Business and Risk Management

Business and Risk Management

a) 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.114

¶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.115 Lehman continued to pursue commercial real estate and leveraged loan transactions aggressively until July 2007.116

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¶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.117 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.118

¶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.119 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.120 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.121

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¶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.

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¶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.122 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.123 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.124

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¶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")125 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.126 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.'"127

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¶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.128 Profitability depends largely on the firm's ability to evaluate the risks of potential investments and balance them against their potential gains.129 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 2007.130

¶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.131 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.132 Lehman had an extensive staff that was devoted solely to risk management.133

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¶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.134 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.135 In addition, Lehman used its risk management system to promote its capabilities to investors, rating agencies, and regulators.136 Lehman's management always retained the discretion to use its judgment to decide whether to pursue particular strategies or transactions.137

¶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

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¶Lehman's risk management system as part of its process of making investment decisions:

● 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.138

● 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.139

● 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.)140

● Lehman's management decided to treat primary firm‐wide risk limit – the risk appetite limit – as a "soft" guideline, notwithstanding Lehman's

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representations to the Securities Exchange Commission ("SEC") and the Board that the risk appetite limit was a meaningful constraint on Lehman's risk‐taking.141 Lehman management's decision not to enforce the risk appetite limit was apparent in several ways:

○ Between December 2006 and December 2007, Lehman raised its firm‐ wide risk appetite limit three times, going from $2.3 to $4.0 billion.142

○ 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.143

○ 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.144

¶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.145

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¶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.146

¶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.147

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¶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.148 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.149

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¶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.150 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."152

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¶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.153

¶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.154

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¶Delaware law permits directors to rely on management's reports and immunizes the directors from personal liability when they do so.155 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.

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¶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 Assets156 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 2008.157

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¶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.

¶b) 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

¶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.

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¶Gregory (Lehman's President and Chief Operating Officer), and Hugh E. (Skip) McGee III (Global Head of Investment Banking) – after significant internal debate.

¶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.158 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.159 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.160

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¶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.161 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.162 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.163 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.164

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¶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.165 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.166 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.167

¶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."168 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.169 That year, Fuld and Gelband (then head of FID) also gave presentations in which they discussed Lehman's aggressive growth strategy.170

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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.171

¶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.

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¶When a financial institution suffers losses, it often needs to raise cash to fund itself.172 But illiquid investments are difficult to use for that purpose because they cannot be sold quickly.173 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.174 Similarly, illiquid assets are more difficult to use as collateral for borrowing.175 They often cannot be used in the repo market, which was a crucial source of funding for investment banks such as Lehman.176 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.177

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¶Financial institutions generally engage in transactions designed to hedge their risks.178 But illiquid investments are typically more difficult to hedge.179 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.180 As a result, Lehman acquired a large volume of unhedged assets that ultimately caused Lehman significant losses.181

¶In a difficult financial environment, it also is important for financial institutions to be able to reduce their leverage and risk profile.182 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.183

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¶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.184

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

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¶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.185

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.186 Lehman did not revise its stress testing to address its evolving business strategy.

¶Lehman was required by the SEC187 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.188 Lehman ran a series of stress tests based on 13 or 14 different scenarios.189 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.190 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."191 Stress testing was designed to measure "tail risk" – a one in ten year type event.

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¶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.192 Because these assets did not trade freely, they were not considered susceptible to stress testing over a short‐term scenario.193 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.194 The SEC was aware of this exclusion.195

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¶At various points in 2006 and 2007, Lehman's risk managers considered whether to include principal investments in Lehman's stress testing.196 An internal audit advised that Lehman "address the main risks in the Firm's portfolio," including "illiquidity" and "concentration risk."197 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.198

¶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.199 This exclusion appears to have been inadvertent.200

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¶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.201

¶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.202 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.203

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¶But these stress tests were conducted long after these assets had been acquired, and they were never shared with Lehman's senior management.204 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."205 Risk appetite was a measure that aggregated the market risk, credit risk, and event risk faced by Lehman.206 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.207 These risk appetite usage figures were calculated every day.208

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¶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.209 Management presented the firm‐wide limit to the Board.210

¶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.211 Lehman's higher‐level limits were "harder" and required greater authorization if they were exceeded.212 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.213 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,214 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.215 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.216

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¶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.217

¶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.218 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.219

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¶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.220 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.221

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¶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."222

¶In late 2006, Lehman's management decided not to enforce the single transaction limit because it had cost Lehman significant opportunities.223 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.224 Lehman's management decided that in the future, it would participate in such deals without regard to the single transaction limit.225 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.226

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¶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.227 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.228 Although Antoncic thought the firm should abide by the single transaction limit,229 Kirk and Antoncic were overruled by Fuld, Gregory, and McGee.230

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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.231 All of the directors told the Examiner that they agreed with Lehman's growth strategy at the time it was undertaken.232.

¶Although the periodic materials that the Finance and Risk Committee233 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,"234 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.235

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¶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.236 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.237 Some directors were not concerned about the exclusion of these investments from the stress testing, saying that the exclusions appeared reasonable at the time.238

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¶However, one director said that if the exclusion was material, he would have wanted to know about it.239

¶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,240 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.242 For example, delinquency rates on subprime loans, which had hovered near 10% in 2004 and 2005, reached 13% by the end of 2006.243 In addition, after peaking in mid‐2006, housing prices began to decline steeply.244 This decline in prices threatened the subprime mortgage market because the market's health depended on continued price appreciation in housing.245 As a result, beginning in November 2006, significant widening of spreads on non‐investment grade tranches of home equity loans was evident.246 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.247

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¶Lehman's management saw the subprime crisis as an opportunity to pick up ground on its competitors.248 Lehman's management adopted a "countercyclical growth strategy."249 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.250 In past recessions and financial crises, Lehman had successfully taken on more risk while its competitors retrenched.251

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¶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.252

¶Lehman, along with other market participants and government regulators, underestimated the severity of the subprime mortgage crisis;253 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.254 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.255 Lehman's growth strategy culminated in the acquisition of the Archstone REIT in late May 2007.256 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.257 By February 2007, FID had a "serious balance sheet issue."258

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¶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

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¶Lehman's officers informed the Board of Directors of the continuing expansion of Lehman's balance sheet and risk‐taking.

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.259 Lehman reacted to these signs by tightening its origination standards, particularly with respect to subprime mortgages,260 but Lehman continued to pursue growth in its mortgage origination business generally, particularly through its Alt‐A originator, Aurora.261 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."262

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¶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 2007.263 This portion of the Report describes those events.

¶Lehman considered its residential mortgage securitization business to be a distribution business.264 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").265 BNC and Aurora were part of Lehman's Mortgage Capital Division, which originated residential mortgages, while FID was responsible for securitizing the mortgages.266 By selling the RMBS to investors, Lehman shifted the risks of the underlying mortgages to the investors.267 Lehman, however, bore the risk that it would not be able to securitize the mortgages or sell the RMBS.268 The mortgages that Lehman could not shift to third‐party investors through securitization were known as "retained interests."269

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¶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."270 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.271

¶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.272 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.273

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¶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.274 Wind and new BNC CEO Steven Skolnik initiated changes to BNC's underwriting guidelines and product mix.275 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.276 Production under the 80/20 program dropped by two thirds from 2005 to 2006, and BNC discontinued the program entirely in late March 2007.277 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).278 Lehman did not discontinue subprime lending (as Lehman defined it) through BNC until its closure of BNC on August 22, 2007.279

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¶Lehman executives had different recollections concerning whether managers within FID had advocated an earlier and more rapid reduction in Lehman's subprime mortgage originations.280 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.281

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¶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.282 Moreover, Aurora's Alt‐A lending reached borrowers of lesser credit quality than those who historically had been considered Alt‐A borrowers.283 The vehicle for that aspect of the Aurora business plan was the Mortgage Maker product.284 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.285

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

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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.286

¶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."287 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.288 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.289

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¶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.290 And by March 2007, Lehman was noting sharp declines in securitization revenue,291 causing the Securitized Products Group within FID to exceed its risk appetite and VaR limits.292

¶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.293 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 2007.294

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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.295 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.296

¶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

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optimistic and constructive – talk about the opportunities that this market creates and how we are uniquely positioned to take advantage of them.297 Consistent with this direction, the Board presentation emphasized that Lehman's

¶management considered the crisis an opportunity to pursue a countercyclical strategy.298 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.299 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.300

¶The presentation concluded by highlighting management's belief that Lehman had "substantial opportunities, as in late 1990's" to improve its competitive position.301 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."302 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."303 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.304 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.305

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¶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.306 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."307 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,"308 but this reference to Alt‐B was deleted from the final version of the materials in favor of "Prime/Alt‐A Mortgages."309

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¶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.310 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).311

¶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.312

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¶These losses were tempered by effective hedging strategies through at least 2007 and into early 2008.313 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.314 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 2008.315 For the second and third quarters of 2008, however, Lehman had essentially no gains on its hedges.316 As a result, during those quarters, Lehman suffered very substantial losses on its residential mortgage business.317

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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.318 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.319 Compared to its competitors, Lehman was the most aggressive lender per dollar of shareholder equity in the first half of 2007.320

¶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.321 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.322 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.323 As of March 2007, the rating agencies "perceived loosening of [Lehman's] risk standards – particularly in leveraged lending. . . ."324 The Examiner has not investigated whether the contractual terms of Lehman's leveraged lending transactions were more aggressive than those of its competitors.

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¶Between December 2006 and June 2007, Lehman participated in more than 11 leveraged buyout deals that each exceeded $5 billion.325 By April 2007, Lehman had approximately 70 high yield contingent commitments in its pipeline – a record number for it.326 In June 2007, Lehman's lending pace had already doubled Lehman's 2006 record‐setting year for high grade and high yield combined.327

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¶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.328 FID was almost $20 billion over its net balance sheet limit for the quarter.329 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.

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¶Many of the leveraged loans that Lehman funded in 2006 and 2007 were "way over the limit."330 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,331 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 2007.332 Some of Lehman's commitments exceeded the loss threshold limit by a factor of six.333 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.334 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.335

¶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 2008.336 By late April 2007, Lehman had exceeded its newly increased high yield risk appetite limit,337 and starting in late July, the high yield business' usage consistently exceeded its limits.338 As Lehman funded more of its commitments, the leveraged loan exposure soon doubled the limit amount.339

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¶Lehman's management made a conscious decision to exceed the risk appetite limits on leveraged loans.340 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.341 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.342 Umezaki noted to O'Meara and others:

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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.343

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.344

¶Despite the opposition, the Executive Committee decided to proceed with many of the deals.345

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¶Some of the opposition to Lehman's increase in leveraged lending was focused on the bridge equity component of those deals.346 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.347 The Examiner, however, also found that sponsors were aggressive in demanding equity bridge components to financing348 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.349 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

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¶By April 2007, the overall size of the firm's leveraged loan commitments became controversial.351 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.352

¶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."353

¶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.354 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.355

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¶Fuld believed that FID and Gelband were not opposed to Lehman expanding its leveraged loan business.356 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.357 In contrast, IBD received credit for half of the income but bore no risk.358 Fuld considered Gelband's concerns an "intramural P+L grab," which concerned him.359

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.360 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).361

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¶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 2008.362

¶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:363

● May 2007, $2.0 billion – Lehman financing to Broadway Partners to acquire a sub‐portfolio of Beacon Capital Strategic Partners III, LP.364 ● May 2007, $1.3 billion – Lehman financing to Broadway Real Estate Partners to acquire 237 Park Avenue.365 ● June 2007, $1.2 billion – Lehman financing to Apollo Investment Corp. for a take private of Innkeepers USA Trust;366 ● June 2007, $1.1 billion – Lehman financing to Thomas Properties Group to acquire the EOP Austin portfolio;367

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● June 2007, $1.7 billion – Lehman financing for the acquisition of Northern Rock's commercial real estate portfolio;368 ● July 2007, $1.5 billion – Lehman financing to ProLogis to acquire the Dermody industrial portfolio;369 ● July 2007, $2.9 billion – Lehman financing for the acquisition of the Coeur Defense office building;370 ● August 2007, $1.0 billion – Lehman financing for the acquisition of Northern Rock's commercial real estate portfolio;371 ● October 2007, $1.5 billion – Lehman financing to Blackstone for its acquisition of Hilton Hotels;372 and ● October 2007, $5.4 billion – Lehman financing for the acquisition of the Archstone Smith Trust.373

¶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 2008.374

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,

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¶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 . . . ."375 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."376

¶Lehman's risk appetite limit for the real estate business increased from $600 million in 2006 to $720 million in 2007.377 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."378 Goodman advised

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¶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."379 Management ultimately decided that GREG would not be held to any risk appetite limits.380

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."381 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."382 Lehman's risk managers were also concerned with the real estate bridge equity deals in which Lehman was participating.383 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.384

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¶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;385 $574 million in ProLogis/Dermody portfolio;386 €475 million ($655 million) in Coeur Defense;387 $221 million in EOP Austin;388 and $195 million in the acquisition of the 200 Fifth Avenue building.389 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.390 Including units under construction, Archstone owned over 88,000 apartments, which were spread across more than 340 communities within the United States.391 Mark Walsh was the driving force behind this deal, but Fuld and Gregory strongly supported it as well.392

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¶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.393 After negotiating a price of $60.75 per share and executing a plan of merger,394 the parties announced the deal publicly on May 29, 2007.395 The deal was originally scheduled to close before August 31.396

¶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.397 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.398 Barclays' commitments came out of BofA's share of the debt and equity, and thus did not affect Lehman's exposure to Archstone.399

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¶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.400

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¶At the time the deal was presented to the Executive Committee, Lehman intended to sell all Archstone debt at closing.401 Because Lehman had price flex on the Archstone debt, Lehman management was reasonably confident that it could distribute the debt without suffering a loss.402 Price flex is a mechanism that facilitates syndication or sale of a loan by the initial lender without taking a loss.403 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.404 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.405 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.406

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Risk Management of Lehman's Archstone Commitment

¶Archstone was repeatedly considered by both the Commitment Committee and Executive Committee.407 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.408

¶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.409 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.410 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.411

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¶The Office of Thrift Supervision ("OTS") criticized Lehman's decision to enter into the Archstone transaction in excess of its risk appetite limits.412 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.413 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.414 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."415

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¶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.416

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.417 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.418

¶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.419 Fuld and Gregory also clashed with Gelband with respect to growing the firm's energy business and its leveraged loan business.420

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¶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.421 Nagioff decided to commute from London for a portion of each month.422

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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.423 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,424 and the Board had an extended discussion concerning the fact that the increased risk usage was spread across the firm.425 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.426

¶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.427 While the Archstone transaction was discussed at the June meeting,428

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¶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.

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.429 SEC Chairman Christopher Cox commented that "[o]ur concerns are with any potential systemic fallout."430

¶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.431 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.432

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¶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.

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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.433

¶Nagioff learned about the size of Lehman's leveraged loan exposures from Kirk, then Head of Global Credit Products.434 Lehman's leveraged loan business was "so gargantuan – the exposures jumped out at [him]."435 Nagioff and Kirk believed that this was "banker business, not broker business," which Lehman did not have the balance sheet to support.436 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.437 Nagioff was concerned because the tail risk of Lehman's leveraged loan business totaled billions of dollars.438

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¶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."439 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???"440

¶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.441 Moreover, Lehman had many deals in the pipeline, and those deals were supporting "100 bankers."442 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.443

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¶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.444 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.445 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.446

¶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.447

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¶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 2007.448 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.449

¶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.450 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,

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¶2007.451 As a result, FID ended the quarter roughly $2 billion over its net balance sheet limit.452 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.453

¶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."454 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."455

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.456 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.457 Under that model, in July 2007, the firm's "[L]iquidity Pool one year forward position [was] short $(0.4) billion."458

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¶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.459 In addition, the firm had "effectively been locked out of the capital markets."460

¶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."461

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¶Lowitt responded with a detailed explanation of the problem and his view of the root of the problem:

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.462

¶Nagioff responded: "Last paragraph applies to firm broadly."463

¶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."464

¶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."465 Prior to the formation of ALCO, Lehman's

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¶Treasury Department relied on pipeline reports from the businesses.466 ALCO convened frequent meetings from August 2007 through February 2008,467 and began to track and monitor more closely the firm's monthly projections for cash capital and maximum cumulative outflow.

¶The cash capital model was a pillar of the firm's funding framework.468 The sources of cash capital were equity and debt with a remaining life of greater than one year.469 The firm always funded leveraged loans and commercial real estate with cash capital.470 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.471 It was the firm's policy always to have a cash capital surplus of at least $2 billion.472

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¶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.473 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.474 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.475 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."476 Kirk responded: "Good. We will need skip [McGee] to kill as much stuff as early as possible."477

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¶At about the same time, the leveraged loan market generally collapsed, and new issues slowed to a trickle in the third quarter.478 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, 2007.479 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,"480 and Lehman's attempts at selling Archstone bridge equity largely failed.481

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¶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?"482 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.483

¶While the report and a Wall Street Journal article discussing it were widely read at Lehman,484 Lehman never seriously considered walking away from the deal.485 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,486 and another $7.1 billion of Archstone debt to Fannie Mae.487 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.488

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¶The Archstone deal closed on October 5, 2007.489 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):490

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.491

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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 2007.492 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.493 At least one other real estate bridge equity transaction, Dermody/ProLogis, also was not included in risk appetite until that date.494

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¶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.495 Lehman would also have been over the risk appetite limits for FID and the real estate business by substantial margins.496 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 2007.497

¶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.498

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¶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.499 The firm's risk appetite usage started to be discussed more widely within the firm.500

¶Lehman raised its firm‐wide risk appetite limit from $3.3 billion to $3.5 billion on September 7, 2007.501 Lehman's risk managers questioned whether Lehman truly had increased risk‐taking capacity, however. Two weeks after the firm first included the

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¶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?"502 Antoncic replied that they "did not close the loop on this" because of concerns related to a fourth‐quarter slowdown in revenues.503 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."504

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.505 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.506 The committee projected negative month end cash capital positions for the remainder of the year.507

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¶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."508 Moreover, the firm's cash capital projections for the end of October went negative immediately after the firm closed on Archstone.509

¶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.510 O'Meara was slated to be the presenter.511 The presentation concluded that the firm's capital adequacy over the last five to six quarters had "materially deteriorated."512 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.513 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 2007.514 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.515

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¶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 2007.516 The industry high in August 2007 was 18.7%.517 From August to November 2007, Lehman posted the lowest total capital ratio in the industry.518 The firm was at or near its SEC‐imposed 10% requirement for six months in 2007‐2008.519 On three separate occasions, Lehman had at least a concern that the total capital ratio would fall below the 10% requirement.520

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¶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.521 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."522

¶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.523 From November 2006 to August 2007, the firm's illiquid holdings grew by 72%, while "Tier 1 capital grew by only 26%."524

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¶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."525 In addition, Lehman was able to sell some of its leveraged loan positions, thereby raising cash capital and reducing its illiquid holdings.526

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.527 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.528 In January 2008, Lehman's Aurora subsidiary suspended its origination through wholesale and correspondent channels, which represented the bulk of the program.529 Lehman had curtailed the flow of Mortgage Maker originations approximately five months earlier.530

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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 2007.531 In the presentation, the Committee was informed that while risk appetite usage had increased, Lehman still remained within its risk appetite limit.532 The Committee was informed of the recent increase in the risk appetite limit from $3.3 billion to $3.5 billion.533

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¶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.534 Additionally, Lehman had been over the $3.5 billion limit each business day that month except for September 3, 2007.535 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.536 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.537 Before the October 2007 Board meeting, however, O'Meara directed that the limit information be removed from the final version of the chart.538 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.539

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¶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,540 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.541 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.542

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¶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 distribute543 – but did not mention other factors such as the addition of Archstone and other new deals.544

¶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.545 Some directors did not recall knowing that Lehman had ever been in breach of its risk appetite limits.546 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.547

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¶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:

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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.548 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.549 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.550 A chart that accompanied his presentation shows that Lehman's "macro hedges" reduced Lehman's "HY Closed Loan Net Exposure" by approximately 20%.551

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¶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.552 (Relatedly, there is no evidence that management disclosed the extent to which Lehman's commercial real estate investments were unhedged.)553

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¶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.554

¶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, 2007,555 or that Lehman's management had approved at least 30 leveraged loans that exceeded Lehman's single transaction limit.556 Some directors believed that the decision to exceed Lehman's high yield and single transaction limits should have been disclosed to the Board.557

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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.558 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.559

¶The new adequacy measures included a measurement for equity, the CSE capital ratios, and Lehman's internal equity adequacy framework.560

¶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.561

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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 2007.562 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."563

¶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.564 The materials stated that Lehman did not project the need to tap the capital markets because Lehman had "significant liquidity to fund these activities."565 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.566

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¶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 2007.567 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.568

¶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, 2007.569 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.570

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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 2007,571 and much of the growth was concentrated in illiquid holdings that Lehman was already unable to sell without incurring significant losses.572 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.573 Indeed, Lehman had been over its risk limits for the prior six months.574 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.

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¶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 2007.575 Lehman did not raise substantial amounts of equity during this period.576

¶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.577 The countercyclical growth strategy continued to be reflected in Lehman's strategy in the first quarter of 2008.578

¶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.579 However, documentary evidence shows that Lehman did not aggressively begin to sell assets until the second quarter of 2008.580

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¶During the first quarter of 2008, Fuld also decided that Lehman would not raise equity unless it could do so at a premium.581 While many of Lehman's competitors entered into strategic transactions to raise equity in late 2007 and early 2008,582 Lehman did not want to signal weakness by raising equity at a discount,583 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.584 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.585

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¶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."586 The limit increase had the effect of eliminating any firm‐wide limit excesses from that date forward.587

¶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.588

¶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.589 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.590

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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.591 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."592

¶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.593 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.594 Callan discussed Lehman's target leverage ratio with the Board and said that it would come back down.595

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¶At the Finance and Risk Committee meeting, management reviewed Lehman's monthly stress tests and scenario analyses.596 Stress tests indicated a worst‐case loss of $3.2 billion.597 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).598

¶At these January meetings, Lehman's management also recommended the new risk appetite limit to the Board.599 The directors were generally not aware or did not recall any discussion regarding the adjustments of the risk appetite calculation.600 Two of the directors said that they would have wanted to know about significant changes in the methodology.601 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.602

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Executive Turnover

¶In January 2008, Nagioff decided for personal reasons to resign as global head of FID.603 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.604

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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 2007.605 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."606 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.607 Goodman expressed a willingness to "take some losses" to achieve this goal.608 In a November 2007 presentation to Fuld, the commercial real estate group recommended reducing its global balance sheet by $15 billion.609

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¶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.610 Fuld decided during the December 2007 holiday season that it was time to pursue an aggressive reduction of Lehman's risk profile.611

¶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."612 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.613 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.614 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.615 Lehman's Treasurer at the time, Paolo Tonucci, was comfortable with FID's balance sheet overages in the first quarter of 2008.616 At the end of the first quarter of 2008, Tonucci did not require FID to sell off more assets.617

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¶It was not until February 26, 2008 that Gregory instructed Walsh to "get balance sheet down quickly,"618 and GREG set out to reduce its global balance sheet by $5 billion by March 18, 2008.619 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

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¶Bear Stearns.620 McDade was made the firm's "balance sheet czar" in mid‐March and was given authority to enforce firm‐wide balance sheet targets.621 Fuld intended to reduce all of Lehman's positions, including commercial real estate and leveraged loans positions.622 Balance sheet reduction targets were not sent out to Lehman's businesses until after the Executive Committee meeting on March 20, 2008.623

¶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."624 GREG's overseas businesses in particular were slow to reduce their positions in the first and second quarters of 2008,625 but GREG's U.S. business met its balance sheet reduction targets, despite continuing to engage in some originations.626

¶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.627 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."628 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.629

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¶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.630 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.631 The FID Compensation Committee assessed performance against VaR, balance sheet usage, and risk appetite.632

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¶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.633 To calculate revenue for its compensation pool, Lehman included revenue not

¶yet recognized but recorded based on mark‐to‐market positions.634 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.635

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¶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.

c) 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.

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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."636 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.'"637

¶The business judgment rule has rarely been applied to officers. However, based upon a recent decision by the Delaware Supreme Court638 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.639

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¶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.640

¶If the evidence overcomes the presumption of the business judgment rule, the plaintiff must then prove a violation of the duty of care.641 The standard of proof for a duty of care claim for corporate misconduct is generally defined as gross negligence.642 Gross negligence means "reckless indifference to or a deliberate disregard" of the corporation's interests, or "actions which are without the bounds of reason."643

¶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.644 Therefore, a plaintiff asserting a breach of the duty of care by Lehman's senior managers would face significant burdens.

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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.

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¶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."645 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

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¶Board, the rating agencies, and regulators that Lehman was prudently managing risk through its risk management system.646

¶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.

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¶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.

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¶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.

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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.

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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.647 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

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¶Lehman's entire pre‐existing real estate book put together.648 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.649 Similarly, Mark Walsh, the head of GREG, said he was informed that GREG was allocated excess risk appetite from other business divisions.650

¶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.

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¶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.651 These two transactions were not included in the firm's risk appetite calculation until August 13, 2007.652 After the exclusion was acknowledged in August 2007, Lehman retroactively corrected its risk appetite figures to include the previously omitted risks.653 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

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¶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.

¶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).

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¶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.654 The chart below demonstrates the magnitude of these overages:

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Leveraged Finance Deals with Single Transaction Loss ("STL") in Excess of Limit1 (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 Date2 over $250MM3 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:

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¶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."655

¶Although Lehman's decision to enter into huge illiquid transactions during a recognized "credit bubble"656 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.

¶655 E‐mail from Ian T. Lowitt, Lehman, to Christopher M. O'Meara, Lehman (July 20, 2007) [LBEX‐DOCID 194066]. 656 E‐mail from Christopher M. O'Meara, Lehman, to Paulo R. Tonucci, Lehman (Apr. 6, 2007) [LBEX‐ DOCID 1349076].

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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.657

¶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.658

¶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,

¶657 Examiner's Interview of Jeffrey Goodman, Aug. 28, 2009. 658 SEC, Notes from Lehman's Monthly Risk Review meeting (Oct. 11, 2007), at p. 6 [LBEX‐SEC 007438].

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¶Lehman did not pursue aggressive risk reduction strategies until sometime in 2008, particularly with respect to commercial real estate.

¶Rather than reduce its risk usage, Lehman cured its risk appetite overages by increasing the firm‐wide risk appetite limit yet again.659 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

¶659 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].

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¶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.

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.660

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 mortgage660 For further detail regarding the Repo 105 transactions, see Section III.A.4 of this Report.

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¶backed securities ("CMBS"), its private equity investments, and, during a crucial period, its leveraged loan commitments.661 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.

¶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.662 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.663 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.

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[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.664

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.

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¶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."665

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¶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";667 or if the exclusions from the stress testing were sufficiently significant;668 they would have wanted to know about these facts.669

¶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.

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¶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.

¶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."670

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¶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.

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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.671 It involves the process by which directors make business decisions, not the content of those decisions.672 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.'"673

¶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)

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for any transaction from which the director derives an improper personal benefit.674 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.675 Courts uphold such a clause to protect directors from liability provided that the conduct in question does not violate their duty of loyalty.676 In addition, Delaware protects directors from personal liability to the extent their decisions are based on information provided to them by management.677

¶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

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failed to undertake their responsibilities would they breach their duty of loyalty.678

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."679 The duty of loyalty chiefly involves situations in which directors utilize their positions to confer special benefits onto themselves or majority stockholders.680 These situations are frequently referred to as "self‐dealing" or "interested" situations.681 "A director is considered interested when he will receive a personal financial benefit from a transaction that is not equally shared by the stockholders."682 Directors are also considered interested where their motivations in executing a business decision appear to be subservient to the interests of a majority stockholder.683

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

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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."684 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."685 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.686

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."687 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."688 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."689

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¶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.690

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¶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.691 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. . . ."692 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.693

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."694 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.

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¶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."695 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.

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¶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.696