkenfeld to "kill everything" for the rest of the quarter.⁴⁷⁵⁴⁷⁵ Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at p. 10. Nagioff believed the Executive Committee should not have approved any large deals before the end of the quarter, saying: "Do not think any large deal can get thru exec[utive committee] pre qtr end . . . this cannot be expressed publicly."⁴⁷⁶⁴⁷⁶ E‐mail from Roger Nagioff, Lehman, to Alex Kirk, Lehman (Aug. 7, 2007) [LBEX‐DOCID 173496]. Kirk responded: "Good. We will need skip [McGee] to kill as much stuff as early as possible."⁴⁷⁷⁴⁷⁷ E‐mail from Alex Kirk, Lehman, to Roger Nagioff, Lehman (Aug. 7, 2007) [LBEX‐DOCID 173496].

128

¶At about the same time, the leveraged loan market generally collapsed, and new issues slowed to a trickle in the third quarter.⁴⁷⁸⁴⁷⁸ Lehman, Loan Syndicate/Year‐End Recap (Jan. 4, 2008), at p. 5. [LBHI_SEC07940_066190]. Lehman's leveraged loan commitments thus halted in early August 2007, three months after Nagioff first concluded that Lehman's exposure was already "gargantuan," and two months after Nagioff's first conversation with Fuld about the issue.

Lehman Delays the Archstone Closing

¶Because of the funding concerns, Lehman delayed the closing on Archstone from the originally anticipated August 2007 closing date to October 5, 2007.⁴⁷⁹⁴⁷⁹ E‐mail from Randall B. Whitestone, Lehman, to Steven Berkenfeld, Lehman, et al. (Aug. 5, 2007) [LBEX‐ DOCID 988270]; Archstone‐Smith Trust, Press Release: Archstone‐Smith Amends Merger Agreement With Tishman Speyer Partnership (Aug. 6, 2007) [LBEX‐DOCID 2140354]; e‐mail from Chip Heflin, Lehman, to Loan Sales ‐ 4th Floor, Lehman (May 29, 2007) [LBEX‐DOCID 1488757]. As the market crisis escalated in June and July 2007, Lehman attempted to syndicate its Archstone debt. But by late July 2007, the institutional market for commercial real estate was "virtually closed,"⁴⁸⁰⁴⁸⁰ E‐mail from Mark Walsh, Lehman, to Alex Kirk, Lehman, et al. (July 27, 2007) [LBEX‐DOCID 174304]. and Lehman's attempts at selling Archstone bridge equity largely failed.⁴⁸¹⁴⁸¹ See Appendix generally e‐mail from Paul A. Hughson, Lehman, to Mark A. Walsh, Lehman, et al., (July 27, 2007) [LBEX‐DOCID 155079] (reflecting the fact that on July 27, 2007, D.E. Shaw informed Lehman that "given the sell‐off in the reit market and the volatility of the credit markets" its Risk Committee had rejected the deal); e‐mail from Jonathan Cohen, Lehman, to Christopher M. O'Meara, Lehman, et al. (July 27, 2007) [LBEX‐DOCID 1904232] (showing that by July 2007, Lehman began to worry that the market "implosion" might force Lehman to provide $9 billion in funding for the Archstone transaction, rather than the $6.8 billion it had previously assumed would be necessary.).Show full note

129

¶In the midst of the market deterioration, an analyst at Citigroup issued an analyst report entitled "Archstone Smith Trust (ASN): Could the Buyers Cut Their Losses and Walk Away?"⁴⁸²⁴⁸² Jonathan Litt, Citigroup Global Markets Inc., Archstone Smith Trust (ASN): Could the Buyers Cut Their Losses and Walk Away? (July 26, 2007) [LBEX‐DOCID 1714588]. The report suggested that Lehman, BofA, and Barclays might be better off walking away from the Archstone deal and paying the $1.5 billion breakup fee, rather than closing the deal at a significant loss.⁴⁸³⁴⁸³ Id. at pp. 1‐2.

¶While the report and a Wall Street Journal article discussing it were widely read at Lehman,⁴⁸⁴⁴⁸⁴ See e.g., e‐mail from Webster Neighbor, Lehman, to Paul A. Hughson, Lehman (July 31, 2007) [LBEX‐ DOCID 2500559]; e‐mail from Gerard Reilly, Lehman, to Christopher M. O'Meara, Lehman (Aug. 1, 2007) [LBEX‐DOCID 210156]; e‐mail from Stephen F. Rossi, Lehman, to Anna Yu, Lehman, et al. (Aug. 1, 2007) [LBEX‐DOCID 3271158]. Lehman never seriously considered walking away from the deal.⁴⁸⁵⁴⁸⁵ Examiner's Interview of Lisa Beeson, Oct. 23, 2009, at p. 5; Examiner's Interview of Mark A. Walsh, Oct. 21, 2009, at p. 9; Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at p. 4; Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at p. 3; Examiner's Interview of Sir Christopher Gent, Oct. 21, 2009, at p. 3; Examiner's Interview of John D. Macomber, Sept. 25, 2009, at pp. 13‐14. One reason Lehman was comfortable proceeding with the deal was that Lehman was ultimately able to sell approximately $2.09 billion in Archstone debt to Freddie Mac,⁴⁸⁶⁴⁸⁶ Freddie Mac, Holdco Term Sheet (Sept. 5, 2007) [LBEX‐DOCID 4452813]; Freddie Mac, Sellco Term Sheet (Sept. 5, 2007) [LBEX‐DOCID 4452811]; Lehman, Project Easy Living Debt Funding Detail (Oct. 5, 2007), at p. 1 [LBEX‐DOCID 598184]. and another $7.1 billion of Archstone debt to Fannie Mae.⁴⁸⁷⁴⁸⁷ Examiner's Interview of Mark A. Walsh, Oct. 22, 2009, at p. 9; Examiner's Interview of Lisa Beeson, Oct. 23, 2009, at p. 8; Letter from Lehman Brothers Holdings Inc. to Fannie Mae re: Rate Lock Terms (Sept. 17, 2007), at p. 1. [LBEX‐DOCID 2704241]. During the same time period, however, Lehman and its partners were able to sell only $71 million of the deal's $4.6 billion in bridge equity.⁴⁸⁸⁴⁸⁸ Lehman, Archstone Smith Multifamily JV Debt and Equity Redemption Schedule (Jan. 3, 2008), at p. 1 [LBEX‐DOCID 2502413], attached to e‐mail from Keith Cyrus, Lehman, to Paul A. Hughson, Lehman, et al. (Jan. 1, 2008) [LBEX‐DOCID 2646616].

130

¶The Archstone deal closed on October 5, 2007.⁴⁸⁹⁴⁸⁹ Lehman, Acquisition of Archstone‐Smith Trust Corporate Closing Documents Table of Contents (Oct. 5, 2007), at p. 2 [LBEX‐WGM 960404]. As of October 12, 2007, Lehman's total Archstone exposure was approximately $6 billion, $2.39 billion of which was in the riskiest equity portions of the deal (permanent equity and bridge equity portions):⁴⁹⁰⁴⁹⁰ Lehman, Lehman Expected Share of Real Estate Commitments (Oct. 17, 2007), at p. 2 [LBEX‐DOCID 624620].

¶Permanent equity $250 million

¶Bridge equity $2.14 billion

¶Mezzanine loan $240 million

¶Term loan $2.47 billion

¶Senior debt $850 million

¶When Secretary of the Treasury Henry M. Paulson, Jr. learned late in 2007 that Lehman had closed on Archstone, despite the shut‐down in the securitization market, he questioned the wisdom of the decision and the direction in which Lehman was heading.⁴⁹¹⁴⁹¹ Examiner's Interview of Henry Paulson, June 25, 2009, at p. 9.

131

Lehman Increases the Risk Appetite Limit to Accommodate the Additional Risk Attributable to the Archstone Transaction

¶The risk in Lehman's book was dramatically increasing during 2007.⁴⁹²⁴⁹² Some of the increase in risk usage, of course, was the result of market volatility and its effect upon existing assets; some was the result of decisions to close new deals. In any event, usage increased dramatically in 2007 and limits were raised accordingly, from $3.3 billion to $3.5 billion to $4.0 billion. See e‐mail from Manhua Leng, Lehman, to Mynor Gonzalez, Lehman, et al. (Sept. 10, 2007) [LBEX‐DOCID 262797]; e‐mail from Christopher M. O'Meara, Lehman, to David Goldfarb, Lehman (Aug. 15, 2007) [LBEX‐DOCID 211183]; Lehman, Material for Market Risk Control Committee Meeting (Jan. 14, 2008), at p. 33 [LBEX‐DOCID 271352], attached to e‐mail from Mark Weber, Lehman, to Paul Shotton, Lehman, et al. (Jan. 14, 2008) [LBEX‐DOCID 223263]. As revenues increased, the capacity for risk increased; management calculated, albeit sometimes by adjusting the formula, that each increase was justified by anticipated revenues. See e‐mail from Madelyn Antoncic, Lehman, to David Goldfarb, Lehman, et al. (Aug. 28, 2007) [LBEX‐DOCID 193203]; see Appendix 10, showing the calculation of Lehman's increased $4.0 billion risk appetite limit.Show full note Lehman's management reacted to the increasing risk appetite usage by increasing its limit amounts.

¶Although Lehman ordinarily included the risk appetite usage attributable to a transaction immediately after entering into the commitment for the transaction, Lehman did not include the very substantial increase in risk appetite usage attributable to Archstone in the risk appetite calculation for almost three months.⁴⁹³⁴⁹³ See e‐mail from Mark Weber, Lehman, to Jeffrey Goodman, Lehman (June 4, 2007) [LBEX‐DOCID 247960]; Mark Weber, Lehman, Chart Showing Risk Appetite Adjustment for Archstone (July 24, 2008) [LBEX‐DOCID 425705], attached to e‐mail from Mark Weber, Lehman, to PortfolioRisk Support, Lehman, et al. (July 24, 2008) [LBEX‐DOCID 265567]; see also e‐mail from Mark Weber, Lehman, to Laura M. Vecchio, Lehman (July 31, 2008) [LBEX‐DOCID 264849].Show full note At least one other real estate bridge equity transaction, Dermody/ProLogis, also was not included in risk appetite until that date.⁴⁹⁴⁴⁹⁴ Lehman, VaR / Risk Appetite Restatements, (Nov. 12, 2007) at p. 17 [LBEX‐DOCID 271334].

132

¶If Archstone (and the other transactions) had been included in the firm's risk appetite usage from the Archstone commitment date in late May 2007, consistent with the firm's usual practice, Lehman would have been over the firm‐wide risk appetite limit for much of the intervening period.⁴⁹⁵⁴⁹⁵ Id. Lehman would also have been over the risk appetite limits for FID and the real estate business by substantial margins.⁴⁹⁶⁴⁹⁶ Id. As the summer of 2007 wore on, the volatility in the markets began to exacerbate the situation, and Lehman's risk appetite usage increased markedly, even though Lehman generally stopped entering into major new commitments after the third quarter of 2007.⁴⁹⁷⁴⁹⁷ E‐mail from Jeffrey Goodman, Lehman, to Christopher M. O'Meara, Lehman, et al. (Dec. 4, 2007) [LBEX‐DOCID 251204]; e‐mail from Paul Shotton, Lehman, to Christopher M. O'Meara, Lehman et al. (Dec. 6, 2007) [LBEX‐DOCID 251204]; Examiner's Interview of Mark Weber, Aug. 11, 2009, at p. 9; Examiner's Interview of David Goldfarb, Sept. 21, 2009, at p. 8; Examiner's Interview of Madelyn Antoncic, Oct. 6, 2009, at p. 7; Examiner's Interview of Richard S. Fuld, Jr., Nov. 19, 2009, at p. 13; but see Lehman, September 2007 Financial Information Presentation to Lehman Board of Directors with Christopher M. O'Meara's handwritten notes (Oct. 15, 2007), at p. 6 [LEH_CMO_0000001] (attributing the increase in risk appetite to increased market volatility as well as increased leveraged finance and commercial real estate positions, particularly since the market environment had prevented the firm from selling those assets); e‐mail from Joe Li, Lehman, to Madelyn Antoncic, Lehman (Sept. 11, 2007) [LBEX‐ DOCID 157247] (stating that 50% of the recent VaR increase for Global Capital Products was due to volatility and 50% was from the origination book); see also Lehman, Firm‐wide Risk Driver (Oct. 22, 2007) [LBEX‐DOCID 190147] (attributing the firm's rising risk appetite and VaR usage figures primarily to increased correlation across divisions).Show full note

¶Archstone and Dermody/ProLogis were not included sooner in Lehman's risk appetite usage calculation because Lehman's risk managers were trying to calculate a stable usage amount for these bridge equity transactions. Initial calculations yielded varying risk appetite usage figures that Lehman's risk managers considered unreasonable.⁴⁹⁸⁴⁹⁸ Examiner's Interview of Jeffrey Goodman, Aug. 28, 2009; Examiner's Interview of Mark Weber, Aug. 11, 2009, at p. 4; but cf. Examiner's Interview of Madelyn Antoncic, Oct. 6, 2009, at p. 11 (reflecting statements that she was unaware that the bridge equity portion of the Archstone deal had been excluded from the firm's risk measurements and that she "hit the roof" when Jeffrey Goodman told her that the bridge equity had not been included in the firm's metrics).Show full note

133

¶Once these positions were officially included in risk appetite usage in August 2007, it became clear to senior management that the firm had been exceeding the firm‐ wide risk appetite on a persistent basis for some time.⁴⁹⁹⁴⁹⁹ Examiner's Interview of Jeffrey Goodman, Aug. 28, 2009; Examiner's Interview of Paul Shotton, June 5, 2009, at p. 19; Appendix No. 9, comparing risk appetite and VaR usage versus limits; e‐mail from Mark Weber, Lehman, to Laura M. Vecchio, Lehman (July 31, 2008) [LBEX‐DOCID 264849]; Mark Weber, Lehman, Chart Showing Risk Appetite Adjustment for Archstone (July 24, 2008) [LBEX‐DOCID 425705], attached to e‐mail from Mark Weber, Lehman, to Portfolio Risk Support, Lehman, et al. (July 24, 2008) [LBEX‐DOCID 265567]; e‐mail from Madelyn Antoncic, Lehman, to David Goldfarb, Lehman, et al. (Aug. 14, 2007) [LBEX‐DOCID 211183].Show full note The firm's risk appetite usage started to be discussed more widely within the firm.⁵⁰⁰⁵⁰⁰ See Lehman, September 2007 Financial Information Presentation to Lehman Board of Directors (Oct. 15, 2007), at p. 6 [LBHI_SEC07940_026377]; Lehman Brothers Holdings Inc., Minutes of Meeting of the Finance and Risk Committee of the Board of Directors (Sept. 11, 2007), at p. 2 [LBEX‐AM 067018]; Lehman Brothers Holdings Inc., Minutes of Meeting of Board of Directors (Sept. 11, 2007), at p. 3 [LBHI_SEC07940_026364]; e‐mail from Madelyn Antoncic, Lehman, to David Goldfarb, Lehman, et al. (Aug. 14, 2007) [LBEX‐DOCID 211183].Show full note

¶Lehman raised its firm‐wide risk appetite limit from $3.3 billion to $3.5 billion on September 7, 2007.⁵⁰¹⁵⁰¹ E‐mail from Manhua Leng, Lehman, to Mynor Gonzalez, Lehman, et al. (Sept. 10, 2007) [LBEX‐DOCID 262797]; e‐mail from Christopher M. O'Meara, Lehman, to David Goldfarb, Lehman (Aug. 15, 2007) [LBEX‐DOCID 211183]. But see e‐mail from Madelyn Antoncic, Lehman, to David Goldfarb, Lehman, et al. (Aug. 28, 2007) [LBEX‐DOCID 193203] (showing that Antoncic did not believe that the decision to raise the limit had been made ‐ "we did not close the loop on this. Robert worked up some numbers but I think we need to revisit the expected rev for Q4 given a slowdown").Show full note Lehman's risk managers questioned whether Lehman truly had increased risk‐taking capacity, however. Two weeks after the firm first included the Archstone and Dermody/ProLogis bridge equity positions in the firm's risk appetite usage calculation, Goldfarb e‐mailed O'Meara and Antoncic: "I thought we increased [risk] appetite to reflect YTD performance?"⁵⁰²⁵⁰² E‐mail from David Goldfarb, Lehman, to Madelyn Antoncic, Lehman, et al. (Aug. 28, 2007) [LBEX‐ DOCID 193203]. Antoncic replied that they "did not close the loop on this" because of concerns related to a fourth‐quarter slowdown in revenues.⁵⁰³⁵⁰³ E‐mail from Madelyn Antoncic, Lehman, to David Goldfarb, Lehman, et al. (Aug. 28, 2007) [LBEX‐ DOCID 193203]. Under the methodology for calculating the risk appetite limit, a slowdown in revenues would have reduced Lehman's ability to take risk. Similarly, in an October 2007 CSE meeting, Goodman informed the SEC that Lehman had increased its risk appetite limit, but "admitted that they probably shouldn't have raised the limit to $3.5b when they did, given that they were almost there and there wasn't enough headroom."⁵⁰⁴⁵⁰⁴ SEC, Notes from Lehman's Monthly Risk Review Meeting (Oct. 19, 2007), at p. 6 [LBEX‐SEC 007438].

134

Cash Capital Concerns

¶ALCO continued to have serious concerns about Lehman's cash capital and liquidity position. Until the final week of September 2007, Lehman did not expect its ending cash capital positions for the months of September, October, and November to meet the $2 billion minimum requirement.⁵⁰⁵⁵⁰⁵ Lehman, ALCO Summary Package (Sept. 4, 2007), at p. 2 [LBEX‐DOCID 514862]; Lehman, ALCO Summary Package (Sept. 5, 2007), at p. 2 [LBEX‐DOCID 514863]; Lehman, ALCO Summary Package (Sept. 6, 2007), at p. 2 [LBEX‐DOCID 514865]; Lehman, ALCO Summary Package (Sept. 7, 2007), at p. 2 [LBEX‐DOCID 514866]; Lehman, ALCO Summary Package (Sept. 10, 2007), at p. 2 [LBEX‐DOCID 514867]; Lehman, ALCO Summary Package (Sept. 11, 2007), at p. 2 [LBEX‐DOCID 514868]; Lehman, ALCO Summary Package (Sept. 12, 2007), at p. 3 [LBEX‐DOCID 514869]; Lehman, ALCO Summary Package (Sept. 13, 2007), at p. 3 [LBEX‐DOCID 514870]; Lehman, ALCO Summary Package (Sept. 14, 2007), at p. 3 [LBEX‐DOCID 514871]; Lehman, ALCO Summary Package (Sept. 17, 2007), at p. 3 [LBEX‐DOCID 514872]; Lehman, ALCO Summary Package (Sept. 18, 2007), at p. 3 [LBEX‐DOCID 514873]; Lehman, ALCO Summary Package (Sept. 19, 2007), at p. 3 [LBEX‐DOCID 514874]; Lehman, ALCO Summary Package (Sept. 21, 2007), at p. 3 [LBEX‐DOCID 514875]; Lehman, ALCO Summary Package (Sept. 24, 2007), at p. 3 [LBEX‐DOCID 514876]; Lehman, ALCO Summary Package (Sept. 26, 2007), at p. 3 [LBEX‐DOCID 514877].Show full note The average ending cash capital positions for September, October, and November 2007 were projected to be $0.05 billion, ‐$2.15 billion and ‐$1.75 billion respectively.⁵⁰⁶⁵⁰⁶ Id. The committee projected negative month end cash capital positions for the remainder of the year.⁵⁰⁷⁵⁰⁷ Id.

135

¶On the day that Archstone closed, Tonucci informed O'Meara that Lehman was "looking at being $1‐2 [billion] short [in equity]…should not really be surprised."⁵⁰⁸⁵⁰⁸ E‐mail from Paolo R. Tonucci, Lehman, to Christopher M. O'Meara, Lehman (Oct. 5, 2007) [LBEX‐ DOCID 1360792]. Moreover, the firm's cash capital projections for the end of October went negative immediately after the firm closed on Archstone.⁵⁰⁹⁵⁰⁹ Lehman, ALCO Summary Package (Sept. 4, 2007), at p. 2 [LBEX‐DOCID 514881].

¶A draft presentation on the firm's equity adequacy dated October 2007 was prepared for the Executive Committee shortly after the exchange between O'Meara and Tonucci.⁵¹⁰⁵¹⁰ Lehman, Equity Adequacy Presentation to Executive Committee [Draft] (Oct. 26, 2007) [LBEX‐DOCID 1698460], attached to e‐mail from Ari Axelrod, Lehman, to Christopher M. O'Meara, Lehman, et al. (Oct. 26, 2007) [LBEX‐DOCID 1912826]. O'Meara was slated to be the presenter.⁵¹¹⁵¹¹ E‐mail from Ari Axelrod, Lehman, to Christopher M. O'Meara, Lehman, et al. (Oct. 26, 2007) [LBEX‐ DOCID 1902541]. The presentation concluded that the firm's capital adequacy over the last five to six quarters had "materially deteriorated."⁵¹²⁵¹² Ari Axelrod, Lehman, Equity Adequacy Presentation Summary Page [Draft] (Oct. 25, 2007), at p. 1 [LBEX‐DOCID 1696067], attached to e‐mail from Ari Axelrod, Lehman, to Christopher M. O'Meara, Lehman, et al. (Oct. 26, 2007) [LBEX‐DOCID 1902541]. Lehman was at the bottom of its peer range with respect to the regulatory requirement of a minimum 10% total capital ratio imposed by the SEC.⁵¹³⁵¹³ Lehman, Equity Adequacy Presentation to Executive Committee [Draft] (Oct. 26, 2007), at p. 1 [LBEX‐ DOCID 1698460], attached to e‐mail from Ari Axelrod, Lehman, to Christopher M. O'Meara, Lehman, et al. (Oct. 26, 2007) [LBEX‐DOCID 1912826]. The equity adequacy framework illustrated how the firm's capital position decreased from a $7.2 billion surplus in the beginning of 2006 to a $42 million deficit at the end of the third quarter of 2007.⁵¹⁴⁵¹⁴ Id. The Examiner was unable to find a final version of this presentation, and was unable to determine if the presentation ever was given. Fuld said that he was not aware of the information contained in the presentation, and if he had been, he would have been able to resolve the situation.⁵¹⁵⁵¹⁵ Examiner's Interview of Richard S. Fuld, Jr., Dec. 9, 2009, at p. 5.

136

¶The deterioration of Lehman's capital was also apparent from the decline in its total capital ratio from 18.2% in early 2006 to 10.5% in August 2007.⁵¹⁶⁵¹⁶ Lehman, Monthly CSE Capital Reports for SEC (Mar. 2006), at p. 1 [LBEX‐SEC 000303]; Lehman, Equity Adequacy Presentation to Executive Committee [Draft] (Oct. 26, 2007), at p. 5 [LBEX‐DOCID 1698460], attached to e‐mail from Ari Axelrod, Lehman, to Christopher M. O'Meara, Lehman, et al. (Oct. 26, 2007) [LBEX‐DOCID 1912826]. The industry high in August 2007 was 18.7%.⁵¹⁷⁵¹⁷ E‐mail from Anna Yu, Lehman, to Erin M. Callan, Lehman, et al. (Dec. 9, 2007) [LBEX‐DOCID 3761740]. From August to November 2007, Lehman posted the lowest total capital ratio in the industry.⁵¹⁸⁵¹⁸ Lehman, CSE Methodology Impact Summary (Apr. 4, 2008), at p. 2 [LBEX‐DOCID 382980]. The firm was at or near its SEC‐imposed 10% requirement for six months in 2007‐2008.⁵¹⁹⁵¹⁹ Lehman, CSE Methodology Impact Summary (Apr. 4, 2008), at p. 2 [LBEX‐DOCID 382980]. On three separate occasions, Lehman had at least a concern that the total capital ratio would fall below the 10% requirement.⁵²⁰⁵²⁰ E‐mail from Anna Yu, Lehman, to Paolo R. Tonucci, Lehman (Oct. 3, 2007) [LBEX‐DOCID 1654567]; e‐ mail from Anna Yu, Lehman, to undisclosed recipients (Nov. 26, 2007) [LBEX‐DOCID 638715]; e‐mail from Anna Yu, Lehman, to Georges Assi, Lehman, et al. (Dec. 7, 2007) [LBEX‐DOCID 307968].

137

¶The SEC expected Lehman to notify it if the total capital ratio fell below or was expected to fall below the 10% requirement, but Lehman did not do so.⁵²¹⁵²¹ 17 C.F.R. § 240.15c3‐1g (e) (1) (i); 17 C.F.R. § 240.17i‐8 (a) (2) (2007); The Goldman Sachs Group Inc., Quarterly Report as of May 31, 2008 (Form 10‐Q) (filed on July 7, 2008), at p. 90 ("Goldman Sachs 10‐Q (filed on July 7, 2008)") ("Goldman Sachs is required to notify the SEC in the event that the Total Capital Ratio falls below 10% or is expected to do so within the next month"); Merrill Lynch & Co., Inc., Quarterly Report as of June 27, 2008 (Form 10‐Q) (filed on Aug. 5, 2008), at p. 108 ("Merrill Lynch 10‐Q (filed on Aug. 5, 2008)") ("Merrill Lynch is required to notify the SEC in the event that the Total Capital Ratio falls or is expected to fall below 10%"); Erik R. Sirri, SEC, Testimony Concerning Lessons Learned in Risk Management Oversight at Federal Financial Regulators Before the Subcommittee on Securities, Insurance and Investment Committee on Banking, Housing and Urban Affairs, United States Senate, Mar. 19, 2009 ("CSEs were also required to file an 'early warning' notice with the SEC in the event that certain minimum thresholds, including the 10% capital ratio, were breached or were likely to be breached"); Examiner's Interview of Matthew Eichner, Nov. 23, 2009, at p. 13.Show full note Tonucci told the SEC that Lehman was "comfortable" with landing close to the 10% limit at the end of the year "given how difficult it is to issue right now."⁵²²⁵²² SEC, Notes from Monthly Risk Meeting with Lehman (Nov. 15, 2007), at p. 2 [LBEX‐SEC 007467].

¶The dominant cause for the rapid decline in Lehman's equity position was a shift in the firm's asset mix to illiquid assets, including high yield loans, real estate, and principal investments.⁵²³⁵²³ Lehman, Equity Adequacy Presentation to Executive Committee [Draft] (Oct. 26, 2007), at p. 7 [LBEX‐ DOCID 1698460], attached to e‐mail from Ari Axelrod, Lehman, to Christopher M. O'Meara, Lehman, et al. (Oct. 26, 2007) [LBEX‐DOCID 1912826]. From November 2006 to August 2007, the firm's illiquid holdings grew by 72%, while "Tier 1 capital grew by only 26%."⁵²⁴⁵²⁴ Id. at p. 6.

138

¶Thereafter, Lehman's cash capital and equity adequacy position temporarily improved. The improvement was the result of several factors. For one thing, the SEC changed the method of calculating the total capital ratio, and, as a result, Lehman picked up several percentage points and saved "roughly $4 billion in capital charges on average every month."⁵²⁵⁵²⁵ E‐mail from Anna Yu, Lehman, to Martin Kelly, Lehman, et al. (Feb. 6, 2008) [LBEX‐DOCID 2799485]. In addition, Lehman was able to sell some of its leveraged loan positions, thereby raising cash capital and reducing its illiquid holdings.⁵²⁶⁵²⁶ Lehman, ALCO Summary Package (Jan. 31, 2008), at p. 2 [LBEX‐DOCID 527115].

Lehman's Termination of Its Residential Mortgage Originations

¶During this same period, mid‐August 2007, Lehman decided to close BNC and cease subprime originations entirely.⁵²⁷⁵²⁷ Lehman Brothers Holdings Inc., Press Release: Lehman Brothers Announces Closure of BNC Mortgage (Aug. 22, 2007) [LBEX‐DOCID 880148]; Lehman, Subprime(r) (Sept. 6, 2007), at p. 14 [LBEX‐DOCID 894656]; e‐mail from Edward Grieb, Lehman, to Christopher M. O'Meara, Lehman (Aug. 22, 2007) [LBEX‐ DOCID 197143]; e‐mail from Tasha Pelio, Lehman, to Jasjit (Jesse) Bhattal, Lehman, et al. (Aug. 22, 2007) [LBEX‐DOCID 176893].Show full note The anticipated turn in the residential mortgage market still had not arrived, and management could not justify Lehman's continued exposure to liability on the origination of subprime mortgages.⁵²⁸⁵²⁸ Examiner's Interview of Lana Franks Harber, Sept. 23, 2009, at pp. 2, 10, 11; Examiner's Interview of David N. Sherr, Sept. 25, 2009, at pp. 2, 6, 8. In January 2008, Lehman's Aurora subsidiary suspended its origination through wholesale and correspondent channels, which represented the bulk of the program.⁵²⁹⁵²⁹ Lehman Brothers Holdings Inc., Press Release: Lehman Brothers Suspends Wholesale and Correspondent U.S. Residential Mortgage Origination Activities (Jan. 17, 2008) [LBEX‐DOCID 156125]. Lehman had curtailed the flow of Mortgage Maker originations approximately five months earlier.⁵³⁰⁵³⁰ Dimitrios Kritikos, Lehman, Aurora Loan Services Risk Review January 2008 (Feb. 7, 2008), at p. 12 [LBEX‐DOCID 394711].

139

September, October, and November 2007 Meetings of Board of Directors

¶Lehman had a series of Board meetings in the fall of 2007. At these meetings, Lehman's management continued to report on the firm's elevated risk profile and concentration of real estate and leveraged loan risk, but did not present the Board with additional negative information concerning the firm's risk and liquidity profile.

Risk Appetite Disclosures

¶At the September 11, 2007 Finance and Risk Committee meeting, the Finance and Risk Committee was shown a presentation disclosing that the firm's average risk appetite usage rose from $2.12 billion in November 2006 to $3.27 billion in August 2007.⁵³¹⁵³¹ Lehman, Presentation on Risk, Liquidity, Capital and Balance Sheet Update to Finance and Risk Committee of Lehman Board of Directors (Sept. 11, 2007), at p. 2 [LBEX‐AM 067167]. In the presentation, the Committee was informed that while risk appetite usage had increased, Lehman still remained within its risk appetite limit.⁵³²⁵³² Lehman Brothers Holdings Inc., Minutes of Meeting of Finance and Risk Committee of the Board of Directors (Sept. 11, 2007), at p. 3 [LBEX‐AM 067018]; Lehman, Daily Risk Appetite Report (Sept. 6, 2007) [LBEX‐DOCID 1340197], attached to e‐mail from Christopher M. O'Meara, Lehman, to David Goldfarb, Lehman (Sept. 7, 2007) [LBEX‐DOCID 1345985]. The Committee was informed of the recent increase in the risk appetite limit from $3.3 billion to $3.5 billion.⁵³³⁵³³ Lehman, Risk, Liquidity, Capital and Balance Sheet Update Presentation to Finance and Risk Committee of Lehman Board of Directors with Welikson's handwritten notes (Sept. 11, 2007), at p. 25 [WGM_LBEX_02248].

140

¶Although it was correct that the firm's monthly average risk appetite for August 2007 was within the firm's risk appetite limit, by the time of the meeting, Lehman actually was over its newly increased limit by $97 million.⁵³⁴⁵³⁴ Appendix No. 9, comparing risk appetite and VaR usage and limits. Additionally, Lehman had been over the $3.5 billion limit each business day that month except for September 3, 2007.⁵³⁵⁵³⁵ Id. There is no evidence that the Board was informed that Archstone and at least one other bridge equity deal had been excluded from Lehman's risk appetite usage calculation for almost three months, or that Lehman would have been over its risk appetite limit for much of the period since June 1, 2007 if those bridge equity deals had been included in the calculation in a timely manner.

¶When the full Board met again on October 15, 2007, O'Meara disclosed that Lehman was over its firm‐wide risk appetite limit. But O'Meara did not want the Board to conclude that Lehman was "out of bounds," so O'Meara edited the standard chart provided to the Board at each meeting.⁵³⁶⁵³⁶ Examiner's Interview of Christopher M. O'Meara, Aug. 14, 2009, at p. 11. Previously, that chart showed the firm's risk appetite usage and risk appetite limit in close proximity, so that the directors could easily see how much below (or above) the usage was compared to the limit.⁵³⁷⁵³⁷ Lehman, Second Quarter Financial Information Presentation to Lehman Board of Directors (June 19, 2007), at p. 6 [LBHI_SEC07940_026226]; Lehman, Estimated Third Quarter Financial Information Presentation to Lehman Board of Directors (Sept. 11, 2007), at p. 6 [LBHI_SEC07940_026288]. Before the October 2007 Board meeting, however, O'Meara directed that the limit information be removed from the final version of the chart.⁵³⁸⁵³⁸ Lehman, Presentation to Lehman Board of Directors on September 2007 Financial Information [Draft] (Oct. 8, 2007), at p. 6 [LBEX‐DOCID 510227]; Lehman, Final Presentation to Lehman Board of Directors on September 2007 Financial Information (Oct. 15, 2007), at p. 6 [LBHI_SEC07940_026377]; Examiner's Interview of Christopher M. O'Meara, Sept. 23, 2009, at p. 4. He explained to the Examiner that management was not troubled by being over the limit and he preferred to explain the overage to the Board orally rather than through written materials.⁵³⁹⁵³⁹ Id.

141

¶In addition, O'Meara informed the Board that Lehman's average daily risk appetite usage for the prior month was $3.7 billion, $200 million above the new risk appetite limit,⁵⁴⁰⁵⁴⁰ Lehman, Presentation to Lehman Board of Directors on September 2007 Financial Information (Oct. 15, 2007), at p. 6 [LBHI_SEC07940_026377]. but he did not disclose that on the day of the Board meeting, Lehman's daily risk appetite usage was $4.269 billion, 22% (or $769 million) above the new risk appetite limit.⁵⁴¹⁵⁴¹ Lehman, Daily Firm‐wide Risk Driver (Oct. 15, 2007) [LBEX‐DOCID 147304], attached to e‐mail from Jeffrey Goodman, Lehman, to Madelyn Antoncic, Lehman, et al. (Oct. 14, 2007) [LBEX‐DOCID 155737]. Moreover, at this October meeting, O'Meara also said he told the Board that Lehman had a higher "capacity" – the outside edge of the amount of risk that Lehman could absorb – than its actual risk appetite limit and that the capacity was at least $4.0 billion.⁵⁴²⁵⁴² Examiner's Interview of Christopher M. O'Meara, Aug. 14, 2009, at pp. 10, 12.

142

¶O'Meara did not inform the Board that Lehman generally had been in excess of its firm‐wide risk appetite limit since entering into the Archstone transaction in late May 2007; O'Meara attributed Lehman's limit excesses to recent changes in market conditions – specifically, the inability to securitize or syndicate risks that Lehman had previously expected to be able to distribute⁵⁴³⁵⁴³ Examiner's Interview of Christopher M. O'Meara, Sept. 23, 2009, at pp. 14‐15; Lehman, Presentation on Risk, Liquidity, Capital and Balance Sheet Update to Finance and Risk Committee of Lehman Board of Directors (Sept. 11, 2007), at p. 2 [LBEX‐AM 067167]; Lehman Brothers Holdings Inc., Minutes of Meeting of Board of Directors (Oct. 15, 2007), at p. 6 [LBHI_SEC07940_026407]. – but did not mention other factors such as the addition of Archstone and other new deals.⁵⁴⁴⁵⁴⁴ Lehman, September 2007 Financial Information Presentation to Lehman Board of Directors with Christopher M. O'Meara's handwritten notes (Oct. 15, 2007), at p. 6 [LEH_CMO_0000001]; Lehman, September 2007 Financial Information Presentation to Lehman Board of Directors with Jeffrey A. Welikson's handwritten notes (Oct. 15, 2007), at p. 6 [WGM_LBEX_00540].

¶Many of Lehman's directors told the Examiner that this information about the extent and duration of any risk appetite limit excess would have been helpful for them to have received.⁵⁴⁵⁵⁴⁵ Examiner's Interview of Roger Berlind, May 8, 2009, at p. 4; Examiner's Interview of Dr. Henry Kaufman, May 19, 2009, at p. 7; Examiner's Interview of Marsha Johnson Evans, May 22, 2009, at pp. 7‐9; Examiner's Interview of John D. Macomber, Sept. 25, 2009, at p. 3; Examiner's Interview of Roland A. Hernandez, Oct. 2, 2009. Some directors did not recall knowing that Lehman had ever been in breach of its risk appetite limits.⁵⁴⁶⁵⁴⁶ Examiner's Interview of Roger Berlind, May 8, 2009, at p. 4; Examiner's Interview of John D. Macomber, Sept. 25, 2009, at p. 17; Examiner's Interview of Marsha Johnson Evans, May 22, 2009, at p. 9; Examiner's Interview of Sir Christopher Gent, Oct. 21, 2009, at p. 14; Examiner's Interview of Roland A. Hernandez, Oct. 2, 2009, at p. 10. Although none of the directors said that they would have changed their views had they received that information, they did say that they would have wanted to have a conversation with management about the reason for the limit overages and management's strategy for resolving them.⁵⁴⁷⁵⁴⁷ Examiner'sInterview of Roger Berlind, May 8, 2009, at p. 4; Examiner's Interview of John D. Macomber, Sept. 25, 2009, at p. 13; Examiner's Interview of Marsha Johnson Evans, May 22, 2009, at p. 7; Examiner's Interview of Sir Christopher Gent, Oct. 21, 2009, at p. 15; Examiner's Interview of Roland A. Hernandez, Oct. 2, 2009, at p. 10; Examiner's Interview of Dr. Henry Kaufman, May 19, 2009, at p. 7.Show full note

143

¶The following chart illustrates the lag between the beginning of the risk appetite limit overages and the notification of the Board. The straight dotted line represents the firm‐wide risk appetite limit and the jagged solid line represents the firm‐wide usage:

144

Firm‐wide Risk Appetite Usage vs. Limit Q2 2007 Q3 2007 Q4 2007 Q1 2008

4.5 Period between RA excess and Board notification

¶4.0

¶3.5

¶3.0

¶$ in Billions

¶2.5

¶2.0

¶1.5

¶1.0

¶0.5

0.0 Feb 28, 07 May 31, 07 Aug 31, 07 Nov 30, 07 Feb 29, 08

May 29, 2007 Aug 13, 2007 Sep 11, 2007 Oct 15, 2007 Archstone Archstone is Board of Board is first agreement. added into RA. RA Directors is told told about RA was later that RA "remains excess. RA excesses retroactively within the begin soon updated to reflect established risk thereafter. the commitment limits." since June 1, 2007.

¶Firm‐wide Usage Firm‐wide Limit

Source: LehmanRisk Summary Note: Dates may reflect actual date, or the first business day after the event.

Leveraged Loan Disclosures

¶Both the Finance and Risk Committee and the full Board were apprised of Lehman's risk exposure to high yield bonds and leveraged loan.⁵⁴⁸⁵⁴⁸ Lehman Brothers Holdings Inc., Minutes of Meeting of Finance and Risk Committee of Lehman Board of Directors (Sept. 11, 2007), at pp. 1‐2 [LBEX‐AM 067018]; Lehman, Risk, Liquidity, Capital and Balance Sheet Update Presentation to Finance and Risk Committee of Lehman Board of Directors (Sept. 11, 2007), at p. 13 [LBEX‐AM 067167]; Lehman Brothers Holdings Inc., Minutes of Meeting of Board of Directors (Sept. 11, 2007), at p. 6 [LBHI_SEC07940_026364].Show full note O'Meara discussed with the Committee the "comprehensive risk framework for high‐yield debt products" and referred to Lehman's "extensive risk controls," spanning the approval process through post‐closing.⁵⁴⁹⁵⁴⁹ Lehman Brothers Holdings Inc., Minutes of Meeting of Finance and Risk Committee of the Board of Directors (Sept. 11, 2007), at pp. 2‐3 [LBEX‐AM 067018]. O'Meara told the Finance and Risk Committee that Lehman had a disciplined approach to risk mitigation through syndication, outright sales, sale through silent partner participation, and single‐name and macro hedging.⁵⁵⁰⁵⁵⁰ Lehman, Risk, Liquidity, Capital and Balance Sheet Update Presentation to Finance and Risk Committee of Lehman Board of Directors (Sept. 11, 2007), at p. 14 [LBEX‐AM 067167]. A chart that accompanied his presentation shows that Lehman's "macro hedges" reduced Lehman's "HY Closed Loan Net Exposure" by approximately 20%.⁵⁵¹⁵⁵¹ Id.

145

¶The Board was not informed that in 2007 Lehman's managers had decided not to increase the size of its macro hedges on the leveraged loans exposure to cover the remaining 80% of the closed loans or to cover any portion of Lehman's much greater volume of commitments because these exposures were considered potentially not capable of being hedged.⁵⁵²⁵⁵² Examiner's Interview of Paul Shotton, June 5, 2009, at pp. 7‐8; Examiner's Interview of Kentaro Umezaki, June 25, 2009, at p. 17; Examiner's Interview of Fred Orlan, Sept. 21, 2009, at p. 6; Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at p. 13; Examiner's Interview of Alex Kirk, Jan. 12, 2010, at p. 9; Lehman Brothers Holdings Inc., Minutes of Meeting of Finance and Risk Committee of the Board of Directors (Sept. 11, 2007), at pp. 2‐3 [LBEX‐AM 067018].Show full note (Relatedly, there is no evidence that management disclosed the extent to which Lehman's commercial real estate investments were unhedged.)⁵⁵³⁵⁵³ Examiner's Interview of Marsha Johnson Evans, May 22, 2009, at pp. 3, 9‐10; Examiner's Interview of Roger Berlind, May 8, 2009, at p. 7. Some members of Lehman management were concerned that hedging the leveraged loans would be ineffective and could create a "double whammy" – simultaneous losses on the loans and the hedges.⁵⁵⁴⁵⁵⁴ Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at pp. 3, 13; Examiner's Interview of Madelyn Antoncic, Mar. 27, 2009, at p. 10.

146

¶The Board was not informed that the risk appetite usage of Lehman's leveraged loan business was almost double the limit applicable to that business and that the usage had been over the limit almost continuously since July 19, 2007,⁵⁵⁵⁵⁵⁵ Lehman Brothers Holdings Inc., Minutes of Meeting of Board of Directors (Sept. 11. 2007), at p. 6 [LBHI_SEC07940_263264]; Lehman, Update on Liquidity, Leveraged Loan Commitments and Mortgage Positions Presentation to Lehman Board of Directors with Weliksonʹs handwritten notes (Sept. 11, 2007) [LBHI_SEC07940_026355]; Mynor Gonzalez, Lehman, Daily Risk Appetite and VaR Report (Sept. 11, 2007) [LBEX‐DOCID 3296330], attached to e‐mail from Mynor Gonzalez, Lehman, to Mark Weber, Lehman (Sept. 12, 2007) [LBEX‐DOCID 3295527]; Appendix No. 9, comparing risk appetite and VaR usage versus limits.Show full note or that Lehman's management had approved at least 30 leveraged loans that exceeded Lehman's single transaction limit.⁵⁵⁶⁵⁵⁶ Lehman, Risk, Liquidity, Capital, and Balance Sheet Update Presentation to Finance and Risk Committee of Lehman Board of Directors (Sept. 11, 2007) [LBEX‐AM 067167]; Lehman Brothers Holdings Inc., Minutes of Meeting of the Finance and Risk Committee of Board of Directors (Sept. 11, 2007) [LBEX‐ AM 067018]; e‐mail from Joe Li, Lehman, to Fred Orlan, Lehman, et al. (July 25, 2007) [LBEX‐DOCID 2563167].Show full note Some directors believed that the decision to exceed Lehman's high yield and single transaction limits should have been disclosed to the Board.⁵⁵⁷⁵⁵⁷ Examiner's Interview of Dr. Henry Kaufman, Sept. 2, 2009, at p. 6 (noting importance of concentration limits); Examiner's Interview of John D. Macomber, Sept. 25, 2009, at pp. 6, 17 (stating that significant excesses ought to have been disclosed).

147

Leverage Ratios and Balance Sheet Disclosures

¶At these September 11, 2007 meetings, O'Meara also reported to the Finance and Risk Committee that Lehman's net leverage ratio was in line with Lehman's peers.⁵⁵⁸⁵⁵⁸ Lehman, Risk, Liquidity, Capital and Balance Sheet Update Presentation to Finance and Risk Committee of Lehman Board of Directors with Welikson's Handwritten Notes (Sept. 11, 2007), at pp. 2, 30 [WGM_LBEX_02247‐02340]; Lehman Brothers Holdings Inc., Finance and Risk Committee Minutes (Sept. 11, 2007), at pp. 2‐3 [LBEX‐AM 067018]. Management's presentation regarding the net leverage metric noted:

In the past, leverage was the key measure of equity adequacy. Between 2003 and 2006 we significantly reduced leverage. Low leverage was positively viewed by rating agencies and contributed to our 2005 upgrades. In 2006 and 2007, we worked with the regulatory and rating agencies to implement more accurate adequacy measures. As a result, we are comfortable with allowing our leverage to increase.⁵⁵⁹⁵⁵⁹ Lehman, Presentation on Risk, Liquidity, Capital and Balance Sheet Update to Finance and Risk Committee of Lehman Board of Directors (Sept. 11, 2007), at p. 50 [LBEX‐AM 067167].

¶The new adequacy measures included a measurement for equity, the CSE capital ratios, and Lehman's internal equity adequacy framework.⁵⁶⁰⁵⁶⁰ Id. at p. 51.

¶O'Meara did not disclose the firm's use of Repo 105 transactions to manage its net leverage ratio at this Board meeting or any other, and no director asked by the Examiner ever was aware of these off‐balance sheet transactions.⁵⁶¹⁵⁶¹ Examiner's Interview of Roger Berlind, Dec. 18, 2009, at p. 4; Examiner's Interview of Roland A. Hernandez, Oct. 2, 2009, at p. 22; Examiner's Interview of John D. Macomber, Sept. 25, 2009, at p. 20; Examiner's Interview of Dr. Henry Kaufman, Sept. 2, 2009, at p. 21; Examiner's Interview of Michael L. Ainslie, Dec. 22, 2009, at p. 4; Examiner's Interview of Thomas Cruikshank, Oct. 8, 2009, at p. 2; Examiner's Interview of Sir. Christopher Gent, Jan. 20, 2010, at p. 4; Examiner's Interview of Jerry A. Grundhofer, Sept. 16, 2009, at p. 10; Lehman Brothers Holdings Inc., Minutes of the Board of Directors (Sept. 11, 2007), at p. 3 [LBHI_SEC07940_026364]; Lehman, Board of Directors Materials for Sept. 11, 2007 Board Meeting (Sept. 7, 2007) [LBHI_SEC07940‐026282]; Lehman Brothers Holdings Inc., Minutes of the Board of Directors (Oct. 15, 2007), at p. 6 [LBHI_SEC07940_026407]; Lehman, Board of Directors Materials for Oct. 15, 2007 Board Meeting (Oct. 11, 2007) [LBHI_SEC07940‐026371]; Lehman Brothers Holdings Inc., Minutes of the Board of Directors (Nov. 8, 2007), at p. 6 [LBHI_SEC07940_026650]; Lehman, Board of Directors Materials for Nov. 8, 2007 Board Meeting (Nov. 2, 2007) [LBHI_SEC07940‐026520]; see also Section III.A.4 of this Report.Show full note

148

Liquidity and Capital Disclosures

¶Tonucci reported to the Board's Finance and Risk Committee that Lehman had record levels of liquidity and cash capital surplus at the end of the third quarter of 2007.⁵⁶²⁵⁶² Lehman Brothers Holdings Inc., Minutes of Meeting of Finance and Risk Committee of the Board of Directors (Sept. 11, 2007), at p. 3 [LBEX‐AM 067018]. He also reviewed Lehman's "liquidity pool year‐to‐date and over the last four years, noting the conservative nature of the firm's liquidity pool as compared to its peers, which [had] been recognized by the leading credit rating agencies."⁵⁶³⁵⁶³ Id.

¶The materials presented to the Board showed that Lehman had a third quarter "record" liquidity pool of $36 billion (an increase from $25.7 billion at the end of the second quarter 2007) and a cash capital position of $8.1 billion (an increase from $2.5 billion at the end of the second quarter) against a $2 billion policy minimum.⁵⁶⁴⁵⁶⁴ Lehman, Update on Liquidity, Leveraged Loan Commitments and Mortgage Positions Presentation to Lehman Board of Directors with Welikson's handwritten notes (Sept. 11, 2007), at p. 1 [LBHI_SEC07940_026355]; Lehman, Risk, Liquidity, Capital and Balance Sheet Update Presentation to Finance and Risk Committee of Lehman Board of Directors (Sept. 11, 2007), at p. 31 [LBEX‐AM 067167]. The materials stated that Lehman did not project the need to tap the capital markets because Lehman had "significant liquidity to fund these activities."⁵⁶⁵⁵⁶⁵ Id. Management similarly emphasized to the full Board Lehman's conservative approach to funding its balance sheet and strong liquidity pool, but acknowledged that for the last two months liquidity had been more challenging to maintain.⁵⁶⁶⁵⁶⁶ Lehman Brothers Holdings Inc., Minutes of Meeting of Board of Directors (Sept. 11, 2007), at p. 5 [LBHI_SEC07940_026364].

149

¶Management did not tell the Board or the Finance and Risk Committee about ALCO's concerns about Lehman's ability to fund its commitments, or that Lehman had nearly stopped entering into new deals in August 2007.⁵⁶⁷⁵⁶⁷ Examiner's Interview of Kentaro Umezaki, June 25, 2009, at pp. 16‐17; Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at pp. 9‐10; e‐mail from Roger Nagioff, Lehman, to Ian T. Lowitt, Lehman (July 20, 2009) [LBEX‐DOCID 175646]; e‐mail from Alex Kirk, Lehman, to Roger Nagioff, Lehman (Aug. 6, 2007) [LBEX‐DOCID 173492]; e‐mail from Alex Kirk, Lehman, to Roger Nagioff, Lehman (Aug. 7, 2007) [LBEX‐ DOCID 173496].Show full note Some directors said that if any of Lehman's senior management had concerns about the firm's funding or capital adequacy, that is "clearly" something they would have wanted to know.⁵⁶⁸⁵⁶⁸ Examiner's Interview of John D. Macomber, Sept. 28, 2009, at p. 16; Examiner's Interview of Dr. Henry Kaufman, Dec. 22, 2009 (saying it might have been appropriate to disclose liquidity concerns if they were more than short‐lived).

¶On September 20, 2007, Lehman issued a press release announcing that O'Meara would replace Antoncic as Lehman's Global Head of Risk Management (or CRO) as of December 1, 2007.⁵⁶⁹⁵⁶⁹ Lehman Brothers Holdings Inc., Press Release: Lehman Brothers Announces Management Changes (Sept. 20, 2007) [LBEX‐DOCID 533362]. The Examiner did not find any evidence to suggest that Antoncic's replacement was related to the risk limit or risk disclosure issues that had occurred during the prior three to four months. However, the SEC noted its concern that the risk limit excesses occurred during a period when Lehman's CRO position was in transition.⁵⁷⁰⁵⁷⁰ SEC, Notes from Lehman's Monthly Risk Review meeting (Oct. 11, 2007), at p. 6 [LBEX‐SEC 007438].

150

Late Reactions: Lehman Slowly Exits Its Illiquid Real Estate Investments

¶The last quarter of 2007 and first quarter of 2008 – from September 2007 through February 2008 – was a crucial juncture for Lehman. Lehman's overall balance sheet had grown by 37% during 2007,⁵⁷¹⁵⁷¹ Lehman, 2008 Financial Plan Presentation to Finance and Risk Committee of Board of Directors (Jan. 29, 2008), at p. 8 [LBHI_SEC07940_068559]. and much of the growth was concentrated in illiquid holdings that Lehman was already unable to sell without incurring significant losses.⁵⁷²⁵⁷² Examiner's Interview of Herbert H. (Bart) McDade III, Sept. 16, 2009, at p. 3; Examiner's Interview of Treasury Secretary Timothy F. Geithner, Nov. 24, 2009, at p. 7. As a result, without the accounting device of Repo 105 transactions, FID was already well over its balance sheet limit of approximately $230 billion by $18 billion.⁵⁷³⁵⁷³ Andrew J. Morton, Notes: First Sixty Days (Apr. 7, 2008), at p. 6 [LBEX‐DOCID 1734462]. Indeed, Lehman had been over its risk limits for the prior six months.⁵⁷⁴⁵⁷⁴ Appendix No. 9, comparing risk appetite and VaR usage versus limits. In hindsight, this quarter may have been Lehman's final opportunity to take decisive action to improve its balance sheet before the near collapse of Bear Stearns changed the rules of the road for Lehman and all of its peer investment banks.

¶Before Bear Stearns' near collapse in March 2008, Lehman had two basic ways of reducing its leverage: (1) selling assets, to reduce the numerator in the net leverage formula; or (2) raising equity, to increase the denominator in the net leverage formula. But Lehman did not successfully take either of these tacks during the final quarter of 2007 or the first quarter of 2008: Lehman's net balance sheet was $23.7 billion higher at the end of the first quarter of 2008 than at the end of 2007.⁵⁷⁵⁵⁷⁵ LBHI 10‐Q (filed on Apr. 9, 2008), at p. 70. Lehman did not raise substantial amounts of equity during this period.⁵⁷⁶⁵⁷⁶ Lehman, 2008 Financial Plan Presentation to Finance and Risk Committee of Board of Directors (Jan. 29, 2008), at p. 16 [LBHI_SEC07940_068559]; Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at pp. 25‐27.

151

¶Lehman's failure to sell assets sooner was based partly on its previous decision to pursue a countercyclical growth strategy, which entailed a conscious acceptance of greater risk even while Lehman's peer investment banks were curtailing their risk‐ taking.⁵⁷⁷⁵⁷⁷ See Lehman, 2008 Financial Plan Presentation to Finance and Risk Committee of Board of Directors (Jan. 29, 2008), at p. 6 [LBHI_SEC07940_068559]. The countercyclical growth strategy continued to be reflected in Lehman's strategy in the first quarter of 2008.⁵⁷⁸⁵⁷⁸ Id.

¶Fuld told the Examiner that he decided after the December 2007 holiday season to instruct his senior managers to reduce the firm's balance sheet.⁵⁷⁹⁵⁷⁹ Examiner's Interview of Richard S. Fuld, Jr., Nov. 19, 2009, at p. 2. However, documentary evidence shows that Lehman did not aggressively begin to sell assets until the second quarter of 2008.⁵⁸⁰⁵⁸⁰ Lehman, Commercial Real Estate Update (Mar. 25, 2008), at p. 3 [LBHI_SEC07940_127250]; Lehman, Balance Sheet and Disclosure Scorecard For Trade Date April 21, 2008 (Apr. 22, 2008), at p. 3 [LBEX‐ DOCID 3187588], attached to e‐mail from Tal Litvin, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (Apr. 22, 2008) [LBEX‐DOCID 3187333]; e‐mail from Gary Mandelblatt, Lehman, to Alex Kirk, Lehman (Jan. 15, 2008) [LBEX‐DOCID 1600235]; e‐mail from Erin M. Callan, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (Apr. 3, 2008) [LBEX‐DOCID 1538729]; e‐mail from Paul A. Hughson, Lehman, to Mark Walsh, Lehman (Apr. 1, 2008) [LBEX‐DOCID 1866761]; Lehman, Balance Sheet and Disclosure Scorecard For Trade Date August 12, 2008 (Aug. 13, 2008), at p. 7 [LBEX‐SIPA 006539].Show full note

152

¶During the first quarter of 2008, Fuld also decided that Lehman would not raise equity unless it could do so at a premium.⁵⁸¹⁵⁸¹ Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at p. 8; Examiner's Interview of Jeremy Isaacs, Oct. 1, 2009, at p. 3. While many of Lehman's competitors entered into strategic transactions to raise equity in late 2007 and early 2008,⁵⁸²⁵⁸² See, e.g., Merrill Lynch & Co., Inc., Annual Report for 2007 as of Dec. 28, 2007 (Form 10‐K) (filed on Feb. 25, 2008), at p. 23 ("Merrill Lynch 2007 10‐K") (stating that Merrill Lynch issued $6.2 billion in common stock during the fourth quarter of 2007, and $6.6 billion of mandatory convertible preferred stock during the first quarter of 2008); Morgan Stanley, Annual Report for 2007 as of Nov. 30, 2007 (Form 10‐K) (filed on Jan. 29, 2008), at pp. 178‐79 ("Morgan Stanley 2007 10‐K") (stating that Morgan Stanley sold equity units to the Chinese Investment Corporation for approximately $5.579 billion in December 2007); Citigroup Inc., Annual Report for 2007 as of Dec. 31, 2007 (Form 10‐K) (filed on Feb. 22, 2008), at p. 77 ("Citigroup 2007 10‐K") (stating that Citigroup sold $7.5 billion of equity units to the Abu Dhabi Investment Authority on December 3, 2007); UBS AG, Annual Report for 2007 as of Dec. 31, 2007 (Form 20‐F) (filed on Mar. 18, 2008), at pp. 276‐77 ("UBS AG 2007 20‐F") (stating that UBS issued shares corresponding to approximately 13.4% of the then current share capital on February 27, 2008); see Section III.A.3 of this Report.Show full note Lehman did not want to signal weakness by raising equity at a discount,⁵⁸³⁵⁸³ E‐mail from David Goldfarb, Lehman, to Richard S. Fuld, Jr., Lehman, et al. (Jan. 9, 2008) [LBHI_SEC07940_670045]. and, unlike its peers, had not yet suffered losses that might have signaled a more urgent need for such action.

Fiscal 2008 Risk Appetite Limit Increase

¶In October 2007, the firm‐wide risk appetite usage continued to increase, and for several days was more than $500 million over the limit; the limit excess peaked at almost 22% of the limit amount.⁵⁸⁴⁵⁸⁴ Appendix No. 9, comparing risk appetite and VaR usage versus limits. The limit excess was partly the result of Lehman's decision to enter into several significant commercial real estate and leveraged loan transactions in May, June, and July 2007, which were gradually being funded and thus increasing Lehman's risk appetite usage; partly the result of Lehman's inability to securitize or syndicate those and other transactions; and partly the result of increased volatility in the market.⁵⁸⁵⁵⁸⁵ SEC, Notes from Lehman's Monthly Risk Review Meeting (Aug. 17, 2007), at p. 7 [LBEX‐SEC 007383]; e‐mail from Jeffrey Goodman, Lehman, to Christopher M. O'Meara, Lehman, et al. (Dec. 4, 2007) [LBEX‐ DOCID 251204].

153

¶Lehman increased the firm‐wide risk appetite limit for fiscal 2008. Approval for the increase was given on January 14, 2008, when Lehman raised the limit from $3.5 billion to $4 billion, "with [the] increase [being] backdated to December 3, 2007."⁵⁸⁶⁵⁸⁶ Lehman, Material for Market Risk Control Committee Meeting (Jan. 14, 2008), at p. 33 [LBEX‐DOCID 271352], attached to e‐mail from Mark Weber, Lehman, to Paul Shotton, Lehman, et al. (Jan. 14, 2008) [LBEX‐DOCID 223263]. The limit increase had the effect of eliminating any firm‐wide limit excesses from that date forward.⁵⁸⁷⁵⁸⁷ Appendix No. 9, comparing risk appetite and VaR usage versus limits.

¶To arrive at the $4 billion risk appetite limit figure, Lehman's officers made significant changes to the limit calculation as compared to prior years' calculations. The Examiner's financial advisors calculate that if the same assumptions used for the 2007 risk appetite limit had been used to determine the limit for 2008, the 2008 limit would have been approximately $2.5 billion rather than $4.0 billion.⁵⁸⁸⁵⁸⁸ For a more detailed explanation of the changes in the risk appetite calculation, see Appendix 10, describing calculation of increased $4.0 billion risk appetite limit.

¶The 2008 risk appetite limit also was based on a very aggressive projected revenue figure. Lehman's projected revenues were the starting point for setting the limit, and perhaps the single most important input to the formula. Lehman used a $21 billion projected revenue figure in calculating the $4 billion limit amount.⁵⁸⁹⁵⁸⁹ Paolo R. Tonucci, Lehman, 2008 Financial Plan Presentation (Jan. 29, 2008), at p. 1 [LBHI_SEC07940_068559]. Despite the difficulties in the market, this amount constituted a 9% increase over 2007 revenues. Contemporaneous external analyst reports projected 2008 revenues of only about $19.2 billion – a figure that would have resulted in a much lower risk appetite limit for the year.⁵⁹⁰⁵⁹⁰ E.g., Douglas Sipkin, Wachovia Capital Markets, L.L.C., Tough Year Ahead ‐ Sowing Seeds for Share Gains (Jan. 15, 2008), at p. 1 [LBEX‐DOCID 095883]; Appendix 10, describing calculation of increased $4.0 billion risk appetite limit.

154

January 2008 Meeting of Board of Directors

¶On January 29, 2008, the Finance and Risk Committee and the entire Board met. During these meetings, management discussed the difficult market, but believed that it presented opportunities for Lehman to grow.⁵⁹¹⁵⁹¹ Lehman, 2008 Financial Plan Summary (Jan. 29, 2009), at p. 5 [LBHI_SEC07940_027374]. Lehman's senior officers told the Board: "[The market environment] presents an opportunity for the firm to pursue a countercyclical growth strategy, similar to what it did during the 2001‐2002 downturn, to improve its competitive position and, over time, generate superior returns for our shareholders."⁵⁹²⁵⁹² Id.

¶Management provided the Finance and Risk Committee with an overview of Lehman's net assets and leverage levels and told the Committee that Lehman's balance sheet continued to grow across almost all asset classes and businesses.⁵⁹³⁵⁹³ Lehman Brothers Holdings Inc., Minutes of Meeting of Finance and Risk Committee of the Board of Directors (Jan. 29, 2008), at pp. 2‐3 [LBEX‐AM 067022]; Lehman, Additional Materials for the Finance and Risk Committee (Jan. 29, 2008), at p. 3 [LBEX‐AM 067260]. At the full Board meeting, Kaufman reported to the Board on Lehman's balance sheet growth and Lehman's year end increase in net leverage.⁵⁹⁴⁵⁹⁴ Lehman Brothers Holdings Inc., Minutes of Meeting of Board of Directors (Jan. 29, 2008), at p. 3 (LBHI_SEC07940_027446]. Callan discussed Lehman's target leverage ratio with the Board and said that it would come back down.⁵⁹⁵⁵⁹⁵ Id. at p. 8; Lehman, December 2007 Presentation to Lehman Board with Welikson's handwritten notes (Jan. 29, 2008), at p. 6 [WGM_LBEX_00708].

155

¶At the Finance and Risk Committee meeting, management reviewed Lehman's monthly stress tests and scenario analyses.⁵⁹⁶⁵⁹⁶ Lehman, 2008 Financial Plan Presentation to Finance and Risk Committee of the Board of Directors (Jan. 29, 2008), at p. 18 [LBHI_SEC07940_068559]. Stress tests indicated a worst‐case loss of $3.2 billion.⁵⁹⁷⁵⁹⁷ Id. at p. 19. Management did not inform the Committee of a new "Credit Crunch" scenario that was added to Lehman's portfolio of stress testing scenarios in October 2007 that predicted the worst loss of all the scenarios, with a loss of $3.99 billion (although early drafts of the presentation did include the scenario).⁵⁹⁸⁵⁹⁸ Lehman, Monthly Risk Review Package (Oct. 11, 2007), at p. 10 [LBEX‐SEC 007438] (noting Lehman "added a new stress test, called the Credit Crunch which is essentially Summer 2007"); Lehman, 2008 Financial Plan Presentation to Lehman Board of Directors [Draft] (Jan. 2008), at p. 5 [LBEX‐DOCID 384192], attached to e‐mail from Mark Weber, Lehman, to Jennifer Bale, Lehman, et al. (Jan. 16, 2008) [LBEX‐DOCID 306708].Show full note

¶At these January meetings, Lehman's management also recommended the new risk appetite limit to the Board.⁵⁹⁹⁵⁹⁹ Lehman, 2008 Financial Plan Summary (Jan. 29, 2008), at p. 11 [LBHI_SEC07940_027374]. The directors were generally not aware or did not recall any discussion regarding the adjustments of the risk appetite calculation.⁶⁰⁰⁶⁰⁰ Examiner's Interview of Sir Christopher Gent, Oct. 21, 2009, at p. 16; Examiner's Interview of Dr. Henry Kaufman, Sept. 2, 2009, at p. 2; Examiner's Interview of Roland A. Hernandez, Oct. 2, 2009, at p. 14; Examiner's Interview of John D. Macomber, Sept. 25, 2009, at p. 18. Two of the directors said that they would have wanted to know about significant changes in the methodology.⁶⁰¹⁶⁰¹ Examiner's Interview of Dr. Henry Kaufman, Sept. 2, 2009, at p. 2; Examiner's Interview of John Macomber, Sept. 25, 2009, at p. 2. However, Lehman's managers told the Board that the $21 billion revenue projection was "very aggressive," and the Board had an extended discussion of the impact of potentially lower revenues on Lehman's business.⁶⁰²⁶⁰² Jeffrey A. Welikson, Lehman, Notes from the 2008 Financial Plan Presentation (Jan. 29, 2008), at p. 1 [WGM_LBEX_03249].

156

Executive Turnover

¶In January 2008, Nagioff decided for personal reasons to resign as global head of FID.⁶⁰³⁶⁰³ Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at p. 20; Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at p. 22 (Fuld indicated that Nagioff's decision to step down was entirely voluntary and was the result of Nagioff's frustration with his commute from London); Examiner's Interview of Sir Christopher Gent, Oct. 21, 2009, at p. 5 (Gent explained that, based on conversations with Nagioff, he believed Nagioff's resignation was entirely due to the logistical disruption of Nagioff's family life on account of his commute); Examiner's Interview of Hugh E. (Skip) McGee III, Aug. 12, 2009, at p. 13 (McGee denied that Nagioff's resignation had anything to do with Lehman's cessation of residential mortgage originations, and tied Nagioff's decision to the difficulty of Nagioff's commute); Examiner's Interview of John F. Akers, Apr. 22, 2009, at p. 2 (Akers expressed the belief that Nagioff left voluntarily and that his departure was mutual between him and management, but also noted that along with the commute from London, difficulty also arose because Nagioff failed to meet Fuld's expectations); Examiner's Interview of Eric Felder, May 21, 2009, at p. 6 (Felder indicated that Nagioff left Lehman voluntarily).Show full note In addition, that month, Alex Kirk, co‐chief operating officer of FID since October 2007, left Lehman. Kirk agreed with Fuld that he would leave Lehman at about the same time.⁶⁰⁴⁶⁰⁴ Transcript of deposition testimony of Alex Kirk, In re Lehman Brothers Holdings Inc., Case No. 08‐13555, Bankr. S.D.N.Y., Aug. 31, 2009, at pp. 7‐8.

157

Commercial Real Estate Sell‐Off: Too Little, Too Late

¶Although Lehman ultimately took aggressive action to reduce its balance sheet and thus its net leverage, Lehman's management did not make a firm‐wide decision to reduce these figures until well after the beginning of the risk appetite and balance sheet limit overages in mid‐2007. Moreover, even after Lehman's senior officers directed the business lines to reduce their balance sheets, it took several months for the reduction to be effectuated, particularly with respect to Lehman's illiquid holdings of commercial real estate assets.

¶Although the firm persistently was over its balance sheet limits, and had been over the risk appetite limit since about June 1, 2007, the first written indication that the Risk Committee considered the risk limit overage was in October 2007.⁶⁰⁵⁶⁰⁵ E‐mail from Christopher M. O'Meara, Lehman, to Paul Shotton, Lehman, et al. (Oct. 2, 2007) [LBEX‐ DOCID 155020]. On October 2, 2007, O'Meara noted in an e‐mail that the Risk Committee agreed to "temporarily approve the Risk Appetite limit overage, due to the unusual circumstances in the marketplace today / recently, especially concerning Leveraged Finance and Real Estate businesses."⁶⁰⁶⁶⁰⁶ E‐mail from Christopher M. O'Meara, Lehman, to Paul Shotton, Lehman, et al. (Oct. 2, 2007) [LBEX‐ DOCID 155020]. Thus, Lehman's management decided not to reduce its risk position aggressively at that time.

¶Later in October, in advance of a planned conversation with the Executive Committee, O'Meara proposed formulating "specific recommendations about where to make the cuts" to bring down risk appetite.⁶⁰⁷⁶⁰⁷ E‐mail from Jeffrey Goodman, Lehman, to Mark Weber, Lehman, et al. (Oct. 22, 2007) [LBEX‐DOCID 318367]. Goodman expressed a willingness to "take some losses" to achieve this goal.⁶⁰⁸⁶⁰⁸ Id. In a November 2007 presentation to Fuld, the commercial real estate group recommended reducing its global balance sheet by $15 billion.⁶⁰⁹⁶⁰⁹ Global Real Estate Group, Lehman, Global Real Estate Update (Nov. 6, 2007), at pp. 1, 2 [LBEX DOCID 514264], attached to e‐mail from Jeffrey Goodman, Lehman, to Madelyn Antoncic, Lehman, et al. (Nov. 6, 2007) [LBEX DOCID 531492]; e‐mail from Jonathan Cohen, Lehman, to Christopher M. O'Meara, Lehman, et al. (Nov. 3, 2007) [LBEX DOCID 523669] (indicating that Fuld was the intended audience of the presentation).Show full note

158

¶When Erin M. Callan became CFO on December 1, 2007, one of her objectives was to reduce balance sheet, particularly in the areas of residential and commercial real estate.⁶¹⁰⁶¹⁰ Examiner's Interview of Erin M. Callan, Oct. 23, 2009, at pp. 10‐13. Fuld decided during the December 2007 holiday season that it was time to pursue an aggressive reduction of Lehman's risk profile.⁶¹¹⁶¹¹ Examiner's Interview of Richard S. Fuld, Jr., Dec. 9, 2009, at p. 10.

¶Lehman did not aggressively pursue these reductions for several months, however. According to Callan, she had discussions with Fuld and Gregory about reducing balance sheet in January and February 2008, but "didn't get traction quickly on it."⁶¹²⁶¹² Examiner's Interview of Erin M. Callan, Oct. 23, 2009, at pp. 10‐13. Between the fourth quarter of 2007 and the first quarter of 2008, Lehman's gross and net assets actually increased from $691 billion to $786 billion, and from $373 billion to $397 billion, respectively.⁶¹³⁶¹³ Lehman, Q2 2008 Update (June 18, 2008), at p. 5 [LBEX‐DOCID 1302959], attached to e‐mail from Anu Jacob, Lehman, to Dennis Rodrigues, Lehman, et al. (July 8, 2008) [LBEX‐DOCID 1326944]. In addition, FID exceeded its balance sheet limit in the fourth quarter of 2007 by $11.17 billion, with overages concentrated in securitized products and real estate.⁶¹⁴⁶¹⁴ Andrew J. Morton, Notes: First Sixty Days (Apr. 7, 2008), at p. 6 [LBEX‐DOCID 1734462], attached to e‐ mail from Gary Mandelblatt, Lehman, to Andrew J. Morton, Lehman, et al. (Apr. 7, 2008) [LBEX‐DOCID 1834937]. In the first quarter of 2008, FID was over the balance sheet limit by $18 billion with nearly 50% of the overages concentrated in securitized products and real estate.⁶¹⁵⁶¹⁵ Id. at p. 4. Lehman's Treasurer at the time, Paolo Tonucci, was comfortable with FID's balance sheet overages in the first quarter of 2008.⁶¹⁶⁶¹⁶ E‐mail from Clement Bernard, Lehman, to Andrew J. Morton, Lehman, et al. (Feb. 27, 2008) [LBEX‐ DOCID 1849839]. At the end of the first quarter of 2008, Tonucci did not require FID to sell off more assets.⁶¹⁷⁶¹⁷ Id.

159

¶It was not until February 26, 2008 that Gregory instructed Walsh to "get balance sheet down quickly,"⁶¹⁸⁶¹⁸ E‐mail from Mark A. Walsh, Lehman, to Andrew J. Morton, Lehman (Feb. 26, 2008) [LBHI_SEC07940_115814]. and GREG set out to reduce its global balance sheet by $5 billion by March 18, 2008.⁶¹⁹⁶¹⁹ E‐mail from Paul A. Hughson, Lehman, to Mark Gabbay, Lehman, et al. (Feb. 27, 2008) [LBEX‐DOCID 1869265] (discussing the schedule for the $5 billion reduction target); e‐mail from Paul A. Hughson, Lehman, to Mark Gabbay, Lehman, et al. (Mar. 7, 2008) [LBEX‐DOCID 1723168] (Hughson gives update on sales progress and asks for updates from others on their progress towards the $5 billion reduction target).Show full note Even after that, Callan told the Examiner that she pleaded with Fuld and Gregory to reduce the balance sheet and finally persuaded them to add the issue to the Executive Committee's March 20, 2008 agenda after the near collapse of Bear Stearns.⁶²⁰⁶²⁰ Examiner's Interview of Erin M. Callan, Oct. 23, 2009, at pp. 10, 11. McDade was made the firm's "balance sheet czar" in mid‐March and was given authority to enforce firm‐wide balance sheet targets.⁶²¹⁶²¹ Id. at p. 12; Examiner's Interview of Andrew J. Morton, Sept. 21, 2009, at p. 11. Fuld intended to reduce all of Lehman's positions, including commercial real estate and leveraged loans positions.⁶²²⁶²² Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at p. 26. Balance sheet reduction targets were not sent out to Lehman's businesses until after the Executive Committee meeting on March 20, 2008.⁶²³⁶²³ Examiner's Interview of Erin M. Callan, Oct. 23, 2009, at pp. 11‐12.

160

¶On May 13, 2008, two weeks before the end of the second quarter, Callan urged Gregory and Fuld to "deliver on the balance sheet reduction this quarter" and not give "any room to FID for slippage."⁶²⁴⁶²⁴ E‐mail from Erin M. Callan, Lehman, to Joseph Gregory, Lehman, et al. (May 13, 2008) [LBHI_SEC07940_034732]. GREG's overseas businesses in particular were slow to reduce their positions in the first and second quarters of 2008,⁶²⁵⁶²⁵ Examiner's Interview of Paul A. Hughson, Oct. 28, 2009, at p. 5; Lehman, Balance Sheet and Disclosure Scorecard for Trade Date June 23, 2008 (June 24, 2008), at p. 10 [LBEX‐DOCID 1742000], attached to e‐mail from Michael McGarvey, Lehman, to Paul Mitrokostas, Lehman, et al. (June 25, 2008) [LBEX‐DOCID 1856557]; e‐mail from Paul A. Hughson, Lehman, to Kentaro Umezaki, Lehman, et al. (Oct. 2, 2007) [LBEX‐DOCID 1809381]; e‐mail from Paul A. Hughson, Lehman, to Jonathan Cohen, Lehman (July 20, 2007) [LBEX‐DOCID 1426881].Show full note but GREG's U.S. business met its balance sheet reduction targets, despite continuing to engage in some originations.⁶²⁶⁶²⁶ Examiner's Interview of Mark A. Walsh, Oct. 21, 2009, at pp. 10‐11 (stating that he and Gregory realized at the time that halting originations was not as easy as flipping a switch).

¶Some witnesses believed that GREG was not aggressive enough in selling off its portfolio, holding on to positions in a belief that the market would eventually rebound.⁶²⁷⁶²⁷ Examiner's Interview of Erin M. Callan, Oct. 23, 2009, at p. 13; Examiner's Interview of Mark Weber, Aug. 11, 2009, at pp. 8‐9. In one memorandum, Lehman's Head of Global Strategy expressed the concern that "the team responsible for selling down these positions is the same one that originated them."⁶²⁸⁶²⁸ Memorandum from Timothy Lyons, Lehman, to David Goldfarb, Lehman, Strategic Imperatives for the Firm (July 3, 2008), at p. 1 [LBEX‐DOCID 1377945]. But several witnesses denied there was any incentive not to sell down the portfolio because they knew that no one in GREG would be getting a 2008 bonus.⁶²⁹⁶²⁹ Examiner's Interview of David O'Reilly, Oct. 26, 2009, at p. 3; Examiner's Interview of Mark A. Walsh, Oct. 21, 2009, at p. 11; Examiner's Interview of Kenneth Cohen, Oct. 20, 2009, at p. 11; Examiner's Interview of Andrew J. Morton, Sept. 21, 2009, at pp. 19‐20 (Morton notes that Walsh knew by February 2008 that he would receive only a straight salary for 2008, with no bonus, thus Walsh had no compensation‐based incentive to inflate his marks). For a more detailed discussion of the effect of Lehman's officers' compensation structure on the incentive to take risks, see Appendix 11, Compensation.Show full note

161

¶Regardless of the reasons for Lehman's slow reaction to its oversized commercial real estate holdings, the fact remains that Lehman's balance sheet did not decline until the end of the second quarter of 2008, after Bear Stearns had already nearly collapsed.

Lehman's Compensation Practices

¶The Examiner considered, in the course of determining whether the officers and directors of Lehman breached their fiduciary duties, the impact that Lehman's compensation practices may have had on Lehman's conduct such as the expansion into potentially highly profitable, but riskier, lines of business, as discussed above.

¶Lehman's compensation policy was designed, in theory, to penalize excessive risk taking. At times, FID businesses that exceeded balance sheet limits and breached risk limits faced diminution of their compensation pool.⁶³⁰⁶³⁰ Examiner's Interview of Kentaro Umezaki, June 25, 2009, at pp. 8‐9; Lehman, Global Consolidated Balance Sheet (May 31, 2007) [LBEX‐DOCID 276740]; e‐mail from Kentaro Umezaki, Lehman, to Kaushik Amin, Lehman, et al. (July 10, 2007) [LBEX‐DOCID 252873]. At other times, FID used a "Compensation Scorecard" that included risk‐weighted metrics such as return on risk equity and return on net balance sheet to determine compensation pool allocations.⁶³¹⁶³¹ Lehman, 2004 Fixed Income Division Compensation Scorecard (Undated) [LBEX‐DOCID 1748807]. The FID Compensation Committee assessed performance against VaR, balance sheet usage, and risk appetite.⁶³²⁶³² Lehman, COMPMETRICS Excel Spreadsheet (Undated), at pp. 1‐9 [LBEX‐LL 1054327]; Lehman, 2007 FID Forecast Budget Support Excel Spreadsheet (Undated), at pp. 1‐11 [LBEX‐BARCMP 0000001].

162

¶But in practice, Lehman rewarded its employees based upon revenue with minimal attention to risk factors in setting compensation. None of these risk‐related adjustments was applied rigorously or consistently. Ken Umezaki, then Head of FID Strategy, noted after a firm‐wide speech by Fuld:

[T]he majority of the trading businesses focus is on revenues, with balance sheet, risk limit, capital or cost implications being a secondary concern.⁶³³⁶³³ E‐mail from Kentaro Umezaki, Lehman, to Scott J. Freidheim, Lehman, et al. (Apr. 19, 2007) [LBEX‐ DOCID 318475].

¶To calculate revenue for its compensation pool, Lehman included revenue not yet recognized but recorded based on mark‐to‐market positions.⁶³⁴⁶³⁴ Examiner's Interview of John D. Macomber, Sept. 25, 2009, at pp. 5, 22; Examiner's Interview of James Emmert, Oct. 9, 2009, at p. 2‐3. In theory, therefore, traders and business units were incented to enter into transactions for short‐term profits, even if those transactions created long‐term risks for the firm.⁶³⁵⁶³⁵ See Section III.A.1.b.1.2 of this Report. The Examiner finds that Lehman's assumption of ever‐ increasing business risk did not come from the bottom up but rather from the top down. Similarly

163

¶Lehman's mark‐to‐market accounting also incented Lehman to value investments at the high end to generate higher net revenues. Lehman had procedures to control such valuations, however, and in practice, the Examiner found no evidence to support a finding that any improper valuations were taken to affect compensation.

¶A more detailed description of Lehman's compensation practices may be found at Appendix 11.

Analysis

¶The Examiner investigated three potential claims in connection with Lehman's management of its risks: (1) whether any Lehman officer breached the fiduciary duty of care to the firm by assuming excessive risk with respect to Lehman's investments, or by failing to follow the firm's risk management policies; (2) whether any Lehman officer breached the fiduciary duty of good faith and candor by not providing the Board with material information concerning risk issues; and (3) whether any Lehman director breached the fiduciary duty of good faith to monitor Lehman's risk management.

¶Lehman's senior officers – Fuld and Gregory in particular – had sizeable holdings of Lehman stock and may have been more incented to increase Lehman's long‐term stock price than to generate short‐term revenues.

164

The Examiner Does Not Find Colorable Claims That Lehman's Senior Officers Breached Their Fiduciary Duty of Care by Failing to Observe Lehman's Risk Management Policies and Procedures

Legal Standard

¶To assert a colorable duty of care claim concerning corporate conduct, the plaintiff must first overcome the protection of the business judgment rule. Under the traditional business judgment rule as it applies to directors, there is a "presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company."⁶³⁶⁶³⁶ Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 954 (Del. 1985) (quoting Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984)) (internal quotation marks omitted). Thus, "a court will not substitute its judgment for that of the board if the latter's decision can be 'attributed to any rational business purpose.'"⁶³⁷⁶³⁷ Id. (quoting Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971)); see the discussion of Delaware corporate fiduciary law in Appendix 1, Legal Issues.

¶The business judgment rule has rarely been applied to officers. However, based upon a recent decision by the Delaware Supreme Court⁶³⁸⁶³⁸ Gantler v. Stephens, 965 A.2d 695, 709 (Del. 2009). holding that the fiduciary duties of directors and officers are identical, the Examiner concludes that Delaware courts will likely hold, at a minimum, that officers are protected by the business judgment rule whenever they act under an express delegation of authority from the Board; the Delaware courts are also likely to hold that officers are protected by the rule whenever they act within the scope of their discretion even if not pursuant to express delegation by the Board.⁶³⁹⁶³⁹ Cf. id. (holding that the fiduciary duties of officers and directors are identical).

165

¶The Examiner concludes that the Delaware courts are likely to hold that an officer can be stripped of the protection of the business judgment rule only in fairly narrow circumstances not presented here.⁶⁴⁰⁶⁴⁰ See, e.g., McMullin v. Beran, 765 A.2d 910, 922 (Del. 2000); see also Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985), overruled on other grounds by Gantler, 965 A.2d at 713 n.54; Aronson, 473 A.2d at 812, overruled on other grounds by Brehm v. Eisner, 746 A.2d 244, 254 (Del. 2000). Ryan v. Gifford, 918 A.2d 341, 354 (Del. Ch. 2007); Massaro v. Vernitron Corp, 559 F. Supp. 1068, 1080 (D. Mass. 1983); Omnibank of Mantee v. United S. Bank, 607 So. 2d 76, 84‐85 (Miss. 1992) Cf. Mills Acquisition Co. v. MacMillan, Inc., 559 A.2d 1261, 1279 (Del. 1989) ("[J]udicial reluctance to assess the merits of a business decision ends in the face of illicit manipulation of a board's deliberative process by self‐interested corporate fiduciaries.").Show full note

¶If the evidence overcomes the presumption of the business judgment rule, the plaintiff must then prove a violation of the duty of care.⁶⁴¹⁶⁴¹ Unlike the directors, Lehman's officers are not immunized by Lehman's articles of incorporation from personal liability for breaching the duty of care. See Lehman Brothers Holdings Inc., Certificate of Incorporation, at § 10.1, Limitation of Liability of Directors. The standard of proof for a duty of care claim for corporate misconduct is generally defined as gross negligence.⁶⁴²⁶⁴² Van Gorkom, 488 A.2d at 873. Gross negligence means "reckless indifference to or a deliberate disregard" of the corporation's interests, or "actions which are without the bounds of reason."⁶⁴³⁶⁴³ Tomczak v. Morton Thiokol, Inc., No. 7861, 1990 WL 42607, at *12 (Del. Ch. Apr. 5, 1990).

¶Overcoming the business judgment rule and establishing gross negligence are particularly difficult when a plaintiff is challenging the risk‐taking of a financial institution. As a court applying Delaware law has recently noted, taking risks is at the heart of a financial institution's business, and decisions about what risks to take are inherently protected by the business judgment rule from hindsight challenge.⁶⁴⁴⁶⁴⁴ In re Citigroup Inc. S'holder Derivative Litig., 964 A.2d 106, 126 (Del. Ch. 2009) ("The essence of the business judgment of managers and directors is deciding how the company will evaluate the trade‐off between risk and return. Businesses – and particularly financial institutions – make returns by taking on risk; a company or investor that is willing to take on more risk can earn a higher return.").Show full note Therefore, a plaintiff asserting a breach of the duty of care by Lehman's senior managers would face significant burdens.

166

Background

¶The Examiner finds insufficient evidence to support a claim that any Lehman officer breached the fiduciary duty of care in connection with managing the risks associated with the more aggressive business strategy Lehman adopted in 2006.

¶As mentioned above, Lehman's business strategy in 2006 and 2007 was premised on using more of its balance sheet to increase its principal investments. In addition to the risks in the proprietary investments themselves, many of the firm's proprietary investments entailed a commitment by Lehman to a much larger amount of debt or equity than Lehman ultimately expected to retain for itself. Although these bridge equity and bridge debt transactions were risky, Lehman's management decided to engage in these transactions because they were profitable in their own right, because they helped Lehman participate in more and larger deals, and because they helped Lehman to develop long‐term client relationships.

167

¶Lehman's officers were entitled under Delaware law to pursue this aggressive high‐risk strategy, and the Examiner does not question their business decision to do so; decisions of this type are at the core of the business judgment rule.

¶Although its management was entitled to pursue a business strategy of increasing its principal investments and engaging in substantial bridge debt and equity transactions, Lehman's own policies required management to consider and analyze the risks of that strategy in a systematic manner. The Examiner has found evidence that raises questions whether Lehman's senior management disregarded Lehman's risk management framework, including its risk appetite limits, its single transaction limits, its stress testing, its balance sheet limits, and the advice of the risk managers. As one former risk manager put it, "whatever risk governance process we had in place was ultimately not effective in protecting the Firm. . . . The function lacked sufficient authority within the Firm. Decision‐making was dominated by the business."⁶⁴⁵⁶⁴⁵ E‐mail from Vincent DiMassimo, Lehman, to Christopher M. O'Meara, Lehman (Sept. 1, 2008) [LBEX‐ DOCID 203219]. Indeed, there is substantial evidence that after Lehman adopted a more aggressive business strategy in 2006, its risk management policies and limits were not a major factor in the firm's investment decisions, even though management continued to tell the Board, the rating agencies, and regulators that Lehman was prudently managing risk through its risk management system.⁶⁴⁶⁶⁴⁶ E.g., SEC, Lehman Monthly Risk Review Meeting Notes (July 19, 2007), at p. 5 [LBEX‐SEC 007363] ("Jeff [Goodman] told us that . . . VaR is just one measure that Lehman uses, and is more of a speed bump/warning sign than a true, hard limit ‐‐ that role falls to RA [(i.e. risk appetite)]. [….] He said that Madelyn [Antoncic], Dave [Goldfarb], and the executive committee tend to look more at RA. As an aside, Madelyn came in after Jeff's explanation and gave virtually the same speech.").Show full note

168

¶The evidence that Lehman disregarded its risk controls is particularly strong with respect to bridge equity and bridge debt. In several important contexts, Lehman excluded bridge equity and bridge debt commitments entirely from its risk metrics. These exclusions were apparently based on management's assumption that it would be able to distribute the equity and debt successfully to other parties. When the subprime crisis erupted into the credit markets generally, this expectation proved to be erroneous.

¶However, the Examiner does not find that the decisions by Lehman's officers were not entitled to the protection of the business judgment rule. Although Lehman's senior officers chose to disregard indications from Lehman's risk management systems that the firm was undertaking excessive risk, the Examiner did not find evidence that Lehman's management entered into financial transactions without informing themselves of the basic facts of the transactions, as would be necessary to strip them of the business judgment rule's protection and prove gross negligence. Lehman's officers were entitled to set and decide to exceed risk limits, which were merely tools to assist them in their investment decisions, not legal restraints on their authority. They made considered business decisions to do so because of profit‐making opportunities.

169

¶Nor does the Examiner find that Lehman's officers exceeded the scope of their authority by pursuing an aggressive countercyclical growth strategy. Lehman's management was entitled to calculate that the subprime crisis offered Lehman the opportunity to become a dominant residential mortgage originator, to expand its already powerful commercial real estate franchise, and to use large leveraged loans as a means towards developing its investment banking business. Although management's disclosures to the Board on the risks of this strategy were not as detailed or as objective as they might have been, the Examiner does not find that management's disclosures were so lacking as to deprive the officers of the protection of the business judgment rule.

¶Even if the business judgment rule did not apply to the officers' pursuit of a countercyclical growth strategy, the Examiner would not find gross negligence sufficient to establish a breach of the duty of care. Gross negligence requires proof that the officer made decisions that were irrational or reckless. Lehman's senior officers decided to make business decisions primarily based on their intuitive understanding of the markets and their evaluation of the risks and rewards of entering into certain transactions. Their decision to use their practical business experience rather than rely on certain quantitative risk limits and other metrics cannot be considered irrational or reckless.

170

¶The decisions by Lehman's management must also be considered in context. In many respects, Lehman's transactions were no different from those conducted by other market participants, and were, in some respects, less aggressive than those of their competitors. For example, several financial institutions suffered catastrophic losses on investments in CDOs and credit default swaps; Lehman prudently limited its exposure in these areas. Lehman's officers would argue that an analysis of their management of Lehman's risks should consider the risks that Lehman prudently avoided along with the risks that Lehman unsuccessfully took.

¶Moreover, a breach of the duty of care claim would rely heavily on the testimony and e‐mail communications of Lehman's risk managers and financial controllers. But risk managers and controllers are by definition more risk‐averse than "risk‐takers" – the business people who actually make the decisions on behalf of the enterprise. Indeed, risk managers and controllers are naturally inclined to see limits and controls as "harder" and less susceptible to judgment than businesspersons. Lehman's officers would have a compelling argument that the risk managers' opposition to various strategies and transactions must be considered in this context.

171

Countercyclical Growth Strategy with Respect to Residential Mortgage Origination

¶The Examiner does not find that Lehman's countercyclical growth strategy with respect to its residential mortgage origination gives rise to a colorable duty of care claim. Lehman's management took significant steps to curtail and control its origination of subprime mortgages, including discontinuing certain mortgage programs, installing improved risk management systems, and replacing management of its subprime originator. Lehman's management also successfully hedged its subprime mortgage risk, at least until early 2008, and avoided some of the catastrophic investments that other financial institutions made in the mortgage market, for example in CDOs.

¶Lehman's management can be second‐guessed, perhaps, for its decision to continue originating Alt‐A mortgages through its Aurora subsidiary even as it was curtailing the origination of subprime mortgages through its BNC subsidiary, and for failing to curtail its subprime mortgage originations more quickly. As described above, however, these business decisions were part of Lehman's strategy to benefit from a consolidation in the mortgage origination industry. In 2007, Lehman curtailed origination of riskier segments of its Alt‐A production after it became evident that these riskier segments were performing as poorly as subprime loans.

¶The business judgment rule shields from judicial review the foregoing decisions by Lehman concerning its Alt‐A and subprime originations. The Examiner does not find that Lehman's management should be deprived of that protection, or that these business decisions were irrational or reckless.

172

Lehman's Concentration of Risk in Its Commercial Real Estate Business

¶As described above, Lehman entered into large commercial real estate transactions during the course of 2007, including transactions that left Lehman with a substantial investment in bridge equity. The most significant of these transactions was Archstone.

¶Lehman entered into these commercial real estate bridge equity transactions at a precarious time in the financial markets. After the onset of the subprime mortgage crisis in December 2006 or January 2007, there was a risk of contagion to the commercial real estate market. Lehman's officers recognized this risk but concluded that it was manageable.⁶⁴⁷⁶⁴⁷ Examiner's Interview of Richard S. Fuld, Jr., Sept. 30, 2009, at pp. 14‐15; Examiner's Interview of Joseph Gregory, Nov. 13, 2009, at pp. 7‐8; Examiner's Interview of Mark A. Walsh, Oct. 21, 2009, at pp. 7‐9. Although in hindsight this conclusion was wrong, the Examiner cannot conclude that at the time it was reckless or irrational.

¶Lehman's officers exercised judgment to pursue commercial real estate opportunities, and to override indicators from the firm's risk systems. Before Lehman entered into the Archstone transaction, Lehman's Real Estate group was already near its risk limits. And the risk in the Archstone commitment and several contemporaneous real estate bridge equity deals was enormous – perhaps as large as or larger than Lehman's entire pre‐existing real estate book put together.⁶⁴⁸⁶⁴⁸ See Mark Weber, Lehman, Chart Showing Risk Appetite Adjustment for Archstone (July 24, 2008) [LBEX‐DOCID 425705], attached to e‐mail from Mark Weber, Lehman, to PortfolioRisk Support, Lehman, et al. (July 24, 2008) [LBEX‐DOCID 265567] (showing that as a result of the inclusion of the Archstone positions into the firm's risk measurements, GREG's risk appetite usage increased from $689 million to $1.233 billion); e‐mail from Madelyn Antoncic, Lehman, to Roger Nagioff, Lehman, et al. (June 29, 2007) [LBEX‐DOCID 1478403]; e‐mail from Jeffrey Goodman, Lehman, to Mark A. Walsh, Lehman, et al. (June 29, 2007) [LBEX‐DOCID 2538925] (same).Show full note Thus, it was obvious that entering into Archstone and these other transactions would put Lehman well over its real estate risk appetite limit. Several witnesses, including Jeffrey Goodman, the risk manager primarily responsible for GREG, said in their interviews that the commercial real estate group was not subject to its risk appetite limits.⁶⁴⁹⁶⁴⁹ Examiner's Interview of Jeffrey Goodman, Aug. 28, 2009; Examiner's Interview of David S. Lazarus, Nov. 18, 2009, at p. 4; Examiner's Interview of Paul A. Hughson, Oct. 28, 2009, at p. 4; Examiner's Interview of Kenneth Cohen, Oct. 20, 2009, at p. 6; Examiner's Interview of Mark Weber, Aug. 11, 2009, at p. 3. Similarly, Mark Walsh, the head of GREG, said he was informed that GREG was allocated excess risk appetite from other business divisions.⁶⁵⁰⁶⁵⁰ Examiner's Interview of Mark Walsh, Oct. 21, 2009, at p. 5.

173

¶The risk appetite limit applicable to an individual business line may be viewed as a type of concentration limit. Concentration limits are important to ensure that a firm does not take too much risk in a single, undiversified business or area. By exceeding the concentration limits applicable to Lehman's real estate business, Lehman's officers took the risk that the firm would over‐concentrate its capital in commercial real estate investments.

174

¶The risk attributable to Archstone and at least one other bridge equity transaction was excluded from Lehman's risk appetite usage calculation for almost three months after the May 2007 commitment date for Archstone.⁶⁵¹⁶⁵¹ Mark Weber, Lehman, Chart Showing Risk Appetite Adjustment for Archstone (July 24, 2008) [LBEX‐ DOCID 425705], attached to e‐mail from Mark Weber, Lehman, to PortfolioRisk Support, Lehman, et al. (July 24, 2008) [LBEX‐DOCID 265567]; accord Examiner's Interview of Jeffrey Goodman, Aug. 28, 2009; e‐ mail from Mark Weber, Lehman, to Laura Vecchio, Lehman, et al. (July 31, 2008) [LBEX‐DOCID 264849]; Lehman, Market Risk Control Committee Meeting Agenda (Nov. 12, 2007), at p. 17 [LBEX‐DOCID 271334], attached to e‐mail from Mark Weber, Lehman, to Paul Shotton, Lehman, et al. (Nov. 12, 2007) [LBEX‐DOCID 265289].Show full note These two transactions were not included in the firm's risk appetite calculation until August 13, 2007.⁶⁵²⁶⁵² Mark Weber, Lehman, Chart Showing Risk Appetite Adjustment for Archstone (July 24, 2008) [LBEX‐ DOCID 425705], attached to e‐mail from Mark Weber, Lehman, to PortfolioRisk Support, Lehman, et al. (July 24, 2008) [LBEX‐DOCID 265567]; see also e‐mail from Mark Weber, Lehman, to Laura Vecchio, Lehman, et al. (July 31, 2008) [LBEX‐DOCID 264849]; Lehman, Market Risk Control Committee Meeting Agenda (Nov. 12, 2007), at p. 17 [LBEX‐DOCID 271334], attached to e‐mail from Mark Weber, Lehman, to Paul Shotton, Lehman, et al. (Nov. 12, 2007) [LBEX‐DOCID 265289].Show full note After the exclusion was acknowledged in August 2007, Lehman retroactively corrected its risk appetite figures to include the previously omitted risks.⁶⁵³⁶⁵³ Mark Weber, Lehman, Chart Showing Risk Appetite Adjustment for Archstone (July 24, 2008) [LBEX‐ DOCID 425705], attached to e‐mail from Mark Weber, Lehman, to PortfolioRisk Support, Lehman, et al. (July 24, 2008) [LBEX‐DOCID 265567]. The retroactive calculation shows that if these transactions had been included in the risk appetite usage, Lehman would have been over its firm‐wide and real estate risk appetite limits almost continuously from the date of the Archstone commitment.

¶Although Lehman's decision to concentrate heavily in real estate bridge equity was unwise in retrospect, and excluding major transactions from Lehman's risk usage calculation was a breach of risk management protocol, the fact remains that Lehman's management seriously considered the risks in the Archstone transaction in a series of Executive Committee and Commitment Committee meetings over a period of weeks, modified the transaction in several important ways to try to manage the risk, and ultimately decided that the rewards from the transaction outweighed the risk. Moreover, Lehman's management plainly was aware of the risk associated with the Archstone transaction during this period. In fact, Lehman's management was focused on trying to distribute the Archstone debt and equity and reduce the firm's risk in advance of the closing of that transaction.

175

¶The Examiner thus concludes that there is no colorable claim of breach of fiduciary duty on the part of Lehman's officers. Lehman management's decision to exceed its limit for this business and invest heavily in commercial real estate is protected by the business judgment rule. That rule does not operate retroactively to judge a business decision based on its ultimate failure, but instead focuses on the reasons for making that decision as of the time and in the context in which it was made. The officers' decision not to follow the guidance of its internal and voluntary risk management system does not give rise to a breach of the duty of care.

Concentrated Investments in Leveraged Loans

¶As described above, Lehman's principal investment strategy also included participating in leveraged loan transactions. This business grew spectacularly in 2006 and the first half of 2007. Many of these loans were made to private equity firms, or sponsors, who were purchasing companies as part of leveraged buy‐outs. These transactions were risky for Lehman because they consumed tremendous amounts of capital, were made on terms that strongly favored the borrowers, and often involved bridge equity or bridge debt that Lehman hoped to distribute to other financial institutions (but was committed to keep for itself if it was unable to do so).

176

¶The evidence is that during the first eight months of Lehman's fiscal 2007, Lehman's leveraged loan business, like its commercial real estate business, was not subject to any limits. Between August 2006 and July 2007, Lehman entered into approximately 30 leveraged loans that exceeded the single transaction limit that had previously been adopted for these transactions, often by significant margins.⁶⁵⁴⁶⁵⁴ Joe Li, Lehman, STL Backtesting Excel Spreadsheet (July 25, 2007) [LBEX‐DOCID 2506462], attached to e‐mail from Joe Li, Lehman, to Fred S. Orlan, Lehman, et al. (July 25, 2007) [LBEX‐DOCID 2563167]. The chart below demonstrates the magnitude of these overages:

177

Leveraged Finance Deals with Single Transaction Loss ("STL") in Excess of Limit¹¹ Table includes all deals from August 2006 to July 2007 that are in excess of $900M and also have a calculated STL of > $250M under the loss calculation methodology in place July 2007 (See "Old Framework" STL column). Highlighted deals have an STL in excess of the applied limit stated in column title. Transactions in excess of the Limits would have required Executive Committee approval (LBEX‐DOCID 2170674).Show full note (July 2007 Analysis, Deals between August 2006 and July 2007) ($ in Millions) Deal Name Original "Old Framework" STL "New Framework" Commitment for deals with STL STL for deals with Date²² "Original commitment" indicates earliest known date on which a deal was committed to by Lehman, as presented in the LPG Weekly Reviews. over $250MM³³ All deal data is from an Excel spreadsheet (LBEX‐DOCID 2506463) attached to a July 25, 2007 Joe Li email (LBEX‐DOCID 2563148) stating: "Previously we have used a loss limit of 250mm to 350mm. We would like to propose a 400mm as the Firm's revenue has increased." In addition to changing the limit, it was proposed that risk factors be adjusted to exclude default risk, leaving only systematic risk as the Single Transaction Loss. This proposed change had the effect of halving the STL (calculated risk of the position), and simultaneously increasing the limit. Items highlighted in the "Old Framework" column are STL numbers calculated under the methodology in place in July 2007 that exceed the $250M loss limit in place at the time. Highlighted items in the "New Framework" column represent STL numbers calculated under the proposed methodology (which halved the STL amount) that exceed the proposed $400M Limit. Please note that a September 2007 presentation on STL (LBEX‐DOCID 194075) stated that the current limit was $250 and proposed that the limit be increased to $300M. A leveraged finance risk presentation to the Executive Committee one month later recommended that the limit be increased to $400M (LBEX‐DOCID 569902).Show full note STL over $400MM3

¶Intelsat ‐ 2,090 1,045 Weatherford 4/30/2007 2,030 1,015

¶

• Houghton Mifflin Riverdeep Group 7/16/2007 1,389 — 694

• TXU Corp 2/26/2007 1,368 — 684

• First Data Corporation 4/2/2007 1,203 — 601

• Alcoa Inc. 5/24/2007 1,200 — 600

• Home Depot Supply 6/19/2007 971 — 486

• CDW Corporation 5/29/2007 909 — 455

• Dollar General 3/1/2007 882 — 441

• Harman International Industries 4/25/2007 692 — 346

• US FoodService ‐ 651 — 326

• CVS 1/16/2007 600 — 300

• BCE 6/29/2007 553 — 277

• BAWAG PSK 3/1/2007 550 — 275

• Tognum AG ‐ 515 — 258

• ProSiebenSat.1 Media AG 1/31/2007 500 — 250

• CBS Corporation ‐ 476 — 238

• West Corp ‐ 465 — 232

• IBM International Group BV ‐ 440 — 220

• Sequa Corp 6/18/2007 431 — 216

• Tesoro 4/10/2007 431 — 215

• Alliance Data 5/31/2007 424 — 212

• Applebee's International, Inc. 7/16/2007 403 — 202

• Allison Transmission 5/21/2007 390 — 195

• Dockwise ‐ 388 — 194

• Univision Communications 7/14/2006 387 — 193

• PHH Corporation 3/15/2007 386 — 193

• Formula One Group ‐ 378 — 189

• United Rentals, Inc. 7/22/2007 372 — 186

• Thermo Electron Corp. 5/7/2006 360 — 180

• National Beef Packing Co. 5/11/2007 335 — 168

• Bulgarian Telecommunications 3/28/2007 327 — 164

• Endemol Holdings 5/11/2007 322 — 161

• Linde Material Handling Group ‐ 293 — 146

• Pinnacle Foods 2/10/2007 277 — 138

• The Klockner Pentaplast Group ‐ 276 — 138

• Guitar Center, Inc. 6/20/2007 263 — 132

¶Note: Highlighted cells indicate transactions with STL in excess of the limit conditions described below:

178

¶Lehman's decision to exceed the single transaction limit proved to be unwise. Just as Lehman was entering into a particularly large volume of commitments, Lehman won a huge volume of deals, and the credit markets froze, causing Lehman to be left with tremendous risk on its books. Before long, Lehman's high yield book showed a risk appetite usage almost double the limit for those exposures – an enormous concentration of risk in a single, illiquid asset class.

¶As a result of this high volume of commitments, some in Lehman's management became concerned, as early as July 2007, that the firm would not be able to fund all of its commitments. As Ian Lowitt, then the CAO, wrote in an e‐mail dated July 20, 2007: "In case we ever forget; this is why one has concentration limits and overall portfolio limits. Markets do seize up."⁶⁵⁵⁶⁵⁵ E‐mail from Ian T. Lowitt, Lehman, to Christopher M. O'Meara, Lehman (July 20, 2007) [LBEX‐DOCID 194066].

¶Although Lehman's decision to enter into huge illiquid transactions during a recognized "credit bubble"⁶⁵⁶⁶⁵⁶ E‐mail from Christopher M. O'Meara, Lehman, to Paulo R. Tonucci, Lehman (Apr. 6, 2007) [LBEX‐ DOCID 1349076]. was unwise, the large leveraged loan transactions were considered and approved by Lehman's Executive Committee, which was entitled to increase or override the single transaction limit, just as it was entitled to increase or override the risk appetite limits. Such decisions are subject to the business judgment rule.

179

Firm‐Wide Risk Appetite Excesses

¶The Examiner also considered whether Lehman's handling of its overall risk limits was a breach of the duty of care. As described above, Lehman's management decided to treat the firm's risk appetite limit as a soft limit rather than as a meaningful constraint on management's assumption of risk.

¶Lehman decided to exceed the firm‐wide risk appetite limit at several junctures. First, though Lehman dramatically increased the limit for fiscal 2007, Lehman nevertheless approached the new limit by May 2007. Lehman entered into Archstone and several other bridge equity transactions notwithstanding the obvious fact that those transactions would immediately put Lehman over its firm‐wide risk appetite limits.⁶⁵⁷⁶⁵⁷ Examiner's Interview of Jeffrey Goodman, Aug. 28, 2009.

¶Several months later, with Lehman's firm‐wide risk usage actually in excess of the limit, Lehman decided to increase the limit again, even as one of its senior risk managers admitted to the SEC that Lehman did not in fact have increased risk‐taking capacity.⁶⁵⁸⁶⁵⁸ SEC, Notes from Lehman's Monthly Risk Review meeting (Oct. 11, 2007), at p. 6 [LBEX‐SEC 007438].

¶Then, in early October 2007, when Lehman's risk appetite excesses were at their peak, at least some members of Lehman's senior management discussed the limit breaches and decided to grant a temporary reprieve from the limits based on the difficult conditions in the real estate and leveraged loan markets. For the most part, Lehman did not pursue aggressive risk reduction strategies until sometime in 2008, particularly with respect to commercial real estate.

180

¶Rather than reduce its risk usage, Lehman cured its risk appetite overages by increasing the firm‐wide risk appetite limit yet again.⁶⁵⁹⁶⁵⁹ Examiner's Interview of Christopher M. O'Meara, Aug. 14, 2009, at p. 10; Lehman's Material for Market Risk Control Committee Meeting (Jan. 14, 2008), at p. 33 [LBEX‐DOCID 271352], attached to e‐ mail from Mark Weber, Lehman, to Paul Shotton, Lehman, et al. (Jan. 14, 2008) [LBEX‐DOCID 223263]; Estimated Third Quarter 2007 Financial Information Presentation to Lehman Board of Directors (Sept. 11, 2007), at p. 6 [LBHI_SEC07940_026288].Show full note There is evidence which raises the question whether Lehman's risk‐taking capacity had in fact increased. The increased limit amount was calculated by substantially changing the assumptions previously used in calculating the risk appetite limit, and by using a very aggressive 2008 budgeted revenue figure. If Lehman had used the same assumptions as it had previously used for calculating the risk appetite limit, and a more realistic revenue figure, it would likely have concluded that it was necessary to reduce its risk appetite limit to take account of its diminished profitability relative to its equity base. Such a conclusion might have impelled management more urgently to sell assets, reduce the firm's risk profile, and reduce the firm's leverage.

¶Although Lehman's risk appetite limits ultimately provided little or no limiting function at all, the Examiner does not find that the decision to exceed or disregard these limits gives rise to a colorable claim of breach of fiduciary duty. These internal limits were intended only for the guidance of Lehman's own management; they did not put any legal constraints on the scope of management's authority. And because business in general and investment banking in particular is an inherently risky enterprise, Lehman's management was entitled to pursue a countercyclical growth strategy based on its evaluation of the markets and of Lehman's business, even if that strategy necessarily posed a risk to the firm. Moreover, Lehman's risk appetite limit overages were reported to the SEC. The Examiner does not find that management's decision to increase and then exceed Lehman's risk appetite levels gives rise to a colorable claim for breach of fiduciary duties.

181

Firm‐Wide Balance Sheet Limits

¶Lehman also failed to apply its balance sheet limits in late 2007. Application of these limits would also have restricted Lehman's risk‐taking. Instead, Lehman dramatically increased the size of its balance sheet, and used increasingly large volumes of Repo 105 transactions to create the appearance that the firm's net leverage ratio remained within a reasonable range of such ratios established by the rating agencies.⁶⁶⁰⁶⁶⁰ For further detail regarding the Repo 105 transactions, see Section III.A.4 of this Report.

Stress Testing

¶As described above, Lehman's stress tests suffered from a significant flaw. Although Lehman made a strategic decision in 2006 to take more principal risk, Lehman did not modify its stress tests to include the risks arising from many of its principal investments – including its real estate investments other than commercial mortgagebacked securities ("CMBS"), its private equity investments, and, during a crucial period, its leveraged loan commitments.⁶⁶¹⁶⁶¹ E‐mail from Melda Elagoz, Lehman, to Stephen Lax, Lehman, et al. (June 21, 2007) [LBEX‐DOCID 2546617]; Examiner's Interview of Paul Shotton, Oct. 16, 2009, at pp. 4‐5. Thus, Lehman's management pursued its countercyclical growth strategy, including an increasing concentration of risk in illiquid assets, without availing itself of a common risk management technique for evaluating the potential risk to the firm from that strategy.

182

¶But stress tests, like risk limits, are an instrument available for use of management as it deems appropriate; Lehman's management was not legally required to make business decisions based on the results of stress testing.⁶⁶²⁶⁶² Lehman was required to conduct certain stress testing as part of its participation in the CSE program. See 17 C.F.R. 240.15c3‐1 (2007). Moreover, the SEC was aware that Lehman's stress tests excluded untraded investments and did not question the exclusion, because historically it had been the norm to limit stress tests only to traded positions.⁶⁶³⁶⁶³ Examiner's Interview of Matthew Eichner, Nov. 23, 2009, at p. 12; Examiner's Interview of Paul Shotton, Oct. 16, 2009, at pp. 4‐5; Examiner's Interview of Jeffrey Goodman, Aug. 28, 2009. Based on these facts, the Examiner does not find that Lehman management's use of the stress tests gives rise to a colorable claim for a breach of the duty of care.

Summary: Officers' Duty of Care

¶The Examiner reviewed extensive evidence concerning Lehman's senior officers' decision to disregard the guidance provided by Lehman's risk management system as they implemented the firm's aggressive business strategy in 2006 and 2007. That evidence goes to the heart of Lehman's ultimate financial failure because the illiquid investments acquired during that period could not be sold off sufficiently quickly, and Lehman's liquidity and confidence suffered as a result. When the run on Lehman began in September 2008, Lehman lacked the liquidity to survive. Thus, Lehman's collapse can be traced in part to Lehman management's adoption of a countercyclical growth strategy in 2006 and 2007. Although management turned out to be wrong in their business judgments, the evidence does not establish that management's actions and decisions were so reckless and irrational as to give rise to a colorable claim of breach of fiduciary duty.

183

[B]usiness failure is an ever‐present risk. The business judgment rule exists precisely to ensure that directors and managers acting in good faith may pursue risky strategies that seem to promise great profit. If the mere fact that a strategy turned out poorly is in itself sufficient to create an inference that the directors who approved it breached their fiduciary duties, the business judgment rule will have been denuded of much of its utility.⁶⁶⁴⁶⁶⁴ Trenwick Am. Litig. Trust v. Ernst & Young, L.L.P., 906 A.2d 168, 193 (Del. Ch. 2006), aff'd sub nom. Trenwick Am. Litig. Trust v. Billett, 931 A.2d 438 (Del. 2007).

The Examiner Does Not Find Colorable Claims That Lehman's Senior Officers Breached Their Fiduciary Duty to Inform the Board of Directors Concerning the Level of Risk Lehman Had Assumed

¶The Examiner also does not find a colorable claim that, during the period from May 2007 through January 2008, Lehman's senior officers breached their duty of candor with respect to their disclosures to the Board of Directors concerning Lehman's risk management system. Lehman's management gave the Board regular reports concerning the state of the firm's business, including reports containing quantitative risk, balance sheet, revenue, and other metrics. Lehman's management also discussed market conditions and their potential impact on the firm with the Board. The Examiner did not find evidence that managers knowingly made false statements to the Board.

184

¶In light of the Board's limited role in supervising the risk management of the enterprise, and the absence of authority mandating greater disclosure to the Board, the Examiner does not believe that the officers had a legal duty to provide the Board with additional negative information. The Examiner does not find that the evidence gives rise to a colorable claim for a breach of the duty of candor.

¶Lehman's management repeatedly disclosed to the Board that Lehman intended to grow its business dramatically, increase its risk profile, and embrace risk even in declining markets. The Board undoubtedly understood and approved of Lehman's growth strategy.

¶During 2007, there were a number of instances in which management did not provide information to the Board. For example, management did not disclose its decision to exceed or disregard the various concentration limits applicable to the leveraged loan business and to the commercial real estate businesses, including especially the single transaction limit, contrary to representations to the Board that management took steps to "avoid [] over‐concentration in any one area."⁶⁶⁵⁶⁶⁵ David Goldfarb, et al, Managing the Firm Presentation to Lehman Board of Directors (May 15, 2007), at p. 20 [LBHI_SEC07940_026136]

185

¶In hindsight, various Board members stated that it would have been helpful to have had more information. For example, some directors said that if the risk limit breaches were sufficiently large and long‐lasting;⁶⁶⁶⁶⁶⁶ Examiner's Interview of Roger Berlind, May 8, 2009, at p. 4; Examiner's Interview of Marsha Johnson Evans, May 22, 2009, at p. 6; Examiner's Interview of Roland A. Hernandez, Oct. 2, 2009, at p. 10; Examiner's Interview of John D. Macomber, Sept. 25, 2009, at p. 17. Examiner's Interview of Dr. Henry Kaufman, May 19, 2009, at p. 17. if management's liquidity concerns were more than a "single incursion";⁶⁶⁷⁶⁶⁷ Examiner's Interview of Dr. Henry Kaufman, Dec. 22, 2009. or if the exclusions from the stress testing were sufficiently significant;⁶⁶⁸⁶⁶⁸ Examiner's Interview of John D. Macomber, Sept. 25, 2009, at pp. 6, 17. they would have wanted to know about these facts.⁶⁶⁹⁶⁶⁹ See III.A.1.b of this Report.

¶On the other hand, the Board did not explicitly direct management to provide it with this information, and there is no evidence that the Board asked questions that management did not answer, or answered inaccurately. Moreover, as discussed above, management was not required by any regulatory authority or by Delaware common law to provide such detailed information to the Board of Directors.

¶Although Lehman's management did not provide the Board with all available information concerning the risks faced by the firm during 2007 and early 2008, that fact is not surprising given the Board's limited role in overseeing the firm's risk management, and the extraordinarily detailed information available to management. After reviewing this evidence, the Examiner finds insufficient evidence to support a colorable claim that Lehman's management was either grossly negligent or intentionally deceptive in providing information to the Board concerning risk management.

186

¶First, the Examiner has found no colorable claim that Lehman's senior managers violated their fiduciary duty of care through their handling of risk issues. Management's disclosure of the risk appetite excesses to the SEC supports the view that management did not believe it was acting imprudently, much less violating the law, by taking on a higher level of risk than was consistent with the firm's pre‐existing risk policies and limits. Under these circumstances it would take very substantial evidence of management's intent to mislead the Board in order to lay a sufficient foundation for a claim that Lehman's senior officers breached their duty of candor.

¶Establishing a violation of the duty of candor with respect to risk management is particularly difficult. As the Delaware Chancery Court recently explained in connection with directors' monitoring of risk decisions by management: "It is almost impossible for a court, in hindsight, to determine whether the directors of a company properly evaluated risk and thus made the 'right' business decision. . . . Business decision‐makers must operate in the real world, with imperfect information, limited resources, and an uncertain future."⁶⁷⁰⁶⁷⁰ In re Citigroup Inc. S'holder Derivative Litig., 964 A.2d 106, 126 (Del. Ch. 2009).

187

¶Management's duty of candor concerning risk management adds another level of complexity beyond the issues raised by the duty of care. Risk limits, policies, and metrics were designed for use by management, not the board. Absent express direction from the board as to what information concerning risk management it should be given (and there was no such direction here), management must make the determination of what level of detail the board needs to fulfill its obligation to monitor risk decisions.

¶Applying the standard of proof requiring at least gross negligence and perhaps intentional deception to establish a breach of the duty of candor means that senior managers may make a good‐faith mistake by not providing material information to the board without violating their fiduciary duties. Although it can be fairly debated whether Lehman's management should have provided its Board with more information and more timely information concerning the firm's risk usage, stress test results, and liquidity, the Examiner does not find that any mistake by management in this regard constituted gross negligence or intentional deception.

188

The Examiner Does Not Find Colorable Claims That Lehman's Directors Breached Their Fiduciary Duty by Failing to Monitor Lehman's Risk‐Taking Activities

Lehman's Directors are Protected From Duty of Care Liability by the Exculpatory Clause and the Business Judgment Rule

¶Corporate directors' duty of care is a duty of informed decision making.⁶⁷¹⁶⁷¹ Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985), overruled on other grounds, Gantler v. Stephens, 965 A.2d 695, 713 n.54 (Del. 2009). It involves the process by which directors make business decisions, not the content of those decisions.⁶⁷²⁶⁷² In re Caremark Int'l. Inc. Derivative Litig., 698 A.2d 959, 967 (Del. Ch. 1996). However, directors are generally afforded additional protection by the business‐judgment rule, a judicial presumption that a court should "not substitute its judgment for that of the board if the latter's decision can be 'attributed to any rational business purpose.'"⁶⁷³⁶⁷³ Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 954 (Del. 1985) (quoting Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971)). For a more detailed discussion of Delaware law governing corporate directors' fiduciary duties, see Appendix 1, Legal Issues.

¶Lehman, like many Delaware corporations, immunized its directors from claims of breaching the duty of care. Lehman's certificate of incorporation provides:

A director shall not be personally liable to the Corporation or its stockholders for monetary damages for breach of fiduciary duty as a director; provided that this sentence shall not eliminate or limit the liability of a director (i) for any breach of his duty of loyalty to the Corporation or its stockholders, (ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law, (iii) under Section 174 of [the Delaware General Corporation Law], or (iv) for any transaction from which the director derives an improper personal benefit.⁶⁷⁴⁶⁷⁴ Lehman Brothers Holdings Inc., Certificate of Incorporation, at § 10.1, Limitation of Liability of Directors.

189

¶The wording of this clause is nearly identical to that in Section 102(b)(7) of the Delaware General Corporate Law, which authorizes a corporation to exculpate its directors from personal liability for breaches of fiduciary duties, except in the four exceptions stated in the statute: conduct violating the directors' duty of loyalty; acts or omissions not in good faith; intentional misconduct; and knowing violations of law.⁶⁷⁵⁶⁷⁵ See DEL. CODE ANN. tit. 8, § 102(b)(7) (2009). Courts uphold such a clause to protect directors from liability provided that the conduct in question does not violate their duty of loyalty.⁶⁷⁶⁶⁷⁶ See Stone ex rel. AmSouth Bancorporation v. Ritter, 911 A.2d 362, 367 (Del. 2006) ("Such a provision can exculpate directors from monetary liability for a breach of the duty of care, but not for conduct that is not in good faith or a breach of the duty of loyalty."). In addition, Delaware protects directors from personal liability to the extent their decisions are based on information provided to them by management.⁶⁷⁷⁶⁷⁷ See DEL. CODE ANN. tit. 8, § 141(e) (2009); see also Brehm v. Eisner, 746 A.2d 244, 261 (Del. 2000); In re Citigroup Inc. S'holder Derivative Litig., 964 A.2d 106, 132 & n.86 (Del. Ch. 2009).

¶Therefore, Delaware has chosen to impose personal liability only on those directors who have handled their responsibility in a reckless or irrational manner:

Directors' decisions must be reasonable, not perfect. "In the transactional context, [an] extreme set of facts [is] required to sustain a disloyalty claim premised on the notion that disinterested directors were intentionally disregarding their duties." . . . Only if they knowingly and completely failed to undertake their responsibilities would they breach their duty of loyalty.⁶⁷⁸⁶⁷⁸ Lyondell Chem. Co. v. Ryan, 970 A.2d 235, 243‐44 (Del. 2009) (quoting In re Lear Corp. S'holder Litig., 967 A.2d 640, 654‐55 (Del. Ch. 2008)).

190

Lehman's Directors Did Not Violate Their Duty of Loyalty

¶A director's duty of loyalty "[e]ssentially . . . mandates that the best interest of the corporation and its shareholders take precedence over any interest possessed by a director, officer or controlling shareholder and not shared by the stockholders generally."⁶⁷⁹⁶⁷⁹ Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 361 (Del. 1993), modified on other grounds, 636 A.2d 956 (Del. 1994). The duty of loyalty chiefly involves situations in which directors utilize their positions to confer special benefits onto themselves or majority stockholders.⁶⁸⁰⁶⁸⁰ Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984), overruled on other grounds, Brehm v. Eisner, 746 A.2d 244, 254 (Del. 2000). These situations are frequently referred to as "self‐dealing" or "interested" situations.⁶⁸¹⁶⁸¹ See id. "A director is considered interested when he will receive a personal financial benefit from a transaction that is not equally shared by the stockholders."⁶⁸²⁶⁸² Globis Partners, L.P. v. Plumtree Software, Inc., No. 1577‐VCP, 2007 WL 4292024, at *5 (Del. Ch. Nov. 30, 2007). Directors are also considered interested where their motivations in executing a business decision appear to be subservient to the interests of a majority stockholder.⁶⁸³⁶⁸³ See, e.g., Emerald Partners v. Berlin, 787 A.2d 85 (Del. 2001); Tooley v. AXA Fin., Inc., No. 18414, 2005 WL 1252378, at * 5 (Del. Ch. May 13, 2005).

¶The Examiner has found no evidence of self‐dealing by Lehman's directors, and Lehman did not have a majority stockholding interest.

191

Lehman's Directors Did Not Violate Their Duty to Monitor

¶Under Delaware law, directors have a fiduciary duty to monitor management's compliance with corporate reporting and control systems. The Delaware Supreme Court has adopted the Caremark standard "for assessing director oversight liability."⁶⁸⁴⁶⁸⁴ Stone, 911 A.2d at 364‐65. Under Caremark, the fiduciary duty to monitor management is breached if "(a) the directors utterly failed to implement any reporting or information system or controls; or (b) having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention."⁶⁸⁵⁶⁸⁵ In re Citigroup Inc. S'holder Derivative Litig., 964 A.2d 106, 123 (Del. Ch. 2009) (quoting Stone, 911 A.2d at 370). The Delaware Supreme Court stressed, however, that a director can be held liable only for a "conscious" failure to fulfill the oversight function:

[I]mposition of liability requires a showing that the directors knew that they were not discharging their fiduciary obligations. Where directors fail to act in the face of a known duty to act, thereby demonstrating a conscious disregard for their responsibilities, they breach their duty of loyalty by failing to discharge that fiduciary obligation in good faith.⁶⁸⁶⁶⁸⁶ Stone, 911 A.2d at 370 (internal citations omitted).

Application of Caremark to Risk Oversight: In re Citigroup Inc

¶In the Citigroup case, the Delaware Chancery Court rejected a claim that Citigroup's current and former directors and officers had "breached their fiduciary duties by failing to properly monitor and manage the risks the Company faced from problems in the subprime lending market and for failing to properly disclose Citigroup's exposure to subprime assets."⁶⁸⁷⁶⁸⁷ Citigroup, 964 A.2d at 111. The complaint alleged various theories of liability including a breach of the duty to monitor under Caremark. Plaintiffs based their claim on several "red flags" that allegedly "should have given defendants notice of the problems that were brewing in the real estate and credit markets."⁶⁸⁸⁶⁸⁸ Id. Noting that the supposed red flags "amount[ed] to little more than portions of public documents that reflected the worsening conditions in the subprime mortgage market and in the economy generally," the Court found the allegations legally insufficient "to show that the directors were or should have been aware of any wrongdoing at the Company or were consciously disregarding a duty somehow to prevent Citigroup from suffering losses."⁶⁸⁹⁶⁸⁹ Id. at p. 128.

192

¶The Court also held that a Caremark claim involving risk management must be consistent with the business judgment rule:

It is almost impossible for a court, in hindsight, to determine whether the directors of a company properly evaluated risk and thus made the "right" business decision.

¶...

To impose liability on directors for making a 'wrong' business decision would cripple their ability to earn returns for investors by taking business risks.⁶⁹⁰⁶⁹⁰ Id. at p. 126.

193

¶The Court held that plaintiffs had failed to tie the Caremark claim to a failure of the corporate risk management system:

[P]laintiffs' allegations do not even specify how the board's oversight mechanisms were inadequate or how the director defendants knew of these inadequacies and consciously ignored them. Rather, plaintiffs seem to hope the Court will accept the conclusion that since the Company suffered large losses, and since a properly functioning risk management system would have avoided such losses, the directors must have breached their fiduciary duties in allowing such losses.⁶⁹¹⁶⁹¹ Id. at 128.

¶The Court emphasized that "red flags" sufficient to state a Caremark claim must go beyond "signs in the market that reflected worsening conditions and suggested that conditions may deteriorate even further. . . ."⁶⁹²⁶⁹² Id. at 130. The Court was protective of directors facing personal liability because the risk assumed by their corporation resulted in losses:

Oversight duties under Delaware law are not designed to subject directors, even expert directors, to personal liability for failure to predict the future and to properly evaluate business risk.⁶⁹³⁶⁹³ Citigroup, 964 A.2d at 131.

Application of Caremark and Citigroup to Lehman's Directors

¶The Examiner does not find that Lehman's directors breached their Caremark duty to monitor management's compliance with the law.

¶First, the Examiner does not find that "the directors utterly failed to implement any reporting or information system or controls."⁶⁹⁴⁶⁹⁴ Id. at p. 123. As explained above, the Board received regular information at every Board meeting concerning the firm's risk, liquidity, and balance sheet situation. The Board also created a Finance and Risk Committee to receive considerably more detailed information about these topics. Moreover, the Board received regular reports about the firm's risk management systems and controls. The directors plainly implemented a sufficient reporting system and controls.

194

¶Second, the Examiner does not find that the directors "consciously failed to monitor or oversee its operations thus disabling themselves from being informed of risks or problems requiring their attention."⁶⁹⁵⁶⁹⁵ Id. As explained above, the Examiner has not found colorable claims that Lehman's senior officers breached their fiduciary duties through the manner in which they managed risk. To the contrary, management's conduct is protected from liability by the business judgment rule. There is also insufficient evidence that Lehman's management violated any legal requirements or obligations relating to risk management. The risk limits, policies, metrics, and stress tests that Lehman developed were intended to be used internally and did not constitute legal obligations. Because Lehman management's handling of risk did not violate the law, the directors cannot be liable for a breach of their duty to monitor management to prevent such violations.

195

¶Moreover, there is no evidence, as Delaware law requires, that Lehman's directors "consciously disregarded" violations by Lehman's senior officers of their fiduciary or other legal duties through their decisions concerning the amount of risk that Lehman assumed and their management of that risk. The directors were not presented with "red flags" of such misconduct. And in monitoring risk issues, the Board justifiably relied entirely on information provided by management. Under Delaware law, the directors are thereby immunized from personal liability.⁶⁹⁶⁶⁹⁶ See DEL. CODE ANN. tit. 8, § 141(e) (2009).

727

¶

• TABLE OF CONTENTS 4. Repo 105 — 732

• a) Repo 105 – Executive Summary — 732

• b) Introduction — 750

• c) Why the Examiner Investigated Lehman's Use of Repo 105 Transactions — 764

• d) A Typical Repo 105 Transaction — 765

• (1) The Genesis of Lehman's Repo 105 Program in 2001 — 765

• (2) Repo 105 Transactions Versus Ordinary Repo Transactions — 766

• (a) Lehman's Accounting Treatment of Repo 105 Transactions Versus Ordinary Repo Transactions — 768

• (b) Lehman's Accounting Policy for Repo 105 Transactions — 775

• (c) The Accounting Purpose of the Larger Haircut — 777

• (d) Lehman Did Not Record a Cash Borrowing but Recorded a Derivative Asset in a Repo 105 Transaction — 781

• (3) Anatomy of Repo 105 Transactions and the Linklaters True Sale Opinion Letter — 782

• (4) Types of Securities Used in Repo 105 Transactions — 793

• (5) Product Controllers Manually Booked Repo 105 Transactions — 797

• e) Managing Balance Sheet and Leverage — 800

• (1) Lehman Management's Focus in Late 2007 on Reducing the Firm's Reported Leverage — 802

• (a) Lehman's Calculation of Net Leverage — 804

• (2) By January 2008, Lehman Decided to Cut its Net Leverage in Half to Win Back the Confidence of the Market, Lenders and Investors — 805

• (a) Bart McDade, as Newly Appointed Balance Sheet Czar, Advised the Executive Committee in March 2008 to Cap Lehman's Use of Repo 105 Transactions — 809

• (b) McDade Became President and COO on June 12, 2008 and Authorized the Reduction of Repo 105 Usage — 819

• (3) The Market's Increased Scrutiny of the Leverage of Investment Banks — 822

• (a) The Cost of Deleveraging — 825

728

¶

• (4) "Sticky" Inventory and FID's Balance Sheet Breaches Hampered Lehman's Ability to Manage Its Net Leverage — 828

• (5) Deleveraging Resulted in Intense Pressure at Quarter‐End to Meet Balance Sheet Targets for Reporting Purposes — 843

• (6) Lehman's Earnings Calls and Press Release Statements Regarding Leverage — 845

• (a) Analysts' Statements Regarding Lehman's Leverage — 850

• f) The Purpose of Lehman's Repo 105 Program Was to Reverse Engineer Publicly Reported Financial Results — 853

• (1) Lehman Did Not Disclose Its Accounting Treatment For or Use of Repo 105 Transactions in Its Forms 10‐K and 10‐Q — 853

• (a) Lehman's Outside Disclosure Counsel Was Unaware of Lehman's Repo 105 Program — 855

• (2) Lehman's Repo 105 Practice Improved the Firm's Public Balance Sheet Profile at Quarter‐End — 856

• (a) Contemporaneous Documents Confirm That Lehman Undertook Repo 105 Transactions to Reduce Its Balance Sheet and Reverse Engineer Its Leverage — 859

• (b) Witness Statements to the Examiner Regarding the True Purpose of Lehman's Repo 105 Practice — 867

• (3) Quarter‐End Spikes in Lehman's Repo 105 Usage Also Suggest the True Purpose of Lehman's Repo 105 Practice Was Balance Sheet Manipulation — 870

• (4) Repo 105 Transactions Served No Business Purpose Other Than Balance Sheet Reduction — 877

• (a) Repo 105 Transactions Came at a Higher Cost Than Ordinary Repo Transactions — 877

• (b) Witnesses Also Stated That Financing Was Not the Real Motive for Undertaking Repo 105 Transactions — 882

• g) The Materiality of Lehman's Repo 105 Practice — 884

• (1) The Repo 105 Program Exposed Lehman to Potential "Reputational Risk" — 884

• (2) Lehman's Repo 105 Practice Had a Material Impact on Lehman's Net Leverage Ratio — 888

• (a) Lehman Significantly Expanded Its Repo 105 Practice in Late 2007 and Early 2008 — 890

729

¶

• (3) Balance Sheet Targets for FID Businesses Were Unsustainable Without the Use of Repo 105 Transactions — 899

• (4) Rating Agencies Advised the Examiner that Lehman's Accounting Treatment and Use of Repo 105 Transactions to Manage Its Net Leverage Ratio Would Have Been Relevant Information — 902

• (5) Government Regulators Had No Knowledge of Lehman's Repo 105 Program — 910

• (a) Officials from the Federal Reserve Bank Would Have Wanted to Know about Lehman's Use of Repo 105 Transactions — 910

• (b) Securities and Exchange Commission CSE Monitors Were Unaware of Lehman's Repo 105 Program — 913

• h) Knowledge of Lehman's Repo 105 Program at the Highest Levels of the Firm — 914

• (1) Richard Fuld, Former Chief Executive Officer — 917

• (2) Lehman's Former Chief Financial Officers — 921

• (a) Chris O'Meara, Former Chief Financial Officer — 921

• (b) Erin Callan, Former Chief Financial Officer — 930

• (c) Ian Lowitt, Former Chief Financial Officer — 937

• (3) Lehman's Board of Directors — 945

• i) Ernst & Young's Knowledge of Lehman's Repo 105 Program — 948

• (1) Ernst & Young's Comfort with Lehman's Repo 105 Accounting Policy — 948

• (2) The "Netting Grid" — 951

• (a) Quarterly Review and Audit — 953

• (3) Ernst & Young Would Not Opine on the Materiality of Lehman's Repo 105 Usage — 954

• (4) Matthew Lee's Statements Regarding Repo 105 to Ernst & Young — 956

• (5) Accounting‐Motivated Transactions — 962

• j) The Examiner's Conclusions — 962

• (1) Materiality — 963

• (a) Whether Lehman's Repo 105 Transactions Technically Complied with SFAS 140 Does Not Impact Whether a Colorable Claim Exists — 964

730

¶

• (2) Disclosure Requirements and Analysis — 967

• (a) Disclosure Obligations: Regulation S‐K and the MD&A — 968

• (b) Duty to Disclose — 972

• (c) Lehman's Public Filings — 973

• (i) Summary of Lehman's 2000 through 2007 Public Filings — 974

• (ii) Lehman's 2007 Form 10‐K, First Quarter 2008 Form 10‐Q, and Second Quarter 2008 Form 10‐Q — 977

• a. Treatment of Repo Transactions and SFAS 140 — 978

• b. Net Leverage — 980

• c. Derivatives — 981

• d. A Reader of Lehman's Forms 10‐K and 10‐Q Would Not Have Been Able to Ascertain That Lehman Engaged in Temporary Sales Using Liquid Securities — 984

• (d) Conclusions Regarding Lehman's Failure to Disclose — 985

• (3) Colorable Claims — 990

• (4) Fiduciary Duty Claims — 991

• (a) Breach of Fiduciary Duty Claims Against Board of Directors — 991

• (b) Breach of Fiduciary Duty Claims Against Specific Lehman Officers — 992

• (i) Richard Fuld — 996

• a. There Is Sufficient Evidence to Support a Finding By the Trier of Fact That Fuld Was at Least Grossly Negligent in Causing Lehman to File Misleading Periodic Reports — 997

• (ii) Chris O'Meara — 1002

• a. There Is Sufficient Evidence To Support a Colorable Claim That O'Meara Was at Least Grossly Negligent in Allowing Lehman to File Misleading Financial Statements and Engage in Material Volumes of Repo 105 Transactions — 1007

¶b. There Is Sufficient Evidence To Support a Colorable Claim That O'Meara Breached His Fiduciary Duties by Failing to Inform the

731

¶

• Board and His Superiors of Lehman's Repo 105 Practice — 1009

• (iii) Erin Callan — 1013

• a. There Is Sufficient Evidence To Support a Finding By the Trier of Fact That Callan Breached Her Fiduciary Duties by Causing Lehman to Make Materially Misleading Statements — 1017

• b. There Is Sufficient Evidence to Support a Colorable Claim That Callan Breached Her Fiduciary Duty of Care by Failing to Inform the Board of Directors of Lehman's Repo 105 Program — 1019

• (iv) Ian Lowitt — 1021

• (c) Remedies — 1024

• (5) Malpractice Claims Against Ernst & Young — 1027

• (a) Background and Legal Standards — 1028

• (i) Professional Standards — 1028

• (ii) Common Law Standards — 1031

• (b) There Is Sufficient Evidence to Support a Colorable Claim That Ernst & Young Was Negligent — 1032

• (i) Malpractice in Failure to Advise Audit Committee of Repo 105 Activity and Lee's Allegations — 1033

• (ii) Lehman's 2008 Forms 10‐Q — 1040

• (iii) Lehman's 2007 Form 10‐K — 1048

• (iv) Effect on Prior Filings — 1050

• (v) Causation and Damages — 1051

• (c) Possible Defenses — 1053

732