Report of Anton R. Valukas, Examiner, In re Lehman Brothers Holdings Inc., et al. — Volumes 1 and 3

Anton R. Valukas, Examiner (Jenner & Block LLP), U.S. Bankruptcy Court, S.D.N.Y.

Report

Report of Anton R. Valukas, Examiner, In re Lehman Brothers Holdings Inc., et al. — Volumes 1 and 3

Anton R. Valukas, Examiner (Jenner & Block LLP) · 11 March 2010

Original document ↗

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TABLE OF CONTENTS Introduction — 2
I. Executive Summary of The Examiner's Conclusions — 15
A. Why Did Lehman Fail? Are There Colorable Causes of Action That Arise From Its Financial Condition and Failure? — 15
B. Are There Administrative Claims or Colorable Claims For Preferences or Voidable Transfers? — 24
C. Do Colorable Claims Arise From Transfers of LBHI Affiliate Assets to Barclays, or From the Lehman ALI Transaction? — 26
II. Procedural Background and Nature of the Examination — 28
A. The Examiner's Authority — 28
B. Document Collection and Review — 30
C. Systems Access — 33
D. Witness Interview Process — 35
E. Cooperation and Coordination With the Government and Parties — 37

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INTRODUCTION

¶On January 29, 2008, Lehman Brothers Holdings Inc. ("LBHI"¹¹ There are a significant number of acronyms, abbreviations and other specialized terms used throughout this Report. To avoid the necessity of defining terms repeatedly, the Report will generally use them without definition; the reader should consult the Glossary attached as Appendix 2. Except where the specific identity of an entity is relevant and set out, this Report will use "Lehman" to refer collectively to Lehman Brothers Holdings Inc. ("LBHI") and all of its affiliates and subsidiaries.Show full note) reported record revenues of nearly $60 billion and record earnings in excess of $4 billion for its fiscal year ending November 30, 2007.²² Lehman Brothers Holdings Inc. ("LBHI"), Annual Report for 2007 as of Nov. 30, 2007 (Form 10‐K) (filed Jan. 29, 2008), at p. 29 ("LBHI 2007 10‐K"). LBHI was the holding company for hundreds of individual corporate entities, twenty‐two of which are currently Chapter 11 debtors in jointly administered proceedings. During January 2008, Lehman's stock traded as high as $65.73 per share and averaged in the high to mid‐fifties,³³ Morningstar Document Research Co., LBHI Historic Stock Prices, Jan. 1, 2008 through Sept. 15, 2008, [LBEX‐EXM 000001‐14] (printed from www.10kwizard.com) (last visited Feb. 3, 2010). implying a market capitalization of over $30 billion.⁴⁴ LBHI, Quarterly Report as of Feb. 29, 2008 (Form 10‐Q) (filed on Apr. 9, 2008), at p. 1 ("LBHI 10‐Q Apr. 9, 2008") (554 million common equity shares outstanding times $55 = approximately $30 billion). Less than eight months later, on September 12, 2008, Lehman's stock closed under $4, a decline of nearly 95% from its January 2008 value.⁵⁵ Morningstar Document Research Co., LBHI Historic Stock Prices (Jan. 1, 2008 through Sept. 15, , 2008) [LBEX‐EXM 000001‐14] (printed from www.10kwizard.com) (last visited Feb. 3, 2010). On September 15, 2008, LBHI sought Chapter 11 protection,⁶⁶ Voluntary Petition (Chapter 11), Docket No. 1, Lehman Brothers Holdings Inc., No. 08‐13555 (Bankr. S.D.N.Y. Sept. 15, 2008). in the largest bankruptcy proceeding ever filed.⁷⁷ Yalman Onaran & John Helyar, Fuld Sought Buffet Offer He Refused as Lehman Sank (Update 1), Bloomberg.com (Nov. 10, 2008), at p. 2.

¶There are many reasons Lehman failed, and the responsibility is shared. Lehman was more the consequence than the cause of a deteriorating economic climate. Lehman's financial plight, and the consequences to Lehman's creditors and shareholders, was exacerbated by Lehman executives, whose conduct ranged from serious but non‐culpable errors of business judgment to actionable balance sheet manipulation; by the investment bank business model, which rewarded excessive risk taking and leverage; and by Government agencies, who by their own admission might better have anticipated or mitigated the outcome.

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¶Lehman's business model was not unique; all of the major investment banks that existed at the time followed some variation of a high‐risk, high‐leverage model that required the confidence of counterparties to sustain. Lehman maintained approximately $700 billion of assets, and corresponding liabilities, on capital of approximately $25 billion.⁸⁸ LBHI 2007 10‐K, at p. 29; LBHI 10‐Q Apr. 9, 2008, at pp. 5‐6. But the assets were predominantly long‐term, while the liabilities were largely short‐term.⁹⁹ Examiner's Interview of Paolo R. Tonucci, Sept. 16, 2009, at p. 8. Lehman funded itself through the short‐term repo markets and had to borrow tens or hundreds of billions of dollars in those markets each day from counterparties to be able to open for business.¹⁰¹⁰ Examiner's Interview of Paolo R. Tonucci, Sept. 16, 2009, at pp. 4, 8 (Lehman financed the majority of its balance sheet in the short‐term repo market, more than $200 billion a day in 2008; Lehman was reliant on short‐term secured financing to conduct its daily operations); Examiner's Interview of Raymond Abary, Mar. 12, 2009. Confidence was critical. The moment that repo counterparties were to lose confidence in Lehman and decline to roll over its daily funding, Lehman would be unable to fund itself and continue to operate. So too with the other investment banks, had they continued business as usual. It is no coincidence that no major investment bank still exists with that model.¹¹¹¹ Bank of America, Press Release, Bank of America Buys Merrill Lynch Creating Unique Financial Services Firm (Sept. 15, 2008) (announcing its acquisition of Merrill Lynch); Morgan Stanley, Press Release, Morgan Stanley and Citi to Form Industry‐Leading Wealth Management Business Through Joint Venture (Jan. 13, 2009) (announcing joint venture with Citi's Smith Barney Group to form Morgan Stanley Smith Barney); Federal Reserve, Press Release, Sept. 21, 2008 (announcing that the Federal Reserve granted the applications by Goldman Sachs and Morgan Stanley, the last two major investment banks, to become bank holding companies); Goldman Sachs, Press Release, Sept. 21, 2008 (announcing that Goldman Sachs will become a bank holding company and will be regulated by the Federal Reserve).Show full note

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¶In 2006, Lehman made the deliberate decision to embark upon an aggressive growth strategy, to take on significantly greater risk, and to substantially increase leverage on its capital.¹²¹² See David Goldfarb, Lehman, Global Strategy Offsite (Mar. 2006) [LBEX‐DOCID 2489987]. In 2007, as the sub‐prime residential mortgage business progressed from problem to crisis, Lehman was slow to recognize the developing storm and its spillover effect upon commercial real estate and other business lines. Rather than pull back, Lehman made the conscious decision to "double down," hoping to profit from a counter‐cyclical strategy.¹³¹³ Examiner's Interview of Dr. Henry Kaufman, May 19, 2009, at p. 9 (at a March 20, 2007 Board meeting, management advised that "virtually all subprime originators have cut back on their operations or gone out of business," but, despite that fact, it was management's view that "the current distressed environment provides substantial opportunities as in the late 1990s"). As it did so, Lehman significantly and repeatedly exceeded its own internal risk limits and controls.¹⁴¹⁴ Duff & Phelps, High Yield Total ‐ Usage Versus Limits (Nov. 19, 2009), at pp. 4‐9 (showing that Lehman's monthly average risk appetite exceeded its limit by $41 million in July 2007, $62 million in August 2007, $608 million in September 2007, $670 million in October 2007, $508 million in November 2007, $562 million in December 2007, $708 million in January 2008, and $578 million in February 2008).

¶With the implosion and near collapse of Bear Stearns in March 2008, it became clear that Lehman's growth strategy had been flawed, so much so that its very survival was in jeopardy.¹⁵¹⁵ Examiner's Interview of Henry M. Paulson, Jr., June 25, 2009, at p. 11 (former Secretary of the Treasury Paulson stated that after Bear Stearns' near‐collapse he was less optimistic about Lehman's chances than Fuld, and he informed Fuld that Lehman needed to raise capital, find a strategic partner or sell the firm). The markets were shaken by Bear's demise, and Lehman was widely considered to be the next bank that might fail.¹⁶¹⁶ Examiner's Interview of Timothy F. Geithner, Nov. 24, 2009, at p. 2 (former President of the FRBNY and current Treasury Secretary Geithner believed that after Bear Stearns' near‐collapse, Lehman was the most vulnerable investment bank); Examiner's Interview of Ben S. Bernanke, Dec. 22, 2009, at p. 3 (Chairman of the Federal Reserve Bernanke believed that, after Bear Stearns, Lehman was the next most vulnerable bank); Examiner's Interview of Henry M. Paulson, Jr., June 25, 2009, at p. 2 (Paulson thought Lehman could be next to fail after Bear Stearns); Examiner's Interview of Christopher Cox, Jan. 8, 2010, at p. 8 (former Chairman of the SEC Cox said that after Bear Stearns collapsed Lehman was the SEC's "number one focus." Lehman had suffered "diminution of value" and had "troubled assets").Show full note Confidence was eroding. Lehman pursued a number of strategies to avoid demise.

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¶But to buy itself more time, to maintain that critical confidence, Lehman painted a misleading picture of its financial condition.

¶Lehman required favorable ratings from the principal rating agencies to maintain investor and counterparty confidence; and while the rating agencies looked at many things in arriving at their conclusions, it was clear – and clear to Lehman – that its net leverage and liquidity numbers were of critical importance.¹⁷¹⁷ Erin M. Callan, Lehman Brothers Leverage Analysis (Apr. 7, 2008), at p. 1 [LBEX‐DOCID 1401225] ("Reducing leverage [i]s necessary to remove refinancing risk and win back the confidence of the market, lenders, and investors."); Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at p. 8 (rating agencies looked at net leverage); Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 5 (senior management made a "concerted effort" to manage and reduce the balance sheet with a view towards the rating agencies); Examiner's Interview of Eileen A. Fahey, Fitch, Sept. 17, 2009, at p. 6; Standard & Poor's RatingsDirect, Liquidity Management In Times Of Stress: How The Major Broker‐Dealers Fare (Nov. 8, 2007), at p. 3 [LBHI_SEC07940_439424].Show full note Indeed, Lehman's CEO Richard S. Fuld, Jr., told the Examiner that the rating agencies were particularly focused on net leverage;¹⁸¹⁸ Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at p. 7. Lehman knew it had to report favorable net leverage numbers to maintain its ratings and confidence. So at the end of the second quarter of 2008, as Lehman was forced to announce a quarterly loss of $2.8 billion – resulting from a combination of write‐downs on assets, sales of assets at losses, decreasing revenues, and losses on hedges – it sought to cushion the bad news by trumpeting that it had significantly reduced its net leverage ratio to less than 12.5, that it had reduced the net assets on its balance sheet by $60 billion, and that it had a strong and robust liquidity pool.¹⁹¹⁹ Final Transcript of Lehman Brothers Holdings Inc. Second Quarter Preliminary Earnings Call (June 9, 2008), at pp. 7‐8.

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¶Lehman did not disclose, however, that it had been using an accounting device (known within Lehman as "Repo 105") to manage its balance sheet – by temporarily removing approximately $50 billion of assets from the balance sheet at the end of the first and second quarters of 2008.²⁰²⁰ LBHI 2007 10‐K, at p. 63; LBHI 10‐Q Apr. 9, 2008, at p. 72; Lehman Brothers Holdings Inc., Quarterly Report as of May 31, 2008 (Form 10‐Q) (filed on July 10, 2008), at p. 88 ("LBHI 10‐Q July 10, 2008"); Examiner's Interview of Martin Kelly, Oct. 1, 2009; Examiner's Interview of Ed Grieb, Oct. 2, 2009. In an ordinary repo, Lehman raised cash by selling assets with a simultaneous obligation to repurchase them the next day or several days later; such transactions were accounted for as financings, and the assets remained on Lehman's balance sheet. In a Repo 105 transaction, Lehman did exactly the same thing, but because the assets were 105% or more of the cash received, accounting rules permitted the transactions to be treated as sales rather than financings, so that the assets could be removed from the balance sheet.²¹²¹ See Section III.A.4 (discussing Repo 105). With Repo 105 transactions, Lehman's reported net leverage was 12.1 at the end of the second quarter of 2008; but if Lehman had used ordinary repos, net leverage would have to have been reported at 13.9.²²²² LBHI 10‐Q July 10, 2008, at p. 89; Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), at p. 7. See also Section I.A of this Report, which discusses net leverage.

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¶Contemporaneous Lehman e‐mails describe the "function called repo 105 whereby you can repo a position for a week and it is regarded as a true sale to get rid of net balance sheet."²³²³ E‐mail from Anthony Jawad, Lehman, to Andrea Leonardelli, Lehman (Feb. 29, 2008) [LBEX‐DOCID 224902]. Lehman used Repo 105 for no articulated business purpose except "to reduce balance sheet at the quarter‐end."²⁴²⁴ E‐mail from Raymond Chan, Lehman, to Paul Mitrokostas, Lehman, et al. (Jul. 15, 2008) [LBEX‐DOCID 3384937]. Rather than sell assets at a loss, "[a] Repo 105 increase would help avoid this without negatively impacting our leverage ratios."²⁵²⁵ Joseph Gentile, Lehman, Proposed Repo 105/108 Target Increase for 2007 (Feb. 10, 2007), at p. 1 [LBEX‐ DOCID 2489498], attached to e‐mail from Joseph Gentile, Lehman, to Ed Grieb, Lehman (Feb. 10, 2007) [LBEX‐DOCID 2600714]. Lehman's Global Financial Controller confirmed that "the only purpose or motive for [Repo 105] transactions was reduction in the balance sheet" and that "there was no substance to the transactions."²⁶²⁶ Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 9.

¶Lehman did not disclose its use – or the significant magnitude of its use – of Repo 105 to the Government, to the rating agencies, to its investors, or to its own Board of Directors.²⁷²⁷ Lehman did not disclose its use of Repo 105 in public filings. Examiner's Interview of Ed Grieb, Oct. 2, 2009, at p. 14; Examiner's Interview of Marie Stewart, Sept. 2, 2009, at p. 15; Examiner's Interview of Matthew Lee, July 1, 2009, at p. 16. Lehman did not disclose its use of Repo 105 to rating agencies. See Lehman, S&P Ratings Q2 2008 Update (June 5, 2008) [S&P‐Examiner 000946] (Lehman did not disclose its use of Repo 105 to Standard & Poor's in its ratings presentation); Lehman, Fitch Ratings Q2 2008 Update (June 3, 2008) [LBHI_SEC07940_513239] (Lehman similarly did not disclose its use of Repo 105 to Fitch as part of its presentation where Lehman touted its balance sheet reduction). The Examiner interviewed representatives from the three leading ratings agencies, Fitch, S&P and Moody's, and none had knowledge of Lehman's use of Repo 105/108 transactions, either by name or by description. Examiner's Interview of Eileen A. Fahey, Sept. 17, 2009, at p. 7; Examiner's Interview of Diane Hinton, Sept. 22, 2009, at p. 6; Examiner's Interview of Peter E. Nerby, Oct. 8, 2009, at p. 5. Lehman did not disclose its use of Repo 105 to Government regulators. Examiner's Interview of Ronald S. Marcus, Nov. 4, 2009, at p. 11; Examiner's Interview of Timothy F. Geithner, Nov. 24, 2009, at p. 5; Examiner's Interview of Jan H. Voigts, Oct. 1, 2009. Lehman did not disclose its use of Repo 105 to its Board of Directors. Examiner's Interview of Dr. Henry Kaufman, Sept. 2, 2009, at p. 21; Examiner's Interview of Jerry A. Grundhofer, Sept. 16, 2009, at p. 10; Examiner's Interview of Roland Hernandez, Oct. 2, 2009; Examiner's Interview of Sir Christopher Gent, Oct. 21, 2009, at p. 22; Examiner's Interview of Roger Berlind, Dec. 18, 2009, at p. 4.Show full note Lehman's auditors, Ernst & Young, were aware of but did not question Lehman's use and nondisclosure of the Repo 105 accounting transactions.²⁸²⁸ Examiner's Interview of Ernst & Young, Repo 105 session, Oct. 16, 2009, at pp. 8‐9 (statement of William Schlich); Examiner's Interview of Ernst & Young, Nov. 3, 2009, at pp. 14‐15 (statement of Hillary Hansen).

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¶In mid‐March 2008, after the Bear Stearns near collapse, teams of Government monitors from the Securities and Exchange Commission ("SEC") and the Federal Reserve Bank of New York ("FRBNY") were dispatched to and took up residence at Lehman,²⁹²⁹ Examiner's Interview of Matthew Eichner, Nov. 23, 2009, at p. 5 (Eichner told the Examiner that after Bear Stearns nearly collapsed, the SEC had monitors on‐site at Lehman "almost all the time." Eichner also told the Examiner that the FRBNY had people "in residence" with actual offices at Lehman); Examiner's Interview of Jan H. Voigts, Aug. 25, 2009, at p. 1 (Voigts monitored Lehman's liquidity position, embedded on‐site with the firm, from March 16, 2008 through mid‐September, 2008).Show full note to monitor Lehman's financial condition with particular focus on liquidity.³⁰³⁰ Examiner's Interview of Timothy F. Geithner, Nov. 24, 2009, at p. 4 (after Bear Stearns nearly collapsed, Geithner met with Lehman and other investment banks about moving the banks to a "more conservative place" regarding capital and liquidity. Geithner indicated that his primary concern was Lehman's funding structure. He told the Examiner that he was "consumed" with figuring out how to make Lehman "get more conservatively funded").Show full note Lehman publicly asserted throughout 2008 that it had a liquidity pool sufficient to weather any foreseeable economic downturn.³¹³¹ Final Transcript of Lehman Brothers Holdings Inc. Second Quarter 2008 Preliminary Earnings Call (June, 9, 2008), at p. 8 (Lehman's liquidity pool reported at $45 billion); Final Transcript of Lehman Brothers Holdings Inc. Second Quarter 2008 Earnings Call (June 16, 2008), at p. 6 (Lehman's liquidity pool reported at $45 billion); Final Transcript of Lehman Brothers Holdings Inc. Third Quarter 2008 Preliminary Earnings Call (Sept. 10, 2008), at p. 10 (Lehman's liquidity pool reported at $42 billion).Show full note

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¶But Lehman did not publicly disclose that by June 2008 significant components of its reported liquidity pool had become difficult to monetize.³²³² Lehman, Liquidity Pool Table Listing Collateral and Ability to Monetize (Sept. 12, 2008) [LBEX‐WGM 784607] (listing $30.1 billion of assets as "low ability to monetize"). As late as September 10, 2008, Lehman publicly announced that its liquidity pool was approximately $40 billion;³³³³ Final Transcript of Lehman Brothers Holdings Inc. Third Quarter 2008 Preliminary Earnings Call (Sept. 10, 2008), at p. 10. but a substantial portion of that total was in fact encumbered or otherwise illiquid.³⁴³⁴ Examiner's Interview of Paolo R. Tonucci, Sept. 16, 2009, at p. 19 (Lehman included $2 billion that it pledged to Citibank as a comfort deposit in its liquidity pool); Security Agreement between LBHI and Bank of America, N.A. (Aug. 25, 2008) [LBEX‐DOCID 000584] (providing for a $500 million security deposit from Lehman to BofA); Lehman, Liquidity Pool Table Listing Collateral and Ability to Monetize (Sept. 9, 2008), at p. 2 [LBHI_SEC07940_557815] (showing the $500 million BofA deposit in the liquidity pool); Lehman, Liquidity Update (Sept. 10, 2008), at p. 3 ($1 billion in Lehman's liquidity pool was earmarked to HSBC and listed as "Low ability to monetize.").Show full note From June on, Lehman continued to include in its reported liquidity substantial amounts of cash and securities it had placed as "comfort" deposits with various clearing banks; Lehman had a technical right to recall those deposits, but its ability to continue its usual clearing business with those banks had it done so was far from clear.³⁵³⁵ See Section III.A.5 (discussing potential claims against secured lenders). By August, substantial amounts of "comfort" deposits had become actual pledges.³⁶³⁶ Id. By September 12, two days after it publicly reported a $41 billion liquidity pool, the pool actually contained less than $2 billion of readily monetizable assets.³⁷³⁷ See Lehman, Liquidity Pool Table Listing Collateral and Ability to Monetize (Sept. 12, 2008) [LBEX‐ WGM 784607] (listing $1.4 billion of assets as "high ability to monetize" and $934 million of assets as "mid ability to monetize").

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¶Months earlier, on June 9, 2008, Lehman pre‐announced its second quarter results and reported a loss of $2.8 billion, its first ever loss since going public in 1994.³⁸³⁸ Lehman Brothers Holdings Inc., Press Releases (Mar. 14, 2007, June 12, 2007, Sept. 18, 2007, Dec. 13, 2007, Mar. 18, 2008 and June 9, 2008). Despite that announcement, Lehman was able to raise $6 billion of new capital in a public offering on June 12, 2008.³⁹³⁹ Lehman Brothers Holdings Inc., Press Release (June 12, 2008); Lehman Brothers Holdings Inc., Press Release (June 16, 2008). But Lehman knew that new capital was not enough. Treasury Secretary Henry M. Paulson, Jr., privately told Fuld that if Lehman was forced to report further losses in the third quarter without having a buyer or a definitive survival plan in place, Lehman's existence would be in jeopardy.⁴⁰⁴⁰ Fuld does not recall that warning. Examiner's Interview of Richard S. Fuld, Jr., Sept. 30, 2009, at p. 3, but Paulson told the Examiner that he consistently communicated to Fuld how dire Lehman's situation was and that he pointedly urged Fuld to find a buyer after Lehman announced a $2.8 billion loss for the second quarter of 2008, Examiner's Interview of Henry M. Paulson, June 25, 2009, at pp. 11‐15.Show full note

¶On September 10, 2008, Lehman announced that it was projecting a $3.9 billion loss for the third quarter of 2008.⁴¹⁴¹ Final Transcript of Lehman Brothers Holdings Inc. Third Quarter 2008 Preliminary Earnings Call (Sept. 10, 2008), at p. 8; Lehman Brothers Holdings Inc., Press Release (Sept. 10, 2008), at p. 1 [LBHI_SEC07940_042866]. Although Lehman had explored options over the summer, it had no buyer in place; its only announced survival plan was to spin off troubled assets into a separate entity. Secretary Paulson's prediction turned out to be right – it was not enough.

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¶By the close of trading on September 12, 2008, Lehman's stock price had declined to $3.65 per share, a 94% drop from the $62.19 January 2, 2008 price.⁴²⁴² Morningstar Document Research Co., LBHI Historic Stock Prices (Jan. 1, 2008 through Sept. 15, 2008) [LBEX‐EXM 000001‐14] (printed from www.10kwizard.com) (last visited on Feb. 3, 2010).

70.00 $62.19 60.00 50.00 40.00 $31.75

¶Lehman Stock Price $27.50

30.00 $20.96 20.00 $7.79 $7.25 10.00 $3.65 0.00 2-Jan-08 17-Mar-08 10-Jun-08 1-Jul-08 9-Sep-08 10-Sep-08 12-Sep-08 Landmark Dates

¶Over the weekend of September 12‐14, an intensive series of meetings was conducted by and among Treasury Secretary Paulson, FRBNY President Timothy F. Geithner, SEC Chairman Christopher Cox, and the chief executives of leading financial institutions.⁴³⁴³ Examiner's Interview of Henry M. Paulson, Jr., June 25, 2009, at p. 15; Examiner's Interview of Christopher Cox, Jan. 8, 2010, at pp. 15‐17; Examiner's Interview of Thomas C. Baxter, Jr., May 20, 2009 at p. 9. Secretary Paulson began the meetings by stating the Government was there to do all it could – but that it could not fund a solution.⁴⁴⁴⁴ Examiner's Interview of Henry M. Paulson, Jr., June 25, 2009, at pp. 15‐16 (Paulson told the Examiner that these meetings were part of the Government's attempt to "pull a rabbit out of a hat" and save Lehman); Examiner's Interview of Thomas C. Baxter, Jr., May 20, 2009 at pp. 9‐10 (FRBNY General Counsel Baxter told the Examiner that Paulson explained to the group that the purpose of the meeting was twofold ‐ (1) to attempt to facilitate the acquisition of Lehman; and (2) in the alternative, to resolve the consequences of Lehman's failure).Show full note The Government's analysis was that it did not have the legal authority to make a direct capital investment in Lehman, and Lehman's assets were insufficient to support a loan large enough to avoid Lehman's collapse.⁴⁵⁴⁵ Examiner's Interview of Henry M. Paulson, Jr., June 25, 2009, at pp. 16‐17 (Paulson told the Examiner that he concluded that the Federal Government lacked authority to inject capital into Lehman, even via an "exigent circumstances" loan from the Federal Reserve, because Lehman was not an institution "perceived to have capital and able to provide a guarantee."); Chairman of the Federal Reserve Ben S. Bernanke, Speech at the Kansas City Federal Bank Conference in Jackson Hole, Wyoming (Aug. 21, 2009) ("[T]he company's available collateral fell well short of the amount needed to secure a Federal Reserve loan of sufficient size to meet its funding needs."); Examiner's Interview of Ben S. Bernanke, Dec. 22, 2009, at p. 2 (Lehman's assets and securities fell "considerably short of the obligations that would become due").Show full note

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¶It appeared by early September 14 that a deal had been reached with Barclays which would save Lehman from collapse.⁴⁶⁴⁶ Examiner's Interview of Richard S. Fuld, Jr., Apr. 28, 2009, at p. 9 (Fuld told the Examiner that on the morning of September 14, 2008, he woke up thinking he had a transaction in place with Barclays); Lehman Brothers Holdings Inc., Minutes of Meeting of Board of Directors (Sept. 13, 2008), at p. 1 [LBEX‐ AM 003927‐003931] (The Lehman Board met at 5:00 p.m. to discuss a potential deal with Barclays).Show full note But later that day, the deal fell apart when the parties learned that the Financial Services Authority ("FSA"), the United Kingdom's bank regulator, refused to waive U.K. shareholder‐approval requirements.⁴⁷⁴⁷ Examiner's Interview of Henry M. Paulson, Jr., June 25, 2009, at pp. 19‐20; Examiner's Interview of Richard Fuld, Jr., Apr. 28, 2009, at 9. In a written statement to the Examiner, the FSA said that it never received a formal request to waive the shareholder‐approval requirement. According to the FSA's statement, the FSA had serious concerns about the lack of precedent for such waivers. The FSA was also concerned about Lehman's liquidity and funding. FSA, Statement of the Financial Services Authority to the Examiner (Jan. 20, 2010), at pp. 8, 10.Show full note

¶Lehman no longer had sufficient liquidity to fund its daily operations.⁴⁸⁴⁸ Lehman, Liquidity of Lehman Brothers [Draft] (Oct. 7, 2008), at p. 9 [LBHI_SEC07940_844701] (LBIE faced a cash shortage of $4.5 billion on September 15, 2008). On the evening of September 14, SEC Chairman Cox phoned the Lehman Board and conveyed the Government's strong suggestion that Lehman act before the markets opened in Asia.⁴⁹⁴⁹ Examiner's Interview of Christopher Cox, Jan. 8, 2010, at pp. 16‐17 (Cox called Lehman's Board to urge that Lehman take whatever action it decided upon as soon as possible, before the markets opened. During the call, Cox related, FRBNY General Counsel Thomas C. Baxter, Jr., added that it had been made clear in the meetings earlier that day that the "action" should be that Lehman declare bankruptcy. Cox told the Examiner that the SEC was not "offering guidance or trying to influence the fiduciary responsibilities of [Lehman's] directors.").Show full note On September 15, 2008, at 1:45 a.m., LBHI filed for Chapter 11 bankruptcy protection.⁵⁰⁵⁰ Voluntary Petition (Chapter 11), Docket No. 1, Lehman Brothers Holdings Inc., Case No. 08‐13555 (Bankr. S.D.N.Y. Sept. 15, 2008); Docket Activity Report, Lehman Brothers Holdings Inc., Case No. 08‐13555 (Bankr. S.D.N.Y. Sept. 15, 2008).

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¶Sorting out whether and the extent to which the financial upheaval that followed was the direct result of the Lehman bankruptcy filing is beyond the scope of the Examiner's investigation. But those events help put into context the significance of the Lehman filing. The Dow Jones index plunged 504 points on September 15.⁵¹⁵¹ Alexandra Twin, Stocks Get Pummeled, CNNMoney.com, Sept. 21, 2008, at p. 1 (stating "Wall Street sees worst day in 7 years with Dow down 504 points . . . "), available at http://money.cnn.com/2008/09/15/markets/markets_newyork2/index.htm (last visited Jan. 28, 2010). On September 16, AIG was on the verge of collapse; the Government intervened with a financial bailout package that ultimately cost about $182 billion.⁵²⁵² Sewell Chan, Bernanke Wants an Audit of Fed's Bailout of AIG, N.Y. Times, Jan. 19, 2010 (stating that the FRBNY and Treasury Department made about $182 billion available to AIG). On September 16, 2008, the Primary Fund, a $62 billion money market fund, announced that – because of the loss it suffered on its exposure to Lehman – it had "broken the buck," i.e., its share price had fallen to less than $1 per share.⁵³⁵³ See Markus K. Brunnermeier, Deciphering the Liquidity and Credit Crunch 2007‐2008, 23 J. Econ. Perspectives, Winter 2009, at 87 (2009); NewYorkFed.org, Financial Turmoil Timeline, http://www.newyorkfed.org/research/global_economy/Crisis_Timeline.pdf (last visited Jan. 26, 2010). On October 3, 2008, Congress passed a $700 billion Troubled Asset Relief Program ("TARP") rescue package.⁵⁴⁵⁴ David M. Herszenhorn, A Curious Coalition Opposed Bailout Bill, N.Y. Times, Oct. 3, 2008, at p. 1.

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¶In his recent reconfirmation hearings, Federal Reserve Chairman Ben Bernanke, speaking of the overall economic crisis, candidly conceded that "there were mistakes made all around" and "we should have done more."⁵⁵⁵⁵ Edmund L. Andrews, Bernanke Says Fed "Should Have Done More," N.Y. Times, Dec. 4, 2009, at p. 1. The official transcript of Chairman Ben S. Bernanke's Confirmation Hearing Before the Senate Committee on Banking, Housing, and Urban Affairs, Dec. 3, 2009, was not available at the time this Report was released. Lehman should have done more, done better. Some of these failings were simply errors of judgment which do not give rise to colorable causes of action; some go beyond and are indeed colorable.

¶Part I of this Report provides an executive summary of the Examiner's findings and conclusions.

¶Part II discusses the procedural background of the Examiner's appointment, the Examiner's authority, and the manner in which the Examiner conducted his investigation.

¶Part III details the facts and analysis on the topics assigned by the Court to the Examiner and contains the Examiner's analysis and conclusions.

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¶I. EXECUTIVE SUMMARY OF THE EXAMINER'S CONCLUSIONS

¶The Order appointing the Examiner (the "Examiner Order") assigns ten specific bulleted topics for the Examiner to investigate; in addition, the Examiner Order directs the Examiner to perform the duties specified in Section 1106(a)(3) and (4) of the Bankruptcy Code, that is, to "file a statement of . . . any fact ascertained pertaining to fraud, dishonesty, incompetence, misconduct, mismanagement, or irregularity in the management of the affairs of the debtor, or to a cause of action available to the estate."⁵⁶⁵⁶ Order Directing Appointment of an Examiner Pursuant to Section 1104(c)(2) of the Bankruptcy Code, at pp. 3‐5, Docket No. 2569, Lehman Brothers Holdings Inc., Case No. 08‐13555 (Bankr. S.D.N.Y. Jan. 16, 2009). Because the ten bulleted topics set out at pages 3‐4 of the Examiner Order overlap, the Examiner has grouped them into three substantive areas: (A) Why Did Lehman Fail? Are There Colorable Causes of Action That Arise From Its Financial Condition and Failure? (B) Are There Administrative Claims or Colorable Claims for Preferences or Voidable Transfers? and (C) Are There Colorable Claims Arising Out of the Barclays Sale Transaction?

Why Did Lehman Fail? Are There Colorable Causes of Action That Arise From Its Financial Condition and Failure?

¶Section (A) addresses the fifth, eighth and tenth bullets of the Examiner Order:

[Bullet 10] The events that occurred from September 4, 2008 through September 15, 2008 or prior thereto that may have resulted in commencement of the LBHI Chapter 11 case.

[Bullet 5] Whether there are colorable claims for breach of fiduciary duties and/or aiding or abetting any such breaches against the officers and directors of LBCC and/or other Debtors arising in connection with the financial condition of the Lehman enterprise prior to the commencement of the LBHI Chapter 11 case on September 15, 2008.

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[Bullet 8] The transactions and transfers, including but not limited to the pledging or granting of collateral security interest among the debtors and the pre‐Chapter 11 lenders and/or financial participants including but not limited to, JPMorgan Chase, Citigroup, Inc., Bank of America, the Federal Reserve Bank of New York and others.

¶Lehman failed because it was unable to retain the confidence of its lenders and counterparties and because it did not have sufficient liquidity to meet its current obligations. Lehman was unable to maintain confidence because a series of business decisions had left it with heavy concentrations of illiquid assets with deteriorating values such as residential and commercial real estate. Confidence was further eroded when it became public that attempts to form strategic partnerships to bolster its stability had failed.⁵⁷⁵⁷ See Lehman Brothers Holdings Inc., Minutes of Meeting of the Board of Directors (Mar. 31, 2008) (Lehman approached Warren E. Buffett about a potential $3.5 billion private investment, but discussions were preliminary and did not result in any agreement on terms) [LBEX‐AM 003597‐604]; Examiner's Interview of Richard S. Fuld, Jr., May 6, 2009, at p. 11 (Fuld told the Examiner that KDB's press release on Sept. 9, 2008, announcing that negotiations between KDB and Lehman about a strategic partnership had ended, triggered Lehman's decision to announce third quarter earnings early. According to Fuld, Lehman's stock dropped significantly after KDB's announcement and short‐sellers were "kicking the daylights" out of Lehman); Morningstar Document Research Co., LBHI Historic Stock Prices (Jan. 1, 2008 through Sept. 15, 2008) [LBEX‐EXM 000001] (printed from www.10kwizard.com) (last visited on Feb. 3, 2010 (Lehman's stock fell 45% after KDB's announcement).Show full note And confidence plummeted on two consecutive quarters with huge reported losses, $2.8 billion in second quarter 2008⁵⁸⁵⁸ Lehman Brothers Holdings Inc., Press Release (June 9, 2008). and $3.9 billion in third quarter 2008,⁵⁹⁵⁹ Lehman Brothers Holdings Inc., Press Release (Sept. 10, 2008). without news of any definitive survival plan.

¶The business decisions that brought Lehman to its crisis of confidence may have been in error but were largely within the business judgment rule. But the decision not to disclose the effects of those judgments does give rise to colorable claims against the senior officers who oversaw and certified misleading financial statements – Lehman's CEO Richard S. Fuld, Jr., and its CFOs Christopher O'Meara, Erin M. Callan and Ian T. Lowitt. There are colorable claims against Lehman's external auditor Ernst & Young for, among other things, its failure to question and challenge improper or inadequate disclosures in those financial statements.

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¶The Examiner Order does not contain a definition of what constitutes a "colorable" claim. The Second Circuit has described colorable claims as ones "that on appropriate proof would support a recovery,"⁶⁰⁶⁰ In re STN Enters., 779 F.2d 901, 905 (2d Cir. 1985). "much the same as that undertaken when a defendant moves to dismiss a complaint for failure to state a claim."⁶¹⁶¹ In re KDI Holdings, Inc., 277 B.R. 493, 508 (Bankr. S.D.N.Y. 1999) (quoting In re America's Hobby Center, 223 B.R. 275, 281 (Bankr. S.D.N.Y. 1998)), accord In re Adelphia Commc'ns Corp., 330 B.R. 364, 376 (Bankr. S.D.N.Y. 2005). But under such a standard, the Examiner would find colorable claims wherever bare allegations might survive a motion to dismiss. Because he has conducted an extensive factual investigation, the Examiner believes it is more appropriate to use a higher threshold standard, and in this Report a colorable claim is one for which the Examiner has found that there is sufficient credible evidence to support a finding by a trier of fact. The Examiner is not the ultimate decision‐maker; whether claims are in fact valid will be for the triers of fact to whom claims are presented. The identification of a claim by the Examiner as colorable does not preclude the existence of defenses and is not a prediction as to how a court or a jury may resolve any contested legal, factual, or credibility issues.⁶²⁶² For a more complete analysis of the law relating to the colorable claim standard, see Appendix 1. The Examiner is not the ultimate decision‐maker on any colorable claim; he simply is directed to identify the existence of such claims. While the Examiner has evaluated the at‐times conflicting evidence to make his determinations as to potential colorable claims, it is neither necessary nor appropriate for the Examiner to make credibility assessments or resolve conflicting evidence; that will be the responsibility of a trier of fact when and if those claims are litigated.Show full note

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¶Although Repo 105 transactions may not have been inherently improper, there is a colorable claim that their sole function as employed by Lehman was balance sheet manipulation. Lehman's own accounting personnel described Repo 105 transactions as an "accounting gimmick"⁶³⁶³ Examiner's Interview of Murtaza Bhallo, Sept. 14, 2009, at p. 3. and a "lazy way of managing the balance sheet as opposed to legitimately meeting balance sheet targets at quarter end."⁶⁴⁶⁴ Examiner's Interview of Marie Stewart, Sept. 2, 2009, at p. 7. Lehman used Repo 105 "to reduce balance sheet at the quarter‐end."⁶⁵⁶⁵ E‐mail from Raymond Chan, Lehman, to Paul Mitrokostas, Lehman, et al. (July 15, 2008) [LBEX‐DOCID 3384937].

¶In 2007‐08, Lehman knew that net leverage numbers were critical to the rating agencies and to counterparty confidence.⁶⁶⁶⁶ Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at p. 8 (rating agencies looked at net leverage); Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 2; Examiner's Interview of Anuraj Bismal, Sept. 16, 2009, at pp. 5‐6 (Bismal told the Examiner that meeting leverage ratio targets was the most critical issue ("a very hot topic") for senior management by the end of 2007). Its ability to deleverage by selling assets was severely limited by the illiquidity and depressed prices of the assets it had accumulated.⁶⁷⁶⁷ Examiner's Interview of Timothy F. Geithner, Nov. 24, 2009, at pp. 7‐8 (Starting in mid 2007, many of Lehman's inventory positions had grown increasingly "sticky" – i.e., difficult to sell without incurring substantial losses. Moreover, selling sticky inventory at reduced prices could also have led to loss of market confidence in Lehman's valuations for inventory remaining on the firm's balance sheet).Show full note Against this backdrop, Lehman turned to Repo 105 transactions to temporarily remove $50 billion of assets from its balance sheet at first and second quarter ends in 2008 so that it could report significantly lower net leverage numbers than reality.⁶⁸⁶⁸ Lehman, Spreadsheet Summarizing Total Repo 105 & Repo 108 (May 30, 2008) [LBEX‐DOCID 2078195] (total Repo 105 firm‐wide on Feb. 29, 2008 was $49.102 billion and on May 30, 2008 was $50.383 billion). Lehman did so despite its understanding that none of its peers used similar accounting at that time to arrive at their leverage numbers, to which Lehman would be compared.⁶⁹⁶⁹ Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 8 (Kelly told the Examiner that Lehman was the last of the CSE firms to continue using Repo 105‐type transactions to manage its balance sheet by late 2007); Examiner's Interview of Marie Stewart, Sept. 2, 2009, at p. 4 (Stewart believed that Lehman was the last of its peer group using Repo 105 transactions by December 2007).

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¶Lehman defined materiality, for purposes of reopening a closed balance sheet, as "any item individually, or in the aggregate, that moves net leverage by 0.1 or more (typically $1.8 billion)."⁷⁰⁷⁰ Ernst & Young, Walkthrough Template: Balance Sheet Close Process (Nov. 30, 2007), at p. 14 [EY‐SEC‐ LBHI‐CORP‐GAMX‐07‐033384]. Lehman's use of Repo 105 moved net leverage not by tenths but by whole points:

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Date Repo 105 Reported Net Difference Usage Net Leverage Leverage Without Repo 105 Q4 2007 $38.6 B⁷¹⁷¹ Lehman, Spreadsheet of Total Repo 105/108 Trend [LBHI_SEC07940_1957956] (listing total use of Repo 105/108 for the fourth quarter of 2007 as $38.634 billion). 16.1⁷²⁷² See LBHI 2007 10‐K, at p.29. 17.8⁷³⁷³ See Section III.A.4 (discussing Repo 105/108); Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), at p. 8. 1.7 Q1 2008 $49.1 B⁷⁴⁷⁴ Lehman, Spreadsheet of Total Repo 105/108 Trend [LBHI_SEC07940_1658543]. 15.4⁷⁵⁷⁵ LBHI 10‐Q Apr. 9, 2008, at p. 72. 17.3⁷⁶⁷⁶ See Section III.A.4 (discussing Repo 105/108); Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), at p. 8. 1.9 Q2 2008 $50.4 B⁷⁷⁷⁷ Lehman, Spreadsheet of Total Repo 105/108 Trend [LBHI_SEC07940_1658543]. 12.1⁷⁸⁷⁸ LBHI 10‐Q July 10, 2008, at p. 89. 13.9⁷⁹⁷⁹ See Section III.A.4 (discussing Repo 105/108); Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), at p. 8. 1.8

¶Lehman's failure to disclose the use of an accounting device to significantly and temporarily lower leverage, at the same time that it affirmatively represented those "low" leverage numbers to investors as positive news, created a misleading portrayal of Lehman's true financial health.⁸⁰⁸⁰ Examiner's Interview of Matthew Lee, July 1, 2009, at p. 15 ("[Lehman] was telling the public they reduced the balance sheet, but not telling them they were doing so by unartful means." – Lehman "had way more leverage than people thought; it was just out of [the public's] sight"). Colorable claims exist against the senior officers who were responsible for balance sheet management and financial disclosure, who signed and certified Lehman's financial statements and who failed to disclose Lehman's use and extent of Repo 105 transactions to manage its balance sheet.⁸¹⁸¹ See Section III.A.4 (discussing Repo 105/108).

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¶In May 2008, a Lehman Senior Vice President, Matthew Lee, wrote a letter to management alleging accounting improprieties;⁸²⁸² Letter from Matthew Lee, Senior Vice President, Lehman, to Martin Kelly, Controller, Lehman, et al., re: possible accounting improprieties (May 16, 2008), at pp. 1‐3 [EY‐LE‐LBHI‐KEYPERS 5826885]. in the course of investigating the allegations, Ernst & Young was advised by Lee on June 12, 2008 that Lehman used $50 billion of Repo 105 transactions to temporarily move assets off balance sheet and quarter end.⁸³⁸³ Examiner's Interview of Ernst & Young's Hillary Hansen, Nov. 3, 2009 at p. 14; e‐mail from Beth Rudofker, Lehman, to William Schlich, Ernst & Young (June 5, 2008) [EY‐SEC‐LBHI‐ML 000001‐000142], forwarding May 21, 2008 e‐mail from Matthew Lee regarding second request for balance sheet substantiation. The next day ‐ on June 13, 2008 ‐ Ernst & Young met with the Lehman Board Audit Committee but did not advise it about Lee's assertions, despite an express direction from the Committee to advise on all allegations raised by Lee.⁸⁴⁸⁴ Examiner's Interview of Roger Berlind, Dec. 18, 2009, at p. 2; Examiner's Interview of Michael L. Ainslie, Dec. 22, 2009, at pp. 2‐3; Examiner's Interview of Sir Christopher Gent, Jan. 20, 2010, at p. 2; Examiner's Interview of Thomas Cruikshank, Jan. 20, 2010, at p. 3; Examiner's Interview of Beth Rudofker, Dec. 15, 2009, at pp. 6‐7; see also Lehman Brothers Holdings Inc., Minutes of the Audit Committee (June 13, 2008) [LBEX‐AM 003759‐60].Show full note Ernst & Young took virtually no action to investigate the Repo 105 allegations.⁸⁵⁸⁵ Examiner's Interview of Ernst & Young's Hillary Hansen, Nov. 3, 2009, at p. 15 (Hansen told the Examiner that she did no further follow up specifically on Repo 105/108 because E&Y was in the midst of collecting all the data, and its investigation was not finalized). Ernst & Young took no steps to question or challenge the non‐disclosure by Lehman of its use of $50 billion of temporary, off‐balance sheet transactions. Colorable claims exist that Ernst & Young did not meet professional standards, both in investigating Lee's allegations and in connection with its audit and review of Lehman's financial statements.⁸⁶⁸⁶ See Section III.A.4 (discussing Repo 105/108).

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¶In the sections that follow, this report will describe in detail the facts and analysis that support the Examiner's conclusions. That detail will include the bases not only for the colorable claims that the Examiner has found, but also for those the Examiner has considered but not found. The Examiner believes it is appropriate to set forth the facts and analysis on colorable claims that he has not found in equal detail, so that the parties can understand the process that led to those conclusions. The issues that the Examiner investigated were framed by the Examiner Order itself, by suggestions made by the parties and Government agencies with whom the Examiner has had extensive coordination, and by the natural course of investigation, where a new path (such as Repo 105) was uncovered in the course of the investigation.

¶The Report begins with a discussion of the business decisions that Lehman made well before the bankruptcy, and the risk management issues raised by those business decisions. Ultimately, the Examiner concludes that while certain of Lehman's risk decisions can be described in retrospect as poor judgment, they were within the business judgment rule and do not give rise to colorable claims. But those judgments, and the facts related to them, provide important context for the other subjects on which the Examiner has found colorable claims. For example, after saddling itself with an enormous volume of illiquid assets that it could not readily sell, Lehman increasingly turned to Repo 105 to manage its balance sheet and reduce its reported net leverage.

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¶Lehman's acquisition of illiquid assets is also the predicate for the liquidity and valuation issues investigated by the Examiner.

¶Accordingly, the report will detail the following subjects that the Examiner has explored:

Business and Risk Management – The Examiner has explored this subject because it is central to the question of how and why Lehman amassed the assets that ultimately it could not monetize in time to maintain liquidity, acceptable leverage and confidence. The Examiner explored Lehman's reaction to the subprime lending crisis and other economic events to analyze whether Lehman's officers and directors fulfilled their fiduciary duties. The Examiner concludes that some of Lehman's management's decisions can be questioned in retrospect, but none fall outside the business judgment rule; the Examiner finds no colorable claims.⁸⁷⁸⁷ See Section III.A.1 (discussing Lehman's risk management).

Valuation – The Examiner has explored this subject because it is central to the question of Lehman's solvency and to whether Lehman's financial statements were accurately stated. The Examiner concludes that Lehman's valuation procedures may have been wanting and that certain valuations may have been unreasonable for purposes of a bankruptcy solvency analysis. The Examiner's conclusion that valuations were unreasonable for solvency analysis does not necessarily mean that individuals acted with sufficient scienter to support claims for breach of fiduciary duty, and the Examiner does not find sufficient credible evidence to support colorable claims.⁸⁸⁸⁸ See Section III.A.2 (discussing Lehman's valuation).

Survival – The Examiner has explored this subject because it is central to the question whether the officers and directors discharged their fiduciary duties. The Examiner finds no colorable claims.⁸⁹⁸⁹ See Section III.A.3 (discussing Lehman's survival).

Repo 105 – The Examiner has explored this subject after uncovering the issue in the course of his investigation. The Examiner finds there are colorable claims against Richard Fuld, Jr., Christopher O'Meara, Erin Callan, and Ian Lowitt in connection with their failure to disclose the use of the practice and against Ernst & Young for its failure to meet professional standards in connection with that lack of disclosure.⁹⁰⁹⁰ See Section III.A.4 (discussing Repo 105/108). After reaching the tentative conclusion that these claims existed, the Examiner contacted counsel for each, advised them of the basis for the potential finding, and invited each of them to present any additional facts or materials that might bear on the final conclusion. The Examiner had individual, face‐to‐face meetings with each and carefully considered the materials raised by each. While the Examiner was directed to credible facts and arguments that might form the basis for successful defenses, the Examiner concluded in all cases that these possible defenses do not change his now final conclusion that there is sufficient credible evidence from which a trier of fact could find a breach of duty after weighing the credible evidence on both sides of the issue.Show full note

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Secured Lenders – The Examiner has explored this subject because it was specifically assigned as part of the Examiner Order and because the subject was addressed in multiple communications with the parties. The Examiner finds colorable claims against JPMorgan Chase ("Chase") and CitiBank in connection with modifications of guaranty agreements and demands for collateral in the final days of Lehman's existence.⁹¹⁹¹ See Section III.A.5 (discussing potential claims against Lehman's secured lenders). The demands for collateral by Lehman's Lenders had direct impact on Lehman's liquidity pool; Lehman's available liquidity is central to the question of why Lehman failed.

Lehman's Interaction With Government Agencies – As part of the Examiner's overall investigation, it was necessary to consider the interaction between Lehman and the Government agencies who regulated and monitored Lehman; for example, Lehman officers suggested to the Examiner that he should consider, in the course of determining whether they had breached any fiduciary duties, the completeness of the disclosures they made to the Government.⁹²⁹² See Section III.A.6(discussing the government's role).

Are There Administrative Claims or Colorable Claims For Preferences or Voidable Transfers?

¶Section (B) addresses the first, second, third, fourth, seventh and eighth bullets of the Examiner Order:

[Bullet 1] Whether LBCC [Lehman Brothers Commercial Corporation] or any other entity that currently is an LBHI Chapter 11 debtor subsidiary or affiliate ("LBHI Affiliate(s)") has any administrative claims against LBHI resulting from LBHI's cash sweeps of cash balances, if any, from September 15, 2008, the commencement date of LBHI's Chapter 11 case, through the date that such applicable LBHI affiliate commenced its Chapter 11 case.

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[Bullet 2] All voluntary and involuntary transfers to, and transactions with, affiliates, insiders and creditors of LBCC or its affiliates, in respect of foreign exchange transactions and other assets that were in the possession or control of LBHI Affiliates at any time commencing on September 15, 2008 through the day that each LBHI Affiliate commenced its Chapter 11 case.

[Bullet 3] Whether any LBHI Affiliate has colorable claims against LBHI for potentially insider preferences arising under the Bankruptcy Code or state law.

[Bullet 4] Whether any LBHI Affiliate has colorable claims against LBHI or any other entities for potentially voidable transfers or incurrences of debt, under the Bankruptcy Code or otherwise applicable law.

[Bullet 7] The inter‐company accounts and transfers among LBHI and its direct and indirect subsidiaries, including but not limited to: LBI, LBIE, Lehman Brothers Special Finance ("LBSF") and LBCC, during the 30‐day period preceding the commencement of the Chapter 11 cases by each debtor on September 15, 2008 or thereafter or such longer period as the Examiner deems relevant to the Investigation.

[Bullet 8] The transactions and transfers, including but not limited to the pledging or granting of collateral security interest among the debtors and the pre‐Chapter 11 lenders and/or financial participants including but not limited to, JPMorgan Chase, Citigroup, Inc., Bank of America, the Federal Reserve Bank of New York and others

¶The Examiner has identified approximately $60 million of administrative claims.⁹³⁹³ See Section III.B.2 (discussing possible administrative claims).

¶The Examiner has identified colorable claims that there were a limited number of preferential transfers.⁹⁴⁹⁴ See Section III.B.3 (discussing possible avoidance actions).

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¶The Examiner has determined that there are a limited number of colorable claims for avoidance actions against JPMorgan⁹⁵⁹⁵ The Examiner notified counsel for JPMorgan of his tentative conclusion and counsel made a presentation in response. The Examiner carefully considered that presentation but concludes that a colorable claim exists. and Citibank.⁹⁶⁹⁶ See Section III.B.3 (discussing possible avoidance actions).

Do Colorable Claims Arise From Transfers of LBHI Affiliate Assets to Barclays, or From the Lehman ALI Transaction?

¶Section (C) addresses the sixth and ninth bullets of the Examiner Order:

[Bullet 6] Whether assets of any LBHI Affiliates (other than Lehman Brothers, Inc.) were transferred to Barclays Capital Inc. as a result of the sale to Barclays Capital Inc. that was approved by order of the Bankruptcy Court entered September 20, 2008, and whether consequences to any LBHI Affiliate as a result of the consummation of the transaction created colorable causes of action that inure to the benefit of the creditors of such LBHI subsidiary or affiliate.

[Bullet 9] The transfer of the capital stock of certain subsidiaries of LBI on or about September 19, 2008 to Lehman ALI Inc.

¶In the course of reviewing whether affiliates other than LBI were adversely impacted by the Barclays sale, the Examiner reviewed the facts related to the transfer of LBI assets in the post‐filing sale to Barclays. Because the issues related to the sale are the subject of active, pending litigation filed by the Debtors, on which discovery is far from complete, the Examiner expresses no view on the merits of that litigation and will limit himself to setting out the factual record he has developed on the issues.⁹⁷⁹⁷ See Section III.C (discussing the Barclays sale transaction).

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¶The Examiner concludes that a limited amount of assets of LBHI Affiliates other than LBI were improperly transferred to Barclays.⁹⁸⁹⁸ See Section III.C (discussing the Barclays sale transaction).

¶The Examiner concludes that the transfer of capital stock to ALI served a legitimate purpose and that there was no impropriety in those transactions.⁹⁹⁹⁹ See Section III.C (discussing the Examiner's conclusions regarding the Lehman ALI transaction).

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¶II. PROCEDURAL BACKGROUND AND NATURE OF THE EXAMINATION

The Examiner's Authority

¶On January 16, 2009, the United States Bankruptcy Court for the Southern District of New York entered an order directing the U.S. Trustee to nominate an Examiner, and outlining the subject matter of the Examiner's investigation (the "Examiner Order").¹⁰⁰¹⁰⁰ Order Directing Appointment of an Examiner Pursuant to Section 1104(c)(2) of the Bankruptcy Code, at pp. 3‐5, Docket No. 2569, In re Lehman Brothers Holding Inc., et al., Case No. 08‐13555 (Bankr. S.D.N.Y. Jan. 16, 2009). The Examiner Order lists ten bulleted topics that the Examiner was to investigate and, further, mandates that the "Examiner shall perform the duties specified in sections 1106(a)(3) and (4) of the Bankruptcy Code [unless otherwise ordered.]"¹⁰¹¹⁰¹ Id. at p. 5. Under 11 U.S.C. § 1106(a)(3), the Examiner is to "investigate the acts, conduct, assets, liabilities, and financial condition of the debtor, the operation of the debtor's business and the desirability of the continuance of such business, and any other matter relevant to the case or to the formulation of a plan [unless ordered otherwise.]" Under 11 U.S.C. § 1106(a)(4), the Examiner must, inter alia, "file a statement of any investigation conducted . . . including any fact ascertained pertaining to fraud, dishonesty, incompetence, misconduct, mismanagement, or irregularity in the management of the affairs of the debtor, or to a cause of action available to the estate[.]"

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¶On January 19, 2009, the U.S. Trustee appointed Anton R. Valukas as Examiner.¹⁰²¹⁰² Notice of Appointment of Examiner, Docket No. 2570, In re Lehman Brothers Holdings Inc.,Case No. 08‐ 13555 (Bankr. S.D.N.Y. Jan. 19, 2009). The Court approved the appointment on January 20, 2009.¹⁰³¹⁰³ Order Approving Appointment of Examiner, Docket No. 2583, In re Lehman Brothers Holdings Inc., Case No. 08‐13555 (Bankr. S.D.N.Y. Jan. 20, 2009). On February 11, 2009, the Court approved the Examiner's request to employ Jenner & Block LLP as counsel and provided the Examiner with authority to issue subpoenas under Fed. R. Bankr. P. 2004.¹⁰⁴¹⁰⁴ Order Authorizing the Examiner to Retain and Employ Jenner & Block LLP as His Counsel Nunc Pro Tunc as of January 19, 2009, Docket No. 2803, In re Lehman Brothers Holdings Inc., Case No. 08‐13555 (Bankr. S.D.N.Y. Feb. 11, 2009); and Order Granting Examiner's Motion Directing the Production of Documents and Authorizing the Examinations of the Debtors' Current and Former Officers, Directors and Employees, and Other Persons and Entities, Docket No. 2804, In re Lehman Brothers Holdings Inc., Case No. 08‐13555 (Bankr. S.D.N.Y. Feb. 11, 2009).Show full note On February 17, 2009, the Court approved the Examiner's Preliminary Work Plan.¹⁰⁵¹⁰⁵ Order Approving the Preliminary Work Plan of Anton R. Valukas, Examiner, Docket No. 2855, In re Lehman Brothers Holdings Inc., Case No. 08‐13555 (Bankr. S.D.N.Y. Feb. 17, 2009). On February 25, 2009, the Court authorized the Examiner to employ Duff & Phelps, LLC as his financial advisors.¹⁰⁶¹⁰⁶ Order Authorizing the Examiner to Retain and Employ Duff & Phelps LLC as His Financial Advisors Nunc Pro Tunc as of February 6, 2009, Docket No. 2924, In re Lehman Brothers Holdings Inc., Case No. 08‐ 13555 (Bankr. S.D.N.Y. Feb. 17, 2009).

¶Despite the complexity of Lehman's bankruptcy and the broad scope of the Examiner's investigation, the time available for the examination was limited by the practical needs of the bankruptcy proceeding. The Examiner initially targeted the week of February 1, 2010 to submit his report to the Court in order to assure that the report would be available prior to the March 15, 2010 deadline of the Debtors' exclusivity period to propose a plan of reorganization.¹⁰⁷¹⁰⁷ Order Granting Debtors' Motion, Pursuant to Section 1121(d) of the Bankruptcy Code, Requesting Second Extension of Exclusive Periods for the Filing of and Solicitation of Acceptances for Chapter 11 Plans, Docket No. 4449, In re Lehman Brothers Holdings Inc., Case No. 08‐13555 (Bankr. S.D.N.Y. July 20, 2009). Even though the Debtors have suggested that they may not file a plan by that date, the Examiner determined that all parties would be better served if he adhered to his self‐imposed February 2010 schedule.

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Document Collection and Review

¶The available universe of Lehman e‐mail and other electronically stored documents is estimated at three petabytes of data – roughly the equivalent of 350 billion pages. The Examiner carefully selected a group of document custodians and search terms designed to cull out the most promising subset of Lehman electronic materials for review. In addition, the Examiner requested and received hard copy documents from Lehman and both electronic and hard copy documents from numerous third parties and Government agencies, including the Department of the Treasury, the SEC, the Federal Reserve, FRBNY, the Office of Thrift Supervision, the SIPA Trustee, Ernst & Young, JPMorgan, Barclays, Bank of America, HSBC, Citibank, Fitch, Moody's, S&P, and others.¹⁰⁸¹⁰⁸ See Appendix 5 for full details of custodians, search request, search terms and related document metrics. Although a handful of subpoenas were threatened and in a few cases served, ultimately the Examiner received nearly all requested documents voluntarily. In the interest of time and efficiency, the Examiner did not, except where significant deficiencies were apparent, challenge the completeness of production or the withholding of documents upon claims of privilege.Show full note

¶In total, the Examiner collected in excess of five million documents, estimated to comprise more than 40,000,000 pages. All of these documents have been converted to electronic form and are maintained on two computerized databases, Stratify and CaseLogistix. The Stratify database, which is housed and maintained on servers by the Debtors' professionals, Alvarez & Marsal, contains approximately four and a half million unique documents, and consists of collected Lehman e‐mails and attachments; the CaseLogistix database, which is housed and maintained by the Examiner's counsel, Jenner & Block, contains approximately seven hundred thousand unique documents, primarily consisting of third‐party productions.

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¶Documents were reviewed on at least two levels. First level review was conducted by lawyers trained to identify documents of possible interest and to code the substantive areas to which the documents pertained; those so identified were subjected to further and more careful review by lawyers or financial advisors especially immersed in the earmarked subjects. In order to reduce the cost of review, the Examiner sought and obtained the Court's approval to retain contract attorneys.¹⁰⁹¹⁰⁹ Order Authorizing the Examiner to Retain Certain Contract Attorneys to Perform Specific Document Review Tasks Nunc Pro Tunc as of April 15, 2009, Docket No. 3577, In re Lehman Brothers Holdings Inc., Case No. 08‐13555 (Bankr. S.D.N.Y. May 15, 2009); Order Authorizing the Examiner to Retain Additional Contract Attorneys to Perform Specific Document Review Tasks Nunc Pro Tunc as of May 11, 2009, Docket No. 3750, In re Lehman Brothers Holdings Inc., Case No. 08‐13555 (Bankr. S.D.N.Y. June 3, 2009); and Order Authorizing the Examiner to Retain Additional Contract Attorneys to Perform Specific Document Review Tasks Nunc Pro Tunc as of June 11, 2009, Docket No. 4428, In re Lehman Brothers Holdings Inc., Case No. 08‐13555 (Bankr. S.D.N.Y. July 16, 2009).Show full note A group of more than 70 contract attorneys, supplemented by Jenner & Block attorneys, conducted first level reviews. All second level (and beyond) reviews were performed by Jenner & Block attorneys or Duff & Phelps professionals.

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¶The Examiner estimates that he has reviewed approximately 34,000,000 pages of documents in the course of his investigation. The entire body of e‐mail in the Stratify database – 4,439,924 documents, approximately 26 million pages – has been reviewed.¹¹⁰¹¹⁰ On January 30, 2010, the Examiner received about 55,500 unique e‐mails from the Debtors responsive to long‐outstanding requests that had not earlier been produced due to a data transfer issue. Earlier that week, the Examiner received 30,000 pages of documents from Ernst & Young responsive to long‐ outstanding requests that had not earlier been produced because a single custodian's files had inadvertently not been included. Despite the lateness of the receipt of these documents, the Examiner was able to complete review of them by deploying a team of lawyers to the task.Show full note Approximately 340,000 of the CaseLogistix documents – roughly eight million pages – have been reviewed.¹¹¹¹¹¹ The Examiner is able to count documents loaded in the two databases with precision, but page numbers are estimates. On average, the e‐mail and attachments in the Stratify database are six pages per document; the documents in the CaseLogistix database tend to be larger, averaging 23 pages per document. Although a large number of the CaseLogistix documents were not reviewed, that database is fully searchable, and the Examiner is reasonably confident that the repeated and focused searches applied against that database have discovered most if not all of the most relevant documents.¹¹²¹¹² A substantial number of additional documents were produced in the pending Barclays sale litigation in the weeks before this Report was due. Given the ongoing nature of that litigation and the Court's concurrence that the Examiner need not express conclusions on these still‐in‐active‐litigation issues, those documents have not been reviewed except on a limited, focused basis.

¶In most cases, documents were produced to the Examiner under stipulated protective orders, which are described in Appendix 5. Subject to those orders, the document databases created by the Examiner remain a resource for the estate and the parties. The database includes computerized tagging which will allow persons interested in making their own searches to narrow and focus search requests. The Examiner will work with the parties and the Court to resolve logistical and confidentiality issues so that the databases can become an asset available to all interested parties.

33

Systems Access

¶Answering the questions posed by the Examiner Order necessarily required an extensive investigation and review of Lehman's operating, trading, valuation, financial, accounting and other data systems. Interrogating those systems proved particularly challenging, first because the vast majority of the systems had been transferred and were under the control of Barclays; by the time of the Examiner's appointment, Barclays had integrated its own proprietary and confidential data into some of the systems, so Barclays had legitimate concerns about granting access to those systems. Although it took some time, Barclays was cooperative and those issues were for the most part resolved.

¶The second challenge was more daunting. At the time of its bankruptcy filing, Lehman maintained a patchwork of over 2,600 software systems and applications. The Examiner, in consultation with his financial advisors, decided early on that it would not be cost effective to undertake the enormous effort and expense that would be required to learn and access each of these 2,600 systems. Rather, the Examiner directed his financial advisors to identify and acquire an in‐depth understanding of the most promising of the systems.

34

¶The Examiner's financial advisors ultimately requested access to 96 of the most relevant systems.¹¹³¹¹³ See Appendix 6. The process of identifying those presented it own challenges. Many of Lehman's systems were arcane, outdated or non‐standard. Becoming proficient enough to use the systems required training in some cases, study in others, and trial and error experimentation in others. In numerous instances, the Examiner's professionals would request access to a particular system, expend the time necessary to learn how to use the system and only then discover that access to two or three additional systems was required to answer the necessary questions. Lehman's systems were highly interdependent, but their relationships were difficult to decipher and not well documented. It took extraordinary effort to untangle these systems to obtain the necessary information.

¶Because some systems were in current use by Barclays in its operations, Barclays limited access to 79 of the requested 96 systems to "read‐only." Read‐only access made the review and organization of data more difficult. And in some cases, read‐only access was severely restricted. For some systems, the ability to query the data and search for a particular transaction was limited to certain parameters. For others, the Examiner was denied direct access altogether, requiring the need to request that searches be done by Barclays's technology personnel, who would then forward findings to the Examiner.

35

¶Finally, the accessibility of data was complicated by the fact that the filing of a bankruptcy petition by Lehman came with virtually no advance preparation. The filing did not occur at the close of a month or a quarter when Lehman would prepare reconciliations and summaries of its financial data. Record‐keeping quickly fell into disarray upon Lehman's hurried filing. Reconstructing data during this period has proven a challenge not only for the Examiner but for all who must rely upon this data in Lehman's Chapter 11 proceedings.

¶In the end, the Examiner's financial advisors were generally able to get sufficient data to inform and support the Examiner's Report, but there may be areas, specifically noted where appropriate in the text below, where data limitations need to be considered.

Witness Interview Process

¶Shortly after his appointment, the Examiner spoke with examiners from other large bankruptcy proceedings, including WorldCom, SemCrude and Refco, and obtained their advice on best practices. One of the suggestions made was that wherever possible interviews be conducted informally, without requiring that the witness be sworn and without transcripts. There are obvious pros and cons to the use of sworn, transcribed interviews. On the plus side, oath and transcription make citations to testimony more certain; on the minus side, the formality of oath and transcription inevitably takes more time, creates additional expense and makes some witnesses less willing to give full cooperation; moreover, the creation of transcribed statements might have impacted pending Government investigations. Balancing these factors, the Examiner decided to use informal interviews wherever possible – and that turned out to be possible in all cases. To assure accuracy, all interviews were conducted by at least two attorneys, one of whom was assigned to keep careful notes. Flash summaries were prepared as soon as possible, usually the day of the interview, and reviewed by all lawyers present while recollections remained sharp; and full summaries were made and reviewed as soon as practical after that.

36

¶In the vast majority of cases, the interviewees were represented by counsel. Nevertheless, the Examiner advised each interviewee that he is a neutral fact‐finder and that he and his professionals should not be deemed to represent the witness nor any point of view. Consistent with that neutrality, prior to each interview the Examiner provided advance notice of the topics he intended to cover and advance copies of the documents he anticipated showing the witness. The Examiner did so in order to make the interview as efficient as possible and to permit the witness to refresh recollection before the interview rather than on the fly. Each witness was encouraged to advise the Examiner if he or she believed it was appropriate to correct or supplement the information given during the interview.

¶In all, the Examiner has interviewed more than 250 individuals. There was only one individual the Examiner sought to interview but could not. The Examiner requested an interview with Hector Sants, chief executive of the UK's Financial Services Authority ("FSA"), to discuss the FSA's involvement in the events of Lehman Weekend and the Barclays transaction. The FSA considered the request, but did not make Mr. Sants available for an interview. However, the FSA did provide detailed, written answers to specific questions that would have been posed to Mr. Sants.

37

¶A full list of the persons interviewed by the Examiner is set out in Appendix 4.

Cooperation and Coordination With the Government and Parties

¶The Examiner received extraordinary cooperation, both from parties and non‐ parties, without which the completion of this Report would have taken far more time. Although the Debtors' professionals and personnel were and are extremely busy with the day‐to‐day requirements of Lehman's liquidation, they remained responsive to almost daily requests for information from the Examiner and his professionals. Many parties, such as the Debtors, provided documents to the Examiner on an expedited basis without taking the time for privilege review, subject to clawback agreements.

¶Shortly after his appointment, the Examiner met with and established a regular line of contact with the SIPA Trustee to share documents, interview summaries and other information to avoid duplication of effort. The Examiner met with the SEC and three United States Attorney Offices (New Jersey, Eastern District of New York, Southern District of New York) to establish protocols for clearing proposed interviews so as not to interfere with any ongoing investigations. And the Examiner met with interested parties to obtain their guidance and thoughts.

38

¶Throughout the course of the investigation, the Examiner conducted regular, weekly calls with the SEC and U.S. Attorneys to update them on developments and to describe significant documents and the results of interviews. The Examiner has likewise made documents and the results of interviews available to the SIPA Trustee.

¶The Report now continues with the detail.

¶UNITED STATES BANKRUPTCY COURT SOUTHERN DISTRICT OF NEW YORK

¶‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐ x

¶: In re : Chapter 11 Case No. : LEHMAN BROTHERS HOLDINGS INC., : 08‐13555 (JMP) et al., :

: (Jointly Administered) Debtors. :

¶‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐‐ x

REPORT OF EXAMINER ANTON R. VALUKAS

¶Section III.A.1: Risk

39

¶

TABLE OF CONTENTS III. Examiner's Conclusions — 43
A. Why Did Lehman Fail? Are There Colorable Causes of Action That Arise From Its Financial Condition and Failure? — 43
1. Business and Risk Management — 43
a) Executive Summary — 43
(1) 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 — 47
(2) 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 — 52
(3) The Examiner Does Not Find Colorable Claims That Lehman's Directors Breached Their Fiduciary Duty by Failing to Monitor Lehman's Risk‐Taking Activities — 54
b) Facts — 58
(1) From Moving to Storage: Lehman Expands Its Principal Investments — 58
(a) Lehman's Changed Business Strategy — 59
(b) The Increased Risk From Lehman's Changed Business Strategy — 62
(c) Application of Risk Controls to Changed Business Strategy — 65
(i) Stress Testing Exclusions — 66
(ii) Risk Appetite Limit Increase For Fiscal 2007 — 70
(iii) Decision Not To Enforce Single Transaction Limit — 73
(d) The Board's Approval of Lehman's Growth Strategy — 76
(2) Lehman Doubles Down: Lehman Continues Its Growth Strategy Despite the Onset of the Subprime Crisis — 78
(a) Lehman's Residential Mortgage Business — 82
(i) Lehman Decides to Curtail Subprime Originations but Continue to Pursue "Alt‐A" Originations — 82
(ii) The March 20, 2007 Board Meeting — 90

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¶

(b) The Explosion in Lehman's Leveraged Loan Business — 95
(i) Relaxation of Risk Controls to Accommodate Growth of Lehman's Leveraged Loans Business — 97
(c) Internal Opposition to Growth of Leveraged Loans Business — 100
(d) Growth of Lehman's Commercial Real Estate Business at The Start of the Subprime Crisis — 103
(i) Relaxation of Risk Controls to Accommodate Growth of Lehman's Commercial Real Estate Business — 105
(ii) Internal Opposition to Growth of Commercial Real Estate Business — 107
(iii) Archstone — 108
a. Lehman's Commitment — 108
b. Risk Management of Lehman's Archstone Commitment — 112
(e) Nagioff's Replacement of Gelband as Head of FID — 114
(f) The Board of Directors' Awareness of Lehman's Increasing Risk Profile — 116
(3) Early Warnings: Risk Limit Overages, Funding Concerns, and the Deepening Subprime Crisis — 117
(a) Nagioff and Kirk Try to Limit Lehman's High Yield Business — 119
(b) July‐August 2007 Concerns Regarding Lehman's Ability to Fund Its Commitments — 123
(c) Lehman Delays the Archstone Closing — 128
(d) Lehman Increases the Risk Appetite Limit to Accommodate the Additional Risk Attributable to the Archstone Transaction — 131
(e) Cash Capital Concerns — 134
(f) Lehman's Termination of Its Residential Mortgage Originations — 138
(g) September, October, and November 2007 Meetings of Board of Directors — 139
(i) Risk Appetite Disclosures — 139
(ii) Leveraged Loan Disclosures — 144

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¶

(iii) Leverage Ratios and Balance Sheet Disclosures — 147
(iv) Liquidity and Capital Disclosures — 148
(4) Late Reactions: Lehman Slowly Exits Its Illiquid Real Estate Investments — 150
(a) Fiscal 2008 Risk Appetite Limit Increase — 152
(b) January 2008 Meeting of Board of Directors — 154
(c) Executive Turnover — 156
(d) Commercial Real Estate Sell‐Off: Too Little, Too Late — 157
(e) Lehman's Compensation Practices — 161
c) Analysis — 163
(1) 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 — 164
(a) Legal Standard — 164
(b) Background — 166
(i) Countercyclical Growth Strategy with Respect to Residential Mortgage Origination — 171
(ii) Lehman's Concentration of Risk in Its Commercial Real Estate Business — 172
(iii) Concentrated Investments in Leveraged Loans — 175
(iv) Firm‐Wide Risk Appetite Excesses — 179
(v) Firm‐Wide Balance Sheet Limits — 181
(vi) Stress Testing — 181
(vii) Summary: Officers' Duty of Care — 182
(2) 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 — 183
(3) The Examiner Does Not Find Colorable Claims That Lehman's Directors Breached Their Fiduciary Duty by Failing to Monitor Lehman's Risk‐Taking Activities — 188
(a) Lehman's Directors are Protected From Duty of Care Liability by the Exculpatory Clause and the Business Judgment Rule — 188

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¶

(b) Lehman's Directors Did Not Violate Their Duty of Loyalty — 190
(c) Lehman's Directors Did Not Violate Their Duty to Monitor — 191
(i) Application of Caremark to Risk Oversight: In re Citigroup Inc — 191
(ii) Application of Caremark and Citigroup to Lehman's Directors — 193

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¶III. EXAMINER'S CONCLUSIONS

Why Did Lehman Fail? Are There Colorable Causes of Action That Arise From Its Financial Condition and Failure?

Business and Risk Management

Executive Summary

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

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

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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.¹¹⁷¹¹⁷ Lehman, Update on Lehman Brothers' Subprime Mortgage Origination Business Presentation to Lehman Board of Directors (Mar. 20, 2007), at p. 5 [LBHI_SEC07940_025839]. BNC's and Aurora's continued mortgage originations increased the volume of illiquid assets on Lehman's balance sheet – albeit unintentionally – because Lehman became unable to securitize and distribute these mortgages to third parties.¹¹⁸¹¹⁸ Lehman, Securitized Products, MBS: Non Investment Grade Retained Interests (Jan. 16, 2007), at p. 1 [LBEX‐DOCID 839039]; Lehman, Update on Lehman Brothers' Subprime Mortgage Origination Business Presentation to Lehman Board of Directors [Draft] (Mar. 18, 2007), at p. 14 [LBEX‐DOCID 610173] ("Limited ability to sell below Investment Grade risk profitably in current environment"); Examiner's Interview of Matthew Miller, Sept. 24, 2009, at p. 2.Show full note

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

45

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

46

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

47

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

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

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

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

48

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

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

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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.¹³⁴¹³⁴ Id. The role of the risk limits and stress tests was to cause management to consider whether a particular investment or a broad business strategy was worth the risk it carried.¹³⁵¹³⁵ See id. In addition, Lehman used its risk management system to promote its capabilities to investors, rating agencies, and regulators.¹³⁶¹³⁶ Id. Lehman's management always retained the discretion to use its judgment to decide whether to pursue particular strategies or transactions.¹³⁷¹³⁷ See id.

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

50

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

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

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

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

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

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

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

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

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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.¹⁴⁶¹⁴⁶ Appendix No. 1, Legal Issues; In re Amer. Int'l Group, Inc., 965 A.2d 763, 806‐07 (Del. Ch. 2009) ("In colloquial terms, a fraud on the board has long been a fiduciary violation under our law and typically involves the failure of insiders to come clean to the independent directors about . . . information that the insiders fear will be used by the independent directors to take actions contrary to the insidersʹ wishes").Show full note

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

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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.¹⁴⁸¹⁴⁸ Sections III.A.1.b of this Report. Lehman's management also informed the Board, accurately, that the subprime mortgage crisis was constricting profitability and that management was tightening origination standards and taking other steps to address that crisis.¹⁴⁹¹⁴⁹ Section III.A.1.b of this Report.

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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.¹⁵⁰¹⁵⁰ See Appendix No. 8, Risk Management Organization and Controls. While the overall risk management of the firm is an appropriate topic for board consideration, the day‐to‐day decisions are primarily the responsibility of officers, not directors.¹⁵¹¹⁵¹ See 17 C.F.R. §§ 240.15c3‐1e & 15c3‐4 (2007) (requiring Lehman to submit a comprehensive description of its internal risk management control system to the SEC); NYSE, Inc., Listed Company Manual §303A(7)(c)(iii)(D) & cmt. (2010) (requiring audit committee of board to "discuss policies with respect to risk assessment and risk management" while noting that "it is the job of the CEO and senior management to assess and manage the company's exposure to risk").Show full note

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

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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.¹⁵³¹⁵³ In re Citigroup Inc. S'holder Litig., 964 A.2d 106, 126 (Del. Ch. 2009).

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

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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.¹⁵⁵¹⁵⁵ See DEL. CODE ANN. tit. 8, § 141(e) (2009). Consequently, there is insufficient evidence to establish a colorable claim that Lehman's directors breached their duty to monitor Lehman's management of its risks.

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

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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 Assets¹⁵⁶¹⁵⁶ Lehman defined net assets as total assets excluding: (1) cash and securities segregated and on deposit for regulatory and other purposes; (2) securities received as collateral; (3) securities purchases under agreements to resell; (4) securities borrowed; and (5) identifiable intangible assets and goodwill. Lehman Brothers Holdings Inc., Annual Report for 2007 10‐K as of Nov. 30, 2007 (Form 10‐K) (filed on Jan. 29, 2008), at p. 63.Show full note 268.936 300.797 337.667 357.102 372.959 396.673 327.774 Lehman's net assets increased by almost $128 billion or 48% in a little over a year – from the fourth quarter of 2006 through the first quarter of 2008.

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

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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:

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

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;

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

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

Facts

From Moving to Storage: Lehman Expands Its Principal Investments

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

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

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

Lehman's Changed Business Strategy

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

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

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

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

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

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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.¹⁷¹¹⁷¹ Less liquid investments were "Level 3." Level 1 assets have readily available markets to provide prices and liquidity, such as exchange‐traded equities. Level 2 assets have observable events to provide pricing, such as comparable sales. Level 3 assets have no readily available pricing mechanism and therefore are less liquid than Level 1 and 2 assets.

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

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

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

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

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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.¹⁸⁴¹⁸⁴ See Section III.A.4 of this Report.

Application of Risk Controls to Changed Business Strategy

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

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Stress Testing Exclusions

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

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

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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.¹⁹²¹⁹² Examiner's Interview of Paul Shotton, Oct. 16, 2009, at pp. 5‐6; Examiner's Interview of Jeffrey Goodman, Aug. 28, 2009. Because these assets did not trade freely, they were not considered susceptible to stress testing over a short‐term scenario.¹⁹³¹⁹³ Examiner's Interview of Jeffrey Goodman, Aug. 28, 2009. And since Lehman did not then have significant investments in these areas, excluding them from the stress testing did not undermine the usefulness of the results.¹⁹⁴¹⁹⁴ Examiner's Interview of Paul Shotton, Oct. 16, 2009, at pp. 5‐6. The SEC was aware of this exclusion.¹⁹⁵¹⁹⁵ Examiner's Interview of Matthew Eichner, Nov. 23, 2009, at p. 12; Examiner's Interview of Paul Shotton, Oct. 16, 2009, at p. 6.

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

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

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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.²⁰¹²⁰¹ See Section III.A.1.b of this Report.

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

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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.²⁰⁴²⁰⁴ Examiner's Interview of Mark Weber, Aug. 11, 2009, at p. 14; Examiner's Interview of Christopher M. O'Meara, Sept. 23, 2009, at p. 19. For a more detailed discussion of Lehman's stress testing, see Appendix 8, Risk Management Organization and Controls.

Risk Appetite Limit Increase For Fiscal 2007

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

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

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

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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.²¹⁷²¹⁷ Lehman Brothers, 2007 Risk Appetite Limit (Jan. 7, 2007), at p. 1 [LBEX‐DOCID 158938], attachment to e‐mail from Robert Azerad, Lehman, to Madelyn Antoncic, Lehman (Jan. 11, 2007) [LBEX‐DOCID 158331].

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

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

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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."²²²²²² Madelyn Antoncic, Lehman, "Standard" Risk Management Presentation (Undated), at p. 21 [LBEX‐ DOCID 194031], attached to e‐mail from Paul Shotton, Lehman, to Christopher M. O'Meara, Lehman (Feb. 20, 2008) [LBEX‐DOCID 214223]; Madelyn Antoncic, Lehman, "Standard" Risk Management Presentation, at p. 21 [LBEX‐DOCID 194031].

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

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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.²²⁷²²⁷ Examiner's Interview of Alex Kirk, Jan. 12, 2010, at pp. 7‐8. Antoncic also thought that the firm should continue to abide by the single transaction limit in part because the substantive terms of the leveraged loans were increasingly lopsided in favor of the private equity sponsors and unfavorable for the lending banks.²²⁸²²⁸ Examiner's Interview of Madelyn Antoncic, Mar. 27, 2009, at p. 9. Although Antoncic thought the firm should abide by the single transaction limit,²²⁹²²⁹ Id.; Examiner's Interview of Alex Kirk, Jan. 12, 2010, at pp. 6‐8. Kirk and Antoncic were overruled by Fuld, Gregory, and McGee.²³⁰²³⁰ Examiner's Interview of Alex Kirk, Jan. 12, 2010, at pp. 7‐8; Examiner's Interview of Madelyn Antoncic, Mar. 27, 2009, at p. 9.

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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.²³¹²³¹ Examiner's Interview of Sir. Christopher Gent, Oct. 21, 2009, at pp. 7‐8; Examiner's Interview of Thomas Cruikshank, Oct. 8, 2009, at pp. 2‐3; Examiner's Interview of Roland A. Hernandez, Oct. 2, 2009; Examiner's Interview of John D. Macomber, Sept. 28, 2009, at p. 12; Examiner's Interview of Michael L. Ainslie, Sept. 22, 2009, at p. 8; Examiner's Interview of Marsha Johnson Evans, May 22, 2009, at p. 12; Examiner's Interview of Dr. Henry Kaufman, May 19, 2009, at pp. 7‐8, 14; Examiner's Interview of Roger Berlind, May 8, 2009, at pp. 6‐7; Examiner's Interview of John F. Akers, Apr. 22, 2009, at p. 9.Show full note All of the directors told the Examiner that they agreed with Lehman's growth strategy at the time it was undertaken.²³²²³² Id..

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

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

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

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

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

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

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

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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.²⁵²²⁵² Lehman, Update on Lehman Brothers' Subprime Mortgage Origination Business Presentation to Lehman Board of Directors (Mar. 20, 2007), at pp. 5, 10 [LBHI_SEC07940_025834]; e‐mail from Dimitrios Kritikos, Lehman, to Jeffrey Goodman, Lehman (Feb. 2, 2007) [LBEX‐DOCID 566140] ("While the rest of the industry is tightening credit and increasing prices in these areas, we are moving in the opposite direction.").Show full note

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

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

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Lehman's Residential Mortgage Business

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

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

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

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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."²⁷⁰²⁷⁰ Lehman, Securitized Products, MBS: Non Investment Grade Retained Interests (Jan. 16, 2007), at p. 13 [LBEX‐DOCID 839039]. Lehman's diminished ability to shift the mortgage‐based risk to investors meant that the formerly profitable moving business could become a money‐losing storage business.²⁷¹²⁷¹ Id. at p. 1.

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

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

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

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

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

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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.²⁸⁶²⁸⁶ E‐mail from Dimitrios Kritikos, Lehman, to Jeffrey Goodman, Lehman (Jan. 31, 2007) [LBEX‐DOCID 380035].

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

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

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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.²⁹⁰²⁹⁰ Lehman, Securitized Products, MBS: Non Investment Grade Retained Interests (Jan. 16, 2007), at p. 3 [LBEX‐DOCID 839039]. And by March 2007, Lehman was noting sharp declines in securitization revenue,²⁹¹²⁹¹ Lehman, Mortgage Update 1Q 07, at p. 9 [LBHI_SEC07940_845984]. causing the Securitized Products Group within FID to exceed its risk appetite and VaR limits.²⁹²²⁹² See, e.g.,George Hansman, Lehman, Securitized Products Risk Appetite and VaR limit and overage graphs (May 17, 2007) [LBEX‐DOCID 861260]; e‐mail from Lehman Risk, to Lehman Risk Limit Excess e‐ mail group (Mar. 8, 2007) [LBEX‐DOCID 229930]; e‐mail from Lehman Risk, to Lehman Risk Limit Excess e‐mail group (Mar. 19, 2007) [LBEX‐DOCID 229944]; e‐mail from Lehman Risk, to Lehman Risk Limit Excess e‐mail group (Mar. 22, 2007) [LBEX‐DOCID 229954]; e‐mail from Lehman Risk, to Lehman Risk Limit Excess e‐mail group (Apr. 9, 2007) [LBEX‐DOCID 790039]; e‐mail from Lehman Risk, to Lehman Risk Limit Excess e‐mail group (Apr.16, 2007) [LBEX‐DOCID 790029]; e‐mail from Lehman Risk, to Lehman Risk Limit Excess e‐mail group (May 29, 2007) [LBEX‐DOCID 790059]; e‐mail from Lehman Risk, to Lehman Risk Limit Excess e‐mail group (May 30, 2007) [LBEX‐DOCID 790060]; e‐mail from Lehman Risk, to Lehman Risk Limit Excess e‐mail group (Sept. 5, 2007) [LBEX‐DOCID 230188]; e‐mail from Lehman Risk, to Lehman Risk Limit Excess e‐mail group (Oct. 12, 2007) [LBEX‐DOCID 230789903]; e‐mail from Lehman Risk, to Lehman Risk Limit Excess e‐mail group (Oct. 17, 2007) [LBEX‐DOCID 789908]; e‐ mail from Lehman Risk, to Lehman Risk Limit Excess e‐mail group (Oct. 18, 2007) [LBEX‐DOCID 789910]; e‐mail from Lehman Risk, to Lehman Risk Limit Excess e‐mail group (Oct. 19, 2007) [LBEX‐DOCID 789909]; e‐mail from Lehman Risk, to Lehman Risk Limit Excess e‐mail group (Oct. 22, 2007) [LBEX‐ DOCID 790089]; e‐mail from Lehman Risk, to Lehman Risk Limit Excess e‐mail group (Oct. 30, 2007) [LBEX‐DOCID 789916].Show full note

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

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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.²⁹⁵²⁹⁵ Lehman Brothers Holdings Inc., Minutes of Meeting of Board of Directors (Mar. 20, 2007), at pp. 6‐7 [LBHI_SEC07940_025779]; Lehman, Update on Lehman Brothers' Subprime Mortgage Origination Business Presentation to Lehman Board of Directors (Mar. 20, 2007) [LBHI_SEC07940_025834]. The presentation was given by David N. Sherr, the head of Lehman's Securitized Products Group; Theodore P. Janulis, the head of the Mortgage Capital Division; and Lana Franks Harber, Chief Administrative Officer ("CAO") of the Mortgage Capital Division.²⁹⁶²⁹⁶ Lehman, Update on Lehman Brothers' Subprime Mortgage Origination Business Presentation to Lehman Board of Directors (Mar. 20, 2007) [LBHI_SEC07940_025834]; Examiner's Interview of Lana Franks Harber, Sept. 23, 2009, at p. 2; Examiner's Interview of Theodore P. Janulis, Sept. 25, 2009, at p. 2; Examiner's Interview of David N. Sherr, Sept. 25, 2009, at p. 9.

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

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

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

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

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

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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.³¹⁰³¹⁰ Examiner's Interview of Lana Franks Harber, Sept. 23, 2009, at p. 3; Examiner's Interview of Theodore P. Janulis, Sept. 25, 2009, at pp. 2, 7; Examiner's Interview of David N. Sherr, Sept. 25, 2009, at p. 7. The Lehman risk analyst who had studied the performance issues in Mortgage Maker told the Examiner that leaving Mortgage Maker out of a presentation on subprime was proper given the differences between what Lehman considered subprime (FICO scores below 620) and Mortgage Maker (average FICO score of 691).³¹¹³¹¹ Examiner's Interview of Dimitrios Kritikos, July 29‐30, 2009, at p. 19.

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

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

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

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

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

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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.³²⁸³²⁸ Alex Kirk, Lehman, Leveraged Finance Risk Presentation (June 2007) [LBEX‐DOCID 158975], attached to e‐mail from Olivia Lua, Lehman, to Christopher M. O'Meara, Lehman (June 21, 2007) [LBEX‐DOCID 158975]. FID was almost $20 billion over its net balance sheet limit for the quarter.³²⁹³²⁹ Lehman Brothers, Balance Sheet Trend Presentation (Apr. 2007), at pp. 4‐6 [LBEX‐DOCID 251418], attached to e‐mail from Kentaro Umezaki, Lehman, to Rebecca Miller, Lehman (May 3, 2007) [LBEX‐ DOCID 346520]. Relatedly, as described below, Lehman soon vastly exceeded its risk appetite limits for the high yield business.

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

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

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

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

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

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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.³⁴³³⁴³ Id. (emphasis added); e‐mail from Kentaro Umezaki, Lehman, to Ian T. Lowitt, Lehman (Apr. 18, 2007) [LBEX‐DOCID 743931].

Internal Opposition to Growth of Leveraged Loans Business

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

107

Internal Opposition to Growth of Commercial Real Estate Business

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

108

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

Archstone

Lehman's Commitment

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

109

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

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

110

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

111

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

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

112

Risk Management of Lehman's Archstone Commitment

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

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

113

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

114

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

Nagioff's Replacement of Gelband as Head of FID

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

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

115

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

116

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

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

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

117

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

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

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

118

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

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

119

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

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

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

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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."⁴³⁹⁴³⁹ E‐mail from Steven Berkenfeld, Lehman, to Roger Nagioff, Lehman (May 10, 2007) [LBEX‐DOCID 140669]; e‐mail from Roger Nagioff, Lehman, to Ian T. Lowitt, Lehman (May 10, 2007) [LBEX‐DOCID 140666]; e‐mail from Christopher M. O'Meara, Lehman, to Paulo R. Tonucci, Lehman (Apr. 6, 2007) [LBEX‐DOCID 1349076]; e‐mail from Christopher M. O'Meara, Lehman, to Ian T. Lowitt, Lehman (July 21, 2007) [LBEX‐DOCID 211149].Show full note Months later, Antoncic, for example, reflected back on the general consensus that the markets were in trouble: "every one saw the train wreck coming. 64k question is why didn't anyone get out of the way???"⁴⁴⁰⁴⁴⁰ E‐mail from Madelyn Antoncic, Lehman, to Jack Malvey, Lehman (Apr. 8, 2008) [LBHI_SEC07940_212356].

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

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

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

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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 2007.⁴⁴⁸⁴⁴⁸ E‐mail from Steven Berkenfeld, Lehman, to Scott J. Freidheim, Lehman (June 26, 2007) [LBEX‐DOCID 1819424]; Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at p. 13. The cross‐firm initiative entailed developing more specific and effective limits on Lehman's high yield business (including single transaction limits) and bridge equity, and developing a plan for reducing the existing exposures.⁴⁴⁹⁴⁴⁹ Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at p. 13.

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

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

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

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

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

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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.⁴⁵⁹⁴⁵⁹ Examiner's Interview of Kentaro Umezaki, June 25, 2009, at p. 16; Examiner's Interview of Roger Nagioff, Sept. 30, 2009, at p. 9; Examiner's Interview of Alex Kirk, Jan. 12, 2010, at p. 12. In addition, the firm had "effectively been locked out of the capital markets."⁴⁶⁰⁴⁶⁰ E‐mail from Nahill Younis, Lehman, to Paolo R. Tonucci, Lehman (July 11, 2007) [LBEX‐DOCID 1901826].

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

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

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

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

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

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

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

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

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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.⁴⁷⁸⁴⁷⁸ Lehman, Loan Syndicate/Year‐End Recap (Jan. 4, 2008), at p. 5. [LBHI_SEC07940_066190]. Lehman's leveraged loan commitments thus halted in early August 2007, three months after Nagioff first concluded that Lehman's exposure was already "gargantuan," and two months after Nagioff's first conversation with Fuld about the issue.

Lehman Delays the Archstone Closing

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

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

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

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

¶Permanent equity $250 million

¶Bridge equity $2.14 billion

¶Mezzanine loan $240 million

¶Term loan $2.47 billion

¶Senior debt $850 million

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

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

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

132

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

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

133

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

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

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Cash Capital Concerns

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

135

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

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

136

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

137

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

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

138

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

Lehman's Termination of Its Residential Mortgage Originations

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

139

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

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

Risk Appetite Disclosures

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

140

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

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

141

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

142

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

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

143

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

144

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

4.5 Period between RA excess and Board notification

¶4.0

¶3.5

¶3.0

¶$ in Billions

¶2.5

¶2.0

¶1.5

¶1.0

¶0.5

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

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

¶Firm‐wide Usage Firm‐wide Limit

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

Leveraged Loan Disclosures

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

145

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

146

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

147

Leverage Ratios and Balance Sheet Disclosures

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

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

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

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

148

Liquidity and Capital Disclosures

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

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

149

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

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

150

Late Reactions: Lehman Slowly Exits Its Illiquid Real Estate Investments

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

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

151

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

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

152

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

Fiscal 2008 Risk Appetite Limit Increase

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

153

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

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

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

154

January 2008 Meeting of Board of Directors

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

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

155

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

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

156

Executive Turnover

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

157

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

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

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

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

158

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

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

159

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

160

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

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

161

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

Lehman's Compensation Practices

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

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

162

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

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

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

163

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

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

Analysis

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

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

164

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

Legal Standard

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

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

165

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

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

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

166

Background

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

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

167

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

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

168

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

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

169

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

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

170

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

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

171

Countercyclical Growth Strategy with Respect to Residential Mortgage Origination

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

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

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

172

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

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

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

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

173

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

174

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

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

175

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

Concentrated Investments in Leveraged Loans

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

176

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

177

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

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

¶

Houghton Mifflin Riverdeep Group 7/16/2007 1,389 — 694
TXU Corp 2/26/2007 1,368 — 684
First Data Corporation 4/2/2007 1,203 — 601
Alcoa Inc. 5/24/2007 1,200 — 600
Home Depot Supply 6/19/2007 971 — 486
CDW Corporation 5/29/2007 909 — 455
Dollar General 3/1/2007 882 — 441
Harman International Industries 4/25/2007 692 — 346
US FoodService ‐ 651 — 326
CVS 1/16/2007 600 — 300
BCE 6/29/2007 553 — 277
BAWAG PSK 3/1/2007 550 — 275
Tognum AG ‐ 515 — 258
ProSiebenSat.1 Media AG 1/31/2007 500 — 250
CBS Corporation ‐ 476 — 238
West Corp ‐ 465 — 232
IBM International Group BV ‐ 440 — 220
Sequa Corp 6/18/2007 431 — 216
Tesoro 4/10/2007 431 — 215
Alliance Data 5/31/2007 424 — 212
Applebee's International, Inc. 7/16/2007 403 — 202
Allison Transmission 5/21/2007 390 — 195
Dockwise ‐ 388 — 194
Univision Communications 7/14/2006 387 — 193
PHH Corporation 3/15/2007 386 — 193
Formula One Group ‐ 378 — 189
United Rentals, Inc. 7/22/2007 372 — 186
Thermo Electron Corp. 5/7/2006 360 — 180
National Beef Packing Co. 5/11/2007 335 — 168
Bulgarian Telecommunications 3/28/2007 327 — 164
Endemol Holdings 5/11/2007 322 — 161
Linde Material Handling Group ‐ 293 — 146
Pinnacle Foods 2/10/2007 277 — 138
The Klockner Pentaplast Group ‐ 276 — 138
Guitar Center, Inc. 6/20/2007 263 — 132

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

178

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

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

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

179

Firm‐Wide Risk Appetite Excesses

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

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

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

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

180

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

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

181

Firm‐Wide Balance Sheet Limits

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

Stress Testing

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

182

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

Summary: Officers' Duty of Care

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

183

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

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

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

184

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

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

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

185

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

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

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

186

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

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

187

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

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

188

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

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

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

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

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

189

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

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

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

190

Lehman's Directors Did Not Violate Their Duty of Loyalty

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

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

191

Lehman's Directors Did Not Violate Their Duty to Monitor

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

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

Application of Caremark to Risk Oversight: In re Citigroup Inc

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

192

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

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

¶...

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

193

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

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

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

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

Application of Caremark and Citigroup to Lehman's Directors

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

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

194

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

195

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

727

¶

TABLE OF CONTENTS 4. Repo 105 — 732
a) Repo 105 – Executive Summary — 732
b) Introduction — 750
c) Why the Examiner Investigated Lehman's Use of Repo 105 Transactions — 764
d) A Typical Repo 105 Transaction — 765
(1) The Genesis of Lehman's Repo 105 Program in 2001 — 765
(2) Repo 105 Transactions Versus Ordinary Repo Transactions — 766
(a) Lehman's Accounting Treatment of Repo 105 Transactions Versus Ordinary Repo Transactions — 768
(b) Lehman's Accounting Policy for Repo 105 Transactions — 775
(c) The Accounting Purpose of the Larger Haircut — 777
(d) Lehman Did Not Record a Cash Borrowing but Recorded a Derivative Asset in a Repo 105 Transaction — 781
(3) Anatomy of Repo 105 Transactions and the Linklaters True Sale Opinion Letter — 782
(4) Types of Securities Used in Repo 105 Transactions — 793
(5) Product Controllers Manually Booked Repo 105 Transactions — 797
e) Managing Balance Sheet and Leverage — 800
(1) Lehman Management's Focus in Late 2007 on Reducing the Firm's Reported Leverage — 802
(a) Lehman's Calculation of Net Leverage — 804
(2) By January 2008, Lehman Decided to Cut its Net Leverage in Half to Win Back the Confidence of the Market, Lenders and Investors — 805
(a) Bart McDade, as Newly Appointed Balance Sheet Czar, Advised the Executive Committee in March 2008 to Cap Lehman's Use of Repo 105 Transactions — 809
(b) McDade Became President and COO on June 12, 2008 and Authorized the Reduction of Repo 105 Usage — 819
(3) The Market's Increased Scrutiny of the Leverage of Investment Banks — 822
(a) The Cost of Deleveraging — 825

728

¶

(4) "Sticky" Inventory and FID's Balance Sheet Breaches Hampered Lehman's Ability to Manage Its Net Leverage — 828
(5) Deleveraging Resulted in Intense Pressure at Quarter‐End to Meet Balance Sheet Targets for Reporting Purposes — 843
(6) Lehman's Earnings Calls and Press Release Statements Regarding Leverage — 845
(a) Analysts' Statements Regarding Lehman's Leverage — 850
f) The Purpose of Lehman's Repo 105 Program Was to Reverse Engineer Publicly Reported Financial Results — 853
(1) Lehman Did Not Disclose Its Accounting Treatment For or Use of Repo 105 Transactions in Its Forms 10‐K and 10‐Q — 853
(a) Lehman's Outside Disclosure Counsel Was Unaware of Lehman's Repo 105 Program — 855
(2) Lehman's Repo 105 Practice Improved the Firm's Public Balance Sheet Profile at Quarter‐End — 856
(a) Contemporaneous Documents Confirm That Lehman Undertook Repo 105 Transactions to Reduce Its Balance Sheet and Reverse Engineer Its Leverage — 859
(b) Witness Statements to the Examiner Regarding the True Purpose of Lehman's Repo 105 Practice — 867
(3) Quarter‐End Spikes in Lehman's Repo 105 Usage Also Suggest the True Purpose of Lehman's Repo 105 Practice Was Balance Sheet Manipulation — 870
(4) Repo 105 Transactions Served No Business Purpose Other Than Balance Sheet Reduction — 877
(a) Repo 105 Transactions Came at a Higher Cost Than Ordinary Repo Transactions — 877
(b) Witnesses Also Stated That Financing Was Not the Real Motive for Undertaking Repo 105 Transactions — 882
g) The Materiality of Lehman's Repo 105 Practice — 884
(1) The Repo 105 Program Exposed Lehman to Potential "Reputational Risk" — 884
(2) Lehman's Repo 105 Practice Had a Material Impact on Lehman's Net Leverage Ratio — 888
(a) Lehman Significantly Expanded Its Repo 105 Practice in Late 2007 and Early 2008 — 890

729

¶

(3) Balance Sheet Targets for FID Businesses Were Unsustainable Without the Use of Repo 105 Transactions — 899
(4) Rating Agencies Advised the Examiner that Lehman's Accounting Treatment and Use of Repo 105 Transactions to Manage Its Net Leverage Ratio Would Have Been Relevant Information — 902
(5) Government Regulators Had No Knowledge of Lehman's Repo 105 Program — 910
(a) Officials from the Federal Reserve Bank Would Have Wanted to Know about Lehman's Use of Repo 105 Transactions — 910
(b) Securities and Exchange Commission CSE Monitors Were Unaware of Lehman's Repo 105 Program — 913
h) Knowledge of Lehman's Repo 105 Program at the Highest Levels of the Firm — 914
(1) Richard Fuld, Former Chief Executive Officer — 917
(2) Lehman's Former Chief Financial Officers — 921
(a) Chris O'Meara, Former Chief Financial Officer — 921
(b) Erin Callan, Former Chief Financial Officer — 930
(c) Ian Lowitt, Former Chief Financial Officer — 937
(3) Lehman's Board of Directors — 945
i) Ernst & Young's Knowledge of Lehman's Repo 105 Program — 948
(1) Ernst & Young's Comfort with Lehman's Repo 105 Accounting Policy — 948
(2) The "Netting Grid" — 951
(a) Quarterly Review and Audit — 953
(3) Ernst & Young Would Not Opine on the Materiality of Lehman's Repo 105 Usage — 954
(4) Matthew Lee's Statements Regarding Repo 105 to Ernst & Young — 956
(5) Accounting‐Motivated Transactions — 962
j) The Examiner's Conclusions — 962
(1) Materiality — 963
(a) Whether Lehman's Repo 105 Transactions Technically Complied with SFAS 140 Does Not Impact Whether a Colorable Claim Exists — 964

730

¶

(2) Disclosure Requirements and Analysis — 967
(a) Disclosure Obligations: Regulation S‐K and the MD&A — 968
(b) Duty to Disclose — 972
(c) Lehman's Public Filings — 973
(i) Summary of Lehman's 2000 through 2007 Public Filings — 974
(ii) Lehman's 2007 Form 10‐K, First Quarter 2008 Form 10‐Q, and Second Quarter 2008 Form 10‐Q — 977
a. Treatment of Repo Transactions and SFAS 140 — 978
b. Net Leverage — 980
c. Derivatives — 981
d. A Reader of Lehman's Forms 10‐K and 10‐Q Would Not Have Been Able to Ascertain That Lehman Engaged in Temporary Sales Using Liquid Securities — 984
(d) Conclusions Regarding Lehman's Failure to Disclose — 985
(3) Colorable Claims — 990
(4) Fiduciary Duty Claims — 991
(a) Breach of Fiduciary Duty Claims Against Board of Directors — 991
(b) Breach of Fiduciary Duty Claims Against Specific Lehman Officers — 992
(i) Richard Fuld — 996
a. There Is Sufficient Evidence to Support a Finding By the Trier of Fact That Fuld Was at Least Grossly Negligent in Causing Lehman to File Misleading Periodic Reports — 997
(ii) Chris O'Meara — 1002
a. There Is Sufficient Evidence To Support a Colorable Claim That O'Meara Was at Least Grossly Negligent in Allowing Lehman to File Misleading Financial Statements and Engage in Material Volumes of Repo 105 Transactions — 1007

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

731

¶

Board and His Superiors of Lehman's Repo 105 Practice — 1009
(iii) Erin Callan — 1013
a. There Is Sufficient Evidence To Support a Finding By the Trier of Fact That Callan Breached Her Fiduciary Duties by Causing Lehman to Make Materially Misleading Statements — 1017
b. There Is Sufficient Evidence to Support a Colorable Claim That Callan Breached Her Fiduciary Duty of Care by Failing to Inform the Board of Directors of Lehman's Repo 105 Program — 1019
(iv) Ian Lowitt — 1021
(c) Remedies — 1024
(5) Malpractice Claims Against Ernst & Young — 1027
(a) Background and Legal Standards — 1028
(i) Professional Standards — 1028
(ii) Common Law Standards — 1031
(b) There Is Sufficient Evidence to Support a Colorable Claim That Ernst & Young Was Negligent — 1032
(i) Malpractice in Failure to Advise Audit Committee of Repo 105 Activity and Lee's Allegations — 1033
(ii) Lehman's 2008 Forms 10‐Q — 1040
(iii) Lehman's 2007 Form 10‐K — 1048
(iv) Effect on Prior Filings — 1050
(v) Causation and Damages — 1051
(c) Possible Defenses — 1053

732

Repo 105

Repo 105 – Executive Summary

¶Lehman employed off‐balance sheet devices, known within Lehman as "Repo 105" and "Repo 108" transactions, to temporarily remove securities inventory from its balance sheet, usually for a period of seven to ten days, and to create a materially misleading picture of the firm's financial condition in late 2007 and 2008.²⁸⁴⁷²⁸⁴⁷ Unless otherwise noted, the Report uses the term "Repo 105" to refer to both Repo 105 and Repo 108 transactions. Lehman treated the two transactions identically under the same internal accounting policy and both transactions shared the same anatomy. They differed only in that Repo 105 transactions utilized fixed income securities and required a minimum five percent overcollateralization amount (i.e., a minimum of $105 worth of securities in exchange for $100 cash borrowed) while Repo 108 transactions utilized equities securities and required a minimum eight percent overcollateralization amount (i.e., a minimum of $108 worth of securities in exchange for $100 cash borrowed).Show full note Repo 105 transactions were nearly identical to standard repurchase and resale ("repo") transactions that Lehman (and other investment banks) used to secure short‐term financing, with a critical difference: Lehman accounted for Repo 105 transactions as "sales" as opposed to financing transactions based upon the overcollateralization or higher than normal haircut in a Repo 105 transaction.²⁸⁴⁸²⁸⁴⁸ Sale and repurchase agreements ("repos") are agreements where one party transfers an asset or security to another party as collateral for a short‐term borrowing of cash, while simultaneously agreeing to repay the cash and take back the collateral at a specific point in time. When the repo transaction matures, the borrower repays the funds plus an agreed upon interest rate and takes back its collateral. As explained in Section III.A.4.d.2.c of the Report, overcollateralization amounts, or haircuts, in Repo 105 transactions were higher than the typical haircut applied to ordinary repos using similar securities.Show full note By recharacterizing the Repo 105 transaction as a "sale," Lehman removed the inventory from its balance sheet.²⁸⁴⁹²⁸⁴⁹ Lehman Brothers Holdings Inc., Accounting Policy Manual Repo 105 and Repo 108 (Feb. 13, 2008), at p. 2 [LBEX‐DOCID 3213297]; ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS OF LIABILITIES, Statement of Financial Accounting Standards No. 140, ¶¶ 2, 98 (Fin. Accounting Standards Bd. 2000) ("SFAS 140"). The accounting for a Repo 105 transaction began with the same entries as an ordinary repo; additional entries were then made to recharacterize the Repo 105 from a secured financing to a sale of an inventory security.Show full note

733

¶Lehman regularly increased its use of Repo 105 transactions in the days prior to reporting periods to reduce its publicly reported net leverage and balance sheet.²⁸⁵⁰²⁸⁵⁰ See Sections III.A.4.f.2–4 and III.A.4.g.2 of this Report. Lehman's periodic reports did not disclose the cash borrowing from the Repo 105 transaction – i.e., although Lehman had in effect borrowed tens of billions of dollars in these transactions, Lehman did not disclose the known obligation to repay the debt.²⁸⁵¹²⁸⁵¹ See Sections III.A.4.d.2.d and III.A.4.j.2.c of this Report. Lehman used the cash from the Repo 105 transaction to pay down other liabilities, thereby reducing both the total liabilities and the total assets reported on its balance sheet and lowering its leverage ratios.²⁸⁵²²⁸⁵² Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 7 (stating that incoming cash from Repo 105 transactions was used to pay business expenses); Examiner's Interview of Edward Grieb, Oct. 2, 2009, at pp. 13‐14 (stating that cash received in Repo 105 transactions was used to pay off other liabilities); Examiner's Interview of Matthew Lee, July 1, 2009, at p. 14 (explaining that in order for Lehman to realize the benefit to its leverage ratios as a result of Repo 105 transactions, the firm had to use the cash received to pay off a different liability); e‐mail from Anuraj Bismal, Lehman, to Marie Stewart, Lehman, et al. (Dec. 5, 2007) [LBEX‐DOCID 3223384] (stating the effect of Repo 105 on net leverage ratio, which could only be impacted if Lehman used Repo 105 cash to pay down different liabilities). Given that Lehman undertook $38.6 billion, $49.1 billion, and $50.38 billion of Repo 105 transactions at quarter‐end fourth quarter 2007, first quarter 2008, and second quarter 2008, respectively, Lehman's disclosures of its cash holdings at each quarter‐end further strengthens the witness statements and other evidence that Lehman used the Repo 105 cash borrowing for other business purposes, including to pay down other short‐term liabilities. See Lehman Brothers Holdings Inc., Annual Report for 2007 as of Nov. 30, 2007 (Form 10‐K) (filed on Jan. 29, 2008), at p. 86 ("LBHI 2007 10‐K") (reporting that Lehman had $7.286 billion in cash and cash equivalents on November 30, 2007); Lehman Brothers Holdings Inc., Quarterly Report as of Feb. 29, 2008 (Form 10‐Q) (filed on Apr. 9, 2008), at p. 5 ("LBHI 10‐Q (filed Apr. 9, 2008)") (reporting that Lehman had $7.564 billion in cash and cash equivalents on February 29, 2008); Lehman Brothers Holdings Inc., Quarterly Report as of May 31, 2008 (Form 10‐Q) (filed on July 10, 2008), at p. 5 ("LBHI 10‐Q (filed July 10, 2008)") (reporting that Lehman had $6.513 billion in cash and cash equivalents on May 31, 2008). While Lehman's Repo 105 transactions spiked at quarter‐ends, Lehman's ordinary repo balances dropped off significantly during the same time periods. See Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), at p. 5.Show full note Thus, Lehman's Repo 105 practice consisted of a two‐step process: (1) undertaking Repo 105 transactions followed by (2) the use of Repo 105 cash borrowings to pay down liabilities, thereby reducing leverage. A few days after the new quarter began, Lehman would borrow the necessary funds to repay the cash borrowing plus interest, repurchase the securities, and restore the assets to its balance sheet.²⁸⁵³²⁸⁵³ Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), at p. 4; see also Lehman Brothers Holdings Inc., Accounting Policy Manual Repo 105 and Repo 108 (Feb. 13, 2008), at p. 2 [LBEX‐DOCID 3213297].

734

¶Lehman never publicly disclosed its use of Repo 105 transactions, its accounting treatment for these transactions, the considerable escalation of its total Repo 105 usage in late 2007 and into 2008, or the material impact these transactions had on the firm's publicly reported net leverage ratio.²⁸⁵⁴²⁸⁵⁴ Examiner's Interview of Marie Stewart, Sept. 2, 2009, at p. 15; Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 9; Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 14; Examiner's Interview of Matthew Lee, July 1, 2009, at p. 15; see also Sections III.A.4.f.1 and III.A.4.j.2.c–d of this Report (discussing Lehman's Forms 10‐K and 10‐Q). In its Forms 10‐K and 10‐Q, Lehman defined its "net leverage ratio" as net assets divided by tangible equity capital. Lehman defined net assets as total assets excluding: (1) cash and securities segregated and on deposit for regulatory and other purposes; (2) securities received as collateral; (3) securities purchases under agreements to resell; (4) securities borrowed; and (5) identifiable intangible assets and goodwill. LBHI 2007 10‐K, at p. 63; LBHI 10‐Q (filed Apr. 9, 2008), at p. 72; LBHI 10‐ Q (filed July 10, 2008), at p. 88. Lehman calculated tangible equity capital by including stockholders' equity and junior subordinated notes and excluding identifiable intangible assets and goodwill. See LBHI 2007 10‐K (Nov. 30, 2007), at p. 63; LBHI 10‐Q (filed Apr. 9, 2008), at p. 72; LBHI 10‐Q (filed July 10, 2008), at p. 88. In contrast, Lehman's "leverage ratio" was generally computed by simply dividing total assets by stockholders' equity. The Examiner's conclusion that Lehman never disclosed its Repo 105 practice was confirmed by several Lehman witnesses, including two former Global Financial Controllers who oversaw the preparation of the Forms 10‐K and 10‐Q. Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 9; Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 14.; see also Section III.A.4.j.2 of this Report, infra (containing Examiner's analysis of Lehman's Form 10‐K and Form 10‐Q disclosures). This Report does not reach the question whether Lehman's Repo 105 transactions technically complied with the relevant financial accounting standard, SFAS 140. As set forth below, the answer to that question does not impact whether there is sufficient evidence to support a colorable claim regarding Lehman's failure to disclose its Repo 105 practice and whether that failure rendered the firm's periodic reports materially misleading.Show full note According to former Global Financial Controller Martin Kelly, a careful review of Lehman's Forms 10‐K and 10‐Q would not reveal Lehman's use of Repo 105 transactions.²⁸⁵⁵²⁸⁵⁵ Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 9. Lehman failed to disclose its Repo 105 practice even though Kelly believed "that the only purpose or motive for the transactions was reduction in balance sheet;" felt that "there was no substance to the transactions;" and expressed concerns with Lehman's Repo 105 program to two consecutive Lehman Chief Financial Officers – Erin Callan and Ian Lowitt – advising them that the lack of economic substance to Repo 105 transactions meant "reputational risk" to Lehman if the firm's use of the transactions became known to the public.²⁸⁵⁶²⁸⁵⁶ Id. at pp. 7‐10. In addition to its material omissions, Lehman affirmatively misrepresented in its financial statements that the firm treated all repo transactions as financing transactions – i.e., not sales – for financial reporting purposes.²⁸⁵⁷²⁸⁵⁷ The Notes to Lehman's Consolidated Financial Statements for each period stated that Lehman treated "[r]epurchase and resale agreements" as "collateralized agreements and financings for financial reporting purposes." See LBHI 2007 10‐K, at p. 97; LBHI 10‐Q (filed Apr. 9, 2008), at p. 13; LBHI 10‐Q (filed July 10, 2008), at p. 16. The Notes further stated that "Other secured borrowings principally reflect transfers accounted for as financings rather than sales under SFAS 140." LBHI 2007 10‐K, at p. 97; LBHI 10‐Q (filed Apr. 9, 2008), at p. 13; LBHI 10‐Q (filed July 10, 2008), at p. 16.Show full note

735

¶Starting in mid‐2007, Lehman faced a crisis: market observers began demanding that investment banks reduce their leverage.²⁸⁵⁸²⁸⁵⁸ Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at pp. 5‐6; Mark Jickling, Averting Financial Crisis, CRS Report for Congress, at 7‐9 (Mar. 10, 2008, updated on Oct. 8, 2008). The inability to reduce leverage could lead to a ratings downgrade, which would have had an immediate, tangible monetary impact on Lehman.²⁸⁵⁹²⁸⁵⁹ A downgrade in an issuer's credit rating has a significant negative impact on the financial position of a company like Lehman. See, e.g., e‐mail from Ian T. Lowitt, Lehman, to Herbert H. (Bart) McDade III, Lehman (June 30, 2008) [LBHI_SEC07940_643543] ("One notch downgrade requires 1.7 bn; and 2 notch requires 3.4 bn of additional margin posting."). Counterparties may respond to a downgrade by demanding that the issuer post additional cash collateral to secure its obligations. See Amadou N.R. Sy, The Systemic Regulation of Credit Rating Agencies and Rated Markets 8‐9 (Int'l Monetary Fund, Working Paper, 2009) (noting that broker‐dealers may use credit ratings to determine acceptable counterparties, as well as collateral levels for outstanding credit exposure); e‐mail from Ian T. Lowitt, Lehman, to Eric Felder, Lehman (July 5, 2008) [LBEX‐DOCID 071263] (stating that a downgrade "will affect lines and willingness of counterparties to fund secured"). Some of Lehman's derivative contracts had built‐in "triggers" permitting counterparties to require additional cash collateral in the event of a downgrade. See also Lehman, Global Treasury Downgrade Effect on Cash Capital Facilities (June 3, 2008) [LBHI_SEC07940_513314] (attached to e‐mail from Amberish Ratanghayra, Lehman, to Paolo R. Tonucci, Lehman, et al. (June 3, 2008) [LBHI_SEC07940_513312]); see also Appendix 13, Survival, at pp. 1‐3.Show full note In a September 2007 e‐mail comparing Lehman's net leverage ratio to Bear Stearns', Paolo Tonucci, Lehman's Global Treasurer, wrote that Lehman's net leverage calculation "was intended to reflect the methodology employed by S&P who were most interested and focused on leverage."²⁸⁶⁰²⁸⁶⁰ E‐mail from Paolo R. Tonucci, Lehman, to Marie Stewart, Lehman, et al. (Sept. 10, 2007) [LBEX‐DOCID 1695576]. In mid‐to‐late 2007, top Lehman executives from across the firm felt pressure to reduce the firm's leverage for quarterly and annual reports.²⁸⁶¹²⁸⁶¹ E‐mail from Ian T. Lowitt, Lehman, to Gerard Reilly, Lehman, et al. (Sept. 7, 2007) [LBEX‐DOCID 1357178]; e‐mail from Ryan Traversari, Lehman, to Paolo R. Tonucci, Lehman, et al. (Sept. 11, 2007) [LBEX‐DOCID 1695576]; see Sections III.A.4.e.1–3, 6 of this Report (discussing importance of net leverage for public perception of Lehman and for reporting purposes) In response to Tonucci's September 2007 e‐mail, Ryan Traversari, Senior Vice President for External Reporting, wrote that the "question" of net leverage ratio "has come up multiple times in the 20 seconds that I've been here – largely from [then‐CFO] O'Meara, Freidheim, Lowitt, Corporate Strategy, Investor Relations and the like."²⁸⁶²²⁸⁶² E‐mail from Ryan Traversari, Lehman, to Paolo R. Tonucci, Lehman (Sept. 11, 2007) [LBEX‐DOCID 1695576].

736

¶By January 2008, Lehman CEO Fuld ordered a firm‐wide deleveraging strategy, hoping to reduce the firm's positions in commercial and residential real estate and leveraged loans in particular by half.²⁸⁶³²⁸⁶³ Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at pp. 26‐27. In the words of one internal Lehman presentation, "Reducing leverage is necessary to remove refinancing risk and win back the confidence of the market, lenders, and investors."²⁸⁶⁴²⁸⁶⁴ ErinCallan, Lehman, Lehman Brothers Leverage Analysis (Apr. 7, 2008), at p. 1 [LBEX‐DOCID 1401225].

737

¶Fuld recalled that Lehman had to improve its net leverage ratio by selling inventory because "there was a perception issue" with raising equity.²⁸⁶⁵²⁸⁶⁵ Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at p. 27. According to Fuld, if Lehman had raised equity, it would have improved net leverage, but would not have fixed Lehman's underlying problem. Id. Fuld stated that he wanted Lehman to improve its net leverage by selling assets. Id. Selling inventory, however, proved difficult in late 2007 and into 2008 because, starting in mid‐ 2007, many of Lehman's inventory positions had grown increasingly "sticky" – i.e., difficult to sell without incurring substantial losses. Moreover, selling sticky inventory at reduced prices could have led to a loss of market confidence in Lehman's valuations for inventory remaining on the firm's balance sheet since fire‐sale pricing would reveal that Lehman "had a lot of air in [its] marks."²⁸⁶⁶²⁸⁶⁶ Examiner's Interview of Treasury Secretary Timothy F. Geithner, Nov. 24, 2009, at pp. 7‐8.

¶In light of these factors, Lehman relied at an increasing pace on Repo 105 transactions at each quarter‐end in late 2007 and early 2008. Lehman's expansion of its Repo 105 program mitigated, in part, the adverse impact its increasingly "sticky"/illiquid inventory – comprised mostly of the leveraged loans and residential and commercial real estate positions Fuld wanted to exit – was having on the firm's publicly reported net leverage and net balance sheet.²⁸⁶⁷²⁸⁶⁷ See Section III.A.4.e.4 of this Report (discussing sticky inventory). The concept of "net balance sheet" is used interchangeably with "net assets" in this Report. The "net asset" calculation begins with "total assets" as reported for GAAP purposes in Lehman's Forms 10‐K and 10‐Q. From there, Lehman subtracted certain assets to arrive at "net assets": (i) cash and securities segregated and on deposit for regulatory and other purposes; (ii) collateralized lending agreements (e.g., securities Lehman is holding as collateral for a loan made to a third‐party); and (iii) identifiable intangible assets and goodwill. See LBHI 2007 10‐K, at pp. 30, 61.Show full note An early 2007 document from Lehman's archives concluding that "Repo 105 offers a low cost way to offset the balance sheet and leverage impact of current market conditions," further stated that "[e]xiting large CMBS positions in Real Estate and sub prime loans in Mortgages before quarter end would incur large losses due to the steep discounts that they would have to be offered at and carry substantial reputation risk in the market. . . . A Repo 105 increase would help avoid this without negatively impacting our leverage ratios."²⁸⁶⁸²⁸⁶⁸ Joseph Gentile, Lehman, Proposed Repo 105/108 Target Increase for 2007 (Feb. 10, 2007), at p. 1 [LBEX‐DOCID 2489498] (attached to e‐mail from Joseph Gentile, Lehman, to Edward Grieb, Lehman (Feb. 10, 2007) [LBEX‐DOCID 2600714]). While Lehman did not utilize Repo 105 transactions for selling sticky inventory, the firm's expanded use of Repo 105 transactions at quarter‐end impacted Lehman's publicly reported net leverage ratio.²⁸⁶⁹²⁸⁶⁹ As discussed infra at pp. 843‐46, Lehman attempted to move less liquid inventory into the Repo 105 program, but was unable to find willing counterparties. As discussed in Section III.A.4.d.2.a of this Report, at the moment of a Repo 105 transaction, Lehman reduced its inventory assets but received cash, thereby having a net neutral effect on total assets. Because Lehman did not reflect the cash borrowing on its balance sheet as a liability (as it did in ordinary repo transactions), at the moment of a Repo 105 transaction, the transaction also had a net neutral effect on total liabilities. Lehman, however, used the cash borrowing in Repo 105 transactions to pay different short‐term liabilities, thereby reducing both total assets and total liabilities. By engaging in Repo 105 transactions and using the cash borrowings, Lehman reduced its reported leverage ratios.Show full note

738 739

¶In this way, unbeknownst to the investing public, rating agencies, Government regulators, and Lehman's Board of Directors, Lehman reverse engineered the firm's net leverage ratio for public consumption. Notably, during Lehman's 2008 earnings calls in which it touted its leverage reduction, analysts frequently inquired about the means by which Lehman was reducing its leverage.²⁸⁷⁰²⁸⁷⁰ See Section III.A.4.e.6 of this Report. Although CFO Callan told analysts that Lehman was "trying to give the group a great amount of transparency on the balance sheet," she reported that Lehman was reducing its leverage through the sale of less liquid asset categories but said nothing about the firm's use of Repo 105 transactions.²⁸⁷¹²⁸⁷¹ See Final Transcript of Lehman Brothers Holdings Inc. First Quarter 2008 Earnings Call (Mar. 18, 2008), at p. 13 [LBHI_SEC07940_7277784]; see also Final Transcript of Lehman Brothers Holdings Inc. Fourth Quarter 2007 Earnings Call (Dec. 13, 2007), at p. 7 [LBHI_SEC07940_7222291]; Transcript of Lehman Brothers Holdings Inc. Preliminary Second Quarter 2008 Earnings Call (June 9, 2008), at pp. 3‐4, 12 [LBHI_SEC07940_2554480].Show full note

¶Despite the belief of Lehman personnel that none of the firm's peer investment banks still used similar accounting methods for repo transactions to arrive at their leverage numbers, to which Lehman's reported net leverage was compared, Lehman temporarily reduced its net balance sheet at quarter‐end through its Repo 105 practice by approximately $38.6 billion in fourth quarter 2007, $49.1 billion in first quarter 2008, and $50.38 billion in second quarter 2008.²⁸⁷²²⁸⁷² Numerous Lehman witnesses and internal Lehman e‐mails stated that by December 2007, Lehman personnel believed that Lehman was the last of its peer investment banks to use Repo 105‐type transactions. The Examiner has not verified whether other CSE firms at one time used this type of transaction but later ceased. Martin Kelly (former Global Financial Controller), Anuraj Bismal (former Senior Vice President Balance Sheet Group), Marie Stewart (former Global Head of Accounting Policy), and Michael McGarvey (FID Finance) said that they believed Lehman was the only CSE firm engaging in Repo 105‐type transactions by late 2007. Examiner's Interview of Marie Stewart, Sept. 2, 2009, at p. 14; Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 11; Examiner's Interview of Anuraj Bismal, Sept. 16, 2009, at p. 7; Examiner's Interview of Martin Kelly, Oct. 2, 2009, at p. 8. In a December 2007 e‐mail, Bismal wrote: "[W]as chatting with ex‐lehman employee [Carlos Lo] at Merrill yesterday ‐ he is in their balance sheet group ‐ he told me that they do not use repo 105," to which Marie Stewart replied, "Then that means we are the only one left who does." E‐mail from Marie Stewart, Lehman, to Anuraj Bismal, Lehman, et al. (Dec. 5, 2007) [LBEX‐DOCID 3223386]. In a January 2008 e‐mail, McGarvey wrote: "By the way we are now the only large firm on the street that uses Repo 105." E‐mail from Michael McGarvey, Lehman, to Clement Bernard, Lehman (Jan. 30, 2008) [LBEX‐DOCID 2796630]. In a May 2008 e‐mail to O'Meara (then‐Chief Risk Officer), Ryan Traversari (Senior Vice President External Reporting) reported that Citigroup and JPMorgan "likely do not do Repo 105 and Repo 108 which are UK‐based specific transactions on opinions received by LEH from Linklaters. This would be another reason why LEHʹs daily balance sheet is larger intra‐month then at month‐end." E‐mail from Ryan Traversari, Lehman, to Christopher M. O'Meara, Lehman, et al. (May 16, 2008) [LBEX‐DOCID 574498]. In sum, it was widely believed within Lehman by late 2007 that it was the only firm using Repo 105‐type transactions to reduce balance sheet and impact the firm's net leverage ratio.Show full note

740

¶Lehman first introduced its Repo 105 program in approximately 2001.²⁸⁷³²⁸⁷³ See Section III.A.4.d.1 of this Report. Unable to find a United States law firm that would provide it with an opinion letter permitting the true sale accounting treatment under United States law, Lehman conducted its Repo 105 program under the aegis of an opinion letter the Linklaters law firm in London wrote for LBIE, Lehman's European broker‐dealer in London, under English law.²⁸⁷⁴²⁸⁷⁴ See Section III.A.4.d.3 of this Report and Appendix 17, Repo 105 Appendix. Accordingly, if United States‐based Lehman entities such as LBI and LBSF wished to engage in a Repo 105 transaction, they transferred their securities inventory to LBIE in order for LBIE to conduct the transaction on their behalf.²⁸⁷⁵²⁸⁷⁵ As explained in Section III.A.4.d.3 of this Report, United States‐based Lehman entities engaged only in Repo 105, and not in Repo 108 transactions. Regardless of which Lehman entity transferred securities in either a Repo 105 or Repo 108 transaction, the balance sheet and leverage reduction benefit was firm‐ wide, as Lehman ran its business on a consolidated basis.

¶While not referenced or incorporated into Lehman's internal Repo 105 Accounting Policy, senior Lehman management set limits on the total amount by which the firm could reduce its balance sheet on any given day using Repo 105 transactions.²⁸⁷⁶²⁸⁷⁶ Examiner's Interview of Paolo R. Tonucci, Sept. 16, 2009, at p. 27; Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 8. In July 2006, the limit was set at "1x leverage" for Repo 105 transactions, or $17 billion.²⁸⁷⁷²⁸⁷⁷ Lehman, Global Balance Sheet, Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 2 [LBEX‐ WGM 748489]. When questioned about the calculation of the Repo 105 limit set out in the Global Balance Sheet Overview Presentation, former Lehman Financial Controller Ed Grieb could not recall the calculation of the limit or whether the "1x leverage or $17 billion" definition referred to one of Lehman's leverage ratios or, rather, to tangible equity capital. Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 9. Lehman's Form 10‐Q from the same period as the Global Balance Sheet Overview Presentation shows that Lehman's tangible equity capital was $17.4 billion and that the firm's net leverage ratio was 13.8, suggesting that the setting of Lehman's Repo 105 limit may have been tied to tangible equity capital. Lehman Brothers Holdings Inc., Quarterly Report as of May 31, 2006 (Form 10‐Q) (filed on July 10, 2006), at p. 58 ("LBHI 10‐Q (filed July 10, 2006)"). The Global Balance Sheet Overview Presentation itself suggested that tangible equity is the appropriate measure of leverage. Lehman, Global Balance Sheet, Overview of Repo 105 (FID)/Repo 108 Equities (July 2006), at p. 5 [LBEX‐WGM 748489]; see also Duff & Phelps, Repo 105/108 Usage vs. Limit Comment (Oct. 16, 2009), at p. 1. The conclusion that "1 x leverage" means that the Repo 105 limit was 1 x the tangible equity metric is also supported by the fact that the denominator of Lehman's net leverage ratio is tangible equity. Duff & Phelps, Repo 105/108 Usage vs. Limit Comment (Oct. 16, 2009), at p. 1 & n. 4. The setting of the Repo 105 limit at 1 x tangible equity implies that Lehman management authorized Repo 105 usage to reduce Lehman's net leverage ratio by up to one multiple, or 1.0. Id. at p. 2.Show full note Combined with a $5 billion limit for Repo 108 transactions, Lehman's firm‐ wide cap on combined Repo 105/108 transactions was $22 billion in the summer of 2006.²⁸⁷⁸²⁸⁷⁸ Lehman, Global Balance Sheet, Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 2 [LBEX‐ WGM 748489]. As of January 2008, the firm‐wide cap on combined Repo 105/108 transactions at quarter‐end was $25 billion, though in fact, Lehman exceeded the cap by approximately $25 billion in first and second quarter 2008.²⁸⁷⁹²⁸⁷⁹ E‐mail from Sigrid Stabenow, Lehman, to Clement Bernard, Lehman, et al. (Jan. 25, 2008) [LBEX‐ DOCID 1853428] (requesting that Repo 105 limit of $20 billion be expanded to $23 billion). Beginning in mid‐2007 – the very time that the market began to particularly focus on investment banks' leverage – Lehman breached its internal limit on Repo 105 activity at every quarter‐end,

741 742

¶temporarily removing as much as $50.38 billion in securities inventory from its balance sheet in second quarter 2008.²⁸⁸⁰²⁸⁸⁰ Lehman, Total Repo 105/108 Trend (Feb. 20, 2008) [LBHI_SEC07940_1957956] (stating total Repo 105 usage for August 30, 2007, close of third quarter 2007, was $36.4 billion); Lehman, Total Repo 105 & Repo 108 Report (Dec. 5, 2007) [LBEX‐DOCID 3219746] (attached to e‐mail from Anuraj Bismal, Lehman, to Marie Stewart, Lehman, et al. (Dec. 5, 2007) [LBEX‐DOCID 3223384] and stating that total firm‐wide Repo 105 usage on Nov. 30, 2007 was $38.634 billion); Lehman, Total Repo 105 & Repo 108 Report (June 11, 2008) [LBEX‐DOCID 2078195] (attached to e‐mail from Kristie Wong, Lehman, to Martin Kelly, Lehman (June 11, 2008) [LBEX‐DOCID 2325872] and stating that total firm‐wide Repo 105 usage on Feb. 29, 2008 was $49.102 billion and on May 30, 2008 was $50.383 billion). Note that in 2008, May 31 was a Saturday. As set forth below, the Examiner concludes that the evidence supports the existence of colorable claims arising from Lehman's failure to disclose its Repo 105 practice and the impact these transactions had on Lehman's publicly reported net leverage and balance sheet.Show full note

¶Lehman dramatically ramped up its use of Repo 105 transactions in late 2007 and early 2008 despite concerns about the practice expressed by Lehman officers and personnel. In an April 2008 e‐mail asking if he was familiar with the use of Repo 105 transactions to reduce net balance sheet, Bart McDade, Lehman's former Head of Equities (2005–2008) and President and Chief Operating Officer (June–September 2008), replied: "I am very aware . . . it is another drug we r on."²⁸⁸¹²⁸⁸¹ E‐mail from Herbert H. (Bart) McDade III, Lehman, to Hyung Lee, Lehman (Apr. 3, 2008) [LBEX‐ DOCID 1570783]. A week earlier, McDade had recommended to Lehman's Executive Committee that the firm set a cap on the use of Repo 105 transactions.²⁸⁸²²⁸⁸² Examiner's Interview of Herbert H. (Bart) McDade III, Jan. 28, 2010, at pp. 3‐4. A senior member of Lehman's Finance Group considered Lehman's Repo 105 program to be balance sheet "window‐dressing" that was "based on legal technicalities."²⁸⁸³²⁸⁸³ E‐mail from Michael McGarvey, Lehman, to Jormen Vallecillo, Lehman (July 2, 2008) [LBEX‐DOCID 3379145]. Other former Lehman employees characterized Repo 105 transactions as an "accounting gimmick" and a "lazy way of managing the balance sheet."²⁸⁸⁴²⁸⁸⁴ Examiner's Interview of Murtaza Bhallo, Sept. 14, 2009; Examiner's Interview of Marie Stewart, Sept. 2, 2009, at p. 7.

743

¶In addition to the firm‐wide cap on total Repo 105 usage, management created two related rules loosely known within Lehman as (1) the "80/20" or "continual use" rule and (2) the "120%" rule.²⁸⁸⁵²⁸⁸⁵ Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 13; Lehman, Global Balance Sheet Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 2 [LBEX‐WGM 748489] ("Repo 105 transactions must be executed on a continual basis and remain in force throughout the month. To meet this requirement, the amount outstanding at any time should be maintained at approximately 80% of the amount at month‐ end. [per Chris O'Meara and Ed Grieb.]"); e‐mail from Michael McGarvey, Lehman, to Kentaro Umezaki, Lehman, et al. (Aug. 17, 2007) [LBEX‐DOCID 1635769] ("The guide line for month end usage of repo 105 is that it should not exceed 120% of your daily average.").Show full note These rules prescribed, respectively, a minimal level of continual use of Repo 105 transactions throughout the quarter and a maximum volume of Repo 105 transactions at quarter‐end.²⁸⁸⁶²⁸⁸⁶ See Lehman, Global Balance Sheet Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 2 [LBEX‐WGM 748489] ("Repo 105 transactions must be executed on a continual basis and remain in force throughout the month. To meet this requirement, the amount outstanding at any time should be maintained at approximately 80% of the amount at month‐end. [per Chris O'Meara and Ed Grieb.]"); e‐ mail from Michael McGarvey, Lehman, to Kentaro Umezaki, Lehman, et al. (Aug. 17, 2007) [LBEX‐ DOCID 1635769] ("The guide line for month end usage of repo 105 is that it should not exceed 120% of your daily average.").Show full note Former Financial Controller Ed Grieb described the purpose of the rules: "to make sure there was a legitimate business purpose" for Repo 105 transactions.²⁸⁸⁷²⁸⁸⁷ Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 13.

¶Lehman did not actually follow these self‐imposed rules. That is not surprising, since no witness was able to provide a rational business explanation for the arbitrary 1x leverage, continual use, and 120% rules. If Repo 105 transactions made good business sense on their own, there would be no apparent reason to arbitrarily restrict the amount of such transactions to 1x leverage or to impose intra‐month limits to ensure that the amount of the transactions at reporting periods did not spike to more than 120% of average usage. No reason, that is, except to keep the transactions under the radar, by limiting their total and the amount of a quarter‐end spike.

744

¶Lehman's Fixed Income Division ("FID"), in particular, employed Repo 105 transactions to reach quarter‐end balance sheet targets set by senior Lehman management in connection with the firm‐wide effort to reduce net leverage. For example, four days prior to the close of fiscal year 2007, Jerry Rizzieri was in search of a way to meet his balance sheet target and wrote to Mitchell King: "Can you imagine what this would be like without 105?"²⁸⁸⁸²⁸⁸⁸ E‐mail from Jerry Rizzieri, Lehman, to Mitchell King, Lehman (Nov. 26, 2007) [LBEX‐DOCID 3232804]. When FID's balance sheet was above target in the days leading up to the close of the first quarter 2008, a senior financial officer within that division warned that the division was "looking at selling what ever we can and also doing some more repo 105."²⁸⁸⁹²⁸⁸⁹ E‐mail from Clement Bernard, Lehman, to Martin Potts, Lehman, et al. (Feb. 28, 2008) [LBEX‐DOCID 1854189]. Similarly, the head of the Liquid Markets group within FID wrote at the same quarter‐end regarding the group's balance sheet: "We have a desperate situation and I need another 2 billion from you, either through Repo 105 or outright sales. Cost is irrelevant, we need to do it."²⁸⁹⁰²⁸⁹⁰ E‐mail from Kaushik Amin, Lehman, to Kieran Higgins, Lehman (Feb. 28, 2008) [LBEX‐DOCID 3234351].

745

¶Lehman's reliance upon Repo 105 transactions for quarter‐end balance sheet relief continued into Lehman's second quarter 2008. In an e‐mail titled "Q2 balance sheet" and dated May 21, 2008 – ten days before Lehman's second quarter close – the head of the Liquid Markets group wrote: "Do as much as you can in Repo 105" in response to the question "Do u thk we can be flexible beyond $3bn in 105?"²⁸⁹¹²⁸⁹¹ E‐mail from Kaushik Amin, Lehman, to Thomas Siegmund, Lehman (May 21, 2008) [LBEX‐DOCID 756545]. In another May 21, 2008 e‐mail, the head of Liquid Markets asked: "Are we going to make the FID Europe [balance sheet] target," which elicited the response: "V close . . . anything that moves is getting 105'd."²⁸⁹²²⁸⁹² E‐mail from Kieran Higgins, Lehman, to Kaushik Amin, Lehman (May 21, 2008) [LBEX‐DOCID 3234382].

¶Several additional contemporaneous e‐mails retrieved from Lehman archives succinctly set forth Lehman's purpose for undertaking Repo 105 transactions:

● "[T]he firm has a function called repo 105 whereby you can repo a position for a week and it is regarded as a true sale to get rid of net balance sheet."²⁸⁹³²⁸⁹³ E‐mail from Anthony Jawad, Lehman, to Andrea Leonardelli, Lehman (Feb. 29, 2008) [LBEX‐DOCID 224902].

● "We have been using Repo 105 in the past to reduce balance sheet at the quarter‐end."²⁸⁹⁴²⁸⁹⁴ E‐mail from Raymond Chan, Lehman, to Paul Mitrokostas, Lehman, et al. (July 15, 2008) [LBEX‐ DOCID 3384937].

746

¶When pressed to identify any legitimate business purpose for Lehman's use of Repo 105 transactions, certain witnesses noted the secured short‐term financing afforded by the transactions. While one outcome of Repo 105 transactions was that Lehman received financing in exchange for collateral – which was not reflected in Lehman's periodic reports as a borrowing or liability – a Repo 105 transaction was a more expensive way for Lehman to secure such short‐term financing as compared to an ordinary repo transaction. Lehman had the ability to conduct an ordinary repo transaction using the same securities and with substantially the same counterparties as in Repo 105 transactions, at a lower cost.²⁸⁹⁵²⁸⁹⁵ Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 6. As such, the same witnesses who identified a financing purpose for Repo 105 transactions, as well as several other former Lehman personnel, uniformly acknowledged that the overarching goal of Repo 105 transactions was to meet net balance sheet targets – i.e., reduce the net asset component (the numerator) of the net leverage ratio calculation – in connection with the filing of Lehman's financial statements. While the Examiner found a large number of contemporaneous documents that talk about the use of Repo 105 transactions to manage the balance sheet and meet leverage targets, few, if any, contemporaneous documents describe any other purpose for those transactions. Repo 105 transactions were not used for a business purpose, but instead for an accounting purpose: to reduce Lehman's publicly reported net leverage and net balance sheet.

747

¶As set forth more fully below, the Examiner concludes that a fact finder could find that Lehman's failure to disclose its use of Repo 105 transactions to impact its balance sheet at a time when both the market and senior Lehman management were keenly focused on the reduction of Lehman's firm‐wide net leverage and balance sheet, and particularly in light of the specific volumes at which Lehman undertook Repo 105 transactions at quarter‐end in fourth quarter 2007, first quarter 2008, and second quarter 2008, materially misrepresented Lehman's true financial condition.

¶A trier of fact could find that Lehman's use of tens of billions of dollars of Repo 105 transactions at quarter‐end in late 2007 and early 2008 rendered the firm's financial statements and related disclosures materially misleading. Indeed, audit walk‐through papers prepared by Lehman's outside auditor, Ernst & Young,²⁸⁹⁶²⁸⁹⁶ Ernst & Young refers only to Ernst & Young LLP (i.e., Ernst & Young North America) unless stated otherwise. regarding the process for reopening or adjusting a closed balance sheet stated: "Materiality is usually defined as any item individually, or in the aggregate, that moves net leverage by 0.1 or more (typically $1.8 billion)."²⁸⁹⁷²⁸⁹⁷ Ernst & Young, LBHI/LBI Walkthrough Template for Balance Sheet Close Process (Nov. 30, 2007), at p. 14 [EY‐LE‐LBHI‐CORP‐GAMX‐07‐033384]; see also Section III.A.4.g, which discusses and analyzes the materiality of Repo 105 transactions. Repo 105 moved net leverage not by tenths, but by whole points.²⁸⁹⁸²⁸⁹⁸ See Section III.A.4.g.2 of this Report; e‐mail from Anuraj Bismal, Lehman, to Marie Stewart, Lehman, et al. (Dec. 5, 2007) [LBEX‐DOCID 3223384] (stating that Lehman "would be at net leverage of 18.0x [vs say 16.3x] without repo 105/8").

748

¶Lehman's publicly reported net leverage ratio for November 30, 2007 (fourth quarter 2007), February 29, 2008 (first quarter 2008), and May 31, 2008 (second quarter 2008) was 16.1x, 15.4x and 12.1x, respectively.²⁸⁹⁹²⁸⁹⁹ LBHI 2007 10‐K, at p. 64; LBHI 10‐Q (filed Apr. 9, 2008), at p. 72; LBHI 10‐Q (filed July 10, 2008), at p. 89. Without the balance sheet benefit of Repo 105 transactions, Lehman's net leverage ratios for the same periods would have been 17.8x, 17.3x and 13.9x, respectively:²⁹⁰⁰²⁹⁰⁰ Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), at p. 8; see also Section III.A.4.g.2 of the Report (discussing impact of Lehman's Repo 105 practice on Lehman's net leverage ratio).

Date Repo 105 Reported Net Leverage Difference Usage Leverage Without Repo

Q4 2007 $38.6 B²⁹⁰¹²⁹⁰¹ Lehman, Total Repo 105/108 Trend (Feb. 20, 2008) [LBHI_SEC07940_1957956] (stating that fourth quarter 2007 Repo 105 usage was $38.634 billion); see also Lehman, Global Consolidated Balance Sheet (Final) (Nov. 30, 2007) [LBEX‐DOCID 3439086] (stating that fourth quarter 2007 Repo 105 usage was $38.634 billion). Note that many internal Lehman documents, such as the Global Consolidated Balance Sheet, used a "Repo 105" heading to refer to both Repo 105 and Repo 108 usage. In such documents, Repo 108 usage may be disaggregated from the Repo 105 usage by identifying the line item for Equities. "Repo 105" transactions using Equities inventory were actually "Repo 108" transactions.Show full note 16.1²⁹⁰²²⁹⁰² See LBHI 2007 10‐K, at pp. 29, 64. 17.8²⁹⁰³²⁹⁰³ Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), at p. 8. 1.7 Q1 2008 $49.1 B²⁹⁰⁴²⁹⁰⁴ Lehman, Total Repo 105 & Repo 108 Report (June 11, 2008) [LBEX‐DOCID 2078195] (stating that firm‐ wide Repo 105 usage was $49.102 billion at close of first quarter 2008, Feb. 29, 2008). 15.4²⁹⁰⁵²⁹⁰⁵ See LBHI 10‐Q (filed Apr. 9, 2008), at p. 72. 17.3²⁹⁰⁶²⁹⁰⁶ Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), at p. 8. 1.9 Q2 2008 $50.38 B²⁹⁰⁷²⁹⁰⁷ Lehman, Total Repo 105 & Repo 108 Report (June 11, 2008) [LBEX‐DOCID 2078195] (stating that firm‐ wide Repo 105 usage was $50.3834 billion at close of second quarter 2008, May 30, 2008). Note that May 31 in 2008 was a Saturday. 12.1²⁹⁰⁸²⁹⁰⁸ See LBHI 10‐Q (filed July 10, 2008), at p. 89. 13.9²⁹⁰⁹²⁹⁰⁹ Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), at p. 8. 1.8

749

¶Lehman's directors, the rating agencies, and Government regulators – all of whom were unaware of Lehman's use of Repo 105 transactions – have advised the Examiner that Lehman's Repo 105 usage was material or significant information that they would have wanted to know.²⁹¹⁰²⁹¹⁰ See Sections III.A.4.g.4–5 and III.A.4.h.3 of this Report (discussing rating agencies, Government regulators and Lehman Board of Directors). The Examiner concludes that sufficient evidence exists for a trier of fact to find that Lehman's quarter‐end Repo 105 practice was material and should have been disclosed.²⁹¹¹²⁹¹¹ See Sections III.A.4.j.2.a–d of this Report (explaining disclosure requirements and providing Examiner's conclusions regarding Lehman's disclosures).

¶Because Lehman treated Repo 105 transactions as sales rather than financing transactions, accounting rules did not require Lehman to record the liabilities arising from the cash borrowings in Repo 105 transactions. Nevertheless, there is sufficient evidence to support a determination that disclosure of the obligation to repurchase the securities and repay the cash borrowing was required in the Management's Discussion and Analysis ("MD&A") section of Lehman's publicly filed financial statements because the repurchase was a known event that was reasonably likely to occur and would have had a material effect on the company's financial condition or results of operations.²⁹¹²²⁹¹² See Section III.A.4.j.2 of this Report (discussing and analyzing disclosure requirements). A trier of fact could further find that by failing to disclose the tens of billions of dollars of Repo 105 transactions and cash borrowings, Lehman's disclosures in the Liquidity and Capital Resources Section of the MD&A were deficient.²⁹¹³²⁹¹³ See Section III.A.4.j.2 of this Report (discussing and analyzing disclosure requirements). In addition, Lehman's description of its net leverage was misleading because it omitted disclosing that the ratio was reduced by means of temporary, accounting‐motivated transactions.²⁹¹⁴²⁹¹⁴ See Sections 4.g.2 and 4.j.2.c of the Report (discussing impact of Repo 105 practice on net leverage ratio and Lehman's public filings, respectively).

750

¶The Examiner concludes that there is sufficient evidence to support a colorable claim that: (1) certain of Lehman's officers breached their fiduciary duties by exposing Lehman to potential liability for filing materially misleading periodic reports and (2) Ernst & Young, the firm's outside auditor, was professionally negligent in allowing those reports to go unchallenged. The Examiner concludes that colorable claims of breach of fiduciary duty exist against Richard Fuld, Chris O'Meara, Erin Callan, and Ian Lowitt, and that a colorable claim of professional malpractice exists against Ernst & Young.²⁹¹⁵²⁹¹⁵ See Sections III.A.4.j.4.b and III.A.4.j.5 of this Report (discussing evidence supporting colorable claims against certain Lehman officers and Ernst & Young).

Introduction

¶Sale and repurchase agreements ("repos") are agreements in which one party transfers assets to another party as collateral for a short‐term borrowing of cash, while simultaneously agreeing to repay the cash and take back the collateral at a specific point in time.²⁹¹⁶²⁹¹⁶ See ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS OF LIABILITIES, Statement of Financial Accounting Standards No. 140, ¶ 96 (Fin. Accounting Standards Bd. 2000) ("Government securities dealers, banks, other financial institutions and corporate investors commonly use repurchase agreements to obtain or use short‐term funds. Under those agreements, the transferor ('repo party') transfers a security to a transferee ('repo counterparty' or 'reverse party') in exchange for cash and concurrently agrees to reacquire that security at a future date for an amount equal to the cash exchanged plus a stipulated 'interest' factor.").Show full note When the repo transaction matures, the borrower repays the funds plus an agreed upon interest rate or other charge and takes back its collateral. Repo transactions are widely used by financial institutions and are a legitimate tool for raising short‐term funding.

751

¶Like other large investment banks, Lehman engaged, on a daily basis, in tens of billions of dollars of repo transactions in its normal course of business for financing purposes ("ordinary repo" or "traditional repo" transactions). Lehman accounted for these ordinary repo transactions as financing transactions.²⁹¹⁷²⁹¹⁷ Lehman reported in its Forms 10‐Q and 10‐K that it treated repurchase (repo) transactions as financing transactions for accounting and reporting purposes. See LBHI 2007 10‐K, at p. 97; LBHI 10‐Q (filed Apr. 9, 2008), at p. 13; LBHI 10‐Q (filed July 10, 2008), at p. 16. Accordingly, in Lehman's traditional repo transactions:

● The transferred securities inventory remained on Lehman's balance sheet during the term of the repo.

● Because the inventory remained on Lehman's balance sheet, the incoming borrowed cash increased Lehman's total assets.

● Total liabilities also increased because Lehman recorded a corresponding liability representing its obligation to repay the borrowed cash.

¶While simplified and for illustrative purposes only, the five illustrations that follow demonstrate the impact of an ordinary repo transaction and a Repo 105 transaction on Lehman's balance sheet and leverage ratios.

752

¶Illustration 1

¶Assume this simplified balance sheet for Lehman:

¶Assets (in millions) Liabilities

¶Cash 7,500 Short Term Borrowings 200,000 Financial Instruments 350,000 Collateralized Financings 325,000 Collateralized Agreements 350,000 Long Term Borrowings 150,000 Receivables 20,000 Payables 98,000 Other 72,500 Stockholders' Equity 27,000

¶Total 800,000 800,000

¶

Gross Leverage2918 — 30
Net Leverage2919 — 17

¶Illustration 2, below, shows the impact of an ordinary repo on Lehman's balance sheet and leverage ratios.

753

¶Illustration 2

¶If Lehman executes $50 billion of typical repo transactions with $50 billion of its financial instruments, those instruments remain on the balance sheet; Lehman receives a $50 billion cash borrowing, increasing its cash position; and Lehman records $50 billion of additional collateralized financing liabilities; at the moment of the repo transactions, total balance sheet and leverage increase:

¶Assets (in millions) Liabilities

¶Cash 57,500 Short Term Borrowings 200,000 Financial Instruments 350,000 Collateralized Financings 375,000 Collateralized Agreements 350,000 Long Term Borrowings 150,000 Receivables 20,000 Payables 98,000 Other 72,500 Stockholdersʹ Equity 27,000

¶Total 850,000 850,000

¶

Gross Leverage — 31
Net Leverage — 19

¶Illustration 3, below, shows the impact of an ordinary repo followed by the use of the cash borrowing to pay down liabilities.

754

¶Illustration 3

¶Assuming Lehman were to use the $50 billion cash borrowing from typical repo transactions to pay off current liabilities, the effect on the balance sheet would be neutral – no net increase in total assets/liabilities, and no effect upon leverage:²⁹²⁰²⁹²⁰ This is not to suggest that Lehman regularly used the funds received in a typical repo transaction to pay down liabilities. In the Notes to its Consolidated Financial Statements, for example, Lehman stated "We enter secured borrowing and lending transactions to finance inventory positions, obtain securities for settlement and meet clients' needs." See LBHI 2007 10‐K, at p. 110.

¶Assets (in millions) Liabilities

¶Cash 7,500 Short Term Borrowings 200,000 Financial Instruments 350,000 Collateralized Financings 325,000 Collateralized Agreements 350,000 Long Term Borrowings 150,000 Receivables 20,000 Payables 98,000 Other 72,500 Stockholders' Equity 27,000

¶Total 800,000 800,000

¶

Gross Leverage — 30
Net Leverage — 17

¶Although Lehman publicly reported that it treated all repo transactions as financing transactions for accounting purposes,²⁹²¹²⁹²¹ See LBHI 2007 10‐K, at p. 97 (stating that Lehman treats repo transactions as financing transactions for reporting purposes); LBHI 10‐Q (filed Apr. 9, 2008), at p. 13 (same); LBHI 10‐Q (filed July 10, 2008), at p. 16 (same); see also Lehman, Global Balance Sheet Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 1 [LBEX‐WGM 748489] ("Repo transactions are normally recorded on the balance sheet as financings.").Show full note Lehman booked "Repo 105" transactions as sales under the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 140 ("SFAS 140"), Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.²⁹²²²⁹²² As discussed more fully at Section III.A.4.d.2.c of the Report, the "105" and "108" descriptions refer to the "haircut" necessary for Lehman to account for the transaction as a "sale" under SFAS 140. Lehman utilized treasuries, agencies, and other government securities in "Repo 105" transactions and utilized equities securities in "Repo 108" transactions. See Section III.A.4.d.4 of this Report.

755

¶SFAS 140 governs, in part, when to recognize a transfer of assets as a financing transaction or, alternatively, as a sale.²⁹²³²⁹²³ ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS OF LIABILITIES, Statement of Financial Accounting Standards No. 140, ¶¶ 2, 98 (Fin. Accounting Standards Bd. 2000) ("SFAS 140"). Issued in June 2009 and effective as of the beginning of each reporting entity's first annual reporting period that begins after November 15, 2009, SFAS 160 and SFAS 167 amended certain aspects of SFAS 140. See ACCOUNTING FOR TRANSFERS OF FINANCIAL ASSETS, AN AMENDMENT OF FASB STATEMENT NO. 140, Statement of Financial Accounting Standards No. 166 (Fin. Accounting Standards Bd. 2009); AMENDMENTS TO FASB INTERPRETATION NO. 46(R), Statement of Financial Accounting Standards No. 167 (Fin. Accounting Standards Bd. 2009).Show full note Although SFAS 140 more often is discussed in the context of securitization transactions, a particular provision of SFAS 140 – specifically SFAS 140.98 – permits the transferor of assets in a repo agreement to account for the repo transaction as a "sale" with a forward purchase commitment if the transaction satisfies certain criteria.²⁹²⁴²⁹²⁴ See SFAS 140, ¶ 98; see also Section III.A.4.j.2.c.ii.a of this Report (discussing Lehman's disclosures regarding securitization activities and SFAS 140). As an accounting matter, and consistent with Lehman's publicly reported statements, the vast majority of repo transactions do not satisfy SFAS 140's criteria to recharacterize the repo transaction as a sale and thereby move the transferred inventory "off balance sheet."²⁹²⁵²⁹²⁵ Paragraph 208 of SFAS 140 notes that sale treatment for repo transactions is unusual. Specifically, Paragraph 208 provides, "[P]articipants in the very large markets for repurchase agreements and securities lending transactions are, for the most part, unaccustomed to treating those transactions as sales, and a change to sale treatment would have a substantial impact on their reported financial position." SFAS 140, ¶ 208.Show full note

756

¶The recharacterization of a repo transaction from a financing or "borrowing" transaction to a "sale" transaction pursuant to SFAS 140 leads to several consequences:

● The transferred securities inventory are derecognized, i.e., considered sold and removed from the transferor's/seller's balance sheet during the term of the repo even though the transferor/seller is required to repurchase the inventory at a future date.²⁹²⁶²⁹²⁶ See SFAS 140, ¶ 11.a ("Upon completion of a transfer of financial assets that satisfies the conditions to be accounted for as a sale (paragraph 9), the transferor shall: a. Derecognize all assets sold."); see also Appendix E: Glossary of SFAS 140 ("Derecognize: Remove previously recognized assets or liabilities from the statement of financial position.").

● Additionally, when a repo transaction is recharacterized as a sale, the transferor/seller does not record a liability representing its obligation to repay the borrowed funds.²⁹²⁷²⁹²⁷ See SFAS 140, ¶ 98 ("If the criteria in paragraph 9 are met, including the criterion in paragraph 9(c)(1), the transferor shall account for the repurchase agreement as a sale of financial assets and a forward repurchase commitment, and the transferee shall account for the agreement as a purchase of financial assets and a forward resale commitment."). In other words, the "borrowing" is not reflected on the balance sheet, even though the economic substance of the transaction is a borrowing, and thus, the transferor's total liabilities do not increase.²⁹²⁸²⁹²⁸ Id.

● Although the transferor's inventory decreases, at the moment of the transaction the transferor's total assets remain unchanged because the transferor receives cash borrowings in exchange for the securities inventory.

¶Consequently, Lehman's Repo 105 transactions removed securities inventory from Lehman's balance sheet for the duration of the repo – typically seven to ten days.²⁹²⁹²⁹²⁹ Examiner's Interview of Tejal Joshi, Sept. 15, 2009, at p. 4; Examiner's Interview of Mark Gavin, Sept. 24, 2009, at p. 4; Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 5; Examiner's Interview of Matthew Lee, July 1, 2009, at p. 13. At the moment of the Repo 105 transaction, Lehman received cash.²⁹³⁰²⁹³⁰ Lehman, Global Balance Sheet Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 1 [LBEX‐ WGM 748489]; Examiner's Interview of Edward Grieb, Oct. 2, 2009, at pp. 13‐14 (stating that cash received in Repo 105 transactions was used to pay off other liabilities); Examiner's Interview of Matthew Lee, July 1, 2009, at p. 14 (explaining that in order for Lehman to realize the benefit to its leverage ratios as a result of Repo 105 transactions, the firm had to use the cash received to pay off a different liability); Duff & Phelps, Explanation of Repo 105 Accounting Ledger Entries and Trading System Output (Jan. 5, 2010), at p. 2. In addition, as explained in Letter from Linklaters, to Lehman Brothers International (Europe), re: Repurchase Transactions under a Global Master Repurchase Agreement (May 21, 2006), §2.4 [LBEX‐LBIE 000001], Section III.A.4.d.2.a of this Report and Appendix 17, Repo 105 Appendix, during the term of the Repo 105 transaction – as in a typical repo transaction – Lehman continued to receive the income stream arising from the transferred securities during the term of the transaction.Show full note Thus, although Lehman reduced its inventory, the incoming cash resulted in no change to the volume of Lehman's total assets.²⁹³¹²⁹³¹ Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), at p. 3; Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 13‐14 (stating Lehman used Repo 105 cash borrowing to pay other liabilities); Examiner's Interview of Matthew Lee, July 1, 2009, at p. 14 (explaining that in order for Lehman to realize the benefit to its leverage ratios as a result of Repo 105 transactions, the firm had to use the cash received to pay off a different liability).Show full note Because Lehman booked Repo 105 transactions as sales under SFAS 140, rather than as financings, it did not record any liabilities arising from the obligation to repay the short‐term funding secured by a Repo 105 transaction.²⁹³²²⁹³² Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), at pp. 3‐4. Consequently, as demonstrated in Illustration 4, below, Lehman was also able to borrow tens of billions of dollars without disclosing the borrowing.

757 758

¶Illustration 4

¶If Lehman executes $50 billion of Repo 105 transactions, rather than typical repos, the transaction is recharacterized as a sale and $50 billion of financial instruments, considered sold, are removed from the balance sheet;²⁹³³²⁹³³ As discussed in greater detail in Section III.A.4.d.2.d of this Report, Lehman created a $5 derivative asset for every $105 worth of securities removed from its balance sheet in a Repo 105 transaction. For the sake of simplification, Illustrations 3 and 4 do not include the $5 derivative. Lehman receives $50 billion in cash, exchanging one form of asset for another, so total assets are unchanged; Lehman records no liability to return the cash borrowing so liabilities likewise remain unchanged; at the moment of the Repo 105 transactions, leverage is unaffected:

¶Assets (in millions) Liabilities

¶Cash 57,500 Short Term Borrowings 200,000 Financial Instruments 300,000 Collateralized Financings 325,000 Collateralized Agreements 350,000 Long Term Borrowings 150,000 Receivables 20,000 Payables 98,000 Other 72,500 Stockholders' Equity 27,000

¶Total 800,000 800,000

¶

Gross Leverage — 30
Net Leverage — 17

759

¶Lehman used the borrowed funds from Repo 105 transactions to pay down short‐term liabilities such as ordinary repo transactions, as in Illustration 5, below.2934 By doing so, Lehman reduced its total assets, thereby reducing its leverage ratios.

¶2934 Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 7 (stating that incoming cash from Repo 105 transactions was used to pay business expenses); Examiner's Interview of Edward Grieb, Oct. 2, 2009, at pp. 13‐14 (stating that cash received in Repo 105 transactions was used to pay off other liabilities); Examiner's Interview of Matthew Lee, July 1, 2009, at p. 14 (explaining that in order for Lehman to realize the benefit to its leverage ratios as a result of Repo 105 transactions, the firm had to use the cash received to pay off a different liability); see e‐mail from Anuraj Bismal, Lehman, to Marie Stewart, Lehman, et al. (Dec. 5, 2007) [LBEX‐DOCID 3223384] (stating that Lehman would have a net leverage of 18.0x instead of 16.3x without Repo 105, which indicates that Lehman used Repo 105 cash to pay down different liabilities). Given that Lehman undertook $38.6 billion, $49.1 billion, and $50.38 billion of Repo 105 transactions at quarter‐end fourth quarter 2007, first quarter 2008, and second quarter 2008, respectively, Lehman's disclosures of its cash holdings at each quarter‐end further strengthens the testimony and other evidence that Lehman used the cash borrowing from Repo 105 transactions to pay down short‐term liabilities. See LBHI 2007 10‐K, at p. 86 (reporting that Lehman had $7.286 billion in cash and cash equivalents on November 30, 2007); LBHI 10‐Q (filed Apr. 9, 2008), at p. 5 (reporting that Lehman had $7.564 billion in cash and cash equivalents on February 29, 2008); LBHI 10‐Q (filed July 10, 2008), at p. 5 (reporting that Lehman had $6.513 billion in cash and cash equivalents on May 31, 2008). While Lehman's Repo 105 transactions spiked at quarter‐ends, Lehman's ordinary repo balances dropped off significantly during the same time periods. Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), at p. 5.

760

¶Illustration 5

¶In a Repo 105 transaction, Lehman uses the cash it generates to reduce traditional borrowings, such as ordinary repos ("collateralized financings" in the example below). By applying the cash from a Repo 105 transaction to pay down liabilities such as ordinary repos, Lehman reduces its balance sheet and leverage.

¶Assets (in millions) Liabilities

¶Cash 7,500 Short Term Borrowings 200,000 Financial Instruments 300,000 Collateralized Financings 275,000 Collateralized Agreements 350,000 Long Term Borrowings 150,000 Receivables 20,000 Payables 98,000 Other 72,500 Stockholders' Equity 27,000

¶Total 750,000 750,000

¶

Gross Leverage — 28
Net Leverage — 15

¶When the Repo 105 transaction matured, Lehman borrowed funds to repay the Repo 105 cash borrowing plus interest and the previously transferred securities inventory returned to Lehman's balance sheet as securities inventory.²⁹³⁵²⁹³⁵ Lehman, Global Balance Sheet Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 1 [LBEX‐ WGM 748489]; Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), at p. 4; Duff & Phelps, Explanation of Repo 105 Accounting Ledger Entries and Trading System Output (Jan. 5, 2010), at p. 5. Accordingly, total assets and total liabilities increased.

¶Although it is undisputed that Lehman received cash as part of Repo 105 transactions, the documents and witness testimony reveal that the financing Lehman received under a Repo 105 transaction was not the real or primary purpose for entering into Repo 105 transactions. Lehman could have obtained the same financing at a lower cost by engaging in ordinary repo transactions with substantially the same counterparties using the same assets involved in Repo 105 transactions.²⁹³⁶²⁹³⁶ Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 6.

761

¶Lehman's primary motive for undertaking tens of billions of dollars in Repo 105 transactions at or near each quarter‐end in late 2007 and 2008 was to temporarily remove the securities inventory involved from its balance sheet in order to report lower leverage and net leverage ratios than Lehman actually had.²⁹³⁷²⁹³⁷ Leverage is the relationship of a company's total assets to stockholders' equity. LBHI 2007 10‐K, at p. 30. Lehman believed that "net leverage based on net assets and tangible equity capital" was "a more meaningful measure of leverage." See LBHI 2007 10‐K, at pp. 30, 63. Lehman defined "net leverage ratio" as "net assets divided by tangible equity capital." Id. Lehman's "net asset" calculation begins with "total assets" as reported for GAAP purposes in Lehman's Forms 10‐K and 10‐Q. From there, Lehman subtracted certain assets in order to arrive at "net assets": (i) cash and securities segregated and on deposit for regulatory and other purposes; (ii) collateralized lending agreements (i.e., securities Lehman is holding as collateral for a loan made to a third‐party); and (iii) identifiable intangible assets and goodwill. See id. at p. 30.Show full note Numerous witnesses told the Examiner that Lehman's motive for undertaking a Repo 105 transaction, as opposed to an ordinary repo, turned solely on Lehman's need to manage the firm‐wide balance sheet and effect the publicly disclosed leverage.²⁹³⁸²⁹³⁸ Examiner's Interview of Tejal Joshi, Sept. 15, 2009, at pp. 4, 6 (stating that Repo 105 "allowed us to treat trades of positions that would be financing trades as true sales instead" and that at quarter‐end there was a mad scramble to meet balance sheet targets through use of Repo 105); Examiner's Interview of Paolo R. Tonucci, Sept. 16, 2009, at p. 27 (stating that at the end of reporting periods, Lehman deployed Repo 105 transactions to net down its balance sheet); Examiner's Interview of Mark Gavin, Sept. 24, 2009, at p. 4 (stating purpose of Repo 105 transactions was "balance sheet management"); Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 7 ("[T]he only purpose or motive for the [Repo 105 transactions] was reduction in balance sheet."); Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 11 (stating Repo 105 transactions were used to bring balance sheet in line with targets); Examiner's Interview of John Feraca, Oct. 9, 2009, at pp. 6, 10 ("It was universally accepted throughout the entire institution that Repo 105 was used for balance sheet relief at quarter end"); Examiner's Interview of Joseph Gentile, Oct. 21, 2009, at p. 6 (stating that Repo 105 was a balance sheet management mechanism, "a tool that could be used to reduce Lehman's net balance sheet"); Examiner's Interview of Clement Bernard, Oct. 23, 2009, at p. 7 ("Repo 105 was a mechanism FID relied on to get its balance sheet down"); Examiner's Interview of Matthew Lee, July 1, 2009, at p. 15 (stating Repo 105 transactions driven by management's imperative to reverse‐engineer leverage ratio).Show full note

762

¶From 2001, when Lehman first began using Repo 105 transactions,²⁹³⁹²⁹³⁹ Though Repo 105 started in 2001, Lehman did not initiate Repo 108 transactions, used for equities securities, until May 2006. See Lehman, Global Balance Sheet Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 4 [LBEX‐WGM 748489]. until early‐ to‐mid‐2007, Lehman engaged in a relatively consistent volume of Repo 105 transactions, including at quarter‐end, generally within a range of between $20 and $25 billion.²⁹⁴⁰²⁹⁴⁰ Id. (showing Repo 105 month‐end trend between January 2005 and May 2006 of between approximately $11 billion and $21 billion); Joseph Gentile, Lehman, Proposed Repo 105/108 Target Increase for 2007 (Feb. 10, 2007), at p. 1 [LBEX‐DOCID 2489498] (attached to e‐mail from Joseph Gentile, Lehman, to Edward Grieb, Lehman (Feb. 10, 2007) [LBEX‐DOCID 2600714] and showing daily total Repo 105 usage for December 1, 2006 through February 2, 2007 remained between approximately $14 billion and $24 billion).Show full note Lehman also maintained internal rules – based on senior management's judgment, rather than any accounting requirement – limiting the total firm‐wide use of Repo 105 transactions to $22 billion, later increased to $25 billion.²⁹⁴¹²⁹⁴¹ See, e.g., Lehman, Global Balance Sheet Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 2 [LBEX‐WGM 748489] (setting Repo 105 limit at $17 billion and Repo 108 limit at $5 billion); Joseph Gentile, Lehman, Proposed Repo 105/108 Target Increase for 2007 (Feb. 10, 2007), at p. 1 [LBEX‐DOCID 2489498] (attached to e‐mail from Joseph Gentile, Lehman, to Edward Grieb, Lehman (Feb. 10, 2007) [LBEX‐DOCID 2600714] and proposing to increase $22 billion combined Repo 105/108 limit to $25 billion); e‐mail from Sigrid Stabenow, Lehman, to Clement Bernard, Lehman, et al. (Jan. 25, 2008) [LBEX‐ DOCID 1853428] (requesting that Repo 105 limit of $20 billion be expanded to $23 billion); Examiner's Interview of Andrew J. Morton, Sept. 21, 2009, at pp. 4, 22 (stating Repo 105 limits established at inception of program in 2001); Examiner's Interview of Edward Grieb, Oct. 2, 2009, at pp. 9‐10; Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 10; Examiner's Interview of Joseph Gentile, Oct. 21, 2009, at p. 7. The Repo 105 limit was a management decision, was not based on accounting rules, and was not part of Lehman's internal Repo 105 Accounting Policy.Show full note

¶In mid‐to‐late 2007, however, Lehman increased dramatically the volume of firm‐wide Repo 105 transactions at quarter‐end. By first quarter 2008, the dollar value of assets that Lehman temporarily removed from its balance sheet at quarter‐end through Repo 105 transactions was $49 billion.²⁹⁴²²⁹⁴² See Lehman, Total Repo 105 & Repo 108 Report (June 11, 2008) [LBEX‐DOCID 2078195] (attached to e‐ mail from Kristie Wong, Lehman, to Martin Kelly, Lehman (June 11, 2008) [LBEX‐DOCID 2325872] and showing total firm‐wide Repo 105 usage at May 30, 2008). Lehman escalated its Repo 105 activity despite its understanding that its peer investment banks – to whom Lehman's leverage was compared – did not use similar devices.²⁹⁴³²⁹⁴³ Examiner's Interview of Marie Stewart, Sept. 2, 2009, at p. 14; Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 11; Examiner's Interview of Anuraj Bismal, Sept. 16, 2009, at p. 7; Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 7; Examiner's Interview of Matthew Lee, July 1, 2009, at p. 14; see also e‐mail from Anuraj Bismal, Lehman, to Marie Stewart, Lehman, et al. (Dec. 5, 2007) [LBEX‐DOCID 3223386]; e‐mail from Michael McGarvey, Lehman, to Clement Bernard, Lehman (Jan. 30, 2008) [LBEX‐DOCID 2796630]; e‐mail from Ryan Traversari, Lehman, to Christopher M. O'Meara, Lehman, et al. (May 16, 2008) [LBEX‐DOCID 574498]; e‐mail from Michael McGarvey, Lehman, to Jormen Vallecillo, Lehman (July 2, 2008) [LBEX‐DOCID 3379145].Show full note

763

¶Lehman greatly expanded its Repo 105 program at a time when market observers increased their focus on the leverage of investment banks and Lehman management placed increased pressure on the businesses within the firm to reduce their net assets. CEO Fuld noted that marketplace perceptions of Lehman precluded Lehman from improving its net leverage ratio by means of raising equity.²⁹⁴⁴²⁹⁴⁴ Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at p. 27. Moreover, as Lehman's inventory grew increasingly illiquid, it became difficult to sell without reducing prices and incurring losses or calling into question Lehman's marks for inventory remaining on its balance sheet.²⁹⁴⁵²⁹⁴⁵ See Section III.A.4.e.3–4 of this Report.

764

Why the Examiner Investigated Lehman's Use of Repo 105 Transactions

¶As part of the Examiner's investigation of internal Lehman audits of risk management controls, the Examiner became aware of Lehman's Repo 105 off‐balance sheet effect. As the Examiner obtained a critical mass of information regarding Lehman's use of these transactions and the firm's motive in undertaking them at increasing volumes in late 2007 and 2008, it became apparent that Lehman's use of Repo 105 transactions intersected with several issues involved in the Examiner's investigation, including the directive that the Examiner investigate whether there are colorable claims for breach of fiduciary duties by officers and directors.²⁹⁴⁶²⁹⁴⁶ Order Directing Appointment of an Examiner Pursuant to Section 1104(c)(2) of the Bankruptcy Code, Docket No. 08‐13555 (JMP), In re Lehman Brothers Holdings Inc., No. 08‐13555, at p. 3 (Bankr. S.D.N.Y. Jan. 16, 2009). As described infra, the Examiner concludes that a colorable claim of breach of fiduciary duty exists against certain Lehman officers – namely, Richard Fuld, Chris O'Meara, Erin Callan, and Ian Lowitt.

¶The Examiner further concludes that a colorable claim of professional malpractice exists against Ernst & Young.²⁹⁴⁷²⁹⁴⁷ Ernst & Young's conduct in connection with Lehman's failure to disclose its use of Repo 105 transactions falls within the Court's January 16, 2009 directive that the Examiner "perform the duties specified in sections 1106(a)(3) and (4) of the Bankruptcy Code." Id. at 5. Sections 1106(a)(3) and (4) of the Bankruptcy Code provide that the Examiner shall "investigate the acts, conduct, assets, liabilities and financial condition of the debtor [and] the operation of the debtor's business" and "file a statement of any investigation . . . including any fact ascertained pertaining to fraud, dishonesty, incompetence, misconduct, mismanagement, or irregularity in the management of the affairs of the debtor, or to a cause of action available to the estate." 11 U.S.C. § 1106 (2006).Show full note

765

A Typical Repo 105 Transaction

The Genesis of Lehman's Repo 105 Program in 2001

¶Lehman initiated its Repo 105 program sometime in 2001, soon after SFAS 140 took effect in September 2000.²⁹⁴⁸²⁹⁴⁸ Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 7; Examiner's Interview of John Coghlan, Nov. 11, 2009, at p 5. Lehman added Repo 108 transactions to the program in May 2006. See Lehman, Global Balance Sheet, Lehman, Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 4 [LBEX‐WGM 748489] ("Repo 108 for equity securities was introduced as at May 2006 [$0.6B]."). At that time, heads of various Lehman business units from New York and London, and representing several of the firm's business divisions and groups, including Credit, Treasury, Product Control, Accounting Policy, Legal, and Compliance, convened to assess how Lehman could use SFAS 140 to manage its balance sheet.²⁹⁴⁹²⁹⁴⁹ Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 7. While he did not dispute Feraca's recollection, John Coghlan, former Head of Prime Services to whom Feraca directly reported, recalled that Lehman developed its Repo 105 policy and began engaging in Repo 105 transactions in approximately 2001, after senior management at the firm had grown aware that other peer Consolidated Supervised Entities ("CSE") firms were undertaking similar off‐balance sheet repo transactions. Examiner's Interview of John Coghlan, Nov. 11, 2009, at p. 5.Show full note Lehman's outside auditors and lawyers participated in the firm's review of SFAS 140.²⁹⁵⁰²⁹⁵⁰ Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 7. Asked directly to name the auditors and lawyers, Feraca did not recall the specific identities of the firms or individuals. Although Lehman acquired true sale opinion letters, as required by SFAS 140, from the Linklaters law firm (discussed more fully below), the evidence referencing Linklaters' opinion letters is silent on the issue of Linklaters' involvement at the development stage of Lehman's Repo 105 program.Show full note Indeed, Lehman vetted the concept of a SFAS 140 repo transaction with its outside auditor, before the firm formalized a Repo 105 accounting policy and approved Repo 105 transactions for use by firm personnel.²⁹⁵¹²⁹⁵¹ Id.

766

¶Several months of internal meetings and discussions occurred before Lehman finalized the structure of its Repo 105 program.²⁹⁵²²⁹⁵² Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 7. Ultimately, Lehman designed the model structure for a Repo 105 transaction and drafted an official, internal Lehman Accounting Policy that covered what became known at the firm as "Repo 105," and eventually included "Repo 108," transactions.²⁹⁵³²⁹⁵³ Id.Lehman's Accounting Policy Manual for Repo 105 and Repo 108 is reprinted in its entirety in Appendix 17, Repo 105 Appendix. Lehman's Accounting Policy Manual for Repo 105 transactions was distributed to all "business people" within the firm.²⁹⁵⁴²⁹⁵⁴ Examiner's Interview of Marie Stewart, Sept. 2, 2009, at p. 8; Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 7; Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 7. Repo 105 transactions firm‐wide had to comply with this policy.

Repo 105 Transactions Versus Ordinary Repo Transactions²⁹⁵⁵²⁹⁵⁵ Repo transactions are characterized differently under bankruptcy, tax, insurance, and securities law. That is, some bodies of law characterize repo transactions as sales, while others characterize repo transactions as loans or secured transactions. For example, in bankruptcy disputes between creditors and debtors where a claim involves an alleged breach of the duty to liquidate the securities transferred in a repo transaction in a commercially reasonable manner, the Southern District of New York held that a repo transaction was a sale rather than a secured loan, thereby suggesting that a repo transaction should be governed by Article 8 of the Uniform Commercial Code (the "UCC") as opposed to Article 9 of the UCC. Granite Partners, L.P v. Bear, Stearns & Co., Inc., 17 F. Supp.2d 275, 302 (S.D.N.Y. 1998). On the other hand, for purposes of tax law, the United States Supreme Court has held that repo transactions are secured loans rather than sales. Nebraska Dep't of Revenue v. Loewenstein, 513 U.S. 123, 130‐31 (1994). An analysis of the characterization of repo transactions under law is beyond the scope of this Report, which, with respect to Lehman's Repo 105 program, focuses on the accounting treatment of Repo 105 transactions, the treatment of Repo 105 transactions for financial reporting purposes, and Lehman's disclosure obligations.Show full note

¶Generally, "[r]epurchase Agreements, or repos, are the primary instruments used by [United States] broker‐dealers to finance their inventory positions."²⁹⁵⁶²⁹⁵⁶ Lehman, Repo Manual (Nov. 8, 2005), at p. 6 [LBEX‐LL 1175483]. The Repo Manual was an internal Lehman publication intended as a reference guide for sales people engaging in repo transactions. Repo transactions consist of two legs.²⁹⁵⁷²⁹⁵⁷ See Lehman, Repo Manual (Nov. 8, 2005), at p. 7 [LBEX‐LL 1175483]. In the first leg, Lehman would transfer securities inventory to a repo lender in return for cash.²⁹⁵⁸²⁹⁵⁸ See Examiner's Interview of Marie Stewart, Sept. 2, 2009, at p. 8; Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 7. In the second leg, Lehman would repay the cash amount plus interest, and the repo lender would return the securities inventory.²⁹⁵⁹²⁹⁵⁹ See Lehman, Repo Manual (Nov. 8, 2005), at p. 7 [LBEX‐LL 1175483]. The difference between the value of the securities inventory transferred and the cash received is referred to as the "haircut" on the repo transaction. As explained in detail below, in an ordinary repo transaction involving liquid securities during the late 2007 and 2008 time period, the haircut third parties typically required was approximately 2% while in a Repo 105 or Repo 108 transaction, the haircut involved was required to be at least five percent or eight percent, respectively, and was often more.²⁹⁶⁰²⁹⁶⁰ Examiner's Interview of Mark Gavin, Sept. 24, 2009, at p. 7; Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 6; see Lehman, Global Balance Sheet, Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 2 [LBEX‐WGM 748489].

767 768

Lehman's Accounting Treatment of Repo 105 Transactions Versus Ordinary Repo Transactions

¶For accounting and financial reporting purposes – consistent with Lehman's policy as disclosed in its publicly filed statements – the substance of an ordinary repo transaction is a short‐term borrowing or financing transaction.²⁹⁶¹²⁹⁶¹ See Lehman, Global Balance Sheet, Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 1 [LBEX‐WGM 748489] ("Repo transactions are normally recorded on the balance sheet as financings."); see also Section III.A.4.j.2.c.ii.a of the Report (discussing Lehman's characterization of repo transactions for purposes of financial reporting in Forms 10‐K and 10‐Q). The transferor in an ordinary repo transaction, also known as the "repo borrower," receives cash, but the ordinary repo transaction also creates a liability for the transferor to repay the amount of cash borrowed.²⁹⁶²²⁹⁶² See Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), at p. 2. Accordingly, the accounting impact of an ordinary repo on the transferor's balance sheet is to increase both: (1) total assets, as a result of the incoming cash, and (2) total liabilities, by an amount corresponding to the obligation to repay the cash.²⁹⁶³²⁹⁶³ Id.; see also SFAS 140 ¶ 100 ("Repurchase agreements that do not meet all the criteria in paragraph 9 shall be treated as secured borrowings."). Typically the repo borrower in an ordinary repo continues to receive the income from the coupon payments of the securities that serve as collateral for the borrowing of cash from the transferee.²⁹⁶⁴²⁹⁶⁴ See, e.g., Master Repurchase Agreement (September 1996 Version) between Lehman Brothers Inc., Lehman Commercial Paper Inc. and Lehman Brothers International (Europe) (Oct. 6, 1998), ¶ 5 Income Payment [LBEX‐AM 333493] (stating that repo seller is entitled to receive all income paid or distributed on or in respect of the transferred securities to the full extent it would be so entitled if the securities had not been sold); Master Repurchase Agreement (September 1996 Version) between Dresdner Bank AG, New York Branch and Lehman Brothers Inc., Lehman Commercial Paper Inc. (July 19, 2002, 1998), ¶ 5 Income Payment [LBEX‐AM 334017] (same); Master Repurchase Agreement (September 1996 Version) between Lehman Brothers Inc. and Bank for International Settlements (Aug. 14, 1998), ¶ 5 Income Payment [LBEX‐AM 333532] (same). cf. Lehman Brothers, Repo Manual (Nov. 8, 2005), at p. 15 [LBEX‐LL 1175483] (stating that for its standard repo transactions, Lehman uses BMA Master Repurchase Agreement, which includes interest payment terms). The Supreme Court's decision in Nebraska Dep't of Revenue v. Loewenstein, in which the Court held that repo transactions were secured loans rather than sales, noted that the interest charged by the repo lender bears no relation to the coupon interest paid or accruing on the securities during the term of the repo. 513 U.S. 123, 131 (1994). The fact that the coupon interest on the securities continued to flow to the repo borrower was one factor the Court considered in holding that repo transactions were secured loans rather than sales under tax law. Id. at 130.Show full note

769

¶When an ordinary repo transaction matures, that is, the term of the transaction expires, the transferor repays the cash to the transferee and the transferee, also known as a "repo lender," returns to the transferor the securities held as collateral.²⁹⁶⁵²⁹⁶⁵ Lehman, Repo Manual (Nov. 8, 2005), at p. 7 [LBEX‐LL 1175483]. The effect of the maturing of the ordinary repo transaction on the transferor's balance sheet is to reduce both: (1) total assets, as a result of the repayment of the borrowed cash, and (2) total liabilities, because the obligation to repay has been extinguished.²⁹⁶⁶²⁹⁶⁶ See Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), at p. 2.

770

¶Consistent with the firm's disclosures in its financial statements, Lehman recorded ordinary repo transactions as secured lending or financing transactions.²⁹⁶⁷²⁹⁶⁷ Lehman, Global Balance Sheet, Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 1 [LBEX‐ WGM 748489] ("Repo transactions are normally recorded on the balance sheet as financings."); LBHI 2007 10‐K, at p. 97 (stating that Lehman treats repo transactions as collateralized agreements and financings for financial reporting purposes); LBHI 10‐Q (filed Apr. 9, 2008), at p. 13 (same); LBHI 10‐Q (filed July 10, 2008), at p. 16 (same); see also Duff & Phelps, Explanation of Repo 105 Accounting Ledger Entries and Trading System Output (Jan. 5, 2010), at p. 3 (stating that Lehman's accounting systems recorded repo transactions as financing transactions and that manual intervention required to recharacterize the repo as a sale (i.e., a Repo 105)).Show full note Accordingly, when Lehman engaged in an ordinary repo transaction as transferor, the securities that Lehman transferred remained on Lehman's balance sheet as inventory, a subset of total assets.²⁹⁶⁸²⁹⁶⁸ See SFAS 140, ¶ 100 ("Repurchase agreements that do not meet all the criteria in paragraph 9 shall be treated as secured borrowings.").

¶Repo 105 transactions were structurally and substantively identical to ordinary repo transactions; indeed, Lehman used the same documentation to execute both Repo 105 and ordinary repo transactions, and these transactions were conducted with the same collateral and substantially the same counterparties.²⁹⁶⁹²⁹⁶⁹ John Feraca, who ran Lehman's Secured Funding Desk which was responsible for executing ordinary repo and Repo 105 transactions, stated that with most counterparties, Lehman had capacity to do either an ordinary repo or a Repo 105 transaction; that nothing prevented Lehman from engaging in a standard, overnight repo transaction using the same assets with the same counterparty but at a lower haircut; and that Lehman used the same GMRA for ordinary repo and Repo 105 transactions with the same counterparty. Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 6 Mark Gavin, who worked for LBIE's Secured Financing Desk believed that a single GMRA, which governed both ordinary repo and Repo 105 transactions, was in place for many of Lehman's counterparties. Examiner's Interview of Mark Gavin, Sept. 24, 2009, at p. 6.Show full note Specifically, in a Repo 105 transaction, just as in an ordinary repo transaction, Lehman would transfer securities to a repo lender in exchange for short‐term financing.²⁹⁷⁰²⁹⁷⁰ See Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), at p. 3. Additionally, in a Repo 105 transaction, just as in an ordinary repo transaction, Lehman, as the borrower, was obligated to "repurchase" the securities posted as collateral (stated differently, to repay the cash borrowing) upon maturation of the repo.²⁹⁷¹²⁹⁷¹ Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 9; Examiner's Interview of Matthew Lee, July 1, 2009, at p. 10 (stating that Lehman repurchased the inventory approximately 4 to 5 days after new quarter began).

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¶During the term of a Repo 105 transaction, as with a typical ordinary repo transaction, Lehman continued to receive the stream of income (the coupon payments) from the securities transferred in a Repo 105 transaction.²⁹⁷²²⁹⁷² The May 2001 Linklaters true sale opinion letter, discussed in greater detail below, makes clear that in the transactions contemplated under the letter, income received during the transaction period by the repo buyer (i.e., Lehman's United Kingdom counterparty in the case of Repo 105 transactions) from the transferred securities would be paid or otherwise credited to the repo seller's (i.e., LBIE) account by the buyer. Letter from Linklaters, to Lehman Brothers International (Europe), re: Repurchase Transactions under a Global Master Repurchase Agreement (May 21, 2006), §2.4 [LBEX‐LBIE 000001]. The Global Master Repurchase Agreements, upon which the Linklaters letter is based, also contain wording to this effect. See, e.g., Global Master Repurchase Agreement (2000 Version) between Lehman Brothers International (Europe) and Barclays Bank PLC (May 4, 2006), ¶ 5 Interest Payment [LBEX‐AM 333643]; Global Master Repurchase Agreement (2000 Version) between Lehman Brothers International (Europe) and Fortis Bank NV/SA (July 16, 2004), ¶ 5 Interest Payment [LBEX‐AM 334046]; Global Master Repurchase Agreement (1995 Version) between CS First Boston Limited and Lehman Brothers International (Europe) (Jan. 3, 1996), ¶ 5 Interest Payment [LBEX‐AM 333769].Show full note As in an ordinary repo transaction, Lehman was charged interest on the cash borrowing in a Repo 105 transaction.²⁹⁷³²⁹⁷³ See SFAS 140 ¶ 96 ("Government securities dealers, banks, other financial institutions, and corporate investors commonly use repurchase agreements to obtain or use short‐term funds. Under those agreements, the transferor ('repo party') transfers a security to a transferee ('repo counterparty' or 'reverse party') in exchange for cash and concurrently agrees to reacquire that security at a future date for an amount equal to the cash exchanged plus a stipulated 'interest' factor."); see also Duff & Phelps, Explanation of Repo 105 Accounting Ledger Entries and Trading System Output (Jan. 5, 2010), at p. 5.Show full note Lehman paid the repo interest separately upon the completion of a Repo 105 transaction (i.e., when the term expired), just as Lehman would on all ordinary repo transactions.²⁹⁷⁴²⁹⁷⁴ Duff & Phelps, Explanation of Repo 105 Accounting Ledger Entries and Trading System Output (Jan. 5, 2010), at p. 5. Accordingly, Lehman would debit an "interest expense" income statement item.²⁹⁷⁵²⁹⁷⁵ Id. At the transactional level, each repo – ordinary or Repo 105 – had a specific interest rate charge. But, all the interest charges were rolled up into one number ("interest expense") that appeared in the income statement of Lehman's reported financials.

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¶Despite the identical structure and substance of ordinary repos and Repo 105 transactions, the latter received critically different accounting treatment: Lehman treated Repo 105 transactions as "sales" of financial assets for accounting purposes under SFAS 140, which in effect enabled Lehman to move the securities inventory off its balance sheet during the term of the Repo 105 transaction; with the reduction in inventory, the net impact of the incoming cash from a Repo 105 transaction was that total assets remained unchanged.²⁹⁷⁶²⁹⁷⁶ Lehman Brothers Holdings Inc., Accounting Policy Memo, Repo 105 and Repo 108 (Feb. 13, 2008), at pp. 1‐2 [LBEX‐DOCID 3213297] (attached to e‐mail from Marie Stewart, Lehman, to Martin Kelly, Lehman (Apr. 10, 2008) [LBEX‐DOCID 3223687]; Lehman Brothers Holdings Inc., Accounting Policy Manual Repo 105 and Repo 108 (Sept. 9, 2006), at pp. 1‐2 [LBEX‐DOCID 3213286] (attached to e‐mail from Marie Stewart, Lehman, to Martin Kelly, Lehman, et al. (Dec. 5, 2007) [LBEX‐DOCID 3223386]; Lehman Brothers Holdings Inc., Accounting Policy Manual Repo 105 (Dec. 1, 2004), at pp. 1‐2 [LBEX‐DOCID 647239] (attached to e‐mail from Kieran Higgins, Lehman, to Kaushik Amin, Lehman (Nov. 21, 2007) [LBEX‐DOCID 738606]).Show full note

¶Under SFAS 140, "A transfer of financial assets . . . in which the transferor surrenders control over those financial assets shall be accounted for as a sale to the extent that consideration other than beneficial interests in the transferred assets is received in exchange."²⁹⁷⁷²⁹⁷⁷ ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS OF LIABILITIES, Statement of Financial Accounting Standards No. 140, ¶ 9 (Fin. Accounting Standards Bd. 2000) ("SFAS 140"). SFAS 140 also states that "The transferor has surrendered control over transferred assets if and only if all of the following conditions are met":

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● The transferred assets have been isolated from the transferor – put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership.

● Each transferee has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both constrains the transferee (or holder) from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor.

● The transferor does not maintain effective control over the transferred assets through either (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity or (2) the ability to unilaterally cause the holder to return specific assets, other than through a cleanup call.²⁹⁷⁸²⁹⁷⁸ SFAS 140, ¶ 9.

¶If a repo transaction satisfies each of these three criteria, the repo transferor is deemed to have surrendered control of the transferred collateral, and consequently, SFAS 140 permits the transferor to account for the transaction as a "sale" of financial assets and a forward purchase commitment.²⁹⁷⁹²⁹⁷⁹ SFAS 140, ¶ 11; Lehman, Global Balance Sheet, Overview of Repo 105 (FID)/108 (Equities) (July 2006), p. 1 [LBEX‐WGM 748489]; Lehman Brothers Holdings Inc., Accounting Policy Manual, Repo 105 and Repo 108 (Sept. 9, 2006), at p. 1 [LBEX‐DOCID 3213293] (attached to e‐mail from Anuraj Bismal, Lehman, to Martin Kelly, Lehman, et al. (Mar. 6, 2008) [LBEX‐DOCID 3223442]. Lehman determined that its Repo 105 transactions met these criteria and accounted for them accordingly.²⁹⁸⁰²⁹⁸⁰ Lehman Brothers Holdings Inc., Accounting Policy Manual, Repo 105 and Repo 108 (Sept. 9, 2006), at pp. 1‐2 [LBEX‐DOCID 3213293] (attached to e‐mail from Anuraj Bismal, Lehman, to Martin Kelly, Lehman, et al. (Mar. 6, 2008) [LBEX‐DOCID 3223442].

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¶Consequently, recharacterizing a Repo 105 transaction as a sale had the following immediate consequences:

● Unlike in an ordinary repo transaction, the securities that Lehman transferred in a Repo 105 transaction to the repo lender did not remain on Lehman's balance sheet as securities inventory during the term of the repo. Instead, Lehman removed the securities from its balance sheet, thereby reducing securities inventory (one class of asset) on its balance sheet.²⁹⁸¹²⁹⁸¹ Id.; see also Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), at pp. 3‐4.

● Although there was a reduction in inventory, total assets remained the same as a result of the incoming cash.²⁹⁸²²⁹⁸² Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), at p. 3. Thus, unlike an ordinary repo transaction, in which both total assets and total liabilities increase, Lehman's total assets and total liabilities did not increase as the result of a Repo 105 transaction.²⁹⁸³²⁹⁸³ Lehman's total assets were reduced when Lehman engaged in a Repo 105 transaction because Lehman both removed the inventory from the balance sheet and used the incoming Repo 105 cash for other business purposes, including to pay off other liabilities (rather than having the cash remain on the firm's balance sheet).

● At the moment of a Repo 105 transaction, because total assets and total liabilities were unchanged, Lehman's leverage ratios also remained unaffected even though Lehman had borrowed, in the aggregate, billions of dollars.

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● Moreover, unlike in an ordinary repo transaction where liabilities increased because Lehman recorded the obligation to repay the cash borrowing, in a Repo 105 transaction, Lehman did not record any obligation to repay the cash borrowing.²⁹⁸⁴²⁹⁸⁴ See Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), at p. 3.

¶But Lehman's Repo 105 practice had two steps. While the first step had no impact upon net leverage, in step two Lehman used the cash borrowing from Repo 105 transactions to pay down different liabilities and thereby reduce the firm's reported leverage ratios.²⁹⁸⁵²⁹⁸⁵ Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 7; Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 9; Examiner's Interview of Matthew Lee, July 1, 2009, at p. 14; see also e‐mail from Anuraj Bismal, Lehman, to Marie Stewart, Lehman, et al. (Dec. 5, 2007) [LBEX‐DOCID 3223384] (stating Repo 105's effect on net leverage ratio, which can only be impacted if Lehman used Repo 105 cash to pay down different liabilities); Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), at pp. 4‐5. In addition, Lehman's public disclosures state that it held between approximately $6 to $7 billion cash at quarter‐ends when Lehman undertook $38.6 billion, $49.1 billion, and $50.38 billion of Repo 105 transactions in fourth quarter 2007, first quarter 2008, and second quarter 2008, respectively, also demonstrating that Lehman did not hold the incoming Repo 105 cash borrowing but used it for other business purposes, including to pay down liabilities. See LBHI 2007 10‐K, at p. 86 (reporting that Lehman had $7.286 billion in cash and cash equivalents on November 30, 2007); LBHI 10‐ Q (filed Apr. 9, 2008), at p. 5 (reporting that Lehman had $7.564 billion in cash and cash equivalents on February 29, 2008); LBHI 10‐Q (filed July 10, 2008), at p. 5 (reporting that Lehman had $6.513 billion in cash and cash equivalents on May 31, 2008).Show full note

Lehman's Accounting Policy for Repo 105 Transactions

¶After Lehman established its Repo 105 program in 2001, the firm published an internal Repo 105 Accounting Policy.²⁹⁸⁶²⁹⁸⁶ Lehman Brothers Holdings Inc., Accounting Policy Manual Repo 105 and Repo 108 (Sept. 9, 2006) [LBEX‐DOCID 3213286] (attached to e‐mail from Marie Stewart, Lehman, to Martin Kelly, Lehman, et al. (Dec. 5, 2007) [LBEX‐DOCID 3223386]). All Repo 105 transactions firm‐wide were required to comply with this policy.²⁹⁸⁷²⁹⁸⁷ The Examiner has reproduced Lehman's Repo 105 Accounting Policy in its entirety in Appendix 17, Repo 105 Appendix.

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¶Excerpted here is certain of the policy's more pertinent language:

● The Policy acknowledged that Lehman treated ordinary repo transactions as "secured financing transactions" but treated Repo 105 transactions as "sales of inventory and forward agreements to repurchase."²⁹⁸⁸²⁹⁸⁸ Lehman Brothers Holdings Inc., Accounting Policy Manual Repo 105 and Repo 108 (Sept. 9, 2006), at p. 1 [LBEX‐DOCID 3213286].

● "Repo 105 and Repo 108 transactions refer to repos with a counterparty in which we sell securities valued at a minimum of 105% (for fixed income securities) or 108% (for equity securities) of the cash received. That is, we sell fixed income securities with a fair value of at least $105 in exchange for $100 of cash for Repo 105, and equity securities with a fair value of at least $108 in exchange for $100 of cash for Repo 108."²⁹⁸⁹²⁹⁸⁹ Id. Although Lehman's Accounting Policy required an 8% haircut for a Repo 108 transaction, Ed Grieb (former Lehman Global Financial Controller) had approved as a general matter a 7% haircut for Repo 108 transactions. See e‐mail from Marie Stewart, Lehman, to Christopher McEwan, Lehman, et al. (July 13, 2006) [LBEX‐DOCID 3234337] ("[B]ack in May we had agreed that it was OK to do Repo 108 at 107. . . . I have re‐cleared 107 with Ed Grieb and he is fine.").Show full note

● "Repo 105 and Repo 108 contracts typically are executed by Lehman Brothers International (Europe) ('LBIE') because true sale opinions can be obtained under English law. We generally cannot obtain a true sale opinion under U.S. law."²⁹⁹⁰²⁹⁹⁰ Lehman Brothers Holdings Inc., Accounting Policy Manual Repo 105 and Repo 108 (Sept. 9, 2006), at p. 1 [LBEX‐DOCID 3213290] (attached to e‐mail from Anuraj Bismal, Lehman, to Martin Kelly, Lehman, et al. (Dec. 5, 2007) [LBEX‐DOCID 3223389]); cf. e‐mail from John Feraca, Lehman, to Michael McGarvey, Lehman (Apr. 17, 2008) [LBEX‐DOCID 3213321] (stating that in order to proceed with a Repo 105 transaction, "[y]ou have to get approval from both Finance and Legal" and that "you need a true sale legal opinion for the repo agreement and the entity you operate from and affirmation that your counterpart operates in an enforceable legal jurisdiction. . . .").Show full note

● "Re‐characterization of a repo from a secured financing transaction to a sale of inventory and a forward to repurchase assets is allowed only if we can demonstrate we have relinquished control of the transferred assets."²⁹⁹¹²⁹⁹¹ Lehman Brothers Holdings Inc., Accounting Policy Manual Repo 105 and Repo 108 (Sept. 9, 2006), at p. 2 [LBEX‐DOCID 3213290].

● "When [certain identified] criteria are met, the assets transferred are removed from our balance sheet and an asset under a derivative contract is recorded to reflect that we will repurchase, under a forward contract, the transferred assets."²⁹⁹²²⁹⁹² Id.

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The Accounting Purpose of the Larger Haircut

¶The labels "Repo 105" and "Repo 108" referred to Lehman's "haircut" on the transaction. A haircut in a repo transaction is the difference between the value of the collateral used to secure a borrowing and the amount of cash that is borrowed.²⁹⁹³²⁹⁹³ See Business Definition for "Haircut," available at http://www.allbusiness.com/glossaries/haircut/4948623‐1.html (last visited Jan. 3, 2010). For each $100 Lehman borrowed in a Repo 105 transaction it needed to transfer $105 of collateral to its counterparty (lender), i.e., it over collateralized the borrowing by five percent. As such, in a Repo 105 transaction in which Lehman borrowed $100 and posted $105, the "haircut" was actually ($105 ‐ $100)/ $105 = 4.76%. However, for purposes of discussion in this Report, we refer to the five percent overcollateralization as a five percent "haircut." Similarly, the "haircut" on a Repo 108 transaction was actually ($108 ‐ $100)/$108 = 7.4%, but for purposes of this discussion, we refer to the eight percent overcollateralization as an eight percent haircut.Show full note

¶The five percent minimum required haircut in a Repo 105 transaction (or eight percent minimum in a Repo 108 transaction) was greater than the haircut Lehman faced in an ordinary repo transaction involving treasury‐type securities, which witnesses indicated was typically approximately 2%.²⁹⁹⁴²⁹⁹⁴ Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 6; see also Agreement between Lehman, FRBNY and JP Morgan re: Custodial Undertaking in Connection with Master Open Market Agreement, Schedule of Eligible Securities, Margin Percentage column (Sept. 14, 2008) [JPM‐2004 0055343] (showing repo collateral haircuts at the time). However, the larger haircut in Repo 105 transactions was an essential component for Lehman to avail itself of SFAS 140 accounting treatment.

¶Under SFAS 140, recharacterizing a repo from a financing transaction to a sale of inventory requires the transferor to demonstrate that it has relinquished control over the transferred assets.²⁹⁹⁵²⁹⁹⁵ ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS OF LIABILITIES, Statement of Financial Accounting Standards No. 140 (Fin. Accounting Standards Bd. 2000) ("SFAS 140"). Paragraphs 47 through 49, 217, and 218 of SFAS 140 contain the relevant discussion of "control."²⁹⁹⁶²⁹⁹⁶ SFAS 140, ¶¶ 47‐49, 217‐218. The FASB determined that "to maintain effective control, the transferor must have both the contractual right and the contractual obligation to reacquire securities that are identical to or substantially the same as those concurrently transferred."²⁹⁹⁷²⁹⁹⁷ SFAS 140, ¶ 217 (emphasis in original). "[T]he transferor's right to repurchase is not assured unless it is protected by obtaining collateral sufficient to fund substantially all of the cost of purchasing identical replacement securities during the term of the contract."²⁹⁹⁸²⁹⁹⁸ SFAS 140, ¶ 218.

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¶Paragraph 218 of SFAS 140 further provided:

Judgment is needed to interpret the term substantially all and other aspects of the criterion that the terms of a repurchase agreement do not maintain effective control over the transferred asset. However, arrangements to repurchase or lend readily obtainable securities, typically with as much as 98 percent collateralization (for entities agreeing to repurchase) or as little as 102 percent overcollateralization (for securities lenders), valued daily and adjusted up or down frequently for changes in the market price of the securities transferred and with clear powers to use that collateral quickly in the event of default, typically fall clearly within that guideline. The Board believes that other collateral arrangements typically fall well outside that guideline.²⁹⁹⁹²⁹⁹⁹ Id. (emphasis in original). In other words, the FASB believed that when the collateralization was between 98% and 102%, a repo borrower maintained effective control over transferred assets and consequently the assets could not be moved off the borrower's balance sheet.

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¶Like ordinary repos, Repo 105 transactions included a commitment from Lehman to repurchase the assets/securities upon the maturation of the repo.³⁰⁰⁰³⁰⁰⁰ Examiner's Interview of Ian T. Lowitt, Oct. 28, 2009, at pp. 10‐11; Examiner's Interview of Matthew Lee, July 1, 2009, at p. 14. The boilerplate contract used in Repo 105 transactions – the GMRA – could also be used in ordinary repo transactions. But a general repurchase commitment is not dispositive of "control" for purposes of a SFAS 140 analysis. Consistent with SFAS 140 and FASB's implementation guide for SFAS 140, Lehman interpreted SFAS 140 to mean that the greater haircuts Lehman applied to Repo 105 transactions established the requisite relinquishment of control of the assets involved in the transactions.³⁰⁰¹³⁰⁰¹ SFAS 140 ¶ 218. See also FASB Staff Implementation Guidance, Guide to Implementation of Statement 140 on Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, questions 45 and 46 (issued February 2001, last revised March 2006).

¶Specifically, if Lehman had the ability to "fund substantially all of the cost of purchasing the same or substantially the same replacement assets," Lehman would be "viewed as having the means to replace the assets" and was therefore "considered not to have relinquished control of the assets."³⁰⁰²³⁰⁰² See Lehman Brothers Holdings Inc., Accounting Policy Manual Repo 105 and Repo 108 (Sept. 9, 2006), at p. 2 [LBEX‐DOCID 3213286] (attached to e‐mail from Marie Stewart, Lehman, to Martin Kelly, Lehman, et al. (Dec. 5, 2007) [LBEX‐DOCID 3223386]). Lehman determined, however, that under the rule, it did not have the ability to fund substantially all of the cost of repurchasing the assets because of the difference – via the larger haircut – between the value of the assets/securities transferred and the funding Lehman borrowed in a Repo 105 transaction. Therefore, Lehman effectively relinquished "control" of the assets for purposes of a SFAS 140 analysis.³⁰⁰³³⁰⁰³ Lehman's internal Repo 105 Accounting Policy provided, "[W]e have retained control of the transferred assets if a fixed income security is margined at less than 105% of the cash received or an equity security is margined at less than 107% of the cash received." Lehman Brothers Holdings Inc., Accounting Policy Manual Repo 105 and Repo 108 (Sept. 9, 2006), at p. 2 [LBEX‐DOCID 3213293] (attached to e‐mail from Anuraj Bismal, Lehman, to Martin Kelly, Lehman, et al. (Mar. 6, 2008) [LBEX‐ DOCID 3223442]). It continued: "Transfers in which we transfer fixed income securities valued at a minimum of 105% of the cash received and equity securities at a minimum of 107% of the cash received are considered to be sales and a forward to repurchase rather than secured financing transactions." Id.Show full note

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¶At bottom, Lehman applied a higher haircut to what otherwise could be an ordinary repo transaction in order to avail itself of the accounting classification under SFAS 140.³⁰⁰⁴³⁰⁰⁴ Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 6. In both an ordinary repo transaction and a Repo 105 transaction: (1) the collateral used eventually returned to Lehman; (2) the same assets could be used for either an ordinary repo transaction or a Repo 105 transaction; and (3) with most counterparties, Lehman had capacity to do either an ordinary repo transaction or a Repo 105 transaction. Id.Show full note Thus, Lehman's use of Repo 105 transactions "clearly . . . was an effort to reduce balance sheet. Traders had balance sheet limits and this was one way they could meet them."³⁰⁰⁵³⁰⁰⁵ Id. Counterparties to Lehman's Repo 105 transactions did not necessarily – or even usually – require or ask for a higher five percent or eight percent haircut on a Repo 105 or Repo 108 transaction.³⁰⁰⁶³⁰⁰⁶ Id. Lehman posted more collateral in a Repo 105 transaction for the same loan it could acquire through an ordinary repo in order to achieve the off‐balance sheet treatment for the collateral.³⁰⁰⁷³⁰⁰⁷ Id. (stating that Lehman offered the five percent or eight percent haircut to its counterparties because Lehman wanted to remove the securities from its balance sheet).

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Lehman Did Not Record a Cash Borrowing but Recorded a Derivative Asset in a Repo 105 Transaction

¶Unlike an ordinary repo transaction, Lehman did not record the borrowing of cash from a Repo 105 transaction even though Lehman was obliged to repay the borrowing.³⁰⁰⁸³⁰⁰⁸ See SFAS 140 ¶ 98 ("If the criteria in paragraph 9 are met, including the criterion in paragraph 9(c)(1), the transferor shall account for the repurchase agreement as a sale of financial assets and a forward repurchase commitment, and the transferee shall account for the agreement as a purchase of financial assets and a forward resale commitment."). As discussed above, ordinary repo transactions are considered financing or borrowing transactions. See Lehman, Global Balance Sheet Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 1 [LBEX‐WGM 748489]. In addition to the incoming cash (an asset), in an ordinary repo transaction, the repo borrower also records a liability (the obligation to repay the borrowed cash). See SFAS 140 ¶ 100 ("Repurchase agreements that do not meet all the criteria in paragraph 9 shall be treated as secured borrowings."). If the Repo 105 transaction technically qualified for true sale accounting under SFAS 140, Lehman was not required for accounting purposes to record a liability, although the economic reality was that Lehman had borrowed cash it had to repay. Instead, Lehman recorded the cash proceeds of the Repo 105 transaction as an asset (cash), but re‐characterized this secured financing as a sale of the securities used as collateral for the borrowing, resulting in a reduction to its Securities Inventory balance. Lehman Brothers Holdings Inc., Accounting Policy Manual Repo 105 and Repo 108 (Sept. 9, 2006), at p. 2 [LBEX‐DOCID 3213293] (attached to e‐mail from Anuraj Bismal, Lehman, to Martin Kelly, Lehman, et al. (Mar. 6, 2008) [LBEX‐DOCID 3223442]). Thus, the Repo 105 device allowed Lehman to borrow tens of billions of dollars in cash without reflecting the borrowing on its balance sheet.Show full note Instead, Lehman established a long inventory derivative asset representing the obligation under a forward contract to repurchase the full amount of securities "sold."³⁰⁰⁹³⁰⁰⁹ Lehman Brothers Holdings Inc., Accounting Policy Manual Repo 105 and Repo 108 (Sept. 9, 2006), at p. 2 [LBEX‐DOCID 3213293], at p. 3 (attached to e‐mail from Anuraj Bismal, Lehman, to Martin Kelly, Lehman, et al. (Mar. 6, 2008) [LBEX‐DOCID 3223442]) ("We have a receivable under a derivative contract because we are required to repurchase under a forward contract $105 worth of securities for payment of only $100.") (emphasis added).Show full note As Lehman's internal Repo 105 Accounting Policy explained, assuming Lehman borrowed $100 cash in exchange for a pledge of $105 of fixed income collateral, Lehman booked a $5 derivative, which represented Lehman's obligation to repurchase the securities at the end of the term of the repo transaction.³⁰¹⁰³⁰¹⁰ Id. The $5 arose from the fact that when it came time to repurchase the pledged securities, Lehman paid $100 cash for $105 worth of securities.³⁰¹¹³⁰¹¹ Id. The transaction therefore had a $5 value to Lehman reflecting the market value of the "overcollateralization" amount of the Repo 105 transaction.³⁰¹²³⁰¹² Id. Because it had a positive fair value of $5, the derivative was recorded as an asset under SFAS 133.³⁰¹³³⁰¹³ Ernst & Young work papers from Lehman's second quarter 2008 show that Ernst & Young reviewed the value of Lehman's Repo 105 derivatives. See Ernst & Young, Fair Value of OTC Derivative Contracts by Maturity as of May 31, 2008 (July 8, 2008) [EY‐SEC‐LBHI‐WP‐2Q08‐000535]; see also e‐mail from Jared Pedowitz, Ernst & Young, to James Billingham, Ernst & Young (Apr. 24, 2008), at p. 4 [EY‐LE‐LBHI‐ KEYPERS 0373642–0373645] ("I am currently working on the Q1 Fair Value of OTC Derivative Contracts in the MD&A. . . . [W]e need to verify. . . the Repo 105 population . . . .[W]ould you be able to confirm the $4.818 bn balance is consistent with your teams review of this area?"); Ernst & Young, Repo 105 Pivot Table [EY‐LE‐LBHI‐KEYPERS 0373646] (showing total value of Repo 105/108 derivatives was $4.818 billion). See Section III.A.4.j.2.c.ii.c of this Report for discussion of Lehman's deficient disclosures regarding the Repo 105 derivative.Show full note

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Anatomy of Repo 105 Transactions and the Linklaters True Sale Opinion Letter

¶In addition to the required haircut, Lehman had to take one additional step to qualify Repo 105 transactions as "sales" and enjoy the balance sheet and leverage relief afforded by that classification. Lehman had to either originate these transactions or conduct them through Lehman Brothers International (Europe) ("LBIE") in London.

¶Broadly speaking, Lehman effected Repo 105 transactions through LBIE employing two alternative structures (depending upon the origin of the securities that Lehman ultimately transferred to the counterparty).³⁰¹⁴³⁰¹⁴ This discussion is limited to Repo 105 transactions, and does not include Repo 108 transactions. To understand the reason for Lehman's alternative structures requires a brief detour back through the requirements of SFAS 140.

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¶In order for a repo transferor to be deemed to have surrendered control of an asset under SFAS 140 – so as to achieve "true sale" treatment under SFAS 140 and remove the transferred securities from the transferor's balance sheet – the transferred assets must be isolated from the transferor, that is, put presumptively beyond the reach of the transferor and its creditors, even in the event of the transferor's bankruptcy.³⁰¹⁵³⁰¹⁵ ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS OF LIABILITIES, Statement of Financial Accounting Standards No. 140, ¶ 9.a. (Fin. Accounting Standards Bd. 2000) ("SFAS 140"). To be isolated under SFAS 140, there must have been a true sale at law.³⁰¹⁶³⁰¹⁶ Auditing guidance provides that "A determination about whether the isolation criterion has been met to support a conclusion regarding surrender of control is largely a matter of law. This aspect of surrender of control, therefore, is assessed primarily from a legal perspective." Using the Work of a Specialist: Auditing Interpretations of Section 336, AU § 9336.01, The Use of Legal Interpretations as Evidential Matter to Support Management's Assertion that a Transfer of Financial Assets Has Met the Isolation Criterion in Paragraph 9(a) of SFAS 140 (Pub. Co. Accounting Oversight Bd. 2001) ["Using the Work of a Specialist: Auditing Interpretations of Section 336, AU § 9336"].Show full note Typically, to meet this requirement, the transferor obtains a true sale opinion letter.³⁰¹⁷³⁰¹⁷ "[S]ince the isolation aspect of surrender of control is assessed primarily from a legal perspective, the auditor usually will not be able to obtain persuasive evidence in a form other than a legal opinion." Using the Work of a Specialist: Auditing Interpretations of Section 336, AU § 9336.21.

¶Lehman's internal Repo 105 Accounting Policy echoed the SFAS 140 requirement that the "transaction [be] a true sale at law."³⁰¹⁸³⁰¹⁸ Lehman Brothers Holdings Inc., Accounting Policy Manual Repo 105 and Repo 108 (Sept. 9, 2006), at p. 1 [LBEX‐DOCID 3213293] (attached to e‐mail from Anuraj Bismal, Lehman, to Martin Kelly, Lehman, et al. (Mar. 6, 2008) [LBEX‐DOCID 3223442]). The problem was that Lehman was unable to obtain a true sale opinion from a United States lawyer. Lehman's Repo 105 Accounting Policy states: "We generally cannot obtain a true sale opinion under U.S. law;" "Repos generally cannot be treated as sales in the United States because lawyers cannot provide a true sale opinion under U.S. law."³⁰¹⁹³⁰¹⁹ Id. Several witnesses similarly recalled that Lehman was unable to obtain a true sale opinion from a law firm based in the United States related to Lehman's Repo 105 transactions. Examiner's Interview of Marie Stewart, Sept. 2, 2009, at p. 13; Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 7; Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 8; Examiner's Interview of John Coghlan, Nov. 11, 2009, at p. 9; Examiner's Interview of Matthew Lee, July 1, 2009, at p. 15.Show full note Lehman was able to get a true sale opinion from the Linklaters law firm in London, in several iterations, under the laws of the United Kingdom.³⁰²⁰³⁰²⁰ See generally Letter from Linklaters, to Lehman Brothers International (Europe), re: Repurchase Transactions under a Global Master Repurchase Agreement (May 31, 2006) [LBEX‐LBIE 000001]. Lehman's internal Repo 105 Accounting Policy and an internal PowerPoint presentation referenced several iterations of the Linklaters opinion letter and witnesses state that Lehman refreshed the Linklaters letter on more than one occasion. See Lehman, Global Balance Sheet Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 3 [LBEX‐WGM 748489] (stating that true sale opinion letter for GMRA was first obtained in May 2001, updated in September 2004, and further updated in May 2006); Lehman Brothers Holdings Inc., Accounting Policy Manual Repo 105 and Repo 108 (Sept. 9, 2006), at p. 1 [LBEX‐ DOCID 3213293] (stating that Linklaters has issued opinions under a GMRA); Examiner's Interview of Anuraj Bismal, Sept. 16, 2009, at p. 8 (stating that Ed Grieb refreshed the Linklaters letter). Though Lehman refreshed the letter several times, the Examiner has been able to locate only one version of the Linklaters letter, dated May 31, 2006. The May 2006 Linklaters Letter is reproduced at Appendix 17, Repo 105 Appendix.Show full note

784

¶The Linklaters letter was addressed to LBIE, and analyzes repo transactions executed under a 1995 or 2000 version of a Global Master Repurchase Agreement under English law, as applied by English courts.³⁰²¹³⁰²¹ Letter from Linklaters, to Lehman Brothers International (Europe), re: Repurchase Transactions under a Global Master Repurchase Agreement (May 31, 2006) [LBEX‐LBIE 000001]; see also Lehman Brothers Holdings Inc., Accounting Policy Manual Repo 105 and Repo 108 (Sept. 9, 2006), at p. 1 [LBEX‐DOCID 3213293] ("This policy addresses repo transactions executed in the UK under a Global Master Repurchase Agreement ('GMRA') provided the counterparty resides in a jurisdiction covered under English law…. The UK law firm of Linklaters has issues us true sale opinions covering Repo 105 and Repo 108 transactions documented under a GMRA under English law."); Lehman, Global Balance Sheet Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 1 [LBEX‐WGM 748489] ("A repo under a Global Master Repurchase Agreement [GMRA] is a 'true sale'"); id., at 3 (stating legal opinion in place for GMRA). Lehman's internal Repo 105 Accounting Policy likewise stated that "Repo 105 and Repo 108 contracts are typically executed by Lehman Brothers International (Europe) ('LBIE') because true sale opinions can be obtained under English law." Lehman Brothers Holdings Inc., Accounting Policy Manual Repo 105 and Repo 108 (Sept. 9, 2006), at p. 1 [LBEX‐DOCID 3213293]. Lehman acquired legal opinions from Linklaters covering other forms of contracts – the OSLA (Overseas Securities Lending Agreement), GESLA (Master Gilt Edged Stock Lending Agreement) and GMSLA (Global Master Securities Lending Agreement) – but these were never used. Lehman, Global Balance Sheet Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 3 [LBEX‐WGM 748489]; Lehman Brothers Holdings Inc., Accounting Policy Manual Repo 105 and Repo 108 (Sept. 9, 2006), at p. 1 [LBEX‐DOCID 3213293]. The requirement of a true sale opinion letter was well known throughout the firm. See e‐mail from John Feraca, Lehman, to Annie Lin, Lehman (Apr. 17, 2008) [LBEX‐DOCID 3347035] ("You have to get approval from both Finance and Legal locally before you proceed on this. If they need assistance, they can work with their respective counterparts in London and NY. Effectively you need a true sale legal opinion for the repo agreement and the entity you operate from and affirmation that your counterpart operates in an enforceable legal jurisdiction. Doubt we have one from LBAU. Then you need to get approval from Finance. As such, I know LBIE and the GMRA agreement used by it are ok. You can do back to back repos with LBIE who can in turn repo to third parties. Not ideal though."); see also e‐mail from Brett Beldner, Lehman, to Jignesh Doshi, Lehman, et al. (Dec. 13, 2007) [LBEX‐DOCID 3383368] (transmitting Repo 105 Accounting Policy and stating "beside getting in contact with Europe legal to make sure you can get the true sale opinion, you also should probably get John Feraca and Mike McGarvey into the loop. They deal with Repo 105 from both a structure/capacity side (John) and the Product Control side (Mike) and can probably direct you to the proper contacts to address any legal/operational questions."). All Repo 105 transactions were undertaken pursuant to a "GMRA" or Global Master Repurchase Agreement, which is published by PSA and the International Securities Market Association, used for international repo agreements, and governed by English law, though parties may modify the governing law. See Appendix 17, Repo 105 Appendix (discussing GMRA in contrast to MRA, or Master Repurchase Agreement).Show full note The Linklaters letter provides "[t]his opinion is addressed to you [LBIE] solely for your benefit" and that "[i]t is not to be transmitted to anyone else, nor is it to be relied upon by anyone else or for any other purpose. . . ."³⁰²²³⁰²² Letter from Linklaters, to Lehman Brothers International (Europe), re: Repurchase Transactions under a Global Master Repurchase Agreement (May 31, 2006), at p. 8 [LBEX‐LBIE 000001]. Despite that express condition and the express acknowledgement in Lehman's Repo 105 Accounting Policy that Lehman was unable to obtain a true sale opinion under United States law, Lehman's financial officers were unconcerned that a significant portion of Lehman's firm‐wide Repo 105 transactions utilized securities/assets that were owned by and originated from United States‐based Lehman entities. John Feraca recalled "indifference" among Lehman mid‐level management to the divergence between English and American law that prevented a United States law firm from issuing Lehman a true sale opinion for Repo 105 transactions. Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 8 (stating "there was never any angst about it"). Feraca recalled that Lehman's inability to get a true sale opinion under United States law was discussed as early as 2001, when Lehman first designed its Repo 105 program. Id. Feraca did not recall any Lehman employee undertaking an analysis of whether an intercompany repo between a United States‐based Lehman entity and LBIE, conducted solely for purposes of executing a Repo 105 transaction, complied with Lehman's internal Repo 105 Accounting Policy. Id. Ed Grieb, former Global Financial Controller, was aware that Lehman was unable to get a United States true sale opinion to engage in Repo 105 transactions and that this fact was explicitly referenced in Lehman's Repo 105 Accounting Policy. Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 7. Grieb also knew that some volume of assets was transferred to LBIE from United States‐based Lehman entities for the sole purpose of executing Repo 105 transactions. Id. When the Examiner asked whether Grieb was ever concerned that in the face of not being able to acquire a United States true sale opinion, United States‐ based Lehman entities transferred inventory to LBIE for inclusion in Repo 105 transactions on its behalf, Grieb answered "It never raised a concern because I never linked the issues in my head." Id.Show full note The letter stated, however, that "a copy of this opinion may be

785 786

¶provided by Lehman Brothers to its auditors for the purpose of preparing the firm's balance sheets."³⁰²³³⁰²³ Letter from Linklaters, to Lehman Brothers International (Europe), re: Repurchase Transactions under a Global Master Repurchase Agreement (May 31, 2006) [LBEX‐LBIE 000001], at pp. 8‐9. The Linklaters letter did not contain any reference to United States GAAP or SFAS 140.³⁰²⁴³⁰²⁴ See generally id.

¶Although the Linklaters letter was written for the exclusive benefit of LBIE, a significant volume of Lehman's Repo 105 transactions was executed for the benefit and using the securities of one or more United States‐based Lehman entities, such as LBI and LBSF, based in New York.³⁰²⁵³⁰²⁵ See Section III.A.4.d.3 of this Report. Furthermore, the volume of Repo 105 transactions using LBI securities, for the benefit of LBI's balance sheet, grew significantly after late 2007.

¶Consequently, there were two alternative structures for Repo 105 transactions: (1) a LBIE‐only Repo 105 or Repo 108 transaction, executed by LBIE in London using securities owned by LBIE, and (2) a Repo 105 transaction using securities that were owned by, and originated from, a United States‐based Lehman entity such as LBI or LBSF.³⁰²⁶³⁰²⁶ United States‐based Lehman entities generally engaged in Repo 105, rather than Repo 108 transactions. Repo 108 transactions were limited to equities securities. See Lehman, Global Balance Sheet Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 4 [LBEX‐WGM 748489]; Lehman Brothers Holdings Inc., Accounting Policy Manual Repo 105 and Repo 108 (Sept. 9, 2006), at p. 1 [LBEX‐DOCID 3213304].

787

¶The anatomy of a Repo 105 transaction involving assets that originated on the books of LBIE was identical to the anatomy of an ordinary repo transaction, except the Repo 105 transaction carried a greater haircut. In this type of Repo 105 transaction, LBIE transferred $105 or $108 worth of securities it owned to its counterparty in exchange for $100 in cash.³⁰²⁷³⁰²⁷ The only difference between the anatomy of a standard repo and a Repo 105 transaction is the haircut or overcollateralization; structurally, standard repo and Repo 105 transactions are identical. LBIE then used the $100 in cash to pay down other short‐ term liabilities.³⁰²⁸³⁰²⁸ See LBIE Repo 105 Flow Diagram, infra; Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), at pp. 4‐5; Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 9; Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 7; Examiner's Interview of Matthew Lee, July 1, 2009, at p. 14; LBHI 2007 10‐K, at p. 86 (reporting that Lehman had $7.286 billion in cash and cash equivalents on November 30, 2007); LBHI 10‐Q (filed Apr. 9 2008), at p. 5 (reporting that Lehman had $7.564 billion in cash and cash equivalents on February 29, 2008); LBHI 10‐Q (filed July 10, 2008), at p. 5 (reporting that Lehman had $6.513 billion in cash and cash equivalents on May 31, 2008).Show full note

¶When the Repo 105 transaction matured, LBIE repaid the cash plus interest and received its collateral back.³⁰²⁹³⁰²⁹ See LBIE Repo 105 Flow Diagram, infra; Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), at pp. 6‐8. Because Lehman was a consolidated business and LBIE's financial results were rolled into the consolidated financial statements LBHI filed in the United States, the LBIE‐only Repo 105 practice impacted LBHI's publicly reported balance sheet and leverage ratios.³⁰³⁰³⁰³⁰ Examiner's Interview of Marie Stewart, Sept. 2, 2009, at p. 11; Examiner's Interview of Kaushik Amin, Sept. 17, 2009, at p. 8; Examiner's Interview of Ernst & Young, Oct. 16, 2009, at p. 11 (statement of William Schlich).

788

¶When a United States‐based Lehman entity undertook a Repo 105 transaction, that entity transferred securities valued at a minimum of $105 to LBIE via an intercompany repo transaction.³⁰³¹³⁰³¹ Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 9; Examiner's Interview of Mark Gavin, Sept. 24, 2009, at pp. 6‐7; Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 8; see also Duff & Phelps, Explanation of Repo 105 Accounting Ledger Entries and Trading System Output (Jan. 5, 2010), at p. 1. No haircut was applied to the intercompany repo between the United States‐based Lehman entity and LBIE.³⁰³²³⁰³² Lehman, Global Balance Sheet, Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 1 [LBEX‐ WGM 748489]. Upon receiving the securities inventory from the United States‐based Lehman entity, LBIE would execute a Repo 105 transaction with a European counterparty using those securities.³⁰³³³⁰³³ Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 9; Examiner's Interview of Mark Gavin, Sept. 24, 2009, at pp. 5‐6; Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 8. The minimum haircut for the transaction between LBIE and the counterparty, which was the actual Repo 105 transaction, was five percent.³⁰³⁴³⁰³⁴ Lehman, Global Balance Sheet, Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 1 [LBEX‐ WGM 748489]; Lehman Brothers Holdings Inc., Accounting Policy Manual Repo 105 and Repo 108 (Sept. 9, 2006), at pp. 1‐2 [LBEX‐DOCID 3213293].

789

¶LBHI provided LBIE with an additional $5 cash in order for LBIE to then transfer $105 in cash to the United States‐based Lehman entity in exchange for its securities inventory.³⁰³⁵³⁰³⁵ Lehman, Global Balance Sheet, Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 1 [LBEX‐ WGM 748489]. The United States‐based Lehman entity used the $105 in cash either to pay for the repoed securities inventory or, more likely, to pay down its short‐term liabilities.³⁰³⁶³⁰³⁶ Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 9; Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 7; Examiner's Interview of Matthew Lee, July 1, 2009, at p. 14; LBHI 2007 10‐K, at p. 86 (reporting that Lehman had $7.286 billion in cash and cash equivalents on November 30, 2007); LBHI 10‐ Q (filed Apr. 9, 2008), at p. 5 (reporting that Lehman had $7.564 billion in cash and cash equivalents on February 29, 2008); LBHI 10‐Q (filed July 10, 2008), at p. 5 (reporting that Lehman had $6.513 billion in cash and cash equivalents on May 31, 2008).Show full note When the term of the repo expired, LBIE repurchased the securities from the Repo 105 counterparty and then returned the securities to the United States‐based Lehman entity through an intercompany repo.³⁰³⁷³⁰³⁷ See Lehman, Global Balance Sheet Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 1 [LBEX‐WGM 748489]. In fact, Repo 105 transactions using United States‐based securities could include two intercompany repo transfers: first from LBSF to LBI, and then LBI to LBIE.

790

¶Numerous documents from Lehman's archives and numerous witness statements bear out that when a United States‐based Lehman entity sought to employ Repo 105 transactions to remove securities inventory from its balance sheet at quarter‐ end, the United States‐based Lehman entity would book the Repo 105 transactions through LBIE using an inter‐company repo transaction.3038 A substantial volume of

¶3038 See, e.g., E‐mail from Kaushik Amin, Lehman, to Thomas Siegmund, Lehman, et al. (Aug. 23, 2006) [LBEX‐DOCID 2786869] ("We have additional $2.5 Bln in Repo 105 that the firm has signed off on . . . . So, let's max out the capacity. We should be able to use some of the collateral from the Agency business in the US."); e‐mail from Anthony Jawad, Lehman, to Terry Burke, Lehman (Mar. 3, 2008) [LBEX‐DOCID 224902] ("[W]henever I do 105 for ledgers based in ny we never do a ledger transfer for the 105 part, the true sale is recognized and the long cash account debited."); e‐mail from Michael McGarvey, Lehman, to Jerry Rizzieri, Lehman (Feb. 20, 2008) [LBEX‐DOCID 3235353] (McGarvey: "For quarter end balance sheet do you still feel Rates Americas will be able to make target?" Rizzieri: "Can we get more Repo 105?"); e‐ mail from Jerry Rizzieri, Lehman, to Chaz Gothard, Lehman, et al. (Feb. 20, 2008) [LBEX‐DOCID 3385847] ("I know you work with Mitch King [United States Agency Desk] to secure more repo 105 financing for agency product. I would like to know if we could continue to push the capacity higher. We are likely to use more agency product as collateral and might even use some TIPS and discount notes."); e‐mail from Mark Gavin, Lehman, to John Feraca, Lehman, et al. (Feb. 29, 2008) [LBEX‐DOCID 098494] ("Repo 105 on US T's Agencies, TIPS, Aid Bonds for Q end just shy of $18bln."); e‐mail from Mark Neller, Lehman, to Marc Silverberg, Lehman, et al. (Mar. 4, 2008) [LBEX‐DOCID 3234667] (responding to request for list of confirmed quarter‐end Repo 105 trades done out of LBI, Lehman's New York‐based broker‐dealer, sending Total Repo 105 & Repo 108 Report as attachment [LBEX‐DOCID 3219760], and instructing "if you filter for Sum Americas you should see all your anticipated benefits"); e‐mail from Michael McGarvey, Lehman, to Clement Bernard, Lehman, et al. (Mar. 13, 2008) [LBEX‐DOCID 2794226] ("We have failed on 3 bn of repo 105 to UBS for this week's roll. . . . This is an ops issue that occurs sometimes due to the time difference between NY and London. If the repo desk in London does a 105 trade and those bonds are not in sitting in LBI's box we can fail. . . ."); e‐mail from Jeff Michaels, Lehman, to Phil Morgan, Lehman, et al. (May 22, 2008) [LBEX‐DOCID 3385953] (stating that the Repo 105 "point people" in the United States are Mitch King in Front Office Trading, Michael McGarvey in Finance Control, and Tejal Joshi in Balance Sheet Management); e‐mail from Michael McGarvey, Lehman, to Mark Gavin, Lehman, et al. (Feb. 28, 2008) [LBEX‐DOCID 810932] (sending London desk "a list of corporate bonds held in NY (all above BBB and 10 mm in market value) available for any additional Repo 105 capacity we can find" contained in attached schedule of securities [LBEX‐DOCID 791568]); e‐mail from Chaz Gothard, Lehman, to James W. Hraska, Lehman, et al. (Oct. 1, 2007) [LBEX‐DOCID 3233264] (transmitting attached lists of Repo 105 trades from United States Agency Desk with Mizuho [LBEX‐DOCID 3219676 and LBEX‐DOCID 3235916], Barclays [LBEX‐DOCID 3235823], UBS [LBEX‐DOCID 3235853]); e‐mail from Michael McGarvey, Lehman, to Jerry Rizzieri, Lehman (Nov. 5, 2007) [LBEX‐DOCID 3233300] (transmitting lists of United States Agency Desk Repo 105 trades [LBEX‐DOCID 3235736, LBEX‐DOCID 3235807, LBEX‐DOCID 3235832, LBEX‐DOCID 3235928] and stating that "[w]e will try to get as high as possible for month end," i.e., end of fiscal year 2007); e‐mail from Mark Gavin, Lehman, to James W. Hraska, Lehman, et al. (Dec. 4, 2007) [LBEX‐DOCID 3385990] (transmitting lists [LBEX‐DOCID 3369462, LBEX‐DOCID 3369531, LBEX‐ DOCID 3369532, LBEX‐DOCID 3369537] of Repo 105 trades for United States Agency Desk). Tejal Joshi, Michael McGarvey, Mark Gavin, Mitch King, Ed Grieb and other witnesses stated that LBI was involved in Lehman's Repo 105 program. Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 9; Examiner's Interview of Tejal Joshi, Sept. 15, 2009, at p. 7; Examiner's Interview of Mitchell King, Sept. 21, 2009, at pp. 5‐6, 8; Examiner's Interview of Mark Gavin, Sept. 24, 2009, at pp. 5‐6; Examiner's Interview of Edward Grieb, Oct. 2, 2009, at pp. 7‐8; Examiner's Interview of Kaushik Amin, Sept. 17, 2009, at p. 8; Examiner's Interview of Marie Stewart, Sept. 2, 2009, at p. 13. In order to effectuate timely transfers of securities from United States‐based Lehman entities to LBIE, Lehman's New York desk and its London (LBIE) desk communicated regularly. The United States desk did not use the Repo 108 mechanism, which was used on European Equities securities. Each Friday, Marc Silverberg, an analyst assigned to Lehman's Americas Rates trading desk in New York (within Lehman's Fixed Income Division), compiled lists of securities/assets that Lehman's Americas Rates business wanted to make available for use in Repo 105 transactions through LBIE the following week. E‐mail from Marc Silverberg, Lehman, to Chaz Gothard, Lehman, et al. (Aug. 3, 2007) [LBEX‐DOCID 3232701] (transmitting schedule of United States Agency Desk Repo 105 trades for Aug. 8, 2007 through Aug. 15, 2007 [LBEX‐DOCID 3235803]); e‐mail from Marc Silverberg, Lehman, to Mitchell King, Lehman, et al. (Feb. 26, 2008) [LBEX‐DOCID 3234639] (transmitting attached list of United States Agency Desk collateral used in Repo 105 transactions [LBEX‐ DOCID 3235977; LBEX‐DOCID 3235986]); e‐mail from Marc Silverberg, Lehman, to Michael McGarvey, Lehman, et al. (Mar. 4, 2008) [LBEX‐DOCID 3233386] (transmitting attached lists of Repo 105 trades from United States Agency Desk [LBEX‐DOCID 3232665, LBEX‐DOCID 3235775, LBEX‐DOCID 3236009, LBEX‐DOCID 3236010, and LBEX‐DOCID 3236012]); e‐mail from Marc Silverberg, Lehman, to Mark Gavin, Lehman, et al. (Nov. 27, 2007) [LBEX‐DOCID 3232772] (transmitting lists [LBEX‐DOCID 3219744, LBEX‐DOCID 3235939] of additional collateral United States Agency Desk wished to use for Repo 105 transactions over year‐end); e‐mail from Marc Silverberg, Lehman, to Chaz Gothard, Lehman, et al. (Mar. 28, 2008) [LBEX‐DOCID 3232669] (transmitting list [LBEX‐DOCID 3236024] of United States Agency Desk's Repo 105 trades). Lehman traders based in New York City created the lists of potential Repo 105 securities, which they gave to Silverberg each week. Silverberg then sent the lists to Lehman's London trading desk each Friday, in hopes that LBIE could find Repo 105 capacity among counterparties. According to one document of confirmed, executed Repo 105 trades for securities from New York's trading desk, the Rates Americas business (one unit within Lehman's FID) alone was able to reduce its quarter‐end balance sheet in first quarter 2008 by $14.871 billion through the use of Repo 105 transactions. E‐mail from Mitchell King, Lehman, to Jeff Michaels, Lehman (May 20, 2008) [LBEX‐DOCID 3233043] (transmitting "Rates America Repo 105 Q1 Roll" list [LBEX‐DOCID 3235728] of trades, by ledger, cusip, description of securities, face value, and repo value). On occasion, Michael McGarvey, the former Finance Controller in Lehman's Fixed Income Division, compiled lists of United States securities available for potential use in Repo 105 transactions. E‐mail from Michael McGarvey, Lehman, to Jeff Michaels, Lehman, et al. (May 22, 2008) [LBEX‐DOCID 3385955] ("The attached asset list [LBEX‐DOCID 3369637] shows all available collateral by cusip, what has already been sent out on 105 (including subs) and what will be sent out. Please let us know of any additional collateral that you want to send out."). 3039 See Lehman, Total Repo 105 & Repo 108 Report (Dec. 5, 2007) [LBEX‐DOCID 3219746] (attached to e‐ mail from Anuraj Bismal, Lehman, to Marie Stewart, Lehman, et al. (Dec. 5, 2007) [LBEX‐DOCID 3223384]); Lehman, Total Repo 105 & Repo 108 Report (June 11, 2008) [LBEX‐DOCID 2078195] (attached to e‐mail from Kristie Wong, Lehman, to Martin Kelly, Lehman (June 11, 2008) [LBEX‐DOCID 2325872]. Michael McGarvey, the former Finance Controller in Lehman's FID, said that a certain volume of Repo 105 trades were executed using "assets that were held in U.S. trading books." Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 9. Consequently, according to McGarvey, "the Repo 105 benefit applied to a U.S. trading desk." Id. McGarvey stated that the United States‐based securities were usually "agencies, bullets, Fannie and Freddie." Id. McGarvey also stated that a Lehman New York trading desk would book an intercompany repo, transferring the securities to LBI's "box" in London. Id. John Feraca, who formerly worked in the Secured Funding Desk of Lehman's Prime Services Group, similarly stated that a certain volume of assets used in Lehman's Repo 105 transactions originated in New York at a United States‐based Lehman entity, and landed on the books of LBIE by means of an intercompany transfer between LBI and LBIE, before LBIE transferred the assets to a third‐party via the Repo 105 transaction. Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 8. Feraca said that this process was "well known in Finance and Accounting Policy, completely up the ranks." Id. McGarvey's and Feraca's description of the mechanics of how a United States‐based Lehman entity engaged in Repo 105 transactions, using an inter‐company repo with LBIE, is consistent with both flow diagrams of Repo 105 transactions contained in internal Lehman documents and descriptions from other witnesses. See Lehman, Global Balance Sheet Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 1 [LBEX‐WGM 748489].

791 792

¶Lehman's firm‐wide Repo 105 transactions at each quarter‐end in late 2007 through mid‐2008 involved assets that originated with a United States‐based Lehman entity.3039 Specifically:

¶● fourth quarter 2007: $8.3036 billion³⁰⁴⁰³⁰⁴⁰ See Lehman, Total Repo 105 & Repo 108 Report (Dec. 5, 2007) [LBEX‐DOCID 3219746] (attached to e‐ mail from Anuraj Bismal, Lehman, to Marie Stewart, Lehman, et al. (Dec. 5, 2007) [LBEX‐DOCID 3223384]). The United States entities engaged in $8.3036 billion of Repo 105 transactions, out of a global total of $29.916 billion Repo 105‐only or $38.634 billion combined Repo 105/108. Id.

793

¶● first quarter 2008: $14.889 billion³⁰⁴¹³⁰⁴¹ See Lehman, Total Repo 105 & Repo 108 Report (June 11, 2008) [LBEX‐DOCID 2078195] (attached to e‐ mail from Kristie Wong, Lehman, to Martin Kelly, Lehman (June 11, 2008) [LBEX‐DOCID 2325872]). The United States entities engaged in $14.889 billion of Repo 105 transactions out of a global total of $42.200 billion Repo 105‐only or $49.102 billion combined Repo 105/108. Id.

¶● second quarter 2008: $13.6307 billion.³⁰⁴²³⁰⁴² See Lehman, Total Repo 105 & Repo 108 Report (June 11, 2008) [LBEX‐DOCID 2078195] (attached to e‐ mail from Kristie Wong, Lehman, to Martin Kelly, Lehman (June 11, 2008) [LBEX‐DOCID 2325872]). The United States entities engaged in $13.6307 billion of Repo 105 transactions out of a global total of $44.536 billion of Repo 105‐only or $50.383 billion combined Repo 105/108. Id.

Types of Securities Used in Repo 105 Transactions

¶Lehman's Repo 105 Accounting Policy required that the assets used in a Repo 105 transaction "be readily obtainable," meaning that "a market must exist where the assets are either traded on a formal exchange or are considered liquid and trade in a market where price quotations either are published or are obtainable through another verifiable source."³⁰⁴³³⁰⁴³ See, e.g., Lehman Brothers Holdings Inc., Accounting Policy Manual, Repo 105 and Repo 108 (Sept. 9, 2006), at p. 2 [LBEX‐WGM 754598]. The Linklaters opinion letter for Repo 105 transactions conditioned its opinion on the assumption that "the Purchased Securities consist of liquid securities, so that the Buyer could easily dispose of the Purchased Securities and acquire equivalent securities if it wished."³⁰⁴⁴³⁰⁴⁴ Letter from Linklaters, to Lehman Brothers International (Europe), re: Repurchase Transactions under a Global Master Repurchase Agreement (May 31, 2006), at p. 2 [LBEX‐LBIE 000001]. See Appendix 17, Repo 105 Appendix.

794

¶The "liquidity requirement" for Repo 105 transactions was widely known throughout Lehman.³⁰⁴⁵³⁰⁴⁵ Anuraj Bismal, a former Senior Vice President in Lehman's Balance Sheet Group, explained that the requirement in Lehman's internal Repo 105 Accounting Policy that only highly liquid securities or "govies" could be used in Repo 105 transactions was well known throughout the firm. Examiner's Interview of Anuraj Bismal, Sept. 16, 2009, at p. 10; Examiner's Interview of Herbert H. "Bart" McDade III, Sept. 16, 2009, at p. 4 (stating only highly liquid securities could be used in Repo 105/108); Examiner's Interview of Ian T. Lowitt, Oct. 28, 2009, at p. 14 (same); e‐mail from Thomas Siegmund, Lehman, to Kaushik Amin, Lehman (May 2, 2008) [LBEX‐DOCID 601783] ("[I]nternal accounting set rules on what paper can be 105'ed…in the past, we had to use the most liquid paper . . . . the true sale opinion is linked to liquidity and quality of paper – the lower liquidity and quality, the deeper the discount would have to be… and consequently the more expensive the exercise.").Show full note Lehman had intermittent controls in place to ensure that Lehman personnel transferred only liquid securities as part of Repo 105 transactions, as required by Lehman's Repo 105 Accounting Policy.³⁰⁴⁶³⁰⁴⁶ Examiner's Interview of Anuraj Bismal, Sept. 16, 2009, at p. 9 (explaining that Lehman's Balance Sheet Group would intermittently "ask the guys in Europe to check that the securities were liquid"). Bismal characterized this testing as a "snapshot test" that was "not a regular thing." Id. For example, in June 2008, Martin Kelly received a collateral quality testing report. See Lehman, Repo 105 Collateral Quality Testing (May 30, 2008) [LBEX‐DOCID 2057755] (attached to e‐mail from Kristie Wong, Lehman, to Martin Kelly, Lehman (June 11, 2008) [LBEX‐DOCID 2325872]); see also Lehman, Repo 108 Checklist (June 1, 2008) [LBEX‐DOCID 2078196] (attached to e‐mail from Kristie Wong, Lehman, to Martin Kelly, Lehman (June 11, 2008) [LBEX‐DOCID 2325872]). The May 2008 Collateral Quality Test reported that nearly 95% of the securities Lehman utilized in Repo 105 transactions "were rated investment grade by S&P, Moody's, Fitch, or DBRS Ratings Services." Lehman, Repo 105 Collateral Quality Testing (May 30, 2008) [LBEX‐ DOCID 2057755]. Less than 1% of the securities had no ratings information available. Id. A similar test from May 2007 reported that 8.27% of the tested Repo 105 securities were rated investment grade by S&P, Moody's, Fitch, or DBRS, and that 80.74% of the remaining securities had "similar company Investment grade ratings." Lehman, Repo 105 Collateral Quality Testing (May 31, 2007) [LBEX‐DOCID 2464013] (attached to e‐mail from Divyesh Chokshi, Lehman, to Anuraj Bismal, Lehman, et al. (Oct. 2, 2007) [LBEX‐ DOCID 2687082]).Show full note Contemporaneous documents reveal that employees within Lehman's Product Control group periodically would identify securities that had been included erroneously in Repo 105 transactions. For example, in October 2007, one Lehman employee wrote: "Having spoken to Product Control the following positions should not have been included for Repo 105 benefit as they related to Failed Sale Gross Up for Windermere 11 and 12. . . . Going forward, Product Control will advise us of all positions relating to the FAS140 Failed Sale Gross Up."³⁰⁴⁷³⁰⁴⁷ E‐mail from Divyesh Chokshi, Lehman, to Anuraj Bismal, Lehman, et al. (Oct. 2, 2007) [LBEX‐DOCID 2687082]; see also Lehman, Real Estate Europe Product Schedule (Oct. 2, 2007) [LBEX‐DOCID 2717917] (attached to e‐mail from Divyesh Chokshi, Lehman, to Anuraj Bismal, Lehman, et al. (Oct. 2, 2007) [LBEX‐ DOCID 2687082] and listing Windermere product names). The failed SFAS 140 true sale accounting treatment of the Windermere products was reported up to the Global Head of Accounting Policy. See e‐ mail from Marie Stewart, Lehman, to Todd Weiner, Lehman, et al. (Oct. 23, 2007) [LBEX‐DOCID 3223368].Show full note

795

¶In addition, documentary evidence suggests that as Global Head of Accounting Policy, Marie Stewart, was consulted on new applications of the Repo 105 mechanism.³⁰⁴⁸³⁰⁴⁸ For example, when Mark Cosaitis hoped to use the Repo 105 mechanism to get failed sales deconsolidated, Stewart was involved, along with Ernst & Young and Ed Grieb, in denying him permission. See e‐mail from Brett Beldner, Lehman, to Marie Stewart, Lehman, et al. (Aug. 17, 2008) [LBEX‐DOCID 3223803]; e‐mail from Marie Stewart, Lehman, to Mark Cosaitis, Lehman, et al. (Aug. 17, 2008) [LBEX‐DOCID 3223806]; see also e‐mail from Todd Weiner, Lehman, to Annie Lin, Lehman (Apr. 17, 2008) [LBEX‐DOCID 739685] ("All new repo 105 activity needs to be discussed with Marie Stewart and Martin Kelly in New York.").Show full note Stewart said that it was very "typical of people in the Front Office" to try to apply the Repo 105 mechanism to new situations, such as when FID Asia tried to include Australian securities in a Repo 105 transaction.³⁰⁴⁹³⁰⁴⁹ Examiner's Interview of Marie Stewart, Sept. 2, 2009, at p. 10; e‐mail from Annie Lin, Lehman, to Todd Wiener, Lehman, et al. (Apr. 16, 2007) [LBEX‐DOCID 739685] (asking whether Lehman Brothers Australia Ltd. ("LBAU") could "do a back to back position transfer between LBAU and LBIE in order to benefit from repo 105 rule"); e‐mail from Marie Stewart, Lehman, to Annie Lin, Lehman, et al. (Apr. 17, 2008) [LBEX‐DOCID 739685] ("You cannot do Repo 105 in Australia. We will not approve it even if it technically works. I will explain further when I am back from vacation . . . ."); e‐mail from Thomas Siegmund, Lehman, to Kaushik Amin, Lehman (Apr. 17, 2008) [LBEX‐DOCID 739685] ("As B/S will be super tight, I need to make sure we make best use of 105: I want to investigate whether 105‐mechanics can apply to Aussie paper. An answer like below, 'no . . . will explain when back from vac' is unacceptable in any circumstances and really out of line in the current situation!").Show full note

796

¶For the vast majority of Repo 105 transactions, Lehman used relatively liquid securities, but, there were certain exceptions.³⁰⁵⁰³⁰⁵⁰ See, e.g., e‐mail from Clement Bernard, Lehman, to Roger Nagioff, Lehman, et al. (Nov. 20, 2007) [LBEX‐DOCID 173748] ("In the US we believe that most of our Agency positions will be out through 105 transactions…"); e‐mail from Dominic Gibb, Lehman, to Mark Cosaitis, Lehman, et al. (Feb. 28, 2008) [LBHI_SEC07940_1829372] ("Jock and his team are aggressively working to obtain repo 105 funding for all eligible govvies positions. If they are successful then we will have $23 bn of assets on Repo 105 at quarter end. . . . This would leave FID with a net balance sheet of $51.7bn, $4.7 bn above the FID limit. . . ."). Certain documents, however, suggest that Lehman perhaps attempted to use less liquid collateral in Repo 105 transactions. See e‐mail from Michael McGarvey, Lehman, to Gerard Reilly, Lehman, et al. (Aug. 17, 2007) [LBEX‐DOCID 3213312] ("There was call this morning with John Feraca on getting Mortgages out on 105. London is going to show some examples of fixed AAA non‐agency mortgages to Mizuho (who we have a good relationship with) to see if they would be open to taking them. Based on Mizuho's reaction we are going to meet again Monday to determine [how] much we can do."); e‐mail from Kentaro Umezaki, Lehman, to Christopher M. O'Meara, Lehman, et al. (Aug. 17, 2007) [LBEX‐ DOCID 1533678] ("John Feraca is working on Repo 105 for our IG mortgage and real estate assets to reduce our Q3 balance sheet. . . . He will test the waters a bit in London with one counterparty.").Show full note Notably, these same securities could have been used in ordinary repo transactions as well.

¶Most securities Lehman used in Repo 105 transactions were "governmental" in nature, suggesting a certain level of liquidity.³⁰⁵¹³⁰⁵¹ Governmental securities were used in Repo 105 transactions only. Repo 108 transactions utilized equities securities. Governmental security type includes, but is not limited to, governments, treasuries, and agencies. Agencies included Freddie Mac, Fannie Mae, and Federal Home Loan Bank System securities. See e‐mail from Michael McGarvey, Lehman, to Jeff Michaels, Lehman, et al. (May 22, 2008) [LBEX‐DOCID 482311] (transmitting list [LBEX‐DOCID 472396] of all available collateral for Repo 105, including Freddie Mac and Fannie Mae). By late summer 2008, however, Repo 105 counterparties were unwilling to accept Freddie Mac securities. E‐mail from Marc Silverberg, Lehman, to Chaz Gotthard, Lehman, et al. (Aug. 7, 2008) [LBHI_SEC07940_1742976] (stating that Freddie Mac had been removed from a Repo 105 counterparty's list because it is "no longer acceptable collateral to post for 105."). Some internal Lehman e‐mails from within the Liquid Markets division referred to certain agency securities as "sticky," but the use of that term in such e‐mails would not have indicated illiquidity, only that certain agency securities were more difficult to sell than others. See e‐mail from Jeff Michaels, Lehman, to Kaushik Amin, Lehman (July 30, 2008) [LBEX‐DOCID 613324] (stating "balance sheet allocation[] . . . [which] is really a bottom‐up process about who has sticky inventory. Obviously in the US it is agencies. . . ." and transmitting graph of Agency Desk gross and net balance sheet pre‐Repo 105 [LBEX‐DOCID 775856] and graph of Euro Inflation Desk gross and net balance sheet pre‐Repo 105 [LBEX‐DOCID 775857]).Show full note Indeed, the vast majority of securities Lehman utilized in Repo 105 transactions were investment grade, with all but a few of the securities falling within the A to AAA range.³⁰⁵²³⁰⁵² Duff & Phelps Report, Repo 105 Security Liquidity Analysis (Oct. 21, 2009), at p. 5. In addition, the majority of Lehman's Repo 105 securities fit within Level 1 under SFAS 157's "Fair Value Level" GAAP‐required reporting categories.³⁰⁵³³⁰⁵³ Id. at p. 6. The valuation of Level 1 assets under SFAS 157 requires the use of directly observable inputs, i.e., quoted prices in active markets for identical assets or liabilities accessible on the valuation date. FAIR VALUE MEASUREMENTS, Statement of Fin. Accounting Standards No. 157, ¶ 24 (Fin. Accounting Standards Bd. 2006) ("SFAS 157"). The valuation of Level 2 assets requires the use of directly or indirectly observable prices in active markets for similar assets or liabilities, quoted prices for identical or similar items in markets that are not active and inputs other than quoted prices such as yield curves, credit risks, and volatilities. SFAS 157, ¶ 28. The valuation of Level 3 assets requires the use of unobservable inputs that reflect management's own assumptions about the assumptions that market participants would make. SFAS 157, ¶ 30.Show full note

797

¶Lehman also used the following volumes of non‐"government" securities in Repo 105 transactions:³⁰⁵⁴³⁰⁵⁴ Duff & Phelps Report, Repo 105 Security Liquidity Analysis (Oct. 21, 2009), at p. 3. Note that the figures listed report only the volumes of Repo 105 transactions that Lehman engaged in at quarter‐end for the reported period. The figures do not include the volume of Repo 108 transactions that Lehman undertook at the quarter‐end periods.

● November 30, 2007: $4.8 billion (out of a total of $29.9 billion in Repo 105 transactions), or 16% of the total Repo 105 volume;

● February 29, 2008: $4.8 billion (out of a total of $41.8 billion in Repo 105 transactions), or 11% of the total Repo 105 volume; and

● May 30, 2008: $4.2 billion (out of a total of $44.5 billion in Repo 105 transactions), or 9% of the total Repo 105 volume.

Product Controllers Manually Booked Repo 105 Transactions

¶Repo 105 transactions began as ordinary repos booked in the same trading and accounting systems as ordinary repos.³⁰⁵⁵³⁰⁵⁵ Duff & Phelps, Explanation of Repo 105 Accounting Ledger Entries and Trading System Output (Jan. 5, 2010), at p. 3. Lehman's electronic accounting systems automatically treated all repo transactions as financing transactions, i.e., borrowings.³⁰⁵⁶³⁰⁵⁶ Examiner's Interview of Marie Stewart, Sept. 2, 2009, at pp. 9‐10; Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 9; Examiner's Interview of Matthew Lee, July 1, 2009, at p. 13; Duff & Phelps, Explanation of Repo 105 Accounting Ledger Entries and Trading System Output (Jan. 5, 2010), at p. 3. Since the accounting and trading systems were not designed to treat any repo transactions as sales, a "manual intervention" into Lehman's electronic books and records systems was necessary to re‐characterize Repo 105 borrowings as sales for accounting purposes.³⁰⁵⁷³⁰⁵⁷ Examiner's Interview of Marie Stewart, Sept. 2, 2009, at pp. 9‐10; Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 9; Duff & Phelps, Explanation of Repo 105 Accounting Ledger Entries and Trading System Output (Jan. 5, 2010), at p. 3.

798

¶The financial results of LBIE's business operations rolled up into LBHI's consolidated financial statements filed in the United States. Lehman entities around the world maintained their books and records using United States GAAP principles.³⁰⁵⁸³⁰⁵⁸ Examiner's Interview of Marie Stewart, Sept. 2, 2009, at p. 11. In addition, LBIE and LBSF product controllers were responsible for "transactional policing" and booking Repo 105 transactions manually and in a manner that complied with United States GAAP.³⁰⁵⁹³⁰⁵⁹ Id. at p. 11; Duff & Phelps, Explanation of Repo 105 Accounting Ledger Entries and Trading System Output (Jan. 5, 2010), at p. 3 (citing statements of LBSF Controller Michael Montella and LBHI Controller Clifford Feibus that LBSF manual adjustments were made in New York and LBIE manual adjustments done in London); see also e‐mail from Gerard Reilly, Lehman, to Kentaro Umezaki, Lehman, et al. (Sept. 4, 2007) [LBEX‐DOCID 3232534] (stating that McGarvey, a product controller, "is our point on [Repo 105] from finance"); e‐mail from Marie Stewart, Lehman, to Todd Weiner, Lehman (Sept. 7, 2007) [LBEX‐ DOCID 3223832] (responding to Weiner's request for internal Accounting Policy Manual for Repo 105 transactions "to circulate. . . amongst our colleagues in Product Control. . . apparently more folks looking to use Repo 105," by transmitting a copy of manual [LBEX‐DOCID 3213300] and writing that "certain people in London P[roduct] C[ontrol] have had this policy forever"); e‐mail from Marie Stewart, Lehman, to Gary Bachman, Lehman, et al. (Nov. 21, 2007) [LBEX‐DOCID 3223383] ("Feraca knows all about Repo 105/108 and makes sure we keep by the rules. Also, FYI that we've had a few problems with peopleShow full note

799

¶Consequently, when LBIE's financial statements rolled up into LBHI's consolidated financial statements, no conversion to United States GAAP was claiming Repo 105/108 benefit recently when they should not have."); e‐mail from John Feraca, Lehman, to Marie Stewart, Lehman (Nov. 22, 2007) [LBEX‐DOCID 3223383] ("Conceptually yes I am the point person for the business. But Product Controllers in London are responsible for the day to day transactional policing. . . keep in mind I am not reviewing the transactional detail on a day to day basis nor making final decisions on what remains off balance sheet."). Gerard Reilly, Global Product Controller, appointed McGarvey, a product controller for Finance in FID to be the point person for Lehman's Repo 105 program. Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 10; see also e‐mail from Michael McGarvey, Lehman, to Gerard Reilly, Lehman (Sept. 4, 2007) [LBEX‐DOCID 3232534] ("We have been reviewing with the London repo desk and finance on a regular basis (We have roughly 80% of the month end 105 balance outstanding for the entire month although the daily average has been slipping.) We'll stay in front of it for the rest of the year."). When businesses within FID anticipated breaching their balance sheet limits, they would ask McGarvey for additional Repo 105 capacity. E‐mail from Jerry Rizzieri, Lehman, to Michael McGarvey, Lehman (Feb. 20, 2008) [LBEX‐ DOCID 3235353] (McGarvey: "For quarter end balance sheet do you still feel Rates Americas will be able to make target?" Rizzieri: "Can we get more Repo 105?"). Documentary evidence shows that McGarvey regularly reported to Clement Bernard, CFO for FID, about Repo 105 policy, volumes and actual transactions. See, e.g., e‐mail from Michael McGarvey, Lehman, to Paul Mitrokostas, Lehman, et al. (June 3, 2008) [LBEX‐DOCID 3235388] (reporting to Bernard and others that FID Net Balance Sheet for second quarter 2008 was $213.8 billion, $5.1 billion under target, and that the firm‐wide Repo 105 benefit for second quarter 2008 was $50.9 billion); e‐mail from Michael McGarvey, Lehman, to Clement Bernard, Lehman, et al. (Jan. 30, 2008) [LBEX‐DOCID 2796630] ("We have repo 105 funding benefit trades on constantly in the normal course of business because accounting policy stipulates it must be a regular way fund our positions. We increase the balances for month end but try to keep it within 120 percent of the average daily usage. . . . I have a meeting Thursday with Mark Cositis and the London Repo desk to determine client appetite for Q1."); e‐mail from Michael McGarvey, Lehman, to Clement Bernard, Lehman (Feb. 28, 2008) [LBEX‐DOCID 810932] ("Given the critical balance sheet situation we are currently in I've attached a list of corporate bonds held in NY. . . available for any additional Repo 105 capacity we can find."). Notably, only days before Lehman's bankruptcy filing, Gerard Reilly asked Michael McGarvey to remove all references to Repo 105 from a third quarter schedule of all of Lehman's US government securities. See e‐mail from Gerard Reilly, Lehman, to Michael McGarvey, Lehman, et al. (Sept. 12, 2008) [LBEX‐DOCID 641537]. Bernard and Amin were among the recipients of the e‐mail. Prior to Clement Bernard's assumption of the role of FID Chief Financial Officer, McGarvey reported on total Repo 105 trends. See Lehman, Global Repo 105/108 Trend (Aug. 2007) [LBEX‐DOCID 3219672] (attached to e‐mail from Michael McGarvey, Lehman, to Steven Becker, Lehman, et al. (Aug. 17, 2007) [LBEX‐ DOCID 3221344]); e‐mail from Michael McGarvey, Lehman, to Clement Bernard, Lehman, et al. (Mar. 13, 2008) [LBEX‐DOCID 2794226] (Bernard: "Do you know what is happening here on these repo 105?" McGarvey: "Repo ops has worked through most of it and we have delivered all but 750mm. This is an ops issue that occurs sometimes due to the time difference between NY and London. If the repo desk in London does a 105 trade and those bonds are not sitting in LBI's box we can fail . . . .").

800

¶required.³⁰⁶⁰³⁰⁶⁰ Examiner's Interview of Marie Stewart, Sept. 2, 2009, at p. 11. LBHI did not subsequently verify that the Repo 105 entries manually entered by LBIE employees complied with United States GAAP.³⁰⁶¹³⁰⁶¹ Id. "With a UK legal opinion [i.e., the Linklaters letter] that covered the [Repo] 105 [transactions], [Repo] 105 [transaction]s would be respected as a sale in the books of the entities doing them and booking them in US GAAP."³⁰⁶²³⁰⁶² Id. at p. 12.

¶In short, Lehman undertook transactions in a foreign jurisdiction (the United Kingdom) that purported to comply with SFAS 140, where Lehman was unable to obtain a SFAS 140 true sale opinion from a United States law firm, and Lehman then relied upon the non‐United States‐based Lehman entity to ensure that the transaction complied with United States GAAP.

Managing Balance Sheet and Leverage

¶Starting in mid‐2007, market participants began to more carefully scrutinize the leverage of investment banks.³⁰⁶³³⁰⁶³ Examiner's Interview of John Coghlan, Nov. 11, 2009, at p. 11 (recalling media's focus on the appropriateness of high leverage among financial institutions and that once the market was focused on leverage, Lehman executives believed Lehman should deleverage); Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at p. 8 (stating that one of the motivations behind his desire to reduce net leverage was that rating agencies focused on the net leverage ratio).Show full note Consequently, in 2007, top Lehman executives pressured the firm's businesses to reduce balance sheet and leverage in order to meet market expectations and avoid a ratings downgrade.³⁰⁶⁴³⁰⁶⁴ Examiner's Interview of Anuraj Bismal, Sept. 16, 2009, at p. 5 (stating that the leverage ratio target was "absolutely about how rating agencies would view Lehman" and that leverage was the "most critical" topic for senior Lehman management in late 2007 and 2008). A downgrade in an issuer's credit rating has a significant negative impact on the financial position of a company like Lehman. See, e.g., E‐mail from Ian T. Lowitt, Lehman, to Herbert H. (Bart) McDade III, Lehman (June 30, 2008) [LBHI_SEC07940_643543] ("One notch downgrade requires 1.7 bn; and 2 notch requires 3.4 bn of additional margin posting."). Counterparties may respond to a downgrade by demanding that the issuer post additional cash collateral to secure its obligations. See Amadou N.R. Sy, The Systemic Regulation of Credit Rating Agencies and Rated Markets 8‐9 (Int'l Monetary Fund, Working Paper, 2009) (noting that broker‐dealers may use credit ratings to determine acceptable counterparties, as well as collateral levels for outstanding credit exposure); e‐mail from Ian T. Lowitt, Lehman, to Eric Felder, Lehman (July 5, 2008) [LBEX‐DOCID 071263] (stating that a downgrade "will affect lines and willingness of counterparties to fund secured."). Some of Lehman's derivative contracts had built‐in "triggers" permitting counterparties to require additional cash collateral in the event of a downgrade. Lehman Brothers Holdings Inc., Current Report as of May 31, 2008 (Form 10‐Q) (filed on July 10, 2008) ("LBHI 10‐Q (filed July 10, 2008)"); see also Lehman, Global Treasury Downgrade Effect on Cash Capital Facilities 3‐Jun‐08 (June 2008) [LBHI_SEC07940_513314], attached to e‐mail from Amberish Ratanghayra, Lehman, to Paolo R. Tonucci, Lehman, et al. (June 3, 2008) [LBHI_SEC07940_513312]; see also Appendix 13, Survival, at pp. 1‐3.Show full note By January 2008, Richard Fuld made a strategic decision that Lehman would embark upon a firm‐wide effort to reduce its balance sheet and lower the firm‐wide net leverage ratio by selling assets.³⁰⁶⁵³⁰⁶⁵ Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at pp. 26‐27 (stating that as part of deleveraging efforts in 2008, Fuld wanted Lehman to bring all of its inventory positions down, except the matched book, that he was concerned with reducing net leverage because rating agencies were concerned with net leverage, and that he wanted to reduce net leverage by reducing assets); Examiner's Interview of Richard S. Fuld, Jr., Nov. 19, 2009, at pp. 8‐9 (stating that after Christmas 2007, Fuld gave clear directive to McDade to bring balance sheet down and that Fuld's focus was on less liquid assets, i.e., leveraged loans, residential securities, and CRE); Examiner's Interview of Richard S. Fuld, Jr., Dec. 9, 2009, at p. 10 (stating that he did not want to reduce the balance sheet in the matched book or on‐the‐run governments, but rather, in CMBS and RMBS).Show full note But many of Lehman's inventory positions had by then become increasingly "sticky" or difficult to sell without incurring substantial losses. It is against this backdrop of increased market focus on leverage that Lehman significantly increased its quarter‐end use of Repo 105 transactions.

801 802

Lehman Management's Focus in Late 2007 on Reducing the Firm's Reported Leverage

¶In mid‐to‐late 2007, senior management began to consider the balance sheet and leverage ratios as important metrics followed by investors and the rating agencies.³⁰⁶⁶³⁰⁶⁶ See, e.g., e‐mail from Edward Grieb, Lehman, to Christopher M. O'Meara, Lehman, et al. (Dec. 7, 2007) [LBEX‐DOCID 3759517] (discussing net assets and leverage with Grieb, O'Meara, Callan, Tonucci and Kelly); LBHI 10‐Q (filed Apr. 9, 2008), at p. 65 ("During the 2008 quarter, the Company operated in a liquidity, funding, and capital environment characterized by constrained market liquidity driven in part by balance sheet and leverage concerns."); e‐mail from Ryan Traversari, Lehman, to Paolo R. Tonucci, Lehman, et al. (Sept. 10, 2007) [LBEX‐DOCID 1695576] (comparing Lehman's net leverage ratio to that of Bear Stearns, Tonucci wrote that Lehman's net leverage calculation "was intended to reflect the methodology employed by S&P who were most interested and focused on leverage"). At least until late 2007, Lehman's Finance Committee – comprised of the firm's Chief Financial Officer (in chronological order, Christopher M. O'Meara, Erin M. Callan, and Ian T. Lowitt), Paolo Tonucci, Head of the firm's Fixed Income Division (in chronological order, Michael Gelband, Roger Nagioff, and Andrew Morton), plus other senior executives – set firm‐wide balance sheet targets and leverage ratio targets. Examiner's Interview of Marie Stewart, Sept. 2, 2009, at p. 7; Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 5; Examiner's Interview of Tejal Joshi, Sept. 15, 2009, at p. 5; Examiner's Interview of Anuraj Bismal, Sept. 16, 2009, at p. 5; Examiner's Interview of Kaushik Amin, Sept. 17, 2009, at p. 5; Examiner's Interview of Mitchell King, Sept. 21, 2009, at p. 5; Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 11; Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 9; Examiner's Interview of Joseph Gentile, Oct. 21, 2009, at p. 5; see also Lehman, Treasury October 2007 Balance Sheet and Leverage Ratio Targets (Oct. 19, 2007) [LBEX‐DOCID 3215540] (attached to e‐mail from Lisa Kennish, Lehman, to Michael McGarvey, Lehman, et al. (Oct. 19, 2007) [LBEX‐DOCID 3233628]); e‐mail from Anuraj Bismal, Lehman, to Marie Stewart, Lehman, et al. (Dec. 21, 2007) [LBEX‐DOCID 3223846] ("The finance committee does set balance sheet targets for each and every month end."). In approximately March 2008, however, Bart McDade was named Lehman's "balance sheet czar," tasked with setting and implementing balance sheet targets for Lehman to control leverage. Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at p. 26; Examiner's Interview of Erin M. Callan, Oct. 23, 2009, at p. 3; Examiner's Interview of Richard S. Fuld, Jr., Nov. 19, 2009, at p. 8.Show full note Lehman's Ryan Traversari (Senior Vice President‐External Reporting) wrote in September 2007 to Tonucci that the "question" of net leverage ratio "has come up multiple times in the 20 seconds that I've been here – largely from [CFO] O'Meara, Freidheim, Lowitt, Corporate Strategy, Investor Relations and the like."³⁰⁶⁷³⁰⁶⁷ E‐mail from Ryan Traversari, Lehman, to Paolo R. Tonucci, Lehman, et al. (Sept. 11, 2007) [LBEX‐ DOCID 1695575] (emphasis added).

803

¶In a September 7, 2007 e‐mail to O'Meara and Lowitt, Reilly wrote: "we need to keep the pressure on and get the firm's leverage to a good spot for year end. At least we need to restrict what inventory lines it can be used for."³⁰⁶⁸³⁰⁶⁸ E‐mail from Gerard Reilly, Lehman, to Christopher M. O'Meara, Lehman, et al. (Sept. 7, 2007) [LBEX‐ DOCID 1357178] Lowitt agreed with Reilly's suggestion and said that Lehman "need[ed] to get tighter on B/S."³⁰⁶⁹³⁰⁶⁹ E‐mail from Ian T. Lowitt, Lehman, to Gerard Reilly, Lehman, et al. (Sept. 7, 2007) [LBEX‐DOCID 1357178] Lowitt continued: "I am more worried about how leverage number will be accepted by the market than Chris [O'Meara] is."³⁰⁷⁰³⁰⁷⁰ Id. (emphasis added).

¶Also in September 2007, O'Meara reported to the Finance and Risk Committee that Lehman's net leverage ratio was in line with Lehman's peers.³⁰⁷¹³⁰⁷¹ Lehman, Risk, Liquidity, Capital and Balance Sheet Update Presentation to Finance and Risk Committee of Lehman Board of Directors (Sept. 11, 2007), at pp. 2, 30 [WGM_LBEX_02247] (with Welikson's Handwritten Notes); Lehman Brothers Holdings Inc., Finance and Risk Committee Minutes (Sept. 11, 2007), at pp. 2‐3 [LBEX‐AM 067018]. Management's presentation regarding the net leverage metric noted:

In the past, leverage was the key measure of equity adequacy. Between 2003 and 2006 we significantly reduced leverage. Low leverage was positively viewed by rating agencies and contributed to our 2005 upgrades. In 2006 and 2007, we worked with the regulatory and rating agencies to implement more accurate adequacy measures. As a result, we are comfortable with allowing our leverage to increase.³⁰⁷²³⁰⁷² Lehman, Presentation on Risk, Liquidity, Capital and Balance Sheet Update to Finance and Risk Committee of Lehman Board of Directors (Sept. 11, 2007), at p. 50 [LBEX‐AM 067167].

¶In a November 2007 e‐mail, O'Meara, then‐Lehman CFO, wrote to Reilly, "I realize we're in a tough spot given mkt, but we should be pressuring everywhere to try to end year in good way on balance sheet . . . especially since the rev's are not materializing."³⁰⁷³³⁰⁷³ E‐mail from Christopher M. O'Meara, Lehman, to Gerard Reilly, Lehman (Nov. 20, 2007) [LBEX‐ DOCID 578184]. Upon becoming Global Financial Controller on December 1, 2007, Martin Kelly studied net leverage ratio components and the definition of net assets across peer firms.³⁰⁷⁴³⁰⁷⁴ Lehman, Components of Net Leverage Across Peer Firms Report (Dec. 7, 2007) [LBEX‐DOCID 3299584] (attached to e‐mail from Anuraj Bismal, Lehman, to Martin Kelly, Lehman, et al. (Dec. 7, 2007) [LBEX‐DOCID 3306110]; Lehman, Components of Net Leverage Across Peer Firms Graph (Dec. 7, 2007) [LBEX‐DOCID 3328581] (attached to e‐mail from Anuraj Bismal, Lehman to Martin Kelly, Lehman, et al. (Dec. 7, 2007) [LBEX‐DOCID 3306110]; e‐mail from Marie Stewart, Lehman, to Martin Kelly, Lehman, et al. (Dec. 7, 2007) [LBEX‐DOCID 3306112] ("I understand that everyone negotiates their own definition of net assets with rating agencies and anytime I have asked about this historically I sensed hesitancy for us to renegotiate our definition. I had mentioned to Martin [Kelly] earlier this week that Paolo [Tonucci] and Ed [Grieb] could give him background on why our calculation is different from our peers."); e‐mail from Anuraj Bismal, Lehman, to Martin Kelly, Lehman, et al. (Dec. 7, 2007) [LBEX‐DOCID 3759517] (reporting to Kelly that firm's net leverage was 16.2x). Recall that Lehman calculated net assets by subtracting from total assets: cash and securities segregated and on deposit for regulator and other purposes; securities under agreement to resell; identifiable intangible assets and goodwill; securities received as collateral; securities borrowed. That sum was divided by tangible equity capital, which was calculated by adding total stockholder's equity and junior subordinated notes and subtracting identifiable intangible assets and goodwill. See LBHI 2007 10‐K, at p. 30; LBHI 10‐Q (filed Apr. 9, 2008), at p. 70; LBHI 10‐Q (filed July 10, 2008), at p. 56; Lehman, Components of Net Leverage across Peer Firms (Dec. 7, 2007) [LBEX‐DOCID 3299584].Show full note

804

Lehman's Calculation of Net Leverage

¶Under Lehman's definition of net leverage ratio, Lehman divided net assets by tangible equity, as a more "meaningful" calculation and a "more useful measure of leverage, because it excluded certain low‐risk, non‐inventory assets."³⁰⁷⁵³⁰⁷⁵ LBHI 2007 10‐K, at p. 63; LBHI 10‐Q (filed Apr. 9, 2008), at p. 72; LBHI 10‐Q (filed July 10, 2008), at p. 88. In its Forms 10‐ K and 10‐Q, Lehman defined net assets as total assets excluding: (1) cash and securities segregated and on deposit for regulatory and other purposes; (2) securities received as collateral; (3) securities purchased under agreements to resell; (4) securities borrowed; and (5) identifiable intangible assets and goodwill.³⁰⁷⁶³⁰⁷⁶ LBHI 2007 10‐K, at p. 63; LBHI 10‐Q (filed Apr. 9, 2008), at p. 72; LBHI 10‐Q (filed July 10, 2008) at p. 88. Lehman calculated tangible equity capital by including stockholders' equity and junior subordinated notes and excluding identifiable intangible assets and goodwill.³⁰⁷⁷³⁰⁷⁷ LBHI 2007 10‐K, at p. 63; LBHI 10‐Q (filed Apr. 9, 2008), at p. 72; LBHI 10‐Q (filed July 10, 2008) at p. 88.

805

¶The net leverage ratio calculation – a "brutal, rudimentary measurement"³⁰⁷⁸³⁰⁷⁸ Examiner's Interview of Anuraj Bismal, Sept. 16, 2009, at pp. 6‐7. – did not capture the quality of the assets,³⁰⁷⁹³⁰⁷⁹ Id. at pp. 6‐7; see also U.S. Securities and Exchange Commission Office of Inspector General, Report No. 446‐A, SEC's Oversight of Bear Stearns and Related Entities: The Consolidated Supervised Entity Program (Sept. 25, 2008), at p. 93 ("[A] leverage ratio is a crude measure and implicitly assumes that every dollar of balance sheet involves the same risk whether due to a treasury bond or an emerging market equity. . . . Finally, a leverage limit creates an incentive for firms to move exposures off balance sheet. . . .").Show full note and was therefore an expedient measurement for Lehman to utilize given the firm's "sticky" inventory. As Clement Bernard, former FID CFO wrote in early 2008: "[T]he firm is trying to move away from net leverage. However, they cannot do that until the quality of assets improve ie we reduce our exposure to sticky assets like Mortgages and Real Estate."³⁰⁸⁰³⁰⁸⁰ E‐mail from Clement Bernard, Lehman, to Andrew J. Morton, Lehman, et al. (Feb. 1, 2008) [LBEX‐ DOCID 1853655] (emphasis added).

By January 2008, Lehman Decided to Cut its Net Leverage in Half to Win Back the Confidence of the Market, Lenders and Investors

¶By no later than January 2008, Fuld was focused on net leverage and balance sheet reduction. Soon after Roger Nagioff replaced Michael Gelband as Head of FID in May 2007, Fuld authorized Nagioff to bring down positions in leveraged loans.³⁰⁸¹³⁰⁸¹ Examiner's Interview of Richard S. Fuld, Jr., Nov. 19, 2009, at p. 2. By the end of 2007, Fuld expressed increasing concern about the economy.³⁰⁸²³⁰⁸² Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at pp. 26‐27; Examiner's Interview of Richard S. Fuld, Jr., Nov. 19, 2009, at pp. 8‐9; Examiner's Interview of Richard S. Fuld, Jr., Dec. 9, 2009, at p. 10. According to Fuld, in early 2008 he instructed Bart McDade, who would replace Joe Gregory and become Lehman's President and Chief Operating Officer in June 2008, to bring down Lehman's net balance sheet and net leverage ratio.³⁰⁸³³⁰⁸³ Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at pp. 26‐27; Examiner's Interview of Richard S. Fuld, Jr., Nov. 19, 2009, at p. 8; Examiner's Interview of Richard S. Fuld, Jr., Dec. 9, 2009, at p. 10; e‐mail from Herbert H. (Bart) McDade III, Lehman, to Herbert H. (Bart) McDade III, Lehman (Jan. 14, 2008) [LBEX‐DOCID 3101094] ("[L]earning how to say no again…del[e]vering the balance sheet by 3 turns"); e‐mail from Larry Wieseneck, Lehman, to Michael Konigsberg, Lehman, et al. (Mar. 19, 2008) [LBHI_SEC07940_390282] ("The firm is asking Bart McDade…to represent the firm's interests as the 'Balance Sheet Czar' ‐ the point person for the firm's Exec Comm relative to the use of balance sheet and capital").Show full note Fuld at various times described the balance sheet reduction as applying to: (1) all positions except matched book; and (2) less liquid assets, such as leveraged loans, RMBS, CMBS, and CRE.³⁰⁸⁴³⁰⁸⁴ Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at pp. 26‐27 (recalling that Fuld told McDade to bring down all positions except matched book); Examiner's Interview of Richard S. Fuld, Jr., Nov, 19, 2009, at p. 8 (stating that his focus was on bringing down less liquid assets, i.e., leveraged loans, RMBS, CMBS, and CRE); Examiner's Interview of Richard S. Fuld, Jr., Dec. 9, 2009, at p. 10 (stating that he did not instruct McDade to bring down matched book or on‐the‐run government securities as part of directive to reduce balance sheet).Show full note Fuld and other members of senior firm management were concerned with reducing Lehman's large net balance sheet, i.e., the inventory that Lehman owned, because the rating agencies only looked at Lehman's net leverage.³⁰⁸⁵³⁰⁸⁵ Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at p. 27. Fuld recalled that rating agencies looked at net leverage because gross balance sheet included matched book. Id. Matched book is "where a trader reverses in and repos out collateral to the same or different dates." Lehman, Repo Manual (Nov. 8, 2005), at p. 16 [LBEX‐LL 1175483]. "When the maturities of the reverse repos and repos are the same,Show full note

806 807

¶Contemporaneous documents from the Lehman archives confirm that senior management at all levels were critically focused on reducing Lehman's firm‐wide leverage beginning in early 2008, including focusing on the impact leverage had on the firm's ratings:

● Two weeks before the close of Lehman's first quarter 2008 on February 29, 2008, Erin Callan, then‐CFO, wrote to Tonucci, Reilly and Martin Klein, "would love to see the target projection [for net leverage] at 15.1."³⁰⁸⁶³⁰⁸⁶ E‐mail from Erin M. Callan, Lehman, to Paolo R. Tonucci, Lehman, et al. (Feb. 15, 2008) [LBEX‐DOCID 1729329]. Reilly forwarded Callan's message to Andrew Morton, the head of Lehman's Fixed Income Division, stating "Would be great if fid could come in lower as leverage could be 1 of the few bright spots for the quarter."³⁰⁸⁷³⁰⁸⁷ E‐mail from Gerard Reilly, Lehman, to Andrew J. Morton, Lehman (Feb. 15, 2008) [LBEX‐DOCID 1729329]. Morton replied, "Will pull out all the stops."³⁰⁸⁸³⁰⁸⁸ E‐mail from Andrew J. Morton, Lehman, to Gerard Reilly, Lehman (Feb. 15, 2008) [LBEX‐DOCID 1729329].

● In a March 19, 2008 e‐mail, Larry Wieseneck reported "on a step the firm is taking to more actively manage the balance sheet usage across the firm."³⁰⁸⁹³⁰⁸⁹ E‐mail from Larry Wieseneck, Lehman, to Michael Konigsberg, Lehman, et al. (Mar. 19, 2008) [LBHI_SEC07940_390282]. He continued: "The firm is asking Bart McDade (Head of Global Equities) to represent the firm's interests as the 'Balance Sheet Czar' – the point person for the firm's Exec Comm relative to the use of balance sheet…. He will coordinate with the trading desks and banking businesses across the firm as it relates to managing balance sheets down to target levels…. This will insure that we are 'disciplined'…."³⁰⁹⁰³⁰⁹⁰ Id.

¶he or she is said to be running a matched book. But, in reality, most 'matched' books are actually 'mismatched' in that a trader will reverse in collateral to dates which are different than those maturities on the corresponding repos." Id. "A trader does this to profit from future shifts in interest rates that might occur between the unmatched maturities on the reverse repos and repos." Id. To be clear, Repo 105 transactions were not matched book transactions. See also e‐mail from Robert Azerad, Lehman, to Edward Grieb, Lehman, et al. (Mar. 27, 2008) [LBEX‐DOCID 3184420] (commenting upon external blog's critique of Lehman's leverage ratios calculation and balance sheet).

808

● In a March 27, 2008 e‐mail, Ken Cohen wrote: "We are very much in need of balance sheet. We must move things off by the end of the quarter. I need you all to go back to clients and offer them discounts to move things off. We have a lot of wood to chop in a short period of time but we can't afford to fail. If this means leaving p&l on the table so be it. If you have questions get back to me but we HAVE TO DO THIS!!"³⁰⁹¹³⁰⁹¹ E‐mailfrom Ken Cohen, Lehman, to Carmine Visone, Lehman (Mar. 27, 2008) [LBEX‐DOCID 1374413]. See Section III.A.5.e.2 of the Report for further discussion of Lehman's deleveraging efforts.

¶Statements of numerous senior Lehman personnel also confirm that Lehman was focused on the net leverage ratio and the reduction of net assets beginning in late 2007:

● Tonucci recalled that McDade wanted to bring down Lehman's firm‐wide balance sheet by "a few turns."³⁰⁹²³⁰⁹² Examiner's Interview of Paolo R. Tonucci, Sept. 16, 2009, at p. 26.

● McDade, who was named balance sheet czar in March 2008 and who became President and COO in June 2008, said that deleveraging was "absolutely" a critical issue to Lehman in early 2008.³⁰⁹³³⁰⁹³ Examiner's Interview of Herbert H. "Bart" McDade III, Jan. 28, 2010, at p. 5.

● Ed Grieb, Lehman's former Global Financial Controller, stated that "the focus on balance sheet and net leverage gained much more importance" beginning in mid‐2007.³⁰⁹⁴³⁰⁹⁴ Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 13.

● Murtaza Bhallo, Business/Risk Manager in Proprietary Trading Group for Liquid Markets, said that beginning in 2007, there was a "squeeze" on Lehman's balance sheet, and that Lehman personnel were worried about reporting the level of Lehman's assets against Lehman's equity (i.e., leverage ratio).³⁰⁹⁵³⁰⁹⁵ Examiner's Interview of Murtaza Bhallo, Sept. 14, 2009, at p. 3.

● Anuraj Bismal, a former Senior Vice President in Lehman's Balance Sheet Group, said that Lehman's meeting of its leverage ratio target was the most critical piece ("a very hot topic") for senior management by the end of 2007.³⁰⁹⁶³⁰⁹⁶ Examiner's Interview of Anuraj Bismal, Sept. 16, 2009, at p. 5. Bismal said that balance sheet targets and leverage ratio targets were "absolutely about how rating agencies would view Lehman, and also creditors and the investing public."³⁰⁹⁷³⁰⁹⁷ Id.

809

● John Feraca, the former head of the Secured Funding Desk in Lehman's Prime Services group, said that in late 2007, as the industry was changing and entering a crisis period, Lehman made certain commitments to deleverage.³⁰⁹⁸³⁰⁹⁸ Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 9.

● Marie Stewart, Lehman's former Global Head of Accounting Policy, confirmed that Lehman set balance sheet targets with any eye to reaching certain leverage ratios that rating agencies used to measure and gauge Lehman's performance.³⁰⁹⁹³⁰⁹⁹ Examiner's Interview of Marie Stewart, Sept. 2, 2009, at p. 7.

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

¶Bart McDade, who spent 25 years at Lehman, served as Lehman's Co‐Global Head of FID from 2002 through 2005 and Global Head of Equities from 2005 until 2008.³¹⁰⁰³¹⁰⁰ Examiner's Interview of Herbert H. "Bart" McDade III, Sept. 16, 2009, at p. 1. In March 2008, while remaining Global Head of Equities, McDade took on the additional role of balance sheet "czar" or balance sheet point person, for the Executive Committee.³¹⁰¹³¹⁰¹ Examiner's Interview of Herbert H. "Bart" McDade III, Jan. 28, 2010, at p. 7. McDade later became Lehman's President and Chief Operating Officer, replacing Joe Gregory in June 2008.³¹⁰²³¹⁰² Id. at p. 5.

810

¶According to Fuld, McDade had full authority to reduce firm‐wide net leverage.³¹⁰³³¹⁰³ Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at pp. 26‐27 (stating that Fuld instructed McDade to bring down all of Lehman's positions except for matched book in order to get net leverage down to the low teens); Examiner's Interview of Richard S. Fuld, Jr., Nov. 19, 2009, at pp. 2‐3 (stating that Fuld told McDade, after Christmas 2007, to bring down net leverage by half and that Fuld did not specifically direct Gregory and McDade on which divisions should have their balance sheets brought down); Examiner's Interview of Richard S. Fuld, Jr., Dec. 9, 2009, at p. 10 (stating that Fuld wanted reductions in places that Lehman was vulnerable, such as RMBS and CMBS).Show full note Although Lehman's Treasury and Finance groups previously had set balance sheet targets,³¹⁰⁴³¹⁰⁴ Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 5. beginning in approximately March 2008, Gregory, Lehman's then‐President and COO, assisted McDade with determining the balance sheet targets firm‐wide.³¹⁰⁵³¹⁰⁵ Examiner's Interview of Richard S. Fuld, Jr., Nov. 19, 2009, at pp. 8‐9. Although Fuld did not specifically direct Gregory and McDade on which Lehman divisions should have their balance sheet reduced, Fuld wanted to see the balance sheet reduction, particularly in less liquid asset classes, i.e. leveraged loans and residential and commercial real estate.³¹⁰⁶³¹⁰⁶ Id.

¶McDade took his responsibilities as balance sheet point person "very seriously."³¹⁰⁷³¹⁰⁷ Examiner's Interview of Herbert H. "Bart" McDade III, Jan. 28, 2010, at p. 7; e‐mail from Larry Wieseneck, Lehman, to Michael Konigsberg, Lehman (Mar. 19, 2008) [LBHI_SEC07940_390282]. He viewed his "mission" as to coordinate Lehman's balance sheet issues.³¹⁰⁸³¹⁰⁸ Examiner's Interview of Herbert H. "Bart" McDade III, Jan. 28, 2010, at p. 3. McDade wanted "to organize, coordinate, and influence."³¹⁰⁹³¹⁰⁹ Id. at p. 7. Bear Stearns had just nearly collapsed and McDade knew that Lehman had "tough assets" on its balance sheet.³¹¹⁰³¹¹⁰ Id. at p. 3. In his role as balance sheet czar, McDade created a Daily Balance Sheet and Disclosure Scorecard report in order to have greater transparency with respect to the balance sheet.³¹¹¹³¹¹¹ Id. at pp. 8‐9 (stating also "I needed a daily scorecard to know where I wanted to push" on balance sheet issues). The Daily Scorecard was widely disseminated among senior Lehman management from April through September 2008 and routinely contained references to the impact Repo 105 transactions had on Lehman's daily balance sheet.³¹¹²³¹¹² See, e.g., Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 7, 2008 (Apr. 9, 2008), at p. 9 [LBEX‐DOCID 520619] (attached to e‐mail from Tal Litvin, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (Apr. 9, 2008) [LBEX‐DOCID 523578] and showing consolidated FID and Equities balance sheet reduced by $18.527 billion and Prime Services balance sheet reduced by $4.458 billion through Repo 105 transactions as of April 7, 2008); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 8, 2008 (Apr. 10, 2008), at p. 9 [LBEX‐DOCID 520620] (attached to e‐mail from Tal Litvin, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (Apr. 10, 2008) [LBEX‐DOCID 523579] and showing consolidated FID and Equities balance sheet reduced by $18.853 billion and Prime Services balance sheet reduced by $4.562 billion through Repo 105 transactions as of April 8, 2008); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 9, 2008 (Apr. 10, 2008), at p. 9 [LBEX‐DOCID 251339] (attached to e‐mail from Tal Litvin, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (Apr. 10, 2008) [LBEX‐DOCID 258560] and showing consolidated FID and Equities balance sheet reduced by $19.688 billion and Prime Services balance sheet reduced by $4.548 billion through Repo 105 transactions as of April 9, 2008); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 10, 2008 (Apr. 14, 2008), at p. 9 [LBEX‐DOCID 251342] (attached to e‐mail from Tal Litvin, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (Apr. 14, 2008) [LBEX‐DOCID 275231] and showing consolidated FID and Equities balance sheet reduced by $19.967 billion and Prime Services balance sheet reduced by $4.491 billion through Repo 105 transactions as of April 10, 2008); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 11, 2008 (Apr. 14, 2008), at p. 9 [LBEX‐DOCID 251344] (attached to e‐mail from Tal Litvin, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (Apr. 14, 2008) [LBEX‐DOCID 258562] and showing consolidated FID and Equities balance sheet reduced by $20.260 billion and Prime Services balance sheet reduced by $4.517 billion through Repo 105 transactions as of April 11, 2008); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 12, 2008 (May 13, 2008), at p. 1 [LBEX‐LL 1950262] (attached to e‐mail from Tal Litvin, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (May 13, 2008) [LBEX‐DOCID 3187357] and stating "Rates decreased by $(5.0B) from prior day due to . . . increased Repo 105 usage. . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 22, 2008 (May 27, 2008), at p. 1 [LBEX‐LL 1950706] (attached to e‐mail from Tal Litvin, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (May 27, 2008) [LBEX‐DOCID 275984] and stating "Global rates net balance sheet decreased ($2.0B), predominantly due to an increase in Repo 105 benefit. . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 28, 2008 (May 30, 2008), at p. 1 [LBEX‐LL 1950670] (attached to e‐mail from Tal Litvin, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (May 30, 2008) [LBEX‐DOCID 275995] and stating "Global rates net balance sheet decreased by ($3.1B) primarily due to a decrease in Americas driven by an increased utilization of Repo 105 within the Agency business"); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 29, 2008 (May 30, 2008), at p. 1 [LBEX‐LL 1950658] (attached to e‐mail from Tal Litvin, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (June 2, 2008) [LBEX‐DOCID 011127] and stating "Global Rates net balance sheet decreased ($6.5B) . . . [t]he decrease in Europe is coming from increased utilization of Repo 105"); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date June 18, 2008 (June 20, 2008) [LBEX‐LL 1950514] (attached to e‐mail from Tal Litvin, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (June 20, 2008) [LBEX‐DOCID 275942] and stating that "Global rates net balance sheet decreased…driven by a[n] . . . increase in Repo 105 utilization. . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date August 13, 2008 (Aug. 14, 2008) [LBEX‐LL 782812] (attached to e‐ mail from Tal Litvin, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (Aug. 14, 2008) [LBEX‐ DOCID 4214810] and stating that "Global rates net balance sheet decreased . . . driven by an increase in Repo 105 benefit. . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date August 25, 2008 (Aug. 26, 2008) [LBEX‐LL 782924] (attached to e‐mail from Tal Litvin, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (Aug. 26, 2008) [LBEX‐DOCID 079536] and stating that "Global Rates net balance sheet decreased . . . driven by an increase in repo 105 usage. . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date August 28, 2008 (Aug. 29, 2008) [LBEX‐LL 782966] (attached to e‐ mail from Tal Litvin, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (Aug. 29, 2008) [LBEX‐ DOCID 275880] and stating that "Global rates [net balance sheet] was down . . . driven by increased Repo 105 benefit. . . .").Show full note

811 812

¶In one his first acts as balance sheet point person, and in connection with his plan to aggressively reduce Lehman's firm‐wide balance sheet, McDade requested that Lehman convene a special meeting of the Executive Committee on Friday, March 28, 2008, at 9:00 a.m.³¹¹³³¹¹³ Examiner's Interview of Herbert H. "Bart" McDade III, Jan. 28, 2010, at p. 3. According to McDade, Lehman's Executive Committee usually met only on Mondays or Tuesdays. Id. The March 28, 2008 meeting to discuss firm‐wide balance sheet issues occurred on a Friday. The entire Executive Committee, except Fuld, as well as ex officio members Ian Lowitt and Scott Friedheim, attended the meeting.³¹¹⁴³¹¹⁴ Id. at p. 4.

¶Broadly speaking, McDade's goal going into the March 28 meeting "was to have the Executive Committee come together and agree" about the direction Lehman would pursue, at least from the balance sheet perspective.³¹¹⁵³¹¹⁵ Id. at p. 3. More specifically, McDade said that his purpose in seeking a special meeting of the committee was "to request Joe Gregory's approval to institute" the balance sheet reduction recommendations that McDade presented at the meeting.³¹¹⁶³¹¹⁶ Id.

813

¶The night before the March 28, 2008 Executive Committee meeting, McDade's assistant³¹¹⁷³¹¹⁷ E‐mail from Patricia Lombardi, Assistant to Herbert H. (Bart) McDade III, Lehman, to Lehman Brothers Executive Committee Members, Lehman, et al. (Mar. 28, 2008) [LBEX‐DOCID 120929]. circulated two documents to the entire Executive Committee, Lowitt, and the assistants to Executive Committee members: (1) a meeting agenda, which listed seven total items, including "Repo 105/108," "Delever v Derisk" and "'Limit' Accountability;"³¹¹⁸³¹¹⁸ Lehman Brothers, Executive Committee Meeting Material, Agenda (Mar. 28, 2008) [LBEX‐DOCID 115827] (attached to e‐mail from Patricia Lombardi, Assistant to Herbert H. (Bart) McDade III, Lehman, to Lehman Brothers Executive Committee Members, Lehman, et al. (Mar. 28, 2008) [LBEX‐DOCID 120929]). and (2) a "Balance Sheet and Cash Capital Update."³¹¹⁹³¹¹⁹ Herbert H. (Bart) McDade III, Lehman, Balance Sheet and Cash Capital Update (Mar. 27, 2008) [LBEX‐ DOCID 095961] (attached to e‐mail from Patricia Lombardi, Assistant to Herbert H. (Bart) McDade III, Lehman, to Lehman Brothers Executive Committee Members, Lehman, et al. (Mar. 28, 2008) [LBEX‐ DOCID 120929]). McDade and Gerard Reilly prepared the two documents to be discussed at the March 28 Executive Committee meeting.³¹²⁰³¹²⁰ Examiner's Interview of Herbert H. "Bart" McDade III, Jan. 28, 2010, at p. 3.

¶At the March 28 Executive Committee meeting, McDade presented the Balance Sheet and Cash Capital Update document.³¹²¹³¹²¹ Id. McDade "tried to lay out very specifically the firm‐wide balance sheet for the Executive Committee. We wanted to focus the Executive Committee on those things that impacted the firm's net leverage and balance sheet."³¹²²³¹²² Id. at p. 4. Id. With respect to net balance sheet limits, McDade wanted to impose "accountability," meaning that he "wanted all at the firm to stick within those limits."³¹²³³¹²³ Id. at p. 3.

814

¶McDade specifically recalled discussing with Executive Committee members on March 28, 2008 Lehman's use of Repo 105 transactions.³¹²⁴³¹²⁴ Examiner's Interview of Herbert H. "Bart" McDade III, Jan. 28, 2010, at pp. 3‐4. The Balance Sheet and Capital Update document expressly reported that Lehman's quarter‐end Repo 105 usage for first quarter 2008 was $49.1 billion.³¹²⁵³¹²⁵ Herbert H. (Bart) McDade III, Lehman, Balance Sheet and Cash Capital Update (Mar. 27, 2008), at pp. 1‐2 [LBHI_SEC07940_628517]; Examiner's Interview of Herbert H. "Bart" McDade III, Jan. 28, 2010, at p. 3; see also e‐mail from Jennifer Fitzgibbon, Lehman, to Leonard Sciutella, Lehman, et al. (Mar. 28, 2008) [LBEX‐DOCID 1854825] (transmitting Balance Sheet and Cash Capital Update presentation and stating "attached balance sheet presentation discussed in today's executive committee meeting. . . . Reviewed with Bart [McDade] yesterday"). During his first Interview with the Examiner, McDade said that he was surprised when the Examiner advised him that Lehman reduced its net balance sheet at quarter‐end of second quarter of 2008 by more than $50.38 billion using Repo 105 transactions. Examiner's Interview of Herbert H. "Bart" McDade III, Sept. 16, 2009, at p. 4. McDade said he thought that the volume of Lehman's quarter‐end Repo 105 usage was no higher than $20 billion. Id.Show full note As balance sheet point person, McDade had no authority to authorize a firm‐wide cap on Lehman's use of Repo 105 transactions.³¹²⁶³¹²⁶ Examiner's Interview of Herbert H. "Bart" McDade III, Jan. 28, 2010, at pp. 3‐4. But McDade recommended to the Executive Committee during the meeting that Lehman cap or limit its firm‐wide Repo 105 usage at a certain dollar amount.³¹²⁷³¹²⁷ Id. McDade said that "in order to make the seismic change" he wanted to accomplish with the balance sheet in March 2008, Lehman "had to make big changes," which included significantly reducing or ceasing the firm's use of Repo 105 transactions.³¹²⁸³¹²⁸ Id. From McDade's perspective, Lehman's traders should have sold inventory to reduce balance sheet, rather than engage in Repo 105 transactions.³¹²⁹³¹²⁹ Id.

815

¶On April 2, 2008, McDade received an e‐mail that said "Not sure you are familiar with Repo 105 but it is used to reduce net balance sheet in our government businesses around the world."³¹³⁰³¹³⁰ E‐mail from Hyung Lee, Lehman, to Herbert H. (Bart) McDade III, Lehman (Apr. 3, 2008) [LBEX‐ DOCID 1570783]. McDade responded that he considered Lehman's use of Repo 105 transactions to be undisciplined, "another drug we r on."³¹³¹³¹³¹ See e‐mail from Herbert H. (Bart) McDade III, Lehman, to Hyung Lee, Lehman (Apr. 3, 2008) [LBEX‐ DOCID 1570783]; see also e‐mail from Herbert H. (Bart) McDade III, Lehman, to Andrew J. Morton, Lehman (Apr. 3, 2008) [LBEX‐DOCID 1570784] (explaining that the fact that Lehman's net balance sheet could increase at quarter‐end if it could not find Repo 105 counterparty "is exactly why the drug is a problem").Show full note McDade wanted Lehman's traders to exercise more discipline: "[T]raders knew that they could get access to balance sheet through these more costly transactions," meaning Repo 105 transactions.³¹³²³¹³² Examiner's Interview of Herbert H. "Bart" McDade III, Jan. 28, 2010, at p. 6. Kaushik Amin recalled McDade stating that Lehman should use fewer Repo 105 transactions; Amin believed this was because of "a sense within Lehman that [Repo 105] might not meet a rigorous test in the market place." Examiner's Interview of Kaushik Amin, Sept. 17, 2009, at p. 8. In other words, when traders found it hard to sell sticky assets or wanted to avoid selling them at a discount, they knew that they could "rent the balance sheet," according to McDade, by removing certain inventory temporarily through Repo 105 transactions while allowing other inventory to remain on the balance sheet and still reach Lehman's balance sheet targets.³¹³³³¹³³ Examiner's Interview of Herbert H. "Bart" McDade III, Jan. 28, 2010, at p. 8. McDade wanted traders to sell assets rather than rent the balance sheet.³¹³⁴³¹³⁴ Id.

816

¶Although McDade's Balance Sheet and Cash Capital Update presentation was discussed at the March 28, 2008 Executive Committee meeting,³¹³⁵³¹³⁵ E‐mail from Jennifer Fitzgibbon, Lehman, to Leonard Scicutella, Lehman, et al. (Mar. 28, 2008) [LBEX‐ DOCID 1854825] (transmitting copy of Lehman, Balance Sheet and Cash Capital Update (Mar. 27, 2008) [LBEX‐DOCID 1698670] and stating "please [see] attached balance sheet presentation discussed in today's executive committee meeting"); see also e‐mail from Gerard Reilly, Lehman, to Paolo R. Tonucci, Lehman, et al. (Mar. 28, 2008) [LBEX‐DOCID 124422] (transmitting copy of Lehman, Balance Sheet and Cash Capital Update (Mar. 27, 2008) [LBEX‐DOCID 095966] and stating "This is the bs doc for exec co in the morning"); e‐mail from Gerard Reilly, Lehman, to Martin Kelly, Lehman, et al. (Mar. 28, 2008) [LBEX‐ DOCID 2636182] (transmitting copy of Lehman, Balance Sheet and Cash Capital Update (Mar. 27, 2008) [LBEX‐DOCID 2489767] and stating "This was the exec b[alance] s[heet] pres[entation]"); Examiner's Interview of Herbert H. "Bart" McDade III, Jan. 28, 2010, at pp. 2‐3.Show full note during a time when Erin Callan was a member of the Executive Committee and Lowitt sat as an ex officio member, when questioned by the Examiner, neither Callan nor Lowitt could recall the actual volume of quarter‐end Repo 105 usage in late 2007 and 2008, or whether the Executive Committee discussed Lehman's Repo 105 usage.³¹³⁶³¹³⁶ Examiner's Interview of Erin M. Callan, Oct. 23, 2009, at pp. 17, 19 (stating that she believed Lehman's Repo 105 usage was $20 billion and that she did not recall being part of any discussions regarding limits on Repo 105 usage); Examiner's Interview of Ian T. Lowitt, Oct. 28, 2009, at pp. 11, 13 (stating that he was not present at any Executive Committee meeting at which Repo 105 was discussed and that he had no recollection of focusing on Lehman's Repo 105 usage, including the $25 billion third quarter target); Examiner's Interview of Richard S. Fuld, Jr., Nov. 19, 2009, at p. 7 (stating that he did not attend any Executive Committee meeting where Repo 105 was discussed and stating he had no knowledge of Lehman's Repo 105 usage). Andrew Morton, who served on the Executive Committee beginning in June 2008, however, recalled that Lehman used Repo 105 transactions to reduce its net balance sheet and that these were "widely used, widely understood" transactions. Examiner's Interview of Andrew J. Morton, Sept. 21, 2009, at p. 4.Show full note On April 9, 2008, twelve days after McDade's presentation to the Executive Committee, Callan signed Lehman's quarterly report.³¹³⁷³¹³⁷ LBHI, 10‐Q (filed Apr. 9, 2008), at p. 92.

817

¶Following Fuld's directive, and in connection with McDade's balance sheet point person role, Gregory and McDade sat down with Lehman division heads and discussed targets for asset classes and business lines.³¹³⁸³¹³⁸ Examiner's Interview of Richard S. Fuld, Jr., Nov. 19, 2009, at p. 9. Gregory and McDade frequently checked in with division heads in mid 2008 regarding their progress in meeting balance sheet targets, and provided updates to Fuld, although not on a very granular level.³¹³⁹³¹³⁹ Id. Fuld recalled that Gregory was comfortable with the progress Lehman was making in bringing down its balance sheet and Fuld said that he believed Lehman was meeting its balance sheet targets by selling illiquid assets.³¹⁴⁰³¹⁴⁰ Id.

¶Other documents contemporaneous to McDade's presentation to the Executive Committee demonstrate that the issue of balance sheet and leverage reduction was being discussed at the highest levels of senior Lehman management:³¹⁴¹³¹⁴¹ Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at p. 8 (stating that rating agencies cared about net leverage ratio).

● An April 1, 2008 internal Lehman presentation by Eric Felder, then‐United States Head of Credit Products, highlighted how the market's mood and perception of risk had changed, and Lehman started to penalize brokers for maintaining high leverage.³¹⁴²³¹⁴² EricFelder, Lehman, Untitled Internal Presentation [Draft] (Apr. 1, 2008), at pp. 7‐10 [LBHI_SEC07940_085870]. According to the presentation: "brokers will be forced to de‐lever to maintain ratings and access to low‐cost debt."³¹⁴³³¹⁴³ Id. (emphasis added). Indeed, a ratings downgrade could lead to counterparty demands that Lehman post additional collateral for secured financing.³¹⁴⁴³¹⁴⁴ E‐mail from Ian T. Lowitt, Lehman, to Eric Felder, Lehman (July 5, 2008) [LBEX‐DOCID 071263] (stating that a downgrade "will affect lines and willingness of counterparties to fund secured"); Amadou N.R. Sy, The Systemic Regulation of Credit Rating Agencies and Rated Markets 8‐9 (Int'l Monetary Fund, Working Paper, 2009) (noting that broker‐dealers may use credit ratings to determine acceptable counterparties, as well as collateral levels for outstanding credit exposure).Show full note

818

● An April 2008 "Leverage Analysis" report sent to Tonucci and Reilly compared Lehman's first quarter 2008 leverage ratios and balance sheet by business with the same measurements for Lehman's fourth quarter 2003.³¹⁴⁵³¹⁴⁵ Lehman, Leverage Analysis Report (Apr. 4, 2008) [LBEX‐DOCID 103786] (attached to e‐mail from Robert Azerad, Lehman, to Paolo R. Tonucci, Lehman, et al. (Apr. 4, 2008) [LBEX‐DOCID 125281]). It also compared Lehman's and its competitors' net leverage ratios and net assets.

¶Two weeks before the close of Lehman's second quarter 2008 in May 2008, and following a meeting with Fidelity, Callan wrote to Gregory and Fuld about Fidelity's feedback:

[W]e may get a very short leash if we show up with a rough quarter if we do not get the balance sheet exercise completed. No matter what, the skeptics are focused on our balance sheet and that is the key to the future. . . . I know we are saying it over and over but we HAVE to deliver on the balance sheet reduction this quarter and cannot give any room to FID for slippage.³¹⁴⁶³¹⁴⁶ E‐mail from Erin M. Callan, Lehman, to Richard S. Fuld, Jr., Lehman, et al. (May 13, 2008) [LBHI_SEC07940_034732] (emphasis added).

¶At the close of Lehman's second quarter in May 2008, and in connection with Morton's Global FID meeting on balance sheet issues, Freidheim, a Lehman Managing Director, wrote to Lowitt and Morton about the materiality of Lehman's balance sheet reduction:

819

Regarding balance sheet reduction ‐ I would not say 'we have reduced the balance sheet and brought it down from 15.6 to 12.6' ‐ that is material non public information and everyone (the market) is looking for the number etc. and in a forum of thousands of people is not sr mgmt and leak possibility is very high). however you can say whatever erin has said 'it is a significant accomplishment that we have deleveraged the balance sheet so quickly + positioned ourselves for future' . . . I would not use the number.³¹⁴⁷³¹⁴⁷ E‐mail from Scott J. Freidheim, Lehman, to Ian T. Lowitt, Lehman, et al. (May 30, 2008) [LBEX‐DOCID 1906851] (emphasis added).

McDade Became President and COO on June 12, 2008 and Authorized the Reduction of Repo 105 Usage

¶Lehman used $50.38 billion of Repo 105 transactions at the end of the second quarter on May 30, 2008, up slightly from the previous quarter.³¹⁴⁸³¹⁴⁸ See, e.g., Lehman, Balance Sheet and Key Disclosures 2008 3Q Targets [Draft] (June 16, 2008), at p. 3 [LBHI_SEC07940_641516]. Upon becoming Lehman's President and COO on June 12, 2008, McDade was finally empowered to authorize a firm‐wide reduction in Repo 105 usage.³¹⁴⁹³¹⁴⁹ Examiner's Interview of Herbert H. "Bart" McDade III, Jan. 28, 2010, at p. 9. On June 17, 2008, Reilly circulated to McDade, Lowitt, Andrew Morton (Head of FID), and Chris O'Meara a document entitled "Balance Sheet and Key Disclosures" that incorporated McDade's plan to reduce Lehman's firm‐wide Repo 105 usage by half – from $50 billion to $25 billion in third quarter 2008.³¹⁵⁰³¹⁵⁰ Lehman, Balance Sheet and Key Disclosures 2008 3Q Targets [Draft] (June 16, 2008), at p. 3 [LBEX‐ DOCID 3363493] (attached to e‐mail from Gerard Reilly, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (June 17, 2008) [LBEX‐DOCID 3383643]); see also e‐mail from Gerard Reilly, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (Aug. 17, 2008) [LBEX‐DOCID 4517376] ("Repo 105 should be 25 b about half of what it was last quarter.").Show full note In response to Reilly's circulation of the presentation announcing that Lehman's firm‐wide Repo 105 usage would be cut by 50% in the third quarter 2008, Morton complained that the proposed balance sheet target for FID in third quarter 2008 was identical to the second quarter target, but with the Repo 105 limit cut in half, the Rates business of FID would not survive.³¹⁵¹³¹⁵¹ E‐mail from Andrew J. Morton, Lehman, to Gerard Reilly, Lehman (June 17, 2008) [LBEX‐DOCID 4553451]. Reilly responded to Morton: "Think this is most conservative case and initially Bart [McDade] had a view of keeping total assets flat but that was two weeks ago and may have changed."³¹⁵²³¹⁵² E‐mail from Gerard Reilly, Lehman, to Andrew J. Morton, Lehman (June 17, 2008) [LBEX‐DOCID 4553451].

820

¶McDade, Reilly, Lowitt, Morton and O'Meara met to discuss the Balance Sheet and Key Disclosures document in June 2008.³¹⁵³³¹⁵³ E‐mail from Christopher M. O'Meara, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (June 17, 2008) [LBEX‐DOCID 033813] (replying to receipt of Balance Sheet and Key Disclosures 2008 3Q Targets [Draft] (June 16, 2008) and stating that "meeting is being set up to discuss" the Balance Sheet and Key Disclosure 2008 3Q Targets document); e‐mail from Gerard Reilly, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (June 19, 2008) [LBEX‐DOCID 2962369] (transmitting Lehman, Balance Sheet and Key Disclosures 2008 3Q Targets (June 19, 2008) [LBEX‐DOCID 2932594] and stating "[u]pdated from our meeting"). One e‐mail suggests that the Executive Committee approved the reduction soon thereafter. See e‐mail from Jennifer Fitzgibbon, Lehman, to Francis Pearn, Lehman, et al. (June 23, 2008) [LBEX‐DOCID 1856501] (transmitting Lehman, Balance Sheet and Key Disclosures 2008 3Q Targets (June 19, 2008) [LBEX‐DOCID 1698850] and stating "[a]ttached is final balance sheet and certain key disclosure targets for 3Q. Should be approved by exec comm today").Show full note McDade recalled that he brought O'Meara "back in the [balance sheet] process" to help in light of O'Meara's past experience as CFO.³¹⁵⁴³¹⁵⁴ Examiner's Interview of Herbert H. "Bart" McDade III, Jan. 28, 2010, at p. 8

¶McDade discussed the Balance Sheet and Key Disclosures document with Richard Fuld in June 2008.³¹⁵⁵³¹⁵⁵ Id. at p. 5. McDade "specifically walked Fuld through the presentation. . . ."³¹⁵⁶³¹⁵⁶ Id. McDade discussed page three of the presentation with Fuld, which identified that Lehman used $38.6 billion, $49.1 billion, and $50.3 billion of Repo 105 transactions, at quarters‐end fourth quarter 2007, first quarter 2008, and second quarter 2008, respectively.³¹⁵⁷³¹⁵⁷ Id. McDade said that, as referenced on page three of the Balance Sheet and Key Disclosures document, he also told Fuld that he (McDade) recommended that Lehman reduce its firm‐wide Repo 105 usage to $25 billion in the third quarter 2008.³¹⁵⁸³¹⁵⁸ Id.

821

¶McDade observed that Fuld "was familiar with the term 'Repo 105.'"³¹⁵⁹³¹⁵⁹ Examiner's Interview of Herbert H. "Bart" McDade III, Jan. 28, 2010, at p. 5. McDade recalled that Fuld's response to the entire document was "good, good, good; he was nodding approval" and that Fuld was "supportive of reducing the firm's use of Repo 105."³¹⁶⁰³¹⁶⁰ Id. More specifically, regarding McDade's recommendation to cut Lehman's use of Repo 105 in half in the third quarter 2008, McDade recalled Fuld asked, "Is it doable? Is it necessary? If so, [Fuld] said, go do it."³¹⁶¹³¹⁶¹ Id. at p. 6. McDade concluded that "Fuld knew about the accounting of Repo 105."³¹⁶²³¹⁶² Id.

¶During the June meeting with Fuld over the Balance Sheet and Key Disclosures document, McDade and Fuld discussed that Lehman's need to deleverage was "absolutely" a critical issue to Lehman.³¹⁶³³¹⁶³ Id. at p. 5. On July 10, 2008, a few weeks after discussing the "Balance Sheet and Key Disclosures" document with McDade, Fuld signed Lehman's quarterly report.³¹⁶⁴³¹⁶⁴ LBHI, 10‐Q (filed July 10, 2008), at p. 160. Fuld denied any recollection of conversations with McDade or other members of Lehman's Executive Committee regarding Repo 105.³¹⁶⁵³¹⁶⁵ Examiner's Interview of Richard S. Fuld, Jr., Nov. 19, 2009, at p. 8.

822

The Market's Increased Scrutiny of the Leverage of Investment Banks

¶In mid‐to‐late 2007, Lehman faced a growing challenge: the market began demanding that investment banks shrink their balance sheet and lower their leverage.³¹⁶⁶³¹⁶⁶ Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 6; Mark Jickling, Averting Financial Crisis, CRS Report for Congress, at 18 (Mar. 10, 2008, updated on Oct. 8, 2008) (explaining that the market began demanding that investment banks lower their balance sheet and reduce leverage). Balance sheet management, which refers to the manner in which firms control the size of their balance sheet, is important to firms for numerous reasons, including the impact balance sheet has on leverage. Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at pp. 5‐6; Examiner's Interview of Paolo R. Tonucci, Sept. 16, 2009, at p. 26 (stating that balance sheet targets were driven by what managers considered a good range for leverage); Examiner's Interview of Ian T. Lowitt, Oct. 28, 2009, at pp. 30‐31; e‐mail from Ian T. Lowitt, Lehman, to Roger Nagioff, Lehman (Apr. 16, 2007) [LBEX‐DOCID 175349] (transmitting balance sheet management policy [LBEX‐DOCID 148914] and 2007 Balance Sheet Targets and Usage). The purpose of balance sheet management at Lehman was to control the firm's leverage ratios. Examiner's Interview of Anuraj Bismal, Sept. 16, 2009, at p. 5. Capital adequacy, as that phrase is used vis‐à‐vis large investment banks, is commonly measured using a leverage ratio, which divides some measurement of the investment bank's assets by the capital equity in the bank, to determine the risk profile and relative solvency of the entity. See LBHI 2007 10‐K, at pp. 30, 63; Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), 2009, at p. 6. Thus, in order to control leverage, Lehman's balance sheet targets were "reverse engineered," working backward from the firm's leverage ratio target. Examiner's Interview of Matthew Lee, July 1, 2009, at p. 15; Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 5; Examiner's Interview of Paolo R. Tonucci, Sept. 16, 2009, at p. 6. There is nothing necessarily improper about balance sheet management; it is a normal business practice used by many institutions. As discussed in the Examiner's Conclusions, balance sheet management done in a way that materially misrepresents the true financial position of the company can, however, give rise to a colorable claim.Show full note Before mid‐2007, rating agencies, media, and outside analysts who observed Lehman focused on the firm's revenues and profit and loss, "P&L."³¹⁶⁷³¹⁶⁷ Mike Shedlock, MISH's Global Economic Trend Analysis, Bank Balance Sheets and Earnings, http://globaleconomicanalysis.blogspot.com/2007/09/bank‐balance‐sheets‐and‐earnings.html (Sept. 30, 2007, 1:38 PM); Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 6. Sometime in mid‐2007, however, those same outside rating agencies and analysts pronounced the metrics of an investment bank's balance sheet and capital at least as important, if not more, than revenue and P&L.³¹⁶⁸³¹⁶⁸ See, e.g., Ben Bernanke, Chairman of the Bd. of Governors of the U.S. Fed. Reserve Sys., The Recent Financial Turmoil and its Economic and Policy Consequences, Address at the Economic Club of New York 3 (Oct. 15, 2007), available at: http://www.federalreserve.gov/newsevents/speech/bernanke20071015a.htm (stating that strains in financial markets prompted banks "to become protective of their liquidity and balance sheet capacity"); Tobias Adrian and Hyun Song Shin, Liquidity, Monetary Policy, and Financial Cycles, CURRENT ISSUES IN ECON. & FIN. (Jan. ‐ Feb. 2008), at 4, available at http://www.nyfrb.org/research/current_issues (discussing how financial institutions' chief tool in adjusting leverage is collateralized borrowing and lending (i.e., repo and reverse repo agreements) and that in times of market turmoil, financial institutions try to lower their leverage); The Economic Outlook: Hearing Before H. Comm. on the Budget, 110th Cong. (Jan. 17, 2008) (statement of Ben Bernanke, Chairman of the Bd. of Governors of the U.S. Fed. Reserve Sys.), available at: http://www.federalreserve.gov/newsevents/testimony/bernanke20080117a.htm; Mark Jickling, Averting Financial Crisis, CRS Report for Congress, at 18 (Oct. 8, 2008, updated on Mar. 21, 2009) (explaining that the market began demanding that investment banks lower their balance sheet and reduce leverage); Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 6.Show full note The breakdown of securitization and structured finance markets in late 2007 intensified balance sheet pressures on banks.³¹⁶⁹³¹⁶⁹ Timothy F. Geithner, President, Fed. Reserve Bank of N.Y., Reducing Systemic Risk In A Dynamic Financial System, Remarks at the Economic Club, New York City, New York, (June 9, 2008), available at http://www.newyorkfed.org/newsevents/speeches/2008/tfg060809.html ("The funding and balance sheet pressures on banks were intensified by the rapid breakdown of securitization and structured finance markets. Banks lost the capacity to move riskier assets off their balance sheets, at the same time they had to fund, or to prepare to fund, a range of contingent commitments over an uncertain time horizon."); see also Diane Hinton, Standard & Poor's RatingsDirect, Liquidity Management In Times Of Stress: How The Major U.S. Broker‐Dealers Fare (Nov. 8, 2007), at pp. 2‐3 [LBHI_SEC07940_439424] ("Recent disruptions in the subprime market and its contagion effects into the leveraged finance, asset‐backed commercial paper (ABCP), and CDO spaces have substantially curtailed market liquidity. The sudden loss of appetite for subprime and other high‐yield exposure has significantly narrowed these markets, while uncertainty regarding asset valuations left many institutions unable to unwind exposures at fair market prices. . . . As a result, the markets for these assets have considerably shrunk.").Show full note

823 824

¶One analyst wrote in late September 2007: "[Banks'] net incomes this quarter don't matter. And they don't matter because of one simple rule for financial services firms: The income statement is the past. The balance sheet is the future. . . . At the top of a credit cycle, the income statement for a financial institution shows 'the best of times' but buried in the balance sheet is 'the worst of times' to come."³¹⁷⁰³¹⁷⁰ Mike Shedlock, MISH's Global Economic Trend Analysis, Bank Balance Sheets and Earnings, http://globaleconomicanalysis.blogspot.com/2007/09/bank‐balance‐sheets‐and‐earnings.html (Sept. 30, 2007, 1:38 PM) (emphasis added); see also Cong. Research Serv., 110th Cong., Financial Crisis? The Liquidity Crunch of August 2007 7 (CRS Report RL 34182) (Darryl E. Getter, et al.) (stating that market optimism and underestimation of risk "encouraged the overuse of leverage, or borrowed money, to boost returns"); Mark Jickling, Averting Financial Crisis 6, CRS Report for Congress (Mar. 10, 2008) ("As its capital loses value, the firm must shrink its balance sheet to maintain a given leverage ratio. As firms sell assets to reduce balance sheet exposure, asset prices are driven down.").Show full note

¶The market's increased focus on balance sheet and leverage only intensified in 2008.³¹⁷¹³¹⁷¹ E‐mail from Peter Eavis, Wall Street Journal, to Kerrie Cohen, Lehman (Mar. 18, 2008) [LBEX‐DOCID 1610003] (asking Lehman to explain its net leverage calculation); LBHI 10‐Q (filed Apr. 9, 2008), at p. 65 ("During the 2008 quarter, the Company operated in a liquidity, funding, and capital environment characterized by constrained market liquidity driven in part by balance sheet and leverage concerns."); John Hilsenrath, et al. Goldman, Morgan Scrap Wall Street Model, Become Banks in Bid to Ride Out Crisis, Wall St. J. (Sept. 22, 2008) at A1 (reporting that the "world no longer tolerates high leverage" and that analysts felt that investment banks relied too heavily on short‐term borrowed money).Show full note Rating agencies, analysts, and the media became more concerned about the types of inventory investment banks, including Lehman, maintained on their respective balance sheets, the size of a bank's balance sheet, and how much of its balance sheets a firm used.³¹⁷²³¹⁷² Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 6. For example, following the near collapse of Bear Stearns in March 2008, an editorial columnist asked the question "Will Citibank Survive?" and answered by "examining Citi's balance sheet [and] ignoring its income statement because in a crisis, future cash‐flow is basically irrelevant to a bank's survival and need for liquidity."³¹⁷³³¹⁷³ James Turk, Will Citibank Survive?, Financial Sense, Mar. 17, 2008, http://www.financialsense.com/editorials/turk/2008/0317.html; see also Systemic Regulation, Prudential Matters, Resolution Authority and Securitization: Hearing Before H. Comm. on Financial Servs., 111th Cong. 3 (Oct. 29, 2009) (statement of Jane D'Arista, Americans for Financial Reform) (explaining how excessive leverage throughout the financial system made institutions "vulnerable to any event that might threaten their ability to roll over the funding that supported their inflated balance sheets").Show full note

825

¶The market turned its focus to the leverage of investment banks in mid‐to‐late 2007, just as Lehman found it increasingly difficult to sell its "sticky" inventory.³¹⁷⁴³¹⁷⁴ Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 6. As a consequence, by late 2007, the highest levels of Lehman senior management placed increasing emphasis on reducing the balance sheet and reducing Lehman's leverage.³¹⁷⁵³¹⁷⁵ Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at p. 8. Fuld explained that he made strategic decisions to reduce Lehman's balance sheet and bring down the net leverage ratio to improve market perceptions of Lehman. This "concerted effort" by senior Lehman management was done with an eye towards the rating agencies' views of Lehman.³¹⁷⁶³¹⁷⁶ Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at pp. 5, 8; Examiner's Interview of Anuraj Bismal, Sept. 16, 2009, at p. 5; see also Lehman, Lehman Presentation to Rating Agencies [Draft] (May 12, 2008), at p. 20 [LBEX‐DOCID 3192668] (attached to e‐mail from Kevin Thatcher, Lehman, to Ian T. Lowitt, Lehman, et al. (May 21, 2008) [LBEX‐DOCID 3200389] and stating that "[i]n an effort to reduce Q2 '08 leverage ratios, the Firm is undergoing a deleveraging exercise which will be driven by specific balance sheet reductions coupled with capital raising").Show full note

The Cost of Deleveraging

¶In order to reduce its net leverage, Lehman could have either decreased the numerator used in its net leverage ratio calculation (i.e., net assets), or increased the denominator by raising equity.³¹⁷⁷³¹⁷⁷ Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at p. 27. Fuld acknowledged that although raising equity could also reduce the net leverage ratio, Lehman had to improve its net leverage by reducing its net assets (i.e., selling inventory) because "there was a perception issue" with raising equity.³¹⁷⁸³¹⁷⁸ Id. "If we raised equity, we would have brought the [net leverage ratio] number down, but would not have really fixed anything."³¹⁷⁹³¹⁷⁹ Id. Accordingly, to meet its goal of reducing the firm‐wide net leverage ratio, Lehman sought to reduce its net assets.³¹⁸⁰³¹⁸⁰ Id.; Examiner's Interview of Clement Bernard, Oct. 23 2009, at p. 12. Clement Bernard made a similar point as Fuld regarding Lehman's route to reducing its net leverage ratio. Bernard stated that Lehman could easily have reduced its gross balance sheet by reducing matched book, but that reducing net balance sheet was more difficult as it required Lehman either to sell assets or engage in additional Repo 105 transactions.Show full note

826

¶Reducing net assets through outright sales, however, also came at a cost to Lehman. First, the sale of many of its inventory positions would result in substantial losses to Lehman. An internal Lehman PowerPoint presentation that CFO Erin Callan prepared in early April 2008, entitled "Leverage Analysis," illustrates this point.³¹⁸¹³¹⁸¹ Erin M. Callan, Lehman, Lehman Brothers ‐ Leverage Analysis (Apr. 7, 2008), at p. 1 [LBEX‐DOCID 1401225] (attached to e‐mail from Edward Grieb, Lehman, to Edward Grieb, Lehman (Apr. 5, 2008) [LBEX‐DOCID 1542476]). "Lehman's growth in net balance sheet has been weighted toward mortgages and loans. Deleveraging will require selling these assets, which will result in losses for Lehman. . . . Reducing leverage is necessary to remove refinancing risk and win back the confidence of the market, lenders, and investors."³¹⁸²³¹⁸² Id. at p. 1. Winning back the confidence of the market was necessary, in part, because "[a]fter initially declining, Lehman Brothers' net leverage. . . ha[d] crept back towards the higher end of the peer group in recent years, signaling higher risk."³¹⁸³³¹⁸³ Id. at p. 5. Lehman's "change in Net Leverage [wa]s small, but weighted towards illiquid assets like mortgages and loans."³¹⁸⁴³¹⁸⁴ Id. at p. 7. In fact, the composition of Lehman's Level 3 assets was 60% mortgages.³¹⁸⁵³¹⁸⁵ Id. at p. 9. Callan reported the potential cost to Lehman of deleveraging: moving $22 billion of illiquid assets would have cost Lehman an estimated $750 million.³¹⁸⁶³¹⁸⁶ Erin M. Callan, Lehman, Lehman Brothers ‐ Leverage Analysis (Apr. 7, 2008), at p. 12 [LBEX‐DOCID 1401225].

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¶In addition to the losses Lehman would incur by selling "sticky" assets at fire‐ sale prices, deleveraging also raised the additional problems of market perception and valuation.³¹⁸⁷³¹⁸⁷ Examiner's Interview of Secretary Timothy F. Geithner, Nov. 24, 2009, at pp. 7‐8. As Secretary Timothy Geithner explained to the Examiner, selling "sticky" assets at discounts could hurt Lehman by revealing to the market that Lehman "had a lot of air in [its] marks" and thereby further draining confidence in the valuation of the assets that remained on Lehman's balance sheet.³¹⁸⁸³¹⁸⁸ Id.; see also The Economic Outlook: Hearing Before H. Comm. on the Budget, 110th Cong. (Jan. 17, 2008) (statement of Ben Bernanke, Chairman of the Bd. of Governors of the U.S. Fed. Reserve Sys.), available at: http://www.federalreserve.gov/newsevents/testimony/bernanke20080117a.htm (explaining that as financial institutions came under pressure in 2007 and 2008 to remove hard‐to‐value products from balance sheet of special purpose entities and onto their own balance sheet, banks' balance sheets swelled with illiquid, sticky inventory).Show full note

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"Sticky" Inventory and FID's Balance Sheet Breaches Hampered Lehman's Ability to Manage Its Net Leverage

¶Lehman expanded its Repo 105 practice in the context of an increasingly "sticky" balance sheet. In February 2007, Joseph Gentile, FID's then‐Chief Financial Officer who reported directly to Gerard Reilly, sent a proposal to Ed Grieb, then‐Global Financial Controller, petitioning Grieb to increase the firm's $22 billion combined firm‐wide Repo 105/108 limit to $25 billion.³¹⁸⁹³¹⁸⁹ Joseph Gentile, Lehman, Proposed Repo 105/108 Target Increase for 2007 (Feb. 10, 2007) [LBEX‐ DOCID 2489498] (attached to e‐mail from Joseph Gentile, Lehman, to Edward Grieb, Lehman (Feb. 10, 2007) [LBEX‐DOCID 2600714]). Recall that a July 2006 Overview of Repo 105/108 Presentation stated that Grieb and CFO Chris O'Meara were responsible for setting Lehman's limits on Repo 105 activity at $17 billion and Repo 108 activity at $5 billion for a total of $22 billion in combined Repo 105/108 limits.Show full note Gentile's February 2007 request provided three interrelated reasons why Lehman should increase its internal Repo 105 limit:

● Lehman's Real Estate Group likely would not be able to conduct its Windermere securitization ($2B) in first quarter 2007 and Lehmanʹs Mortgages Group "will have a great deal of difficulty in selling sub prime loans (5.0bn), adversely affecting balance sheet. Exiting these position[s] would be impossible or prohibitively costly."³¹⁹⁰³¹⁹⁰ Joseph Gentile, Lehman, Proposed Repo 105/108 Target Increase for 2007 (Feb. 10, 2007) [LBEX‐ DOCID 2489498].

● "Repo 105 offers a low cost way to offset the balance sheet and leverage impact of current market conditions."³¹⁹¹³¹⁹¹ Id.

● Lehman would have significant difficulty "exiting" large positions in its Real Estate and Mortgage Groups without "incur[ring] large losses due to the steep discounts that they would have to be offered at and [the] substantial reputation risk in the market as it would suggest a serious 'issue' with our Mortgage/Real Estate concentrations. A Repo 105 increase would help avoid this without negatively impacting our leverage ratios."³¹⁹²³¹⁹² Id.; see also e‐mail from Heidimarie Echterman, Lehman, to Gerard Reilly, Lehman (Feb. 23, 2007) [LBEX‐DOCID 1620265] ("Net leverage is down 1 turn vs number discussed at this morning's FOC (15.5x now 15.4x vs target 14.8x). Do you think we will be able to get below this for quarter end? I have not had any discussion with Chris on this ‐ do we need to alert him?"). Echterman forwarded this e‐mail to Paolo Tonucci, then‐Treasurer, adding: "Sorry I meant to copy you – it's all in IRP and Real Estate. They are looking to do more Repo 105 and sell down positions. Gelband has been alerted by Joe [Gentile]." Id.Show full note

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¶Subsequent Lehman e‐mails indicate that Lehman raised the combined Repo 105/108 limit in February 2007 by $3 billion, from $22 billion to $25 billion.³¹⁹³³¹⁹³ E‐mail from Joseph Gentile, Lehman, to Michael Gelband, Lehman, et al. (Feb. 21, 2007) [LBEX‐DOCID 4553218] ("I have been able to get a temp limit of 3 bn for repo 105 activity, which covers known real estate issues. . . ."); e‐mail from Joseph Gentile, Lehman, to Gerard Reilly, Lehman (Feb. 21, 2007) [LBEX‐ DOCID 4553220] (responding to question "Where did the 3bn come from?" by writing: "We spoke with grieb…and he was ok with a temporary excession of $3. . . ."); e‐mail from Michael McGarvey, Lehman, to Anuraj Bismal, Lehman, et al. (May 9, 2007) [LBEX‐DOCID 3223356] ("17 bn was the year end limit for FID. In Q1 Joe Gentile spoke to Edward Grieb about raising it to 20bn (based on the attached doc) and according to Joe Ed agreed.").Show full note

¶As it became increasingly difficult in 2007 for Lehman to exit certain positions, Lehman's maneuverability with respect to meeting balance sheet and leverage targets diminished.³¹⁹⁴³¹⁹⁴ Joseph Gentile, Lehman, Proposed Repo 105/108 Target Increase for 2007 (Feb. 10, 2007) [LBEX‐ DOCID 2489498] (attached to e‐mail from Joseph Gentile, Lehman, to Edward Grieb, Lehman (Feb. 10, 2007) [LBEX‐DOCID 2600714]); e‐mail from Sigrid Stabenow, Lehman, to Eric Addington, et al. Lehman (Feb. 1, 2008), [LBHI_SEC07940_1840953] ("The FID business analysis team . . . review[ed] 'how' FID is using its balance sheet. The purpose [of the review] is . . . to give clarity on what is movable balance sheet in the current env't and . . . to address the Q1 balance sheet limit issues we're facing. . . . [T]he global problem that FID is facing [is] that they are expected to be $15 bn over limit. . . . The stickiness of real estate & securitized products in americas and europe are creating issues."); e‐mail from Clement Bernard, Lehman, to Andrew J. Morton, Lehman, et al. (Feb. 4, 2008) [LBEX‐DOCID 1849805] (discussing firm‐ wide net leverage ratio, FID's sticky/illiquid/Level 3 inventory, the percentage of FID's balance sheet that this sticky inventory constitutes, and that Level 3 assets "have increased a lot in 2007 due [to] some assets becoming less observable"). Lehman management monitored and assessed whether the dollar value of its assets (the numerator in the net leverage ratio equation used at Lehman) was at an appropriate level by setting balance sheet targets for the firm, specific business units, and even for individual traders. Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at pp.5‐6; Examiner's Interview of Tejal Joshi, Sept. 15, 2009, at p. 5; Examiner's Interview of Anuraj Bismal, Sept. 16, 2009, at p. 5; Examiner's Interview of Kaushik Amin, Sept. 17, 2009, at p. 5; Examiner's Interview of Mitchell King, Sept. 21, 2009, at p. 5; Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 11; Examiner's Interview of Joseph Gentile, Oct. 21, 2009, at p. 5. Balance sheet targets were a function of the firm‐wide leverage ratio target, which was reported publicly. See, e.g., e‐mail from Clement Bernard, Lehman, to Roger Nagioff, Lehman, et al. (Nov. DOCID 1728898] ("As of the 28th, Rates had 113.6bn of net assets. Right now our quarter‐end forecast is at ~3bn over target so we should reduce net assets by 68 bn."); e‐mail from Clement Bernard, Lehman, to Roger Nagioff, Lehman, et al. (Nov. 20, 2007) [LBEX‐DOCID 173748] ("The net Balance Sheet forecast for FID for November 30 has increased to $232.6 [billion] from a previous forecast of $227 [billion]. This is $12.6 [billion] above the limit of $220 [billion]. The limit of $220 [billion] equates to a leverage ratio of 16 which is the current firm target. . . . Based on my conversations with Paolo [Tonucci] we need to go down to $225 [billion] in order for the ratio to be back to target."); id. (noting also that most of the United States Agency positions will be off balance sheet through Repo 105 transactions).Show full note This put additional pressure on more liquid businesses within Lehman to reduce balance sheet, as exemplified by Gentile's February 2007 request to Grieb.3195

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¶20, 2007) [LBEX‐DOCID 173748] ("The net Balance Sheet forecast for FID for November 30 has increased to $232.6 Bio from a previous forecast of $227 Bio. This is $12.6 Bio above the limit of $220 Bio. The limit of $220 Bio equates to a leverage ratio of 16 which is the current firm target…. Based on my conversations with Paolo [Tonucci] we need to get down to $225 Bio in order for the ratio to be back to target."); Examiner's Interview of Paolo R. Tonucci, Sept. 16, 2009, at p. 26 (stating that Lehman's balance sheet targets were driven by what an acceptable range of leverage for the firm would be); Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 11; Examiner's Interview of Joseph Gentile, Oct. 21, 2009, at p. 5; Examiner's Interview of Ian T. Lowitt, Oct. 28, 2009, at pp. 30‐31 (stating that collaborative process between Finance, Fixed Income, Markets, and Treasury used to set balance sheet targets for businesses but that leverage ratio target was a firm‐wide target). After the leverage target was set, each Lehman business group or division would allocate balance sheet usage to units within that business based upon how much balance sheet was needed to run a group's operations. For example, as part of his management reporting duties, Joseph Gentile, the former Financial Officer of Lehman's FID, tracked FID's balance sheet on a daily basis and as part of Lehman's balance sheet management process. Examiner's Interview of Joseph Gentile, Oct. 21, 2009, at p. 5. If Lehman's firm‐wide net leverage ratio was too high, individual businesses such as FID would be informed of the impact their respective balance sheet breaches had on the firm's leverage ratio. Id.; see also e‐mail from Gerard Reilly, Lehman, to Joseph Gentile, Lehman (Feb. 21, 2007) (stating the impact of $10 billion balance sheet breach by FID on Lehman's net leverage ratio and stating: "These guys are going to have to take accountability for under performance. At least tell guys to cut b[alance] s[heet] if they don't make money."); e‐mail from Joseph Gentile, Lehman, to Gerard Reilly, Lehman (Feb. 21, 2007) [LBEX‐DOCID 4553347]. Michael McGarvey similarly said that beginning sometime in 2007 (as leverage became increasingly important to market observers) and until September 2008, when Lehman filed for bankruptcy, he assumed a newly‐created role in which he both worked with different product groups within FID to develop daily estimates of the group's balance sheet and how much funding each desk was using, and communicated to FID product controllers the balance sheet targets set by Lehman's Treasury group. Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 6. McGarvey also communicated these targets to the Financial Controller. See e‐mail from Michael McGarvey, Lehman, to Martin Kelly, Lehman (Jan. 30, 2008) [LBHI_SEC07940_861472‐861474] (reporting that FID's Rates business has $113.6 billion in net assets, that the quarter‐end forecast is more than $3 billion over target, so Lehman should reduce net assets by $68 billion). Lehman documents, including PowerPoint presentations and e‐mail communications, confirm the setting of balance sheet targets and leverage ratio targets at the firm. See, e.g., Lehman, Rates Business Projected Balance Sheet Spreadsheet (Aug. 21, 2006) [LBEX‐DOCID 2783441]; e‐mail from Kentaro Umezaki, Lehman, to Ian T. Lowitt, Lehman (Apr. 16, 2007) [LBEX‐DOCID 288764] ("Giving out targets for Q2 as we speak. Numbers attached . . . all biz's are aware of it's importance now . . . Gerry [Reilly] has us working with a 195 net balance sheet target now . . . to get us to 15x net leverage by end of May . . . ."); Lehman, Lehman Asset Statement Balance Sheet January 10, 2007 Spreadsheet (Jan. 11, 2007) [LBEX‐ DOCID 648081]; e‐mail from Michael McGarvey, Lehman, to Clement Bernard, Lehman (Nov. 29, 2007) [LBEX‐DOCID 1852001] (discussing whether Rates Asia, within FID, will make its balance sheet target); Lehman, Rates Projected Balance Sheet Spreadsheet (Jan. 25, 2007) [LBEX‐DOCID 1447282]; e‐mail from Kentaro Umezaki, Lehman, to Joseph Gentile, Lehman (Feb. 21, 2007) [LBEX‐DOCID 1808076] ("What is our lev ratio target this quarter?"); Lehman, Global FID Balance Sheet Forecast as of November 12, 2007 (Nov. 13, 2007) [LBEX‐DOCID 3215542]; e‐mail from Sarah Paek, Lehman, to Balance Sheet Group, Lehman (Nov. 29, 2007) [LBEX‐DOCID 1851789] (transmitting attached FID balance sheet forecast [LBEX‐ DOCID 1733969] reporting amount by which business within FID are over/under gross and net balance sheet targets); e‐mail from Michael McGarvey, Lehman, to Martin Kelly, Lehman (Jan. 30, 2008) [LBEX-Although, as noted above, only highly liquid securities were eligible for Repo 105 treatment, Grieb, Reilly and others explored whether they could remove sticky inventory from Lehman's balance sheet through the use of Repo 105 transactions.³¹⁹⁶³¹⁹⁶ For example, Grieb recommended to Lehman's Accounting Policy Group that Lehman use the Repo 105 program to remove from the balance sheet certain residual positions from mortgage backed and real estate backed securitizations. See e‐mail from Marie Stewart, Lehman, to Mark Cosaitis, Lehman, et al. (Aug. 17, 2007) [LBEX‐DOCID 3223799] ("I discussed the issue . . . with Ed Grieb to make sure he would be OK with doing this. . . . You will need to repo 105 every single piece of the deal on b/sheet. Is that the plan?"); e‐mail from Mark Cosaitis, Lehman, to Marie Stewart, Lehman, et al. (Aug. 17, 2007) [LBEX‐ DOCID 3223800] (discussing whether, if Lehman can transfer all Windermere securities using Repo 105, Lehman "can…eliminate the gross up in addition to netting down the bonds?"); e‐mail from Marie Stewart, Lehman, to Mark Cosaitis, Lehman, et al. (Aug. 17, 2007) [LBEX‐DOCID 3223801] (indicating that Stewart planned to have a meeting that day with Grieb to discuss possibility of placing Windermere bonds into Repo 105 program); e‐mail from Marie Stewart, Lehman, to Brett Beldner, Lehman, et al. (Aug. 17, 2007) [LBEX‐DOCID 3223803] ("Ed told me yesterday that it was his idea that we use Repo 105 to achieve this outcome. . . . I'm not warm and fuzzy about using [Repo 105] to get entire deals off b/sheet and [Ed Grieb] should discuss with E&Y."); e‐mail from Brett Beldner, Lehman, to Marie Stewart, Lehman (Aug. 17, 2007) [LBEX‐DOCID 3223803] ("I am also convinced that E&Y will say it doesn't work."); e‐mail from Marie Stewart, Lehman, to Mark Cosaitis, Lehman, et al. (Aug. 17, 2007) [LBEX‐ DOCID 3223806] ("I spoke to Ed [Grieb]. While a Repo 105 would work for saying the specific assets under the Repo 105 have been sold, because a repo involves a promise to repurchase those assets (and we actually book a fwd) we don't think it will work to get failed sales deals deconsolidated. Brent Beldner in process of double checking with E&Y. . . ."); see also Lehman, Repo 105/108 Benefit Summary (Nov. 9, 2007) [LBEX‐DOCID 3219736] (attached to e‐mail from Anuraj Bismal, Lehman, to David Vasey, Lehman, et al. (Nov. 9, 2007) [LBEX‐DOCID 3223369] and showing $744,212,553 in Repo 105 transactions usingShow full note

831 832

¶Specifically, in the summer of 2007, Grieb and Reilly enlisted the help of John Feraca, Kentaro Umezaki, and Michael McGarvey in an attempt to move mortgage‐backed securities into the Repo 105 program.3197 Though they were unsuccessful in their efforts

¶"real estate held for sale" in third quarter 2007 and calling this "something odd"); e‐mail from Anuraj Bismal, Lehman, to Marie Stewart, Lehman, et al. (Nov. 12, 2007) [LBEX‐DOCID 3223374] ("Sounds to me that we did Repo 105 on Real Estate Held for Sale. We have introduced a control check to try and detect if this happens at Q4."); e‐mail from Marie Stewart, Lehman, to Anuraj Bismal, Lehman, et al. (Nov. 12, 2007) [LBEX‐DOCID 3223375] (replying to news that commercial mortgage backed securities were used for Repo 105 by stating, "My head will explode if we have to talk them about this again"); e‐mail from Marie Stewart, Lehman, to Richard Holmes, Lehman, et al. (Nov. 12, 2007) [LBEX‐DOCID 3223373] (stating that "because the CMBS we hold do not exist for GAAP we cannot get a repo 105 benefit from them"); e‐mail from Marie Stewart, Lehman, to Gary Bachman, Lehman, et al. (Nov. 21, 2007) [LBEX‐ DOCID 3223381] ("FYI that we've had a few problems with people claiming Repo 105/108 benefit recently when they should not have."). 3197 E‐mail from Gerard Reilly, Lehman, to Steven Becker, Lehman, et al. (Aug. 16, 2007) [LBEX‐DOCID 251602] ("Why can't we repo 105 some prime AAA stuff?"); e‐mail from Steven Becker, Lehman, to Gerard Reilly, Lehman, et al. (Aug. 16, 2007) [LBEX‐DOCID 251603] ("I spoke with John who is currently trying to get off as much of the European deals [apparently CMOs or collateralized mortgage obligations] as he can via REPO 105."); e‐mail from Gerard Reilly, Lehman, to Steven Becker, Lehman, et al. (Aug. 16, 2007) [LBEX‐DOCID 251605] ("Any mortgage should be our highest priority."); e‐mail from Kentaro Umezaki, Lehman, to Gerard Reilly, Lehman (Aug. 16, 2007) [LBEX‐DOCID 1905992] ("Who can give me a repo 105 status/projection. This is around the mortgage inventory and using repo 105. . . . I need some sense of what we are doing, and whether we can move some of the high rated mortgage products into that framework."); e‐mail from John Feraca, Lehman, to Gerard Reilly, Lehman (Aug. 18, 2007) [LBEX‐ DOCID 4553350] (Feraca and Reilly discuss putting either commercial mortgage backed securities or residential mortgage backed securities into Repo 105); e‐mail from Gerard Reilly, Lehman, to John Feraca, Lehman (Aug. 18, 2007) [LBEX‐DOCID 4553351] ("Many benefits to us getting these assets [CMBS and RMBS] into the [Repo 105] program."); e‐mail from John Feraca, Lehman, to David Sherr, Lehman, et al. (Aug. 19, 2007) [LBEX‐DOCID 4553352] ("[W]e are looking at the possibility of Repo 105 for AAA RMBS and CMBS positions . . . only want to focus on non‐agency products for this exercise as both agency pass‐ thrus and agency CMOs roll up as government or agency products in the balance sheet, not mortgages."); e‐mail from David Sherr, Lehman, to John Feraca, Lehman, et al. (Aug. 19, 2007) [LBEX‐DOCID 4553353] (discussing placement of CMBS and RMBS into Repo 105 program); e‐mail from Gerard Reilly, Lehman, to John Feraca, Lehman, et al. (Aug. 19, 2007) [LBEX‐DOCID 4553356] (same); e‐mail from Gerard Reilly, Lehman, to Christopher M. O'Meara, Lehman (Aug. 19, 2007) [LBEX‐DOCID 4553354] (forwarding previous e‐mail chain discussions regarding mortgage backed securities and Repo 105 to Chris O'Meara).

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¶to place mortgage‐backed securities into the Repo 105 program in 2007,³¹⁹⁸³¹⁹⁸ E‐mail from John Feraca, Lehman, to David Sherr, Lehman, et al. (Aug. 20, 2007) [LBEX‐DOCID 4553357] ("We spoke to the 3 of the 4 counterparties we currently use for Repo 105 on UST and Agencies via LBIE (the MTS equivalent) and all 3 declined our proposal to use AAA private label RMBS and CMBS. . . . [O]ur only other choice will be to look if any of our existing counterparties in LBI would be willing to transact through LBIE."); see also e‐mail from Gerard Reilly, Lehman, to Christopher M. O'Meara, Lehman, et al. (Aug. 20, 2007) (forwarding Feraca e‐mail discussing use of RMBS and CMBS in Repo 105 program); e‐mail from Kentaro Umezaki, Lehman, to John Feraca, Lehman, et al. (Aug. 20, 2007) [LBEX‐DOCID 4553359] (Umezaki replies to Feraca, "not sure that is worth the effort…we need Chris [O'Meara] to opine."); e‐mail from Gerard Reilly, Lehman, to Kentaro Umezaki, Lehman, et al. (Aug. 21, 2007) [LBEX‐DOCID 4553360] ("What about agency cmo's [collateralized mortgage obligations]? We should pass on non‐agency at this point."); e‐mail from John Feraca, Lehman, to Gerard Reilly, Lehman, et al. (Aug. 21, 2007) [LBEX‐DOCID 4553361] ("My understanding is agency cmos roll up to govt products for our balance sheet disclosures and I do not think it will change the view we got from the lenders we approached yesterday.").Show full note by May 2008, Reilly raised the idea again.³¹⁹⁹³¹⁹⁹ E‐mail from Gerard Reilly, Lehman, to John Feraca, Lehman, et al. (May 1, 2008) [LBEX‐DOCID 4553429] ("If we can get mortgage assets into 105 we need to do that. I would think it is hard to do but clearly they would be our priority.").

¶Lehman was ultimately not able in 2007 to remove non‐agency residential and commercial mortgage‐backed securities ("RMBS" and "CMBS") from its balance sheet through Repo 105 transactions, but senior management soon recognized that ramping‐ up the use of Repo 105 transactions still offered Lehman a way to relieve some of the balance sheet pressure caused by the firm's illiquid and sticky positions.³²⁰⁰³²⁰⁰ Cf. E‐mail from Anuraj Bismal, Lehman, to Martin Kelly, Lehman, et al. (Feb. 25, 2008) [LBEX‐DOCID 3187495] (stating that FID's overage in balance sheet "is in real Estate and Securitized Products which currently have less ability to reduce balance sheet" and that "FID would like to do more [Repo 105] but it's a question of available capacity"). As Reilly wrote in one e‐mail, "At least . . . cut b[alance] s[heet] if [you] don't make money."³²⁰¹³²⁰¹ E‐mail from Gerard Reilly, Lehman to Joseph Gentile, Lehman (Feb. 21, 2007) [LBEX‐DOCID 4553198]. By April 2007, FID's balance sheet had grown 19% since 2005, while its revenue had grown only 3%. Lehman, FID Balance Sheet Management (April 2007), at p. 2 [LBEX‐DOCID 1303268]. Moreover, 52% of FID's balance sheet was in businesses with Return on Assets (ROA) below FID's average. Id. During this same period of time, FID's off‐balance sheet Repo 105 "benefit" grew from $15 billion in first quarter 2006 to $22 billion in first quarter 2007. Id.Show full note In a November 2007 e‐mail from Reilly to Clement Bernard, Reilly wrote: "Let's get our best thoughts on fid b[alance] s[heet]. We are slipping in real estate. Take a look at liquid holdings like cp and items we can put into the repo 105 program. We need fid close to 5b on net."³²⁰²³²⁰² E‐mailfrom Gerard Reilly, Lehman, to Clement Bernard, Lehman (Nov. 20, 2007) [LBEX‐DOCID 3221687] (emphasis added).

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¶Consistent with Gentile's recommendation to Grieb to increase the firm's Repo 105 limits, Anuraj Bismal, a former Senior Vice President in Lehman's Balance Sheet Group, said that the "stickiness" of mortgage‐backed securities and other real estate securities inventory put pressure on "everything else."³²⁰³³²⁰³ Examiner's Interview of Anuraj Bismal, Sept. 16, 2009, at p. 6. That is, to the extent Lehman could not remove sticky inventory from its balance sheet by selling it, Lehman had to remove even greater amounts of other types of inventory from its balance sheet – either via sales or Repo 105 transactions – to meet the balance sheet and leverage ratio targets set by senior management. According to Bismal, this was a factor in Lehman's increased use of Repo 105 transactions starting in mid‐to‐late 2007.³²⁰⁴³²⁰⁴ Id. Mitch King, the former head of Lehman's United States Agencies Trading Desk, also believed that Lehman's increased use of Repo 105 transactions beginning in mid‐to‐late 2007 was linked to the balance sheet pressure Lehman faced caused by illiquid assets on its balance sheet that the firm could not sell.³²⁰⁵³²⁰⁵ Examiner's Interview of Mitchell King, Sept. 21, 2009, at pp. 4‐7.

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¶The reasons Gentile advanced for why Lehman's Repo 105 limit should be increased in February 2007 – namely, sticky inventory Lehman could not sell or could only sell by incurring substantial losses – only became more relevant in late 2007 and early 2008, as even more of Lehman's real estate and mortgage assets became illiquid and difficult to sell without substantial losses. Indeed, a significant portion of Lehman's real estate securities ultimately proved very difficult for Lehman to sell.³²⁰⁶³²⁰⁶ See Section III.A.1.b.4 of the Report. As a result, Lehman's illiquid holdings ballooned during 2007. At the same time during 2007, Lehman's FID consistently breached its balance sheet limits.³²⁰⁷³²⁰⁷ Lehman, FID Balance Sheet Management (April 2007), at p. 2 [LBEX‐DOCID 1303268] (attached to e‐ mail from Anuraj Bismal, Lehman, to Matthew Lee, Lehman (Apr. 30, 2007) [LBEX‐DOCID 1334311]).

¶The origins of Lehman's balance sheet difficulties rest in Lehman's aggressive countercyclical growth strategy spearheaded by Fuld in 2006 and early‐to‐mid‐2007.³²⁰⁸³²⁰⁸ See Sections III.A.1.b.1–2 of the Report; see also Lehman Brothers, Executive Committee Offsite, Opportunities for Additional Risk Deployment (Aug. 3, 2006) [LBEX‐DOCID 2781866]. This strategy included a decision to spend capital to make acquisitions, which, in turn, greatly increased the risk profile of the firm.³²⁰⁹³²⁰⁹ See Sections III.A.1.b.1–2 of the Report; see also Lehman Brothers, Executive Committee Offsite, Opportunities for Additional Risk Deployment (Aug. 3, 2006) [LBEX‐DOCID 2781866]. Within the Global Real Estate Group ("GREG"), a business unit that fell mostly under the firm's Fixed Income Division umbrella,³²¹⁰³²¹⁰ With the exception of Real Estate Private Equity, which was co‐managed with Private Equity, GREG was a unit within FID. the growth strategy involved deploying capital more aggressively, increasing the bridge equity business, and acquiring and originating CMBS.³²¹¹³²¹¹ See Section III.A.1.d of the Report. GREG also oversaw the leveraged buyout of the Archstone‐Smith REIT by the joint venture between Lehman and Tishman Speyer.³²¹²³²¹² See Section III.A.1.d of the Report.

836

¶As a result of these acquisitions, the size of Lehman's commercial real estate ("CRE") asset holdings significantly escalated in 2006 and 2007.³²¹³³²¹³ See Section III.A.1.d of the Report; see also Lehman, Global Real Estate Group, Global Real Estate Update (Nov. 6, 2007) [LBEX‐DOCID 2504331]; Mark Walsh, Lehman, Commercial Real Estate Update, Presentation to Lehman Board of Directors (Mar. 25, 2008), at p. 4 [LBHI_SEC07940_127250] (March 2008 CRE Update). A significant part of the CRE inventory ultimately proved very difficult, if not impossible, for Lehman to sell.³²¹⁴³²¹⁴ See Section III.A.1.b.4 of this Report. In early February 2008, then Lehman President Joseph Gregory warned GREG that it had to get its real estate balance sheet down quickly. E‐mail from Mark Walsh, Lehman, to Andrew J. Morton, Lehman (Feb. 26, 2008) [LBHI_SEC07940_115814]. At that time, firm CFO Erin Callan told GREG to get $5 billion of CRE off its balance sheet by the time of Lehman's March 18, 2008 earnings call. E‐mail from Paul Hughson, Lehman, to Mark Gabbay, et al. Lehman (Feb. 27, 2008) [LBEX‐DOCID 1869265] (discussing the schedule for the $5 billion reduction target); e‐mail from Paul Hughson, Lehman, to Mark Gabbay, Lehman, et al. (Mar. 7, 2008) [LBEX‐DOCID 1723168] (providing update on sales progress and asking for updates regarding progress toward the $5 billion reduction target).Show full note The total illiquid positions on Lehman's balance sheet increased from $41 billion in 2006 to $115 billion in 2007 and $120 billion in the first quarter of 2008.³²¹⁵³²¹⁵ Andrew J. Morton, Lehman, Fixed Income Update, Presentation to Lehman Board of Directors, (May 7, 2008), at p. 4 [LBHI_SEC07940_027994].

¶While deleveraging took on more urgency in 2008, it was not a new subject; Lehman had been concerned about balance sheet and net leverage for some time. An April 2007 internal Lehman FID Balance Sheet Management Presentation reported that FID failed to meet its net balance sheet targets 11 out of the prior 15 months.³²¹⁶³²¹⁶ Lehman, FID Balance Sheet Management (April 2007), at p. 2 [LBEX‐DOCID 1303268] (attached to e‐ mail from Anuraj Bismal, Lehman, to Matthew Lee, Lehman, et al. (Apr. 30, 2007) [LBEX‐DOCID 1334311]; see also e‐mail from Joseph Gentile, Lehman, to Gerard Reilly, Lehman (Feb. 20, 2007) [LBEX‐ DOCID 4553219] (complaining about FID's serious balance sheet breaches and arguing that not only is FID unable to meet the balance sheet target, it isn't even "making money"); e‐mail from Sigrid Stabenow, Lehman, to Gerard Reilly, Lehman, et al. (Apr. 4, 2007) [LBEX‐DOCID 4553228] (transmitting presentation [LBEX‐DOCID 4553110] and saying "talking points and key themes for the argument that FID needs to address balance sheet efficiency"); e‐mail from Paul Mitrokostas, Lehman, to Kentaro Umezaki, Lehman (Nov. 14, 2007) [LBEX‐DOCID 1859142] (reporting that FID Core looks to be $7 to $15 billion over its balance sheet limit).Show full note The presentation further provided, "Accounting changes have grown 'Dead Balance Sheet' to 21.2 bn and continues to put pressure on the balance sheet limit."³²¹⁷³²¹⁷ Lehman, FID Balance Sheet Management (April 2007), at p. 2 [LBEX‐DOCID 1303268] (attached to e‐ mail from Anuraj Bismal, Lehman, to Matthew Lee, Lehman, et al. (Apr. 30, 2007) [LBEX‐DOCID 1334311]). As a result of the stress on its balance sheet, Lehman proposed a policy of incentives and penalties for meeting balance sheet targets.³²¹⁸³²¹⁸ Lehman, FID Balance Sheet Management Policy (April 2007), at p. 3 [LBEX‐DOCID 1303268] ("Penalty Charge of 5mm per billion on net balance sheet overages (Monthly) applicable at a regional POD level."); see also e‐mail from Anuraj Bismal, Lehman, to Martin Kelly, Lehman, et al. (Feb. 25, 2008) [LBEX‐DOCID 3187495] ("In the past the Fixed Income Division has had in place a 'speeding ticket' charge for businesses that exceed their net balance sheet target…"); e‐mail from Kaushik Amin, Lehman, to Kentaro Umezaki, Lehman, (May 18, 2007) [LBEX‐DOCID 1811290] ("[T]he new balance sheet limits are going to really hurt the business. At a time when I am trying to get the traders to take more risk, this is inconsistent.").Show full note The cover e‐mail to FID's April 2007 balance sheet presentation indicated that one of the purposes of the balance sheet management policy changes discussed in the presentation was to position Lehman for a ratings upgrade.³²¹⁹³²¹⁹ E‐mail from Kentaro Umezaki, Lehman, to Kaushik Amin, Lehman, et al. (Apr. 20, 2007) [LBEX‐ DOCID 1334311].

837

¶The same month as the FID Balance Sheet Management Presentation, April 2007, Kentaro Umezaki informed Ian Lowitt that he had distributed balance sheet targets for second quarter 2007 and that relevant Lehman personnel were "aware of its importance now."³²²⁰³²²⁰ E‐mail from Kentaro Umezaki, Lehman, to Ian T. Lowitt, Lehman (Apr. 16, 2007) [LBEX‐DOCID 288764]. The new targets were meant to allow Lehman to reach a 15x net leverage ratio by the end of second quarter 2007.³²²¹³²²¹ Id. ("Gerry has us working with a 195 net balance sheet target . . . to get us to 15x net leverage by end of May. . . ."). Umezaki advised Lowitt that Lehman's mortgage assets and real estate securities were the primary obstacles to Lehman reaching its net leverage ratio target at that time.³²²²³²²² Id.

838

¶Another internal Lehman e‐mail from April 2007 illustrates the discourse and dissension among senior Lehman management regarding the firm's balance sheet.³²²³³²²³ See e‐mail from Kentaro Umezaki, Lehman, to Christopher M. O'Meara, Lehman, et al. (Apr. 18, 2007) [LBEX‐DOCID 187618]; see also e‐mail from Kentaro Umezaki, Lehman, to Paolo R. Tonucci, Lehman (Apr. 19, 2007) [LBEX‐DOCID 318475]. In the e‐mail chain, Chris O'Meara, Umezaki, Lowitt, Gelband and others discussed the "balance sheet belt tightening effort in FID" in light of a talk between Fuld and the firm's managing directors the night before.³²²⁴³²²⁴ E‐mail from Kentaro Umezaki, Lehman, to Christopher M. O'Meara, Lehman, et al. (Apr. 18, 2007) [LBEX‐DOCID 187618]. Umezaki indicated that senior management was sending conflicting messages: Fuld wanted to emphasize revenue growth, while the message within FID was that meeting balance sheet targets was necessary in order to achieve ratings upgrades.³²²⁵³²²⁵ Id. When asked about a related e‐mail from the following day in which Umezaki complained about inconsistent messages around risk and growth, Fuld explained that as CEO, he tried to motivate people but that he left it up to the Executive Committee to translate his remarks to the people in their ranks. Examiner's Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at p. 17. Fuld did not specifically recall hearing that there was confusion about balancing growth and risk and was not aware of Umezaki's concerns. Id.Show full note O'Meara noted that the firm had allowed its leverage ratio to increase higher than planned, which further exacerbated the tension between the two messages (growth vs. balance sheet belt‐tightening).³²²⁶³²²⁶ E‐mail from Kentaro Umezaki, Lehman, to Christopher M. O'Meara, Lehman, et al. (Apr. 18, 2007) [LBEX‐DOCID 187618]. O'Meara continued: "I think we will have to make choices on how to best deploy the balance sheet we have available. From my perspective, getting AA‐ can be accomplished with our planned balance sheet leverage ratio."³²²⁷³²²⁷ Id.

839

¶In May 2007, Jonathan Cohen, a Senior Vice President in GREG, asked Umezaki whether GREG could trade its balance sheet allocation with other firm business groups to ease the pain of GREG's balance sheet breaches.³²²⁸³²²⁸ E‐mail from Jonathan Cohen, Lehman, to Kentaro Umezaki, Lehman, et al. (Apr. 27, 2007) [LBEX‐ DOCID 188165]. Cohen suggested that if trading balance sheet was not an option, GREG would have no choice but to sell certain positions at discount prices in order to meet balance sheet targets and stay under the limit.³²²⁹³²²⁹ Id.; see also Lehman, Global Real Estate Group, Global Real Estate Update (Nov. 6, 2007), at p. 1 [LBEX‐ DOCID 1419292] ("GREG believes that under any circumstances an estimated $15Bn reduction in global balance sheet is warranted.").

¶Significant effort was expended to remind FID, in particular, of its quarter‐end balance sheet targets. Joseph Gentile, and after him, Clement Bernard, each of whom reported directly to Gerard Reilly, Lehman's Global Product Controller, was tasked with applying pressure on the head of FID to ensure FID met its quarterly balance sheet targets.³²³⁰³²³⁰ Examiner's Interview of Joseph Gentile, Oct. 21, 2009, at p. 5; Examiner's Interview of Clement Bernard, Oct. 23, 2009, at p. 11. Typically in this process, Gentile or Bernard would remind and cajole FID business leaders regarding their respective balance sheet targets as quarter‐end approached.³²³¹³²³¹ See, e.g., E‐mail from Joseph Gentile, Lehman, to Michael Gelband, Lehman, et al. (Feb. 21, 2007) [LBEX‐DOCID 810934] ("[W]e have a serious balance sheet issue for FID coming into the end of the Quarter. All businesses with the exception of credit are running large excessions. . . . I need you to stress to [your business leaders] the need to manage down their excessions."); e‐mail from Kentaro Umezaki, Lehman, to Joseph Gentile, Lehman (Feb. 20, 2007) [LBEX‐DOCID 1808077] (Umezaki: "What is 'serious'?" Gentile answers a $10 billion excession of the balance sheet limit and also states that "leverage ratio is too high."); e‐mail from Clement Bernard, Lehman, to Kieran Higgins, Lehman (Feb. 22, 2008) [LBEX‐DOCID 1854016] ("I am following up on the conversation that we had…on the Balance sheet. As you may know we are still struggling on our Balance Sheet. We are currently at 19 bn above our target. Within that number Rates Europe is 3.7 bn above target. . . . You mentioned that you would be doing some reduction in gvt and maybe add repo 105."); e‐mail from Clement Bernard, Lehman, to Kaushik Amin, Lehman (Feb. 25, 2008) [LBEX‐DOCID 756417] ("To follow up on our conversation for Q1. We are currently running at 15.0 bn above and we need to go down an extra $5.0 bn for the firm to meet its net leverage limit of 15.2. I need your help on this. . . . Let me know what you can do. . ."); e‐mail from Clement Bernard, Lehman, to Eric Felder, Lehman (Feb. 25, 2008) [LBEX‐DOCID 2080410] ("We need to reduce our net Balance sheet to hit the firm target net leverage ratio of 15.2. Currently FID is projected to be $15.0bn above its limit. . . . Let me know if there is anything you could do to reduce the Balance Sheet and what would the price of doing that."); e‐mail from Clement Bernard, Lehman, to Eric Felder, Lehman (Feb. 25, 2008) [LBEX‐DOCID 981497] ("I have currently a forecast of 11.8 vs a limit of 10.4. Let me know what you can do and if there is a price to move some BS out."); e‐mail from Clement Bernard, Lehman, to Kaushik Amin, Lehman, et al. (Feb. 28, 2008) [LBEX‐DOCID 1854189] ("FID's net balance sheet overage has increased to 14.3bn from 9.7bn as of yesterday. . . . This will drive Lehman net leverage ratio above target. Please let me know what we can do to minimize the impact. . . . I know it is late in the process but what ever we can do would help our ratio."); e‐mail from Clement Bernard, Lehman, to Martin Potts, Lehman (Feb. 28, 2008) [LBEX‐DOCID 1854189] ("We are looking at selling what ever we can and also doing some more repo 105."); e‐mail from Clement Bernard, Lehman, to Paul Mitrokostas, Lehman, et al. (May 13, 2008) [LBEX‐DOCID 1697936] (discussing progress in reaching quarter‐end balance sheet targets).Show full note Michael McGarvey (Finance) would apply the same pressure on Lehman's individual trading desks and then report back to Reilly and Bernard.³²³²³²³² E‐mail from Michael McGarvey, Lehman to Mark Gavin, Lehman, et al. (Feb. 28, 2008) [LBEX‐DOCID 810932] ("Given the critical balance sheet situation we are currently in I've attached a list of corporate bonds held in NY (all above BBB and 10mm in market value) available for any additional Repo 105 capacity we can find. Please let us know what issues are sent out so we can inform the desk not to trade them for the term of the repo.").Show full note

840

¶In some instances, Gentile recalled having heated discussions with Umezaki in early 2007 about using every effort to ensure that FID attempted to meet its balance sheet target so that Gentile could avoid facing criticism from O'Meara, Lehman's then-CFO, and Grieb, the firm's then‐Global Financial Controller, if FID breached its quarter‐ end balance sheet target.³²³³³²³³ Examiner's Interview of Joseph Gentile, Oct. 21, 2009, at pp. 5‐6. Despite these efforts of senior management, FID routinely failed to meet its balance sheet targets in every quarter of Lehman's 2007 fiscal year and in 2008.³²³⁴³²³⁴ Examiner's Interview of Clement Bernard, Oct. 23, 2009, at p. 11; Lehman, FID Balance Sheet Management (April 2007), at p. 2 [LBEX‐DOCID 1303268] ("FID has missed its net balance sheet target 11 out of the last 15 months."); e‐mail from Dominic Gibb, Lehman, to Mark Cosaitis, Lehman, et al. (Feb. 28, 2009) [LBHI_SEC07940_1829372] ("Jock and his team are aggressively working to obtain repo 105 funding for all eligible govvies positions. If they are successful then we will have $23bn of assets on Repo 105 at quarter end. . . . This would leave FID with a net balance sheet of $51.7bn, $4.7bn above the FID limit. . . "); e‐mail from Clement Bernard, Lehman, to Andrew J. Morton, Lehman (Mar. 3, 2008) [LBEX‐DOCID 1849880] ("We ended up at 15.6% on our net leverage ratio. . . . FID was $238 bn vs a limit of 223 ie 15 bn over limit.").Show full note

841

¶Even near the time of Lehman's bankruptcy, FID continued to perform poorly. In response to a late August 2008 e‐mail from Reilly asking, "How much repo 105 do we have now and how much will we have at 8/31," McGarvey replied, "FID is the worst run division in the company."³²³⁵³²³⁵ E‐mail from Michael McGarvey, Lehman, to Gerard Reilly, Lehman, (Aug. 29, 2008) [LBEX‐DOCID 4517471].

¶In 2008, FID's breaches of the balance sheet limits continued to be concentrated in difficult‐to‐sell securitized products and real estate.³²³⁶³²³⁶ See Section III.A.1.b.4 of the Report; see also e‐mail from Gary Mandelblatt, Lehman, to Alex Kirk, Lehman, et al. (Jan. 15, 2008) [LBEX‐DOCID 1600235] (stating that "the lack of sales and syndication [was] a function of the tight credit markets"); Notes from Lehman Monthly Risk Meeting with SEC (June 19, 2008), at p. 7 [LBEX‐SEC 007583] (Hughson stating that, in June 2008, "buyers and sellers [were] just staring at each other."); see also e‐mail from Anuraj Bismal, Lehman, to Martin Kelly, Lehman, et al. (Feb. 25, 2008) [LBEX‐DOCID 3187495] (stating that "a part of FID Core's [balance sheet] overage is in Real Estate and Securitized Products which currently have less ability to reduce balance sheet anyways.").Show full note A "FID Core Global Balance Sheet Liquidity" document dated January 17, 2008 (reproduced below) indicated that FID held $115.857 billion in illiquid assets at that time.³²³⁷³²³⁷ Lehman, Presentation regarding FID Global Balance Sheet (Jan. 17, 2008), at p. 4 [LBHI_SEC07940_1954891]. Of that amount, $55.747 billion was in real estate.³²³⁸³²³⁸ Id.

842

¶Similarly, an April 29, 2008 FID CORE balance sheet purporting to show first quarter 2008 figures, listed $108.75 billion in total illiquid securities inventory, of which $52.12 billion was real estate securities.³²³⁹³²³⁹ Lehman, FID Core Q1 Balance Sheet (Apr. 29, 2008) [LBEX‐DOCID 1741665] (attached to e‐mail from Neeraj Chopra, Lehman, to Abe Kebede, Lehman (May 15, 2008) [LBEX‐DOCID 1953960]). So large was the amount of illiquid assets that some within Lehman referred colloquially to these FID balance sheets as "dead asset schedules."³²⁴⁰³²⁴⁰ Examiner's Interview of Anuraj Bismal, Sept. 16, 2009, at p. 6; Examiner's Interview of Matthew Lee, July 1, 2009, at pp. 10‐11.

843

Deleveraging Resulted in Intense Pressure at Quarter‐End to Meet Balance Sheet Targets for Reporting Purposes

¶The market focus on balance sheet and leverage in late 2007 and 2008 meant increased pressure from Lehman senior management on its various business units to meet their balance sheet targets to position the firm to meet its net leverage ratio target.³²⁴¹³²⁴¹ Examiner's Interview of Tejal Joshi, Sept. 15, 2009, at pp. 5‐6; Examiner's Interview of Kaushik Amin, Sept. 17, 2009, at p. 5; Examiner's Interview of Mitchell King, Sept. 21, 2009, at pp. 4‐6. In the time leading up to each of the firm's quarter‐ends, business units and individual traders scurried to meet their balance sheet targets in time for the reporting period, in the case of FID, often through the expanding use of Repo 105 transactions.³²⁴²³²⁴² Examiner's Interview of Tejal Joshi, Sept. 15, 2009, at pp. 5‐6; Examiner's Interview of Kaushik Amin, Sept. 17, 2009, at p. 5; Examiner's Interview of Mitchell King, Sept. 21, 2009, at pp. 4‐6. Numerous documents demonstrate the intense balance sheet pressure, especially near or at quarter‐end. See, e.g., e‐ mail from Mitchell King, Lehman, to Mark Gavin, Lehman, et al. (Dec. 3, 2007) [LBEX‐DOCID 3232555] (stating with respect to US Agency Desk use of Repo 105, "As we approach our quarter end, we start to raise the balances so that we 'reserve' size with our counterparties the week we really need it (over quarter end). At this fiscal year end we took the amounts as high as we could, as we knew there would be intense balance sheet pressure."); e‐mail from Jerry Rizzieri, Lehman, to Mitchell King, Lehman (Feb. 19, 2008) [LBEX‐DOCID 3233177] (stating ten days before close of quarter, "Balance Sheet still a big push. Agency business, even with 105, still over by almost $4 billion. . . ."); e‐mail from Mark Gavin, Lehman, to John Feraca, Lehman, et al. (Feb. 28, 2008) [LBEX‐DOCID 098492] ("Just took a call from FID mgmt ‐ seems they're up on net b/s by 3 bln unanticipated & are a little excited w Q end. I am looking to do an additional repo 105 with Mizuho using this additional limit . . . if they have appetite."); e‐mail from Alvaro Mucida, Lehman, to Gabriel Buteler, Lehman, et al. (May 2, 2008) [LBEX‐DOCID 601783] ("[P]ressure for balance sheet here is enormous and I was told that even 105 was scarce…"); e‐mail from Mitchell King, Lehman, to Ryan Murphy, Lehman (May 19, 2008) [LBEX‐DOCID 3233040] (stating 12 days before close of quarter, "Getting close, management walking around talking balance sheet"); e‐mail from Mark Gavin, Lehman, to Michael McGarvey, Lehman, et al. (May 22, 2008) [LBEX‐DOCID 3232907] (stating nine days before close of quarter, "there is a drive to get more Repo 105 in place"); e‐mail from Kevin Croutier, Lehman, to Mitchell King, Lehman (May 22, 2008) [LBEX‐DOCID 3233057] (nine days before close of quarter, Croutier: "How much more repo 105 trades are you trying to do before month end?" King: "We are trying to get everything out that we can."); e‐mail from Mitchell King, Lehman, to Marc Silverberg, Lehman (May 28, 2008) [LBEX‐DOCID 3233083] (stating three days before close of quarter, "I just want to see if there is any possibility to add to 105. . . . I'm pretty sure we have almost everything out, but want to check").Show full note

844

¶In November 2007, Lehman's Treasurer Paolo Tonucci informed Clement Bernard, FID's Chief Financial Officer, that FID's balance sheet limit had to be reduced, despite FID's repeated breaches of the balance sheet limit, in order to meet the firm's leverage ratio targets.³²⁴³³²⁴³ E‐mail from Clement Bernard, Lehman, to Roger Nagioff, Lehman, et al. (Nov. 20, 2007) [LBEX‐ DOCID 272199]. Bernard typically communicated balance sheet limits and related net leverage ratio targets to FID personnel and pressured the FID business heads to reduce balance sheet by any means necessary, which usually entailed increased Repo 105 transactions at or near quarter‐ends.³²⁴⁴³²⁴⁴ Examiner's Interview of Clement Bernard, Oct. 23, 2009, at pp. 9‐11.

¶In a January 2008 e‐mail, Michael McGarvey informed Bernard about a discussion with Alex Kirk and Andrew Morton regarding FID's $13 billion breach of the balance sheet limit. McGarvey wrote: "Alex was going to have a conversation with Kaushik [Amin] about potentially coming in under their target for balance sheet if need be" and that "[a] meeting has been set up . . . to review the next steps for Repo 105 for the Q1 (It would be helpful to know if Gerry [Reilly] has a view on what the maximum tolerable level of repo 105 is for the firm)."³²⁴⁵³²⁴⁵ E‐mail from Michael McGarvey, Lehman, to Clement Bernard, Lehman (Jan. 28, 2008) [LBEX‐DOCID 3384755].

¶Mitch King, the former Head of FID's United States Agencies Trading Desk, recalled "there was always balance sheet pressure at quarter ends," but that sometime in mid‐2007 "there was a definite change" and the firm began "trying desperately to reduce its balance sheet," thereby further intensifying the quarter‐end alarm.³²⁴⁶³²⁴⁶ Examiner's Interview of Mitchell King, Sept. 21, 2009, at p. 4. When he held the position of Global Financial Controller, Edward Grieb would hold monthly "issues" meetings with his staff. Examiner's Interview of Matthew Lee, July 1, 2009, at p. 16. At least one attendee, Matthew Lee, recalled that when the issue of the volume of Lehman's Repo 105 transactions was raised, the response was usually that then‐Chief Financial Officer Chris O'Meara was "quite keen on" reducing the balance sheet. Id.Show full note The message from senior Lehman management was to "keep making P&L but . . . get balance sheet down."³²⁴⁷³²⁴⁷ Examiner's Interview of Mitchell King, Sept. 21, 2009, at p. 5. King continued: "There was a way to . . . to reduce balance sheet at quarter end . . . . To the powers that be, Repo 105 counted as balance sheet reduction."³²⁴⁸³²⁴⁸ Id.

845

¶Thus, Repo 105 transactions were used as a shortcut for meeting quarter‐end balance sheet targets (i.e., avoiding balance sheet limit breaches) and reaching the firm‐ wide net leverage ratio target:

● "Is there a formal limit on Repo 105? We are trying to do more of these in order to reduce the bs [balance sheet]."³²⁴⁹³²⁴⁹ E‐mail from Clement Bernard, Lehman, to Gerard Reilly, Lehman (Jan. 27, 2008) [LBEX‐DOCID 2793484].

● "As B/S [balance sheet] will be super tight, I need to make sure we make best use of [Repo] 105."³²⁵⁰³²⁵⁰ E‐mail from Thomas Siegmund, Lehman, to Kaushik Amin, Lehman (Apr. 17, 2008) [LBEX‐DOCID 739685].

Lehman's Earnings Calls and Press Release Statements Regarding Leverage

¶In its earnings calls and press releases in 2008, Lehman spoke extensively about the size of the firm‐wide balance sheet, FID's performance, and firm‐wide aggressive efforts to deleverage. Notably, Lehman never disclosed that it relied upon an expanded use of Repo 105 transactions at quarter‐end to manage its balance sheet when market conditions declined. Similarly, Lehman never disclosed that its net leverage ratio – which Lehman publicly touted as evidence of its discipline and financial health – depended upon Lehman's Repo 105 practice.

846

¶During the first quarter 2008 earnings conference call, then‐Chief Financial Officer Erin Callan remarked that since the previous quarter, Lehman had been "trying to give the group [i.e., the analysts] a great amount of transparency on the balance sheet."³²⁵¹³²⁵¹ Final Transcript of Lehman Brothers Holdings Inc., First Quarter 2008 Earnings Call (Mar. 18, 2008), at p. 7 [LBHI_SEC07940_7579849]. At no time, however, did Callan or anyone else from Lehman disclose the firm's use of Repo 105 transactions to manage the balance sheet. Callan told the analysts that Lehman "did, very deliberately, take leverage down for the quarter. We ended with a net leverage ratio of 15.4 times down from 16.1 at year end. And we will continue to allocate capital on the balance sheet in the market in a way that we consider prudent, and that reflects the liquidity profile of the balance sheet."³²⁵²³²⁵² Id. at p. 8. This "deliberate" deleveraging strategy is consistent with documentary evidence in which Clement Bernard, Kaushik Amin and others pressured FID business leaders to reduce their respective balance sheets at quarter‐end, through either sales or Repo 105 transactions, so the firm could make its net leverage ratio target. Callan's statement also indicates that senior management gave orders to aggressively deleverage.Show full note

¶When Callan briefly addressed Lehman's ordinary repo transactions during the first quarter 2008 earnings call, she made no mention of Lehman's Repo 105 program.³²⁵³³²⁵³ Id. at p. 9 ("Total repo, exclusive of the match[ed] book, was 215 billion of which a substantial majority of this collateral is eligible to be pledged under the new fed facility. We have 115 billion of tri‐party

847

¶During the question and answer portion of the first quarter 2008 earnings call, an Oppenheimer analyst asked Callan to comment on "the lack of a permanent buyer for so many of these securities" and the time horizon and pace at which Lehman anticipated bringing down its leverage ratios.³²⁵⁴³²⁵⁴ Id. at p. 13. Callan's response linked the increased illiquidity of Lehman's balance sheet with Lehman's deliberate plan to deleverage, but she indicated that Lehman achieved the reduction in leverage through the sale of assets:

We did have a deliberate decision this quarter to take leverage down, which I think is more appropriate for the increased illiquidity of the balance sheet, and if the environment continues to stay this way we'll continue to be focused on that discipline. The real balancing act that I'm sure you can appreciate, that we think hard about is the balancing act of our fundamental view of the assets themselves, what we consider to be the loss of P&L associated with selling an asset at a given price today, given what we think its MPV is. And the trade‐off with that with prudent balance sheet management.³²⁵⁵³²⁵⁵ Id.

¶When a Bank of America analyst again raised the topic of leverage during the first quarter 2008 earnings call, Callan explained that Lehman would continue to sell assets in order to reduce its leverage.³²⁵⁶³²⁵⁶ Final Transcript of Lehman Brothers Holdings Inc., First Quarter 2008 Earnings Call (Mar. 18, 2008), at p. 23 [LBHI_SEC07940_7579849]. Callan told analysts that Lehman's "goal is to continue to take that leverage down . . . . In order to do so . . . we will sell assets as appropriate and within the right pricing context, to get to that outcome . . . . I don't see why there's any reason at this point to change off that course and we'll stay on that path secured financing, which is really just the total repo amount less treasuries and agencies which go through the FICC system anonymously.").

848

¶until . . . something about the environment . . . tells us we should behave differently."³²⁵⁷³²⁵⁷ Id. No analyst could have been aware, on the basis of Lehman's statements during the first quarter 2008 earnings call, that Lehman employed over $49 billion of quarter‐end Repo 105 transactions to manage its publicly reported net leverage for first quarter 2008.

¶In its second quarter 2008, which ended on May 31, 2008, Lehman continued to highlight its deleveraging efforts.³²⁵⁸³²⁵⁸ In addition to lowering its leverage ratios in second quarter 2008, Lehman also grew its cash capital surplus to $15 billion from $7 billion in first quarter 2008, and its liquidity pool to $45 billion from $34 billion in the previous quarter. Final Transcript of Lehman Brothers Holdings Inc. Second Quarter 2008 Preliminary Earnings Call (June 9, 2008), at p. 3. During this time, the performance of Lehman's Fixed Income Division was weak, with revenues of negative $3 billion. Id. at p. 4.Show full note Early in a June 9 analysts call, Callan focused on Lehman's success in reducing its net leverage and balance sheet:

The net loss of $2.8 billion compares to net income of $489 million last quarter and $1.3 billion in the second quarter of 2007. Importantly – and you will hear this throughout the call – during the quarter we executed on a number of the capital and liquidity goals that we set out for ourselves, which includes as follows – lowering growth and net leverage to less than 25 times and less than 12.5 times, respectively. Both of those numbers are prior to today's capital raise. Reducing our gross assets by approximately $130 billion and our net assets by approximately $60 billion with a large part of the reduction, as I will talk about in detail, coming from less liquid asset categories and also providing significant price visibility for marking the remainder of our inventory.³²⁵⁹³²⁵⁹ Id. at pp. 3‐4.

¶Callan said that, taking into account the early June 2008 capital raise, Lehman reduced its net leverage to 10x.³²⁶⁰³²⁶⁰ Id. at p. 7. Callan described the firm's deleveraging effort as "aggressive" but said "we do not expect to use the proceeds of this equity raise to further decrease leverage but rather to take advantage of future market opportunities."³²⁶¹³²⁶¹ Final Transcript of Lehman Brothers Holdings Inc. Second Quarter 2008 Preliminary Earnings Call (June 9, 2008), at p. 7. A Goldman Sachs analyst questioned Callan about Lehman's "defensive" deleveraging process during the second quarter preliminary earnings call.³²⁶²³²⁶² Id. at p. 9. Callan's reply confirmed that senior Lehman management imposed strict balance sheet targets that quarter:

849

I think part of the rationale for us this quarter of why we were so aggressive, why we put out explicit targets, and why we had such a tight schedule was exactly that. . . . [T]he business operators . . . knew what the targets were. We were explicit from the beginning of the quarter. . . . So I think the discipline of getting it done primarily in a single quarter was important to keep the mindsets focused.³²⁶³³²⁶³ Id. at p. 9.

¶One Merrill Lynch analyst asked Callan during the June 9 call to respond "to critics who are going to say that the $130 billion of assets sales [by which Lehman deleveraged] must be the absolute easiest assets to sell."³²⁶⁴³²⁶⁴ Id. at p. 12. Callan provided "anecdotal evidence" that Lehman sold whole loan positions from its commercial real estate and residential real estate books.³²⁶⁵³²⁶⁵ Id. Callan said nothing about Lehman's use of Repo 105 transactions, which as noted above involved only the firm's most liquid securities, to effectuate temporary sales at quarter‐end to remove assets from the firm's balance sheet.

850

¶Lehman held another second quarter 2008 earnings call on June 16, 2008. By that time, Ian Lowitt had replaced Callan as Lehman's CFO and Bart McDade had replaced Joe Gregory as Lehman's President and Chief Operating Officer. McDade stated on the call that Lehman made "substantial improvements" in its balance sheet and that Lehman's "balance sheet improvements give us the additional resources and additional capacity to drive our client model."³²⁶⁶³²⁶⁶ Final Transcript of Lehman Brothers Holdings Inc. Second Quarter 2008 Earnings Call (June 16, 2008), at p. 10 [LBHI_SEC07940_1139550]. Asked whether the sales by which Lehman achieved the balance sheet improvements were "pretty much ratably spread over the quarter or were they more skewed toward either the early or latter part of the quarter," Lowitt replied that the sales "were spread over the whole quarter."³²⁶⁷³²⁶⁷ Id. at p. 14. Lehman's use of Repo 105 transactions, however, spiked at quarter‐end, including the end of the second quarter 2008. For example, the total amount of assets involved in Repo 105 transactions on April 30, 2008 was $24.74 billion, but increased to $50.38 billion on May 30, 2008, at Lehman's quarter‐end.³²⁶⁸³²⁶⁸ Lehman, Total Repo 105 & Repo 108 Report (June 11, 2008), at p. 1 [LBEX‐DOCID 2078195] (attached to e‐mail from Kristie Wong, Lehman, to Martin Kelly, Lehman (June 11, 2008) [LBEX‐DOCID 2325872]. (May 31, 2008, Lehman's quarter‐end, was a Saturday).

Analysts' Statements Regarding Lehman's Leverage

¶In addition to documents demonstrating that Lehman, internally, continued to focus in 2008 on reducing its firm‐wide leverage, analysts and the market similarly continued their focus on the firm's leverage. A few illustrative examples of analyst comments follow:

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● "The modest silver lining is that LEH was able to reduce gross assets by $130 billion, including large reductions in mortgage related (15%‐20%) and leveraged loan (35%) exposures."³²⁶⁹³²⁶⁹ Sandler O'Neill & Partners Report, Lehman Brothers Holdings Inc. (June 9, 2008), at p. 1 [LBEX‐ DOCID 015863] (attached to e‐mail from Roopali Hall, Lehman, to Lehman Brothers Executive Committee Members, Lehman (June 9, 2008) [LBEX‐DOCID 15861]).

● "Leverage is down a lot (and even more post capital raise) . . . illiquid positions are down 15%‐20% . . . ."³²⁷⁰³²⁷⁰ UBS Investment Research, First Read: Lehman Brothers (June 9, 2008), at p. 1 [LBEX‐DOCID 015863] (attached to e‐mail from Roopali Hall, Lehman, to Lehman Brothers Executive Committee Members, Lehman, et al. (June 9, 2008) [LBEX‐DOCID 15861]).

● "While LEH reduced gross leverage from 32x to 25x, increased their liquidity pool from $34B to $45B, and drove reductions across most troubled asset classes (and reduced total assets by $130B or 17%), we await more details on total remaining troubled assets in aggregate as well as a L‐III or illiquid asset update to help answer the question of whether $6B in incremental capital raise is sufficient."³²⁷¹³²⁷¹ Bank of America Equity Research Report, Lehman Brothers Holdings Inc. (June 9, 2008), at p. 1 [LBEX‐ DOCID 015863] (attached to e‐mail from Roopali Hall, Lehman, to Lehman Brothers Executive Committee Members, Lehman, et al. (June 9, 2008) [LBEX‐DOCID 15861]).

● "[T]he firm aggressively de‐leveraged in the quarter as total balance sheet assets declined by $130 bn and net assets declined by about $60 bn, bringing gross leverage to 25.0x from 31.7x and net leverage to 12.5x from 15.4x. This broad based selling likely exacerbated the write‐downs the firm took this quarter. As part of its de‐leveraging, Lehman reduced RMBS and CMBS exposure by 15‐20%, leveraged loans by 35% and high yield by 20%. While Lehman is clearly not out of the woods just yet, we believe today's announced capital raise will reduce investors' fears and help promote a better liquidation of assets should LEH want to continue to reduce its leverage."³²⁷²³²⁷² Goldman Sachs Report, Lehman Brothers Holdings Inc. (June 9, 2008), at p. 1 [LBEX‐DOCID 015863] (attached to e‐mail from Roopali Hall, Lehman, to Lehman Brothers Executive Committee Members, Lehman, et al. (June 9, 2008) [LBEX‐DOCID 15861])

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● "Despite the negative results this quarter, there were some positive takeaways: Balance sheet and leverage reduced . . . . Riskier assets cut . . . ."³²⁷³³²⁷³ Buckingham Research Report, Lehman Brothers Holdings Inc. (June 9, 2008), at p. 2 [LBEX‐DOCID 245428] (attached to e‐mail from Roopali Hall, Lehman, to Lehman Brothers Executive Committee Members, Lehman, et al. (June 9, 2008) [LBEX‐DOCID 244039]).

● "Overall, we believe the company's moves to de‐leverage the balance sheet are positive factors from a ratings perspective."³²⁷⁴³²⁷⁴ CreditSights Report, Lehman Brothers Holdings Inc. (June 9, 2008), at p. 4 [LBEX‐DOCID 245428] (attached to e‐mail from Roopali Hall, Lehman, to Lehman Brothers Executive Committee Members, Lehman, et al. (June 9, 2008) [LBEX‐DOCID 244039]).

● "LEH reduced its balance sheet by $130bn (or 17%) and reduced net assets by $60bn. Even despite the large loss, this drove net leverage down to 12.5x and gross leverage below 25x. After the announced capital raise of $4bn in common equity and $2bn in mandatory convertible preferred, we expect gross leverage on a pro forma basis to fall to close to 20x and net leverage to fall to 10x – by far the lowest in the industry (25% – 35% lower than peers) . . . . [M]anagement noted that much of the sell down was focused on the riskier and less liquid assets, rather than the high grade and more liquid securities."³²⁷⁵³²⁷⁵ Buckingham Research Report, Lehman Brothers Holdings Inc. (June 9, 2008), at p. 2 [LBEX‐DOCID 245428] (attached to e‐mail from Roopali Hall, Lehman, to Lehman Brothers Executive Committee Members, Lehman, et al. (June 9, 2008) [LBEX‐DOCID 244039]).

● "Lehman is the most levered large investment bank to the fixed income market, and hence a more challenging fixed income market (with higher long‐term interest rates, lower volatility and wider credit spreads) could hurt them the most . . . . While Lehman reduced gross leverage from 32x to 25x, increased their liquidity pool from $34B to $45B, & drove reductions across most troubled asset classes (& reduced total assets by $130B, or 17%), we await more details on total remaining troubled assets in aggregate as well as a L‐III or illiquid asset update to help answer the question of whether $6B in incremental capital raise is sufficient."³²⁷⁶³²⁷⁶ Bank of America Equity Research Report, Lehman Brothers Holdings Inc. (June 9, 2008), at pp. 1, 3 [LBEX‐DOCID 245428] (attached to e‐mail from Roopali Hall, Lehman, to Lehman Brothers Executive Committee Members, Lehman, et al. (June 9, 2008) [LBEX‐DOCID 244039]).

● "The company's gross leverage ratio improved to 24.3x (vs. 31.7x in 1Q08) and its net leverage ratio decreased to 12.0x, down from 15.4x in the prior quarter. The improvement in the leverage ratios were driven by lower asset levels, partially offset by a drop in equity as the firm delevered its balance sheet. Lehman noted that it had finished the balance sheet de‐leveraging it wanted to achieve, but it had not achieved the balance sheet mix that it wanted. So, we sense the company will continue to opportunistically dispose of mortgage‐related exposures and leveraged lending."³²⁷⁷³²⁷⁷ CreditSights Report, Lehman Brothers Holdings Inc. (June 16, 2008), at p. 2 [LBEX‐DOCID 015911].

853

The Purpose of Lehman's Repo 105 Program Was to Reverse Engineer Publicly Reported Financial Results

¶When senior management gave balance sheet targets to business divisions within Lehman, the orders were given so that the firm could manage its business towards a target net leverage ratio with an eye toward rating agencies and the firm's public disclosures.³²⁷⁸³²⁷⁸ Examiner's Interview of Joseph Gentile, Oct. 21, 2009, at p. 5 (stating that Lehman as a firm managed its entire business towards a target net leverage ratio); Examiner's Interview of Ian T. Lowitt, Oct. 28, 2009, at p. 10 (stating that businesses within Lehman managed their respective businesses toward balance sheet targets). Lehman used SFAS 140's true sale accounting treatment for Repo 105 transactions and Repo 105 cash borrowings to make its balance sheet appear stronger than it actually was. In order for this off‐balance sheet device to benefit Lehman, the firm had to conceal information regarding its Repo 105 practice from the public.

Lehman Did Not Disclose Its Accounting Treatment For or Use of Repo 105 Transactions in Its Forms 10‐K and 10‐Q

¶Lehman reported a lower net leverage ratio in its publicly filed financial statements without revealing that it employed Repo 105 transactions to manage its net leverage ratio. Several Lehman witnesses with financial reporting responsibilities confirmed the Examiner's conclusion that Lehman did not disclose its accounting treatment or use of Repo 105 transactions in its Forms 10‐K and 10‐Q.³²⁷⁹³²⁷⁹ A detailed analysis of Lehman's Form 10‐K and 10‐Q misstatements and omissions appears in Section III.A.4.j.2.c.ii of this Report.

854

¶Ed Grieb, former Lehman Financial Controller who prepared Lehman's Form 10‐ Q and Form 10‐K statements, recalled that Lehman did not disclose its use of Repo 105 transactions or the accounting treatment they received.³²⁸⁰³²⁸⁰ Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 14. Marie Stewart, former Global Head of Accounting Policy, also said that Lehman made no disclosures relating to its Repo 105 program.³²⁸¹³²⁸¹ Examiner's Interview of Marie Stewart, Sept. 2, 2009, at p. 15.

¶Lehman's increasing reliance on Repo 105 transactions and the absence of any disclosure of that fact in Lehman's Forms 10‐Q and 10‐K disquieted Martin Kelly (whose department was responsible for the preparation of Lehman's periodic reports).³²⁸²³²⁸² Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 9. Kelly, Grieb's successor, told the Examiner that if an analyst or a member of the investing public were to read Lehman's Forms 10‐Q and 10‐K from cover to cover, taking as much time as she or he needed, "they would have no transparency into [Lehman's] Repo 105 program."³²⁸³³²⁸³ Id.

¶Similarly, Matthew Lee, who reported to Kelly, recalled that Lehman did not disclose its Repo 105 practice in its publicly filed statements. "If you don't say anything, is that disclosure? [Lehman] was telling the public they reduced the balance sheet, but not telling them they were doing so by unartful means."³²⁸⁴³²⁸⁴ Examiner's Interview of Matthew Lee, July 1, 2009, at p. 16. Lee recalled that Lehman "had way more leverage than people thought; it was just out of [the public's] sight."³²⁸⁵³²⁸⁵ Id.

855

Lehman's Outside Disclosure Counsel Was Unaware of Lehman's Repo 105 Program

¶Simpson Thacher & Bartlett served as Lehman's disclosure counsel in connection with Lehman's preparation and filing of its Forms 10‐Q and 10‐K statements during the time periods relevant to the Examiner's investigation. Andrew Keller, a Simpson Thacher partner involved in the preparation of Lehman's publicly filed financial statements, was not aware of Lehman's use of Repo 105 transactions, either by name or description. Nor was Keller aware of the impact Lehman's use of Repo 105 transactions had on Lehman's reported net leverage.³²⁸⁶³²⁸⁶ Examiner's Interview of Andrew Keller, Nov. 20, 2009, at p. 3. Keller explained that he generally spoke directly to Lehman's in‐house counsel and Ryan Traversari, Senior Vice President of External Reporting, who reported to Lehman's Global Financial Controller. Id.

¶In his role as Lehman's disclosure counsel, Keller "always assumed that repos were treated as secured financings" because that was the "general rule" and was Lehman's stated policy in the notes to its financial statements.³²⁸⁷³²⁸⁷ Id.; cf. Section III.A.4.j.2.c of this Report, discussing Lehman's actual Form 10‐K and 10‐Q disclosures regarding its repo transactions, including its statement that it treated repo transactions as financing transactions for reporting purposes.

¶Though he never had such a discussion with Lehman personnel regarding Repo 105, Keller advised the Examiner that if he had needed to discuss an off‐balance sheet item with Lehman as a general matter, he would have likely spoken to Ryan Traversari, Lehman's Senior Vice President of External Reporting, who reported to the Financial Controller.³²⁸⁸³²⁸⁸ Examiner's Interview of Andrew Keller, Nov. 20, 2009, at p. 3. Traversari, whom Keller relied upon, knew about but did not disclose Lehman's Repo 105 practice in his discussions with Keller.³²⁸⁹³²⁸⁹ Id. (stating that Ryan Traversari would have been the Lehman employee to inform him of off‐balance sheet arrangements and that Keller was never informed of Repo 105 transactions or their accounting treatment); Examiner's Interview of Ryan Traversari, Sept. 24, 2009, at pp. 4‐5 (stating that he was aware of Lehman's Repo 105 program and the impact of these transactions on Lehman's balance sheet). In an interview with the Examiner, Traversari said he was familiar with Lehman's use of Repo 105 transactions and recalled that Lehman undertook these transactions on the basis of an opinion letter that a Lehman United Kingdom subsidiary had acquired.³²⁹⁰³²⁹⁰ Examiner's Interview of Ryan Traversari, Sept. 24, 2009, at pp. 4‐5. Traversari understood that Repo 105 transactions effectively reduced Lehman's net balance sheet and he did not recall any business purpose to the transactions.³²⁹¹³²⁹¹ Id.

856

Lehman's Repo 105 Practice Improved the Firm's Public Balance Sheet Profile at Quarter‐End

¶Kaushik Amin, the former head of the Liquid Markets group within Lehman's FID (a large user of Repo 105 transactions), pressured those who reported to him to meet the balance sheet targets that senior management imposed on Amin.³²⁹²³²⁹² See, e.g., E‐mail from Gary Lynn, Lehman, to Kaushik Amin, Lehman (Aug. 22, 2006) [LBEX‐DOCID 2786867] (informing Amin, nine days before quarter‐end, that he may use $20 billion, rather than $17.5 billion, of Repo 105 transactions in order to meet balance sheet target, but that with the additional $2.5 billion of Repo 105, he is still $7.9 billion over his net balance sheet target); e‐mail from Kaushik Amin, Lehman, to Thomas Siegmund, Lehman (Aug. 23, 2006) [LBEX‐DOCID 2786869] ("We have additional $2.5 Bln in Repo 105 that the firm has signed off on . . . . So, let's max out the capacity. We should be able to use some of the collateral from the Agency business in the US."); e‐mail from Gary Lynn, Lehman, to Sharan Mirchandani, Lehman, et al. (Feb. 21, 2007) [LBEX‐DOCID 1431154] (writing one week before quarter‐end, "[W]e are significantly over the Q1 balance sheet limits for IRP and LMP with one week to go, and Kaushik has delivered that message to the business heads that we need to come down further as there is no room for us to be over our limits"); e‐mail from Clement Bernard, Lehman, to Kaushik Amin, Lehman (Feb. 25, 2008) [LBEX‐DOCID 1849835] (Bernard: "To follow up on our conversation on Friday on the net balance sheet for Q1. We are currently running at 15.0 bn above and we need to go down an extra $5.0 bn for the firm to meet its net leverage limit of 15.2." Amin: "The entire team is focused on this and I am pushing everybody pretty hard. We should make the target."); e‐mail from Kaushik Amin, Lehman, to Martin Kelly, Lehman (Apr. 17, 2008) [LBEX‐DOCID 3223698] (following FID Asia's attempt to apply the Repo 105 mechanism to Australian securities, which Marie Stewart in Lehman's Accounting Policy forbade, Amin implored Kelly: "This is important for us. Would appreciate your help here").Show full note Amin explained that the quarter‐end rush to meet balance sheet targets put discipline on traders to liquidate securities inventory as quickly as possible.³²⁹³³²⁹³ Examiner's Interview of Kaushik Amin, Sept. 17, 2009, at pp. 5‐6. Indeed, the investigation and review of internal Lehman documents revealed that Amin often sent forceful balance sheet target e‐mails to those who reported to him, or on behalf of his peers, often at or near the close of the quarter.³²⁹⁴³²⁹⁴ E‐mail from Gary Lynn, Lehman, to Sharan Mirchandani, Lehman, et al. (Feb. 21, 2007) [LBEX‐DOCID 1431154] ("As you are aware we are significantly over the Q1 balance sheet limits…with one week to go, and Kaushik has delivered that message to the business heads that we need to come down further as there is no room for us to be over our limits."); e‐mail from Kaushik Amin, Lehman, to Kieran Higgins, Lehman (Feb. 28. 2008) [LBEX‐DOCID 3234351] ("We have a desperate situation and I need another 2 billion from you, either through Repo 105 or outright sales. Cost is irrelevant, we need to do it."); e‐mail from Kaushik Amin, Lehman, to Borut Miklavcic, Lehman (May 13, 2008) [LBEX‐DOCID 2103909] ("[M]y target for Global Rates is only $75 Billion. There is no way I can hit my global target with you anywhere close to your current number."); e‐mail from Kaushik Amin, Lehman, to Thomas Siegmund, Lehman (May 21, 2008) [LBEX‐DOCID 756545] ("Do as much as you can in Repo 105. Can you find Repo 105 capacity among Japanese counterparties to take US Agencies?"); e‐mail from Kaushik Amin, Lehman, to Kieran Higgins, Lehman (May 21, 2008) [LBEX‐DOCID 3234382] ("Let's max out on the Repo 105 for your stuff and see where we end up.").Show full note

857

¶Lehman management cared more about meeting quarter‐end balance sheet targets, as opposed to monthly balance sheet targets, because Lehman's quarter‐end balance sheet figures were published in the firm's quarterly financial reports and 10‐Q statements.³²⁹⁵³²⁹⁵ Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 5. As one e‐mail put it, "The recent increase in [Repo] 105 business was urgently transacted to improve the Firm's balance sheet profile over . . . quarter‐end."³²⁹⁶³²⁹⁶ See e‐mail from Stephen Allery, Lehman, to Miyuki Suzuki, Lehman (Aug. 31, 2007) [LBEX‐DOCID 98492]. This e‐mail chain regarding Allery's ongoing attempt to get increased capacity to undertake Repo 105 transactions with Mizuho contains interesting dialogue that provides transparency into the levels to which Lehman personnel went to utilize Repo 105 transactions for balance sheet relief during the late 2007‐early 2008 time period. In November 2007, Allery implored Suzuki, "Given the very sensitive business environment faced by Lehman at present and our on‐going desire to manage balance sheet to bolster our image and financial strength objectives, I am rather disappointed that Credit is imposing this rigid approach [i.e., a limit to Repo 105 capacity]. Is there any latitude to trade at higher levels across key reporting dates such as Nov 30th?" E‐mail from Stephen Allery, Lehman, to Miyuki Suzuki, Lehman (Nov. 8, 2007) [LBEX‐DOCID 98492] (emphasis added). November 30 was the end of Lehman's fiscal year. Allery continued to press for Repo 105 capacity with Mizuho. On February 19, 2008, he wrote, "Quarter‐end is approaching and we would like to maximize balance sheet efficiency via Mizuho." E‐ mail from Stephen Allery, Lehman, to Miyuki Suzuki, Lehman (Feb. 19, 2008) [LBEX‐DOCID 98492]. The next day, he wrote again to Suzuki, "Sorry to chase, but we are being asked about our capacity to help FID reduce B/S at qtr‐end." E‐mail from Stephen Allery, Lehman, to Miyuki Suzuki, Lehman (Feb. 20, 2008) [LBEX‐DOCID 98492]. Suzuki replied, "Could you advise how much you need for the balance sheet relief for the quarter end?" E‐mail from Miyuki Suzuki, Lehman, to Stephen Allery, Lehman (Feb. 21, 2008) [LBEX‐DOCID 98492]. On February 28, 2008, one day before the close of the quarter, Lehman's credit line for Repo 105 transactions with Mizuho was finally doubled to $5 billion. E‐mail from Miyuki Suzuki, Lehman, to Stephen Allery, Lehman (Feb. 28, 2008) [LBEX‐DOCID 98492]; see also Lehman Brothers, Credit Risk Management, Credit Review, Mizuho Financial Group, Inc. (Nov. 27, 2007) [LBEX‐ DOCID 2513180] (containing review and proposal for Repo 105 line increase with Mizuho, stating that "limit increase is to accommodate . . . increasing business requests for repo 105 activities at LBIE for our balance sheet relief, especially toward our fiscal year end" and attached to e‐mail from Fumiyoshi Ooka, Lehman, to Patrick McGarry, Lehman (Nov. 27, 2007) [LBEX‐DOCID 2552287]).Show full note In another e‐mail discussing Repo 105 usage at quarter‐end, Michael McGarvey wrote: "We only focus on meeting our quarter end balance sheet targets. The intra month targets historically haven't been actively managed."³²⁹⁷³²⁹⁷ E‐mail from Michael McGarvey, Lehman, to Dominic Gibb, Lehman, et al. (Dec. 20, 2007) [LBEX‐ DOCID 3223846]. Later in the same e‐mail, McGarvey continued: "Being the non‐quarter month end balance sheets aren't

858 859

¶published in the financials we don't focus on them. We don't want traders spending money to come down in balance sheet unless it's really necessary."³²⁹⁸³²⁹⁸ E‐mail from Michael McGarvey, Lehman, to Dominic Gibb, Lehman (Dec. 20, 2007) [LBEX‐DOCID 3223846]. Dominic Gibb, a Lehman Managing Director based in London, became "nervous" about McGarvey's statements regarding quarter‐end focus, writing: "We historically haven't liked to see massive swings in our utilisation of repo 105 just at quarter end." E‐mail from Dominic Gibb, Lehman, to Michael McGarvey, Lehman (Dec. 20, 2007) [LBEX‐DOCID 3223846]. This sentiment was echoed by Gerard Reilly, who replied to a request by Clement Bernard for expanded capacity for Repo 105 transactions to reduce the firm's balance sheet as follows: "If we fund our positions in this manner all the time then we can do it. Can't just be at quarter end." E‐mail from Gerard Reilly, Lehman, to Clement Bernard, Lehman (Jan. 29, 2008) [LBEX‐DOCID 2796630]. See Section III.A.4.f.3 (discussing continual use and 120% rules).Show full note

Contemporaneous Documents Confirm That Lehman Undertook Repo 105 Transactions to Reduce Its Balance Sheet and Reverse Engineer Its Leverage

¶Lehman's Repo 105 practice engendered a certain level of cynicism within the firm.³²⁹⁹³²⁹⁹ One e‐mail appears to reflect a certain level of nervousness by one Lehman employee with respect to how counterparties would react to the "truth" about Repo 105 transactions. In the e‐mail, LBIE's Jawad wrote to Higgins about his "quest for more counterparties for 105." See e‐mail from Anthony Jawad, Lehman, to Kieran Higgins, Lehman (May 22, 2008) [LBEX‐DOCID 3234386]. Jawad reported that the Reserve Bank of Australia asked Lehman why Lehman wanted to engage in Repo 105 transactions. Id. Jawad then stated, "I spoke to Mark Cosaitis about this and he obviously would like us to give a vague reason about getting better net down treatment, which isn't a lie. However, if they want a deeper explanation then we may have to get down to the nitty gritty of the truth. Do you want us to go down this line or want us to just give it a miss . . . . [T]he more people that know the truth, the more dodgy it can be." Id. Assi wrote back, "For the record the truth is that what we are doing is perfectly legal." Id. Amin replied, "My view is the same as Georges'. Accounting rules are very clear around Repo 105 . . . ." Id. The statement by Jawad about "better net down treatment" refers to Lehman's terminology for the reduction of net assets by means of Repo 105. See Duff & Phelps, Explanation of Repo 105 Accounting Ledger Entries and Trading System Output (Jan. 5, 2010), at pp. 3‐4 (stating that "net down was the method of removal of the security from Lehman's consolidated balance sheet, i.e., the amount by which the securities inventory would be reduced (sold) in a Repo 105 transaction pursuant to Lehman's Accounting Policy"). Though Assi referred to the legality of repo transactions, the issue from the Examiner's perspective is whether proper disclosure has been made by Lehman in its securities filings and other public statements.Show full note Notably, in response to an e‐mail stating "[n]ot sure you are familiar with Repo 105 but it is used to reduce net balance sheet in our governments businesses around the world," Bart McDade, Lehman's former President and Chief Operating Officer, replied: "I am very aware . . . it is another drug we r on."³³⁰⁰³³⁰⁰ E‐mail from Herbert H. (Bart) McDade III, Lehman, to Hyung Lee, Lehman (Apr. 3, 2008) [LBEX‐ DOCID 1570783]. During his first interview with the Examiner, McDade attempted to explain his "drug" comment as simply the thought that Repo 105 might be an easier way of managing the balance sheet than a more disciplined approach. Examiner's Interview of Herbert H. "Bart" McDade III, Sept. 16, 2009, at p. 4. In a related e‐mail, McDade continued with his drug analogy. In response to an e‐mail stating that a Repo 105 counterparty's refusal to roll Lehman's Repo 105 transactions would lead to an increase in Lehman's quarter‐end net balance sheet unless Lehman could find an additional Repo 105 counterparty, McDade stated that this was "exactly why the drug is a problem." E‐mail from Herbert H. (Bart) McDade III, Lehman, to Andrew J. Morton, Lehman (Apr. 3, 2008) [LBEX‐DOCID 2984871].Show full note

860

¶Numerous internal Lehman e‐mails referred to Repo 105 transactions in pejorative terms, such as "balance sheet window‐dressing." An illustrative example is found in the following July 2008 e‐mail exchange:

Vallecillo: "So what's up with repo 105? Why are we doing less next quarter end?"³³⁰¹³³⁰¹ E‐mail from Jormen Vallecillo, Lehman, to Michael McGarvey, Lehman (July 2, 2008) [LBEX‐DOCID 3379145].

McGarvey: "It's basically window‐dressing. We are calling repos true sales based on legal technicalities. The exec committee wanted the number cut in half."³³⁰²³³⁰² E‐mail from Michael McGarvey, Lehman, to Jormen Vallecillo, Lehman (July 2, 2008) [LBEX‐DOCID 3379145] (emphasis added).

Vallecillo: "I see . . . so it's legally do‐able but doesn't look good when we actually do it? Does the rest of the street do it? Also is that why we have so much BS [balance sheet] to Rates Europe?³³⁰³³³⁰³ E‐mail from Jormen Vallecillo, Lehman, to Michael McGarvey, Lehman (July 2, 2008) [LBEX‐DOCID 3379145].

¶McGarvey: "Yes, No and yes. :)"³³⁰⁴³³⁰⁴ E‐mail from Michael McGarvey, Lehman, to Jormen Vallecillo, Lehman (July 2, 2008) [LBEX‐DOCID 3379145].

861

¶Numerous other internal Lehman e‐mails confirm that Lehman's true purpose for undertaking Repo 105 transactions at quarter‐end was balance sheet and leverage manipulation. By way of example only:

● In reference to the Agencies business's use of Repo 105 transactions: "As we approach quarter end, we start to raise the balances so that we 'reserve' size with our counterparties the week we really need it (over quarter end). At this fiscal year end we took the amounts up as high as we could, as we knew there would be intense balance sheet pressure."³³⁰⁵³³⁰⁵ E‐mail from Mitchell King, Lehman, to Mark Gavin, Lehman, et al. (Dec. 3, 2007) [LBEX‐DOCID 3232555].

● "[T]he firm has a function called repo 105 whereby you can repo a position for a week and it is regarded as a true sale to get rid of net balance sheet."³³⁰⁶³³⁰⁶ E‐mail from Anthony Jawad, Lehman, to Andrea Lenardelli, Lehman (Mar. 3, 2008) [LBEX‐DOCID 235036].

● "We have been using Repo 105 in the past to reduce balance sheet at quarter‐ end. . . ."³³⁰⁷³³⁰⁷ E‐mail from Raymond Chan, Lehman, to Paul Mitrokostas, Lehman (July 15, 2008) [LBEX‐DOCID 3384937].

● When Lehman's repo trading desk in London informed personnel in Lehman's New York Fixed Income Division that certain Repo 105 counterparties were no longer interested in participating in Repo 105 transactions, Kentaro Umezaki wrote to Clement Bernard and Gerard Reilly, copying Kaushik Amin and Andrew Morton, stating "Looks like we may need to rethink how much of [Repo 105] we can rely on for balance sheet relief. Could someone in Finance coordinate how much of this we should expect to have available for balance sheet relief at month/quarter end going forward?"³³⁰⁸³³⁰⁸ E‐mail from Kentaro Umezaki, Lehman, to Clement Bernard, Lehman, et al. (Sept. 4, 2007) [LBEX‐ DOCID 3232534]. Numerous other documents support the conclusion that Lehman's Repo 105 program was a mechanism for managing the balance sheet at quarter‐end. See, e.g., e‐mail from Anuraj Bismal, Lehman, to Marie Stewart, Lehman, et al. (Jan. 29, 2008) [LBHI‐SEC07940_861461] (consisting of e‐mail chain discussion regarding balance sheet projections and rise in net leverage in which Michael McGarvey states that additional Repo 105 will clean up the balance sheet and Anuraj Bismal calls Repo 105/108 "an important feature."); e‐mail from Sigrid Stabenow, Lehman, to Gerard Reilly, Lehman, et al. (Jan. 30, 2008) [LBEX‐DOCID 4292184] (reporting to Reilly and Clement Bernard regarding "the gap to quarter endShow full note

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● Bernard wrote to Amin and Higgins on February 28, 2008, regarding FID's net balance sheet overage; in particular, Bernard indicated that FID's Rates business was $4.5 billion over target.³³⁰⁹³³⁰⁹ E‐mail from Clement Bernard, Lehman, to Kaushik Amin, Lehman, et al. (Feb. 28, 2008) [LBEX‐DOCID 1854189]. Bernard warned: "This will drive Lehman net leverage ratio above target. Please let me know what we can do to minimize this impact . . . . I know it is late in the process but what ever we can do would help our ratio."³³¹⁰³³¹⁰ Id. Later that day, Bernard forwarded that message to Martin Potts, adding the message: "We are looking at selling what ever we can and also doing some more repo 105."³³¹¹³³¹¹ E‐mail from Clement Bernard, Lehman, to Martin Potts, Lehman (Feb. 28, 2008) [LBEX‐DOCID 1854189].

● After successfully lobbying for additional Repo 105 capacity at quarter‐end, Jeff Michaels wrote to Amin: "The good news is . . . as soon as lehman gives the green light, we can reduce the net/gross by another 2.5–3 bn."³³¹²³³¹² E‐mail from Jeff Michaels, Lehman, to Kaushik Amin, Lehman (May 21, 2008) [LBEX‐DOCID 736186].

¶Indeed, Repo 105 transactions became such a deeply ingrained feature of balance sheet management that balance sheet targets and Repo 105 often were discussed together, as when Michaels e‐mailed Amin "a spreadsheet Tejal [Joshi] helped me put together with my suggested allocations for the global balance sheet/repo 105 for this quarter."³³¹³³³¹³ E‐mail from Jeff Michaels, Lehman, to Kaushik Amin, Lehman, et al. (July 31, 2008) [LBEX‐DOCID 756327] (transmitting attached spreadsheet of balance sheet targets and Repo 105 allocations [LBEX‐ DOCID 633334]). When Michaels explained in an e‐mail that he was working on balance target" and stating that "FID is forecasting to be $15 bn over quarter end limit" and FID leaders made a "[r]ecommendation that Repo 105 program is expanded."); e‐mail from Jerry Rizzieri, Lehman, to Kieran Higgins, Lehman, et al. (Apr. 22, 2008) [LBEX‐DOCID 756532] (following the announcement of "new balance sheet targets for quarter end," Rizzieri wrote: "We will need to be focused very early in the process in order to meet these targets," that there is "no room for error this quarter" and that accordingly "we also need to have a coordinated approach to repo 105 allocation").

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¶sheet allocations, he wrote: "It is really a bottom‐up process about who has sticky inventory. Obviously in the US it is Agencies, and in London it is Inflation."³³¹⁴³³¹⁴ E‐mail from Jeff Michaels, Lehman, to Kaushik Amin, Lehman (July 30, 2008) [LBEX‐DOCID 613324]. Because Michaels worked for the Liquid Markets division, "sticky" in this context does not refer to actually illiquid assets, but rather, is used relative to the most liquid inventory. Sticky agencies, for example, would likely refer to "off‐the‐run" securities – all government and treasury securities issued before the most recently issued security of a particular maturity is "off the run." "Off the run" securities are less frequently traded and are therefore "illiquid" compared to the most recently issued security.Show full note

¶Lehman's internal balance sheets tracked the firm's Repo 105 usage and its resulting benefit to the firm‐wide balance sheet.³³¹⁵³³¹⁵ See, e.g., Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary [Draft] (Aug. 31, 2007) [LBEX‐DOCID 3215510] (stating Repo 105 usage on Aug. 31, 2007 was $36.627 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary [Draft] (Sept. 28, 2007) [LBEX‐DOCID 2705059] (stating Repo 105 usage on Sept. 28, 2007 was $24.406 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary [Draft] (Oct. 31, 2007) [LBEX‐DOCID 2705943] (stating Repo 105 usage on Oct. 31, 2007 was $29.623 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Nov. 30, 2007) [LBEX‐DOCID 3439086] (stating Repo 105 usage on Nov. 30, 2007 (quarter‐end) was $38.634 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Jan. 29, 2008) [LBEX‐DOCID 3363236] (stating Repo 105 usage on Jan. 29, 2008 was $28.883 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Feb. 13, 2008) [LBEX‐DOCID 1697794] (stating Repo 105 usage on Feb. 13, 2008 was $23.602 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Feb. 22, 2008) [LBEX‐DOCID 3363289] (stating Repo 105 usage on Feb. 22, 2008 was $31.029 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Feb. 29, 2008) [LBEX‐DOCID 579841] (stating Repo 105 usage on Feb. 29, 2008 (quarter‐end) was $49.102 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Mar. 13, 2008) [LBEX‐DOCID 765323] (stating Repo 105 usage on Mar., 13, 2008 was $26.212 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Apr. 14, 2008) [LBEX‐DOCID 766086] (stating Repo 105 usage on Apr. 14, 2008 was $19.546 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Apr. 21, 2008) [LBEX‐DOCID 766088] (stating Repo 105 usage on Apr. 21, 2008 was $21.907 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Apr. 28, 2008) [LBEX‐DOCID 766092] (stating Repo 105 usage on Apr. 28, 2008 was $24.077 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Draft) (Apr. 30, 2008) [LBEX‐DOCID 394333] (stating Repo 105 usage on Apr. 30, 2008 was $24.709 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (May 6, 2008) [LBEX‐DOCID 766102] (stating Repo 105 usage on May 6, 2008 was $24.388 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (May 13, 2008) [LBEX‐DOCID 766107] (stating Repo 105 usage on May 13, 2008 was $25.282 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (May 28, 2008) [LBEX‐DOCID 766924] (stating Repo 105 usage on May 28, 2008 was $43.112 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (May 29, 2008) (stating Repo 105 usage on May 29, 2008 was $46.820 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Aug. 14, 2008) [LBEX‐DOCID 84891] (stating Repo 105 usage on Aug. 14, 2008 was $18.274 billion); see also e‐mail from Mark Neller, Lehman, to Anthony Kush, Lehman, et al. (Dec. 5, 2007) [LBEX‐DOCID 3223384] ("Please be aware that all Repo 105 benefit taken to Management Balance Sheet at November month end needs to be replicated within respective entities DBS accounting.").Show full note These balance sheets were used by management and were not reported externally.³³¹⁶³³¹⁶ See e‐mail from Jody Li, Lehman, to Paolo R. Tonucci, Lehman, et al. (Mar. 15, 2008) [LBEX‐DOCID 117307] (transmitting to Lehman's Treasurer the Global Consolidated Balance Sheet [LBEX‐DOCID 120158] showing Repo 105 balance on Mar. 13, 2008); e‐mail from Gerard Reilly to Herbert H. (Bart) McDade III (Mar. 27, 2008) [LBEX‐DOCID 560109] (transmitting Global Consolidated Balance Sheet for Feb. 29, 2008 (Mar. 27, 2008) [LBEX‐DOCID 579841] and stating "Bart this is the firm bs"); e‐mail from Atiba Rodriguez, Lehman, to Clement Bernard, Lehman, et al. (May 29, 2008) [LBEX‐DOCID 3221577] (transmitting Global Consolidated Balance Sheet [LBEX‐DOCID 3237577] to Chief Financial Officer for FID).Show full note LBHI's Global Consolidated Balance Sheet, for example, showed securities inventory levels pre‐Repo 105 usage and with Repo 105, and contained columns for "Repo 105/108 added back" as well as balance sheet targets.³³¹⁷³³¹⁷ E‐mail from Gerard Reilly to Herbert H. (Bart) McDade III (Mar. 27, 2008) [LBEX‐DOCID 560109] (transmitting Global Consolidated Balance Sheet for Feb. 29, 2008 (Mar. 27, 2008) [LBEX‐DOCID 579841] to President and COO and stating "Bart this is the firm bs"). The Fixed Income Division's Global Rates business's balance sheet projections spreadsheets recorded the balance sheet target and projected net balance sheet, and populated with data individual columns for "actual pre‐Repo 105," "Repo 105," "actual post‐Repo 105," and "Repo 105 target."³³¹⁸³³¹⁸ Lehman, Global Rates Net Balance Sheet (Dec. 20, 2007) [LBEX‐DOCID 3215591] (attached to e‐mail from Mark Neller, Lehman, to Divyesh Chokshi, Lehman (Dec. 21, 2007) [LBEX‐DOCID 3234333]). The Global Rates business's balance sheet management reports included side‐by‐side columns for gross balance sheet, net balance sheet, and Repo 105.³³¹⁹³³¹⁹ Lehman, Global Rates Q3 Balance Sheet Management (Aug. 18, 2008) [LBEX‐DOCID 637339] (attached to e‐mail from Tejal Joshi, Lehman, to Kaushik Amin, Lehman, et al. (Aug. 19, 2008) [LBEX‐DOCID 736504]); Lehman, Global Rates Q3 Balance Sheet Management (Aug. 19, 2008) [LBEX‐DOCID 637341] (attached to e‐mail from Tejal Joshi, Lehman, to Kaushik Amin, Lehman, et al. (Aug. 20, 2008) [LBEX‐ DOCID 736507]); Lehman, Global Rates Q3 Balance Sheet Management (Aug. 21, 2008) [LBEX‐DOCID 637338] (attached to e‐mail from Tejal Joshi, Lehman, to Kaushik Amin, Lehman, et al. (Aug. 22, 2008) [LBEX‐DOCID 736506]).Show full note Other balance sheet spreadsheets from the

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¶Rates business tracked net balance sheet, "[a]dditional Repo 105," reduction of government inventory, and total balance sheet reduction by trading desk.³³²⁰³³²⁰ Lehman, Rates Americas Balance Sheet (Feb. 26, 2008) [LBEX‐DOCID 3218412] (attached to e‐mail from Michael McGarvey, Lehman, to Jerry Rizzieri, Lehman (Feb. 28, 2008) [3233807]. Similarly, the Liquid Markets group within FID reported internal balance sheet projection figures for both gross and net balance sheet targets along with Repo 105.³³²¹³³²¹ Lehman, Liquid Markets Balance Sheet (May 15, 2008) [LBEX‐DOCID 3439007] (attached to e‐mail from Michael McGarvey, Lehman, to Tal Litvin, Lehman (May 19, 2008) [LBEX‐DOCID 3383917].

¶Senior management exerted pressure, particularly at or near quarter‐end, to utilize the Repo 105 mechanism to meet the firm‐imposed balance sheet targets:

● Four days before the close of Lehman's fiscal year in November 2007, Mitch King wrote to Marc Silverberg: "Let me know if we have room for any more repo 105. I have some more I can put in over month end."³³²²³³²² E‐mail from Mitchell King, Lehman, to Marc Silverberg, Lehman (Nov. 26, 2007) [LBEX‐DOCID 3232804]. Jerry Rizzieri, who reported directly to Kaushik Amin, replied to King: "Can you imagine what this would be like without 105?"³³²³³³²³ E‐mail from Jerry Rizzieri, Lehman, to Mitchell King, Lehman (Nov. 26, 2007) [LBEX‐DOCID 3232804].

● On February 28, 2008, one day before the close of Lehman's first quarter 2008, Amin, then‐Head of Liquid Markets, wrote to Kieran Higgins: "We have a desperate situation and I need another 2 billion from you, either through Repo 105 or outright sales. Cost is irrelevant, we need to do it."³³²⁴³³²⁴ E‐mail from Kaushik Amin, Lehman, to Kieran Higgins, Lehman (Feb. 28, 2008) [LBEX‐DOCID 3234351].

● Also on February 28, 2008, Mark Gavin wrote to John Feraca: "Just took a call from FID mgmt ‐ seems they're up on net b/s by 3 bln unanticipated & are a little excited w Q end. I am looking to do an additional repo 105 with Mizuho. . . ."³³²⁵³³²⁵ E‐mail from Mark Gavin, Lehman, to John Feraca, Lehman, et al. (Feb. 28, 2008) [LBEX‐DOCID 98492].

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● Higgins wrote to Jeff Michaels, on May 2, 2008: "In light of…the firms max ratio at q end to month avg [] we started to [Repo] 105 irp balance sheet several weeks ago for q end (this has a real cost though)."³³²⁶³³²⁶ E‐mail from Kieran Higgins, Lehman, to Jeff Michaels, Lehman (May 2, 2008) [LBEX‐DOCID 601783].

● On May 21, 2008, Amin wrote to Higgins: "Let's max out on the Repo 105 for your stuff and see where end up."³³²⁷³³²⁷ E‐mail from Kaushik Amin, Lehman, to Kieran Higgins, Lehman (May 21, 2008) [LBEX‐DOCID 3234382]. When Amin asked Higgins for an update on the balance sheet management, Higgins replied: "[A]nything that moves is getting 105'd."³³²⁸³³²⁸ E‐mail from Kieran Higgins, Lehman, to Kaushik Amin, Lehman (May 21, 2008) [LBEX‐DOCID 3234382] (emphasis added).

● In an e‐mail from McGarvey to Reilly written ten days before the close of Lehman's second quarter 2008, McGarvey wrote: "Kaushik [Amin] has just requested that they do as much Repo 105 as possible."³³²⁹³³²⁹ E‐mail from Michael McGarvey, Lehman, to Gerard Reilly, Lehman, et al. (May 21, 2008) [LBEX‐ DOCID 3221744].

● In an e‐mail to Thomas Siegmund, also ten days from the close of Lehman's second quarter, Amin wrote: "Do as much as you can in Repo 105. Can you find Repo 105 capacity among Japanese counterparties to take US Agencies?"³³³⁰³³³⁰ E‐mail from Kaushik Amin, Lehman, to Thomas Siegmund, Lehman (May 21, 2008) [LBEX‐DOCID 756545]; see also e‐mail from Jeff Michaels, Lehman, to Kaushik Amin, Lehman (May 27, 2008) [LBEX‐ DOCID 723365] (responding to Amin's message "Important to get as much of the Agency inventory out as possible," by stating: "They continue to do so, and have repo 105'd everything they can. . . .").

● As the close of Lehman's third quarter 2008 was approaching, Amin asked Andrew Morton, then‐head of Lehman's Fixed Income Division, for additional Repo 105 authority in order to make balance sheet targets.³³³¹³³³¹ See e‐mail from Kaushik Amin, Lehman, to Andrew J. Morton, Lehman (Aug. 20, 2008) [LBEX‐DOCID 3234406] (responding to Morton's question "Can you keep going on bal sheet[?]" by stating: "I am squeezing hard. But, the challenge is that liquidity is poor given the European holidays. Most of our tough balance sheet is inflation and Agencies, which is extremely illiquid. I think we should relax the Repo 105 constraints a bit. Instead of $20 Bln, we should take it up to say $25 Bln.").Show full note

867

Witness Statements to the Examiner Regarding the True Purpose of Lehman's Repo 105 Practice

¶Virtually every witness the Examiner questioned regarding Lehman's Repo 105 practice, including some in the top echelon of Lehman's management, agreed that Lehman relied upon Repo 105 transactions to reduce its net balance sheet at quarter‐ end. Among the statements made during the investigation of the Repo 105 issue are:

● Paolo Tonucci, former Treasurer, recalled that near the end of reporting periods, Lehman would deploy Repo 105 transactions to reduce its balance sheet.³³³²³³³² Examiner's Interview of Paolo R. Tonucci, Sept. 16, 2009, at p. 27. He also acknowledged that Lehman's use of Repo 105 transactions impacted Lehman's net leverage ratio.³³³³³³³³ Examiner's Interview of Paolo R. Tonucci, Sept. 16, 2009, at p. 26.

● Ian Lowitt, former Chief Financial Officer, recalled that Lehman established a "regime of limits," meaning balance sheet targets, for each business unit to manage to and that Repo 105 was one way to "sell down assets" to meet the targets.³³³⁴³³³⁴ Examiner's Interview of Ian T. Lowitt, Oct. 28, 2009, at p. 10.

● Ed Grieb, former Global Financial Controller, stated that Lehman's total assets were reduced by Repo 105 transactions because the securities inventory came off Lehman's books and, importantly, the cash that Lehman received in a Repo 105 transaction was used to pay down other liabilities or to pay for securities it repoed.³³³⁵³³³⁵ Examiner's Interview of Edward Grieb, Oct. 2, 2009, at pp. 9, 11. Grieb made clear that Lehman would not have simply sat on the cash it received in Repo 105 transactions, which would have resulted in a net zero impact on Lehman's assets.³³³⁶³³³⁶ Id. Accordingly, Grieb agreed that one consequence of Lehman's Repo 105 transactions was a reduction in Lehman's net leverage ratio.³³³⁷³³³⁷ Id. at p. 11.

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● Martin Kelly, former Global Financial Controller, said that "the only purpose or motive for [Repo 105] transactions was reduction in the balance sheet" and that "there was no substance to the transactions."³³³⁸³³³⁸ Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 7.See Sections III.A.4.g.1 and III.A.4.h.3.b–c of the Report for discussion of Kelly's discomfort with Repo 105 transactions; see also e‐mail from Martin Kelly, Lehman, to Marie Stewart, Lehman (Feb. 14, 2008) [LBEX‐DOCID 3223647] ("What is our current BS 'advantage' resulting from Repo 105/108 approx?"). When asked about this e‐mail, Kelly told the Examiner that balance sheet "advantage" referred to a reduction of net balance sheet through Repo 105. Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 6.Show full note

● Clement Bernard, former Chief Financial Officer for FID, said that as the end of a quarter drew near, Lehman personnel relied upon Repo 105 transactions for "balance sheet relief" and to reach firm‐imposed balance sheet targets.³³³⁹³³³⁹ Examiner's Interview of Clement Bernard, Oct. 23, 2009, at p. 7.

● John Feraca, who ran the Secured Funding Desk in Lehman's Prime Services Group, stated: "Senior people felt urgency only in the sense of trying to get to their targets because the Finance Division wanted to report as healthy a balance sheet and leverage ratio as possible for investors, creditors, rating agencies and analysts."³³⁴⁰³³⁴⁰ Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 9. He added: "It was universally accepted throughout the entire institution that Repo 105 was used for balance sheet relief at quarter end."³³⁴¹³³⁴¹ Id.

● Kaushik Amin, former Head of Liquid Markets, said that Lehman reduced its net balance sheet at quarter‐end by engaging in tens of billions of dollars of Repo 105 transactions and that a number of days after the opening of the new quarter, the Repo 105 inventory would return to Lehman's balance sheet.³³⁴²³³⁴² Examiner's Interview of Kaushik Amin, Sept. 17, 2009 at p. 6.

● Matthew Lee, former Senior Vice President, Finance Division, in charge of Global Balance Sheet and Legal Entity Accounting, recalled that Lehman would "sell" assets through Repo 105 transactions approximately four or five days before the close of a quarter and then repurchase them approximately four or five days after the beginning of the next quarter in order to "reverse engineer" its net leverage ratio for its publicly filed financial statements.³³⁴³³³⁴³ Examiner's Interview of Matthew Lee, July 1, 2009, at p. 13.

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● Marie Stewart, the former Global Head of Lehman's Accounting Policy Group, described Repo 105 transactions as "a lazy way of managing the balance sheet as opposed to legitimately meeting balance sheet targets at quarter end."³³⁴⁴³³⁴⁴ Examiner's Interview of Marie Stewart, Sept. 2, 2009, at p. 7.

● Anuraj Bismal, former Senior Vice President in Lehman's Balance Sheet group, agreed with other witness statements describing the firm's Repo 105 program in pejorative terms, such as "window‐dressing" and a "drug."³³⁴⁵³³⁴⁵ Examiner's Interview of Anuraj Bismal, Sept. 16, 2009, at pp. 7‐8. Bismal explained that although Lehman had acquired a legal opinion and developed an accounting policy justifying Repo 105 transactions, there remained "discomfort" within Lehman regarding the use of Repo 105 transactions for removing securities inventory from the balance sheet.³³⁴⁶³³⁴⁶ Id.

● Murtaza Bhallo, the former Business/Risk Manager for PTG Liquid Markets, said that Repo 105 was "an accounting gimmick."³³⁴⁷³³⁴⁷ Examiner's Interview of Murtaza Bhallo, Sept. 14, 2009).

● Mitch King was the former head of Lehman's United States Agencies trading desk who was required on a weekly basis to compile lists of collateral available for inclusion in Repo 105 transactions and send the lists to LBIE personnel.³³⁴⁸³³⁴⁸ Examiner's Interview of Mitchell King, Sept. 21, 2009, at p. 6. King stated that no business purpose existed for Repo 105 transactions other than to reduce Lehman's net balance sheet.³³⁴⁹³³⁴⁹ Id. King referred to Lehman's Repo 105 program as a "nuisance."³³⁵⁰³³⁵⁰ Id. Accordingly, he said, "[t]here was no reason for me to go out and Repo 105."³³⁵¹³³⁵¹ Id. King further stated that "[f]rom a trader's perspective, I would have rather never seen anything Repo 105‐related. It was just another thing I had to do that was not a trade and that was not a part of my business. I would not go out and seek to Repo 105 [i.e., if he wasn't required to by superiors]."³³⁵²³³⁵² Id.

870

Quarter‐End Spikes in Lehman's Repo 105 Usage Also Suggest the True Purpose of Lehman's Repo 105 Practice Was Balance Sheet Manipulation

¶The documentary evidence and witness statements establish that Lehman employed Repo 105 transactions for quarter‐end balance sheet reduction. This conclusion is further confirmed by the fact that that Lehman's use of Repo 105 transactions regularly spiked up at quarter‐end.³³⁵³³³⁵³ See Duff & Phelps, Repo 105/108 Usage vs. Limit Comment (Oct. 16, 2009), at pp. 7‐9.

¶Notably, this quarter‐end spike in Repo 105 usage occurred notwithstanding evidence that certain Lehman personnel expressed concern about the concentration of transactions at quarter‐end. For example, Martin Kelly, Lehman's Global Financial Controller from December 1, 2007 through September 2008, said that he had "discomfort" with the "skewing of Repo 105 transactions at quarter‐end."³³⁵⁴³³⁵⁴ Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 7. Kelly further explained that he had expressed that concern about the quarter‐end concentration to both CFOs to whom he reported, Erin Callan and Ian Lowitt.³³⁵⁵³³⁵⁵ Id.See Sections III.A.4.h.3.b–c of this Report (describing the conversations between Kelly and each Chief Financial Officer in detail).

¶To the extent senior Lehman personnel had "discomfort" regarding the quarter‐ end spikes in Repo 105 usage, or concern about the risk of growing dependant upon large volumes of Repo 105 transactions at quarter‐end given that the FASB could potentially change SFAS 140, Chris O'Meara, Ed Grieb, and Gerard Reilly mandated a set of two related guidelines loosely known within Lehman as (1) the "80/20" or "continual use rule" and (2) the "120% rule."³³⁵⁶³³⁵⁶ Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 13. Paolo Tonucci, former Treasurer, attributed the setting of a cap on Repo 105 usage to concern regarding overdependence on Repo 105 transactions to manage balance sheet. Examiner's Interview of Paolo R. Tonucci, Sept. 16, 2009, at p. 26. Those guidelines provided, respectively, that (1) Repo 105 transactions outstanding at any time should be maintained at a level throughout an entire month that was approximately 80% of the amount at that month‐end; and (2) the month or quarter‐end spike in Repo 105 activity could not result in a balance that exceeded 120% of the daily average usage throughout that month.³³⁵⁷³³⁵⁷ See Lehman, Global Balance Sheet Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 2 [LBEX‐WGM 748489] ("Repo 105 transactions must be executed on a continual basis and remain in force throughout the month. To meet this requirement, the amount outstanding at any time should be maintained at approximately 80% of the amount at month‐end. [per Chris O'Meara and Ed Grieb."); e‐ mail from Michael McGarvey, Lehman, to Kentaro Umezaki, Lehman, et al. (Aug. 17, 2007) [LBEX‐ DOCID 1635769] ("The guide line for month end usage of repo 105 is that it should not exceed 120% of your daily average."). In another e‐mail, McGarvey explained the rule to Clement Bernard (former FID CFO): "We have repo 105 funding benefit trades on constantly in the normal course of business because accounting policy stipulates it must be a regular way [to] fund our positions. We increase the balances for month end but try to keep it within 120 percent of the average daily usage (we are decent at this, not great)." See e‐mail from Michael McGarvey, Lehman, to Clement Bernard, Lehman (Jan. 31, 2008) [LBEX‐ DOCID 2796633]. McGarvey was mistaken, however, that the "continual use rule" was part of Lehman's Repo 105 Accounting Policy, which does not mention the guideline. Grieb stated that the continual use rule was not an accounting‐based rule. Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 13. See also E‐mail from Clare Christofi, Lehman, to Joseph Gentile, Lehman, et al. (Dec. 1, 2006) [LBEX‐DOCID 3234175] (forwarding earlier message stating "We have a provision for Repo 105/108 which is $24.6 bn…. The daily average for November is $18.1 bn giving $21.8 bn total that can be taken at 120%, so we are over by $2.9 bn."); e‐mail from Anuraj Bismal, Lehman, to Clare Christofi, Lehman, et al. (May 8, 2007) [LBEX‐ DOCID 3234167] ("[I]t's more about consistent usage of Repo 105 and 108 ‐ we should not have the deep troughs of usage that we used to have [in FID world]. The 80% rule that Clare talks about addresses that head on."); e‐mail from Anuraj Bismal, Lehman, to Michael McGarvey, Lehman, et al. (May 9, 2007) [LBEX‐DOCID 3223356] ("As the bs continues to grow‐ then maybe a higher limit would be supported by the 80% math."); e‐mail from Divyesh Chokshi, Lehman, to Anuraj Bismal, Lehman, et al. (Aug. 14, 2007) [LBEX‐DOCID 3234164] ("I thought that we had moved away from the Limit definitions as the desk needs to demonstrate a consistent application during the month of Repo [105] benefit taken."); e‐mail from Divyesh Chokshi, Lehman, to Anuraj Bismal, Lehman, et al. (Aug. 14, 2007) [LBEX‐DOCID 3234166] (disputing with Bismal whether Bismal knew that Lehman had moved away from limits and stating "we needed to ensure that there was a consistent application of Repo 105 Benefit. If hard limits have been set then let me know"; e‐mail from Clare Christofi, Lehman, to Anuraj Bismal, Lehman, et al. (Aug. 14, 2007) [LBEX‐DOCID 3234180] ("Ed [Grieb] and Gerry [Reilly] were interested in the 80/120% of av daily balance…."); Lehman, Global Repo 105/108 vs. 120% of Daily Average Graph (July 31 ‐ Aug. 15, 2007) [LBEX‐DOCID 3219672] (attached to e‐mail from Michael McGarvey, Lehman, to Steven Becker, Lehman, et al. (Aug. 17, 2007) [LBEX‐DOCID 3221344]); e‐mail from Michael Anthony, Lehman, to Kieran Higgins, Lehman (Oct. 12, 2007) [LBEX‐DOCID 738606] ("[I]t looks like the only limitation we have on size [for Repo 105] is the month end balance can't be more than 120% of our daily average throughout the month. More specifically for the index business, if all positions are term repo'd for at least one month than effectively there is no cap on size as our positions will be included as part of the daily average.").Show full note

871 872

¶Grieb stated that the guidelines were "put in place to make sure the transactions had a legitimate business purpose."³³⁵⁸³³⁵⁸ Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 13. Grieb, O'Meara, and Reilly "put together" the guidelines because they "wanted to see there was a business purpose, that counterparties were doing this on an ongoing basis, and . . . that there were no spikes just at the end of the month or quarter‐end."³³⁵⁹³³⁵⁹ Id.

¶Anuraj Bismal similarly recalled that Lehman management mandated Repo 105 usage throughout a quarter to demonstrate that Lehman's use of Repo 105 transactions was not solely window‐dressing aimed at improving the firm's quarter‐end financial number.³³⁶⁰³³⁶⁰ Examiner's Interview of Anuraj Bismal, Sept. 16, 2009, at p. 8. According to Bismal, in approximately 2005, then‐Chief Financial Officer Chris O'Meara requested that John Feraca prepare a "business case justification" document. Id. Bismal believed that the document set forth the proposition that if Repo 105 transactions were a normal (i.e., constant) source of funding for Lehman, a valid business reason existed to undertake the transactions. Id.Show full note Bismal stated that the so‐called "80/20" rule was aimed at addressing firm‐ wide "discomfort" that no valid business reason existed for Repo 105 transactions.³³⁶¹³³⁶¹ Id. In Bismal's words, the continual use rule was for mitigating "the dips between the peaks."³³⁶²³³⁶² Id.

873

¶Lehman did not actually follow these self‐imposed rules. That is not surprising, since no witness was able to explain a business rationale for the arbitrary 1x leverage, continual use, and 120% rules.³³⁶³³³⁶³ Note that Lehman's former Global Treasurer, Paolo Tonucci, cited two reasons why Lehman management set limits on Repo 105 usage: (1) if there were a change to SFAS 140, such that true sale treatment for repo transactions was no longer available, Lehman did not want to experience a seismic shift in its balance sheet; and (2) without limits, there was a risk that Lehman's businesses would become "too dependent on the amount of flexibility the Repo [105] arrangement provided." Examiner's Interview of Paolo R. Tonucci, Sept. 16, 2009, at p. 27.Show full note If Repo 105 transactions made good business sense on their own, there would be no apparent reason to arbitrarily restrict the amount of such transactions to 1x leverage or to impose intra‐month limits to ensure that the amount of the transactions at reporting periods did not spike to more than 120% of average usage. No reason, that is, except to keep the transactions under the radar, by limiting their total and the amount of a quarter‐end spike.

¶These dips were nevertheless pronounced. For instance, the total amount of Repo 105 transactions at the end of first quarter (February) 2008 was approximately $49 billion, the intra‐quarter dip as of April 30, 2008 was approximately $24.7 billion and the quarter‐end amount for second quarter (May) 2008 was approximately $50.38 billion.³³⁶⁴³³⁶⁴ See Lehman, Total Repo 105 & Repo 105 Report (June 11, 2008) [LBEX‐DOCID 2078195] (showing that total Repo 105 usage at close of first quarter 2008 was $49.1024 billion, April 30, 2008 total Repo 105 usage was $24.7439 billion, and total Repo 105 usage at close of second quarter 2008 was $50.3834). Numerous balance sheet documents from Lehman's archives establish that Lehman's intra‐quarter use of Repo 105 transactions dipped significantly, as low as $12.75 billion.3365

874

¶3365 See, e.g., Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Aug. 31, 2007) [LBEX‐DOCID 3237230] (stating Repo 105 usage on Aug. 31, 2007, a quarter‐end, was $36.407 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary [Draft] (Sept. 28, 2007) [LBEX‐DOCID 2705059] (stating Repo 105 usage on Sept. 28, 2007 was $24.406 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Draft) (Oct. 31, 2007) [LBEX‐DOCID 2705943] (stating Repo 105 usage on Oct. 31, 2007 was $29.936 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Nov. 30, 2007) [LBEX‐DOCID 3439086] (stating Repo 105 usage on Nov. 30, 2007, a quarter‐end, was $38.634 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Jan. 29, 2008) [LBEX‐DOCID 3363236] (stating Repo 105 usage on Jan. 29, 2008 was $28.883 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Feb. 13, 2008) [LBEX‐DOCID 1697794] (stating Repo 105 usage on Feb. 13, 2008 was $23.602 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Feb. 15, 2008) [LBEX‐ DOCID 3215625] (stating Repo 105 usage on Feb 15, 2008 was $24.217 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Feb. 22, 2008) [LBEX‐DOCID 3363289] (stating Repo 105 usage on Feb. 22, 2008 was $31.029 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Feb. 28, 2008) [LBEX‐DOCID 4517138] (stating Repo 105 usage on Feb. 28, 2008 was $40.003 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Feb. 29, 2008) [LBEX‐DOCID 579841] (stating Repo 105 usage on Feb. 29, 2008, a quarter‐end, was $49.102 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Mar. 12, 2008) [LBEX‐DOCID 022302] (stating Repo 105 usage on Mar. 12, 2008 was $26.685 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Mar. 13, 2008) [LBEX‐DOCID 765323] (stating Repo 105 usage on Mar., 13, 2008 was $26.212 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Mar. 14, 2008) [LBEX‐DOCID 3438624] (stating Repo 105 usage on Mar. 14, 2008 was $12.750 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Mar. 27, 2008) [LBEX‐DOCID 3363367] (stating Repo 105 usage on Mar. 27, 2008 was $22.104 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Mar. 28, 2008) [LBEX‐DOCID 3363367] (stating Repo 105 usage on Mar. 28, 2008 was $24.597 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Apr. 3, 2008) [LBEX‐DOCID 3438756] (stating Repo 105 usage on Apr. 3, 2008 was $21.835 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Apr. 4, 2008) [LBEX‐DOCID 3438756] (stating Repo 105 usage on Apr. 4, 2008 was $18.653 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Apr. 11, 2008) [LBEX‐DOCID 766086] (stating Repo 105 usage on Apr. 11, 2008 was $20.260 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Apr. 14, 2008) [LBEX‐ DOCID 766086] (stating Repo 105 usage on Apr. 14, 2008 was $19.546 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Apr. 18, 2008) [LBEX‐DOCID 1961054] (stating Repo 105 usage on Apr. 18, 2008 was $19.785 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Apr. 21, 2008) [LBEX‐DOCID 766088] (stating Repo 105 usage on Apr. 21, 2008 was $21.907 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Apr. 28, 2008) [LBEX‐DOCID 766092] (stating Repo 105 usage on Apr. 28, 2008 was $24.077 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Draft) (Apr. 30, 2008) [LBEX‐DOCID 394333] (stating Repo 105 usage on Apr. 30, 2008 was $24.709 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (May 6, 2008) [LBEX‐DOCID 766102] (stating Repo 105 usage on May 6, 2008 was $24.388 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (May 12, 2008) [LBEX‐DOCID 766107] (stating Repo 105 usage on May 12, 2008 was $25.550 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (May 13, 2008) [LBEX‐DOCID 766107] (stating Repo 105 usage on May 13, 2008 was $25.282 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (May 27, 2008) [LBEX‐ DOCID 3237577] (stating Repo 105 usage on May 27, 2008 was $39.237 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (May 28, 2008) [LBEX‐DOCID 766924] (stating Repo 105 usage on May 28, 2008 was $43.112 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (May 29, 2008) (stating Repo 105 usage on May 29, 2008 was $46.820 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (May 30, 2008) [LBEX‐DOCID 1427836] (stating Repo 105 usage on May 30, 2008, a quarter end, was $50.383 billion); Lehman, Total Repo 105 & Repo 108 Report (July 14, 2008) [LBEX‐DOCID 3363529] (stating Repo 105 usage on July 14, 2008 was $17.315 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (July 15, 2008) [LBEX‐DOCID 3363529] (stating Repo 105 usage on July 15, 2008 was $16.828 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (July 21, 2008) [LBEX‐DOCID 3363538] (stating Repo 105 usage on July 21, 2008 was $15.528 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (July 23, 2008) [LBEX‐DOCID 3363541] (stating Repo 105 usage on July 23, 2008 was $14.786 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (July 29, 2008) [LBEX‐DOCID 3363542] (stating Repo 105 usage on July 29, 2008 was $14.548 billion); Lehman, Global Consolidated Balance Sheet, Global Consolidated Summary (Aug. 14, 2008) [LBEX‐DOCID 84891] (stating Repo 105 usage on Aug. 14, 2008 was $18.274 billion).

875 876

¶The chart above, for illustrative purposes only, uses confirmed Repo 105 data reported in Lehman's Global Consolidated Balance Sheet, a comprehensive report Lehman produced for purposes of tracking its success in achieving its gross and net balance sheet targets.³³⁶⁶³³⁶⁶ See note 3365, supra (providing more data from Lehman's Global Consolidated Balance Sheet regarding Repo 105 usage on particular dates) and Appendix 17, Repo 105 Appendix (providing data in table form). Lehman's Global Consolidated Balance Sheet generally summarized, by division and business unit, Lehman's consolidated financial position – e.g., its balance sheet size, day‐over‐day changes, net and gross balance sheet targets, amounts by which it was over/under targets – and the impact of Repo 105 on the net balance sheet was summarized as well. The impact of Repo 105 on Lehman's gross and net balance sheet as presented in the Global Consolidated Balance Sheet reports is consistent with the impact of Repo 105 usage on Lehman's net balance sheet that Duff & Phelps independently ascertained in its analyses. See Duff & Phelps, Assumed Hierarchy of Repo 105 Usage Data (Jan. 26, 2010), at p. 2 (also stating that Lehman's Global Consolidated Balance Sheet data on Repo 105 is very authoritative).Show full note The data from the Global Consolidated Balance Sheets demonstrate that Lehman's Repo 105 usage spiked at quarter‐ends and fell off on an intra‐quarter basis.³³⁶⁷³³⁶⁷ See note 3365, supra; Appendix 17, Repo 105 Appendix.

¶Lehman consistently failed to comply with the 80/20 rule.³³⁶⁸³³⁶⁸ Duff & Phelps, Repo 105/108 Usage vs. Limit Comment (Oct. 16, 2009), at p. 7; see also e‐mail from Michael McGarvey, Lehman, to Clement Bernard, Lehman (Jan. 30, 2008) [LBEX‐DOCID 2796630] ("We increase the balances for month end but try to keep it within 120 percent of the average daily usage (we are decent at this, not great.)"). For most months (and all quarter‐end months) Lehman failed to maintain an average daily balance throughout the month that equaled or exceeded 80% of the month‐end balance.³³⁶⁹³³⁶⁹ See Duff & Phelps, Repo 105/108 Usage vs. Limit Comment (Oct. 16, 2009), at p. 7. Similarly, at every quarter‐end (and most month ends) after the first quarter 2006, Lehman's Repo 105 usage exceeded 120% of the preceding month's daily average usage.³³⁷⁰³³⁷⁰ See id.

877

Repo 105 Transactions Served No Business Purpose Other Than Balance Sheet Reduction

¶When pressed to identify any legitimate business purpose for Lehman's use of Repo 105 transactions, several witnesses noted the secured short‐term financing for the transactions in addition to the balance sheet reduction purpose.³³⁷¹³³⁷¹ Examiner's Interview of Mark Gavin, Sept. 24, 2009, at pp. 4‐5 (stating that primary purpose of Repo 105 transactions was balance sheet management, but stating that they also had a funding purpose, though repeatedly acknowledging that "a regular repo would have been cheaper"); Examiner's Interview of John Coghlan, Nov. 11, 2009, at p. 7 (stating that the purpose was balance sheet reduction and financing, and acknowledging that Repo 105 transactions were more expensive than ordinary repo transactions).Show full note While one consequence of Repo 105 transactions was that Lehman received financing in exchange for collateral (which, as noted above, it did not record as a borrowing), a Repo 105 transaction was a more expensive way for Lehman to secure short‐term financing as compared to an ordinary repo.³³⁷²³³⁷² Examiner's Interview of Mitchell King, Sept. 21, 2009, at p. 7; Examiner's Interview of Mark Gavin, Sept. 24, 2009, at pp.4‐5; Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 6; Examiner's Interview of Matthew Lee, July 1, 2009, at p. 14.

Repo 105 Transactions Came at a Higher Cost Than Ordinary Repo Transactions

¶Nothing prevented Lehman from engaging in a traditional overnight repo transaction – using the same assets, with the same counterparty, but at a lower haircut (e.g., 102 assets/$100 versus 105 or 108 assets/$100) and lower cost – on any particular date when Lehman engaged in a Repo 105 transaction.³³⁷³³³⁷³ Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 6 (stating that the same assets could be used in either an ordinary repo or a Repo 105 transaction, that with most counterparties, Lehman had the capacity to do either type of transaction). This is not to suggest that any counterparty with which Lehman engaged in ordinary repos would have also agreed to enter into a Repo 105 agreement with Lehman. Rather, Repo 105 counterparties would have been willing to enter into ordinary repo transactions.Show full note The more expensive route was taken because the traditional repo transaction would not have provided Lehman the balance sheet benefit that Repo 105 transactions provided to the firm – namely, Repo 105 transactions enabled Lehman to reverse engineer its externally reported net balance sheet and net leverage ratio for public consumption.³³⁷⁴³³⁷⁴ Examiner's Interview of Mark Gavin, Sept. 24, 2009, at pp. 4‐5 (stating that a regular repo transaction would have been cheaper than a Repo 105 transaction and that the latter was chosen for balance sheet management); Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 6 (stating that Repo 105 transactions were more expensive and that Lehman engaged in them because "[c]learly, this was an effort to reduce balance sheet."); Examiner's Interview of Matthew Lee, July 1, 2009, at p. 14.Show full note

878

¶A Repo 105 transaction was more expensive to Lehman than an ordinary repo transaction for several reasons:³³⁷⁵³³⁷⁵ Andrew J. Morton Interview, Sept. 21, 2009, at p. 22 (Repo 105 transaction more expensive than ordinary repo transaction); Examiner's Interview of John Coghlan, Nov. 11, 2009, at p. 7 (same); e‐mail from Mark Gavin, Lehman, to Mark Neller, Lehman, et al. (Aug. 26, 2008) [LBEX‐DOCID 3232989] ("FYI – am now running into pretty unpalatable levels on these trades . . . .")

● Repo 105 transactions generally carried a higher yield, that is, the interest rate the counterparty charged Lehman for the borrowing.³³⁷⁶³³⁷⁶ Examiner's Interview of Mitchell King, Sept. 21, 2009, at p. 7 (stating that Repo 105 was "more costly" and "expensive way to finance," that he believed the charges were "unfair," and that there were sometimes discrepancies of 5 bps in the amount different Repo 105 counterparties charged for the same securities); Examiner's Interview of Mark Gavin, Sept. 24, 2009, at p. 7 (explaining that haircut, interest rate, and offshore trading made Repo 105 more expensive than ordinary repo); Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 5 (explaining why Repo 105 more expensive than ordinary repo). But note that Kaushik Amin said even though Repo 105 transactions were costlier than regular repo transactions, the additional cost was negligible and immaterial. Examiner's Interview of Kaushik Amin, Sept. 17, 2009, at p. 7. Unlike ordinary repos, the most common of whose term was overnight, Repo 105 transactions typically had a seven or ten day term. The longer term could carry a costlier interest rate than the overnight rate. However, during the relevant period (late 2007 to 2008), the interest rate on overnight repos was just as likely to be more expensive than the interest rate on a week‐long repo using the sameShow full note "[C]ertain of our counterparties charge very expensive levels [for Repo 105], so we cannot retain those types of trades for any longer than necessary."³³⁷⁷³³⁷⁷ E‐mail from Mitchell King, Lehman, to Mark Gavin, Lehman, et al. (Dec. 3, 2007) [LBEX‐DOCID 3232555].

879

● As set forth above, Repo 105 transactions were required to carry a higher margin or haircut (e.g., the minimum five percent haircut for Repo 105 transactions, as opposed to a two percent haircut for an ordinary repo transaction using highly liquid collateral), which Lehman itself had to fund.³³⁷⁸³³⁷⁸ Examiner's Interview of Mitchell King, Sept. 21, 2009, at p. 7 (stating that Repo 105 was "more costly" and "expensive way to finance," that he believed the charges were "unfair," and that there were sometimes discrepancies in the amount different Repo 105 counterparties charged for the same securities); Examiner's Interview of Mark Gavin, Sept. 24, 2009, at p. 7 (explaining that haircut, interest rate, and offshore trading made Repo 105 more expensive than ordinary repo); Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 5 (explaining why Repo 105 more expensive than ordinary repo). In late 2007 and 2008, Lehman often faced a 6.5% or higher haircut on Repo 105 transactions and a nine percent haircut on Repo 108 transactions. Lehman had been "losing liquidity" since July 2007, as repo lenders across the board gradually increased collateral requirements in their transactions with Lehman. Examiner's Interview of Richard Policke, May 28, 2009, at p. 4; see also Peter Hordahl & Michael R. King, Developments in Repo Markets During the Financial Turmoil, Banking Int'l Settlements Q. Rev., Dec. 2008, at 37 (focusing on the period since the start of the financial turmoil in mid‐2007 and noting that "[a]s financing in unsecured markets became more expensive or unavailable, financial institutions with funding requirements bid more aggressively in repo markets to secure financing"); Gary Gorton, National Bureau of Economic Research, Securitized Banking and the Run on Repo, Yale ICF Working Paper No. 09‐14 (Nov. 13, 2009), at 1, available at: http://ssrn.com/abstract=1440752 ("We argue that the financial crisis that began in August 2007 is a 'systemic event'. . . . We argue that the current crisis is similar [to the banking panics of the 19th century] in that contagion led to . . . unprecedented repo haircuts and even the cessation of repo lending on many forms of collateral."). Consequently, it appears that haircuts for all repos – not just Repo 105 transactions – could have increased in mid‐2007 and 2008. See e‐mail from Michael McGarvey, Lehman, to Divyesh Chokshi, Lehman (Aug. 21, 2007) [LBEX‐DOCID 3234192] ("I was on a call with the funding desk on Friday and was told they were having difficulty maintaining Repo 105 term liquidity on even the best collateral."); e‐mail from Michael McGarvey, Lehman, to Anuraj Bismal, Lehman (Aug. 23, 2007) [LBEX‐DOCID 3232709] (stating that Mizuho rejected Freddie Mac subdebt for Repo 105 transactions and that "[t]his is just indicative of the liquidity situation in the market."); e‐mail from Michael McGarvey, Lehman, to Anuraj Bismal, Lehman, et al. (Jan. 31, 2008) [LBEX‐DOCID 3223415] (referring to "disruptions in the repo market which Jawad described as the worst he's seen in 7 years").Show full note That is, Lehman would have had to fund the additional haircut by either dipping into its equity or through long term borrowings.³³⁷⁹³³⁷⁹ The contribution to the cost of a Repo 105 transaction of 3% additional collateral, relative to an ordinary repo, is significant. Ultimately, if all other features of a Repo 105 and ordinary repo transaction (including stated interest rate) were identical, the Repo 105 transaction would be more expensive. This is John

¶treasury collateral. See Bloomberg Finance L.P. "RP GT 01D" Repo Financing OVERNIGHT and "RP GT 01W" Repo Financing 1 Week. Consequently, the higher interest rate in a Repo 105 could not have been a function of the term of the repo.

880

Feraca, who was responsible for Lehman's Secured Funding Desk, said that unlike ordinary repo haircuts, the haircut on a Repo 105 was funded with more expensive forms of financing, such as long term debt.³³⁸⁰³³⁸⁰ Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 5.

● "Offshore trading" of United States agency securities, treasuries, and government securities was potentially more expensive than domestic trading within the United States.³³⁸¹³³⁸¹ Examiner's Interview of Mark Gavin, Sept. 24, 2009, at p. 7. (Recall that a substantial volume of Lehman's Repo 105 transactions, conducted in Europe, involved these types of securities).

● As one witness recalled, "We were in a bit of a price‐taking situation because the range of [Repo 105] counterparties was limited."³³⁸²³³⁸² Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 5; see also e‐mail from Stephen Gerber, Lehman, to Gary Lynn, Lehman (Aug. 22, 2007) [LBEX‐DOCID 3234616] (responding to Gerber's statement that "As we discussed yesterday, counterparties are getting a little pickier with Repo," by stating, "Uh oh…is this for repo 105?" to which Gerber responded: "Yes."). In the 2007 to 2008 period, Lehman's Repo 105 counterparties were primarily restricted to Mizuho, Barclays, UBS, Mitsubishi, and KBC, though some of these also tapered off their Repo 105 trading in 2008. E‐mail from Chaz Gothard, Lehman, to Mark Gavin, Lehman, et al. (Sept. 4, 2007) [LBEX‐DOCID 4553246] ("KBC are no longer able to finance our 105 agency trades. . . . This effectively means we only have 3 counterparts with which to transact this business – Mizuho, Barclays & UBS. Whilst they have taken all the paper we've thrown at them to date this situation should not be relied upon."); e‐mail from John Feraca, Lehman, to Ian T. Lowitt, Lehman, et al. (Feb. 28, 2008) [LBEX‐DOCID 3207903] (reporting Repo 105 trades with "Barclays – $ 3 billion, UBS – $ 6 billion, Mizuho – $ 2 billion"); e‐mail from Mark Gavin, Lehman, to Daniel Malone, Lehman, et al. (May 20, 2008) [LBEX‐DOCID 736184] (noting in e‐mail with subject line "RE: Repo 105 CPS" that "Mizuho ‐ $5bln," "[n]o longer at the table: Barclays up to $15 bln," "UBS up to $10 bln," "Mitsubishi up to $1 bln," and "KBC up to $2 bln"); see also Lehman, US Agency Desk, Repo 105 12 Mar–19 Mar Mizuho @ 2.73% (Mar. 12, 2008) [LBEX‐DOCID 4523953] (listing 6.5% haircut on Repo 105 transactions); Lehman, US Agency Desk, Repo 105 12 Mar–19 Mar. UBS @ 3.10% (Mar. 12, 2008) [LBEX‐DOCID 4523950] (listing seven percent haircut on Repo 105 transactions); Lehman, US Agency Desk Repo 105 12 Mar–19 Mar UBS @ 2.75% (Mar. 12, 2008) [LBEX‐DOCID 4523955] (listing 6.5% haircut on Repo 105 transactions); Lehman, US Agency Desk, Repo 105 28 May–4 Jun Mizuho @ 2.24 (May 27, 2008) [LBEX‐DOCID 4523968] (reflecting haircuts on Repo 105 transactions ranging from 6.5% to 210%); Lehman, US Agency Desk, Repo 105 Mizuho 28 May–4 June (May 27, 2008) (showing 2.6% and 2.42% interest rate and 6.5% haircut on Repo 105 transaction). Lehman frequently petitioned to expand its Repo 105 line with Mizuho. See, e.g., E‐mail from Paolo R. Tonucci, Lehman, to Matthew Pinnock, Lehman (May 22, 2008) [LBEX‐DOCID 1548434] ("Think I can get Chris [O'Meara] to agree [to] another $2 bill, but it is critical to get some context around what is changing."). In May 2008, only ten days before quarter‐end, Matthew Pinnock, on behalf of Jeff Michaels and Kaushik Amin of FID, attempted to increase its Repo 105 line with counterparty Mizuho. Id. Tonucci and O'Meara were involved in this process of authorizing a temporary increase in Lehman's Repo 105 capacity limits for the close of second quarter 2008. Id. In February 2008, Lehman found a new Repo 105 counterparty in ABN Amro Bank NV (London Branch). See e‐mail from Nirav Patel, Lehman, to Kandy Hosea, Lehman, et al. (Feb. 29, 2008) [LBEX‐DOCID 3383394]. Deutsche Bank was also a Repo 105 counterparty to Lehman in 2008. When a Repo 105 transaction with Deutsche Bank failed, Tonucci assigned Carlo Pellerani (International Treasurer) to ensure the problem was resolved. See e‐mail from Paolo R. Tonucci, Lehman, to John Coghlan, Lehman (Mar. 25, 2008) [LBEX‐DOCID 117336].Show full note

¶due to the fact that the additional overcollateralization of Repo 105 borrowings was not financeable in the transaction and had to be funded by Lehman itself with equity or other long‐term, more permanent forms of funding that carried higher costs. Further, the haircut determined the amount of leverage an institution undertook in a transaction. Such increases in haircuts from very low levels can have a particularly harmful impact on an institution's ability to maintain its level of earnings and its return on equity. This places a significant burden, potentially including the need to raise equity capital, on institutions that experience increasing haircuts. See Tobias Adrian, et al. Financial Intermediaries, Financial Stability and Monetary Policy, Federal Reserve Bank of New York Staff Report No. 346 (Sept. 2008), at pp. 11‐13, available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1266714.

881

¶Many variables impacted the interest rate for both an ordinary repo transaction and a Repo 105 transaction, so it is difficult to precisely measure the magnitude by which the interest rate on a Repo 105 was greater than an ordinary repo.³³⁸³³³⁸³ Lehman's Repo Manual, a reference guide the firm published for internal use by its own sales people, provided that "[T]he rate used to calculate the interest is a function of many factors, including, but not limited to: the supply and demand for the securities used as collateral, the supply and demand for cash, the maturity of the Repo, and the method used to transfer the securities used as collateral from the dealer to the investor." Lehman, Repo Manual (Nov. 8, 2005), at p. 10 [LBEX‐LL 1175483]. The Manual also stated that the repo interest rate "bears no relation to the interest rate on the securities used as collateral." Id. The calculation of the repo interest rate payment is as follows: (cash investment) x (repo interest rate) x (number of days repo outstanding) divided by 360 = repo interest. Id.Show full note However, witnesses who have knowledge on the subject uniformly advised the Examiner that Repo 105 trades generally were more expensive to Lehman than ordinary repos.³³⁸⁴³³⁸⁴ Examiner's Interview of Anuraj Bismal, Sept. 16, 2009, at p. 10; Examiner's Interview of Mitchell King, Sept. 21, 2009, at p. 7; Examiner's Interview of Mark Gavin, Sept. 24, 2009, at p. 7; Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 5; Examiner's Interview of John Coghlan, Nov. 11, 2009, at p. 7.

¶As one e‐mail succinctly states: "Everyone knows 105 is an off balance sheet mechanism so counterparties are looking for ridiculous levels to take them."³³⁸⁵³³⁸⁵ E‐mail from Michael McGarvey, Lehman, to Anuraj Bismal, Lehman (Jan. 31, 2008) [LBEX‐DOCID 3384033]. Given that in a Repo 105 transaction, Lehman provided its counterparty with more collateral for the same amount of cash as in an ordinary repo, one might expect the interest rate to be lower, as the terms were better for the lender, i.e., had greater protection in the form of more collateral in the case Lehman did not repay its borrowing. The Examiner's analysis shows that, on the contrary, the interest rate in a Repo 105 transaction was higher than in an ordinary week‐long repo despite the overcollateralization. Based on witness statements that Lehman was in a "price taking situation," and documents such as the e‐mail in which Lehman staffers begged to increase the Repo 105 credit line with Mizuho to improve the balance sheet profile at quarter end, the higher interest rate in a Repo 105 transaction was likely a consequence of Repo 105 counterparties being aware of Lehman's desperation. Examiner's Interview of John Feraca (Oct. 9, 2009), at p. 5; see e‐mail from Stephen Allery, Lehman, to Miyuki Suzuki, Lehman (Feb. 19, 2008) [LBEX‐DOCID 098492].Show full note Asked by the Examiner to explain this statement, McGarvey, the author of the e‐mail, stated that counterparties such as Mizuho knew that Repo 105 transactions received off‐ balance sheet treatment and as a result might "try to squeeze Lehman."³³⁸⁶³³⁸⁶ Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 10.

882

Witnesses Also Stated That Financing Was Not the Real Motive for Undertaking Repo 105 Transactions

¶When asked directly, Joseph Gentile, a former FID Finance executive who reported to Gerard Reilly, did not believe that Lehman's motive for undertaking Repo 105 transactions was financing.³³⁸⁷³³⁸⁷ Examiner's Interview of Joseph Gentile, Oct. 21, 2009, at pp. 6‐7. Similarly, Irina Veksler believed that Repo 105 transactions were not used to generate liquidity. Examiner's Interview of Irina Veksler, Sept. 11, 2009, at p. 8. What these witnesses meant is that Lehman's motive or purpose for entering into Repo 105 transactions was not financing. In other words, although Lehman received cash just as it did in an ordinary repo transaction, this was just an outcome of the transaction but not Lehman's motive for undertaking Repo 105 transactions. As described in detail in this Report, Lehman conceived its Repo 105 program for purposes of managing its balance sheet, particularly at quarter‐end reporting periods. If Lehman had actually wanted to use its assets for purely financing arrangements to raise needed cash, Repo 105 transactions were a costlier and less effective means of generating liquidity than ordinary repo transactions.Show full note Gentile stated unequivocally that no business purpose for Lehman's Repo 105 transactions existed other than obtaining balance sheet relief.³³⁸⁸³³⁸⁸ Examiner's Interview of Joseph Gentile, Oct. 21, 2009, at p. 6. Gentile said that he received his "Repo 105 education" sometime near the end of Lehman's 2006 fiscal year from Ed Grieb, Lehman's Global Financial Controller who reported directly to then‐CFO Chris O'Meara.³³⁸⁹³³⁸⁹ Id. Before arriving at Lehman in June 2006, Gentile had never heard of Repo 105 transactions, either by name or description. Id. Without any prompting, Gentile said that it was his understanding that neither JP Morgan, where Gentile he had worked for 11 years, nor Bank of America, where he had worked for 5 years, used such a mechanism. Id. According to Gentile, Grieb explained that Repo 105 transactions were a balance sheet management mechanism: "a tool that could be used to reduce Lehman's net balance sheet."³³⁹⁰³³⁹⁰ Id. John Feraca similarly told the Examiner that the purpose of Repo 105 transactions was to take advantage of SFAS 140 for purposes of managing its balance sheet. Examiner's Interview of John Feraca, Oct. 9, 2009, at pp. 6‐7, 12‐13.

883

¶Though Gentile did not understand the specific mechanics of Repo 105 transactions, he recalled that "Repo 105 was a vehicle that Grieb owned and he was using it to take my balance sheet away."³³⁹¹³³⁹¹ Examiner's Interview of Joseph Gentile, Oct. 21, 2009, at p. 6. When the Examiner asked for further explanation of that statement, Gentile said that if FID had "excessions" in its balance sheet, Grieb would authorize additional Repo 105 capacity to alleviate potential breaches of the balance sheet limit.³³⁹²³³⁹² Id. As Lehman's quarter‐end approached, O'Meara, Grieb and Reilly would pressure Gentile to ensure that FID met its balance sheet targets. Id. Grieb, on the other hand, denied having any recollection of Lehman facing balance sheet pressures in its Fixed Income Division in 2007. Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 11. Gentile explained that two ways existed for FID to make its balance sheet targets where excessions existed: by selling assets or by engaging in Repo 105 transactions.³³⁹³³³⁹³ Examiner's Interview of Joseph Gentile, Oct. 21, 2009, at p. 6. Repo 105 transactions filled the gap between what Lehman could sell through normal business practices and the assets that Lehman needed to move off its balance sheet in order to meet balance sheet targets.³³⁹⁴³³⁹⁴ See, e.g., E‐mail from Kaushik Amin, Lehman, to Herbert H. (Bart) McDade III, Lehman (June 3, 2008) [LBEX‐DOCID 574610] (stating that the Liquid Markets business within FID "targeted lower numbers since the rest of FID was having difficulty meeting its target," transmitting Liquid Markets Balance Sheet Report for May 30, 2008 [LBEX‐DOCID 522198] showing that Liquid Markets used $42.221 billion in Repo 105 transactions to come in $9.2 billion below its quarter‐end net balance sheet target, and stating "we spent a lot of money to achieve these targets. Now, we have to make money").Show full note

884

¶Similarly, Matthew Lee said there was no legitimate business purpose for Repo 105 transactions.³³⁹⁵³³⁹⁵ Examiner's Interview of Matthew Lee, July 1, 2009, at p. 16. In his view, Lehman's Repo 105 practice was for "window‐dressing the balance sheet to make the credit rating higher."³³⁹⁶³³⁹⁶ Id.

The Materiality of Lehman's Repo 105 Practice

The Repo 105 Program Exposed Lehman to Potential "Reputational Risk"

¶Martin Kelly, who CFO Erin Callan hand‐picked to assume the role of Global Financial Controller on December 1, 2007 (replacing Ed Grieb) and who retained that position until Lehman's bankruptcy petition date in September 2008, first became familiar with Lehman's use of Repo 105 transactions soon after he became Financial Controller.³³⁹⁷³³⁹⁷ Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 6. Kelly described a transition period at the end of 2007, when Grieb was transitioning out of the role of Financial Controller and Kelly was transitioning in. Id. In a November 6, 2007 e‐mail, Marie Stewart (Global Head of Accounting Policy) sent Kelly a copy of the August 2007 version of the Balance Sheet Netting Grid, an accounting policy document that outlined the various mechanisms by which Lehman made adjustments to its balance sheet. E‐mail from Marie Stewart, Lehman to Martin Kelly, Lehman (Nov. 6, 2007) [LBEX‐DOCID 2736621] (stating "this is the doc that summarizes every reason we net down the b/sheet. As discussed, E&Y are in the process of reviewing it" and transmitting Accounting Policy Review Balance Sheet Netting and Other Adjustments (Aug. 2007) [LBEX‐DOCID 2720761] ("The Netting Grid")). The Netting Grid includes a brief discussion of the Repo 105 program. See Accounting Policy Review Balance Sheet Netting and Other Adjustments (Aug. 2007), at p. 26 [LBEX‐DOCID 2720761] ("Under certain conditions that meet the criteria as described in paragraphs 9 and 218 of FAS 140, Lehman policy permits…repo agreements to be recharacterized as purchases and sales of inventory."). An e‐mail from December 2007 reveals that Kelly and Stewart intended to discuss the Repo 105 program sometime after Lehman filed its 2007 Form 10‐K. See e‐mail from Marie Stewart, Lehman, to Martin Kelly, Lehman (Dec. 18, 2007) [LBEX‐DOCID 3221244].Show full note Lehman's reliance on Repo 105 transactions for balance sheet relief caused Kelly "discomfort,"³³⁹⁸³³⁹⁸ Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 7. because of the magnitude of Lehman's usage and, in part, because he believed Lehman was the last of its peer CSE firms to employ similar accounting for these types of transactions.³³⁹⁹³³⁹⁹ Id.The Balance Sheet Group regularly apprised Kelly of the volume of Lehman's Repo 105 transactions. See, e.g., E‐mail from Anuraj Bismal, Lehman, to Martin Kelly, Lehman, et al. (Dec. 5, 2007) [LBEX‐DOCID 3223388] ("We ended the year with $38 billion of repo 105/8 nettings"); Lehman, Current Day November 30, 2007 Total Repo 105 and Repo 108 Graph (Dec. 5, 2007) [LBEX‐DOCID 3238265] (attached to e‐mail from Anuraj Bismal, Lehman, to Martin Kelly, Lehman, et al. (Dec. 5, 2007) [LBEX‐ DOCID 3223388] and stating that total Repo 105 usage on November 30, 2007 was $38.634 billion); e‐mail from Anuraj Bismal, Lehman, to Martin Kelly, Lehman, et al. (Feb. 28, 2008) [LBEX‐DOCID 3223439] ("Per PC ‐ look like Repo 105/108 may land at $40B or slightly higher"); e‐mail from Anuraj Bismal, Lehman, to Martin Kelly, Lehman, et al. (Mar. 6, 2008) [LBEX‐DOCID 3223441] ("Our initial estimates are that for Q1 2008 we used $48 Billion of repo 105/8 nettings."). Numerous witnesses and internal e‐mails state that Lehman was the last of its peer investment banks to be using Repo 105‐type transactions by December 2007. The Examiner has not verified whether other CSE firms had at one time used these kinds of transactions but later ceased using them. Bismal, Stewart, and McGarvey said that they believed that Lehman was the only CSE firm engaging in Repo 105 transactions by late 2007. Murtaza Bhallo said that Barclays did not use Repo 105 transactions. Joseph Gentile said that he had personal knowledge that JP Morgan and Bank of America did not engage in Repo 105‐type transactions for managing their respective balance sheets. In December 2007, Bismal wrote: "Was chatting with ex‐lehman employee [Carlos Lo] at Merrill yesterday – he is in their balance sheet group – he told me that they do not use repo 105/8," to which Marie Stewart replied, "Then that means we are the only one left who does." E‐mail from Anuraj Bismal, Lehman, to Marie Stewart, Lehman (Dec. 5, 2007) [LBEX‐DOCID 3223386]. In a January 2008 e‐ mail, McGarvey wrote: "By the way we are now the only large firm on the street that uses Repo 105." E‐ mail from Michael McGarvey, Lehman, to Clement Bernard, Lehman (Jan. 30, 2008) [LBEX‐DOCID 2796630]. In a May 2008 e‐mail from Ryan Traversari to O'Meara, Traversari reported that Citigroup and JP Morgan "likely do not do Repo 105 and Repo 108 which are UK‐based specific transactions on opinions received by LEH from Linklaters. This would be another reason why LEHʹs daily balance sheet is larger intra‐month then at month‐end." E‐mail from Ryan Traversari, Lehman, to Christopher M. O'Meara, Lehman, et al. (May 16, 2008) [LBEX‐DOCID 574498].Show full note

885

¶Kelly further attributed his discomfort with Lehman's use of Repo 105 transactions to the fact "that the only purpose or motive for the transactions was reduction in balance sheet" and that "there was no substance to the transactions."³⁴⁰⁰³⁴⁰⁰ Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 7. Kelly thought that the lack of business purpose for these transactions, combined with the magnitude of Lehman's Repo 105 usage at quarter‐end (at $38.6 billion at fiscal year end 2007, when Kelly became Global Financial Controller) carried a potential for "reputational risk" to Lehman and that, should it become public knowledge, it may "reflect[] poorly on the firm."³⁴⁰¹³⁴⁰¹ Id.; cf. e‐mail from Martin Kelly, Lehman, to Kaushik Amin, Lehman (Apr. 17, 2008) [LBEX‐DOCID 488108] ("[Repo 105] Program has some risk to it. Reluctance to expand to new regions/geographies.").

886

¶Kelly further explained that "the size of the program in an absolute sense was of a size that presented headline risk," particularly as "the program was skewed to quarter ends."³⁴⁰²³⁴⁰² Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 8. When asked by the Examiner what he meant by "headline risk," Kelly stated that "if there were more transparency to people outside the firm around the transactions, it would present a dim picture" of Lehman.³⁴⁰³³⁴⁰³ Id.

¶Lehman's increasing reliance on the Repo 105 transactions and the absence of any disclosure of that fact in Lehman's Forms 10‐Q and 10‐K disquieted Kelly; he remarked that if an analyst or a member of the investing public were to read Lehman's Forms 10‐Q and 10‐K from cover to cover, taking as much time as she or he needed, "they would have no transparency into [Lehman's] Repo 105 program"³⁴⁰⁴³⁴⁰⁴ Id.

¶Kelly's concerns about Lehman's use of Repo 105 transactions prompted him to raise them to both of the Chief Financial Officers in place during Kelly's tenure as Global Financial Controller: Erin Callan and, later, Ian Lowitt.³⁴⁰⁵³⁴⁰⁵ Id.; see also e‐mail from Marie Stewart, Lehman, to Dominic Gibb, Lehman (Dec. 21, 2007) [LBEX‐ DOCID 3223846] ("FYI that our use of Repo 105 is a conversation at the CFO level at this point."). According to Kelly, "the purpose of the conversations being to make sure they understood the size of the program and that there was risk in the program."³⁴⁰⁶³⁴⁰⁶ Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 8.

887

¶Kelly spoke first to Callan and then to Lowitt, Callan's successor, regarding Lehman's use of Repo 105 transactions on separate occasions when each was serving as Lehman's CFO.³⁴⁰⁷³⁴⁰⁷ Id. Kelly recalled raising the following topics in his Repo 105 conversations with both Callan and Lowitt: (1) Kelly's discomfort with the possible "reputational risk" Lehman would suffer if the investing public and analysts learned that Lehman used Repo 105 transactions solely to reduce its balance sheet; (2) the size of Lehman's Repo 105 program, that is, the volume of Repo 105 transactions that Lehman undertook at quarter‐end to reduce its balance sheet; (3) the "technical basis," from an accounting perspective, by which Lehman was authorized to engage in Repo 105 transactions; (4) Kelly's belief that none of Lehman's peer investment banks used Repo 105 transactions; and (5) the fact that Lehman's Repo 105 activity was "skewed at quarter‐end," in other words, that the firm's Repo 105 usage spiked at quarter‐end, during Lehman's reporting periods.³⁴⁰⁸³⁴⁰⁸ Id. Kelly's discussion with the CFOs is discussed further at Sections III.A.4.h.2.b–c of this Report.

888

Lehman's Repo 105 Practice Had a Material Impact on Lehman's Net Leverage Ratio

¶Lehman's Repo 105 practice at quarter‐end in late 2007 and for the first two quarters 2008 had a material impact on Lehman's publicly‐reported net leverage ratio – and Lehman management knew it. For example, in a December 5, 2007 e‐mail, Bismal reported that Lehman "would be at net leverage of 18.0x [vs say 16.3x] without repo 105/8."³⁴⁰⁹³⁴⁰⁹ E‐mail from Anuraj Bismal, Lehman, to Marie Stewart, Lehman, et al. (Dec. 5, 2007) [LBEX‐DOCID 3223384]. Consistent with Bismal's e‐mail, Lehman publicly reported a firm‐wide net leverage ratio of 16.1x in its Form 10‐K for the 2007 fiscal year.³⁴¹⁰³⁴¹⁰ LBHI 2007 10‐K, at pp. 29, 64.

¶Using Lehman's firm‐wide Repo 105 usage at the end of each quarter from November 2006 through May 2008, the Examiner analyzed the impact that Lehman's removal of assets from its balance sheet using Repo 105 transactions had on the firm's publicly‐reported net leverage ratio. As the chart below demonstrates, for each of those seven reporting periods – fourth quarter 2006 through second quarter 2008 – by employing Repo 105 transactions rather than ordinary repo transactions, Lehman was able to reduce its published net leverage ratio by a minimum of 9%, with that reduction increasing to 12% and 15% in first quarter 2008 and second quarter 2008, respectively:

889

¶Gross and Net Balance Sheet Ratios

At the Quarter Ended May 31 Feb 29, Nov 30, Aug 31, May 31, Feb 28, Nov 30,

¶

$ in Millions 2008 2008 2007 2007 2007 2007 — 2006

¶(a) Total Assets 639,432 786,035 691,063 659,216 605,861 562,283 503,545

Less: Cash and securities segregated and on deposit for regulatory and other purposes (13,031) (16,569) (12,743) (10,579) (7,154) (6,293) (6,091) Collateralized lending agreements * (294,526) (368,681) (301,234) (287,427) (257,388) (251,662) (225,156) Identifiable intangible assets and goodwill (4,101) (4,112) (4,127) (4,108) (3,652) (3,531) (3,362)

¶(b) Net Assets 327,774 396,673 372,959 357,102 337,667 300,797 268,936

¶(c) Total Stockholder's Equity 26,276 24,832 22,490 21,733 21,129 20,005 19,191

¶(d) Tangible Equity Capital ** 27,179 25,696 23,103 22,164 21,881 19,487 18,567

Leverage Ratio (a) / (c) 24.3 x 31.7 x 30.7 x 30.3 x 28.7 x 28.1 x 26.2 x Net Leverage Ratio (b) / (d) 12.1 x 15.4 x 16.1 x 16.1 x 15.4 x 15.4 x 14.5 x

¶(e) Repo 105/108 Usage 50,383 49,102 38,634 36,407 31,943 27,284 24,519

¶If repos were used in place of repo 105s:

Leverage Ratio ((a) + (e)) / (c) 26.3 x 33.6 x 32.4 x 32.0 x 30.2 x 29.5 x 27.5 x % increase over actual Leverage Ratio 8% 6% 6% 6% 5% 5% 5% Net Leverage Ratio ((b) + (e)) / (d) 13.9 x 17.3 x 17.8 x 17.8 x 16.9 x 16.8 x 15.8 x % increase over actual Net Leverage Ratio 15% 12% 10% 10% 9% 9% 9%

¶Notes:

¶

Collateralized lending agreements are securities received as collateral, securities purchased under agreements to resell, and securities borrowed

¶** Tangible Equity Capital is Total Stockholders' Equity plus junior subordinated notes less identifiable intangible assets and goodwill.

¶Sources:

¶Asset and Equity data: Lehman Brothers' SEC 10‐K and 10‐Q filings.

¶Repo 105/108 Usage: Q4 2006, Q1, Q2 and Q3 2007: LBEX‐DOCID 3363434; Q4 2007: LBEX‐DOCID 3219746; Q1 and Q2 2008: LBEX‐DOCID 2078195

890

¶As a result of its quarter‐end Repo 105 practice from late 2007 through the second quarter 2008, Lehman publicly reported a net leverage ratio that was 1.7 to 1.9 points lower than what its net leverage ratio would have been if Lehman had used ordinary repo transactions instead of Repo 105 transactions.

Lehman Significantly Expanded Its Repo 105 Practice in Late 2007 and Early 2008

¶Although Lehman had used Repo 105 transactions since 2001, beginning in mid‐ 2007, Lehman required greater amounts of Repo 105 relief to improve its reported net leverage ratio.³⁴¹³³⁴¹³ Andrew Morton, the former Global Head of Lehman's Fixed Income Division, stated that Lehman established limits on Repo 105 usage at the inception of the program in 2001. Examiner's Interview of Andrew J. Morton, Sept. 21, 2009, at p. 4. John Feraca also recalled that Lehman placed limits on Repo 105 usage at the program's inception: "There were limits to Repo 105 going back to the beginning. Sometimes these were more emphatic and sometimes relaxed." Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 8. Feraca recalled a firm‐wide limit of between $10 billion and $20 billion when Lehman first conceived its Repo 105 program in 2001. Id. Feraca said that a certain level of seniority was required to set the caps on Repo 105 and that these caps/limits were communicated to the trading desks as well as to him at the funding desk. Id.Show full note As a result, Lehman's quarter‐end use of Repo 105 transactions significantly increased beginning in mid‐2007 with the close of Lehman's third quarter 2007 in August 2007, at which time Lehman's combined Repo 105 usage was $36.4 billion.³⁴¹⁴³⁴¹⁴ Lehman, Total Repo 105/108 Trend (Feb. 20, 2008) [LBHI_SEC07940_1957956]. At the close of Lehman's fiscal year in November 2007, Lehman's total Repo 105 was $38.63 billion, in contrast to the $25 billion internal limit supposedly in effect at that time.³⁴¹⁵³⁴¹⁵ Id.; Lehman, Total Repo 105 & Repo 108 Report [LBEX‐DOCID 3219746] (Dec. 5, 2007) (attached to e‐ mail from Anuraj Bismal, Lehman, to Marie Stewart, Lehman, et al. (Dec. 5, 2007) [LBEX‐DOCID 3223384]); e‐mail from Michael McGarvey, Lehman, to Kentaro Umezaki, Lehman, et al. (May 8, 2007) [LBEX‐DOCID 1811432] ("25 bn is the total Lehman Repo 105/108 limit. FID's share is 20bn. Rates has been generally using 16‐18bn out of the 20bn with the remainder in credit."); e‐mail from Sigrid Stabenow, Lehman, to Clement Bernard, Lehman, et al. (Jan. 25, 2008) [LBEX‐DOCID 1853428] (recommending that Repo 105 program be expanded from $20 billion to $23 billion).Show full note Total Repo 105/108 at Quarter‐End³⁴¹⁶³⁴¹⁶ E‐mail from Mark Ciolli, Lehman, to Michelle Ng, Lehman, et al. (Sept. 6, 2006) [LBEX‐WGM 748487] (stating that total Repo 105 usage on August 31, 2006, close of third quarter 2006, was $27.1533 billion); Lehman, Total Repo 105 & Repo 108 Report (Jan. 2, 2007) [LBEX‐DOCID 2715058] (stating total Repo 105 usage on November 30, 2006, close of fourth quarter 2006, was $24.5192 billion); Lehman, Total Repo 105/108 Trend (Feb. 20, 2008) [LBHI_SEC07940_1957956] (stating total Repo 105 usage on August 30, 2007, close of third quarter 2007, was $36.4 billion); Lehman, Total Repo 105 & Repo 108 Report (Dec. 5, 2007) [LBEX‐DOCID 3219746] (stating total Repo 105 usage on November 30, 2007, close of fourth quarter 2007, was $38.634 billion); Lehman, Total Repo 105 & Repo 108 Report (June 11, 2008) [LBEX‐DOCID 2078195] (stating total Repo 105 usage on February 29, 2008, close of first quarter 2008, was $49.102 billion and for May 30, 2008, close of second quarter 2008, was $50.3834 billion); see also Lehman, Total Repo 105/108 Trend Report (June 20, 2008) [LBEX‐DOCID 3363434] (stating total quarter‐end Repo 105 usage for fourth quarter 2006 through second quarter 2008).Show full note

891

¶Q3 2006 Q4 2006 Q1 2007 Q2 2007 Q3 2007 Q4 2007 Q1 2008 Q2 2008 Repo 105 n/a $19.213 $20.578 $23.054 $29.054 $29.727 $42.200 $44.536 Repo 108 n/a $5.091 $6.4 $8.575 $6.863 $8.854 $6.902 $5.847 Total $27.153 $24.519 $27.284 $31.943 $36.407 $38.634 $49.102 $50.383 Key:

¶ Dollar amounts are given in billions.

 For purposes of this chart, Repo 105 amount refers to the total volume of Repo 105 transactions undertaken by the Fixed Income Division.

 For purposes of this chart, Repo 108 amount refers to the total volume of Repo 108 transactions undertaken by the Equities Division.

 Total Repo 105/108 amount may be greater than the sum of Repo 105 and Repo 108 volumes reported in this chart due to intermittent and de minimis amount of Repo 105 transactions undertaken by other Lehman divisions or groups.

892

¶Lehman Treasurer Paolo Tonucci recalled that Lehman placed a cap on total Repo 105 usage because accounting rules could potentially change and without a limit in place, there was a risk that Lehman's business would become "too dependent" on the Repo 105 off‐balance sheet arrangement.³⁴¹⁷³⁴¹⁷ Examiner's Interview of Paolo R. Tonucci, Sept. 16, 2009 at p. 26. A July 2006 document reveals that, at that time, the limits were: $17 billion for Repo 105 transactions and $5 billion for Repo 108 transactions.³⁴¹⁸³⁴¹⁸ Lehman, Global Balance Sheet Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 2 [LBEX‐ WGM 748489] ("Global Balance Sheet Overview"); see also e‐mail from Gary Lynn, Lehman, to Kaushik Amin, Lehman, et al. (Aug. 22, 2006) [LBEX‐DOCID 2786867] (discussing temporary increase of Repo 105 limit to $20 billion from $17.5 billion). The $17 billion limit on Repo 105 transactions was keyed to tangible equity.³⁴¹⁹³⁴¹⁹ See Duff & Phelps, Repo 105/108 Usage vs. Limit Comment (Oct. 16, 2009), at pp. 1‐2 (explaining that the Repo 105 limit was set at 1 x Tangible Equity). The Global Balance Sheet Overview said that "Repo 105 is capped at $15 B (1 x leverage)." Lehman, Global Balance Sheet, Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 2 [LBEX‐WGM 748489]. The Overview also implied that "1 x leverage" meant that Repo 105 usage should not exceed Tangible Equity. Id. at p. 5.Show full note Other documents demonstrate that throughout 2007 and into January 2008, the official internal limits on Lehman's use of Repo 105/108 transactions remained in the mid‐$20 billion range, generally $17 to $20 billion for Repo 105 transactions and $5 billion for Repo 108 transactions.³⁴²⁰³⁴²⁰ E‐mail from Gary Lynn, Lehman, to Kaushik Amin, Lehman, et al. (Aug. 22, 2006) [LBEX‐DOCID 2786868]; e‐mail from Clare Christofi, Lehman, to Anuraj Bismal, Lehman, et al. (May 8, 2007) [LBEX‐ DOCID 3234172] ("Limits were $5 bn for Eq[uities] and $17 bn for FID."); e‐mail from Michael McGarvey, Lehman, to Kentaro Umezaki, Lehman, et al. (May 8, 2007) [LBEX‐DOCID 1811432] ("25 bn is the total Lehman Repo 105/108 limit. FID's share is 20bn. Rates has been generally using 16‐18bn out of the 20bn with the remainder in credit."); e‐mail from Michael McGarvey, Lehman, to Gerard Reilly, Lehman (May 23, 2007) [LBEX‐DOCID 4553348] ("We're projecting to land at 24.5bn in Repo 105/108. 18.5bn FID/6.5bn Equities."); e‐mail from Sigrid Stabenow, Lehman, to Clement Bernard, Lehman, et al. (Jan. 25, 2008) [LBEX‐DOCID 1853428] (recommending that Repo 105 program be expanded from $20 billion to $23 billion).Show full note

893

¶As market conditions worsened and the pressures on Lehman to reduce its net leverage ratio increased, pressure mounted inside Lehman to adjust upward these limits on Repo 105 transactions.³⁴²¹³⁴²¹ See Sections III.A.4.e.1 and III.A.4.e.4–5 of this Report. As discussed above, in February 2007, Joseph Gentile (FID Chief Financial Officer) recommended to Grieb that Lehman increase the $22 billion combined Repo 105/108 limit ($17 billion in Repo 105 and $5 billion in Repo 108) by $3 billion to mitigate problems caused by: "[e]xiting large CMBS positions in Real Estate and sub prime loans in Mortgages [that] before quarter would [result in] large losses."³⁴²²³⁴²² Lehman, Proposed Repo 105/108 Target Increase for 2007 (Feb. 9, 2007) [LBEX‐DOCID 2489498] (attached to e‐mail from Joseph Gentile, Lehman, to Edward Grieb, Lehman (Feb. 10, 2007) [LBEX‐ DOCID 2600714]; see also e‐mail from Joseph Gentile, Lehman, to Edward Grieb, Lehman (Feb. 8, 2007) [LBEX‐DOCID 2604414] ("What is your appetite for us exceeding our repo 105 limit by $1.6 bn at month end? From 17.0 to 18.6?"). Gentile's proposal is discussed at length, supra, at Section III.A.4.e.4. When the Examiner interviewed Gentile, he did not recall preparing the February 2007 analysis and recommendation he sent to Grieb in which he requested the $3 billion increase in the firm‐wide Repo 105 limit for first quarter 2007 (from $22 billion to $25 billion), though he recalled that authorization was required to exceed the firm‐wide Repo 105 limit. Examiner's Interview of Joseph Gentile, Oct. 21, 2009, at p. 8. Gentile speculated that someone from Lehman's Balance Sheet group may have prepared portions of the report for him, but Gentile was absolutely certain that he would have shown the analysis and recommendation to Reilly, to whom he reported, before submitting it to Grieb. Id.Show full note

¶When interviewed by the Examiner, Grieb had no recollection of receiving this recommendation from Gentile.³⁴²³³⁴²³ Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 12. Similarly, Grieb claimed to have never before heard the phrase "sticky assets" and claimed to have no recollection of market conditions in 2007. Grieb said that he did not even recollect that the $22 billion combined Repo 105 limit was in place in February 2007, though he said he had no reason to dispute this fact. Id. Likewise (and contrary to numerous documents and other witness statements), Grieb said that he had no recollection of balance sheet pressures within Lehman's FID in 2007. Id.Show full note Grieb also did not recall what happened as a result of Gentile's request to increase the Repo 105 limit by $3 billion and further disclaimed knowledge of whether Chris O'Meara and Gerard Reilly received similar petitions.³⁴²⁴³⁴²⁴ Id. Though Grieb had no recollection "specifically" of a $3 billion increase in the Repo 105 cap (even when shown later e‐mails which confirm that Grieb granted Gentile's request for the $3 billion increase), he recalled "generally" that "at some point in time, as a result of discussions with O'Meara and Reilly, we raised the limit."³⁴²⁵³⁴²⁵ Id.; see e‐mail from Joseph Gentile, Lehman, to Gerard Reilly, Lehman (Feb. 21, 2007) [LBEX‐DOCID 4553220] ("We spoke with grieb and . . . he was ok with a temporary excession of $3. . . ."); e‐mail from Gary Lynn, Lehman, to Sharan Mirchandani, Lehman, et al. (Feb. 21, 2007) [LBEX‐DOCID 1431154] ("As you are aware we are significantly over the Q1 balance sheet limits…with one week to go, and Kaushik has delivered that message to the business heads that we need to come down further as there is no room for us to be over our limits. Please note that the current projected overage…already includes an additional $3bn of Repo 105 that we have been granted above the normal Repo 105 limits, but it has been communicated to me that this additional Repo 105 is to satisfy overages we currently have in other business lines."). Marie Stewart (former Global Head of Accounting Policy) recalled that Repo 105 transactions became more prevalent in late 2007 and 2008, but she did not specifically recall an official "ramping up" policy. Examiner's Interview of Marie Stewart, Sept. 2, 2009, at p. 10.Show full note

894

¶Gentile also did not recall specifically whether Grieb approved the $3 billion increase, which would have pushed Lehman's firm‐wide Repo 105 limit to $25 billion.³⁴²⁶³⁴²⁶ Examiner's Interview of Joseph Gentile, Oct. 21, 2009, at p. 8. But when shown an e‐mail he sent to Michael Gelband (then‐Head of FID) indicating that Grieb had approved the requested increase, Gentile said that he would never have written such an e‐mail unless Grieb had in fact authorized the increase.³⁴²⁷³⁴²⁷ Examiner's Interview of Joseph Gentile, Oct. 21, 2009, at p. 8; e‐mail from Joseph Gentile, Lehman, to Michael Gelband, Lehman, et al. (Feb. 20, 2007) [LBEX‐DOCID 1808077] ("I have been able to get a temp limit of 3 bn for repo 105 activity, which covers known real estate issues. We have issues in mortgages and liquid markets."). In the same e‐mail, Gentile also noted that FID was more than $10 billion over its balance sheet target for the quarter and that consequently, Lehman's firm‐wide net leverage ratio was 15.6 rather than the target, 14.8. Id.Show full note Consistent with statements in his e‐mail to Gelband, Gentile stated that the $3 billion increase was temporary and intended to apply to Lehman's first quarter 2007 only.³⁴²⁸³⁴²⁸ E‐mail from Joseph Gentile, Lehman, to Kentaro Umezaki, Lehman (Feb. 21, 2007) [LBEX‐DOCID 1808077]. Other e‐mails confirm that the $3 billion increase was granted.³⁴²⁹³⁴²⁹ E‐mail from Gerard Reilly, Lehman, to Joseph Gentile, Lehman (Feb. 21, 2007) [LBEX‐DOCID 4553218] (asking after Gentile informed Reilly of a $3 billion increase to the Repo 105 limit, "Where did the 3b come from? How far over is fid?"); e‐mail from Joseph Gentile, Lehman, to Gerard Reilly, Lehman (Feb. 21, 2008) [LBEX‐DOCID 4553220] ("We spoke with grieb and did an analysis which showed we did not spike and he was ok with a temporary excession [in the Repo 105 limit] of $3 [billion].").Show full note As noted in this Report, however, within months of February 2007, Lehman's firm‐wide Repo 105 usage was exceeding even that increased limit.³⁴³⁰³⁴³⁰ No witness was able to explain to the Examiner why Lehman exceeded, by a significant margin, Lehman's self‐imposed Repo 105 limits. Martin Kelly was not involved with the setting or increasing of Lehman's Repo 105 limits at any time while he was Financial Controller. Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 6. In fact, Kelly said he would have had no authority to set a firm‐wide Repo 105 limit and that "a broader and more senior group than [him]" would have had authority over those limits. Id. Gentile stated unequivocally that authorization from senior Lehman personnel was required to exceed Lehman's firm‐wide Repo 105 limit during Gentile's tenure at Lehman (June 2006 through May 2007). Examiner's Interview of Joseph Gentile, Oct. 21, 2009, at p. 7. Gentile explained that "You had to go through the chain of command through the legal entity side of the business to get more Repo 105" and that "FID could never blow by the [Repo 105] limits. . .someone had to approve it." Id. If an individual or group at Lehman sought to exceed the Repo 105 limit, according to Gentile, they needed to obtain approval from Grieb for the "excession." Id. According to Grieb, the limits on Lehman's Repo 105 usage were not exclusively for quarter‐end; rather, they represented the limit for any given moment throughout the quarter. Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 9. Accounting rules applicable to Repo 105 transactions did not prescribe a firm‐wide limit on Repo 105 usage. Id. Rather, Grieb, O'Meara, and Reilly set Repo 105 limits as a prophylactic measure to prevent firm personnel from becoming too reliant upon Repo 105 transactions as a tool for balance sheet relief "just in case that funding source drie[d] up and counterparties los[t] interest." Id. During his interview with the Examiner, Grieb had no recollection of the quarter‐end amounts of assets moved off Lehman's balance sheet via Repo 105 transactions. Id. Grieb recalled, however, that at the time he was Lehman's Financial Controller, he would have read, at least several times a month, reports that listed Lehman's firm‐wide Repo 105 usage, but that he simply did not recall the volumes at present. Id. When the Examiner showed Grieb a Lehman‐prepared chart that indicated the total firm‐wide Repo 105 usage at the end of fourth quarter 2007 was $38.634 billion – when Grieb was still Lehman's Controller – Grieb stated that he had no recollection of this number but did not dispute its accuracy and said the figure did not "shock" him. Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 12. When asked to explain how Lehman's firm‐ wide Repo 105 usage got as high as $39 billion in November 2007, approximately six months after Lehman increased its firm‐wide Repo 105 limit to $25 billion, Grieb recalled having discussions with O'Meara and Reilly about possibly increasing Lehman's firm‐wide repo limit in mid‐to‐late‐2007. Id.Show full note

895 896

¶By the close of Lehman's first quarter 2008, February 29, 2008, Lehman's total Repo 105 quarter‐end usage was $49.1 billion.³⁴³¹³⁴³¹ See Lehman, Total Repo 105 & Repo 108 Report (June 11, 2008) [LBEX‐DOCID 2078195] (showing February 29 and May 30, 2008 total Repo 105 usage). Note that May 31, 2008 was a Saturday. And at the close of Lehman's second quarter 2008, May 30, 2008, Lehman's total Repo 105 usage was $50.38 billion.³⁴³²³⁴³² Id. Thus, Lehman's use of Repo 105 transactions more than doubled in the span of five reporting periods, from approximately $24 billion at fourth quarter 2006 (November 2006) to $49.1 billion and $50.38 billion at first quarter 2008 (February 2008) and second quarter 2008 (May 2008), respectively.³⁴³³³⁴³³ Lehman, Total Repo 105 & 108 Report (Dec. 13, 2006) [LBEX‐DOCID 2521357] (stating November 30, 2006 total Repo 105 usage was $24.519 billion); e‐mail from Michael McGarvey, Lehman, to Gerard Reilly, Lehman, et al. (May 23, 2007) [LBEX‐DOCID 4553348] (stating firm‐wide Repo 105 usage projected at $24.5 billion); Lehman, Balance Sheet and Cash Capital (Mar. 27, 2008), at p. 1 [LBEX‐DOCID 1698667] (attached to e‐mail from Clement Bernard, Lehman to Lisa Rivera, Lehman (Mar. 28, 2008) [LBEX‐DOCID 1854835] and showing firm‐wide quarter‐end Repo 105 usage of $49.1 billion for first quarter 2008); e‐mail from Michael McGarvey, Lehman, to Clement Bernard, Lehman, et al. (Apr. 15, 2008) [LBEX‐DOCID 3221734] ("FID used 42bn in Repo 105 in Q1 and Equities used 7.0b so 49 bn was the total firm number. This was an increase of 24bn from Q4'06.").Show full note The Examiner tracked Lehman's actual Repo 105 usage and compared it to the limit as a ratio of tangible equity, as seen in the chart below:

897

Repo 1051 Usage vs. 1 X Tangible Equity (Repo 105 Usage as a Multiple of Tangible Equity) 50,000

1.6 X 45,000 1.6 X

¶40,000

¶35,000

1.3 X 30,000 1.3 X

$ in Millions 25,000 1.1 X 1.1 X 1.0 X 20,000

¶15,000

¶10,000

¶5,000

¶Q4 2006 Q1 2007 Q2 2007 Q3 2007 Q4 2007 Q1 2008 Q2 2008

¶At Quarter End Repo 105 Usage 1 X Tangible Equity

Q4 2006 Q1 2007 Q2 2007 Q3 2007 Q4 2007 Q1 2008 Q2 2008 Repo 105 Usage 19,213 20,578 23,054 29,075 29,916 41,844 44,536 1 X Tangible Equity 18,567 19,487 21,881 22,164 23,103 25,696 27,179 Usage X Tangible Equity 1.0 X 1.1 X 1.1 X 1.3 X 1.3 X 1.6 X 1.6 X

Please note these amounts refer only to Repo 105, not to combined Repo 105 and Repo 108 amounts.

¶Sources:

Actual Repo 105/108 Usage: Q4 2006, Q1, Q2 and Q3 2007: LBEX‐DOCID 3363434. Repo 105 Usage is assumed to be the Fixed Income Division's total usage. Q4 2007: LBEX‐DOCID 3219746 Q1 2008: LBEX‐DOCID 3219760 Q2 2008: LBEX‐DOCID 2078195

Tangible Equity: Lehman Brothers' SEC 10‐K and 10‐Q filings.

¶Repo 105 Limit as 1 X Tangible Equity:

¶LBEX‐WGM 748489: See page 2 for "Operating Rules." See page 5 for suggestion that Tangible Equity is the appropriate measure of leverage.

¶Clement Bernard, who replaced Gentile in approximately August 2007, did not recall how Lehman's firm‐wide Repo 105 usage reached $50 billion in early 2008, even though a series of e‐mails shown to him revealed that: (1) he was informed of the total Repo 105 usage in 2008; (2) he was informed that the usage had doubled since 2006; and

898

¶(3) he pressured FID leaders to meet quarter‐end balance sheet targets by means of either sales of assets or Repo 105 transactions.³⁴³⁴³⁴³⁴ E‐mail from Clement Bernard, Lehman, to Kieran Higgins, Lehman (Feb. 22, 2008) [LBEX‐DOCID 1854016] (informing Higgins that "[w]e are currently at 19 bn above our target" and asking him how many Repo 105 transactions he can undertake); e‐mail from Clement Bernard, Lehman, to Kaushik Amin, Lehman (Feb. 25, 2008) [LBEX‐DOCID 756417] (informing Amin that "[w]e are currently running at 15.0 bn above [net balance sheet target] and we need to go down an extra $5.0 bn for the firm to meet its net leverage limit of 15.2. I need your help on this…"); e‐mail from Clement Bernard, Lehman, to Eric Felder, Lehman (Feb. 25, 2008) [LBEX‐DOCID 2080410] ("We need to reduce our net Balance sheet to hit the firm target net leverage ratio of 15.2. Currently FID is projected to be $15.0 bn above its limit… Let me know if there is anything you could do to reduce the Balance Sheet and what would [be] the price of doing that."); e‐mail from Clement Bernard, Lehman, to Martin Potts, Lehman, et al. (Feb. 28, 2008) [LBEX‐DOCID 1854189] ("We are looking at selling what ever we can and also doing some more repo 105 [because over balance sheet target by $ 14.3 billion]."); e‐mail from Clement Bernard, Lehman, to Mark Cosaitis, Lehman (Feb. 29, 2008) [LBEX‐DOCID 2803733] (thanking Cosaitis for his efforts in undertaking Repo 105 transactions using corporate positions during last day of quarter and stating he expects the firm to make the 15.2 net leverage ratio target); Lehman, Balance Sheet and Cash Capital (Mar. 27, 2008), at p. 1 [LBEX‐ DOCID 1698667] (attached to e‐mail from Clement Bernard, Lehman to Lisa Rivera, Lehman (Mar. 28, 2008) [LBEX‐DOCID 1854835] and showing $49.1 billion in Repo 105 quarter‐end usage first quarter 2008); e‐mail from Michael McGarvey, Lehman, to Clement Bernard, Lehman, et al. (Apr. 15, 2008) [LBEX‐DOCID 3221734] ("FID used 42bn in Repo 105 in Q1 and Equities used 7.0b so 49 bn was the total firm number. This was an increase of 24 bn from Q4'06.").Show full note When asked by the Examiner if the significant increase in Lehman's firm‐wide Repo 105 usage in late 2007 and 2008 caused him any alarm, Bernard answered: "no."³⁴³⁵³⁴³⁵ Examiner's Interview of Clement Bernard, Oct. 23, 2009, at p. 9. Bernard explained that he had been focused at that time on Lehman's sticky assets – like commercial real estate and leveraged loans – and that he did not pay particular attention to Lehman's use of Repo 105 transactions. Id. Bernard did not recall discussions with Reilly, Bernard's supervisor, or anyone else about the volumes of Lehman's Repo 105 usage or discomfort with Lehman's reliance upon Repo 105 transactions. Id. Bernard did, however, recall that Reilly wanted Lehman to curtail its use of Repo 105 in 2008, though Bernard could only speculate why. Id. Bernard recalled that it would not have been uncommon for Lehman traders to have the ability to move upwards of $2 billion of assets, through Repo 105 transactions, in a single hour as a quarter was ending. Id.Show full note

¶Lehman's Repo 105 usage as of November 30, 2007, February 29, 2008, and May 31, 2008 was "in line with" what John Feraca, the former head of the Secured Funding Desk for Lehman's Prime Services Group, "would have expected" even though it far exceeded the last known limit of $25 billion, which was in place in early 2007.³⁴³⁶³⁴³⁶ Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 11; see also Lehman, Total Repo 105 & Repo 108 Report (Dec. 5, 2007) [LBEX‐DOCID 3219746] (showing Repo 105 usage at close of fourth quarter 2007); Lehman, Total Repo 105 & Repo 108 Report (June 11, 2008) [LBEX‐DOCID 2078195] (showing Repo 105 usage at close of first quarter and second quarter 2008). The ramp‐up in Lehman's firm‐wide Repo 105 usage was "probably a combination of an increase in limits and a lack of policing, though probably more of the latter."³⁴³⁷³⁴³⁷ Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 11. Feraca continued: "The fact that we were going to breach the [Repo 105] limit at quarter‐end was not an issue for management."³⁴³⁸³⁴³⁸ Id. Feraca had no recollection "of anyone saying 'you're over limit,'" nor did he have any recollection of a formal increase of the Repo 105 limit.³⁴³⁹³⁴³⁹ Id. "I know why it happened. The business wanted more, needed more, to make targets. The numbers were reported internally, daily, so there was transparency, but there was no stoppage."³⁴⁴⁰³⁴⁴⁰ Id.

899

Balance Sheet Targets for FID Businesses Were Unsustainable Without the Use of Repo 105 Transactions

¶Bart McDade's description of the Repo 105 mechanism for quarter‐end balance sheet relief as a "drug" was apt: Repo 105 enhanced Lehman's reported net leverage ratio and without the artificial floor Repo 105 created, balance sheet and net leverage ratio targets were beyond reach. In a March 19, 2008 e‐mail to McDade, Andrew Morton, Mark Walsh, and other Lehman personnel, Munir Dauhajire warned that "RUNNING A FIRM WIDE BALANCE SHEET OF 15.3 X LEVG IS NOT GOING TO BE A SUSTAINABLE BUSINESS MODEL FOR THE FIRM."³⁴⁴¹³⁴⁴¹ E‐mail from Munir Dauhajre, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (Mar. 19, 2008) [LBEX‐DOCID 119728] (all capitals in original).

900

¶After engaging in over $49.1 billion and $50.38 billion of Repo 105 transactions at the end of the first and second quarters 2008, respectively, by June 2008, when Bart McDade had become President and COO, McDade set a quarter‐end Repo 105 target for third quarter 2008 of $25 billion.³⁴⁴²³⁴⁴² One week before close of Lehman's third quarter 2008, Reilly wrote to McGarvey: "How much repo 105 do we have now and how much will we have at 8/31?" E‐mail from Gerard Reilly, Lehman, to Michael McGarvey, et al. Lehman (Aug. 26, 2008) [LBEX‐DOCID 4297834]. McGarvey replied that the forecast at quarter‐end was $21 billion in Repo 105 and $3.8 billion in Repo 108. Id.; see also Lehman, Balance Sheet and Key Disclosures 2008 3Q Targets [Draft] (June 16, 2008) [LBEX‐DOCID 012458] (attached to e‐mail from Gerard Reilly, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (June 17, 2008) [LBEX‐DOCID 011380] and containing balance sheet target and proposing a Repo 105 target of $25 billion for Q3 2008).Show full note The evidence also shows that senior Lehman management sought to completely abolish the firm's use of Repo 105 transactions by the beginning of the fourth quarter 2008.³⁴⁴³³⁴⁴³ See e‐mail from Jeff Michaels, Lehman, to Kaushik Amin, Lehman (July 30, 2008) [LBEX‐DOCID 613324] ("Repo 105 is going away by Q4…."); e‐mail from Jeff Michaels, Lehman, to Kaushik Amin, Lehman, et al. (July 31, 2008) [LBEX‐DOCID 756327] ("Repo 105 is going to zero in Q4….").

¶The reduction in Repo 105 usage for third became well known throughout the firm.³⁴⁴⁴³⁴⁴⁴ See Section III.A.4.e.2.a of this Report (discussing role of Bart McDade in proposing reduction in Repo 105 usage). A July 2008 e‐mail noted that "[t]he exec committee wanted the number [of Repo 105] cut in half."³⁴⁴⁵³⁴⁴⁵ E‐mail from Michael McGarvey, Lehman, to Jormen Vallecillo, Lehman (July 2, 2008) [LBEX‐DOCID 3379145]. When questioned about this e‐mail, McGarvey could not explain why the Executive Committee had decided to reduce Lehman's Repo 105 usage by half. Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 11. The result of the announced reduction in approved firm‐wide Repo 105 usage was disquiet. As one internal Lehman presentation put succinctly: "Wean ourselves off Repo 105 ASAP!"³⁴⁴⁶³⁴⁴⁶ Lehman, Global Rates Mid‐Year Review 2008 (Sept. 12, 2008) [LBEX‐DOCID 659022], at p. 5 (attached to e‐mail from Jeff Michaels, Lehman, to Kaushik Amin, Lehman (Sept. 12, 2008) [LBEX‐DOCID 679130]). A hard copy of this presentation was also found among Clement Bernard's documents. See Lehman, Global Rates Mid‐Year Review 2008 (no date) [LBEX‐WGM 756153].

901

¶When in June 2008 Reilly communicated the proposed $25 billion Repo 105 cap for third quarter 2008, Andrew Morton, then‐Head of FID, replied: "rates business cannot survive at these levels, ie reducing r105 by 20."³⁴⁴⁷³⁴⁴⁷ E‐mail from Andrew J. Morton, Lehman, to Gerard Reilly, Lehman (June 17, 2008) [LBEX‐DOCID 4553446]. When also in June 2008, Paul Mitrokostas, the Chief Operating Officer of FID, communicated the third quarter 2008 balance sheet target and the fact that FID's Repo 105 limit for that quarter was being reduced to $25 billion, Amin protested that a $55 billion net balance sheet limit for the firm's Rates business, with $22 billion less of Repo 105 capacity available at quarter‐end, was unsustainable: "We can't run the business under those parameters."³⁴⁴⁸³⁴⁴⁸ E‐mail from Kaushik Amin, Lehman, to Paul Mitrokostas, Lehman, et al. (June 20, 2008) [LBEX‐ DOCID 2319659].

¶Similarly, Jeff Michaels complained to Amin in July 2008 that given the reduction in FID's Repo 105 capacity for third quarter 2008, and the complete curtailment of Repo 105 usage in fourth quarter 2008, "there are not many places we can reallocate balance sheet from if Repo 105 is gone for the inflation book."³⁴⁴⁹³⁴⁴⁹ E‐mail from Jeff Michaels, Lehman, to Kaushik Amin, Lehman (July 30, 2008) [LBEX‐DOCID 613324]. Inflation book or inventory likely refers to Treasury Inflation Protected Securities ("TIPS"), which are inflation‐indexed bonds issued by the United States Treasury. In another e‐mail, Michaels wrote: "[Repo] 105 is going to zero in Q4, which means we either need more balance sheet from FID or we need to make significant reductions in Europe, which has not happened until now. There is no way we can make Q4 balance sheet without Repo 105 unless our inflation inventory is cut by 60‐75% from current levels."³⁴⁵⁰³⁴⁵⁰ E‐mail from Jeff Michaels, Lehman, to Kaushik Amin, Lehman, et al. (July 31, 2008) [LBEX‐DOCID 756327] (transmitting Lehman, Balance Sheet‐Global Rates [LBEX‐DOCID 633334], and showing Global Rates business Repo 105 usage).

902

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

¶Just as it did in its Forms 10‐Q and 10‐K, Lehman emphasized its net leverage ratio to the ratings agencies throughout 2008 as Lehman attempted to forestall a ratings downgrade. The concerted effort by Lehman's senior management to cut the balance sheet by half, achieved by reducing the firm's net leverage ratio, and Lehman's public statements about this achievement, improved the firm's standing with at least two of the three rating agencies, Fitch Rating ("Fitch"), and Standard & Poor's ("S&P").³⁴⁵¹³⁴⁵¹ Fitch's and S&P's analysis of Lehman took into account the firm's net leverage ratio. Examiner's Interview of Eileen A. Fahey, Sept. 17, 2009, at p. 6; Examiner's Interview of Diane Hinton, Sept. 22, 2009, at p. 5. Moody's, on the other hand, looked primarily to other indicators, particularly risk. Examiner's Interview of Peter E. Nerby, Oct. 8, 2009, at p. 5.

¶In May 2008, Lehman gave a presentation to Moody's Investor Service in which one of the key messages in the presentation was that because Lehman had strengthened its capital position through "active deleveraging" including "approximately $50 billion reduction in net assets," no negative rating action for the firm was justified.³⁴⁵²³⁴⁵² Lehman, Moody's Investor Service Q2 2008 Update (May 29, 2008), at pp. 1, 4, 6‐8 [Moody's Confidential Shared Information 1114‐1159]. The presentation to Moody's noted that net leverage was expected to decrease from 15.4x to 12.6x and that the net balance sheet reduction of $50.38 billion in second quarter 2008 included key FID high‐risk assets, such as commercial and residential mortgages.³⁴⁵³³⁴⁵³ Id. at pp. 6‐7. Lehman's presentation also noted that the "net leverage ratio" was "heavily quoted by journalists and analysts."³⁴⁵⁴³⁴⁵⁴ Id. at p. 8.

903

¶On June 3, 2008, Lehman gave a similar presentation to Fitch, stating that Lehman did "not believe Q2 '08 results justify any negative rating action for Lehman Brothers."³⁴⁵⁵³⁴⁵⁵ Lehman, Fitch Ratings Q2 2008 Update (June 3, 2008), at p. 4 [FITCH‐LEH BK 00000151]. Lehman told Fitch that its "[c]apital position is stronger than ever with de‐ levering bringing both net and gross leverage ratios to multi‐year lows."³⁴⁵⁶³⁴⁵⁶ Id. at p. 40.

¶On June 5, 2008, Lehman made a similar presentation to S&P in which Lehman advanced its position that second quarter 2008 "results [do not] justify any negative rating action for Lehman Brothers"³⁴⁵⁷³⁴⁵⁷ Lehman, S&P Ratings Q2 2008 Update (June 5, 2008), at p. 4 [S&P Examiner 000946]. in part because of Lehman's "shrinkage of the balance sheet."³⁴⁵⁸³⁴⁵⁸ Id. at p. 6. In that presentation, Lehman advised S&P that "Net balance sheet (primarily inventory) is expected to be almost $70 billion lower than Q1 '08, and gross balance sheet is expected to be almost $140 billion lower."³⁴⁵⁹³⁴⁵⁹ Id. The presentation also projected that Lehman's net leverage ratio would drop to 12.1x in second quarter

904

¶2008.³⁴⁶⁰³⁴⁶⁰ Id. Another slide in the presentation touted Lehman's historically low net leverage ratio and contrasted it with that of peer investment banks.³⁴⁶¹³⁴⁶¹ Id. at p. 8.

¶Nowhere in the presentations that Lehman made to the rating agencies in May or June 2008 did Lehman disclose its use of Repo 105 transactions, the impact Repo 105 transactions had on the firm's quarter‐end balance sheet, or the impact Repo 105 transactions ultimately had on Lehman's net leverage ratio.³⁴⁶²³⁴⁶² See generally Lehman, Moody's Investor Service Q2 2008 Update (May 29, 2008) [Moody's Confidential Shared Information 1114‐1159]; Lehman, Fitch Ratings Q2 2008 Update (June 3, 2008) [FITCH‐LEH BK 00000151]; Lehman, S&P Ratings Q2 2008 Update (June 5, 2008) [S&P Examiner 000946].

¶Following Fitch's decision in June 2008 to downgrade Lehman by one ratings grade, from AA‐ to A+ (long‐term) and F‐1+ to F‐1 (short‐term), Tonucci sent Fitch another Lehman presentation "to consider in the context of a potential appeal."³⁴⁶³³⁴⁶³ Lehman, Presentation to Fitch Ratings Rating Appeal [Draft] (June 9, 2008) [FITCH‐LEH BK 00002449] (attached to e‐mail from Paolo R. Tonucci, Lehman, to Eileen A. Fahey, Fitch (June 9, 2008) [FITCH‐LEH BK 00002447]). Lehman marshaled certain facts in defense of its "disagreement" with the ratings downgrade by Fitch. Under the heading "Significant Shrinkage of the Balance Sheet," Lehman informed Fitch that "Net balance sheet (primarily inventory) is expected to be almost $70 billion lower than Q1 '08. . . ."³⁴⁶⁴³⁴⁶⁴ Id. at p. 2. Not including the impact of the $4 billion common equity and $2 billion non‐cumulative preferred offering that Lehman had undertaken in June 2008, Lehman boasted to Fitch that it reduced its net leverage ratio from 15.4x in first quarter 2008 to an anticipated 12.0x in second quarter 2008.³⁴⁶⁵³⁴⁶⁵ Id. Accounting for the equity raise, Lehman touted that it had reached its "lowest leverage ratios since becoming a public firm."³⁴⁶⁶³⁴⁶⁶ Id. at p. 3.

905

¶Lehman, as with its prior presentations to the rating agencies, made no mention in its second presentation to Fitch of its reliance on Repo 105 transactions to manage its balance sheet and net leverage.³⁴⁶⁷³⁴⁶⁷ See generally id. Recall that at the end of its second quarter 2008, May 31, 2008 – just weeks before Tonucci sent the presentation to Fitch – Lehman had reduced its net balance sheet by over $50.38 billion using Repo 105 transactions. Yet, despite the significant role of the firm's Repo 105 practice in its balance sheet management, this fact was not disclosed in Lehman's presentations.

¶The Examiner interviewed representatives from the three leading ratings agencies, Fitch, Standard & Poor's, and Moody's, and none had knowledge of Lehman's use of Repo 105 transactions, either by name or by description.³⁴⁶⁸³⁴⁶⁸ Examiner's Interview of Eileen A. Fahey, Sept. 17, 2009, at p. 7; Examiner's Interview of Diane Hinton, Sept. 22, 2009, at p. 6; Examiner's Interview of Peter E. Nerby, Oct. 8, 2009, at pp. 5‐6. Not one of the rating agencies was aware that Lehman recorded some volume of repo transactions as true sales to temporarily remove the securities inventory from its balance sheet at quarter‐ end thereby reducing Lehman's publicly reported leverage ratios.

906

¶Eileen Fahey, an analyst at Fitch, said that she had never heard of repo transactions being accounted for as true sales on the basis of a true sale opinion letter or repo transactions known as Repo 105 transactions.³⁴⁶⁹³⁴⁶⁹ Examiner's Interview of Eileen A. Fahey, Sept. 17, 2009, at p. 7. Fahey stated that a transfer of $40 billion or $50 billion of securities inventory – regardless of the liquidity of that inventory – from Lehman's balance sheet at quarter‐end would be "material" in Fitch's view, and upon having a standard Repo 105 transaction described, Fahey remarked that such a transaction "sounded like fraud."³⁴⁷⁰³⁴⁷⁰ Id. While freely admitting that Lehman moved tens of billions of dollars' worth of inventory off the firm's net balance sheet at quarter‐end through Repo 105 transactions, and that the moved inventory came back on to the firm's balance sheet a week to ten days later, Kaushik Amin, former Head of Liquid Markets, believed it was immaterial and "completely irrelevant." Examiner's Interview of Kaushik Amin, Sept. 17, 2009, at p. 9. Amin believed that neither the rating agencies nor the investing public would have cared about Lehman's Repo 105 practice because Lehman used liquid inventory. Id. In Amin's view, "our risk was not represented any differently because of [Repo] 105." Id. Amin's view is belied by the statements of representatives of each of the three main ratings agencies, one of whom said that Lehman's undisclosed Repo 105 activity would have been "material" to the agency's view of Lehman and the other two who said they would have wanted to know of Lehman's Repo 105 activity. Examiner's Interview of Eileen A. Fahey, Sept. 17, 2009, at p. 7; Examiner's Interview of Diane Hinton, Sept. 22, 2009, at p. 6; Examiner's Interview of Peter E. Nerby, Oct. 8, 2009, at p. 5. Like Fahey, when asked whether it would have changed her answers if the securities that were removed from the balance sheet in Repo 105 transactions were liquid, S&P's Hinton responded that it would not. Examiner's Interview of Diane Hinton, Sept. 22, 2009, at p. 6.Show full note

¶The Examiner inquired whether, if Fitch had known about Lehman's use of such transactions to remove assets off its balance sheet at quarter‐end, it likely would have affected the Fitch rating of Lehman.³⁴⁷¹³⁴⁷¹ Examiner's Interview of Eileen A. Fahey, Sept. 17, 2009, at p. 7. Fitch used three leverage numbers to assess Lehman, including the net leverage ratio. Id. at p. 6. Fahey replied that the transaction spoke to Lehman's liquidity, and that the impact on Fitch's rating would depend on whether the described transaction was done repeatedly or if it was a one‐time occurrence.³⁴⁷²³⁴⁷² Id. at p. 7.

907

¶Fahey also remarked that treating a repo transaction as a sale (thereby removing the securities from the transferor's balance sheet) appears to be an accounting manipulation done to make the business look better, as contrasted with an ordinary repo transaction, which she described as a financing transaction done in the regular course of business (and for which the securities remain on the transferor's balance sheet).³⁴⁷³³⁴⁷³ Id. Fahey likened this "manipulation" to an investment bank telling regulators that it did not own any mortgage‐backed securities when, in fact, it owned them but had temporarily transferred them to a counterparty and was obligated to repurchase them shortly thereafter.³⁴⁷⁴³⁴⁷⁴ Id.

¶Diane Hinton, an analyst at Standard & Poor's and the firm's lead analyst for Lehman from April 2007 until July 2008, likewise was unaware of Lehman engaging in Repo 105 transactions.³⁴⁷⁵³⁴⁷⁵ Examiner's Interview of Diane Hinton, Sept. 22, 2009, at p. 6. When the Examiner described the "true sale" accounting treatment of Repo 105 transactions to Hinton, she stated that S&P "would have wanted to know" if Lehman had moved $20 billion, $40 billion, or $50 billion in net assets off its balance sheet at quarter‐end.³⁴⁷⁶³⁴⁷⁶ Id. While advising the Examiner that she "would have wanted to know" about Lehman's Repo 105 practice, Hinton neither stated nor denied that information about Lehman's use of Repo 105 transactions would have been "material." When asked whether it would have changed her answers if the securities that were removed from the balance sheet in Repo 105 transactions were liquid, Hinton responded that it would not.³⁴⁷⁷³⁴⁷⁷ Id. at p. 6.

908

¶Hinton explained that S&P looked at leverage ratios – including the net leverage ratio – in the context of its capital analysis of Lehman. Hinton further explained that S&P began its calculation of the net leverage ratio with information taken solely from Lehman's Forms 10‐K and 10‐Q, and that "anything that affects the balance sheet is something we would have wanted to know."³⁴⁷⁸³⁴⁷⁸ Id. at pp. 5‐6. She further stated that S&P only tracked Lehman's leverage ratios at quarter‐end.³⁴⁷⁹³⁴⁷⁹ Id. at p. 6. She said that any change in the net leverage ratio would have been relevant, but whether such a change was relevant to S&P's rating of Lehman would depend on other factors and committee deliberations.³⁴⁸⁰³⁴⁸⁰ Examiner's Interview of Diane Hinton, Sept. 22, 2009, at p. 6.

¶Peter Nerby of Moody's similarly stated that Moody's had no knowledge of Lehman engaging in Repo 105 transactions, either by name or by description.³⁴⁸¹³⁴⁸¹ Examiner's Interview of Peter E. Nerby, Oct. 8, 2009, at p. 5. However, unlike S&P and Fitch, the net leverage ratio did not drive many rating decisions at Moody's.³⁴⁸²³⁴⁸² Id. Moody's focused more on the risk effects of a transaction. Id. at p. 6. While a repo transaction that was recorded as a true sale affects a firm's net leverage ratio, it would not affect other ratios (e.g., VaR, stress test results, Level III assets to total inventory) and Moody's, according to Nerby, examined all of these ratios. Id. Nerby speculated that if the transaction was off balance sheet, it would probably be captured by some other risk measure. Id. When the Examiner asked Nerby if Moody's view of Repo 105 transactions would have been impacted if the assets involved were purely liquid assets, Nerbyʹs counsel instructed him not to answer the question, claiming that the question delved into Moodyʹs deliberative process. Examiner's Interview of Peter E. Nerby, Oct. 8, 2009, at p. 6.Show full note Nerby said that Lehman would have been aware that Moody's considered net leverage ratio to have "limited usefulness" as revealed by Moody's published rating methodology.³⁴⁸³³⁴⁸³ Id. Still, Nerby stated that if Lehman reduced its net balance sheet by $20 billion or up to $50 billion, he would have wanted to know and that Moody's would have looked to see if and where the reduction was captured by some risk measure.³⁴⁸⁴³⁴⁸⁴ Id.

909

¶A number of Lehman witnesses said that Lehman remained at risk for the assets it removed from its balance sheet as a result of Repo 105 transactions because of Lehman's obligation to repurchase the securities and repay the cash borrowing.³⁴⁸⁵³⁴⁸⁵ Examiner's Interview of Marie Stewart, Sept. 2, 2009, at p. 11; Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 8; Examiner's Interview of Tejal Joshi, Sept. 15, 2009, at p. 6; Examiner's Interview of Anuraj Bismal, Sept. 16, 2009, at p. 9. A June 2008 e‐mail from Dominic Gibb recommended to Martin Kelly that Lehman "have another look" at its definition of "long inventory at risk in the daily balance sheet and disclosure scorecard" because the definition did not include "any of the assets on repo 105/108" even though they are "still at risk."³⁴⁸⁶³⁴⁸⁶ E‐mail from Dominic Gibb, Lehman, to Martin Kelly, Lehman, et al. (June 19, 2008) [LBEX‐DOCID 3233813]. Gibb concluded: "[W]e are understating what we have at risk by a material amount especially around quarter ends."³⁴⁸⁷³⁴⁸⁷ Id. (emphasis added).

910

Government Regulators Had No Knowledge of Lehman's Repo 105 Program

¶Lehman did not disclose the fact of its engaging in Repo 105 transactions, or any other information regarding its use of Repo 105 transactions to manage its balance sheet, to Government regulators.³⁴⁸⁸³⁴⁸⁸ Forexample, Lehman's external regulatory reporting did not disclose Lehman's use of Repo 105 transactions to the Office of Thrift Supervision ("OTS") of the Department of the Treasury. OTS was responsible for reviewing Lehman Brothers Bank, FSB ("LBB") and examined the holding company ("LBHI") to determine its influence and connections with LBB. In response to the economic downturn, the OTS decided in 2008 to create a continuous supervision program of Lehman, Merrill Lynch, and Morgan Stanley. Examiner's Interview of Ronald S. Marcus, Nov. 4, 2009, at p. 5. The purpose, as to Lehman, was to obtain a general understanding of Lehman's risk as it related to LBB. Id. The OTS documented all of LBHI's repo transactions in its Report of Examination on the secured funding and lending activities of LBI and LBIE, the principal broker‐dealer subsidiaries of Lehman Brothers Holdings Inc. ("LBHI"). See OTS, Dept. of Treasury, Report of Examination for Lehman Brothers Bank, FSB (Aug. 6, 2007), at pp. 4‐5 [LBEX‐OTS 000082]. This report was the end‐product of an on‐site field visit OTS conducted on May 30, 2008. Id. Absent from the report is any reference to Repo 105 transactions, either by name or description (i.e., as repo transactions that are treated as true sales for accounting purposes). Id. Ronald Marcus, who served as the examiner for the continuous program at Lehman beginning in March 2008 and completed two targeted reviews prior to the bankruptcy, had no knowledge of Lehman's use of Repo 105 transactions. Examiner's Interview of Ronald S. Marcus, Nov. 4, 2009, at p. 11.Show full note

Officials from the Federal Reserve Bank Would Have Wanted to Know about Lehman's Use of Repo 105 Transactions

¶From 2003 to 2009, Treasury Secretary Timothy Geithner served as President of the Federal Reserve Bank of New York ("FRBNY"). The Examiner described to Secretary Geithner how Lehman used Repo 105 transactions to remove approximately $50 billion of liquid assets from the balance sheet at quarter‐end in 2008 and explained that this practice reduced Lehman's net leverage. Secretary Geithner "did not recall being aware of" Lehman's Repo 105 program, but stated: "If this had been a bank we were supervising, that [i.e., Lehman's Repo 105 program] would have been a huge issue for the New York Fed."³⁴⁸⁹³⁴⁸⁹ Examiner's Interview of Treasury Secretary Timothy F. Geithner, Nov. 24, 2009, at p. 5. By his comment "if this had been a bank we were supervising," Secretary Geithner meant that the SEC – and not the FRBNY – was the primary regulator of Lehman. Id.

911

¶Jan Voigts, who was an Examining Officer in FRBNY's Bank Supervision Department, had no knowledge of Lehman removing assets from its balance sheet at or near quarter‐end via a repo trade treated as a true sale under a United Kingdom opinion letter.³⁴⁹⁰³⁴⁹⁰ Examiner's Interview of Jan H. Voigts, Oct. 1, 2009, at p. 5. Voigts was surprised at and unfamiliar with the idea of using a repo to remove assets from the balance sheet under a true sale opinion where those assets would return to the balance sheet the following quarter.³⁴⁹¹³⁴⁹¹ Id. When the Examiner described to Voigts the steps Lehman undertook in a standard Repo 105 transaction, Voigts said that knowledge of such a practice by Lehman would have been "very important" to him.³⁴⁹²³⁴⁹² Id.

¶After having Repo 105 transactions described to him generally, Voigts differentiated Repo 105 transactions from other forms of balance sheet management like certain matched book repo trading.³⁴⁹³³⁴⁹³ Id. The matched book business consisted of entering into offsetting long and short positions through repo and reverse repo transactions of the same government securities. Under OFFSETTING OF AMOUNTS RELATED TO CERTAIN REPURCHASE AND REVERSE REPURCHASE AGREEMENTS, FASB Interpretation No. 41 (Fin. Accounting Standards Bd. 1994) ("FIN 41"), which may be applied only to repo and reverse repo transactions if certain criteria are satisfied, Lehman could offset the asset (reverse repo) and liability (repo). As a consequence of offsetting the reverse repos and repos, Lehman could include in its balance sheet totals for repo and reverse repo agreements only as a net amount with each of its counterparties, resulting in a reduction in the size of the gross balance sheet. Offsetting under FIN 41 is optional and permitted only if all of the following requirements (provided in summary form) are met: (1) the repo and reverse are executed with the same counterparty; (2) the repo and reverse have the same explicit settlement date specified at inception of the agreement; (3) the repo and reverse are executed in accordance with a master netting agreement; (4) the securities underlying the repos and reverses exist in "book entry" form; (5) the repos and reverses are settled in a securities transfer system that transfers "book entry" securities and banking arrangements are in place so that the entities must only keep cash on deposit sufficient to cover net payables; and (6) the same account at the clearing bank is used for the cash inflows of the settlement of the reverses and for settlement of the cash outflows of the repos. See FIN 41, ¶ 3. "Netting" under FIN 41 is very different from balance sheet reduction achieved by means of Repo 105 transactions. With Repo 105, Lehman: (1) recharacterized a repo transaction (a liability) as a sale, and thereby removed inventory from its balance sheet and (2) borrowed cash without reflecting the borrowing on its financial statements and related disclosures. With FIN 41, two counterparties that owe each other money are simply netting identical transactions and showing the net amounts on the balance sheet.Show full note Voigts said that he also found interesting that Lehman was repoing out treasury securities at a higher haircut than would normally be used for such liquid collateral.³⁴⁹⁴³⁴⁹⁴ Examiner's Interview of Jan H. Voigts, Oct. 1, 2009, at p. 5. Voigts said he would have wanted to know more about any "off‐market" transactions Lehman undertook.³⁴⁹⁵³⁴⁹⁵ Id.

912

¶Arthur Angulo, who was a Senior Vice President in FRBNY's Bank Supervision department, likewise was unaware that Lehman engaged in repo transactions at quarter‐end, under a United Kingdom true sale opinion letter, where the assets would be returned to Lehman's balance sheet following the end of the reporting period.³⁴⁹⁶³⁴⁹⁶ Examiner's Interview of Arthur G. Angulo, Oct. 1, 2009, at p. 2. Angulo said that the described repo transactions appeared to go "beyond other types of [permissible] balance sheet management."³⁴⁹⁷³⁴⁹⁷ Id. The question of whether and why some window‐dressing may be considered acceptable by the financial community is beyond the scope of the Examiner's Report. The Examiner has investigated Lehman's use of Repo 105 transactions and has concluded that the balance sheet manipulation was intentional, for deceptive appearances, had a material impact on Lehman's net leverage ratio, and, because Lehman did not disclose the accounting treatment of these transactions, rendered Lehman's Forms 10‐K and 10‐Q (financial statements and MD&A) deceptive and misleading.Show full note Angulo also said that he would have wanted to know about off‐market transactions where Lehman accepted a higher haircut than a repo seller normally would accept for a certain type of collateral.³⁴⁹⁸³⁴⁹⁸ Id.

913

¶Thomas Baxter, FRBNY General Counsel, had no knowledge of Repo 105 transactions, either by name or design.³⁴⁹⁹³⁴⁹⁹ Examiner's Interview of Thomas C. Baxter, Jr., Aug. 31, 2009, at pp. 3‐4, 9. Baxter was generally aware of firms using quarter‐end and month‐end "balance sheet window‐dressing," but did not recall this being an issue linked to Lehman specifically.³⁵⁰⁰³⁵⁰⁰ Id.

Securities and Exchange Commission CSE Monitors Were Unaware of Lehman's Repo 105 Program

¶The Examiner interviewed multiple employees of the Securities and Exchange Commission who had some responsibility to monitor Lehman's business operations as part of the Consolidated Supervised Entity ("CSE") division: Michael Macchiaroli, Phillip Minnick, James Giles, Michelle Danis, Gina Lai, and Raymond Doherty. None had been informed of Lehman's use of Repo 105 transactions.³⁵⁰¹³⁵⁰¹ Examiner's Interview of SEC Staff, Aug. 24, 2009, at pp. 3, 10.

¶The SEC's Matthew Eichner, who was involved with the CSE division, was not aware of Lehman's use of Repo 105 transactions, by name or description, to remove assets from the balance sheet and impact its leverage ratios.³⁵⁰²³⁵⁰² Examiner's Interview of Matthew Eichner, Nov. 23, 2009, at p. 9. Asked if the SEC – in connection with its monitoring responsibilities under the CSE division – would have wanted to know that Lehman's net leverage calculation was based, in part, on "true sale" accounting for certain repo transactions, Eichner explained that because the SEC's CSE monitors did not put much stock in leverage numbers, knowledge of the volumes of Repo 105 transactions would not have signaled to them "that something was terribly wrong."³⁵⁰³³⁵⁰³ Id.Note that Eichner was not involved in monitoring public disclosures. His comments about net leverage were made in reference to the SEC's role in monitoring Lehman under the CSE division. See Section III.A.6.b of this Report (discussing the SEC's oversight of Lehman and the CSE program). The SEC's CSE division had the "strong view that, for complicated financial institutions, leverage information is not often going to give you the right answer for a variety of business reasons."³⁵⁰⁴³⁵⁰⁴ Examiner's Interview of Matthew Eichner, Nov. 23, 2009, at p. 9.

914

Knowledge of Lehman's Repo 105 Program at the Highest Levels of the Firm

¶Many former members of senior Lehman management recalled generally Lehman's use of Repo 105 transactions – such as the existence of Lehman's Repo 105 program, that Lehman used these transactions to manage its balance sheet, and that the internal Repo 105 accounting policy had been vetted by outside auditors and lawyers.³⁵⁰⁵³⁵⁰⁵ Examiner's Interview of Christopher M. O'Meara, Aug. 14, 2009, at p. 4 (stating he knew that Repo 105 transactions netted down the balance sheet); Examiner's Interview of Herbert H. "Bart" McDade III, Sept. 16, 2009, at p. 4 (stating that Lehman had vetted its Repo 105 policy with Ernst & Young and that inventory was removed from Lehman's balance sheet as a result of Lehman's Repo 105 transactions); Examiner's Interview of Erin M. Callan, Oct. 23, 2009, at pp. 17‐19 (acknowledging she was aware, as CFO, that Lehman's Repo 105 practice impacted net balance sheet, that the transactions had to be routed through Europe); Examiner's Interview of Ian T. Lowitt, Oct. 28, 2009, at pp. 10‐12, 14 (acknowledging that he was aware of Lehman's Repo 105 program for many years, that Lehman used the transactions toShow full note These same witnesses, however, disavowed any knowledge on a number of significant topics:³⁵⁰⁶³⁵⁰⁶ Examiner's Interview of Christopher M. O'Meara, Sept. 23, 2009, at pp. 7‐8 (disavowing any knowledge of a cap on Repo 105 usage or volume of Lehman's Repo 105 usage); Examiner's Interview of Erin M. Callan, Oct. 23, 2009, at pp. 17, 20 (disavowing knowledge of the volume of Lehman's Repo 105 transactions and stating she had no awareness of or discussions regarding a cap on Repo 105 usage); Examiner's Interview of Ian T. Lowitt, Oct. 28, 2009, at pp. 12‐13 (stating that he had no recollection of volume of Lehman's Repo 105 usage or that senior management had decided by mid‐2008 to reduce Lehman's Repo 105 usage). When the Examiner first interviewed Bart McDade in September 2009, McDade disavowed any knowledge that Lehman's Repo 105 usage every exceeded $20 billion. Examiner's Interview of Herbert H. "Bart" McDade III, Sept. 16, 2009, at p. 4. When the Examiner interviewed McDade a second time, McDade acknowledged that he was aware of the volume of Lehman's Repo 105 usage and that in 2008, he had ordered a firm‐wide cap on Repo 105 usage for third quarter 2008 of $25 billion down from more than $50 billion at the end of the second quarter 2008. Examiner's Interview of Herbert H. "Bart" McDade III, Jan. 28, 2010, at pp. 2‐8.Show full note

915

● the volumes of Repo 105 transactions that Lehman engaged in at quarter‐ end;

● that Lehman more than doubled its Repo 105 usage from late 2006 to February and May 2008;

● that Lehman vastly exceeded its self‐imposed limits on Repo 105 transactions in 2007 and 2008;

● that Lehman's use of Repo 105 transactions had a material impact on the firm's net leverage ratio; and

● that securities of United States‐based Lehman entities were used for Repo 105 transactions.

¶Notwithstanding the professed ignorance by witnesses of virtually any of these issues central to the scope of Lehman's Repo 105 program, contemporaneous documents demonstrate that many former top executives were regularly apprised of the scope of the firm's Repo 105 usage.³⁵⁰⁷³⁵⁰⁷ The Examiner's role is not to make credibility determinations but rather to point out where a trier of fact would be justified in doing so and, therefore, that a colorable claim exists. The Examiner does not opine one way or another on the credibility of the statements of various officers denying any substantive knowledge of Repo 105 transactions. But the Examiner notes that a trier of fact would have to assess the credibility of individual denials of recollection against the notable, collective lack of memory of a $50 Herbert H. (Bart) McDade III, Lehman, et al. (June 2, 2008) [LBEX‐DOCID 011127] and stating ("Global Rates net balance sheet decreased ($6.5B) . . . [t]he decrease in Europe is coming from increased utilization of Repo 105").Show full note For example, a report entitled the "Balance Sheet meet balance sheet targets, that Repo 105 transactions used only liquid inventory, and that Lehman set internal limits on Repo 105 usage but that Chris O'Meara was involved with limit‐setting).

916

¶and Disclosure Scorecard," which was circulated to various members of senior Lehman management on a daily basis from April 2008 through September 2008, tracked, among other things, the daily benefit that Repo 105 transactions provided to Lehman's balance sheet.3508 Lehman created the Daily Balance Sheet and Disclosure Scorecard in April billion ongoing program, disclosed on multiple documents, that impacted the report of a critical metric, by the firm's one CEO, a COO and three CFOs. 3508 This Daily Balance Sheet and Disclosure Scorecard was a more comprehensive PowerPoint version of a daily balance sheet and disclosures scorecard e‐mail report that was distributed regularly. The condensed e‐mail summary of the report also contained frequent references to Repo 105. The PowerPoint version of the report contained an Executive Summary that also contained frequent references to Repo 105 transactions, as well as global and regional Net Balance Sheet, Gross Balance Sheet, Balance Sheet at Risk, and Cash Capital schedules. This report was regularly distributed to Bart McDade, Chris O'Meara, Erin M. Callan, Ian T. Lowitt, and many other top Lehman executives and members of senior management between April 2008 and September 2008. See, e.g., Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 7, 2008 (Apr. 9, 2008) [LBEX‐DOCID 520619] (attached to e‐mail from Tal Litvin, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (Apr. 9, 2008) [LBEX‐DOCID 523578]); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 8, 2008 (Apr. 10, 2008) [LBEX‐ DOCID 520620] (attached to e‐mail from Tal Litvin, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (Apr. 10, 2008) [LBEX‐DOCID 523579]); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 9, 2008 (Apr. 10, 2008) [LBEX‐DOCID 251339] (attached to e‐mail from Tal Litvin, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (Apr. 10, 2008) [LBEX‐DOCID 258560]); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 10, 2008 (Apr. 14, 2008) [LBEX‐DOCID 251342] (attached to e‐mail from Tal Litvin, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (Apr. 14, 2008) [LBEX‐DOCID 275231]; Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 11, 2008 (Apr. 14, 2008) [LBEX‐DOCID 251344] (attached to e‐mail from Tal Litvin, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (Apr. 14, 2008) [LBEX‐DOCID 258562]; Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 14, 2008 (Apr. 15, 2008) [LBEX‐DOCID 012177] (attached to e‐ mail from Tal Litvin, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (Apr. 15, 2008) [LBEX‐ DOCID 079620]); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 12, 2008 (May 13, 2008) [LBEX‐LL 1950262], at p. 1 (attached to e‐mail from Tal Litvin, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (May 13, 2008) [LBEX‐DOCID 3187357] and stating "Rates decreased by $(5.0B) from prior day due to…increased Repo 105 usage. . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 22, 2008 (May 27, 2008), at p. 1 [LBEX‐LL 1950706] (attached to e‐mail from Tal Litvin, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (May 27, 2008) [LBEX‐DOCID 275984] and stating "Global rates net balance sheet decreased ($2.0B), predominantly due to an increase in Repo 105 benefit. . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 28, 2008 (May 30, 2008), at p. 1 [LBEX‐LL 1950670] (attached to e‐mail from Tal Litvin, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (May 30, 2008) [LBEX‐DOCID 275995] and stating "Global rates net balance sheet decreased by ($3.1B) primarily due to a decrease in Americas driven by an increased utilization of Repo 105 within the Agency business"); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 29, 2008 (May 30, 2008), at p. 1 [LBEX‐LL 1950658] (attached to e‐mail from Tal Litvin, Lehman, to

917

¶2008 at Bart McDade's specific request and in connection with his role as balance sheet point person.³⁵⁰⁹³⁵⁰⁹ Examiner's Interview of Herbert H. (Bart) McDade III, Jan. 28, 2010, at p. 8. According to McDade, "I needed a daily scorecard to know where I wanted to push" on balance sheet issues.³⁵¹⁰³⁵¹⁰ Id. McDade recalled that he was focused on the "Repo 105" figures that appeared in many of the Daily Balance Sheet and Disclosure Scorecards.³⁵¹¹³⁵¹¹ Id. at pp. 8‐9. For example, a column entitled "Repo 105" in the report's Consolidated Balance Sheet Summary clearly documented the volume of Repo 105 transactions undertaken by each Lehman business unit or division.³⁵¹²³⁵¹² See, e.g., Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 8, 2008 (Apr. 10, 2008), at p. 9 [LBEX‐DOCID 520620]; Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 18, 2008 (Apr. 21, 2008), at p. 10 [LBEX‐DOCID 275233].

Richard Fuld, Former Chief Executive Officer

¶Richard Fuld, Lehman's former Chief Executive Officer denied any recollection of Lehman's use of Repo 105 transactions.³⁵¹³³⁵¹³ Examiner's Interview of Richard S. Fuld, Jr., Nov. 19, 2009, at pp. 7‐8. Fuld said he had no knowledge that Lehman treated any kind of repo transaction as a true sale or that Lehman ever removed from its balance sheet assets transferred in a repo transaction.³⁵¹⁴³⁵¹⁴ Id. In addition, Fuld did not recall having seen any reports referencing the amount of the firm's Repo 105 activity.³⁵¹⁵³⁵¹⁵ Id. Fuld further stated that he did not know that Lehman removed approximately $49 and $50 billion in inventory off its balance sheet at quarter‐end through the use of Repo 105 transactions in first quarter 2008 and second quarter 2008, respectively.³⁵¹⁶³⁵¹⁶ Id. Fuld said, however, that if he had learned that Lehman was temporarily cleansing its balance sheet of assets at quarter‐end through Repo 105 transactions, it would have concerned him.³⁵¹⁷³⁵¹⁷ Id.

918

¶Fuld's denial of recollection must be weighed by a trier of fact against other evidence. Fuld recalled having many conversations with his executives about reducing net leverage and emphasized to the Examiner how important it was for Lehman to reduce its net leverage.³⁵¹⁸³⁵¹⁸ Examiner's Interview of Richard S. Fuld, Jr., Nov. 19, 2009, at pp. 7‐8. The night before the March 28, 2008 Executive Committee meeting, Fuld received materials for the meeting, including an agenda of topics including "Repo 105/108" and "Delever v Derisk" and a presentation that referenced Lehman's quarter‐end Repo 105 usage for first quarter 2008 – $49.1 billion.³⁵¹⁹³⁵¹⁹ Lehman, Balance Sheet and Cash Capital Update (Mar. 27, 2008), at p. 1 [LBEX‐DOCID 506399] (attached to e‐mail from Angela Judd, Assistant to Richard S. Fuld, Jr., Lehman, to Scott J. Freidheim, Lehman, et al. (Mar. 28, 2008) [LBEX‐DOCID 561761], containing Firm Balance Sheet Details with Repo 105/108 column showing total usage of $49.102 billion and break‐out for Repo 105 usage by business group); Lehman, Executive Committee Meeting Material, Agenda (Mar. 28, 2008) [LBEX‐DOCID 545869] (attached to e‐mail from Angela Judd, Assistant to Richard S. Fuld, Jr., Lehman, to Scott J. Freidheim, Lehman, et al. (Mar. 28, 2008) [LBEX‐DOCID 561761], listing topics for discussion at Executive Committee meeting, including "Repo 105/108" and "Delever v Derisk").Show full note The materials also were forwarded by Fuld's assistant to other Lehman executives.³⁵²⁰³⁵²⁰ E‐mail from Angela Judd, Assistant to Richard S. Fuld, Jr., Lehman, to Scott J. Freidheim, Lehman, et al. (Mar. 28, 2008) [LBEX‐DOCID 561761]. Fuld's attorney asserted to the Examiner that Fuld does not use a computer, uses only a Blackberry and does not have the ability to open attachments. Examiner's Meeting with Patricia Hynes re: Richard S. Fuld, Jr., Jan. 20, 2010, at p. 2.

919

¶It appears that Fuld did not attend the March 28 meeting, but Bart McDade recalled having specific discussions with Fuld about Lehman's Repo 105 usage in June 2008.³⁵²¹³⁵²¹ Richard S. Fuld, Jr., Lehman, Call Log, at pp. 6‐7 [LBHI_SEC07940_016911] (showing Fuld had telephone calls the morning of the Executive Committee meeting); Examiner's Interview of Herbert H. "Bart" McDade III, Jan. 28, 2010, at pp. 3‐4 (stating that Fuld did not attend the March 28, 2008 Executive Committee meeting but that "in quarter three, I certainly talked to Fuld about Repo 105."). Sometime that month, McDade spoke to Fuld about reducing Lehman's use of Repo 105 transactions.³⁵²²³⁵²² Examiner's Interview of Herbert H. "Bart" McDade III, Jan. 28, 2010, at p. 4. McDade walked Fuld through the Balance Sheet and Key Disclosures document (reproduced in part below) and discussed with Fuld Lehman's quarter‐end Repo 105 usage – $38.6 billion at year‐end 2007; $49.1 billion at first quarter 2008; and $50.3 billion at second quarter 2008.³⁵²³³⁵²³ Id. at p. 5; see also Lehman, Balance Sheet and Key Disclosures 2008 3Q Targets (Draft) (June 16, 2008), at p. 3 [LBHI_SEC07940_641516].

920

¶Based upon their conversation, McDade understood that "Fuld knew, at a basic level, that Repo 105 was used in the firm's bond business" and that Fuld "was familiar with the term Repo 105."³⁵²⁴³⁵²⁴ Examiner's Interview of Herbert H. "Bart" McDade III, Jan. 28, 2010, at p.5. McDade recalled that when he advised Fuld in June 2008 that Lehman should reduce its Repo 105 usage to $25 billion, "Fuld understood that this would put pressure on traders."³⁵²⁵³⁵²⁵ Id. at p. 6. McDade also recalled that "Fuld knew about the accounting of Repo 105."³⁵²⁶³⁵²⁶ Id.

921

Lehman's Former Chief Financial Officers

¶Although interview statements given to the Examiner were inconsistent at times, no reasonable dispute exists that each of Lehman's Chief Financial Officers from late 2007 to September 2008 possessed some knowledge of and/or involvement with multiple aspects of Lehman's Repo 105 program, including the existence of firm‐wide Repo 105 limits, the volume of Repo 105 activity Lehman engaged in at quarter‐end, and Lehman's efforts to manage its balance sheet using Repo 105 transactions.

Chris O'Meara, Former Chief Financial Officer

¶Chris O'Meara served as Lehman's CFO from December 2004 through December 2007.³⁵²⁷³⁵²⁷ Examiner's Interview of Christopher M. O'Meara, Aug. 14, 2009, at p. 6. No later than July 2006, O'Meara and Ed Grieb, then Global Financial Controller, set a limit or cap on Lehman's firm‐wide Repo 105 usage.³⁵²⁸³⁵²⁸ Lehman, Global Balance Sheet Overview of Repo 105 (FID)/Repo 108 Equities (July 2006), at p. 2 [LBEX‐WGM 748489]; Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 8. According to a July 2006 internal Lehman presentation, O'Meara and Grieb set the limit for Repo 105 at $17 billion or "1 x leverage" and the limit for Repo 108 at $5 billion.³⁵²⁹³⁵²⁹ Lehman, Global Balance Sheet, Overview of Repo 105 (FID)/Repo 108 Equities (July 2006), at p. 2 [LBEX‐WGM 748489]. The same document also suggests that total Repo 105 usage should be maintained at 80% tangible equity intra‐month. See Section III.A.4.f.3 of this Report (discussing continual use rule). When questioned about the calculation of the Repo 105 limit set out in the Global Balance Sheet Overview Presentation, Grieb could not recall the calculation of the limit or whether the "1x leverage or $17 billion" definition referred to one of Lehman's leverage ratios or, rather, to tangible equity capital. Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 9. Lehman's Form 10‐Q from the same period as the Global Balance Sheet Overview Presentation shows that Lehman's tangible equity capital was $17.4 billion and that the firm's net leverage ratio was 13.8, suggesting that the calculation of Lehman's Repo 105 limit may have been tied to tangible equity capital. Lehman Brothers Holdings Inc., Quarterly Report as of May 31, 2006 (Form 10‐Q) (filed on July 10, 2006), at p. 58 ("LBHI 10‐Q (filed July 10, 2006)"). The Global Balance Sheet Overview Presentation itself suggested that tangible equity is the appropriate measure of leverage. Lehman, Global Balance Sheet, Overview of Repo 105 (FID)/Repo 108 Equities (July 2006), at p. 5 [LBEX‐ WGM 748489]; see also Duff & Phelps, Repo 105/108 Usage vs. Limit Comment (Oct. 16, 2009), at p. 1. Bismal described the "1 x leverage" metric as 1 x the net leverage ratio. Examiner's Interview of Anuraj Bismal, Sept. 16, 2009, at p. 10. The conclusion that "1 x leverage" means that the limit was 1 x tangible equity metric is also supported by the fact that the denominator of the net leverage ratio is tangible equity. Duff & Phelps, Repo 105/108 Usage vs. Limit Comment (Oct. 16, 2009), at p. 1 & n. 4. The setting of the Repo 105 limit at 1 x tangible equity implies that senior Lehman management determined Repo 105 usage would be permitted by the firm to reduce Lehman's net leverage ratio by up to one multiple. Duff & Phelps, Repo 105/108 Usage vs. Limit Comment (Oct. 16, 2009), at p. 2.Show full note The Examiner questioned O'Meara about Lehman's Repo 105 program on two separate occasions. During his first interview, O'Meara disavowed knowledge of the program, stating that he was "not that close to" the Repo 105 issue.³⁵³⁰³⁵³⁰ Examiner's Interview of Christopher M. O'Meara, Aug. 14, 2009, at p. 29. O'Meara further stated during his initial interview that he never instructed Lehman's business units to lower their balance sheets at quarter‐end using Repo 105 transactions.³⁵³¹³⁵³¹ Id.

922

¶Internal Lehman documents and interview statements of other witnesses evidence greater involvement than O'Meara recalls. For example, the July 2006 internal Lehman Power Point presentation titled "Overview of Repo 105 (FID)/108 (Equities)" identifies numerous "Operating Rules" related to Lehman's Repo 105 program, including "Repo 105 is capped at $17B (1 x leverage) [per Chris O'Meara and Ed Grieb]"; "Repo 108 is capped at $5B [per Chris O'Meara and Ed Grieb]"; and "Repo 105 transactions must be executed on a continual basis and remain in force throughout the month. To meet this requirement, the amount outstanding at any time should be maintained at approximately 80% of the amount at month‐end. [per Chris O'Meara and Ed Grieb]."³⁵³²³⁵³² Lehman, Global Balance Sheet, Overview of Repo 105 (FID)/Repo 108 Equities (July 2006), at p. 2 [LBEX‐WGM 748489].

923

¶During O'Meara's second interview, the Examiner showed O'Meara the July 2006 presentation.³⁵³³³⁵³³ Examiner's Interview of Christopher M. O'Meara, Sept. 23, 2009 at p. 6. O'Meara said he had never before seen the presentation and did not know who drafted it.³⁵³⁴³⁵³⁴ Id. at pp. 6‐8. O'Meara continued that he had "no specific recollection" that he was involved in setting firm‐wide limits or caps for Lehman's Repo 105 usage.³⁵³⁵³⁵³⁵ Id. When the Examiner asked directly whether he was the "source for the cap on Repo 105," O'Meara said no.³⁵³⁶³⁵³⁶ Id. O'Meara further said that he could not recall if anyone ever told him that Repo 105 transactions would help reduce Lehman's balance sheet or net leverage.³⁵³⁷³⁵³⁷ Id.

¶Finally, when asked why Lehman would choose to engage in Repo 105 transactions instead of ordinary repo transactions, given the higher haircut for Repo 105 transactions, O'Meara could not explain, saying only "I'm just not close enough to it."³⁵³⁸³⁵³⁸ Examiner's Interview of Christopher M. O'Meara, Sept. 23, 2009, at p. 7. O'Meara stated also that he could not recall having any conversations regarding Lehman's Repo 105 program with Richard Fuld, Joe Gregory, Erin Callan, Ed Grieb, any Government personnel, or anyone from the ratings agencies.³⁵³⁹³⁵³⁹ Id.

924

¶Grieb, on the other hand, recalled many conversations with O'Meara about Lehman's use of Repo 105 transactions.³⁵⁴⁰³⁵⁴⁰ Examiner's Interview of Edward Grieb, Oct. 2, 2009, at pp. 10, 12‐13. Grieb communicated regularly, throughout his tenure as Global Financial Controller – which Grieb recalled lasted for "several years" and ended on December 1, 2007 – with O'Meara and Reilly about firm‐wide limits or targets for Lehman's Repo 105 program.³⁵⁴¹³⁵⁴¹ Id. Grieb stated that he never discussed Repo 105‐related issues with Callan or Lowitt, each of whom became CFO after Grieb left his Financial Controller position.

¶According to Grieb, he, O'Meara, and Reilly shared responsibilities in setting firm‐wide Repo 105 limits for several years, as late as November 2007.³⁵⁴²³⁵⁴² Id.; see also Lehman, Global Balance Sheet Overview of Repo 105 (FID)/Repo 108 Equities (July 2006), at p. 2 [LBEX‐WGM 748489]. Grieb said that he alone did not have the authority to change or increase the limit or to authorize a person or group to exceed the limit; instead, a change in Lehman's firm‐wide Repo 105 limit required consensus among Grieb, O'Meara and Reilly.³⁵⁴³³⁵⁴³ Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 8. Although acknowledging that he had some role in setting the Repo 105 limits, Grieb denied any recollection of the formula by which Lehman calculated the limits. Id. at p. 9. When the Examiner attempted to refresh his recollection with the July 2006 Lehman presentation which stated that the firm‐wide cap on Repo 105 was set at "1x leverage," or $17 billion, Grieb stated his belief that the cap was related to firm's "overall leverage ratio." Id. But when shown Lehman's Form 10‐Q for second quarter 2006 (the same general time period as the July 2006 presentation), which disclosed that Lehman's firm‐wide shareholder equity was approximately $17 billion and the firm's net leverage ratio was 13.8x, Grieb stated he was less certain that the Repo 105 limit was calculated on the basis of leverage. Id.Show full note

925

¶A number of other documents show that O'Meara was involved with Lehman's Repo 105 program:

● As CFO, O'Meara regularly received a report titled "Weekly Finance Update," at least one version of which included a reference to the firm's use of Repo 105 transactions.³⁵⁴⁴³⁵⁴⁴ Lehman, Weekly Finance Update, Week Ended August 11, 2006 (Aug. 15, 2006), at p. 11 [LBEX‐ DOCID 1346667] ("IRP's Net Balance Sheet increased by $5B mostly due to Repo 105.") (attached to e‐ mail from Polina Savelieva, Lehman to Christopher M. O'Meara, Lehman, et al. (Aug. 15, 2006) [LBEX‐ DOCID 1361132].

● In August 2007, Kentaro Umezaki wrote to O'Meara and others: "FYI: John Feraca is working on Repo 105 for our IG mortgage and real estate assets to reduce our Q3 balance sheet. We've agreed we'd regroup on Tuesday to see to what extent we can utilize that facility for Qend."³⁵⁴⁵³⁵⁴⁵ E‐mail from Kentaro Umezaki, Lehman, to Christopher M. O'Meara, Lehman, et al. (Aug. 17, 2007) [LBEX‐DOCID 197155]. The following day, Reilly replied to O'Meara alone: "I thought 105 would be a better answer than the cds structure we talked about. May be no appetite."³⁵⁴⁶³⁵⁴⁶ E‐mail from Gerard Reilly, Lehman, to Christopher M. O'Meara, Lehman (Aug. 18, 2007) [LBEX‐ DOCID 197155].

● Another August 2007 e‐mail chain regarding Repo 105 usage was forwarded to O'Meara from Reilly.³⁵⁴⁷³⁵⁴⁷ E‐mail from Gerard Reilly, Lehman, to Christopher M. O'Meara, Lehman (Aug. 19, 2007) [LBEX‐ DOCID 4553354]; e‐mail from Gerard Reilly, Lehman, to Christopher M. O'Meara, Lehman (Aug. 20, 2007) [LBEX‐DOCID 4553358]. Around the same time that Grieb recommended to Lehman's Accounting Policy Group that Lehman use the Repo 105 program to remove from the balance sheet certain residual positions from mortgage‐backed securitizations, Reilly was pursuing a similar effort.³⁵⁴⁸³⁵⁴⁸ E‐mail from Marie Stewart, Lehman, to Brett Beldner, Lehman, et al. (Aug. 17, 2007) [LBEX‐DOCID 3223803] (discussing Grieb's idea of placing mortgage‐backed securities into Repo 105 program). In a series of e‐mails from August 2007, Reilly unsuccessful attempted to transfer non‐agency mortgage‐backed securities into the Repo 105 program.³⁵⁴⁹³⁵⁴⁹ E‐mail from John Feraca, Lehman, to Gerard Reilly, Lehman (Aug. 18, 2007) [LBEX‐DOCID 4553350]; e‐mail from Gerard Reilly, Lehman, to John Feraca, Lehman (Aug. 18, 2007) [LBEX‐DOCID 4553351]; e‐ mail from John Feraca, Lehman, to David Sherr, Lehman, et al. (Aug. 19, 2007) [LBEX‐DOCID 4553352]; e‐ mail from David Sherr, Lehman, to Gerard Reilly, Lehman, et al. (Aug. 19, 2007) [LBEX‐DOCID 4553353]; e‐mail from Gerard Reilly, Lehman, to John Feraca, Lehman, et al. (Aug. 19, 2007) [LBEX‐DOCID 4553356]; e‐mail from John Feraca, Lehman, to David Sherr, Lehman, et al. (Aug. 20, 2007) [LBEX‐DOCID 4553357].Show full note Reilly enlisted the help of John Feraca and David Sherr in this effort so that Lehman could reduce its mortgage positions through the Repo 105 program.³⁵⁵⁰³⁵⁵⁰ E‐mail from John Feraca, Lehman, to Gerard Reilly, Lehman (Aug. 18, 2007) [LBEX‐DOCID 4553350]; e‐mail from Gerard Reilly, Lehman, to John Feraca, Lehman (Aug. 18, 2007) [LBEX‐DOCID 4553351]; e‐ mail from John Feraca, Lehman, to David Sherr, Lehman, et al. (Aug. 19, 2007) [LBEX‐DOCID 4553352]; e‐ mail from David Sherr, Lehman, to Gerard Reilly, Lehman, et al. (Aug. 19, 2007) [LBEX‐DOCID 4553353]; e‐mail from Gerard Reilly, Lehman, to John Feraca, Lehman, et al. (Aug. 19, 2007) [LBEX‐DOCID 4553356]; e‐mail from John Feraca, Lehman, to David Sherr, Lehman, et al. (Aug. 20, 2007) [LBEX‐DOCID 4553357].Show full note Notably, Reilly kept O'Meara informed of these efforts by forwarding to him the e‐mail communications with Feraca and Sherr.³⁵⁵¹³⁵⁵¹ E‐mail from Gerard Reilly, Lehman, to Christopher M. O'Meara, Lehman (Aug. 19, 2007) [LBEX‐ DOCID 4553354]; e‐mail from Gerard Reilly, Lehman, to Christopher M. O'Meara, Lehman (Aug. 20, 2007) [LBEX‐DOCID 4553358]. At the same time, per O'Meara's request, Grieb made inquiries regarding a potential credit default swap structure for Lehman's RMBS and CMBS securities in addition to the plan to move them into the Repo 105 program.³⁵⁵²³⁵⁵² E‐mail from Gerard Reilly, Lehman, to Christopher M. O'Meara, Lehman (Aug. 20, 2007) [LBEX‐ DOCID 197157]. Specifically, O'Meara told Reilly that "the plan is to do both [Repo 105 and credit default swap] if all checks out fine with legal and accounting."³⁵⁵³³⁵⁵³ Id.

926

¶Documents also establish that O'Meara continued to be involved in Lehman's Repo 105 program after leaving the CFO position in December 2007³⁵⁵⁴³⁵⁵⁴ Lehman's fiscal year ended on November 30, 2007. Though Lehman did not file its 2007 10‐K – signed by Callan – until January 29, 2008, O'Meara served as CFO for the entire period reflected in the 2007 10‐K. Moreover, the Examiner has located evidence suggesting that O'Meara sub‐certified the 2007 10‐K for Callan and was responsible for certain financial reporting in Lehman's Form 10‐Q for first quarter 2008. See Lehman Brothers Holdings Inc., Reporting Instructions, Quarter Ended February 29, 2008 (Feb. 22, 2008), at p. 5 ( [LBEX‐DOCID 3756724] (stating that O'Meara was the certifier for the Review of Risk Management narrative for accuracy of MD&A discussions of credit risk, market risk, operational risk, reputational risk, value at risk, other measures of risk and distribution of trading revenues); e‐mail from Martin Kelly, Lehman, to Ian T. Lowitt, Lehman (July 8, 2008) [LBEX‐DOCID 2329856] ("[W]ould you like to have Erin sign a sub‐certification letter (not necessary strictly speaking but we did have Chris sub‐ certify to Erin at year end."); e‐mail from Martin Kelly, Lehman, to Erin M. Callan, Lehman (July 9, 2008) [LBEX‐DOCID 1536331] (asking Callan "if I could have you sub‐certify on the quarter[ly report] (Chris [O'Meara] sub‐certified to you at year end)"); e‐mail from Ian T. Lowitt, Lehman, to Martin Kelly, Lehman (July 9, 2008) [LBEX‐DOCID 2329856] ("I spoke to Tom [Russo about sub‐certification] and heShow full note and taking on the role of Chief Risk Officer:

927

● O'Meara received a March 2008 e‐mail transmitting an internal presentation, "Balance Sheet and Cash Capital Update," that illustrated the quarter‐end volume of Repo 105 transactions for first quarter 2008, $49.102 billion, and broke out the amount of Repo 105 usage by business segment.³⁵⁵⁵³⁵⁵⁵ Lehman, Balance Sheet and Cash Capital Update (Mar. 27, 2008), at p. 1 [LBEX‐DOCID 506398] (attached to e‐mail from Christopher M. O'Meara, Lehman, to James Emmert, Lehman (Mar. 28, 2008) [LBEX‐DOCID 574581]).

● An April 11, 2008 e‐mail from O'Meara to Reilly indicates that the two men were planning to discuss Lehman's Repo 105 program on April 14, 2008.³⁵⁵⁶³⁵⁵⁶ E‐mail from Christopher M. O'Meara, Lehman, to Gerard Reilly, Lehman (Apr. 11, 2008) [LBEX‐ DOCID 4553298].

● An e‐mail from Traversari to O'Meara reveals that O'Meara asked Traversari questions about daily balance sheet management at Lehman "compared to traditional banks."³⁵⁵⁷³⁵⁵⁷ E‐mail from Ryan Traversari, Lehman, to Christopher M. O'Meara, Lehman (May 16, 2008) [LBEX‐ DOCID 3233899]. Traversari wrote to O'Meara that one reason why Lehman's balance sheet was larger intra‐month than at month‐end was because, unlike other banks, Lehman used Repo 105 transactions "which are UK‐based specific transactions on opinions received by LEH from Linklaters."³⁵⁵⁸³⁵⁵⁸ Id.

● When Lehman was facing "significant reduction in repo 105 availability for month end" only ten days before the close of the second quarter 2008 because certain counterparties "retrenched" and Lehman had already used its available credit line with Mizuho, Matthew Pinnock asked Tonucci to "speak[] with O'Meara for a temp increase [in repo 105] to get us over month end."³⁵⁵⁹³⁵⁵⁹ E‐mail from Matthew Pinnock, Lehman, to Paolo R. Tonucci, Lehman (May 21, 2008) [LBEX‐DOCID 1548431]. Tonucci replied that he would speak with O'Meara about a Repo 105 increase. See e‐mail from Paolo R. Tonucci, Lehman, to Matthew Pinnock, Lehman (May 21, 2008) [LBEX‐DOCID 1548433]. Tonucci inquired: "Any room to upsize Mizuho?"³⁵⁶⁰³⁵⁶⁰ E‐mail from Paolo R. Tonucci, Lehman, to Christopher M. O'Meara, Lehman (May 21, 2008) [LBEX‐ DOCID 1533687]; see also e‐mail from Jeff Michaels, Lehman, to Kaushik Amin, Lehman (May 21, 2008) [LBEX‐DOCID 3234376] (regarding Repo 105 counterparties, Pinnock reports that Tonucci "understands urgency and is discussing with O'Meara"); e‐mail from Jeff Michaels, Lehman, to Kaushik Amin, Lehman O'Meara thereafter continued the discussion with Tonucci by telephone.³⁵⁶¹³⁵⁶¹ E‐mail from Christopher M. O'Meara, Lehman, to Paolo R. Tonucci, Lehman (May 21, 2008) [LBEX‐ DOCID 1533688].

¶thinks better if didn't come from him and better to present as consistent with what Chris did when Erin overlapped.").

928

● A June 17, 2008 e‐mail from Reilly to O'Meara, McDade, Lowitt, and Morton, attached a "strawman target doc for Q3" entitled "Balance Sheet and Key Disclosures 2008 3Q Targets."³⁵⁶²³⁵⁶² Lehman, Balance Sheet and Key Disclosures 2008 3Q Targets [Draft] (June 16, 2008) [LBEX‐DOCID 3363493] (attached to e‐mail from Gerard Reilly, Lehman, to Christopher M. O'Meara, Lehman, et al. (June 17, 2008) [LBEX‐DOCID 3383643]. The attachment, dated June 16, 2008, identified not only net and gross balance sheet targets for various Lehman business groups, but also contained a Repo 105 target chart.³⁵⁶³³⁵⁶³ Lehman, Balance Sheet and Key Disclosures 2008 3Q Targets [Draft] (June 16, 2008), at p. 3 [LBEX‐ DOCID 3363493]. The Repo 105 target chart noted the total volume of Repo 105³⁵⁶⁴³⁵⁶⁴ The chart refers only to Repo 105, but Lehman frequently used "Repo 105" to refer to both Repo 105 and Repo 108. The figures used in the chart are consistent with the total combined Repo 105/108 amounts reported in other documents. transactions Lehman engaged in at quarter‐end for fourth quarter 2007 ($38.6 billion), first quarter 2008 ($49.1 billion), and second quarter 2008 ($50.3 billion).³⁵⁶⁵³⁵⁶⁵ Brothers, Balance Sheet and Key Disclosures 2008 3Q Targets [Draft] (June 16, 2008), at p. 3 [LBEX‐ DOCID 3363493]. On June 17, 2008, O'Meara replied to Reilly and the other recipients of Reilly's e‐mail, stating: "A meeting is being set up to discuss this, this week."³⁵⁶⁶³⁵⁶⁶ E‐mail from Christopher M. O'Meara, Lehman, to Gerard Reilly, Lehman, et al. (June 17, 2008) [LBEX‐ DOCID 033813]. The meeting appears to have taken place on Thursday, June 19, 2008. See e‐mail from Gerard Reilly, Lehman, to Janet Marrero, Lehman (June 19, 2008) [LBEX‐DOCID 4553465] ("Can you print me 6 copies of this [Lehman, Balance Sheet and Key Disclosures 2008 3Q Targets] for the meeting at 3:30 [?]").Show full note

● When Bank of France terminated a Repo 105 trade in September 2008, O'Meara received an e‐mail with subject line "IRP LBI inventory risk" informing him of the fail.³⁵⁶⁷³⁵⁶⁷ E‐mail from Jeffrey Goodman, Lehman, to Christopher M. O'Meara, Lehman, et al. (Sept. 17, 2008) [LBEX‐DOCID 182776] (Jeff Michaels: "Just to be clear, I am not hedging this risk because I know it is substantially wrong. Bank of France terminated a repo 105 trade yesterday as it went through LBIE…." Goodman: "Can we get ops/mo to book terminates/sales for positions that we know to be terminated so we can have a semblance of reality in what we are showing in the systems?") decreased…driven by an increase in repo 105 usage …."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date August 28, 2008 (Aug. 29, 2008) [LBEX‐LL 782966] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (Aug. 29, 2008) [LBEX‐DOCID 275880] and stating that "Global rates [net balance sheet] was down…driven by increased Repo 105 benefit….").Show full note

● In addition, O'Meara received a recurring report between April and September 2008, the "Daily Balance Sheet Disclosure Scorecard," which often referenced Repo 105 activity and its impact on Lehman's balance sheet.3568

¶(May 21, 2008) [LBEX‐DOCID 3234378] (stating, in response to Amin's request, that Amin can get an additional $3.5 billion of Repo 105 with Mizuho "[i]f O'Meara and Paolo let us").

929

¶3568 See, e.g., Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 7, 2008 (Apr. 9, 2008) [LBEX‐DOCID 520619], at p. 9 (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (Apr. 9, 2008) [LBEX‐DOCID 523578] and showing consolidated FID and Equities balance sheet reduced by $18.527 billion and Prime Services balance sheet reduced by $4.458 billion through Repo 105 transactions as of April 7, 2008); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 8, 2008 (Apr. 10, 2008) [LBEX‐DOCID 520620], at p. 9 (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (Apr. 10, 2008) [LBEX‐DOCID 523579] and showing consolidated FID and Equities balance sheet reduced by $18.853 billion and Prime Services balance sheet reduced by $4.562 billion through Repo 105 transactions as of April 8, 2008); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 9, 2008 (Apr. 10, 2008) [LBEX‐DOCID 251339], at p. 9 (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (Apr. 10, 2008) [LBEX‐ DOCID 258560] and showing consolidated FID and Equities balance sheet reduced by $19.688 billion and Prime Services balance sheet reduced by $4.548 billion through Repo 105 transactions as of April 9, 2008); Balance Sheet and Disclosure Scorecard for Trade Date April 10, 2008 [LBEX‐DOCID 251342], at p. 9 (attached to e‐mail from Tal Litvin, Lehman to Christopher M. O'Meara, Lehman, et al. (Apr. 14, 2008) [LBEX‐DOCID 275231] and showing consolidated FID and Equities balance sheet reduced by $19.967 billion and Prime Services balance sheet reduced by $4.491 billion through Repo 105 transactions as of April 10, 2008); Balance Sheet and Disclosure Scorecard for Trade Date April 11, 2008 [LBEX‐DOCID 251344], at p. 9 (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (Apr. 14, 2008) [LBEX‐DOCID 258562] and showing consolidated FID and Equities balance sheet reduced by $20.260 billion and Prime Services balance sheet reduced by $4.517 billion through Repo 105 transactions as of April 11, 2008); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 12, 2008 (May 13, 2008) [LBEX‐LL 1950262], at p. 1 (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (May 13, 2008) [LBEX‐DOCID 3187357] and stating "Rates decreased by $(5.0B) from prior day due to . . . increased Repo 105 usage. . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 22, 2008 (May 27, 2008), at p. 1 [LBEX‐LL 1950706] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (May 27, 2008) [LBEX‐DOCID 275984] and stating "Global rates net balance sheet decreased ($2.0B), predominantly due to an increase in Repo 105 benefit. . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 28, 2008 (May 30, 2008), at p. 1 [LBEX‐LL 1950670] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (May 30, 2008) [LBEX‐DOCID 275995] and stating "Global rates net balance sheet decreased by ($3.1B) primarily due to a decrease in Americas driven by an increased utilization of Repo 105 within the Agency business"); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 29, 2008 (May 30, 2008), at p. 1 [LBEX‐LL 1950658] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (June 2, 2008) [LBEX‐DOCID 011127] and stating ("Global Rates net balance sheet decreased ($6.5B)…[t]he decrease in Europe is coming from increased utilization of Repo 105"); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date June 18, 2008 (June 20, 2008) [LBEX‐LL 1950514] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (June 20, 2008) [LBEX‐DOCID 275942] and stating that "Global rates net balance sheet decreased . . . driven by a[n] . . . increase in Repo 105 utilization. . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date August 13, 2008 (Aug. 14, 2008) [LBEX‐LL 782812] (attached to e‐ mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (Aug. 14, 2008) [LBEX‐DOCID 4214810] and stating that "Global rates net balance sheet decreased . . . driven by an increase in Repo 105 benefit. . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date August 25, 2008 (Aug. 26, 2008) [LBEX‐LL 782924] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (Aug. 26, 2008) [LBEX‐DOCID 079536] and stating that "Global Rates net balance sheet

930

Erin Callan, Former Chief Financial Officer

¶Erin Callan served as Lehman's CFO from December 1, 2007 until June 12, 2008.³⁵⁶⁹³⁵⁶⁹ Examiner's Interview of Erin M. Callan, Oct. 23, 2009, at pp. 7‐9. In her interview with the Examiner, Callan recalled very little about Lehman's Repo 105 program.³⁵⁷⁰³⁵⁷⁰ Id. at p. 17. Callan said she had little to no independent recollection of Lehman's use of Repo 105 transactions, but that her memory had been refreshed to a limited extent by documents the Examiner provided to her in advance of her interview.³⁵⁷¹³⁵⁷¹ Id.

¶Martin Kelly told the Examiner that he spoke to Callan about Kelly's discomfort with Lehman's use of Repo 105 transactions, raising five discrete concerns about Repo 105: (1) Kelly's discomfort with the possible "reputational risk" Lehman would suffer if the investing public and analysts learned that Lehman used Repo 105 transactions solely to reduce its balance sheet; (2) the size of Lehman's Repo 105 program, that is, the volume of Repo 105 transactions that Lehman undertook at quarter‐end to reduce its balance sheet; (3) the "technical basis," from an accounting perspective, by which Lehman was authorized to engage in Repo 105 transactions; (4) Kelly's belief that none of Lehman's peer investment banks used Repo 105 transactions; and (5) the fact that Lehman's Repo 105 activity was "skewed at quarter‐end," in other words, that the firm's Repo 105 usage spiked at quarter‐end, during Lehman's reporting periods.³⁵⁷²³⁵⁷² Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 8; see also Section III.A.4.f of this Report. Kelly recalled having several conversations with Callan about Lehman's use of Repo 105 transactions.³⁵⁷³³⁵⁷³ Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 9.

931

¶With regard to Kelly's discussion with Callan of the very technical accounting basis underlying Lehman's reliance on Repo 105 transactions, Kelly "wanted Callan to make sure Repo 105 transactions were being accounted for properly."³⁵⁷⁴³⁵⁷⁴ Id. Indeed, Kelly recalled a detailed discussion with Callan about each of SFAS 140's requirements for a transaction to receive "true sale" accounting treatment.³⁵⁷⁵³⁵⁷⁵ Id. Kelly "wanted to present [to Callan] a balanced analysis of the transactions . . . what GAAP requires and . . . [whether] we compl[ied] with GAAP."³⁵⁷⁶³⁵⁷⁶ Id.

¶With respect to the issue that none of Lehman's peer investment banks used Repo 105 transactions, Kelly informed Callan of this understanding because he "was trying to give Callan a balanced presentation or analysis" and "wanted to frame the quantum of risk involved in the program."³⁵⁷⁷³⁵⁷⁷ Id. at p. 10.

¶Callan recalled speaking to Kelly in late February or March 2008 about Repo 105 transactions, and recalled that Kelly advised her that he was unsure whether Lehman's peer CSE firms were also engaging in Repo 105 transactions at that time.³⁵⁷⁸³⁵⁷⁸ Examiner's Interview of Erin M. Callan, Oct. 23, 2009, at p. 17. Callan did not dispute Kelly's account of his conversations with her about the potential "reputational risk" Lehman's Repo 105 program might have posed to the firm, but did not specifically recall Kelly's comments.³⁵⁷⁹³⁵⁷⁹ Id. Callan speculated that Kelly's concerns about "reputational risk" likely were subsumed in his concerns about whether Lehman was the only Wall Street firm using Repo 105‐type transactions.³⁵⁸⁰³⁵⁸⁰ Id.

932

¶According to Callan, she and Kelly agreed that Kelly should determine whether Lehman was the lone user of Repo 105‐type transactions on Wall Street and, if so, to ensure the practice was appropriate.³⁵⁸¹³⁵⁸¹ Id. In addition, Callan recalled that she and Kelly agreed that Kelly would consult with Ernst & Young and certain of Lehman's business units about the firm's Repo 105 practices.³⁵⁸²³⁵⁸² Id. Callan, however, could not recall whether Kelly followed through on their conversation or whether he ever reported back to Callan with his findings.³⁵⁸³³⁵⁸³ Examiner's Interview of Erin M. Callan, Oct. 23, 2009, at p. 17. Callan suggested that Kelly's concerns about Lehman's Repo 105 program likely fell by the wayside, given Bear Stearns' near collapse shortly after their conversation, and that she and Kelly became deeply engaged in more pressing issues at that time, such as capital raises and setting balance sheet limits.³⁵⁸⁴³⁵⁸⁴ Id.

933

¶Kelly advised the Examiner that, based upon Callan's reaction to his concerns about Lehman's use of Repo 105 transactions, Kelly "inferred general awareness of what the program was and how it was used" at the senior management level within Lehman and that assuaged his concerns at least to a certain extent.³⁵⁸⁵³⁵⁸⁵ Examiner's Interview of Martin Kelly, Oct. 1, 2009, at pp. 8, 10. According to Kelly, Callan's initial response was to "gather facts and think about it" but she eventually "acknowledged there was risk and that [Kelly] felt discomfort."³⁵⁸⁶³⁵⁸⁶ Id. Kelly "[couldn't] say she [Callan] shared the concern."³⁵⁸⁷³⁵⁸⁷ Id.

¶Specifically as regards the issue of quarter‐end spikes in Repo 105 usage, Kelly recalled that Callan merely "acknowledged" or "understood" Kelly's concern that "the program increased significantly at quarter‐end," but that Callan appeared not to be surprised at the quarter‐end increases.³⁵⁸⁸³⁵⁸⁸ Id. Although he agreed that the volume of Lehman's Repo 105 transactions gave him concern as a general matter, Kelly was unable to specifically recall the approximate volume of Lehman's Repo 105 usage at each quarter‐end. Id. Kelly had no specific recollection of the tens of billions of dollars in Lehman's total Repo 105 usage at quarter‐end for fourth quarter 2007, first quarter 2008 and second quarter 2008, even though those figures were reported in numerous charts and e‐mails Kelly received and which the Examiner used as exhibits during the interview. Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 11; see also Repo 105 & Repo 108 Current Day Report (Nov. 30, 2007) [LBEX‐DOCID 3238268] (showing over $38 billion of total Repo 105 usage on November 30, 2007 and attached to e‐mail from Anuraj Bismal, Lehman, to Martin Kelly, Lehman, et al. (Dec. 5, 2007) [LBEX‐DOCID 3223389] (stating "We ended the year with $38 Billion of repo 105/8 nettings")).Show full note All told, Kelly said that it was his impression that Callan understood each of the issues he raised, but nonetheless that Callan authorized Lehman's continued use of Repo 105 transactions.³⁵⁸⁹³⁵⁸⁹ Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 10. Although one December 2007 document states that "Repo 105 [was] a conversation at the CFO level,"³⁵⁹⁰³⁵⁹⁰ E‐mail from Marie Stewart, Lehman, to Dominic Gibb, Lehman, et al. (Dec. 21, 2007) [LBEX‐DOCID 3223846] ("[O]ur use of Repo 105 is a conversation at the CFO level at this point….Also, I think anymore on this topic is best by conversations and not email."). Callan said that Lehman's use of Repo 105 transactions was "not high on [her] list," and that she did not recall spending "any meaningful amount of time on the topic at all."³⁵⁹¹³⁵⁹¹ Examiner's Interview of Erin M. Callan, Oct. 23, 2009, at p. 17. Asked if she recalled Lehman having engaged in $50 billion worth of Repo 105 transactions at the end of first quarter 2008, Callan said no, and said that she had thought the total amount was approximately "twenty something."³⁵⁹²³⁵⁹² Id.

934

¶Callan told the Examiner that she did not recall engaging in any discussions about Repo 105 transactions with Fuld, McDade, Gregory, Tonucci, Lehman's Executive Committee, or Ernst & Young.³⁵⁹³³⁵⁹³ Id. Callan said she had no recollection of any internally set caps or limits on Lehman's Repo 105 usage.³⁵⁹⁴³⁵⁹⁴ Id. Callan and Kelly's direct predecessors, O'Meara and Grieb, respectively set the firm's Repo 105 limits. See Lehman, Global Balance Sheet Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 2 [LBEX‐WGM 754587] ("Repo 105 is capped at $17B (1x leverage) [per Chris O'Meara and Ed Grieb]" and "Repo 108 is capped at $5 B [per Chris O'Meara and Ed Grieb].").

¶Callan, however, attended the March 28, 2008 Executive Committee meeting requested by McDade to make certain balance sheet reduction recommendations.³⁵⁹⁵³⁵⁹⁵ Examiner's Interview of Herbert H. "Bart" McDade III, Jan. 28, 2010, at p. 4 (stating that the entire Executive Committee, except for Fuld, and ex officio members Lowitt and Friedheim attended the March 28, 2008 meeting). The night before the meeting, McDade's assistant circulated to Callan and other members of the Executive Committee two documents in connection with the meeting:

935

¶(1) an agenda, listing "Repo 105/108" as one of seven topics to be discussed, and (2) a "Balance Sheet and Cash Capital Update," the first page of which included various firm‐wide financial data, including a column titled "Repo 105/108," which listed the $49.1 billion in Repo 105 transactions that Lehman had undertaken at the end of the first quarter 2008.³⁵⁹⁶³⁵⁹⁶ Herbert H. (Bart) McDade III, Lehman, Balance Sheet and Cash Capital Update (Mar. 27, 2008), at p. 1 [LBEX‐DOCID 095966] (attached to e‐mail from Gerard Reilly, Lehman, to Erin M. Callan, Lehman, et al. (Mar. 28, 2008) [LBEX‐DOCID 124422] and indicating that the attachment is for the Executive Committee meeting)); see also Herbert H. (Bart) McDade III, Lehman, Executive Committee Meeting Material, Agenda (Mar. 28, 2008) [LBEX‐DOCID 115827] (attached to e‐mail from Patricia Lombardi, Assistant to Herbert H. (Bart) McDade III, to Lehman Executive Committee Members, Lehman (Mar. 28, 2008) [LBEX‐ DOCID 120929] and listing among seven topics of discussion for March 28, 2008 Executive Committee meeting "Repo 105/108" and "Delever v Derisk"). Callan was a member of the Executive Committee.Show full note The presentation also broke out the volumes of Repo 105 usage by business segment.³⁵⁹⁷³⁵⁹⁷ Lehman, Balance Sheet and Cash Capital Update (Mar. 27, 2008), at p. 1 [LBEX‐DOCID 095966]. McDade specifically recalled discussing with Executive Committee members on March 28, 2008, Lehman's use of Repo 105 transactions and recommending that Lehman place a cap on Repo 105.³⁵⁹⁸³⁵⁹⁸ Id. at pp. 3‐4. On April 9, 2008, twelve days after McDade's presentation to the Executive Committee, Callan signed Lehman's quarterly report for first quarter 2008.³⁵⁹⁹³⁵⁹⁹ LBHI, 10‐Q (filed Apr. 9, 2008), at p. 92, 31.02.

¶During her tenure as CFO, Callan received numerous other documents that referenced Lehman's use of Repo 105 transactions to meet balance sheet targets.

● In a January 2008 e‐mail, Reilly forwarded Callan an e‐mail in which McGarvey informed Bernard that Rates (a business within the Fixed Income Division) was running over its balance sheet target for December 2007 by $72.3 billion and that a contributing factor was that Rates was using $18 billion less in Repo 105 transactions in December 2007 because there was little counterparty appetite.³⁶⁰⁰³⁶⁰⁰ E‐mail from Gerard Reilly, Lehman, to Erin M. Callan, Lehman (Jan. 3, 2008) [LBEX‐DOCID 3383445]. In his e‐mail to Callan, Reilly referenced the balance sheet overage and stated, "Repo 105 liquidity was very tight (this should only be a year end issue but I don't recall it being this material in the past)."³⁶⁰¹³⁶⁰¹ Id.

936

● In February 2008, Reilly again wrote Callan, forwarding to her an e‐mail with an attached FID Balance Sheet PowerPoint presentation that "was used to educate sr fid guys on the bs and generate ideas to make the bs target."³⁶⁰²³⁶⁰² E‐mail from Gerard Reilly, Lehman, to Erin M. Callan, Lehman (Feb. 1, 2008) [LBEX‐DOCID 3383459] (transmitting Lehman Brothers, FID ‐ Balance Sheet (Jan. 17, 2007) [LBEX‐DOCID 3363222]). The e‐mail forwarded to Callan noted that the FID team working on balance sheet issues had reached the "recommendation that Repo 105 program is expanded."³⁶⁰³³⁶⁰³ E‐mail from Gerard Reilly, Lehman, to Erin M. Callan, Lehman (Feb. 1, 2008) [LBEX‐DOCID 3383459]

● In March 2008, Reilly e‐mailed Callan, as well as Lowitt and McDade, to report on the net balance sheet trend since the end of the first quarter. Reilly wrote: "Rates is way up w PT trade and drop off in Repo 105."³⁶⁰⁴³⁶⁰⁴ E‐mail from Gerard Reilly, Lehman, to Erin M. Callan, Lehman (Mar. 20, 2008) [LBEX‐DOCID 3221723] (transmitting Daily Net Average Assets March 2008 schedule [LBEX‐DOCID 3215629]).

● From April through the end of June 2008, Callan received the "Daily Balance Sheet Scorecard," which routinely referenced the impact of Lehman's Repo 105 transactions on the firm's daily balance sheet.³⁶⁰⁵³⁶⁰⁵ See, e.g., Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 7, 2008 (Apr. 9, 2008), at p. 9 [LBEX‐DOCID 520619] (attached to e‐mail from Tal Litvin, Lehman, to Erin M. Callan, Lehman, et al. (Apr. 9, 2008) [LBEX‐DOCID 523578] and showing consolidated FID and Equities balance sheet reduced by $18.527 billion and Prime Services balance sheet reduced by $4.458 billion through Repo 105 transactions); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 10, 2008 (Apr. 14, 2008), at p. 9 [LBEX‐DOCID 251342] (attached to e‐mail from Tal Litvin, Lehman, to Erin M. Callan, Lehman, et al. (Apr. 14, 2008) [LBEX‐DOCID 275231] and showing consolidated FID and Equities balance sheet reduced by $19.967 billion and Prime Services balance sheet reduced by $4.491 billion through Repo 105 transactions); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 11, 2008 (Apr. 14, 2008), at p. 9 [LBEX‐DOCID 251344] (attached to e‐mail from Tal Litvin, Lehman, to Erin M. Callan, Lehman, et al. (Apr. 14, 2008) [LBEX‐DOCID 258562] and showing consolidated FID and Equities balance sheet reduced by $20.260 billion and Prime Services balance sheet reduced by $4.517 billion through Repo 105 transactions); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 12, 2008 (May 13, 2008), at p. 1 [LBEX‐LL 1950262] (attached to e‐mail from Tal Litvin, Lehman, to Erin M. Callan, Lehman, et al. (May 13, 2008) [LBEX‐DOCID 3187357] and stating "Rates decreased by $(5.0B) from prior day due to . . . increased Repo 105 usage. . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 22, 2008 (May 27, 2008), at p. 1 [LBEX‐LL 1950706] (attached to e‐mail from Tal Litvin, Lehman, to Erin M. Callan, Lehman, et al. (May 27, 2008) [LBEX‐DOCID 275984] and stating "Global rates net balance sheet decreased ($2.0B), predominantly due to an increase in Repo 105 benefit. . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 28, 2008 (May 30, 2008), at p. 1 [LBEX‐LL 1950670] (attached to e‐mail from Tal Litvin, Lehman, to Erin M. Callan, Lehman, et al. (May 30, 2008) [LBEX‐ DOCID 275995] and stating "Global rates net balance sheet decreased by ($3.1B) primarily due to a decrease in Americas driven by an increased utilization of Repo 105 within the Agency business"); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 29, 2008 (May 30, 2008), at p. 1 [LBEX‐LL 1950658] (attached to e‐mail from Tal Litvin, Lehman, to Erin M. Callan, Lehman, et al. (June 2, 2008) [LBEX‐DOCID 011127] and stating "Global Rates net balance sheet decreased ($6.5B) . . . [t]he decrease in Europe is coming from increased utilization of Repo 105").Show full note

937

Ian Lowitt, Former Chief Financial Officer

¶Ian Lowitt served as Lehman's CFO from June 12, 2008 through LBHI's bankruptcy filing on September 15, 2008.³⁶⁰⁶³⁶⁰⁶ Examiner's Interview of Ian T. Lowitt, Oct. 28, 2009, at p. 7. Prior to his appointment to the CFO position, Lowitt served as Lehman's co‐CAO.³⁶⁰⁷³⁶⁰⁷ Id.

¶Lowitt acknowledged that Lehman initiated its Repo 105 program "at some point in the early 2000s."³⁶⁰⁸³⁶⁰⁸ Id. pp. 10‐11. Asked to describe how he came to be aware of Lehman's Repo 105 program, Lowitt recalled that Lehman had established a "regime" of month‐end balance sheet targets for each business unit, and that each business unit had the discretion to determine how to meet that target with support from Product Control and Finance.³⁶⁰⁹³⁶⁰⁹ Id. One means available to the Fixed Income and Equities Divisions for reaching balance sheet targets, Lowitt recalled, was by "sell[ing] down assets" through Lehman's Repo 105 program.³⁶¹⁰³⁶¹⁰ Id. Lowitt recalled senior Lehman management setting aggressive targets to reduce commercial and residential real estate inventory, but he stated that he had no specific recollection of Repo 105 targets even though he recalled that Repo 105 was "one of the things that the businesses were doing to operate at their [balance sheet] limits."³⁶¹¹³⁶¹¹ Examiner's Interview of Ian T. Lowitt, Oct. 28, 2009, at p. 13.

938

¶Lowitt believed that Ernst & Young had approved the firm's use of Repo 105 transactions early in the Repo 105 process (sometime in the early 2000s), and as a result, Lowitt never was concerned about Lehman's use of the transactions.³⁶¹²³⁶¹² Id. at p. 3. Lowitt also said he was unaware of any geographical limitations with respect to Repo 105 – for instance, he did not know that Lehman's internal Repo 105 Accounting Policy limited the transactions to LBIE.³⁶¹³³⁶¹³ Id. at p. 11. Lowitt had no recollection of ever having read the Accounting Policy, but he recalled that only the most liquid assets could be used in Repo 105 transactions.³⁶¹⁴³⁶¹⁴ Id. at pp. 11, 14.

¶Despite recalling very little specific information about his own involvement in Lehman's Repo 105 program, Lowitt generally recalled that O'Meara played a role in Lehman's Repo 105 program.³⁶¹⁵³⁶¹⁵ Id. at pp. 11, 14. Lowitt stated that O'Meara and Grieb were responsible for setting firm‐wide limits on Repo 105 usage.³⁶¹⁶³⁶¹⁶ Id.As explained elsewhere in the Report, O'Meara told the Examiner that he had no involvement in the setting of Repo 105 limits. Examiner's Interview of Christopher M. O'Meara, Aug. 14, 2009 at pp. 28‐ 29 (stating he was "not close to" Lehman's Repo 105 program); Examiner's Interview of Christopher M. O'Meara, Sept. 23, 2009, at pp. 6‐7 (stating, with respect to Lehman's Repo 105 usage and limits "I don't have a recollection of any of this"). On the other hand, Grieb recalled O'Meara's involvement in the Repo 105 program. Examiner's Interview of Edward Grieb, Oct. 2, 2009, at pp. 10, 12‐13; see also Lehman, Global Balance Sheet Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 2 [LBEX‐WGM 754587].Show full note In addition, when Lowitt was Lehman's Chief Administrative Officer in Europe, between 2005 and 2006, he recalled that O'Meara "felt some need to establish guidelines for Repo 105" usage in Lehman's European offices.³⁶¹⁷³⁶¹⁷ Examiner's Interview of Ian T. Lowitt, Oct. 28, 2009, at p. 13.

939

¶Kelly raised with Lowitt the same Repo 105‐related concerns that Kelly raised with Callan, including concerns about Lehman's reliance on Repo 105 transactions for balance sheet relief, the expanding nature of that reliance, the technical accounting basis for the transactions, the quarter‐end spikes in usage, and the possible "reputational risk" to Lehman.³⁶¹⁸³⁶¹⁸ Examiner's Interview of Martin Kelly, Oct. 1, 2009, at pp. 8‐10. Kelly continued to press his concerns with Lehman's Repo 105 program following his discussion with Callan. Id. In a May 2008 internal Lehman Power Point presentation to Finance Control entitled "Information, Controls and Issues," discussing problems faced by Finance Control and strategies for dealing with them, Kelly included "Repo 105/108" as an issue for discussion in the third quarter 2008. Martin Kelly, Lehman, Information, Control and Issues (May 2008), at p. 10 [LBEX‐DOCID 1999716].Show full note Kelly noted, however, that his Repo 105 discussions with Lowitt were "more truncated" because, unlike Callan, Kelly viewed Lowitt as "quite familiar with the program and [Lowitt] understood its details."³⁶¹⁹³⁶¹⁹ Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 10.

¶Kelly recalled that after he "expressed the same reservations" to Lowitt about Lehman's use of Repo 105 transactions that Kelly had previously expressed to Callan, his concerns met a similar result with Lowitt: "Even [after a] consideration of the size of the program and the risks involved did not change the fact that the program should continue."³⁶²⁰³⁶²⁰ Id.

940

¶Lowitt said that "no one raised [Repo 105] to me as something I should be spending any more attention on" and he did not recall any conversations with Kelly on the subject.³⁶²¹³⁶²¹ Examiner's Interview of Ian T. Lowitt, Oct. 28 2009, at p. 11. Similarly, Lowitt did not recall discussing Lehman's use of Repo 105 transactions with Fuld, McDade, Gregory, Callan, O'Meara, Lehman's Executive Committee, or Ernst & Young.³⁶²²³⁶²² Id.The Examiner attempted to refresh Lowitt's recollection of his involvement in the Repo 105 program through documents (including e‐mails in which Lowitt specifically inquired about Repo 105 transactions), and by recounting communications that Kelly told the Examiner he had with Lowitt. But, Lowitt's memory was not revived and he continually stated that he "knew [Repo 105] was something the firm engaged in" but that it was not an issue he focused on or understood. Id.Show full note

¶Lowitt, however, attended as an ex officio member the March 28, 2008 Executive Committee meeting, and received the agenda and balance sheet document circulated by McDade's assistant.³⁶²³³⁶²³ Herbert H. (Bart) McDade III, Lehman, Balance Sheet and Cash Capital Update (Mar. 27, 2008), at p. 1 [LBEX‐DOCID 095961] (attached to e‐mail from Gerard Reilly, Lehman, to Ian T. Lowitt, Lehman, et al. (Mar. 28, 2008) [LBEX‐DOCID 120929] and indicating that the attachment is for the Executive Committee meeting)); see also Herbert H. (Bart) McDade III, Lehman, Executive Committee Meeting Material, Agenda (Mar. 28, 2008) [LBEX‐DOCID 115827] (attached to e‐mail from Patricia Lombardi, Assistant to Herbert H. (Bart) McDade III, to Ian T. Lowitt, Lehman, et al. (Mar. 28, 2008) [LBEX‐DOCID 120929] and listing among seven topics of discussion for March 28, 2008 Executive Committee meeting "Repo 105/108" and "Delever v Derisk").Show full note Lowitt received two other copies of the balance sheet presentation on March 28, 2008 – one set sent personally by McDade³⁶²⁴³⁶²⁴ Herbert H. (Bart) McDade III, Lehman, Balance Sheet and Cash Capital Update (Mar. 27, 2008) [LBEX‐ DOCID 095965] (attached to e‐mail from Herbert H. (Bart) McDade III, Lehman, to Ian T. Lowitt, Lehman, et al. (Mar. 28, 2008) [LBEX‐DOCID 110658]). and the other sent by Reilly.³⁶²⁵³⁶²⁵ Id.

941

¶On June 17, 2008, Reilly sent to Lowitt the "Balance Sheet and Key Disclosures" document that incorporated McDade's planned directive to reduce Lehman's firm‐wide Repo 105 usage by half – from $50 billion to $25 billion in third quarter 2008.³⁶²⁶³⁶²⁶ Lehman, Balance Sheet and Key Disclosures 2008 3Q Targets [Draft] (June 16, 2008), at p. 3 [LBEX‐ DOCID 3363493] (attached to e‐mail from Gerard Reilly, Lehman, to Ian T. Lowitt, Lehman, et al. (June 17, 2008) [LBEX‐DOCID 3383643]). The report also stated that Lehman's firm‐wide Repo 105 usage at quarter‐end for second quarter 2008 was $50.3 billion.³⁶²⁷³⁶²⁷ Id. Lowitt met with McDade, Reilly, O'Meara, and Morton to discuss the Balance Sheet and Key Disclosures document, which was then updated and redistributed to Lowitt and the others.³⁶²⁸³⁶²⁸ E‐mail from Christopher M. O'Meara, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (June 17, 2008) [LBEX‐DOCID 033813] (replying to receipt of Balance Sheet and Key Disclosures 2008 3Q Targets [Draft] (June 16, 2008) and stating that "meeting is being set up to discuss" the Balance Sheet and Key Disclosure 2008 3Q Targets document); e‐mail from Gerard Reilly, Lehman, to Ian T. Lowitt, Lehman, et al. (June 19, 2008) [LBEX‐DOCID 2962369] (transmitting updated version of Lehman, Balance Sheet and Key Disclosures 2008 3Q Targets (June 19, 2008) [LBEX‐DOCID 2932594]).Show full note These discussions and meeting took place only weeks before Lehman filed its second quarter 2008 Form 10‐Q, signed by Lowitt, on July 10, 2008.

942

¶In addition, Lowitt received a number of other documents that referenced Lehman's use of Repo 105 transactions both prior to and during his tenure as Lehman's CFO:

● In an August 2007 e‐mail, Kentaro Umezaki informed Lowitt about John Feraca's attempts to place real estate securities into the Repo 105 program.³⁶²⁹³⁶²⁹ E‐mail from Kentaro Umezaki, Lehman, to Ian T. Lowitt, Lehman, et al. (Aug. 17, 2008) [LBEX‐DOCID 1533678].

● On February 28, 2008, Feraca notified Lowitt and Tonucci that Lehman had executed $11 billion in Repo 105 trades via LBIE with Barclays, UBS, and Mizuho, using agencies securities.³⁶³⁰³⁶³⁰ E‐mail from John Feraca, Lehman, to Ian T. Lowitt, Lehman, et al. (Feb. 28, 2008) [LBEX‐DOCID 3207903]. Feraca later informed Lowitt that the final tally of Repo 105 trades using United States Liquid Markets Products was close to $13 billion³⁶³¹³⁶³¹ E‐mail from John Feraca, Lehman, to Ian T. Lowitt, Lehman, et al. (Feb. 28, 2008) [LBEX‐DOCID 3207907]. and by the next day reported yet again another revised number of $17 billion.³⁶³²³⁶³² E‐mail from John Feraca, Lehman, to Ian T. Lowitt, Lehman, et al. (Feb. 29, 2008) [LBEX‐DOCID 3207911]. Lowitt questioned Feraca why the amount of Repo 105 changed from quarter to quarter.³⁶³³³⁶³³ E‐mail from Ian T. Lowitt, Lehman, to John Feraca, Lehman (Feb. 28, 2008) [LBEX‐DOCID 3207905]; e‐ mail from John Feraca, Lehman, to Ian T. Lowitt, Lehman (Feb. 28, 2008) [LBEX‐DOCID 3207908]; e‐mail from John Feraca, Lehman, to Ian T. Lowitt, Lehman, et al. (Feb. 29, 2008) [LBEX‐DOCID 3207910].

¶When Lowitt was asked about the February 28, 2008 e‐mail, he said that he was "wondering if we were doing more or less of it [i.e., Repo 105 transactions]," that he was attempting to gauge how "material" Lehman's Repo 105 usage was.³⁶³⁴³⁶³⁴ Examiner's Interview of Ian T. Lowitt, Oct. 28, 2009, at p. 12. Asked why as co‐Chief Administrative Officer, he would have been communicating with Feraca of the Secured Funding Desk about Lehman's Repo 105 program, Lowitt replied that Feraca likely thought it was important to report on the status of Lehman's Repo 105 usage to

943

¶Lowitt and Tonucci because of their involvement in Lehman's Asset Liability Committee ("ALCO").³⁶³⁵³⁶³⁵ Id. When shown the same e‐mail, Feraca could not recall, specifically, why Lowitt and Tonucci would have asked him for information about Repo 105. Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 11. Feraca recalled generally that "[b]alance sheet targets were more important at this time. There was more heightened concern regarding balance sheet and leverage ratio." Id.

● In March 2008, Reilly informed Lowitt that the Rates Business' balance sheet was "way up" since the close of the first quarter because of a "drop off in Repo 105."³⁶³⁶³⁶³⁶ E‐mail from Gerard Reilly, Lehman, to Ian T. Lowitt, Lehman, et al. (Mar. 20, 2008) [LBEX‐DOCID 103526] (transmitting March Net Balance Sheet Daily Trend Excel Sheet (Mar. 20, 2008) [LBEX‐DOCID 103961]). Reilly later provided more color to Lowitt regarding the "breakdown" of the $95 billion increase in the Rates Business's balance sheet since close of first quarter, $22.4 billion of which was a reduction in Repo 105 usage since quarter‐end.³⁶³⁷³⁶³⁷ E‐mail from Gerard Reilly, Lehman, to Ian T. Lowitt, Lehman, et al. (Mar. 20, 2008) [LBEX‐DOCID 2973597].

● In May 2008, Lowitt asked Feraca if Lehman was experiencing any funding issues with its secured transactions.³⁶³⁸³⁶³⁸ E‐mail from Ian T. Lowitt, Lehman, to John T. Feraca, Lehman, et al. (May 27, 2008) [LBEX‐DOCID 070831]. Feraca replied to Lowitt and Tonucci, "There were a few counterparties last week who had at least noted some of the rumblings in the press last week. . . . Daiwa who [was] contemplating a Repo 105 trade with us. Not a big funder for us. I think counterparties will reserve judgment for now. . ."³⁶³⁹³⁶³⁹ E‐mail from John Feraca, Lehman, to Ian T. Lowitt, Lehman, et al. (May 27, 2008) [LBEX‐DOCID 070831].

● In a July 2008 e‐mail to Lowitt and Tonucci regarding FID's plans for cash capital limits and balance sheet targets in third quarter 2008, Robert Azerad said that FID's plan to "shrink[] the repo book potentially a lot (20 bn). . .is not consistent with B/S targets given to FID (flat excluding Repo 105)."³⁶⁴⁰³⁶⁴⁰ E‐mail from Robert Azerad, Lehman, to Ian T. Lowitt, Lehman, et al. (July 9, 2008) [LBEX‐DOCID 8961]. 4214810] and stating that "Global rates net balance sheet decreased . . . driven by an increase in Repo 105 benefit . . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date August 25, 2008 (Aug. 26, 2008) [LBEX‐LL 782924] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (Aug. 26, 2008) [LBEX‐DOCID 079536] and stating that "Global Rates net balance sheet decreased . . . driven by an increase in repo 105 usage . . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date August 28, 2008 (Aug. 29, 2008) [LBEX‐LL 782966] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (Aug. 29, 2008) [LBEX‐DOCID 275880] and stating that "Global rates [net balance sheet] was down . . . driven by increased Repo 105 benefit . . . .").Show full note

944

● Lowitt also received the "Daily Balance Sheet and Disclosures Scorecard" between April and September 2008, which frequently referred to the impact of Repo 105 transactions on Lehman's firm‐wide balance sheet.3641

¶3641 See, e.g., Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 7, 2008 (Apr. 9, 2008), at p. 9 [LBEX‐DOCID 520619] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (Apr. 9, 2008) [LBEX‐DOCID 523578] and showing consolidated FID and Equities balance sheet reduced by $18.527 billion and Prime Services balance sheet reduced by $4.458 billion through Repo 105 transactions as of April 7, 2008); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 8, 2008 (Apr. 10, 2008), at p. 9 [LBEX‐DOCID 520620] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (Apr. 10, 2008) [LBEX‐DOCID 523579] and showing consolidated FID and Equities balance sheet reduced by $18.853 billion and Prime Services balance sheet reduced by $4.562 billion through Repo 105 transactions as of April 8, 2008); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 9, 2008 (Apr. 10, 2008), at p. 9 [LBEX‐DOCID 251339] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (Apr. 10, 2008) [LBEX‐ DOCID 258560] and showing consolidated FID and Equities balance sheet reduced by $19.688 billion and Prime Services balance sheet reduced by $4.548 billion through Repo 105 transactions as of April 9, 2008); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 10, 2008 [LBEX‐DOCID 251342], at p. 9 (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (Apr. 14, 2008) [LBEX‐DOCID 275231] and showing consolidated FID and Equities balance sheet reduced by $19.967 billion and Prime Services balance sheet reduced by $4.491 billion through Repo 105 transactions as of April 10, 2008); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 11, 2008 (Apr. 14, 2008), at p. 9 [LBEX‐DOCID 251344] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (Apr. 14, 2008) [LBEX‐DOCID 258562] showing consolidated FID and Equities balance sheet reduced by $20.260 billion and Prime Services balance sheet reduced by $4.517 billion through Repo 105 transactions as of April 11, 2008); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 12, 2008 (May 13, 2008), at p. 1 [LBEX‐LL 1950262] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (May 13, 2008) [LBEX‐DOCID 3187357] and stating "Rates decreased by $(5.0B) from prior day due to . . . increased Repo 105 usage . . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 22, 2008 (May 27, 2008), at p. 1 [LBEX‐LL 1950706] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (May 27, 2008) [LBEX‐DOCID 275984] and stating "Global rates net balance sheet decreased ($2.0B), predominantly due to an increase in Repo 105 benefit . . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 28, 2008 (May 30, 2008), at p. 1 [LBEX‐LL 1950670] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (May 30, 2008) [LBEX‐DOCID 275995] and stating "Global rates net balance sheet decreased by ($3.1B) primarily due to a decrease in Americas driven by an increased utilization of Repo 105 within the Agency business"); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 29, 2008 (May 30, 2008), at p. 1 [LBEX‐LL 1950658] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (June 2, 2008) [LBEX‐DOCID 011127] and stating "Global Rates net balance sheet decreased ($6.5B) . . . [t]he decrease in Europe is coming from increased utilization of Repo 105"); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date June 18, 2008 (June 20, 2008) [LBEX‐LL 1950514] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (June 20, 2008) [LBEX‐DOCID 275942] and stating that "Global rates net balance sheet decreased . . . driven by a[n] . . . increase in Repo 105 utilization . . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date August 13, 2008 (Aug. 14, 2008) [LBEX‐LL 782812] (attached to e‐ mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (Aug. 14, 2008) [LBEX‐DOCID

945

Lehman's Board of Directors

¶Without exception, former Lehman directors were unaware of Lehman's Repo 105 program and transactions.³⁶⁴²³⁶⁴² Examiner's Interview of Dr. Henry Kaufman, Sept. 2, 2009, at p. 21; Examiner's Interview of Jerry A. Grundhofer, Sept. 16, 2009, at p. 10; Examiner's Interview of Roland Hernandez, Oct. 2, 2009, at p. 22; Examiner's Interview of Sir Christopher Gent, Oct. 21, 2009, at p. 22; Examiner's Interview of Roger Berlind, Dec. 18, 2009, 4; Examiner's Interview of Michael L. Ainslie, Dec. 22, 2009, at p. 4; Examiner's Interview of Thomas Cruikshank, Jan. 20, 2010, at p. 2; Examiner's Interview of Sir Christopher Gent, Jan. 20, 2010, at p. 4.Show full note

¶As discussed in greater detail below, Lehman's own Corporate Audit group led by Beth Rudofker, together with Ernst & Young, investigated allegations about balance sheet substantiation problems made in a May 16, 2008 "whistleblower" letter sent to senior management by Matthew Lee.³⁶⁴³³⁶⁴³ See Section III.A.4.i.4 of this Report (discussing Matthew Lee's statements to Ernst & Young). On June 12, 2008, during the investigation, Lee informed Ernst & Young about Lehman's use of $50 billion of Repo 105 transactions in the second quarter of 2008.³⁶⁴⁴³⁶⁴⁴ Id. At a June 13, 2008 meeting, Ernst & Young failed to disclose that allegation to the Board's Audit Committee.³⁶⁴⁵³⁶⁴⁵ Id.

¶Former Lehman director Cruikshank recalled that he made very clear he wanted a full and thorough investigation into each allegation made by Lee, whether the allegation was contained in Lee's May 16, 2008 letter or raised by Lee in the course of the investigation.³⁶⁴⁶³⁶⁴⁶ Examiner's Interview of Thomas Cruikshank, Oct. 8, 2009, at p. 7. Another former Lehman director, Berlind, similarly stated that the Audit Committee explicitly instructed Lehman's Corporate Audit Group and Ernst & Young to keep the Audit Committee informed of all of Lee's allegations.³⁶⁴⁷³⁶⁴⁷ Examiner's Interview of Roger Berlind, Dec. 18, 2009, at p. 4. Berlind also said that he would have wanted to know about Lehman's Repo 105 program and that if he had known about Lehman's Repo 105 transactions, he would have asked Lehman's auditors to test the transactions to ensure they were appropriate.³⁶⁴⁸³⁶⁴⁸ Id. Upon learning from the Examiner the volume of Repo 105 transactions at quarter‐end in late 2007 and 2008, Sir Christopher Gent said that he believed the volume mandated disclosure to the Audit Committee and further investigation.³⁶⁴⁹³⁶⁴⁹ Examiner's Interview of Sir Christopher Gent, Jan. 20, 2010, at p. 3.

946

¶Dr. Kaufman, on the other hand, stated that he would have wanted to know about Repo 105 transactions only if they were "huge" and fraudulent, by which he meant in violation of specific accounting rules or in violation of the law.³⁶⁵⁰³⁶⁵⁰ Examiner's Interview of Henry Kaufman, Dec. 22, 2009. Dr. Kaufman did not believe that $50 billion in Repo 105 transactions was significant even if that volume changed Lehman's net leverage ratio by approximately two points.³⁶⁵¹³⁶⁵¹ Id. Dr. Kaufman considered a four or five point change in the net leverage ratio to be significant.³⁶⁵²³⁶⁵² Id.

947

¶In late 2007 and 2008, management made numerous presentations to the Board regarding balance sheet reduction and deleveraging; in no case was the use of Repo 105 transactions disclosed in those presentations.³⁶⁵³³⁶⁵³ See, e.g., Lehman Brothers Holdings Inc., Minutes of Meeting of the Board of Directors (Sept. 11, 2007), at p. 3 [LBHI_SEC07940_026364] (including O'Meara statements regarding leverage ratios); Lehman Brothers Holdings Inc., Minutes of Meeting of the Board of Directors (Oct. 15, 2007), at p. 3 [LBHI_SEC07940_026407]; Lehman Brothers Holdings Inc., Minutes of Meeting of the Board of Directors (Nov. 8, 2007), at p. 4 [LBHI_SEC07940_026650] (same); Lehman Brothers Holdings Inc., Minutes of Meeting of the Finance and Risk Committee (Jan. 29, 2008), at pp. 2 [LBEX‐AM 067022]; Lehman Brothers, Confidential Presentation to Finance and Risk Committee of the Board of Directors, 2008 Financial Plan (Jan. 29, 2008), at p. 8 [LBHI_SEC07940_068559] (stating "We plan to deploy the capital created to reduce leverage and support $60 billion of asset growth" and that "[b]alance sheet growth in December [2007] was largely in highly liquid asset classes for which we were able to source repo financing."); Lehman Brothers, Confidential Presentation to Finance and Risk Committee, Additional Materials (Jan. 29, 2008), at pp. 1‐2 [LBEX‐AM 067269] (stating "We have been able to grow repo financing to meet the balance sheet and leverage increases," and that Lehman's net assets and leverage grew in 2007 across all asset classes and leverage increased at a lesser rate than peer firms); Eric Felder, Lehman, 2008 Financial Supply/Demand Dynamics, Presentation to Lehman Board of Directors (Jan. 28, 2008), at p. 10 [LBHI_SEC07940_027353] (noting rise in leverage ratios among the five big investment banks); Lehman Brothers Holdings Inc., Minutes of Meeting of the Finance and Risk Committee (Mar. 25, 2008), at p. 2 [LBEX‐AM 003592] (informing the Board of "industry‐wide pressure to delever" and that the firm was working on a plan for reducing total assets which would most likely focus on the Fixed Income and Principal Investment business units); Erin M. Callan, Lehman, Estimated March 2008 Financial Information, Confidential Presentation to Lehman Brothers Board of Directors (Apr. 15, 2008), at p. 8 [LBHI_SEC07940_027952] (explaining that as part of the "de‐levering plan," Lehman's "[t]argeted balance sheet reduction by Q2 '08" included a reduction of net assets by $55 billion to $342 billion); Lehman Brothers Holdings Inc., Finance and Risk Committee of the Board, Liquidity and Risk Management Update (May 7, 2008), at p. 10 [LBEX‐AM 067320] ("The Firm has set aggressive targets to reduce balance sheet and cash capital usage below their Q4 2007 levels by the end of this quarter. This should result in bringing net leverage to 12x, gross leverage to 25x and generating a cash capital surplus of $8‐10 billion – large enough to avoid the need to issue in public debt markets for the rest of the year."); id. at p. 16 (stating "lower leverage going forward will help reduce the Firm's liquidity risk"); Lehman Brothers Holdings Inc., Minutes of Meeting of the Board of Directors (June 19, 2008), at p. 3 [LBEX‐AM 003764] (discussing Lehman's plans regarding leverage, and "potential changes in GAAP which would potentially require companies to bring certain assets back onto the balance sheet"); Lehman Brothers Holdings Inc., Minutes of Meeting of the Board of Directors (July 22, 2008), at p. 7 [LBEX‐AM 003866] (informing the Board that "it was important to size the Firm's financial leverage to maintain the Firm's 'A' credit rating in order to maintain the value of the Firm's franchise").Show full note

948

Ernst & Young's Knowledge of Lehman's Repo 105 Program

¶During several Rule 30(b)(6)‐type³⁶⁵⁴³⁶⁵⁴ Federal Rule of Civil Procedure Rule 30(b)(6) governs depositions of a corporation or organization. The organization designates one or more representatives to testify on the identified areas of inquiry. The representative speaks for the organization. interview sessions, the Examiner interviewed members of Ernst & Young's Lehman audit team regarding Ernst & Young's knowledge of and involvement in Lehman's Repo 105 program.

Ernst & Young's Comfort with Lehman's Repo 105 Accounting Policy

¶The Examiner interviewed Ernst & Young's lead partner on the Lehman audit team, William Schlich, regarding Lehman's Repo 105 program. According to Schlich, Ernst & Young had been aware of Lehman's Repo 105 policy and transactions for many years.³⁶⁵⁵³⁶⁵⁵ Examiner's Interview of Ernst & Young, Repo 105 Session, Oct. 16, 2009, at p. 4. Consistent with the statements of Lehman's John Feraca (Secured Funding Desk), Schlich stated that Lehman introduced its Repo 105 Accounting Policy on the heels of the FASB's promulgation of SFAS 140.³⁶⁵⁶³⁶⁵⁶ Id. at p. 5. During that time, Ernst & Young "discussed" the Repo 105 Accounting Policy (including Lehman's structure for Repo 105 transactions) and Ernst & Young's team had a number of additional conversations with Lehman about Repo 105 over the years.³⁶⁵⁷³⁶⁵⁷ Id. However, according to Schlich, Ernst & Young had no role in the drafting or preparation of Lehman's Repo 105 Accounting Policy.³⁶⁵⁸³⁶⁵⁸ Id.

949

¶Schlich stated definitively that Ernst & Young had no advisory role with respect to Lehman's use of Repo 105 transactions and that Ernst & Young did not "approve" the Accounting Policy.³⁶⁵⁹³⁶⁵⁹ Id. Rather, according to Schlich, Ernst & Young "bec[a]me comfortable with the Policy for purposes of auditing financial statements."³⁶⁶⁰³⁶⁶⁰ Examiner's Interview of Ernst & Young, Repo 105 Session, Oct. 16, 2009, at p. 5.

¶Following "consultation and dialogue" about the proper interpretation and application of SFAS 140, Ernst & Young "clearly. . .concurred with Lehman's approach" to SFAS 140 and subsequent literature by FASB on the issue of "control" of assets involved in a repo transactions.³⁶⁶¹³⁶⁶¹ Id. at pp. 5‐6. Ernst & Young's view, however, was not based upon an analysis of whether actual Repo 105 transactions complied with SFAS 140.³⁶⁶²³⁶⁶² Id. at p. 6. Rather, Ernst & Young's review of Lehman's Repo 105 Accounting Policy was purely "theoretical."³⁶⁶³³⁶⁶³ Id. In other words, Ernst & Young solely assessed Lehman's understanding of the requirements of SFAS 140 in the abstract and as reflected in its Accounting Policy; Ernst & Young did not opine on the propriety of the transactions as a balance sheet management tool.³⁶⁶⁴³⁶⁶⁴ Id. Ernst & Young did not review the Linklaters letter, referenced in the Accounting Policy Manual.³⁶⁶⁵³⁶⁶⁵ The Examiner asked Schlich a series of questions to establish whether a good faith basis existed for showing him the Linklaters letter. Schlich told the Examiner that he did not know if anyone at Ernst & Young LLP (i.e., the United States‐based Ernst & Young) ever reviewed the Linklaters letter. Examiner's Interview of Ernst & Young, Repo 105 Session, Oct. 16, 2009, at p. 10. Schlich further stated that LBIE's books and records were audited by Ernst & Young United Kingdom, not Ernst & Young LLP, though he acknowledged that LBIE's financials rolled up into LBHI's publicly filed financial statements, which Ernst & Young LLP audited. Id. at pp. 10‐11. Because, based upon Schlichʹs statements, the Examiner did not have a good faith basis to believe Ernst & Young LLP previously had seen the Linklaters letter (as is required under the Examinerʹs protective order with Alvarez & Marsal/LBHI to show the letter to Ernst & Young LLP), the Examiner did not show Schlich the Linklaters letter.Show full note

950

¶According to Martin Kelly, it was not unusual for him to discuss various issues, including Repo 105, with Ernst & Young.³⁶⁶⁶³⁶⁶⁶ Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 11. Indeed, Kelly recalled specifically speaking with Schlich about Repo 105 transactions soon after becoming Financial Controller on December 1, 2007, in an effort to learn more about the program and "to understand [Ernst & Young's] approach before talking to Callan."³⁶⁶⁷³⁶⁶⁷ Id.

¶Kelly "wanted to ensure that Ernst & Young analyzed the program in the same way that [Marie] Stewart [Global Head of Accounting Policy] had analyzed it."³⁶⁶⁸³⁶⁶⁸ Id. Kelly's conversations with Ernst & Young focused on the accounting treatment of Repo 105 transactions.³⁶⁶⁹³⁶⁶⁹ Id. According to Kelly, Ernst & Young "was comfortable with the treatment under GAAP for the same reasons that Lehman was comfortable."³⁶⁷⁰³⁶⁷⁰ Id. Kelly also discussed with Ernst & Young Lehman's inability to get a true sale opinion under United States law for Repo 105 transactions.³⁶⁷¹³⁶⁷¹ Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 11. Kelly could not recall whether he discussed with Ernst & Young his discomfort with Lehman's Repo 105 program.³⁶⁷²³⁶⁷² Id.

951

The "Netting Grid"

¶Throughout 2007, Lehman maintained a document entitled "Accounting Policy Review Balance Sheet Netting and Other Adjustments," known colloquially among Lehman's Accounting Policy and Balance Sheet Groups, as well at Ernst & Young, as the "Netting Grid." The Netting Grid identified and described various balance sheet netting mechanisms employed by Lehman: one such balance sheet mechanisms was Lehman's use of Repo 105 transactions.³⁶⁷³³⁶⁷³ See, e.g., Lehman, Accounting Policy Review Balance Sheet Netting and Other Adjustments (Aug. 2007) [LBEX‐DOCID 2720761] (attached to e‐mail from Marie Stewart, Lehman, to Martin Kelly, Lehman (Nov. 6, 2007) [LBEX‐DOCID 2736621] ("[T]his is the doc that summarizes every reason we net down the b/sheet. As discussed, E&Y are in the process of reviewing it."); Lehman, Accounting Policy Review Balance Sheet Netting and Other Adjustments (Nov. 2007) [LBEX‐DOCID 2720762] (attached to e‐mail from Marie Stewart, Lehman, to Martin Kelly (Nov. 6, 2007) [LBEX‐DOCID 2736622]).Show full note

¶Lehman provided the Netting Grid to Ernst & Young at least in August 2007 (the close of Lehman's third quarter 2007) and in November 2007 (the close of Lehman's fiscal year 2007).³⁶⁷⁴³⁶⁷⁴ E‐mail from Margaret Sear, Lehman, to Jerry Gruner, Ernst & Young, et al. (Aug. 15, 2007) [LBEX‐ DOCID 3235498] ("Here is the netting grid as you requested."); Lehman, Accounting Policy Review Balance Sheet Netting and Other Adjustments (Aug. 2007) [LBEX‐DOCID 3213803] (attached to e‐mail from Margaret Sear, Lehman, to Jerry Gruner, Ernst & Young, et al. (Aug. 15, 2007) [LBEX‐DOCID 3235498]); e‐mail from Margaret Sear, Lehman, to Jerry Gruner, Ernst & Young, et al. (Nov. 6, 2007) [LBEX‐DOCID 3235499] (transmitting, Accounting Policy Review Balance Sheet Netting and Other Adjustments [Draft] (Nov. 2007) [LBEX‐DOCID 3213271]).Show full note Notably, the Netting Grid provided by Lehman to Ernst & Young in August 2007 and November 2007 only contained Repo 105 volumes from November 30, 2006 and February 28, 2007.³⁶⁷⁵³⁶⁷⁵ Lehman, Accounting Policy Review Balance Sheet Netting and Other Adjustments (Aug. 2007), at p. 26 [LBEX‐DOCID 3213803] (stating total Repo 105 usage for November 30, 2006 was $24.519 billion and total Repo 105 usage for February 28, 2007 was $29.258 billion); Lehman, Accounting Policy Review Balance Sheet Netting and Other Adjustments [Draft] (Nov. 2007), at p. 26 [LBEX‐DOCID 3213271] (same). Schlich was unaware whether Ernst & Young asked Lehman to provide its second quarter 2007 and third quarter 2007 Repo 105 usage figures or a forecast of Lehman's fourth quarter 2007 Repo 105 numbers.³⁶⁷⁶³⁶⁷⁶ Examiner's Interview of Ernst & Young, Repo 105 Session (Oct. 16, 2009), at p. 9 (statement of William Schlich).

952

¶Ernst & Young reviewed the Netting Grid, analyzed the various balance sheet netting mechanisms identified in the Netting Grid, and used the document in connection with its 2007 year‐end audit of Lehman.³⁶⁷⁷³⁶⁷⁷ Id. at p. 8. By this, Ernst & Young referred to its audit of other balance sheet netting mechanisms. Ernst & Young United States did not audit Repo 105 transactions. According to Schlich, Ernst & Young, as part of its review of Lehman's Netting Grid, approved of Lehman's internal Repo 105 Accounting Policy only, and did not pass upon the actual practice.³⁶⁷⁸³⁶⁷⁸ Id.

¶The Netting Grid described the transactions and United States GAAP reference as follows: "Under certain conditions that meet the criteria described in paragraphs 9 and 218 of SFAS 140, Lehman policy permits reverse repo and repo agreements to be recharacterized as purchases and sales of inventory."³⁶⁷⁹³⁶⁷⁹ Lehman Brothers, Accounting Policy Review Balance Sheet Netting and Other Adjustments (Aug. 2007), at p. 26 [LBEX‐DOCID 3213803]; Lehman, Accounting Policy Review Balance Sheet Netting and Other Adjustments [Draft] (Nov. 2007), at p. 26 [LBEX‐DOCID 3213271]. With respect to Lehman's use of Repo 105 transactions to reduce its net balance sheet, the Netting Grid sets forth the conclusion that Lehman's "current practice [for Repo 105] is correct."³⁶⁸⁰³⁶⁸⁰ Id. Although Lehman's internal Repo 105 Accounting Policy could have theoretically been applied to reverse repos, the policy explicitly stated that Lehman did not, in fact, use the Repo 105 mechanism for reverse repos. See Lehman Brothers Holdings Inc., Accounting Policy Manual Repo 105 and Repo 108 (Sept. 9, 2006), at p. 1 [LBEX‐DOCID 3213286]. Schlich noted that this conclusion about the Repo 105 practice was Lehman's, not Ernst & Young's.³⁶⁸¹³⁶⁸¹ Examiner's Interview of Ernst & Young, Repo 105 Session, Oct. 16, 2009, at p. 8. To test Lehman's conclusion, however, Ernst & Young "reviewed how Lehman applied the control provisions of the accounting rules."³⁶⁸²³⁶⁸² Id.

953

¶Ernst & Young's review, however, applied only to the accounting basis for these transactions, not to their volume or purpose. Specifically, Ernst & Young's review and analysis of Lehman's Repo 105 program did not account for the volumes of Repo 105 transactions Lehman undertook at quarter‐end.³⁶⁸³³⁶⁸³ Id. Indeed, Schlich was unable to confirm or deny the volumes of Repo 105 transactions Lehman undertook at Lehman's fiscal year‐end 2007, or in the first two quarter‐ends of 2008.³⁶⁸⁴³⁶⁸⁴ Id. Nor was Schlich able to confirm or deny that Lehman's use of Repo 105 transactions was increasing in late 2007 and into mid 2008.³⁶⁸⁵³⁶⁸⁵ Id.

Quarterly Review and Audit

¶Through Schlich, Ernst & Young maintained that its duties as Lehman's auditor required it to ensure that transactions were accounted for correctly (i.e., that they complied with accounting rules) and that Lehman's financial disclosures were not materially misstated.³⁶⁸⁶³⁶⁸⁶ Examiner's Interview of Ernst & Young, Repo 105 Session, Oct. 16, 2009, at pp. 6‐7. According to Schlich, Ernst & Young's audit did not require Ernst & Young to consider or review the volume or timing of Repo 105 transactions.³⁶⁸⁷³⁶⁸⁷ Id. at p. 6. Accordingly, as part of its year‐end 2007 audit, Ernst & Young did not ask Lehman about any directional trends, such as whether its Repo 105 activity was increasing during fiscal year 2007.³⁶⁸⁸³⁶⁸⁸ Id. at p. 9. Notably, as part of its quarterly review process, Ernst & Young did not audit any of Lehman's Repo 105 transactions.³⁶⁸⁹³⁶⁸⁹ Id. at p. 3.

954

Ernst & Young Would Not Opine on the Materiality of Lehman's Repo 105 Usage

¶Ernst & Young, through Schlich, was unwilling to comment to the Examiner on the materiality of the volume of Lehman's quarter‐end Repo 105 transactions.³⁶⁹⁰³⁶⁹⁰ Id. at p. 6. Asked whether, as part of its responsibility to ensure Lehman's financial statements were not materially misstated, Ernst & Young should have considered the possibility that strict technical adherence to SFAS 140 or any other specific accounting rule could nonetheless lead to a material misstatement in Lehman's publicly‐reported financial statements, Schlich refrained from comment.³⁶⁹¹³⁶⁹¹ Examiner's Interview of Ernst & Young, Repo 105 Session, Oct. 16, 2009, at p. 6.

¶When pressed further, Schlich stated that the volume of any particular transaction impacts neither the question of whether accounting rules are applied correctly, nor the question of whether a financial statement is materially misleading.³⁶⁹²³⁶⁹² Id. However, Schlich eventually acknowledged that "when you look at a balance sheet issue, volume is a factor."³⁶⁹³³⁶⁹³ Id. at p. 7.

955

¶Notably, the definition of "materiality" contained in a "walk‐through" document related to Ernst & Young's 2007 fiscal year‐end audit of Lehman was: "any transaction that would move Lehman's firm‐wide net leverage by 0.1 or more."³⁶⁹⁴³⁶⁹⁴ Ernst & Young, LBHI/LBI Walkthrough Template for Balance Sheet Close Process (Nov. 30, 2007), at p. 14 [EY‐LE‐LBHI‐CORP‐GAMX‐07‐033384] ("Materiality is usually defined as any item individually, or in the aggregate, that moves net leverage by 0.1 or more (typically $1.8 billion)."). Accordingly, an item that impacted net leverage by 0.1 point was deemed material enough to re‐open the books. The walkthrough paper also stated, "Net leverage is an important ratio analyzed by the rating agencies and included in Lehman's earnings releases." Id.Show full note This definition reflected "Lehman's determination of a materiality threshold" in connection with Lehman's own criteria for when to consider reopening and adjusting its balance sheet.³⁶⁹⁵³⁶⁹⁵ Examiner's Interview of Ernst & Young, Repo 105 Session, Oct. 16, 2009, at p. 7.

¶When Schlich was asked what level of impact to Lehman's firm‐wide net assets Ernst & Young would have considered "material," Schlich replied that Ernst & Young did not have a hard and fast rule defining materiality in the balance sheet context, and that, with respect to balance sheet issues, "materiality" depends upon the facts and circumstances.³⁶⁹⁶³⁶⁹⁶ Id. Schlich agreed that Lehman made no specific disclosures about Repo 105 transactions in its Forms 10‐K and Form 10‐Q, including the MD&A section.³⁶⁹⁷³⁶⁹⁷ Id. Schlich believed, however, that Lehman's public filings would have included general language regarding secured borrowings and compliance with SFAS 140.³⁶⁹⁸³⁶⁹⁸ Id. As noted in Section III.A.4.j.2.c.ii.a, however, language regarding SFAS 140 in Lehman's Forms 10‐ K and 10‐Q relate solely to Lehman's securitization activities. Schlich was not aware whether Ernst & Young ever discussed Lehman's disclosures vel non of Repo 105 activity with senior Lehman management.³⁶⁹⁹³⁶⁹⁹ Examiner's Interview of Ernst & Young, Repo 105 Session, Oct. 16, 2009, at p. 7.

956

Matthew Lee's Statements Regarding Repo 105 to Ernst & Young

¶On May 16, 2008, Matthew Lee, then‐Senior Vice President in the Finance Division responsible for Lehman's Global Balance Sheet and Legal Entity Accounting, sent a letter to certain members of Lehman's senior management identifying possible violations of Lehman's Ethics Code related to accounting/balance sheet issues.³⁷⁰⁰³⁷⁰⁰ Letter from Matthew Lee, Lehman, to Martin Kelly, Lehman, et al. (May 16, 2008) [EY‐LE‐LBHI‐ KEYPERS 5826885]. Lee's letter contained the following six allegations: (1) on the last day of each month, Lehman's books and records contained approximately $5 billion of net assets in excess of what was managed on the last day of the month, thereby suggesting that the firm's senior management was not in control of its assets to be able to present full, fair, and accurate financial statements to the public; (2) Lehman had "tens of billions of dollars of unsubstantiated balances, which may or may not be 'bad' or non‐performing assets or real liabilities;" (3) Lehman had tens of billions of dollars of illiquid inventory and did not value its inventory in a "fully realistic or reasonable" way; (4) given Lehman's rapid growth and increased number of accounts and entities, it had not invested sufficiently in financial systems and personnel to cope with the balance sheet; (5) the India Finance office lacked sufficient knowledgeable management, resulting in the real possibility of potential misstatements of material facts being distributed by that office; and (6) certain senior level audit personnel were not qualified to "properly exercise the audit functions they are entrusted to manage." Id.Show full note Lehman involved Ernst & Young in its investigation of the concerns raised in Lee's May 16, 2008 letter.³⁷⁰¹³⁷⁰¹ Examiner's Interview of Thomas Cruikshank, Oct. 8, 2009, at p. 7 (stating that although Beth Rudofker led the investigation, as Chair of the Audit Committee, he made sure Ernst & Young was involved as well); Examiner's Interview of Michael L. Ainslie, Dec. 22, 2009, at p. 3; Examiner's Interview of Roger Berlind, Dec. 18, 2009, at pp. 2‐3; Examiner's Interview of Sir Christopher Gent, Jan. 20, 2010, at p. 2; Examiner's Interview of Beth Rudofker, Dec. 15, 2009, at p. 7; see also Employee Letter Review, Presentation to the Audit Committee (July 22, 2008), at p. 2 [LBEX‐AM 067664] (noting that "Corporate Audit has largely completed an evaluation of [Lee's] observations in partnership with Financial Control and Ernst and Young").Show full note

957

¶Subsequently, less than a month later, on June 12, 2008, Ernst & Young – Schlich and Hillary Hansen – interviewed Lee.³⁷⁰²³⁷⁰² Examiner's Interview of Ernst & Young, Nov. 3, 2009, at p. 14 (statement of William Schlich) (noting that Lehman's counsel Joe Polizzotto was present initially but left so Schlich and Hansen could interview Lee privately); see also e‐mail from William Schlich, Ernst & Young, to Hillary Hansen, Ernst & Young (June 10, 2008) [EY‐LE‐LBHI‐KEYPERS 0853892 (scheduling meeting with Lee for June 12, 2008).Show full note Hansen's notes of the interview reveal that Lee made certain statements to Ernst & Young about Lehman's Repo 105 practice, including, most notably, the volume of Repo 105 activity that Lehman engaged in at quarter‐end (May 31, 2008).³⁷⁰³³⁷⁰³ Hansen's notes indicate that Lehman's "Rates [and] Liquid Markets" businesses engaged in "Repo 105/Repo 108 [to] reduce[] assets by 50B [by] moving off B/S [i.e., balance sheet] in Europe & back in 5 days later." Hillary Hansen, Ernst & Young, Handwritten Notes (June 12, 2008), at p. 1 [EY‐LE‐LBHI‐ KEYPERS 5826869]. This is consistent with the Examiner's conclusions that at quarter‐end in second quarter 2008, Lehman reduced its balance sheet by slightly more than $50 billion through Repo 105 transactions.Show full note Hansen's notes specifically recount Lee's allegation that Lehman moved $50 billion of inventory off its balance sheet at quarter‐end through Repo 105 transactions and that these assets returned to the balance sheet approximately a week later.³⁷⁰⁴³⁷⁰⁴ Id.

958

¶When interviewed by the Examiner, Schlich did not recall Lee saying anything about Repo 105 transactions during that interview, although he did not dispute the authenticity of Hansen's notes from the Lee interview.³⁷⁰⁵³⁷⁰⁵ Examiner's Interview of Ernst & Young, Oct. 9, 2009, at p. 5; Examiner's Interview of Ernst & Young, Repo 105 Session, Oct. 16, 2009, at p. 5; Examiner's Interview of Ernst & Young, Nov. 3, 2009, at p. 16. In spite of Hansen's notes, Schlich maintained that Ernst & Young did not know that Lehman engaged in the following Repo 105 activity during the listed time periods: $49.1 billion at first quarter 2008 (Feb. 29, 2008); and $50.38 billion at second quarter 2008 (May 31, 2008).³⁷⁰⁶³⁷⁰⁶ Examiner's Interview of Ernst & Young, Repo 105 Session, Oct. 16, 2009, at p. 12 (Schlich (1) disavowed any knowledge on the part of Ernst & Young of Lehman's actual Repo 105 usage for the first and second quarter of 2008 and (2) said he was not personally aware of Lehman's Repo 105 usage at the close of fiscal year 2007).

¶During the Examiner's interview of Hansen, Hansen recalled that while Ernst & Young questioned Lee about his May 16, 2008 letter, Lee "rattled off" a list of additional issues and concerns he held, one of which was Lehman's use of Repo 105 transactions.³⁷⁰⁷³⁷⁰⁷ Examiner's Interview of Ernst & Young, Nov. 3, 2009, at p. 14. Ernst & Young had no further conversations with Lee about Repo 105 transactions.³⁷⁰⁸³⁷⁰⁸ Id. Prior to her interview of Lee in June 2008, Hansen had heard the term Repo 105 "thrown around" but she did not know its meaning; according to Hansen, Schlich described Repo 105 transactions to her shortly after they met with Lee.³⁷⁰⁹³⁷⁰⁹ Id. Schlich maintains that he does not recall discussing Repo 105 either during or after Lee's interview. Id.

¶Following Ernst & Young's June 12, 2008 interview of Lee, Schlich and Hansen met with Lehman's Gerard Reilly to discuss Lee's assertions regarding improper valuations.³⁷¹⁰³⁷¹⁰ Examiner's Interview of Ernst & Young, Oct. 9, 2009, at p. 6 (statement of William Schlich); Examiner's Interview of Ernst & Young, Nov. 3, 2009, at p. 16 (statement of William Schlich). During that meeting, Hansen informed Reilly of the $50 billion Repo 105 figure Lee provided during Ernst & Young's interview of Lee.³⁷¹¹³⁷¹¹ Examiner's Interview of Ernst & Young, Repo 105 Session, Oct. 16, 2009, at p. 11 (statement of William Schlich). According to Schlich, Reilly (now deceased) told the auditors that he had no knowledge that Lehman used Repo 105 transactions to move $50 billion in assets off its balance sheet.³⁷¹²³⁷¹² Id. "Hillary [Hansen] took away from the meeting with Reilly that he did not know and it was not $50 billion."³⁷¹³³⁷¹³ Id. at p. 12 (statement of William Schlich). Schlich had no personal recollection of discussing Repo 105 with Reilly during the meeting. Id. at p. 11. He said he only knew that Hansen recalled discussing the issue with Reilly and Reilly's response. Id. There are no notes from Schlich and Hansen's meeting with Reilly. Examiner's Interview of Ernst & Young, Nov. 3, 2009, at p. 17 (statement of Hillary Hansen).Show full note

959

¶On June 13, 2008 – the day after Lee informed Ernst & Young of the $50 billion in Repo 105 transactions that Lehman undertook at the end of the second quarter 2008 – Ernst & Young spoke to Lehman's Audit Committee but did not inform the committee of Lee's allegation, even though the Chairman of the Audit Committee had clearly stated that he wanted every allegation made by Lee – whether in Lee's May 16 letter or during the course of the investigation – to be investigated.³⁷¹⁴³⁷¹⁴ Examiner's Interview of Thomas Cruikshank, Oct. 8, 2009, at p. 7 (stating that Internal Audit and Ernst & Young were explicitly instructed to report and investigate any allegation made by Lee during course of investigation); Examiner's Interview of Roger Berlind, Dec. 18, 2009, at p. 2 (same); Examiner's Interview of Michael L. Ainslie, Dec. 22, 2009, at p. 3 (same); Examiner's Interview of Sir Christopher Gent, Jan. 20, 2010, at p.2 (same); Examiner's Interview of Thomas Cruikshank, Jan. 20, 2010, at p. 3; Examiner's Interview of Beth Rudofker, Dec. 15, 2009, at pp. 6‐7; see also Lehman Brothers Holdings Inc., Minutes of the Meeting of Audit Committee (June 13, 2008) [LBEX‐AM 003759].Show full note Ernst & Young met with the Audit Committee on July 8, 2008, to review the second quarter financial statements and again did not mention Lee's allegations regarding Repo 105.³⁷¹⁵³⁷¹⁵ Lehman Brothers Holdings Inc., Minutes of Meeting of Audit Committee (July 8, 2008), at pp. 1‐2 [LBEX‐AM 003831]. On July 22, 2008, Ernst & Young was also present when Beth Rudofker, Head of Corporate Audit, gave a presentation to the Audit Committee on the results of the investigation into Lee's allegations.³⁷¹⁶³⁷¹⁶ Lehman Brothers Holdings Inc., Minutes of Meeting of Audit Committee (July 22, 2008), at p. 4 [LBEX‐AM 003861]; see also Employee Letter Review, Presentation to the Audit Committee (July 22, 2008), at p. 2 [LBEX‐AM 067664] (concluding that "[n]o material issues have been identified during the review [of Lee's allegations] and this report to the Audit Committee summarizes the findings and recommendations"). The presentation contains no reference to Lee's allegation regarding Repo 105. Id. Ernst & Young did not inform Rudofker about Lee's allegation regarding Repo 105. Examiner's Interview of Beth Rudofker, Dec. 15, 2009, at p. 7.Show full note

960

¶Ernst & Young did not disclose to the Audit Committee – either during the meetings or in private executive sessions after – that Lee made an allegation related to Repo 105 transactions being used to move assets off Lehman's balance sheet at quarter‐ end.³⁷¹⁷³⁷¹⁷ Examiner's Interview of Thomas Cruikshank, Jan. 20, 2010, at p. 3; Examinerʹs Interview of Roger Berlind, Dec. 18, 2009, at p. 4; Examinerʹs Interview of Michael L. Ainslie, Dec. 22, 2009, at p. 3; Examiner's Interview of Sir Christopher Gent, Jan. 20, 2010, at pp. 2, 3; Examinerʹs Interview of Beth Rudofker, Dec. 15, 2009, at p. 7.; see also Lehman Brothers Holdings Inc., Minutes of Meeting of Audit Committee (June 13, 2008) [LBEX‐AM 003759]; Lehman Brothers Holdings Inc., Minutes of Meeting of Audit Committee (July 8, 2008) [LBEX‐AM 003831]; Lehman Brothers Holdings Inc., Minutes of Meeting of Audit Committee (July 22, 2008) [LBEX‐AM 003861].Show full note Cruikshank told the Examiner that he would have expected to be told about Lee's Repo 105 allegations.³⁷¹⁸³⁷¹⁸ Examiner's Interview of Thomas Cruikshank, Jan. 20, 2010, at p. 3. Cruikshank, who had no knowledge of Lehman's internal Repo 105 Accounting Policy, said that it was the responsibility of Ernst & Young and Lehman management to analyze the accounting treatment for Repo 105 transactions and ensure the standards were properly applied to these transactions. Id. at pp. 2‐3. Similarly, Sir Gent told the Examiner that the alleged volume of Lehman's Repo 105 transactions mandated disclosure to the Audit Committee as well as further investigation.³⁷¹⁹³⁷¹⁹ Examiner's Interview of Sir Christopher Gent, Jan. 20, 2010, at p. 3.

961

¶Ernst & Young did not follow‐up on either Lee's allegations regarding Lehman's Repo 105 activity or Reilly's claim that he had no knowledge of Lehman's alleged $50 billion Repo 105 usage figure.³⁷²⁰³⁷²⁰ Examiner's Interview of Ernst & Young, Nov. 3, 2009, at p. 16 (statement of William Schlich) Ernst & Young signed a Report of Independent Registered Public Accounting Firm for Lehman's second quarter 2008 Form 10‐Q on July 10, 2008, less than four weeks after Schlich and Hansen interviewed Lee.³⁷²¹³⁷²¹ LBHI 10‐Q (filed July 10, 2008), at p. 53 (stating that "[b]ased upon our review, we are not aware of any material modifications that should be made to the consolidated financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles"); Examiner's Interview of Ernst & Young, Nov. 3, 2009, at p. 17 (statement of William Schlich) (stating that Ernst & Young "signed off" on Lehman's second quarter 2008 10‐Q). On June 5, 2008, only a few days after the close of Lehman's second quarter 2008 and a few days before Lehman's $6 billion equity raise, Schlich wrote to Ernst & Young's Carmine DiSibio and Stephen Howe about Lehman's second quarter financial results and a general report on Lehman's performance. E‐mail from William Schlich, Ernst & Young, to Carmine DiSibio, Ernst & Young, et al. (June 5, 2008) [EY‐LE‐LBHI‐KEYPERS 0853883]. Schlich's note to DiSibio and Howe also referenced Matthew Lee's letter to senior Lehman management, as well as certain off‐ balance sheet items: [W]e are also dealing with a whistleblower letter, that is on its face pretty ugly and will take us a significant amount of time to get through. I am confident from what I have seen it shouldn't result in any significant issues around financial reporting, but again there is a lot of work to do yet. This combined with some very difficult accounting issues around off‐balance sheet items is adding stress to everyone. Id. Schlich denied that the "off‐balance sheet items . . . adding stress to everyone" referenced in his note were Repo 105 transactions. Examiner's Interview of Ernst & Young, Oct. 9, 2009, at p. 10 (statement of William Schlich). Rather, Schlich maintained, the "stress" referenced in his message was due to the public criticism Lehman was then facing over its sale of certain assets to the R3 hedge fund, an approximately $4.5 billion deal. Id. The total dollar amount of off‐balance sheet items resulting from Lehman's Repo 105 transactions at the end of second quarter 2008, when Schlich wrote his note, was over $50 billion, or more than eleven times the size of the R3 deal.Show full note

962

Accounting‐Motivated Transactions

¶Ernst & Young did not evaluate the possibility that Repo 105 transactions were accounting‐motivated transactions that lacked a business purpose.³⁷²²³⁷²² Examiner's Interview of Ernst & Young, Repo 105 Session, Oct. 16, 2009, at p. 13 (statement of William Schlich). An SEC staff paper discourages "accounting‐motivated structured transactions" because a company engaging in such transactions runs the risk of presenting an inaccurate picture of its true financial condition. See OFFICE OF THE CHIEF ACCOUNTANT, SEC, REPORT AND RECOMMENDATIONS PURSUANT TO SECTION 401(C) OF THE SARBANES‐OXLEY ACT OF 2002 ON ARRANGEMENTS WITH OFF‐BALANCE SHEET IMPLICATIONS, SPECIAL PURPOSE ENTITIES AND TRANSPARENCY OF FILINGS BY ISSUERS, at p. 100 (2005) ["SEC SOX Off Balance Sheet Report"]. According to this report, "accounting‐motivated structured transactions" are "transactions that are structured in an attempt to achieve reporting results that are not consistent with the economics of the transaction, and thereby impair the transparency of financial reports." Id. "[A]ttempt[s] to portray the transactions differently from their substance do not operate in the interests of investors, and may be in violation of the securities laws." Id.Show full note Schlich characterized the off‐balance sheet treatment of Lehman's assets in Repo 105 transactions as a consequence of the accounting rules, rather than a motive for the transactions.³⁷²³³⁷²³ Id.

The Examiner's Conclusions

¶There is sufficient evidence to support a determination by a trier of fact that Lehman's failure to disclose that it relied upon Repo 105 transactions to temporarily reduce the firm's net balance sheet and net leverage ratio was materially misleading. In addition, a trier of fact could find that Lehman affirmatively misrepresented its accounting treatment for repos by stating that Lehman treated repo transactions as financing transactions rather than sales for financial reporting purposes, despite the fact that Lehman treated tens of billions of dollars in repo transactions – namely, Repo 105 transactions – as true sale transactions.

963

¶The Examiner thus concludes that sufficient evidence exists from which a trier of fact could find the existence of a colorable claim that certain Lehman officers breached their fiduciary duties to Lehman and its shareholders by causing the company to file deficient and materially misleading financial statements, thereby exposing the company to potential liability. Certain officers of Lehman not only failed to inform the public of its reliance on Repo 105 transactions to reduce its balance sheet, they also failed to advise Lehman's Board of Directors of the firm's Repo 105 practice. Thus, the Examiner concludes that a trier of fact could find that certain Lehman officers breached their fiduciary duties to Lehman's Board of Directors by failing to inform them of: (1) the firm's reliance upon Repo 105 to reduce the balance sheet at quarter‐end, (2) the ramp‐ up in Repo 105 usage in mid‐to‐late 2007 and 2008, (3) the impact of these transactions on Lehman's publicly reported net leverage ratio, or (4) the fact that Lehman did not disclose its Repo 105 practice in its publicly reported financials statements and MD&A.

Materiality

¶The materiality of information is evaluated from the perspective of a reasonable investor.³⁷²⁴³⁷²⁴ See SEC v. Stanard, No. 06 Civ. 7736(GEL), 2009 WL 196023, at *26 (S.D.N.Y. Jan. 27, 2009) (citations omitted). Information is deemed material if there is "a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the 'total mix' of information made available."³⁷²⁵³⁷²⁵ Basic, Inc. v. Levinson, 485 U.S. 224, 231‐32 (1988) (quoting TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976)). Materiality does not require, however, that the information be of a type that would cause an investor to change his investment decision.³⁷²⁶³⁷²⁶ Ganino v. Citizens Utils. Co., 228 F.3d 154, 162 (2d. Cir. 2000). Lehman's audit walk‐through papers defined as material any item that alone or in the aggregate had a one‐tenth (0.1) of a point impact on firm‐ wide net leverage ratio (or $1.8 billion). See Ernst & Young, LBHI/LBI Walkthrough Template for Balance Sheet Close Process (Nov. 30, 2007), at p. 14 [EY‐LE‐LBHI‐CORP‐GAMX‐07‐033384] (defining materiality in the context of re‐opening a closed balance sheet).Show full note

964

Whether Lehman's Repo 105 Transactions Technically Complied with SFAS 140 Does Not Impact Whether a Colorable Claim Exists

¶This Report does not reach the question of whether Lehman's Repo 105 transactions technically complied with the relevant financial accounting standard, SFAS 140, because the answer to that question does not impact whether a colorable claim exists regarding Lehman's failure to disclose its Repo 105 practice and whether that failure rendered the firm's financial statements materially misleading.

¶Even if Lehman's use of Repo 105 transactions technically complied with SFAS 140, financial statements may be materially misleading even when they do not violate GAAP.³⁷²⁷³⁷²⁷ See generally United States v. Ebbers, 458 F.3d 110 (2d Cir. 2006), cert. denied, 127 S.Ct. 1483 (2007). The Second Circuit has explained that "GAAP itself recognizes that technical compliance with particular GAAP rules may lead to misleading financial statements, and imposes an overall requirement that the statements as a whole accurately reflect the financial status of the company."³⁷²⁸³⁷²⁸ Id. at 126.

965

¶Similarly, as noted in In re Global Crossing Ltd. Securities Litigation, even if a defendant established that its accounting practices "were in technical compliance with certain individual GAAP provisions . . . this would not necessarily insulate it from liability. This is because, unlike other regulatory systems, GAAP's ultimate goals of fairness and accuracy in reporting require more than mere technical compliance."³⁷²⁹³⁷²⁹ In re Global Crossing, Ltd. Sec. Litig., 322 F. Supp.2d 319, 339 (S.D.N.Y. 2004) (emphasis added). The court explained that "when viewed as a whole," GAAP has no "loopholes" because its purpose, shared by the securities laws, is "to increase investor confidence by ensuring transparency and accuracy in financial reporting."³⁷³⁰³⁷³⁰ Id. Technical compliance with specific accounting rules does not automatically lead to fairly presented financial statements. "Fair presentation is the touchstone for determining the adequacy of disclosure in financial statements. While adherence to generally accepted accounting principles is a tool to help achieve that end, it is not necessarily a guarantee of fairness."³⁷³¹³⁷³¹ Id. at 340 (internal citations omitted). Moreover, registrants are "required to provide whatever additional information would be necessary to make the statements in their financial reports fair and accurate, and not misleading."³⁷³²³⁷³² Id. (citing 17 C.F.R. § 240.10b‐5(b) and 17 C.F.R. § 230.408 (requiring that "in addition to the information expressly required to be included in a registration statement, there shall be added such further material information, if any, as may be necessary to make the required statements, in the light of the circumstances under which they are made, not misleading") (emphasis added); see also SEC v. Seghers, 298 Fed. App'x 319, 331 (5th Cir. 2008) ("The Commission's proof of Segher's misrepresentations and omissions does not depend on compliance with GAAP, but instead depends on evidence that Segher's statements and omissions were false or misleading to investors."); United States v. Olis, Civil Action No. H‐07‐3295, Criminal No. H‐03‐217‐01, 2008 WL 5046342, at *20 (S.D. Tex. Nov. 21, 2008) ("The scheme to defraud alleged and proved in this case did not turn on whether the treatment accorded to Project Alpha in Dynegy's financial statements technically complied with GAAP or whether Olis and his co‐ conspirators intended to violate GAAP but, instead, on whether the defendants' disclosures about Project Alpha intentionally omitted material facts that caused Dynegy's financial statements to be materially false and misleading.") (citing United States v. Rigas, 490 F.3d 208, 221 (2d Cir. 2007), and United States v. Ebbers, 458 F.3d 110, 125‐26 (2d Cir. 2006)).Show full note

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¶This view is echoed in an SEC enforcement order, concluding that GAAP compliance does not excuse a misleading or less than full disclosure regarding a transaction, especially if the transaction's purpose is "the attainment of a particular financial reporting result."³⁷³³³⁷³³ In re PNC Fin. Servs. Group, Inc., 2002 WL 1585523, at *14 (Securities Act Release No. 33‐8112, Exchange Act Release No. 34‐46225) (July 18, 2002). "[E]ven if the transactions comply with GAAP, the issuer is required to evaluate the material accuracy and completeness of the presentation made by its financial statements."³⁷³⁴³⁷³⁴ Id. Issuers must "ensure that the way they publicly portray themselves discloses, as required, the material elements of [their] economic and business realities and risks."³⁷³⁵³⁷³⁵ Id.

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Disclosure Requirements and Analysis

¶Section 13(a) of the Securities Exchange Act of 1934 required Lehman to file periodic reports with the SEC, including its annual reports on Form 10‐K and quarterly reports on Form 10‐Q.³⁷³⁶³⁷³⁶ Section 13(a) is codified at 15 U.S.C. § 78m(a). It requires the filing of such annual and quarterly reports as the SEC prescribes. 17 C.F.R. 249.310 prescribes the Form 10‐K and 17 C.F.R. 249.308a prescribes the Form 10‐Q. Lehman also filed registration statements under the Securities Act with respect to its public offerings of securities in the United States. Each of these filings required certain disclosures, in each instance subject to the requirement that Lehman provide such "further material information, if any, as may be necessary to make the required statements, in light of the circumstances under which they are made, not misleading."³⁷³⁷³⁷³⁷ Securities Exchange Act Rule 12b‐20, 17 C.F.R. § 240.12b‐20; Securities Act Rule 408, 17 C.F.R. § 230.408.

¶A review of Lehman's public filings confirms that Lehman did not disclose its use of Repo 105 transactions, either by name or characterization, in its Forms 10‐K or 10‐ Q. Moreover, Lehman affirmatively represented that it treated its repo transactions as financing transactions – that is, not as sales – for purposes of financial reporting. Further, the net leverage ratio Lehman reported was misleading because Lehman did not disclose how it achieved this result.³⁷³⁸³⁷³⁸ According to two of Lehman's former Global Financial Controllers and Lehman's former Global Head of Accounting Policy, each of whom was responsible in some fashion for preparing and/or reviewing Lehman's public filings, Lehman did not in any way disclose or report its Repo 105 activity in its Forms 10‐K or 10‐Q. Examiner's Interview of Marie Stewart, Sept. 2, 2009, at p. 15; Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 9; Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 14. In particular, Martin Kelly, who served as Lehman's Global Financial Controller from December 1, 2007 until September 20008, stated that if an individual read Lehman's Forms 10‐K and 10‐Q from cover to cover, "they would have no transparency into the Repo 105/108 program." Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 9. Kelly himself met regularly with the SEC and the New York Federal Reserve Bank as a matter of course in his role as Global Financial Controller, both before the near collapse of Bears Stearns in March 2008 and after federal regulators arrived on‐site at Lehman following Bears Stearns' collapse. Id. Kelly stated that he personally never disclosed to the regulators the fact that Lehman engaged in Repo 105 transactions. Id. Grieb, who served as Lehman's Global Financial Controller for several years until November 30, 2007 and then served as Lehman's Director of Investor Relations, similarly said that Lehman did not disclose its Repo 105 practice in its Forms 10‐K or 10‐Q. Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 14. Nor did Grieb recall ever discussing Lehman's Repo 105 program, or the fact of its Repo 105 transactions, with any analyst who covered Lehman. Id.Show full note Lehman's MD&A statements about its liquidity and liabilities (i.e., obligation to repurchase the securities) were also deficient and misleading; in contrast to a borrowing under an ordinary repurchase agreement, the amount borrowed under a Repo 105 was not reflected in Lehman's MD&A statements.³⁷³⁹³⁷³⁹ In an ordinary repurchase agreement, as demonstrated by the accounting entries in Section III.A.4.d.2 of this Report, a liability would have been created reflecting an obligation to repay the borrowing, and securities used as collateral would have remained on the balance sheet in securities inventory.

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Disclosure Obligations: Regulation S‐K and the MD&A

¶Item 303 of Regulation S‐K, Management's Discussion and Analysis of Financial Condition and Results of Operations (the "MD&A"), requires management to discuss the issuer's financial condition, changes in financial condition, and results of operations. MD&A in each periodic report (Form 10‐K/10‐Q) must contain the following:³⁷⁴⁰³⁷⁴⁰ 17 C.F.R. § 229.303 (2009).

● MD&A requires not only a "discussion," but also an "analysis" of known material trends, events, demands, commitments, and uncertainties. The

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MD&A should not be merely a restatement of financial statement information in a narrative form.³⁷⁴¹³⁷⁴¹ Guidance Regarding Management's Discussion and Analysis of Financial Condition and Results of Operation, Securities Act Release No. 8350, Exchange Act Release No. 48,960, 81 SEC Docket 2905 (Dec. 19, 2003).

● When a description of known material trends, events, demands, commitments, and uncertainties is set forth, companies should consider including, and may be required to include, an analysis explaining the underlying reasons or implications, interrelationships between constituent elements, or the relative significance of those matters.³⁷⁴²³⁷⁴² Id.

¶As set forth in SEC guidance regarding MD&A, the principal objectives of MD&A are to provide: (1) a narrative explanation of a company's financial statements that enables investors to see the company through the eyes of management; (2) context within which financial information should be analyzed; and (3) information about the quality of, and potential variability of, a company's earnings and cash flow so that investors can ascertain the likelihood that past performance is indicative of future performance.³⁷⁴³³⁷⁴³ Id.

¶Regulation S‐K – together with SEC guidance – supports the Examiner's conclusion that the trier of fact could find that Lehman had an obligation to disclose certain aspects of its Repo 105 program in the MD&A: Liquidity:

● "Identify any known trends or any known demands, commitments, events or uncertainties that will result in or that are reasonably likely to result in the registrant's liquidity increasing or decreasing in any material way… Also identify and separately describe internal and external sources of liquidity…."³⁷⁴⁴³⁷⁴⁴ Item 303(a)(1) of Regulation S‐K.

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● Identifying the intermediate effects of trends, events, demands, commitments and uncertainties alone, without describing the reasons underlying these effects, may not provide sufficient insight for a reader to see the business through the eyes of management.³⁷⁴⁵³⁷⁴⁵ Guidance Regarding Management's Discussion and Analysis of Financial Condition and Results of Operation, Securities Act Release No. 8350, Exchange Act Release No. 48,960, 81 SEC Docket 2905 (Dec. 19, 2003).

¶Capital Resources:

● "Describe any known material trends, favorable or unfavorable, in the registrant's capital resources. Indicate any expected material changes in the mix and relative cost of such resources. The discussion shall consider changes between equity, debt and any off‐balance sheet financing arrangements."³⁷⁴⁶³⁷⁴⁶ Item 303(a)(2)(ii) of Regulation S‐K (emphasis added).

¶Results of Operations of the MD&A:

● "Describe any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations."³⁷⁴⁷³⁷⁴⁷ Item 303(a)(3) of Regulation S‐K.

¶Off‐balance sheet arrangements:

● "In a separately‐captioned section, discuss the registrant's off‐balance sheet arrangements that have or are reasonably likely to have a current or future effect on the registrant's financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors."³⁷⁴⁸³⁷⁴⁸ Item 303(a)(4)(i) of Regulation S‐K.

● The disclosure of off‐balance sheet arrangements shall include the following items "to the extent necessary to an understanding of such arrangements and effect and shall also include such other information that the registrant believes is necessary for such an understanding"³⁷⁴⁹³⁷⁴⁹ Id.:

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○ "The nature and business purpose to the registrant of such off‐balance sheet arrangements;"³⁷⁵⁰³⁷⁵⁰ Item 303(a)(4)(i)(A) of Regulation S‐K.

○ "The importance to the registrant of such off‐balance sheet arrangements in respect of its liquidity, capital resources, market risk support, credit risk support or other benefits;"³⁷⁵¹³⁷⁵¹ Item 303(a)(4)(i)(B) of Regulation S‐K.

○ "The amounts of revenues, expenses and cash flows of the registrant arising from such arrangements; […]; and the nature and amounts of any other obligations or liabilities (including contingent obligations or liabilities) of the registrant arising from such arrangements that are or are reasonably likely to become material and the triggering events or circumstances that could cause them to arise;"³⁷⁵²³⁷⁵² Item 303(a)(4)(i)(C) of Regulation S‐K.

○ "Any known event, demand, commitment, trend or uncertainty that will result in or is reasonably likely to result in the termination or material reduction in availability to the registrant, of its off‐balance sheet arrangements that provide material benefits to it, and the course of action that the registrant has taken or proposes to take in response to any such circumstances."³⁷⁵³³⁷⁵³ Item 303(a)(4)(i)(D) of Regulation S‐K.

¶SEC guidance explains when disclosure is required:

● Where the reported financial information is NOT indicative of the future – i.e., where additional explanation is required to enhance the indicative value of reported results.³⁷⁵⁴³⁷⁵⁴ Guidance Regarding Management's Discussion and Analysis of Financial Condition and Results of Operation, Securities Act Release No. 8350, Exchange Act Release No. 48,960, 81 SEC Docket 2905 (Dec. 19, 2003).

● To describe unusual events and transactions, demands, commitments, and uncertainties in order to reveal, identify, or further define apparent trends.³⁷⁵⁵³⁷⁵⁵ Id.

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● If management determines that a trend, demand, commitment, event or uncertainty is reasonably likely to occur, disclosure is required unless management determines that a material effect on the company's financial condition or results of operation is not reasonably likely to occur.³⁷⁵⁶³⁷⁵⁶ Management's Discussion and Analysis of Financial Condition and Results of Operation; Certain Investment Company Disclosures, Securities Act Release 33‐6835, Exchange Act Release No. 26,831, Investment Company Act Release No. 16,461, 43 SEC Docket 1330 (May 18, 1989).

¶Disclosure of the agreement to repurchase component of Repo 105 transactions was required in the MD&A. Lehman's repurchase of the securities was a known event that was reasonably likely to occur and would have had a material effect on the company's financial condition or results of operations. Lehman's disclosure in the Liquidity and Capital Resources section should have included a discussion of what was known with respect to the timing and/or amounts of the cash flow created by the repayment of the Repo 105 cash borrowing in the first seven to ten days after quarter‐ end, specifically: (1) the availability of cash as a result of the repayment of the Repo 105 cash borrowing; (2) the ability to borrow more capital because of a reduction in debt rating or deterioration in leverage ratio due to the repayment of the Repo 105 cash borrowing; (3) the effect of the repayment of the Repo 105 cash borrowing on the cost of capital/credit rating; and (4) the economic substance and business purpose of the Repo 105 arrangements.

Duty to Disclose

¶SEC Rule 12b‐20 requires that all filings contain such additional information necessary to make the information contained in the filing not misleading. Moreover, "Once defendants choose to speak about their company, they undertake a duty to 'speak truthfully and to make such additional disclosures as…necessary to avoid rendering the statements misleading.'"³⁷⁵⁷³⁷⁵⁷ Hall v. The Children's Place, 580 F. Supp.2d 212, 226 (S.D.N.Y. 2008) (citing In re Par Pharm., Inc. Sec. Litig., 733 F. Supp. 668, 675 (S.D.N.Y. 1990); see also Lapin v. Goldman Sachs Group, Inc., 506 F. Supp.2d 221, 237 (S.D.N.Y. 2006) (holding that "upon choosing to speak one 'has a duty to be both accurate and complete'") (quoting Caiola v. Citibank, N.A., 295 F.3d 312, 331 (2d Cir. 2002); In re Alstom SA Sec. Litig.,, 406 F. Supp.2d 433, 445 (S.D.N.Y. 2005) ("The Second Circuit has held that 'one circumstance creating a duty to disclose arises when disclosure is necessary to make prior statements not misleading.'") (quoting In re Time Warner, Inc. Sec. Litig., 9 F.3d 259, 268 (2d Cir. 1993)).Show full note

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Lehman's Public Filings

¶An investor reviewing Lehman's 2007 Form 10‐K and two 2008 Forms 10‐Q would not have been able to discern that Lehman was engaged in Repo 105 transactions.³⁷⁵⁸³⁷⁵⁸ Former Lehman Global Financial Controllers Grieb and Kelly, as well as the former Lehman Global Head of Accounting Policy, confirmed that Lehman made no disclosures in its Forms 10‐K and 10‐Q about its Repo 105 practice. Examiner's Interview of Marie Stewart, Sept. 2, 2009, at p. 15; Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 9; Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 14.Show full note Indeed, Lehman made no disclosures in its Statement of Income, Statement of Financial Condition, Statement of Cash Flows, or MD&A sections (including its section on liquidity) from which an investor could infer that Lehman treated a certain volume of repo transactions as sales under SFAS 140, thereby decreasing its net assets and its net leverage ratio.³⁷⁵⁹³⁷⁵⁹ As discussed in Section III.A.4.d.2 of this Report, Lehman used incoming cash from Repo 105 transactions to pay down other liabilities, so an investor reading Lehman's publicly‐filed statements would not have seen an increase in Lehman's cash holdings. See LBHI 2007 10‐K, at p. 86 (reporting that Lehman had $7.286 billion in cash and cash equivalents as of November 30, 2007); LBHI 10‐Q (filed Apr. 9, 2008), at p. 5 (reporting that Lehman had $7.564 billion in cash and cash equivalents as of February 29, 2008); LBHI 10‐Q (filed July 10, 2008), at p. 5 (reporting that Lehman had $6.513 billion in cash and cash equivalents as of May 31, 2008). While Lehman's Repo 105 transactions spiked at quarter‐ends, Lehman'sShow full note

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Summary of Lehman's 2000 through 2007 Public Filings

¶The Examiner reviewed Lehman's Forms 10‐K and Forms 10‐Q from 2000 through third quarter 2007. Several items are worth noting:

● FASB issued SFAS 140 in September 2000. Lehman's first disclosure regarding SFAS 140 is found in its Form 10‐K405 for 2000.³⁷⁶⁰³⁷⁶⁰ Lehman Brothers Holdings Inc., Annual Report for 2000 as of Nov. 30, 2000 (Form 10‐K405) (filed on Feb. 28, 2001), at p. 52 ("LBHI 2000 10‐K405"). In its Form 10‐ K405 (Nov. 30, 2000), Lehman explained that SFAS 140 changed the criteria used to evaluate whether a financial asset is controlled and whether a vehicle constitutes a Qualifying Special Purpose Entity ("QSPE").³⁷⁶¹³⁷⁶¹ Id.; see also Lehman Brothers Holdings Inc., Quarterly Report as of May 31, 2002 (Form 10‐Q) (filed on July 15, 2002), at p. 7 ("LBHI 10‐Q (filed July 15, 2002)").

● Lehman never disclosed in any of its Forms 10‐K and 10‐Q from 2000 through third quarter 2007 that it treated some repo transactions as sales pursuant to SFAS 140.³⁷⁶²³⁷⁶² See generally Lehman Brothers Holdings Inc., Annual Report for 2001 as of Nov. 30, 2001 (Form 10‐ K405) (filed on Feb. 28, 2002) ("LBHI 2001 10‐K405"); Lehman Brothers Holdings Inc., Annual Report for 2002 as of Nov. 30, 2002 (Form 10‐K) (filed on Feb. 28, 2003) ("LBHI 2002 10‐K"); Lehman Brothers Holdings Inc., Quarterly Report as of Aug. 31, 2003 (Form 10‐Q) (filed on Oct. 15, 2003) ("LBHI 10‐Q (filed Oct. 15, 2003)"); Lehman Brothers Holdings Inc., Annual Report for 2003 as of Nov. 30, 2003 (Form 10‐K) (filed on Feb. 26, 2004) ("LBHI 2003 10‐K"); Lehman Brothers Holdings Inc., Quarterly Report as of Feb. 29, 2004 (Form 10‐Q) (filed on Apr. 14, 2004) ("LBHI 10‐Q (filed Apr. 14, 2004)"); Lehman Brothers Holdings Inc., Quarterly Report as of May 31, 2004 (Form 10‐Q) (filed on July 14, 2004) ("LBHI 10‐Q (filed July 14, 2004)"); Lehman Brothers Holdings Inc., Quarterly Report as of Aug. 31, 2004 (Form 10‐Q) (filed on Oct. 15, 2004) ("LBHI 10‐Q (filed Oct. 15, 2004)"); Lehman Brothers Holdings Inc., Annual Report for 2004 as of Nov. 30, 2004 (Form 10‐K) (filed on Feb. 14, 2005) ("LBHI 2004 10‐K"); Lehman Brothers Holdings Inc., Quarterly Report as of Feb. 28, 2005 (Form 10‐Q) (filed on Apr. 11, 2005) ("LBHI 10‐Q (filed Apr. 11, 2005)"); Lehman Brothers Holdings Inc., Quarterly Report as of May 31, 2005 (Form 10‐Q) (filed on July 11, 2005) ("LBHI 10‐Q (filed July 11, 2005)"); Lehman Brothers Holdings Inc., Quarterly Report as of Aug. 31, 2005 (Form 10‐Q) (filed on Oct. 11, 2005) ("LBHI 10‐Q (filed Oct. 11, 2005)"); Lehman Brothers Holdings Inc., Annual Report for 2005 as of Nov. 30, 2005 (Form 10‐K) (filed on Feb. 13, 2006) ("LBHI 2005 10‐K"); Lehman Brothers Holdings Inc., Quarterly Report as of Feb. 28, 2006 (Form 10‐Q) (filed on Apr. 10, 2006) ("LBHI 10‐Q (filed Apr. 10, 2006)"); Lehman Brothers Holdings Inc., Quarterly Report as of May 31, 2006 (Form 10‐Q) (filed on July 10, 2006) ("LBHI 10‐Q (filed July 10, 2006)"); Lehman Brothers Holdings Inc., Quarterly Report as of Aug. 31, 2006 (Form 10‐Q) (filed on Oct. 10, 2006) ("LBHI 10‐Q (filed Oct. 10, 2006)"); Lehman Brothers Holdings Inc., Annual Report for 2006 as of Nov. 30, 2006 (Form 10‐K)Show full note Because Lehman treated Repo 105 transactions as

¶ordinary repo balances dropped off significantly during the same time periods. Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), at p. 5.

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sales rather than borrowings (as it treated other repo transactions), Lehman did not disclose its liabilities arising from the obligation to repay the cash borrowing.

● Lehman consistently represented that it treated repo transactions as "secured financing" transactions "for financial reporting purposes," without disclosing that it treated some repos as sales.³⁷⁶³³⁷⁶³ LBHI 2001 10‐K405, at p. 67; LBHI 2002 10‐K, at p. 69; LBHI 10‐Q (filed Oct. 15, 2003), at pp. 10‐11; LBHI 2003 10‐K, at p. 76; LBHI 10‐Q (filed Apr. 14, 2004), at p. 10; LBHI 10‐Q (filed July 14, 2004), at p. 11; LBHI 10‐Q (filed Oct. 15, 2004), at p. 11; LBHI 2004 10‐K, at p. 89; LBHI 10‐Q (filed Apr. 11, 2005), at pp. 11‐12; LBHI 10‐Q (filed July 11, 2005), at pp. 11‐12; LBHI 10‐Q (filed Oct. 11, 2005), at p. 11; LBHI 2005 10‐ K, at p. 81; LBHI 10‐Q (filed Apr. 10, 2006), at p. 11; LBHI 10‐Q (filed July 10, 2006), at p. 12; LBHI 10‐Q (filed Oct. 10, 2006), at pp. 11‐12; LBHI 2006 10‐K, at pp. 85‐86; LBHI 10‐Q (filed July 10, 2007), at p. 12; LBHI 10‐Q (filed Oct. 10, 2007), at p. 12.Show full note

● Lehman repeatedly disclosed that SFAS 140 required it to classify in its financial statements certain collateral that Lehman owned, but pledged to its counterparty, as "financial instruments and other inventory owned but pledged as collateral."³⁷⁶⁴³⁷⁶⁴ LBHI 2000 10‐K405, at p. 2; Lehman Brothers Holdings Inc., Quarterly Report as of Feb. 28, 2001 (Form 10‐Q) (filed on Apr. 16, 2001), at p. 26 ("LBHI 10‐Q (filed Apr. 16, 2001)"); Lehman Brothers Holdings Inc., Quarterly Report as of May 31, 2001 (Form 10‐Q) (filed on July 16, 2001), at p. 29 ("LBHI 10‐Q (filed July 16, 2001)"); LBHI 2001 10‐K405, at p. 57. One example of collateral that is owned but pledged consists of securities that are transferred in an ordinary repo transaction. Lehman stated that it was required to classify as a separate line item ("Securities Owned Pledged as Collateral") on the balance sheet under "Assets" those securities that were owned by Lehman but pledged to its counterparty if the counterparty had "the right, by contract or custom, to sell or repledge the securities."³⁷⁶⁵³⁷⁶⁵ LBHI 2001 10‐K405, at p. 66; Lehman Brothers Holdings Inc., Quarterly Report as of Aug. 31, 2002 (Form 10‐Q) (filed on Oct. 15, 2002), at p. 17 ("LBHI 10‐Q (filed Oct. 15, 2002)"); LBHI 2002 10‐K, at p. 91; Lehman Brothers Holdings Inc., Quarterly Report as of Feb. 28, 2003 (Form 10‐Q) (filed on Apr. 14, 2003), at pp. 12‐13 ("LBHI 10‐Q (filed Apr. 14, 2003)"); Lehman Brothers Holdings Inc., Quarterly Report as of May 31, 2003 (Form 10‐Q) (filed on July 15, 2003), at pp. 14‐15 ("LBHI 10‐Q (filed July 15, 2003)"); LBHI 10‐Q (filed Oct. 15, 2003), at p. 20; LBHI 10‐Q (filed Apr. 14, 2004), at p. 16; LBHI 10‐Q (filed July 14, 2004), at pp. 16‐17; LBHI 10‐Q (filed Oct. 15, 2004), at p. 17; LBHI 2004 10‐K, at p. 99; LBHI 10‐Q (filed Apr. 11, 2005), at p. 19; LBHI 10‐Q (filed July 11, 2005), at p. 19; LBHI 10‐Q (filed Oct. 11, 2005), at p. 18; LBHI 10‐Q (filed Apr. 10, 2006), at p. 21; LBHI 10‐Q (filed July 10, 2006), at p. 20; LBHI 10‐Q (filed Oct. 10, 2006), at p. 21; LBHI 2006 10‐K (filed Nov. 30, 2006), at p. 95.Show full note Accordingly, securities that Lehman

¶(filed on Feb. 13, 2007) ("LBHI 2006 10‐K"); Lehman Brothers Holdings Inc., Quarterly Report as of May 31, 2007 (Form 10‐Q) (filed on July 10, 2007) ("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) ("LBHI 10‐Q (filed Oct. 10, 2007)").

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transferred in ordinary repo transactions where the repo counterparty had the right to sell or repledge the securities should have been included among the assets reported on Lehman's balance sheet under "Securities Owned Pledged as Collateral."

● Because Lehman treated financial instruments transferred and pledged in Repo 105 transactions as "sold," those securities were not included in the line item for "Securities Owned Pledged as Collateral."

● Lehman repeatedly disclosed that it obtained short‐term financing on a secured basis through the use of repo transactions, which were primarily collateralized by government, agency, and equity securities.³⁷⁶⁶³⁷⁶⁶ See, e.g., LBHI 2000 10‐K405, at p. 62; LBHI 2001 10‐K405, at pp. 67‐68; LBHI 2002 10‐K, at p. 69; LBHI 10‐Q (filed Oct. 15, 2003), at pp. 10‐11; LBHI 2003 10‐K, at p. 76; LBHI 10‐Q (filed Apr. 14, 2004), at p. 10; LBHI 10‐Q (filed Oct. 15, 2004), at p. 11; LBHI 2004 10‐K, at p. 89 (filed Feb. 14, 2005); LBHI 10‐Q, at p. 11‐ 12 (filed Apr. 11, 2005); LBHI 10‐Q, pp. 11‐12 (filed July 11, 2005); LBHI 10‐Q, at p. 11 (filed Oct. 11, 2005); LBHI 2005 10‐K, at p. 81; LBHI 10‐Q, at pp. 11‐12 (filed Apr. 10, 2006); LBHI 10‐Q, at p. 12 (filed July 10, 2006); LBHI 10‐Q, at pp. 11‐12 (filed Oct. 10, 2006); LBHI 2006 10‐K, at pp. 85‐86; LBHI 10‐Q, at p. 12 (filed Apr. 9, 2007); LBHI 10‐Q, at p. 12 (filed Jul 10, 2007); LBHI 10‐Q, at p. 12 (filed Oct. 10, 2007).Show full note

● In a few of its financial statements, Lehman stated that "The Company accounts for transfers of financial assets in accordance with SFAS 140" and followed this statement with a summary of SFAS 140's three criteria for recognizing the transfer of financial assets as sales.³⁷⁶⁷³⁷⁶⁷ LBHI 10‐Q (filed July 15, 2002), at p. 8; see also id. at p. 42 (discussing SFAS 140 in the context of securitizations and special purpose entities). In these instances where Lehman made the general disclosure regarding SFAS 140: (1) the SFAS 140 disclosure was listed under "Consolidation Accounting Policies" along with a disclosure regarding Special Purpose Entities or was part of a "Securitization activities" disclosure; (2) Lehman did not state that it treated some repo transactions as sales under SFAS 140; and (3) the financial statement contained other disclosure(s) stating that Lehman treats repo transactions as secured financings (i.e., not as sales) and/or regarding securities owned and pledged as collateral (as described above).³⁷⁶⁸³⁷⁶⁸ See LBHI 10‐Q (filed July 15, 2002), at pp. 8, 14; LBHI 10‐Q (filed Oct. 15, 2002), at pp. 9‐10, 17; LBHI 2002 10‐K, at pp. 69, 71, 91; LBHI 10‐Q (filed Oct. 15, 2003), at pp. 10‐11, 12‐13, 20; Lehman Brothers Holdings Inc., Quarterly Report as of Feb. 28, 2007 (Form 10‐Q) (filed on Apr. 9, 2007), at pp. 11‐12 ("LBHI 10‐Q (filed Apr. 9, 2007)"); LBHI 10‐Q (filed July 10, 2007), at pp. 11‐12; LBHI 10‐Q (filed Oct. 10, 2007), at pp. 11‐12.Show full note

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¶At no time did Lehman disclose that it recharacterized certain repo transactions as sales or the impact this accounting treatment had on its net balance sheet or leverage ratios. In addition, although Lehman in its 2006 Form 10‐K disclosed that "[t]he overall size of our balance sheet will fluctuate from time to time and, at specific points in time, may be higher than the year‐end or quarter‐end amounts," and that "[o]ur net assets at quarter‐ends were, on average, approximately 5% and 6% lower than amounts based on a monthly average over the four and eight quarters ended November 30, 2006," Lehman removed any such disclosure in its 2007 Form 10‐K and first and second quarter 2008 Forms 10‐Q, at the very time Lehman escalated its quarter‐end Repo 105 usage.³⁷⁶⁹³⁷⁶⁹ LBHI 2006 10‐K, at p. 51; see generally LBHI 2007 10‐K; LBHI 10‐Q (filed Apr. 9, 2008); LBHI 10‐Q (filed July 10, 2008).

Lehman's 2007 Form 10‐K, First Quarter 2008 Form 10‐Q, and Second Quarter 2008 Form 10‐Q

¶Nowhere in Lehman's 2007 Form 10‐K or Forms 10‐Q for the first and second quarter 2008 did Lehman disclose that it engaged in Repo 105 transactions. Moreover, Lehman affirmatively misrepresented how it treated repo transactions for financial reporting purposes. As a result of omitting information regarding its Repo 105 practice, Lehman's statements regarding its net leverage were rendered misleading. Furthermore, Lehman's omissions, including its lack of disclosures regarding Repo 105 derivatives, precluded a reader of the periodic reports from ascertaining that Lehman used temporary off‐balance sheet repo transactions to impact its net leverage.

978

Treatment of Repo Transactions and SFAS 140

¶In its 2007 Form 10‐K, first quarter 2008 Form 10‐Q, and second quarter 2008 Form 10‐Q, Lehman affirmatively represented that it treated repurchase agreements as financings – not as sales. In Note 1 to Lehman's Consolidated Financial Statements in each filing, Lehman stated that it treated "[r]epurchase and resale agreements," as "collateralized agreements and financings for financial reporting purpose" which Lehman described were "collateralized primarily by government and government agency securities."³⁷⁷⁰³⁷⁷⁰ LBHI 2007 10‐K, at p. 97; LBHI 10‐Q (filed Apr. 9, 2008), at p. 13; LBHI 10‐Q (filed July 10, 2008), at p. 16 (emphasis added). This disclosure is under the heading "Collateralized Lending Agreements and Financings." In addition, Lehman further stated in each filing: "Other secured borrowings principally reflect transfers accounted for as financings rather than sales under SFAS 140."³⁷⁷¹³⁷⁷¹ LBHI 2007 10‐K, at p. 97; LBHI 10‐Q (filed Apr. 9, 2008), at p. 13; LBHI 10‐Q (filed July 10, 2008), at p. 16 (emphasis added). In Note 5 to its financial statements, Lehman disclosed that it pledged its own assets to collateralize financing arrangement. LBHI 2007 10‐K, at p. 110. It further stated that "[t]hese pledged securities, where the counterparty has the right by contract or custom to sell or repledge the financial instruments, were approximately $63 billion…at November 30, 2007…." Id.; see also LBHI 10‐Q (filed Apr. 9, 2008), at p. 26 (same); LBHI 10‐Q (filed July 10, 2008), at p. 34 (same). Note 5 refers to a subset of ordinary repo transactions – not to Repo 105 transactions, which Lehman treated as sales rather than financing arrangements and did not identify or disclose.Show full note

¶Lehman disclosed that it recognized the transfer of financial assets as sales pursuant to SFAS 140 – but it said so only with respect to "securitization activities."³⁷⁷²³⁷⁷² LBHI 2007 10‐K, at p. 96; LBHI 10‐Q (filed Apr. 9, 2008), at p. 13; LBHI 10‐Q (filed July 10, 2008), at pp. 15‐16. "Securitization activities" is a separate heading in the Note. Securitization activities, however, bear no relation to repo transactions generally, or to Repo 105 transactions specifically.³⁷⁷³³⁷⁷³ Securitization occurs when a pool of "financial assets such as mortgage loans, automobile loans, trade receivables, credit card receivables, and other revolving charge accounts" is created and then securities representing interests in that pool are sold. ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS OF LIABILITIES, Statement of Financial Accounting Standards No. 140, ¶ 73 (Fin. Accounting Standards Bd. 2000) ("SFAS 140"). The pool is created by transferring the financial assets to a special purpose entity ("SPE"). "An originator of a typical securitization (the transferor) transfers a portfolio of financial assets to an SPE, commonly a trust." SFAS 140, ¶ 74. "Beneficial interests in the SPE are sold to investors and the proceeds are used to pay the transferor for the assets transferred." SFAS 140, ¶ 75. When the criteria of SFAS 140 are met, a company can remove from its balance sheet the loans, receivables or other assets that it transferred to the special purpose vehicle as the first step in the securitization activity. In contrast, and as discussed at length at the beginning of this Report, a repo transaction allows a repo borrower to borrow cash from a repo lender in exchange for the transfer of securities. When the term of the repo matures, the repo borrower repurchases the securities from the repo lender and pays an additional interest rate on the borrowed cash. See SFAS 140, ¶ 96.Show full note Just as Lehman's disclosures dealt with securitization activities and repo transactions separately, SFAS 140 addressed these distinct transactions separately as well.³⁷⁷⁴³⁷⁷⁴ SFAS 140 deals with securitizations in Paragraphs 73 through 84, and with repo agreements in Paragraphs 96 through 101.

979

¶Lehman's MD&A for its 2007 Form 10‐K and Forms 10‐Q for the first and second quarter 2008 were also misleading with respect to Lehman's liabilities, i.e., the obligation to repay the Repo 105 cash borrowing. Lehman's repayment of the Repo 105 cash borrowing (the "repurchase" of the Repo 105 securities) was a known event that would have a material impact on Lehman's cash flow and liabilities.³⁷⁷⁵³⁷⁷⁵ If a Repo 105 transaction technically complied with SFAS 140, SFAS 140 did not require that the cash borrowing be recorded as a liability because the repo transaction was recharacterized as a sale. However, because Lehman made no disclosures in its periodic reports regarding its accounting treatment for and volume of Repo 105 transactions, sufficient evidence exists for a finding that Lehman's MD&A was deficient because it did not disclose that Lehman had borrowed tens of billions of dollars it was required to repay in the short‐term and that repayment of the Repo 105 borrowing would require Lehman to find financing.Show full note

980

Net Leverage

¶As discussed earlier in the Report, Lehman's MD&A discussion of Capital Ratios stated that a "more meaningful" ratio than "leverage ratio" is "net leverage, which is the result of net assets divided by tangible equity capital."³⁷⁷⁶³⁷⁷⁶ LBHI 2007 10‐K, at p. 63; LBHI 10‐Q (filed Apr. 9, 2008), at p. 72; LBHI 10‐Q (filed July 10, 2008), at p. 88. According to Lehman's MD&A, Lehman "calculates net assets by excluding from total assets: (i) cash and securities segregated and on deposit for regulatory and other purposes; (ii) collateralized lending agreements; and (iii) identifiable intangible assets and goodwill."³⁷⁷⁷³⁷⁷⁷ LBHI 2007 10‐K, at p. 63; LBHI 10‐Q (Apr. 9, 2008), at p. 72; LBHI 10‐Q (July 10, 2008), at p. 88. Lehman informed the investing public that it viewed "net leverage based on net assets to be a more useful measure of leverage, because it excludes certain low‐ risk, non‐inventory assets and utilizes tangible equity capital as a measure of equity base."³⁷⁷⁸³⁷⁷⁸ LBHI 2007 10‐K, at p. 63; LBHI 10‐Q (filed Apr. 9, 2008), at p. 72; LBHI 10‐Q (filed July 10, 2008), at p. 88.

¶Lehman's net leverage ratio on November 30, 2007, as reported in its 2007 Form 10‐K, was 16.1x.³⁷⁷⁹³⁷⁷⁹ LBHI 2007 10‐K, at p. 29. If Lehman had used ordinary repos instead of its undisclosed Repo 105 transactions for the approximately $38 billion in Repo 105 transactions that Lehman undertook at the close of its fiscal 2007, Lehman's net leverage at close of fiscal year 2007 would have been 17.8x.³⁷⁸⁰³⁷⁸⁰ See Section III.A.4.g.2 of this Report (discussing the impact of Lehman's Repo 105 practice upon its net leverage); Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), at p. 8.

981

¶Lehman's net leverage ratio on February 29, 2008, as reported in its first quarter 2008 Form 10‐Q, was 15.4x.³⁷⁸¹³⁷⁸¹ LBHI 10‐Q (filed Apr. 9, 2008), at p. 72. If Lehman had used ordinary repo transactions rather than its undisclosed Repo 105 transactions for the $49.1 billion in Repo 105 transactions that Lehman undertook at the close of the first quarter 2008, Lehman's net leverage at close of its first quarter 2008 would have been 17.3x.³⁷⁸²³⁷⁸² See Section III.A.4.g.2 of this Report (discussing the impact of Lehman's Repo 105 practice upon its net leverage); Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), at p. 8.

¶Lehman's net leverage ratio on May 31, 2008, as reported in its second quarter 2008 Form 10‐Q, was 12.06x.³⁷⁸³³⁷⁸³ LBHI 10‐Q (filed July 10, 2008), at p. 89. If Lehman had used ordinary repo transactions rather than its undisclosed Repo 105 transactions for the approximately $50.38 billion in Repo 105 transactions that Lehman undertook at the close of the second quarter 2008, Lehman's net leverage at close second quarter 2008 would have been 13.9x.³⁷⁸⁴³⁷⁸⁴ See Section III.A.4.g.2 of this Report (discussing the impact of Lehman's Repo 105 practice upon its net leverage); Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and Leverage Ratios Summary (Oct. 2, 2009), at p. 8.

Derivatives

¶As discussed supra at Section III.A.4.d.2.d of the Report, when Lehman employed Repo 105 transactions, it established a long inventory derivative asset representing the obligation under a forward contract to repurchase the full amount of securities "sold" in a Repo 105 transaction.³⁷⁸⁵³⁷⁸⁵ Lehman Brothers Holdings Inc., Accounting Policy Manual Repo 105 and Repo 108, at p. 2 [LBEX‐ DOCID 3213293]. Assuming Lehman borrowed $100 cash in exchange for a pledge of $105 of fixed income collateral, Lehman booked a $5 derivative, which represented Lehman's obligation to repurchase the securities at the end of the term of the repo transaction.³⁷⁸⁶³⁷⁸⁶ Id. The $5 reflected the market value of the overcollateralization of the Repo 105 transaction.

982

¶A comprehensive review of Lehman's 2007 Form 10‐K, first quarter 2008 Form 10‐Q, and second quarter 2008 Form 10‐Q does not allow a user – even one who knows of the existence of Lehman's Repo 105 practice, including the creation of a derivative –to identify the amount of the Repo 105 borrowing, or the existence of and size of the derivative asset created that would represent Lehman's obligation to repurchase the securities.³⁷⁸⁷³⁷⁸⁷ Lehman's former Global Financial Controller, Martin Kelly, advised the Examiner that the "risk" of a Repo 105 transaction was represented in the derivatives created by these transactions, which were aggregated with other derivatives. Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 13. Kelly stated that "risk reporting was just an aggregate – you could not have known about Repo 105 from risk disclosures." Id. Lehman's 2007 10‐K MD&A discussion of Off‐Balance Sheet Arrangements included a disclosure of the notional amount of off‐balance sheet arrangements including derivative contracts. LBHI 2007 10‐K, at p. 66. A footnote to the table included in this MD&A discussion states that the fair value of Lehman's derivative contracts as of November 30, 2007, was $38.6 billion. Id. at p. 67. No mention (by name or description) or break out of Repo 105 derivatives is included. The 2007 10‐K MD&A's risk management discussion also references derivatives, breaking out the fair value of OTC derivatives by maturity. Id. at p. 72. Lehman stated that the fair value of its OTC derivative assets at November 30, 2007 was $41.3 billion. Id. Again, there is no mention or break out of Repo 105 derivatives. The volume of Repo 105 derivative assets (roughly $4 billion) would presumably feed into the $313.129 billion line item "Financial Instruments and Other Positions Owned" on Lehman's Consolidated Statement of FinancialShow full note

983

¶Condition as of November 30, 2007, but again, no mention or break out of Repo 105 is given. Id. at p. 86. Note 1 to the financial statements discusses "Derivative Financial Instruments" without mention or break out of Repo 105 derivatives. Id. at p. 95. Note 3 regarding "Financial Instruments and Other Inventory Positions" provides detail on the single line item from the balance sheet, mentioned above. It states that $44.595 billion of the $313.129 billion line item is comprised of derivatives and other contractual agreements. LBHI 2007 10‐K, at p. 103. No break out or disclosure of the Repo 105 derivative exists. Later in the same Note, Lehman broke out individual derivative segments in a table on "Fair Value of Derivatives and Other Contractual Agreements." Id. at p. 106. Again, there is no disclosure regarding Repo 105 derivatives. Note 4 to the financial statements breaks out the fair value of derivatives according to FAS 157 level. Id. at p. 107. Lehman stated that its total derivative assets at fair value as of November 30, 2007 was $44.595 billion. Id. Repo 105 derivatives are not identified or broken out. Derivatives are mentioned in Note 8 solely as interest rate liability tools. See id. at 116 ("End‐User Derivative Activities"). Note 9 on "Commitments, Contingencies and Guarantees" discusses derivative contracts that are guarantees and duplicates the table from the MD&A's discussion of Off‐Balance Sheet Arrangements (discussed above and at LBHI 2007 10‐K, p. 67). Id. at p. 120. The notional amount of derivatives is broken out by year and discussed in the context of guarantor accounting of those derivatives considered to be guarantees. Id. The Note contains no mention or break out of Repo 105 derivatives. Lehman's quarterly reports similarly failed to disclose any information regarding the Repo 105 derivative. See LBHI 10‐Q (filed Apr. 9, 2008), at p. 5 (balance sheet line item "Financial instruments and other inventory positions owned" was $326.569 billion and contains no mention or break out of Repo 105 derivatives); id. at p. 12 (Note 1's discussion of "Derivative financial instruments" makes no reference to Repo 105 derivatives); id. at p. 19 ( Note 3's discussion of "Financial Instruments and Other Inventory Positions" contains derivatives and other contractual agreements line item of $55.612 billion, but no break out or mention of Repo 105 derivative); id. at p. 21 (Note 3 table "Fair Value of Derivatives and Other Contractual Agreements" breaks out some derivative segments but makes no mention of Repo 105 derivative); id. at p. 31 (Note 8 on "Commitments, Contingencies and Guarantees" discusses derivative contracts that are guarantees with no mention of Repo 105 derivatives); LBHI 10‐Q (filed Apr. 9, 2008), at p. 75 (MD&A Off‐Balance‐Sheet Arrangements contains disclosure of the notional amount of off‐balance sheet arrangements including derivative contracts, but no break out or mention of Repo 105 derivatives); id. at p. 80 (discussion of derivatives, breaking out the fair value of OTC derivatives by maturity, but no break‐out or mention of Repo 105 derivatives); see also LBHI 10‐Q (filed July 10, 2008), at p. 5 (balance sheet line item "Financial instruments and other inventory position owned" was $269.409 billion and contains no mention or break out of Repo 105 derivatives); id. at p. 12 (Note 1's discussion of "Derivative financial instruments" makes no reference to Repo 105 derivatives); id. at p. 24 (Note 3's discussion of "Financial Instruments and Other Inventory Positions" contains derivatives and other contractual agreements line item of $46.991 billion, but no break out or mention of Repo 105 derivative); id. at p. 26 (Note 3 table "Fair Value of Derivatives and Other Contractual Agreements" breaks out some derivative segments but makes no mention of Repo 105 derivative); id. at p. 40 (Note 8 on "Commitments, Contingencies and Guarantees" discusses derivative contracts that are guarantees with no mention of Repo 105 derivatives); LBHI 10‐Q (filed July 10, 2008), at p. 91 (MD&A Off‐Balance‐Sheet Arrangements contains disclosure of the notional amount of off‐balance sheet arrangements including derivative contracts, but no break out or mention of Repo 105 derivatives); id. at p. 97 (discussion of derivatives, breaking out the fair value of OTC derivatives by maturity, but no break‐out or mention of Repo 105 derivatives).

984

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

¶In addition, even a sophisticated reader of Lehman's financial statements would not have been able to ascertain from Lehman's 2007 Form 10‐K or its first and second quarter 2008 Forms 10‐Q the amount of Lehman's Repo 105 usage, nor even ascertain the fact that Lehman was engaged in these transactions, by attempting to quantify the amount of liquid securities temporarily removed from the balance sheet, as reported in Lehman's public financial statements.

● Note 3 of Lehman's financial statements provided a break out of the "Financial Instruments and Other Inventory Positions" balance sheet line item.³⁷⁸⁸³⁷⁸⁸ LBHI 2007 10‐K, at p. 103; LBHI 10‐Q (filed Apr. 9, 2008), at p. 19; LBHI 10‐Q (filed July 10, 2008), at p. 24. Note 3 presented Lehman's long and short inventory using very high‐level, generalized descriptions of security type.³⁷⁸⁹³⁷⁸⁹ LBHI 2007 10‐K, at p. 103; LBHI 10‐Q (filed Apr. 9, 2008), at p. 19; LBHI 10‐Q (filed July 10, 2008), at p. 24. The securities inventory that Lehman "sold" through Repo 105 transactions were excluded from the aggregate numbers in the financials, and Lehman's Forms 10‐K and 10‐Q contained no textual disclosures about the exclusions (or the subsequent obligation to repurchase the temporarily "sold" assets). Even if a user of the financials was aware of the existence of Repo 105 transactions, the user would be unable to deduce the size of the Repo 105 program or the securities being used. Since Repo 105 transactions were done on a continual basis and were indistinguishable from ordinary asset sales for the purposes of financial presentation, and since maturities of Repo 105 were staggered, i.e., one week, two week, multi‐month or multi‐quarter, it would have been impossible to disaggregate the fluctuations in assets without being privy to additional information that is not presented in the financial statements.

● Further, a reader of Lehman's Forms 10‐K and 10‐Q would have had no idea that Lehman was selling highly liquid securities in Repo 105 transactions on a temporary basis. The categories of asset classes were very broad, and the disclosures are snapshots of quarter‐end only, which do not allow the user to determine balances of securities moving on or off balance sheet on an intra‐ quarter basis. Additionally, to the extent that the reader could see various security balances increasing or decreasing, i.e., that Lehman sold liquid securities, the reader would not know the sales were temporary from the information provided.

985

● Moreover, sophisticated readers of financial statements – the professional analysts who covered Lehman – asked Lehman officers during earnings calls what Lehman was selling in order to ascertain what types of assets Lehman was moving in its efforts to deleverage.³⁷⁹⁰³⁷⁹⁰ See Section III.A.4.e.6.a of this Report (discussing analyst statements). Former CFO Erin Callan informed analysts that Lehman was selling illiquid positions to deleverage.³⁷⁹¹³⁷⁹¹ Id.

Conclusions Regarding Lehman's Failure to Disclose

¶SEC Filings. As discussed above, Section 13(a) of the Securities Exchange Act of 1934 required Lehman to file periodic reports with the SEC, including its annual report on Form 10‐K and quarterly reports on Form 10‐Q. Those filings must contain the information required by the SEC's Rules and Interpretations, including the MD&A requirement discussed above. In addition, SEC Rule 12b‐20 requires that all filings contain such additional information necessary to make the information contained in the filing not misleading. There is sufficient evidence to support a determination by the trier of fact that Lehman's filings were deficient and misleading. In the wake of the Enron scandal, at the request of four major accounting firms, the SEC provided additional guidance with respect to the duty to provide meaningful discussion of a company's financial statements. Among other things, SEC guidance from 2002 stated:

986

The Commission has long recognized the need for a narrative explanation of the financial statements, because numerical presentations and brief accompanying footnotes alone may be insufficient for an investor to judge the quality of earnings and the likelihood that past performance is indicative of future performance. MD&A is intended to give the investor an opportunity to look at the company through the eyes of management by providing both a short and long‐term analysis of the business of the company.

And, as we said in 1989, '[t]he MD&A requirements are intended to provide in one section of a filing, material historical and prospective textual disclosure enabling investors and other users to assess the financial condition and results of operations of the registrant, with particular emphasis on the registrant's prospects for the future.'³⁷⁹²³⁷⁹² StatementAbout Management's Discussion and Analysis of Financial Condition and Results of Operation, Securities Act No. 8056, Exchange Act No. 45,321, 67 Fed. Reg. 3746 (Jan. 22, 2002).

¶Lehman made no disclosure with respect to its use of Repo 105 transactions. Lehman had a duty to disclose this information because the omission rendered several statements misleading.

¶Lehman's MD&A stated that the firm considered the net leverage ratio to be a more meaningful measurement of leverage than other calculations. When Lehman embarked on an aggressive deleveraging campaign, it announced improvements to this net leverage ratio to shareholders on its periodic reports, as well as press releases, particularly during the run‐up to an equity raise. The point of these announcements was to indicate to current and potentially new shareholders that Lehman was financially healthy and a good investment.

987

¶Sufficient evidence exists to support a finding by the trier of fact that as a result of failing to disclose its use of and accounting treatment for Repo 105 transactions, Lehman misled readers of its Forms 10‐K and 10‐Q about its financial condition. Typically, seven or ten days after executing Repo 105 transactions, Lehman had to repay the Repo 105 cash borrowing (i.e., repurchase the assets). In order to repay the cash borrowing (plus an interest rate) shortly after the reporting period, Lehman had to obtain financing. The obligation to repay the cash borrowing (repurchase the assets) was not reflected in Lehman's periodic reports. As a result, Lehman's statements in its MD&A regarding liquidity were rendered misleading. This is exactly the kind of information the SEC has expressly required:

Disclosure is mandatory where there is a known trend or uncertainty that is reasonably likely to have a material effect on the registrant's financial condition or results of operations. Accordingly, the development of MD&A disclosure should begin with management's identification and evaluation of what information, including the potential effects of known trends, commitments, events, and uncertainties, is important to providing investors and others and accurate understanding of the company's current and prospective financial position and operating results.³⁷⁹³³⁷⁹³ Id.

¶For the reasons outlined above, sufficient evidence exists from which a finder of fact could conclude that the picture Lehman painted of its financial position in late 2007 and into 2008 was materially misleading because Lehman failed to inform investors and the market that it managed its balance sheet by accounting for a large volume of repo transactions as true sales on the basis of an English opinion letter. Lehman employed temporary accounting‐motivated transactions, i.e. Repo 105 transactions, and then failed to disclose them in order to publicly report a reverse‐engineered net leverage ratio in its periodic reports. Consequently, Lehman's statement that the net leverage ratio was a "more meaningful" measurement of leverage was rendered misleading because that ratio – as reported by Lehman – was not an accurate indicator of Lehman's actual leverage, and in fact, understated Lehman's leverage significantly. In light of the market's focus on the leverage of investment banks in late 2007 and 2008, sufficient evidence exists from which a trier of fact could conclude that Lehman's reported net leverage ratio was materially misleading during that period.

988

¶In addition, Lehman was required by law to disclose, in its MD&A, off‐balance sheet arrangements "that have or are reasonably likely to have a current or future effect on the registrant's financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors."³⁷⁹⁴³⁷⁹⁴ Item 303(a)(4)(i) of Regulation S‐K. Lehman made no such disclosure in the MD&A of its use of Repo 105 transactions even though the use of these off‐balance sheet arrangements impacted Lehman's financial reporting by lowering its net leverage ratio by almost two entire points, thereby improving its credit rating, and its liquidity by requiring Lehman to finance the cost of repurchasing all the assets when the repo transaction matured.

989

¶Moreover, Lehman made affirmative misstatements about its practice for recording repo transactions on its financial statements. Lehman stated in its publicly‐ filed financial statements that "securities sold under agreements to repurchase are collateralized primarily by government and government agency securities" and are "treated as collateralized agreements and financings for financial reporting purposes."³⁷⁹⁵³⁷⁹⁵ LBHI 2007 10‐K, at p. 97; LBHI 10‐Q (filed Apr. 9, 2008), at p. 13; LBHI 10‐Q (filed July 10, 2008), at p. 16. This disclosure is under the heading "Collateralized Lending Agreements and Financings."

¶Earnings Calls. In its earnings calls from late 2007 through mid 2008, Lehman spoke extensively about the size of its firm‐wide balance sheet, balance sheet management, and a firm‐wide deliberate, aggressive effort to deleverage. Though Callan stated during the first quarter 2008 earnings call that Lehman was being "transparent" with its management of the balance sheet, at no time did Lehman disclose to analysts that it used Repo 105 transactions, either by name or characterization, to manage its balance sheet – even though Lehman transferred approximately $50 billion in inventory temporarily off its balance sheet at quarter‐end in the first quarter of 2008 through the use of Repo 105 transactions. As Lehman continued to boast of its deleveraging success during earnings calls in the second quarter of 2008, neither Callan nor Lowitt disclosed that Lehman managed its balance sheet and leverage, in part, through Repo 105 transactions, which were only temporary.

990

Colorable Claims

¶The Examiner finds that sufficient evidence exists to support the finding of colorable claims against Richard Fuld, Christopher O'Meara, Erin Callan, and Ian Lowitt in connection with their actions in causing or allowing Lehman to file periodic reports that did not disclose Lehman's use of Repo 105 transactions and against Ernst & Young for its failure to meet professional standards in connection with that lack of disclosure.

¶After reaching the tentative conclusion that claims existed against Fuld, O'Meara, Callan, Lowitt, and Ernst & Young, the Examiner reached out to counsel for each, advised them of the basis for the potential finding, and invited each of them to present any additional facts or materials that might bear on the final conclusion. All counsel accepted the Examiner's offer. In the weeks leading up to the submission of this Report, the Examiner had individual, face to face meetings with counsel for Fuld, O'Meara, Callan, Lowitt, and Ernst & Young, and carefully considered the materials raised by each. While there were credible facts and arguments presented by each that may form the basis for a successful defense, the Examiner concluded that these possible defenses do not change the now final conclusion that there is sufficient evidence to support a finding that claims of breach of fiduciary duty exist against Fuld, O'Meara, Callan, and Lowitt and a colorable claim of professional malpractice exists against Ernst & Young.³⁷⁹⁶³⁷⁹⁶ Prior to this invitation and during Schlich's four‐day interview as an Ernst & Young representative, the Examiner invited Ernst & Young to opine on why Repo 105 transactions were proper and did not result in Lehman filing materially misleading financial statements. Examiner's Interview of Ernst & Young, Repo 105 Session, Oct. 16, 2009, at p. 14. Schlich replied that the transactions were proper if they complied with Lehman's self‐defined Accounting Policy. Id. Despite an additional invitation from the Examiner, Ernst & Young has not offered any further explanation.Show full note

991

Fiduciary Duty Claims

Breach of Fiduciary Duty Claims Against Board of Directors

¶With the exception of Richard Fuld, there is not sufficient evidence to support colorable claims of breach of fiduciary duty against Lehman directors arising from Lehman's use of Repo 105 transactions or the firm's failure to adequately disclose these transactions and the transactions' impact on Lehman's financial position in its publicly filed financial statements.

¶First, Lehman directors were protected by Lehman's certificate of incorporation from breach of duty of care claims:

A director shall not be personally liable to the Corporation or its stockholders for monetary damages for breach of fiduciary duty as a director; provided that this sentence shall not eliminate or limit the liability of a director (i) for any breach of his duty of loyalty to the Corporation or its stockholders, (ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law, (iii) under Section 174 of the [Delaware General Corporation Law], or (iv) for any transaction from which the director derives an improper personal benefit.³⁷⁹⁷³⁷⁹⁷ Lehman Brothers Holdings, Inc., Certificate of Incorporation, at § 10.1, Limitation of Liability of Directors.

992

¶Courts will uphold such a clause as protecting directors from liability so long as there is not a concurrent violation of the duty of loyalty, which was not implicated here.³⁷⁹⁸³⁷⁹⁸ Stone v. Ritter, 911 A.2d 362, 367 (Del. 2006) ("Such a provision can exculpate directors from monetary liability for a breach of the duty of care, but not for conduct that is not in good faith or a breach of the duty of loyalty.").

¶Second, Lehman's directors were not informed about the existence of Lehman's Repo 105 program. No director had even heard of Repo 105 transactions, either by name or description.

Breach of Fiduciary Duty Claims Against Specific Lehman Officers

¶There is sufficient evidence to support a colorable claim that certain Lehman officers – Richard Fuld, Chris O'Meara, Erin Callan, and Ian Lowitt – breached their fiduciary duties by engaging in one or more of the following: (1) allowing and certifying the filing of financial statements that omitted or misrepresented material information regarding Lehman's use of Repo 105 transactions and their accounting treatment, thus exposing the firm to potential liability; and/or (2) failing to disclose to Lehman Directors information about the firm's Repo 105 program.

¶As a threshold matter, the business judgment rule is a standard of judicial review requiring 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."³⁷⁹⁹³⁷⁹⁹ Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 954 (Del. 1985) (internal quotation omitted).. Thus, "a court will not substitute its judgment for that of the board if the latter's decision can be attributed to any rational business purpose."³⁸⁰⁰³⁸⁰⁰ Id. (internal quotation omitted). The business judgment rule presumption may be surmounted when the "decision was the product of an irrational process or . . . directors failed to establish an information and reporting system reasonably designed to provide the senior management and the board with information regarding the corporation's legal compliance and business performance, resulting in liability."³⁸⁰¹³⁸⁰¹ In re Tower Air, Inc., 416 F.3d 229, 238 (3d Cir. 2005). Moreover, the business judgment rule does not protect a director or officer from personal liability for inaction unless the failure to act resulted from a conscious decision to take no action.³⁸⁰²³⁸⁰² In re Dwight's Piano, Co., No. 1:04‐CV‐066, 2009 WL 2913942, at *18 (Bankr. S.D. Ohio Sept. 9, 2009) (applying Delaware law) ("The 'business judgment rule' does not apply to director inaction. The appropriate standard for determining liability for director inaction is generally gross negligence.") (internal citations omitted); see also See McMullin v. Beran, 765 A.2d 910, 922 (Del. 2000) ("The business judgment rule is rebutted if the plaintiff shows that the directors failed to exercise due care in informing themselves before making their decision."); see also Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985), overruled on other grounds by Gantler v. Stephens, 965 A.2d 695, 713 (Del. 2009); Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984), overruled on other grounds by Brehm v. Eisner, 746 A.2d 244, 254 (Del. 2000).Show full note

993

¶The business judgment rule does not protect director's or officer's decisions made in bad faith.³⁸⁰³³⁸⁰³ See Unocal, 493 A.2d at 954. "A failure to act in good faith may be shown, for instance, where the fiduciary intentionally acts with a purpose other than advancing the best interests of the corporation . . . or where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties."³⁸⁰⁴³⁸⁰⁴ In re Walt Disney Co. Deriv. Litig., 906 A.2d 27, 67 (Del. 2006).

994

¶Sufficient evidence exists to support a finding by the trier of fact that Fuld, O'Meara, Callan, and Lowitt are not entitled to the business judgment rule presumption with respect to Lehman's use of Repo 105 transactions because they: (1) were at least grossly negligent in causing Lehman to file deficient and misleading periodic reports that failed to disclose the firm's use of Repo 105 transactions, thus exposing Lehman to potential liability; or (2) withheld from the Board, which relies upon the accurate transmission of information, material information regarding Lehman's Repo 105 program, thereby depriving the Board of the opportunity to make well‐informed decisions about Lehman's leverage and deceiving the Board of Directors regarding Lehman's financial statements. Either one of these factors alone is sufficient to overcome the business judgment rule presumption.³⁸⁰⁵³⁸⁰⁵ See Brehm, 746 A.2d at 264 n.66 ("[D]ecisions will be respected by courts unless the directors have a conflicting interests or lack independence with respect to the decision, do not act in good faith, act in a manner that cannot be attributed to a rational business purpose, or reach their decision by a grossly negligent process that includes the failure to consider all material facts reasonably available.").Show full note

¶In re American Int'l Group, Inc. ("In re AIG") is instructive. There, the court held that shareholders stated a claim for breach of duty of loyalty and failure to monitor by AIG's top managers, including its Chairman/CEO and his "inner circle," for allowing AIG to file materially misleading financial statements that overstated the value of the corporation by billions of dollars and made AIG appear more secure than it really was.³⁸⁰⁶³⁸⁰⁶ In re American Int'l Group, Inc. ("In re AIG"), 965 A.2d 763, 774‐75 (Del. Ch. 2009). The single largest deception involved an elaborate $500 million sham transaction "staged to make AIG's balance sheet look better."³⁸⁰⁷³⁸⁰⁷ Id. at 775. Though the plaintiffs could not allege with great specificity the precise involvement of each of the defendants for each of the schemes and deceptions, the complaint detailed the sham transaction and other schemes with such specificity that the court was unwilling to infer that AIG engaged in risky and innovative transactions of such magnitude without the involvement or knowledge of the Chairman/CEO and his inner circle.³⁸⁰⁸³⁸⁰⁸ See id. at 795‐99. Specifically, the court rejected the notion that the disputed products "came to market through the spontaneous, unsupervised actions of lower‐level AIG actors."³⁸⁰⁹³⁸⁰⁹ Id. at 797.

995

¶One defendant in particular, who possessed knowledge that the sole purpose of the $500 million sham transaction was to dress up the company's balance sheet, tried to escape liability for fraud by imputing his knowledge onto the corporation. The court rejected this argument, stating:

[U]nder Delaware law, where officers and directors have disabling conflicts that give them an interest in hiding information from a corporation's independent directors and stockholders, the conflicted fiduciaries' knowledge is not imputed to the corporation for purposes of holding those fiduciaries liable for the harm they caused to the corporation. In colloquial terms, a fraud on the board has long been a fiduciary violation under our law and typically involves the failure of insiders to come clean to the independent directors about their own wrongdoing, the wrongdoing of other insiders, or information that the insiders fear will be used by the independent directors to take actions contrary to the insiders' wishes. Delaware law provides no safe harbor to high‐level fiduciaries who group together to defraud the board. The Stockholder Plaintiffs have alleged that Tizzio and the other AIG insiders who participated in the Gen Re Transaction [the "sham" transaction] violated their fiduciary duties by causing AIG to engage in illegal conduct. If true, that was bad faith conduct that gave Tizzio and the other guilty insiders an interest in hiding what they had done.³⁸¹⁰³⁸¹⁰ Id. at 806‐7 (emphasis added).

996

¶In re AIG illustrates how fiduciaries that cause their company to engage in illegal conduct breach their duty of loyalty and good faith to the company, and as a result acquire a motive to breach their duty of candor to the board by intentionally failing to disclose information relating to their wrongdoing.³⁸¹¹³⁸¹¹ Cf. In re AIG, 965 A.2d at 795 ("[T]hose who engage in sophisticated forms of financial fraud do their best not to leave an obvious paper trail. Rather, consistent with their improper objectives, those at the top of such schemes try to conceal their roles and not leave marked paths leading to their doorsteps.").

¶The Examiner finds that sufficient evidence exists to support a colorable claim that each of the following officers breached his or her fiduciary duties to Lehman and/or its Board of Directors:

Richard Fuld

¶Having been advised by Bart McDade in June 2008 that the firm relied on Repo 105 transactions to manage the balance sheet, and that McDade believed Lehman should curtail and eventually cease its use of Repo 105 transactions, Fuld took no action to determine whether Lehman's use of Repo 105 transactions materially impacted its publicly filed financial statements and related disclosures. There is sufficient credible evidence to support a determination that Fuld's failure to make a deliberate decision about Lehman's disclosure obligations was grossly negligent or demonstrated a conscious disregard of his duties.³⁸¹²³⁸¹² Pursuant to Section 302 of the Sarbanes‐Oxley Act, the SEC adopted Rules 13a‐14 and 15d‐14, promulgated under the Securities Exchange Act of 1934, requiring the principal executive and financial officers to certify, among other things, that "[b]ased on the officer's knowledge, the report does not contain any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which such statements were made, not misleading" and that "[b]ased on such officer's knowledge, the financial statements, and other financial information included in the report, fairly present in all material respects the financial condition, results of operations and cash flows of the issuer as of, and for, the periods presented in the report." See Pub. L. No. 107‐204 § 302, 116 Stat. 777 (codified at 15 U.S.C. § 7241 (2006)); Certification of Disclosure in Companies' Quarterly and Annual Reports, Exchange Act Release No. 33‐8124, 67 Fed. Reg. 57,276, 57,277 (Aug. 28, 2002). A "fair presentation of an issuer's financial condition, results of operations and cash flows" requires the "disclosure of financial information that is informative and reasonably reflects the underlying transactions and events and the inclusion of any additional disclosure necessary to provide investors with a materially accurate and complete picture of an issuer's financial condition, results of operations and cash flows." Id. at 57,279 (emphasis added).Show full note

997

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

¶The duty of care requires that (1) directors and officers inform themselves, prior to making a business decision, of "all material information reasonably available to them" and (2) directors and officers "act with requisite care in the discharge of their duties."³⁸¹³³⁸¹³ Aronson, 473 A.2d at 812, overruled on other grounds by Brehm v. Eisner, 746 A.2d 244, 254 (Del. 2000). A claim that an officer acted with gross negligence is the same as a claim that he breached his duty of care.³⁸¹⁴³⁸¹⁴ Albert v. Alex Brown Mgmt. Servs. Inc., C.A. Nos. 04C‐05‐250 PLA, 04C‐05‐251 PLA, 2004 WL 2050527, at *6 (Del. Super. Sept. 15, 2004); see also Smith v. Van Gorkom, 488 A.2d 858, 873 (Del. 1985), overruled on other grounds by Gantler v. Stephens, 965 A.2d 695, 713 (Del. 2009).

998

¶Lehman's exculpatory charter shielded directors, but not officers, from liability for good faith breaches of the duty of care.³⁸¹⁵³⁸¹⁵ See Lehman Brothers Holdings, Inc., Certificate of Incorporation, at § 10.1, Limitation of Liability of Directors; see also DEL. CODE ANN. tit. 8, § 102(b)(7) (2009); Stone v. Ritter, 911 A.2d 362, 367 (Del. 2006) ("Such a provision can exculpate directors from monetary liability for a breach of the duty of care, but not for conduct that is not in good faith or a breach of the duty of loyalty."). Although Fuld served Lehman as both an officer and a director, Lehman's exculpatory charter for directors does not shield him from liability for breach of the duty of care with respect to his duties as an officer.³⁸¹⁶³⁸¹⁶ See Arnold v. Society for Savings Bancorp. Inc., 650 A.2d 1270, 1288 (Del. 1994) (stating that officers who are also directors are protected by the exculpatory charter for their actions as directors only and that where a defendant is a director and officer, only those actions taken solely in the defendantʹs capacity as an officer are outside the purview of Section 102(b)(7)) (citing R. Franklin Balotti & Jesse A. Finkelstein, Delaware Law of Corp. & Business Org. § 4.19, at 4‐335 (Supp.1992)).Show full note

¶There is sufficient evidence to support a determination that by no later than March 28, 2008 – twelve days before signing Lehman's first quarter Form 10‐Q – Fuld knew or should have known that Lehman's quarter‐end Repo 105 transactions for first quarter 2008 reduced Lehman's net balance sheet by $49.1 billion.³⁸¹⁷³⁸¹⁷ Lehman, Balance Sheet and Cash Capital Update (Mar. 27, 2008), at p. 1 [LBEX‐DOCID 506399] (attached to e‐mail from Angela Judd, Assistant to Richard S. Fuld, Jr., Lehman, to Scott Friedheim, et al. Lehman (Mar. 28, 2008) [LBEX‐DOCID 561761] and containing Firm Balance Sheet Details with Repo 105 column showing total quarter‐end usage of $49.102 billion); see also Lehman Brothers, Executive Committee Meeting Material, Agenda (Mar. 28, 2008) [LBEX‐DOCID 545869] (attached to e‐mail from Angela Judd, Assistant to Richard S. Fuld, Jr., Lehman, to Scott J. Freidheim, et al. Lehman (Mar. 28, 2008) [LBEX‐DOCID 561761] and containing topics for discussion line‐item "Repo 105/108"); e‐mail from Jennifer Fitzgibbon, Lehman, to Leonard Scicutella, et al. Lehman (Mar. 28, 2008) [LBEX‐DOCID 1854825] (transmitting copy of Balance Sheet and Cash Capital Update (Mar. 27, 2008) [LBEX‐DOCID 1698670] and stating "please [see] attached balance sheet presentation discussed in today's executive committee meeting").Show full note Fuld met regularly, at least twice a week, with Gregory and members of the Executive Committee to discuss the state of the firm. On March 28, 2008, McDade requested a special meeting of the Executive Committee to discuss Lehman's Repo 105 program and other balance sheet reduction issues, and to request Gregory's blessing in freezing Lehman's Repo 105 usage.³⁸¹⁸³⁸¹⁸ See Section III.A.4.e.2.a of this Report. Although Fuld may not have attended the meeting because he was on one or more telephone calls, both Fuld and his assistants received the meeting materials.³⁸¹⁹³⁸¹⁹ Herbert H. (Bart) McDade III, Lehman, Balance Sheet and Cash Capital Update (Mar. 27, 2008) [LBEX‐ DOCID 095961] (attached to e‐mail from Patricia Lombardi, Assistant to Herbert H. (Bart) McDade III, Lehman, to Lehman Brothers Executive Committee Members, Lehman, et al. (Mar. 28, 2008) [LBEX‐ DOCID 120929]); Lehman, Executive Committee Meeting Material, Agenda (Mar. 28, 2008) [LBEX‐ DOCID 115827] (attached to e‐mail from Patricia Lombardi, Assistant to Herbert H. (Bart) McDade III, Lehman, to Lehman Brothers Executive Committee Members, Lehman, et al. (Mar. 28, 2008) [LBEX‐ DOCID 120929]).Show full note The materials also were forwarded by Fuld's assistant to other Lehman executives.³⁸²⁰³⁸²⁰ E‐mail from Angela Judd, Assistant to Richard S. Fuld, Jr., Lehman, to Scott J. Freidheim, Lehman, et al. (Mar. 28, 2008) [LBEX‐DOCID 561761]. The meeting materials included a presentation that referenced Lehman's $49.1 billion quarter‐end Repo 105 usage for first quarter 2008.³⁸²¹³⁸²¹ Lehman, Balance Sheet and Cash Capital Update (Mar. 27, 2008), at p. 1 [LBEX‐DOCID 506399] (attached to e‐mail from Angela Judd, Assistant to Richard S. Fuld, Jr., Lehman, to Scott J. Freidheim, Lehman, et al. (Mar. 28, 2008) [LBEX‐DOCID 561761], containing Firm Balance Sheet Details with Repo 105 column showing total usage of $49.102 billion and break‐out for Repo 105 usage by business group); Lehman, Executive Committee Meeting Material, Agenda (Mar. 28, 2008) [LBEX‐DOCID 545869] (attached to e‐mail from Angela Judd, Assistant to Richard S. Fuld, Jr., Lehman, to Scott J. Freidheim, Lehman, et al. (Mar. 28, 2008) [LBEX‐DOCID 561761], listing topics for discussion at Executive Committee meeting, including "Repo 105/108" and "Delever v Derisk").Show full note

999

¶In light of Fuld's receipt of the presentation, the fact that Fuld regularly communicated with other Executive Committee members including Gregory, Fuld's admitted focus on balance sheet and net leverage reduction in 2008, and the significance that McDade placed on the need to impose discipline on Lehman's Repo 105 program, there is sufficient evidence to support a colorable claim that Fuld knew or should have known before signing Lehman's first quarter Form 10‐Q that Lehman had reduced its net balance sheet by $49.1 billion using Repo 105 transactions. Such a finding could support a claim of gross negligence against Fuld for failing to ensure that Lehman's first quarter 2008 Form 10‐Q fairly presented its financial condition, thereby exposing Lehman to potential liability.

1000

¶In addition, sufficient evidence exists to support a finding that in June 2008, only weeks before he signed Lehman's second quarter Form 10‐Q, Fuld had actual knowledge of Lehman's quarter‐end Repo 105 usage for that quarter. McDade recalled having specific discussions with Fuld in June 2008 about Lehman's Repo 105 usage and McDade's plan to reduce the firm's use of Repo 105 transactions by half in the third quarter 2008.³⁸²²³⁸²² Examiner's Interview of Herbert H. "Bart" McDade III, Jan. 28, 2010, at p. 4 ("[I]n quarter three, I certainly talked to Fuld about Repo 105."). McDade walked Fuld through a report of Lehman's quarter‐end Repo 105 usage – $38.6 billion at year‐end 2007; $49.1 billion at first quarter 2008; and $50.38 billion at second quarter 2008.³⁸²³³⁸²³ Id. at p. 5; see also Lehman, Balance Sheet and Key Disclosures 2008 3Q Targets (Draft) (June 16, 2008), at p. 3 [LBHI_SEC07940_641516]. The Examiner reproduces below one page from the document McDade walked Fuld through in mid‐June 2008.³⁸²⁴³⁸²⁴ Lehman, Balance Sheet and Key Disclosures 2008 3Q Targets (Jun. 19, 2008), at p. 3 [LBEX‐DOCID 2932594].

1001

¶McDade recalled that when he advised Fuld that Lehman should reduce its Repo 105 usage to $25 billion, "Fuld understood that this would put pressure on traders."³⁸²⁵³⁸²⁵ Examiner's Interview of Herbert H. "Bart" McDade III, Jan. 28, 2010, at p. at 6 McDade also recalled that "Fuld knew about the accounting of Repo 105."³⁸²⁶³⁸²⁶ Id. Fuld's Repo 105 discussions with McDade took place only weeks before Lehman filed its second quarter 2008 Form 10‐Q on July 10, 2008. Fuld denied any recollection of conversations with McDade or other members of Lehman's Executive Committee regarding Repo 105.³⁸²⁷³⁸²⁷ Examiner's Interview of Richard S. Fuld, Jr., Nov. 19, 2009, at p. 8. A finder of fact will have to further evaluate Fuld's statements in light of other evidence of his knowledge of Repo 105 and his interest in reducing Lehman's net leverage.

1002

¶Accordingly, there is sufficient evidence to support a colorable claim that Fuld was at least grossly negligent for failing to ensure Lehman's second quarter 2008 Form 10‐Q fairly presented Lehman's financial condition and for allowing Lehman to file financial statements that misrepresented Lehman's accounting treatment for repo transactions.

Chris O'Meara

¶There is credible evidence that, as CFO from December 2004 until December 1, 2007, O'Meara actively managed Lehman's Repo 105 program. Although O'Meara professed limited knowledge of and involvement with Lehman's Repo 105 program, contemporaneous documents show that:

● O'Meara was involved in establishing firm‐wide limits on Repo 105 activity no later than mid‐2006 and through December 1, 2007.³⁸²⁸³⁸²⁸ Lehman, Global Balance Sheet, Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 2 [LBEX‐ WGM 754587] (stating that Grieb and O'Meara set cap on total Repo 105 and Repo 108 usage); Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 8 (stating that Grieb, Reilly and O'Meara shared responsibilities in setting limits through December 2007).

● An increase in the Repo 105 cap required O'Meara's authorization.³⁸²⁹³⁸²⁹ Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 8 (stating that Grieb was not empowered to authorize FID to exceed its Repo 105 limit and that an excession or change in limit required consensus among O'Meara and Reilly). Grieb reported directly to O'Meara. O'Meara was involved with and the evidence shows he approved an increase of the cap, from $22 billion to $25 billion in February 2007.³⁸³⁰³⁸³⁰ See e‐mail from Joseph Gentile, Lehman, to Michael Gelband, Lehman, et al. (Feb. 21, 2007) [LBEX‐ DOCID 4553218] ("I have been able to get a temp limit of 3 bn for repo 105 activity, which covers known real estate issues. . . ."); e‐mail from Joseph Gentile, Lehman, to Gerard Reilly, Lehman (Feb. 21, 2007) [LBEX‐DOCID 4553220] (responding to question "Where did the 3bn come from?" by writing: "We spoke with grieb…and he was ok with a temporary excession of $3. . . ."); e‐mail from Michael McGarvey, Lehman, to Anuraj Bismal, Lehman, et al. (May 9, 2007) [LBEX‐DOCID 3223356] ("17 bn was the year end limit for FID. In Q1 Joe Gentile spoke to Ed Grieb about raising it to 20bn (based on the attached doc) and according to Joe Ed agreed."). Grieb recalled generally that in 2007 "as a result of discussions with O'Meara and Reilly, we raised the limit." Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 12. Grieb further stated that he did not have the authority to change the limit alone and that an increase or change to the limit required consensus among O'Meara and Reilly. Id.Show full note

1003

● O'Meara regularly discussed Repo 105 limits and Lehman's reliance on Repo 105 with Grieb and Reilly, including in mid‐to‐late 2007 at approximately the same time that Lehman began to ramp‐up its use of Repo 105 transactions.³⁸³¹³⁸³¹ Id. at pp. 10, 12.

● O'Meara was instrumental in creating the "80/20" or "continual use" and "120%" rules that, according to Grieb, were intended to ensure Repo 105 transactions were not undertaken solely at quarter‐end.³⁸³²³⁸³² Lehman, Global Balance Sheet Overview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 2 [LBEX‐ WGM 748489]; Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 13; Examiner's Interview of Ian T. Lowitt, Oct. 28, 2009, at p. 13. Based upon documents and witness statements, sufficient credible evidence exists from which a reasonable inference could be drawn that there was no legitimate business purpose for the "80% rule" other than to mask Lehman's Repo 105 practice.

● As CFO until December 2007, O'Meara worked with other members of Lehman's Finance Committee to set balance sheet targets and net leverage ratio targets.³⁸³³³⁸³³ Examiner's Interview of Marie Stewart, Sept. 2, 2009, at p. 7; Examiner's Interview of Michael McGarvey, Sept. 11, 2009, at p. 5; Examiner's Interview of Tejal Joshi, Sept. 15, 2009, at p. 5; Examiner's Interview of Anuraj Bismal, Sept. 16, 2009, at p. 5; Examiner's Interview of Kaushik Amin, Sept. 17, 2009, at p. 5; Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 11; Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 9; Examiner's Interview of Joseph Gentile, Oct. 21, 2009, at p. 5.Show full note During several Board meeting in 2007, O'Meara discussed Lehman's net leverage ratio.³⁸³⁴³⁸³⁴ See, e.g., Lehman Brothers Holdings Inc., Minutes of Meeting of Board of Directors (Sept. 11, 2007), at p. 3 [LBHI_SEC07940_026364]; Lehman Brothers Holdings Inc., Minutes of Meeting of Board of Directors O'Meara also was involved in balance sheet tightening efforts in FID.³⁸³⁵³⁸³⁵ See e‐mail from Kentaro Umezaki, Lehman, to Christopher M. O'Meara, Lehman, et al. (Apr. 18, 2007) [LBEX‐DOCID 187618]; e‐mail from Kentaro Umezaki, Lehman, to Christopher M. O'Meara, Lehman, et al. (Apr. 19, 2007) [LBEX‐DOCID 318475]; e‐mail from Ian T. Lowitt, Lehman, to Christopher M. O'Meara, Lehman, et al. (Sept. 7, 2007) [LBEX‐DOCID 1357178]; Examiner's Interview of Joseph Gentile, Oct. 21, 2009, at p. 6 (discussing O'Meara's criticism of Gentile if FID breached its balance sheet limit); e‐mail from Christopher M. O'Meara, Lehman, to Gerard Reilly, Lehman (Nov. 20, 2007) [LBEX‐DOCID 578184] (stating "we should be pressuring everywhere to try to end year in good way on balance sheet . . . especially since the rev's are not materializing").Show full note

1004

● O'Meara's involvement with Lehman's balance sheet targets continued in 2008, while he was CRO.³⁸³⁶³⁸³⁶ See e‐mail from Jackson Tam, Lehman, to Christopher M. O'Meara, Lehman, et al. (May 29, 2008) [LBEX‐DOCID 079846] (transmitting Lehman, May 2008 Balance Sheet Projection (May 28, 2008) [LBEX‐ DOCID 019912]).

● O'Meara understood that the motivation for, and a consequence of, undertaking Repo 105 transactions was balance sheet reduction, particularly at quarter‐end.³⁸³⁷³⁸³⁷ See e‐mail from Ryan Traversari, Lehman, to Christopher M. O'Meara, Lehman (May 16, 2008) [LBEX‐ DOCID 3233899] (stating that Lehman's balance sheet is larger intra‐month than at month‐end because of Repo 105 transactions). Moreover, Grieb, who reported directly to O'Meara and said that he was not authorized to make decisions about Repo 105 limits without O'Meara's approval, informed Joseph Gentile of Lehman's FID that Repo 105 was "a tool that could be used to reduce Lehman's net balance sheet" when FID was in breach of its balance sheet limit. See Examiner's Interview of Joseph Gentile, Oct. 21, 2009, at p. 6. Given that O'Meara established the Repo 105 cap, authorized increases in Repo 105 volumes, established the continual use rule, and communicated regularly with Grieb and Reilly who were deeply involved in Lehman's Repo 105 program and acknowledged its primary purpose was balance sheet reduction, sufficient evidence exists from which a trier of fact could make a finding that O'Meara also was aware of the motive for undertaking Repo 105 transactions.Show full note For example, on a regular basis between April 2008 and September 2008 while he was CRO, O'Meara received the daily balance sheet scorecard, wherein the consolidated balance sheet routinely tracked the reduction to Lehman's balance sheet caused by Repo 105.³⁸³⁸³⁸³⁸ See, e.g., Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 7, 2008 (Apr. 9, 2008), at p. 9 [LBEX‐DOCID 520619] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (Apr. 9, 2008) [LBEX‐DOCID 523578] and showing consolidated FID and Equities balance sheet reduced by $18.527 billion and Prime Services balance sheet reduced by $4.458 billion through Repo 105 transactions as of April 7, 2008); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 8, 2008 (Apr. 10, 2008), at p. 9 [LBEX‐DOCID 520620] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (Apr. 10, 2008) [LBEX‐DOCID 523579] and showing consolidated FID and Equities balance sheet reduced by $18.853 billion and Prime Services balance sheet reduced by $4.562 billion through Repo 105 transactions as of April 8, 2008); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 9, 2008 (Apr. 10, 2008), at p. 9 [LBEX‐DOCID 251339] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (Apr. 10, 2008) [LBEX‐Show full note

¶(Oct. 15, 2007), at p. 3 [LBHI_SEC07940_026407]; Lehman Brothers Holdings Inc., Minutes of Meeting of the Board of Directors (Nov. 8, 2007), at p. 4 [LBHI_SEC07940_026650].

1005

● O'Meara understood that Reilly and others within Lehman viewed Repo 105 as a temporary means of dealing with "sticky" inventory.³⁸³⁹³⁸³⁹ See e‐mail from Gerard Reilly, Lehman, to Christopher M. O'Meara, Lehman (Aug. 19, 2007) [LBEX‐ DOCID 4553354] (forwarding to Christopher M. O'Meara e‐mail chain discussions between John Feraca, Reilly, and David Sherr regarding possibility of placing mortgage‐backed securities into the Repo 105 program); e‐mail from Gerard Reilly, Lehman, to Christopher M. O'Meara, Lehman, et al. (Aug. 20, 2007) When Reilly

¶DOCID 258560] and showing consolidated FID and Equities balance sheet reduced by $19.688 billion and Prime Services balance sheet reduced by $4.548 through Repo 105 transactions as of April 9, 2008); Balance Sheet and Disclosure Scorecard for Trade Date April 10, 2008 (Apr. 14, 2008), at p. 9 [LBEX‐ DOCID 251342] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (Apr. 14, 2008) [LBEX‐DOCID 275231] and showing consolidated FID and Equities balance sheet reduced by $19.967 billion and Prime Services balance sheet reduced by $4.491 billion through Repo 105 transactions as of April 10, 2008); Balance Sheet and Disclosure Scorecard for Trade Date April 11, 2008 (Apr. 14, 2008), at p. 9 [LBEX‐DOCID 251344] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (Apr. 14, 2008) [LBEX‐DOCID 258562] and showing consolidated FID and Equities balance sheet reduced by $20.260 billion and Prime Services balance sheet reduced by $4.517 billion through Repo 105 transactions as of April 11, 2008); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 12, 2008 (May 13, 2008), at p. 1 [LBEX‐LL 1950262] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (May 13, 2008) [LBEX‐DOCID 3187357] and stating "Rates decreased by $(5.0B) from prior day due to . . . increased Repo 105 usage . . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 22, 2008 (May 27, 2008), at p. 1 [LBEX‐LL 1950706] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (May 27, 2008) [LBEX‐DOCID 275984] and stating "Global rates net balance sheet decreased ($2.0B), predominantly due to an increase in Repo 105 benefit . . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 28, 2008 (May 30, 2008), at p. 1 [LBEX‐LL 1950670] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (May 30, 2008) [LBEX‐DOCID 275995] and stating "Global rates net balance sheet decreased by ($3.1B) primarily due to a decrease in Americas driven by an increased utilization of Repo 105 within the Agency business"); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 29, 2008 (May 30, 2008), at p. 1 [LBEX‐LL 1950658] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (June 2, 2008) [LBEX‐DOCID 011127] and stating "Global Rates net balance sheet decreased ($6.5B) . . . [t]he decrease in Europe is coming from increased utilization of Repo 105"); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date June 18, 2008 (June 20, 2008) [LBEX‐LL 1950514] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (June 20, 2008) [LBEX‐DOCID 275942] and stating that "Global rates net balance sheet decreased…driven by a[n]…increase in Repo 105 utilization . . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date August 13, 2008 (Aug. 14, 2008) [LBEX‐LL 782812] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (Aug. 14, 2008) [LBEX‐DOCID 4214810] and stating that "Global rates net balance sheet decreased . . . driven by an increase in Repo 105 benefit . . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date August 25, 2008 (Aug. 26, 2008) [LBEX‐LL 782924] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (Aug. 26, 2008) [LBEX‐DOCID 079536] and stating that "Global Rates net balance sheet decreased . . . driven by an increase in repo 105 usage . . . . "); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date August 28, 2008 (Aug. 29, 2008) [LBEX‐LL 782966] (attached to e‐mail from Tal Litvin, Lehman, to Christopher M. O'Meara, Lehman, et al. (Aug. 29, 2008) [LBEX‐DOCID 275880] and stating that "Global rates [net balance sheet] was down . . . driven by increased Repo 105 benefit . . . .").

1006

and others attempted to move "sticky" inventory into the Repo 105 program, they informed O'Meara and requested his opinion.³⁸⁴⁰³⁸⁴⁰ See note 993, supra; see also e‐mail from Kentaro Umezaki, Lehman, to John Feraca, Lehman, et al. (Aug. 20, 2007) [LBEX‐DOCID 4553359] (Umezaki replies to Feraca, "not sure that is worth the effort . . . we need Chris [O'Meara] to opine.").

● By no later than June 17, 2008, O'Meara knew that the actual volumes of firm‐wide Repo 105 for the fourth quarter 2007, first quarter 2008, and second quarter 2008 were $38.6 billion, $49.1 billion and $50.38 billion, respectively.³⁸⁴¹³⁸⁴¹ Lehman, Balance Sheet and Key Disclosures 2008 3Q Targets [Draft] (June 16, 2008), at p. 3 [LBEX‐ DOCID 012458] (attached to e‐mail from Gerard Reilly, Lehman, to Christopher M. O'Meara, Lehman, et al. (June 17, 2008) [LBEX‐DOCID 011380]); e‐mail from Christopher M. O'Meara, Lehman, to Gerard Reilly, Lehman, et al. (June 17, 2008) [LBEX‐DOCID 033813]. Lehman filed its second quarter 2008 Form 10‐Q, signed by Fuld and Lowitt, on July 10, 2008, less than four weeks later.

● O'Meara had knowledge of the proposed firm‐wide $25 billion Repo 105 cap for third quarter 2008.³⁸⁴²³⁸⁴² Lehman, Balance Sheet and Key Disclosures 2008 3Q Targets [Draft] (June 16, 2008), at p. 3 [LBEX‐ DOCID 012458] (attached to e‐mail from Gerard Reilly, Lehman, to Christopher M. O'Meara, Lehman, et al. (June 17, 2008) [LBEX‐DOCID 011380]).

● O'Meara was involved in re‐establishing and/or extending credit lines with Repo 105 counterparties.³⁸⁴³³⁸⁴³ See e‐mail from Matthew Pinnock, Lehman, to Paolo R. Tonucci, Lehman (May 21, 2008) [LBEX‐ DOCID 1548431] (asking for authorization from O'Meara for Repo 105 increase with Mizuho); e‐mail from Paolo R. Tonucci, Lehman, to Matthew Pinnock, Lehman (May 21, 2008) [LBEX‐DOCID 1548433] (same); e‐mail from Paolo R. Tonucci, Lehman, to Christopher M. O'Meara, Lehman (May 21, 2008) [LBEX‐DOCID 1533687] (same); e‐mail from Christopher M. O'Meara, Lehman, to Paolo R. Tonucci, Lehman (May 21, 2008) [LBEX‐DOCID 1533688] (same); see also e‐mail from Christopher M. O'Meara, Lehman, to Gerard Reilly, Lehman (Apr. 11, 2008) [LBEX‐DOCID 4553298] (setting up meeting to discuss Lehman's Repo 105 program); e‐mail from Christopher M. O'Meara, Lehman, to Gerard Reilly, Lehman , et al. (June 17, 2008) [LBEX‐DOCID 033813].Show full note

¶(same); see also e‐mail from John Feraca, Lehman, to Gerard Reilly, Lehman (Aug. 18, 2007) [LBEX‐DOCID 4553350] (discussing possibility of moving either CMBS or RMBS into Repo 105); e‐mail from Gerard Reilly, Lehman, to John Feraca, Lehman (Aug. 18, 2007) [LBEX‐DOCID 4553351] ("Many benefits to us getting these assets [CMBS and RMBS] into the [Repo 105] program."); e‐mail from John Feraca, Lehman, to David Sherr, Lehman, et al. (Aug. 19, 2007) [LBEX‐DOCID 4553352] ("[W]e are looking at the possibility of Repo 105 for AAA RMBS and CMBS positions . . . only want to focus on non‐agency products for this exercise as both agency pass‐thrus and agency CMOs roll up as government or agency products in the balance sheet, not mortgages."); e‐mail from David Sherr, Lehman, to John Feraca, Lehman, et al. (Aug. 19, 2007) [LBEX‐DOCID 4553353] (same); e‐mail from Gerard Reilly, Lehman, to John Feraca, Lehman, et al. (Aug. 19, 2007) [LBEX‐DOCID 4553356] (same); e‐mail from John Feraca, Lehman, to David Sherr, Lehman, et al. (Aug. 20, 2007) [LBEX‐DOCID 4553357] ("We spoke to the 3 of the 4 counterparties we currently use for Repo 105 on UST and Agencies via LBIE (the MTS equivalent) and all 3 declined our proposal to use AAA private label RMBS and CMBS . . . our only other choice will be to look if any of our existing counterparties in LBI would be willing to transact through LBIE.").

1007

¶Moreover, net leverage reduction was an issue of importance during O'Meara's tenure as CFO. O'Meara reported to the Finance and Risk Committee on Lehman's net leverage ratio.³⁸⁴⁴³⁸⁴⁴ Lehman, Risk, Liquidity, Capital and Balance Sheet Update Presentation to Finance and Risk Committee of Lehman Board of Directors (Sept. 11, 2007), at pp. 2, 30 [WGM_LBEX_02247] (with Welikson's Handwritten Notes); Lehman Brothers Holdings Inc., Finance and Risk Committee Minutes (Sept. 11, 2007), at pp. 2‐3 [LBEX‐AM 067018]; see also Lehman, Presentation on Risk, Liquidity, Capital and Balance Sheet Update to Finance and Risk Committee of Lehman Board of Directors (Sept. 11, 2007), at p. 50 [LBEX‐AM 067167].Show full note In a November 2007 e‐mail, O'Meara wrote: "I realize we're in a tough spot given mkt, but we should be pressuring everywhere to try to end year in good way on balance sheet . . . especially since the rev's are not materializing."³⁸⁴⁵³⁸⁴⁵ E‐mail from Christopher M. O'Meara, Lehman, to Gerard, Reilly, Lehman (Nov. 20, 2007) [LBEX‐ DOCID 578184].

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

¶The Examiner finds there is sufficient evidence to support a colorable claim that O'Meara breached his fiduciary duties by permitting the expansion of Lehman's Repo 105 practice while the program and its impact on Lehman's reported net leverage ratio remained undisclosed in the firm's publicly reported financial statements. Although O'Meara was no longer Lehman's CFO when the firm filed its 2007 Form 10‐K on January 29, 2008, the Examiner concludes that there is sufficient evidence to support a finding that O'Meara continued to have culpable knowledge and involvement in Lehman's Repo 105 practice in late 2007 and early 2008 as well as involvement in the preparation of Lehman's 2007 Form 10‐K.3846

1008

¶As CFO through December 1, 2007 and the highest ranking officer overseeing Lehman's Repo 105 program, O'Meara had a duty to: (1) monitor Lehman's use of Repo 105 transactions and (2) ensure Lehman filed accurate and complete Forms 10‐K and 10‐ Q. O'Meara and Grieb established an internal limit of $22 billion for firm‐wide Repo 105 transactions, which they increased to $25 billion in February 2007. The limit was not required under accounting rules, and appears to have been a decision on their part to keep Lehman's Repo 105 activity within a range they deemed immaterial.

¶In late 2007 and early 2008, the volume of Lehman's undisclosed Repo 105 transactions was material. Under O'Meara's watch, the volume of Repo 105 transactions rose to $38 billion at the close of Lehman's fourth quarter 2007 – $13 billion (and more than 50%) over the last known "limit" of $25 billion. The expansion of Lehman's Repo 105 activity was due primarily to "a lack of policing" and it was "not an issue for management."³⁸⁴⁷³⁸⁴⁷ Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 11. The volume of Lehman's Repo 105 usage was known to senior management, but because FID needed more Repo 105 to make balance sheet targets, "there was no stoppage."³⁸⁴⁸³⁸⁴⁸ Id.Ed Grieb also recalled reading reports on the firm‐wide volume of Repo 105 transactions on at least a monthly basis. Examiner's Interview of Edward Grieb, Oct. 2, 2009, at p. 12.

¶3846 Though Erin M. Callan took over the role of CFO in December 2007, O'Meara continued to be involved in the drafting sessions for Lehman's 2007 Form 10‐K. E‐mail from Joy Fernandez, Lehman, to Erin M. Callan, Lehman (Nov. 5, 2007) [LBEX‐DOCID 2974570] (stating that Chris O'Meara was scheduled to attend January 14, 2008 meeting to review LBHI 2007 10‐K along with Erin M. Callan, Edward Grieb, Steve Rossi, and Ryan Traversari). Moreover, the Examiner has located evidence suggesting that O'Meara sub‐certified the 2007 10‐K for Callan and was responsible for certain financial reporting in Lehman's Form 10‐Q for first quarter 2008.. See Lehman Brothers Holdings Inc., Reporting Instructions, Quarter Ended February 29, 2008 (Feb. 22, 2008), at p. 5 [LBEX‐DOCID 3756724] (stating that O'Meara was the certifier for the Review of Risk Management narrative for accuracy of MD&A discussions of credit risk, market risk, operational risk, reputational risk, value at risk, other measures of risk and distribution of trading revenues); e‐mail from Martin Kelly, Lehman, to Ian T. Lowitt, Lehman (July 8, 2009) [LBEX‐DOCID 2329856] ("[W]ould you like to have Erin sign a sub‐certification letter (not necessary strictly speaking but we did have Chris sub‐certify to Erin at year end."); e‐mail from Martin Kelly, Lehman, to Erin M. Callan, Lehman (July 9, 2008) [LBEX‐DOCID 1536331] (asking Callan "if I could have you sub‐certify on the quarter[ly report since] (Chris [O'Meara] sub‐certified to you at year end)"); e‐mail from Ian T. Lowitt, Lehman, to Martin Kelly, Lehman (July 9, 2008) [LBEX‐DOCID 2329856] ("I spoke to Tom [Russo about sub‐certification] and he thinks better if didn't come from him and better to present as consistent with what Chris did when Erin overlapped.").

1009

¶In light of O'Meara's knowledge of the volume of Lehman's Repo 105 transactions, his involvement in setting internal management rules for Repo 105 usage, and his awareness of the purpose of Repo 105 transactions, sufficient evidence exists to support a colorable claim that O'Meara was at least grossly negligent in permitting Lehman to file a materially misleading 2007 Form 10‐K.

b. There Is Sufficient Evidence To Support a Colorable Claim That O'Meara Breached His Fiduciary Duties by Failing to Inform the Board and His Superiors of Lehman's Repo 105 Practice

¶The Examiner also finds that sufficient evidence exists to support a colorable claim that, as CRO from December 1, 2007 through September 2008, O'Meara breached his fiduciary duties to the Board of Directors and his superiors, including the CEO and CFO who were responsible for certifying Lehman's financial statements, by failing to report material information within the scope of his agency.

1010

¶O'Meara had a duty to inform his superiors of material information regarding Lehman's Repo 105 usage. Officers and key managerial personnel of Lehman are agents of the corporation that employs them.³⁸⁴⁹³⁸⁴⁹ See Science Accessories Corp. v. Summagraphics Corp., 425 A.2d 957, 962 (Del. 1980). In Science Accessories Corp, the Delaware Supreme Court held that the "principles and limitations of agency law carry over into the field of corporate employment so as to apply not only to officers and directors, but also key management personnel." Id. "[U]nder elemental principles of agency law, an agent owes his principal a duty of good faith, loyalty and fair dealing. Encompassed within such general duties of an agent is a duty to disclose information that is relevant to the affairs of the agency entrusted to him." Id. The imposition of these duties reflects the courts' "concern for the integrity of the employment relationship, which has led courts to establish a rule that demands of a corporate officer or employee undivided and unselfish loyalty to the corporation." Id. (quoting Md. Metals, Inc. v. Metzner, 382 A.2d 564, 568 (Md. 1978); see also Cahall v. Lofland, 114 A. 224, 228 (Del. Ch. 1921) (stating that under "well‐established and familiar rules of equity," a director of a corporation "is not accountable to the stockholder for withholding information" about the value of the stock, but to the corporation) (quoting Du Pont v. Du Pont, 242 F. 98, 136 (D.C. Del. 1917)). The Delaware Supreme Court has characterized these employee‐ agent obligations as fiduciary duties. Science Accessories Corp, 425 A.2d at 965 (former employees' failure to disclose off‐duty development of competing business "was not, without more, a violation of their fiduciary duty of loyalty"); see also Lewis v. Vogelstein, 699 A.2d 327, 334 (Del. Ch. 1997) (describing agent's duties to principal as "fiduciary in character").Show full note Principles of agency law squarely hold that an agent has a duty of candor or a duty to disclose relevant information to his principal.³⁸⁵⁰³⁸⁵⁰ See RESTATEMENT (THIRD) AGENCY § 8.11 ("An agent has a duty to use reasonable effort to provide the principal with facts that the agent knows…or should know…the principal would wish to have…or…are material to the agent's duties to the principal."); RESTATEMENT (SECOND) AGENCY § 381 ("[A]n agent is subject to a duty to use reasonable efforts to give his principal information which is relevant to affairs entrusted to him and which, as the agency has notice, the principal would desire to have and which can be communicated without violating a superior duty to a third person.").Show full note

¶Commentators agree that officers have an obligation to "inform the superior officer to whom, or the board of directors . . . to which, the officer reports of information about the affairs of the corporation known to the officer, within the scope of the officer's functions, and known to the officer to be material to such superior officer, board or committee."³⁸⁵¹³⁸⁵¹ ABA Comm'n on Corporate Laws, Changes in the Model Business Corporations Act, 60 BUS. LAW. 943, 951 (2005); see also Shannon German, What They Don't Know Can't Hurt Them: Corporate Officers' Duty of Candor to Directors, 34 DEL. J. CORP. L. 221, 223 (2009) ("Extending the duty of candor to impose on corporate officers a duty to provide information to the board of directors would give the corporation a way to seek redress for harm caused by misconduct within the corporation of which the board was not aware."); Z. Jill Barclift, Senior Corporate Officers and the Duty of Candor: Do the CEO and CFO Have a Duty to Inform?, 41 VAL. U. L. REV. 269, 270 (2006) ("The broadening of the definition of the duty to inform that senior officers owe directors to include an underlying affirmative duty to provide information, even when director or shareholder action is not requested, offers an opportunity for greater monitoring of corporate governance by focusing on those often most culpable.").Show full note

1011

¶There is sufficient evidence to support a finding that in 2008, as he assisted other Lehman officers with the firm's balance sheet reduction efforts, O'Meara had knowledge of the mechanics and magnitude of Lehman's Repo 105 practice. O'Meara received a copy of McDade's March 28, 2008 balance sheet reduction presentation to the Executive Committee, which included a reference to Lehman's quarter‐end Repo 105 usage for first quarter 2008.³⁸⁵²³⁸⁵² Lehman, Balance Sheet and Cash Capital Update (Mar. 27, 2008) [LBEX‐DOCID 197391] (attached to e‐mail from Gerard Reilly, Lehman, to Christopher M. O'Meara, Lehman (Mar. 28, 2008) [LBEX‐DOCID 214211]). After he became President in June 2008, McDade brought O'Meara "back in the [balance sheet] process" to help in light of O'Meara's past experience as Lehman CFO.³⁸⁵³³⁸⁵³ Examiner's Interview of Herbert H. "Bart" McDade III, Jan. 28, 2010, at p. 8. In June 2008, O'Meara met with McDade and others to discuss the Balance Sheet and Key Disclosures document, which reported the firm‐wide quarter‐end Repo 105 usage.³⁸⁵⁴³⁸⁵⁴ Lehman, Balance Sheet and Key Disclosures 2008 3Q Targets [Draft] (June 16, 2008), at p. 3 [LBEX‐ DOCID 3363493] (attached to e‐mail from Gerard Reilly, Lehman, to Christopher M. O'Meara, Lehman, et al. (June 17, 2008) [LBEX‐DOCID 3383643]); e‐mail from Christopher M. O'Meara, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (June 17, 2008) [LBEX‐DOCID 033813] (replying to receipt of Balance Sheet and Key Disclosures 2008 3Q Targets [Draft] (June 16, 2008) and stating that "meeting is being set up to discuss" the document); e‐mail from Gerard Reilly, Lehman, to Ian T. Lowitt, Lehman, et al. (June 19, 2008) [LBEX‐DOCID 2962369] (transmitting updated version of Lehman, Balance Sheet and Key Disclosures 2008 3Q Targets (June 19, 2008) [LBEX‐DOCID 2932594] and indicating that a meeting among Reilly, Lowitt, O'Meara, McDade and Patrick Whalen took place).Show full note

1012

¶To form a basis for a fiduciary's personal liability for breaching the duty of candor to his principal, the undisclosed or misrepresented facts must be material to the principal's decisions or responsibilities.³⁸⁵⁵³⁸⁵⁵ See RESTATEMENT (THIRD) OF AGENCY § 8.11, cmt. d. While materiality for purposes of information to shareholders is determined under the "total mix of information" standard, the Delaware Supreme Court has adopted a lower standard of materiality with respect to management's disclosure of information to the board.³⁸⁵⁶³⁸⁵⁶ See Brehm v. Eisner, 746 A.2d 244, 260 n. 49 (Del. 2000). Information must be disclosed if it is "relevant" to the board and of sufficient "magnitude" to be important.³⁸⁵⁷³⁸⁵⁷ Id. at n.49 ("The term 'material' is used in this context to mean relevant and of a magnitude to be important to directors in carrying out their fiduciary duty of care in decision‐making."). Similarly, under agency law principles, an agent breaches his duty of care to the principal when he fails to provide information to the principal that may be material to the principal's decision‐making, such as by enabling the principal to: (1) reconsider a course of action or make alternate arrangements; (2) take action to avoid harm to third parties; or (3) take action to protect the principal's interests.³⁸⁵⁸³⁸⁵⁸ See RESTATEMENT (THIRD) OF AGENCY § 8.11 cmts. b‐d.

¶When an agent has an ongoing relationship with his principal and the relationship involves more than the execution of specific orders, the duty to inform the principal is wide in scope.³⁸⁵⁹³⁸⁵⁹ See RESTATEMENT (THIRD) OF AGENCY § 8.11 cmt. c. Thus, although O'Meara was primarily responsible for risk management in 2008, he also had involvement in Lehman's balance sheet reduction efforts and continued to have a duty to report to his principal(s) material information of which he was aware. "If an agent fails to provide information to the principal that is material to decisions that the principal will make, the agent may not have acted with the due diligence and care reasonably to be expected of an agent in a particular position."³⁸⁶⁰³⁸⁶⁰ RESTATEMENT (THIRD) OF AGENCY § 8.11 cmt. d.

1013

¶Given O'Meara's extensive prior involvement in the Repo 105 program and his continued access to information regarding Lehman's use of Repo 105 transactions, O'Meara understood the impact of the transactions on Lehman's balance sheet and the purpose for engaging in these transactions, was aware of FID's difficulties in making balance sheet targets, and knew of the volumes at which FID engaged in Repo 105 transactions. Under agency law principles, O'Meara had a duty to report this information to any of his superiors responsible for Lehman's publicly filed financial statements, including the Board of Directors, CEO and CFO.

Erin Callan

¶Callan became Lehman's CFO on December 1, 2007. As early as January 2008, Callan received e‐mails from Reilly, Lehman's Global Product Controller, and others regarding Lehman's Repo 105 program and its relation to balance sheet management.³⁸⁶¹³⁸⁶¹ E‐mail from Gerard Reilly, Lehman, to Erin M. Callan, Lehman (Jan. 3, 2008) [LBEX‐DOCID 3383445]. One e‐mail that was forwarded to Callan indicated that Lehman's Fixed Income Division had recommended that the Repo 105 program be expanded.³⁸⁶²³⁸⁶² E‐mail from Gerard Reilly, Lehman, to Erin M. Callan, Lehman (Feb. 1, 2008) [LBEX‐DOCID 3383459] (transmitting Lehman, FID – Balance Sheet (Jan. 17, 2008) [LBEX‐DOCID 3363222]).

1014

¶During meetings in early 2008, Callan was warned by Lehman's Global Financial Controller, Martin Kelly, that:

¶● The large size of the Repo 105 program presented "headline risk;"

● Because Lehman did not disclose Repo 105 transactions in its publicly filed statements, Lehman exposed itself to "reputational risk" if its use of Repo 105 were to become public;

● Repo 105 transactions lacked economic substance, and were used to reduce net balance sheet primarily at quarter‐end; and

● Kelly and other Lehman employees believed that none of Lehman's peer investment banks used Repo 105‐type transactions.³⁸⁶³³⁸⁶³ Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 8.

¶In addition to the red flags raised by Kelly, Callan was put on further notice of potential risks or problems with Lehman's Repo 105 program during the March 28, 2008 Executive Committee meeting in which McDade recommended to the Executive Committee that Lehman cap its Repo 105 usage.³⁸⁶⁴³⁸⁶⁴ Examiner's Interview of Herbert H. "Bart" McDade III, Jan. 28, 2010, at p. 4. Callan received the materials the night before the meeting, which listed the $49.1 billion in Repo 105 transactions that Lehman had undertaken at the end of the first quarter 2008.³⁸⁶⁵³⁸⁶⁵ Herbert H. (Bart) McDade III, Lehman, Balance Sheet and Cash Capital Update (Mar. 27, 2008), at p. 1 [LBEX‐DOCID 095966] (attached to e‐mail from Gerard Reilly, Lehman, to Erin M. Callan, Lehman, et al. (Mar. 28, 2008) [LBEX‐DOCID 124422] and indicating that the attachment is for the Executive Committee meeting); see also Herbert H. (Bart) McDade III, Lehman Brothers, Executive Committee Meeting Material, Agenda (Mar. 28, 2008) [LBEX‐DOCID 115827] (attached to e‐mail from Patricia Lombardi, Assistant to Herbert H. (Bart) McDade III, to Lehman Executive Committee Members (Mar. 28, 2008) [LBEX‐DOCID 120929] and listing among seven topics of discussion for March 28, 2008 Executive Committee meeting "Repo 105/108" and "Delever v Derisk"). Callan was a member of the Executive Committee.Show full note McDade discussed with Executive Committee members on March 28, 2008, Lehman's use of Repo 105 transactions and recommended to the Executive Committee during the meeting that Lehman limit its firm‐wide Repo 105 usage to a certain dollar amount.³⁸⁶⁶³⁸⁶⁶ Id. at pp. 3‐4. On April 9, 2008, twelve days after McDade's presentation to the Executive Committee, Callan signed Lehman's quarterly report.³⁸⁶⁷³⁸⁶⁷ LBHI, 10‐Q (filed Apr. 9, 2008), at p. 92.

1015

¶Starting in April 2008, Callan received the Daily Balance Sheet and Disclosure Scorecard, through which she was informed on a regular basis of the impact of Repo 105 transactions on Lehman's firm‐wide balance sheet.³⁸⁶⁸³⁸⁶⁸ See, e.g., Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 7, 2008 (Apr. 9, 2008), at p. 9 [LBEX‐DOCID 520619] (attached to e‐mail from Tal Litvin, Lehman, to Erin M. Callan, Lehman, et al. (Apr. 9, 2008) [LBEX‐DOCID 523578] and showing consolidated FID and Equities balance sheet reduced by $18.527 billion and Prime Services balance sheet reduced by $4.458 billion through Repo 105 transactions); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 10, 2008 (Apr. 14, 2008), at p. 9 [LBEX‐DOCID 251342] (attached to e‐mail from Tal Litvin, Lehman, to Erin M. Callan, Lehman, et al. (Apr. 14, 2008) [LBEX‐DOCID 275231] and showing consolidated FID and Equities balance sheet reduced by $19.967 billion and Prime Services balance sheet reduced by $4.491 billion through Repo 105 transactions); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 11, 2008 (Apr. 14, 2008), at p. 9 [LBEX‐DOCID 251344] (attached to e‐mail from Tal Litvin, Lehman, to Erin M. Callan, Lehman, et al. (Apr. 14, 2008) [LBEX‐DOCID 258562] and showing consolidated FID and Equities balance sheet reduced by $20.260 billion and Prime Services balance sheet reduced by $4.517 billion through Repo 105 transactions); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 12, 2008 (May 13, 2008), at p. 1 [LBEX‐LL 1950262] (attached to e‐mail from Tal Litvin, Lehman, to Erin M. Callan, Lehman, et al. (May 13, 2008) [LBEX‐DOCID 3187357] and stating "Rates decreased by $(5.0B) from prior day due to . . . increased Repo 105 usage. . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 22, 2008 (May 27, 2008), at p. 1 [LBEX‐LL 1950706] (attached to e‐mail from Tal Litvin, Lehman, to Erin M. Callan, Lehman, et al. (May 27, 2008) [LBEX‐DOCID 275984] and stating "Global rates net balance sheet decreased ($2.0B), predominantly due to an increase in Repo 105 benefit. . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 28, 2008 (May 30, 2008), at p. 1 [LBEX‐LL 1950670] (attached to e‐mail from Tal Litvin, Lehman, to Erin M. Callan, Lehman, et al. (May 30, 2008) [LBEX‐ DOCID 275995] and stating "Global rates net balance sheet decreased by ($3.1B) primarily due to a decrease in Americas driven by an increased utilization of Repo 105 within the Agency business"); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 29, 2008 (May 30, 2008), at p. 1 [LBEX‐LL 1950658] (attached to e‐mail from Tal Litvin, Lehman, to Erin M. Callan, Lehman, et al. (June 2, 2008) [LBEX‐DOCID 011127] and stating "Global Rates net balance sheet decreased ($6.5B)…[t]he decrease in Europe is coming from increased utilization of Repo 105").Show full note

1016

¶Callan thus had ample red flags to alert her to potential problems arising from Lehman's Repo 105 program before she signed Lehman's first quarter Form 10‐Q. Callan ignored these red flags even though she trusted the judgment of Kelly and hand‐ picked him to serve as Lehman's Global Financial Controller. Callan did not report to her superiors or the Board of Directors Kelly's discomfort with Lehman's Repo 105 program or the risks that non‐disclosure in Lehman's publicly filed statements entailed.³⁸⁶⁹³⁸⁶⁹ Callan told the Examiner that she did not discuss Repo 105 with Fuld, McDade, Gregory, Tonucci, the Executive Committee, or Ernst & Young. Examiner's Interview of Erin M. Callan, Oct. 23, 2009, at pp. 18‐ 19.

¶Callan told the Examiner that following her meetings with Kelly in early 2008, Kelly's concerns likely fell by the wayside because of other more pressing issues following Bear Stearns' near collapse.³⁸⁷⁰³⁸⁷⁰ Id. at p. 17. Lehman's Repo 105 program was "not high" on Callan's "list" so she did not spend "any meaningful amount of time" on it.³⁸⁷¹³⁸⁷¹ Id. While a trier of fact could accept that explanation, Callan's failure to act, which did not result from a reasoned decision, is not protected by the business judgment rule.³⁸⁷²³⁸⁷² The business judgment rule does not protect an officer from personal liability for inaction unless the failure to act was the result of a conscious and reasoned decision to take no action. McMullin v. Beran, 765 A.2d 910, 922 (Del. 2000) ("The business judgment rule is rebutted if the plaintiff shows that the directors failed to exercise due care in informing themselves before making their decision."). Alternatively, Callan's failure to act in the face of a known duty to act also rebuts the business judgment rule presumption.Show full note

1017

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

¶To establish "director liability based on a disclosure violation, plaintiffs must plead facts that show that the violation was made knowingly or in bad faith, a showing that requires allegations regarding what the directors knew and when."³⁸⁷³³⁸⁷³ In re Citigroup, 964 A.2d at 133‐34. A Delaware court would apply the same standard to officer liability.³⁸⁷⁴³⁸⁷⁴ See Gantler v. Stephens, 965 A.2d 695, 709 (Del. 2009) (stating that fiduciary duties of officers and directors are identical). The evidence of Callan's knowledge of Lehman's Repo 105 program and the warnings she received from Kelly, coupled with Callan's responsibilities as the firm's CFO, is sufficient to support a colorable claim that she breached her fiduciary duties when she knowingly or in bad faith caused Lehman to publicly file periodic reports that contained material omissions and/or misrepresentations.

¶Corporate fiduciaries breach their duty of loyalty under Delaware law by intentionally failing to act in the face of a known duty to act, demonstrating a conscious disregard for their duties and a lack of true devotion to the interests of the corporation and its shareholders.³⁸⁷⁵³⁸⁷⁵ Lyondell Chem. Co. v. Ryan, 970 A.2d 235, 243‐44 (Del. 2009) (stating that directors breach their duty of loyalty "if they knowingly and completely fail[] to undertake their responsibilities").

1018

¶Through her discussions with Kelly regarding the potential reputational harm Lehman would suffer if the public were to learn about the firm's use of Repo 105 transactions to manage its balance sheet and net leverage ratio, Callan was warned not only of the potential harm to Lehman, but also of the likely materiality of information regarding Lehman's Repo 105 program. With knowledge of these aspects of Lehman's Repo 105 program, Callan nonetheless caused Lehman to file its first quarter Form 10‐Q in April 2008 without disclosing the firm's reliance upon Repo 105 transactions, thereby exposing Lehman to potential liability.³⁸⁷⁶³⁸⁷⁶ See Sections III.A.4.j.1–2 of this Report (discussing materiality and disclosure obligations).

¶Sufficient evidence also exists to support a colorable claim that Callan breached her fiduciary duties to Lehman by exposing the firm to potential liability for making misleading statements during Lehman's earnings calls for the first quarter and second quarter of 2008. The March 18, 2008 earnings call demonstrates that "transparency on the balance sheet" and Lehman's efforts at deleveraging were of interest to analysts and the market. During the call, Callan reported to analysts the drop in Lehman's net leverage ratio from the fourth quarter 2007 to the first quarter 2008, but did not disclose that the reduction in leverage was partially attributable to an approximately $11 billion increase in quarter‐end Repo 105 usage between fourth quarter 2007 and first quarter 2008 (from approximately $38 billion at the end of fiscal year 2007 to approximately $49 billion at the end of first quarter 2008). When asked repeatedly about the means by which Lehman deleveraged, Callan only mentioned the sale of assets, at no time mentioning Lehman's use of off‐balance sheet repo transactions to manage the balance sheet and improve net leverage. Similarly, during the preliminary second quarter 2008 earnings call, Callan focused on Lehman's reduced leverage but failed to mention that Lehman had temporarily removed $50 billion in assets from its balance sheet using Repo 105 transactions.

1019

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

¶On March 25, 2008, Callan spoke to the Board's Finance and Risk Committee about the "industry‐wide pressure to delever" and the firm's plan for reducing total assets, focusing primarily on the Fixed Income Division, but she failed to disclose in that presentation that the Fixed Income Division relied heavily on Repo 105 transactions for managing its balance sheet at quarter‐end.³⁸⁷⁷³⁸⁷⁷ Lehman Brothers Holdings Inc., Minutes of Meeting of the Finance and Risk Committee (Mar. 25, 2008), at p. 2 [LBEX‐AM 003592]. During an April 15, 2008 meeting of the Board of Directors, Callan reported Lehman's net leverage ratio and the firm's plan at further reducing leverage through targeted reductions in net assets, but again said nothing about the firm's use of Repo 105 transactions.³⁸⁷⁸³⁸⁷⁸ Lehman Brothers Holdings Inc., Minutes of Meeting of Board of Directors (Apr. 15, 2008), at p. 4 [LBEX‐AM 003654].

1020

¶In light of the market demand that Lehman deleverage and Kelly's concerns about the risks of Lehman's Repo 105 practice, Callan knew or should have known that information regarding Lehman's Repo 105 practice (e.g., accounting treatment, lack of disclosure, volumes of quarter‐end transactions, and impact on Lehman's publicly reported net leverage ratio) would have been material to Lehman's directors.³⁸⁷⁹³⁸⁷⁹ To form a basis for an officer's personal liability for breaching the duty of candor, the undisclosed or misrepresented facts must be material to the principal's decisions or responsibilities. While materiality for purposes of information to shareholders is determined under the "total mix of information" standard, the Delaware Supreme Court has adopted a lower standard of materiality with respect to management's disclosure of information to the board. See Brehm, 746 A.2d at 259‐60 n.49.Show full note Information must be disclosed if it is "relevant" to the board and of sufficient "magnitude" to be important.³⁸⁸⁰³⁸⁸⁰ Id. at 260 n.49 ("The term 'material' is used in this context to mean relevant and of a magnitude to be important to directors in carrying out their fiduciary duty of care in decisionmaking."); see also RESTATEMENT (THIRD) OF AGENCY § 8.11 cmts. b‐d.

¶Given Callan's actual knowledge about Lehman's Repo 105 program when speaking to the Board of Directors and the likely potential materiality of information relating to Repo 105 transactions' impact on the firm‐wide balance sheet and net leverage ratio, the Examiner concludes that sufficient evidence exists to support a colorable claim that Callan violated her duties of loyalty, good faith, and due care by failing to disclose material information to the Board.

1021

Ian Lowitt

¶There is sufficient evidence to support a finding by the trier of fact that Lowitt was at least grossly negligent in causing Lehman to file materially misleading financial statements. According to Kelly, by the time Lowitt became Lehman's CFO in June 2008, Lowitt was "quite familiar" with Lehman's use of Repo 105 transactions to reduce its balance sheet at quarter‐end and "understood [the] details" of the program.³⁸⁸¹³⁸⁸¹ Examiner's Interview of Martin Kelly, Oct. 1, 2009, at p. 10 (stating that when he raised his concerns about Repo 105 to Lowitt, Lowitt was already "quite familiar with the program and understood its details); Examiner's Interview of Ian T. Lowitt, Oct. 28, 2009, at p. 10 (recalling that Lehman had initiated its Repo 105 program in the early 2000s and that FID and Equities division would use Repo 105 transactions to reach balance sheet targets).Show full note In addition:

● While serving as co‐CAO, Lowitt was informed of John Feraca's ultimately unsuccessful attempts to place real estate securities into the Repo 105 program.³⁸⁸²³⁸⁸² E‐mail from Kentaro Umezaki, Lehman, to Christopher M. O'Meara, Lehman, et al. (Aug. 17, 2007) [LBEX‐DOCID 1533678]. Lowitt recalled that Feraca would report on Lehman's Repo 105 use to him because Lowitt was a member of Lehman's Asset Liability Committee ("ALCO").³⁸⁸³³⁸⁸³ Examiner's Interview of Ian T. Lowitt, Oct. 28, 2009, at p. 12. Feraca also informed Lowitt of the volume of Repo 105 transactions with specific counterparties at the close of the first quarter 2008.³⁸⁸⁴³⁸⁸⁴ E‐mail from John Feraca, Lehman, to Ian T. Lowitt, Lehman, et al. (Feb. 28, 2008) [LBEX‐DOCID 3207903]; e‐mail from John Feraca, Lehman, to Ian T. Lowitt, Lehman, et al. (Feb. 28, 2008) [LBEX‐DOCID 3207907]; e‐mail from John Feraca, Lehman, to Ian T. Lowitt, Lehman, et al. (Feb. 28, 2008) [LBEX‐DOCID 3207908]; e‐mail from John Feraca, Lehman, to Ian T. Lowitt, Lehman, et al. (Feb. 29, 2008) [LBEX‐DOCID 3207910].Show full note Lowitt recalled that at the close of the first quarter 2008, he attempted to gauge the materiality of Lehman's Repo 105 usage and asked Feraca for information to determine whether Lehman was increasing its Repo 105 activity.³⁸⁸⁵³⁸⁸⁵ Examiner's Interview of Ian T. Lowitt, Oct. 28, 2009, at p. 12.

1022

● During the second quarter 2008, Lowitt was told that the intra‐quarter balance sheet increase of $95 billion in FID's rates business was due, in part, to a $22.4 billion reduction in Repo 105 since quarter‐end.³⁸⁸⁶³⁸⁸⁶ See e‐mail from Gerard Reilly, Lehman, to Ian T. Lowitt, Lehman, et al. (Mar. 20, 2008) [LBEX‐DOCID 4220790]; Lehman, March Net Balance Sheet Daily Trend (Mar. 20, 2008) [LBEX‐DOCID 4070215]; e‐mail from Gerard Reilly, Lehman, to Ian T. Lowitt, Lehman, et al. (Mar. 20, 2008) [LBEX‐DOCID 2973597].

● Lowitt received the Daily Balance Sheet and Disclosure Scorecard from April to September 2008, which made frequent mention of the impact of Repo 105 transactions on Lehman's balance sheet.³⁸⁸⁷³⁸⁸⁷ See, e.g., Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 7, 2008 (Apr. 9, 2008), at p. 9 [LBEX‐DOCID 520619] (attached to e‐mail from Tal Litvin, Lehman, to Ian T. Lowitt, Lehman, et al. (Apr. 9, 2008) [LBEX‐DOCID 523578] and showing consolidated FID and Equities balance sheet reduced by $18.527 billion and Prime Services balance sheet reduced by $4.458 billion through Repo 105 transactions as of April 7, 2008); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 8, 2008 (Apr. 10, 2008), at p. 9 [LBEX‐DOCID 520620] (attached to e‐mail from Tal Litvin, Lehman, to Ian T. Lowitt, Lehman, et al. (Apr. 10, 2008) [LBEX‐DOCID 523579] and showing consolidated FID and Equities balance sheet reduced by $18.853 billion and Prime Services balance sheet reduced by $4.562 billion through Repo 105 transactions as of April 8, 2008); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 9, 2008 (Apr. 10, 2008), at p. 9 [LBEX‐DOCID 251339] (attached to e‐mail from Tal Litvin, Lehman, to Ian T. Lowitt, Lehman, et al. (Apr. 10, 2008) [LBEX‐DOCID 258560] and showing consolidated FID and Equities balance sheet reduced by $19.688 billion and Prime Services balance sheet reduced by $4.548 billion through Repo 105 transactions as of April 9, 2008); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 10, 2008 (Apr. 14, 2008), at p. 9 [LBEX‐DOCID 251342] (attached to e‐mail from Tal Litvin, Lehman, to Ian T. Lowitt, Lehman, et al. (Apr. 14, 2008) [LBEX‐DOCID 275231] and showing consolidated FID and Equities balance sheet reduced by $19.967 billion and Prime Services balance sheet reduced by $4.491 billion through Repo 105 transactions as of April 10, 2008); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date April 11, 2008 (Apr. 14, 2008) [LBEX‐DOCID 251344], at p. 9 (attached to e‐mail from Tal Litvin, Lehman, to Ian T. Lowitt, Lehman, et al. (Apr. 14, 2008) [LBEX‐DOCID 258562] and showing consolidated FID and Equities balance sheet reduced by $20.260 billion and Prime Services balance sheet reduced by $4.517 billion through Repo 105 transactions as of April 11, 2008); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 12, 2008 (May 13, 2008), at p. 1 [LBEX‐LL 1950262] (attached to e‐mail from Tal Litvin, Lehman, to Ian T. Lowitt, Lehman, et al. (May 13, 2008) [LBEX‐DOCID 3187357] and stating "Rates decreased by $(5.0B) from prior day due to . . . increased Repo 105 usage. . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 22, 2008 (May 27, 2008), at p. 1 [LBEX‐LL 1950706] (attached to e‐mail from Tal Litvin, Lehman, to Ian T. Lowitt, Lehman, et al. (May 27, 2008) [LBEX‐DOCID 275984] and stating "Global rates net balance sheet decreased ($2.0B), predominantly due to an increase in Repo 105 benefit. . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 28, 2008 (May 30, 2008), at p. 1 [LBEX‐LL 1950670] (attached to e‐mail from Tal Litvin, Lehman, to Ian T. Lowitt, Lehman, et al. (May 30, 2008) [LBEX‐DOCID 275995] and stating "Global rates net balance sheet decreased by ($3.1B) primarily due to a decrease in Americas driven by an increased utilization of Repo 105 within the Agency business"); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date May 29, 2008 (May 30, 2008), at p. 1 [LBEX‐LL 1950658] (attached to e‐mail from Tal Litvin, Lehman, to Ian T. Lowitt, Lehman, et al. (June 2, 2008) [LBEX‐DOCID 011127] and stating "Global Rates net balance sheet decreased ($6.5B) . . . [t]he decrease in Europe is coming from increased utilization of Repo 105"); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date June 18, 2008 (June 20, 2008) [LBEX‐LL 1950514] (attached to e‐mail from Tal Litvin, Lehman, to Ian T. Lowitt, Lehman, et al. (June 20, 2008) [LBEX‐DOCID 275942] and stating that "Global rates net balance sheet decreased . . . driven by a[n] . . . increase in Repo 105 utilization. . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date August 13, 2008 (Aug. 14, 2008) [LBEX‐LL 782812] (attached to e‐mail from Tal Litvin, Lehman, to Ian T. Lowitt, Lehman, et al. (Aug. 14, 2008) [LBEX‐ DOCID 4214810] and stating that "Global rates net balance sheet decreased . . . driven by an increase in Repo 105 benefit. . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date August 25, 2008 (Aug. 26, 2008) [LBEX‐LL 782924] (attached to e‐mail from Tal Litvin, Lehman, to Ian T. Lowitt, Lehman, et al. (Aug. 26, 2008) [LBEX‐DOCID 079536] and stating that "Global Rates net balance sheet decreased . . . driven by an increase in repo 105 usage. . . ."); Lehman, Balance Sheet and Disclosure Scorecard for Trade Date August 28, 2008 (Aug. 29, 2008) [LBEX‐LL 782966] (attached to e‐mail from Tal Litvin, Lehman, to Ian T. Lowitt, Lehman, et al. (Aug. 29, 2008) [LBEX‐DOCID 275880] and stating that "Global rates [net balance sheet] was down . . . driven by increased Repo 105 benefit. . . .").Show full note

1023

● Four days before the close of second quarter 2008, Lowitt was informed of funding problems with certain Repo 105 counterparties.³⁸⁸⁸³⁸⁸⁸ E‐mail from John Feraca, Lehman, to Ian T. Lowitt, Lehman, et al. (May 27, 2008) [LBEX‐DOCID 070831]

¶Furthermore, Lowitt attended the March 28, 2008 special meeting of the Executive Committee requested by McDade.³⁸⁸⁹³⁸⁸⁹ Examiner's Interview of Herbert H. "Bart" McDade III, Jan. 28, 2010, at p. 4 (stating that the entire Executive Committee, except for Fuld, and ex officio members Lowitt and Friedheim attended the March 28, 2008 meeting). Lowitt received the same documents that listed the $49.1 billion in Repo 105 transactions Lehman had undertaken at the end of the first quarter 2008, and was present when McDade discussed Lehman's use of Repo 105 transactions.³⁸⁹⁰³⁸⁹⁰ Examiner's Interview of Herbert H. "Bart" McDade III, Jan. 28, 2010, at pp. 3‐4; Herbert H. (Bart) McDade III, Lehman, Balance Sheet and Cash Capital Update (Mar. 27, 2008), at p. 1 [LBEX‐DOCID 095961] (attached to e‐mail from Gerard Reilly, Lehman, to Ian T. Lowitt, Lehman, et al. (Mar. 28, 2008) [LBEX‐DOCID 120929] and indicating that the attachment is for the Executive Committee meeting)); see also Herbert H. (Bart) McDade III, Lehman, Executive Committee Meeting Material, Agenda (Mar. 28, 2008) [LBEX‐DOCID 115827] (attached to e‐mail from Patricia Lombardi, Assistant to Herbert H. (Bart) McDade III, to Ian T. Lowitt, Lehman, et al. (Mar. 28, 2008) [LBEX‐DOCID 120929] and listing among seven topics of discussion for March 28, 2008 Executive Committee meeting "Repo 105/108" and "Delever v Derisk").Show full note

1024

¶Lowitt also received the June 2008 Balance Sheet and Key Disclosures document that incorporated McDade's planned directive to reduce Lehman's firm‐wide Repo 105 usage by half – from $50 billion to $25 billion in third quarter 2008 – and met with McDade, Reilly, O'Meara, and Morton to discuss the issues.³⁸⁹¹³⁸⁹¹ E‐mail from Christopher M. O'Meara, Lehman, to Herbert H. (Bart) McDade III, Lehman, et al. (June 17, 2008) [LBEX‐DOCID 033813] (replying to receipt of Balance Sheet and Key Disclosures 2008 3Q Targets [Draft] (June 16, 2008) and stating that "meeting is being set up to discuss" the Balance Sheet and Key Disclosure 2008 3Q Targets document); e‐mail from Gerard Reilly, Lehman, to Ian T. Lowitt, Lehman, et al. (June 19, 2008) [LBEX‐DOCID 2962369] (transmitting updated version of Lehman, Balance Sheet and Key Disclosures 2008 3Q Targets (June 19, 2008) [LBEX‐DOCID 2932594] and indicating that a meeting with Reilly, Lowitt, O'Meara, and McDade took place).Show full note Thus, at the time Lowitt signed the second quarter 2008 Form 10‐Q, sufficient evidence exists to support a colorable claim that he was aware of the material impact that Lehman's Repo 105 practice had on the firm‐wide balance sheet and publicly reported leverage ratios.

¶Lowitt took no action to ensure Lehman filed accurate and complete financial statements and MD&A. Lowitt certified Lehman's second quarter 2008 Form 10‐Q, exposing Lehman to potential liability for making material misstatements and omissions in publicly filed financial statements and MD&A; there is sufficient evidence to support a colorable claim that Lowitt breached his fiduciary duty of care.

Remedies

¶The primary remedy for a breach of fiduciary duty is forcing the fiduciary to "disgorge" his or her profits. A fiduciary is liable to disgorge profits regardless of whether it can be proven that the breach injured the fiduciary's principal.³⁸⁹²³⁸⁹² Thorpe ex rel. Castleman v. CERBCO, Inc., 676 A.2d 436, 445 (Del. 1996) (finding defendant liable for disgorgement plus reimbursement of "any expenses, including legal and due diligence costs, that the corporation incurred"). If a plaintiff is seeking disgorgement of salary, however, then the plaintiff must also demonstrate a quantifiable harm to the principal.³⁸⁹³³⁸⁹³ See Cintron v. Merritt‐Chapman & Scott Corp., 407 A.2d 1040, 1045 (Del. 1979). Outside Delaware, there is considerable authority for the proposition that a corporate officer must disgorge all of the compensation paid for services during the period of the breach.³⁸⁹⁴³⁸⁹⁴ See, e.g., Wilshire Oil Co. of Texas v. Riffe, 406 F.2d 1061, 1062 (10th Cir. 1969) (holding that, under Oklahoma law, a corporation was entitled to judgment against former officer in an amount equal to seven‐twelfths of the salary and bonus paid him for services during a calendar year, where he was in breach for period of seven months in that year); see also Carco Group, Inc. v. Maconachy, 644 F. Supp. 2d 218, 244 (E.D.N.Y. 2009) ("Under New York law, an employee is required to forfeit all compensation, including 'commissions or salary,' paid beginning with his first disloyal act."); Aramony v. United Way Replacement Benefit Plan, 191 F.3d 140, 153 (S.D.N.Y. 1999) (holding that, under New York law, an unfaithful fiduciary was obligated to return all salary paid to him during the time in which he was in violation of his fiduciary duties); In re Omni Mech. Contractors, Inc., 114 B.R. 518, 541 (Bankr. E.D. Tenn. 1990) ("The general rule . . . is that corporate officers who breach their duty of loyalty or who willfully breach their contract of employment are not entitled to any compensation for services performed during that time period even though some services were performed properly.").Show full note Courts applying Delaware law, however, appear to be split between applying this rule of full disgorgement and requiring disgorgement of only the compensation attributable to the breaching conduct.³⁸⁹⁵³⁸⁹⁵ Compare Borden v. Sinskey, 530 F.2d 478, 497‐98 (3d Cir. 1976) (disgorging unfaithful fiduciary defendant of all salaries earned from companies that he wrongfully acquired for himself instead of presenting his employer with the opportunity to acquire them), and Guth v. Loft, 5 A.2d 503, 508 (Del. 1939) (upholding a decision requiring an officer to turn over to his former employer "all salary or compensation" paid to him by a competing interest from the time he began self dealing as well as any compensation paid above what was reasonable after his fiduciary relationship with the plaintiff ended ) with Technicorp Intern. II, Inc. v. Johnston, No. Civ. A. 15084, 2000 WL 713750, at *53 (Del. Ch. May 31, 2000) (permitting agents to retain an amount representing reasonable compensation for the services they had "legitimately and beneficially performed for the corporations."), and Julian v. E. States Const. Serv., Inc., Civ. A. No. 1892‐VCP, 2008 WL 2673300 at * 1 (Del.Ch. July 8, 2008) (disgorging only the bonuses directors awarded themselves in violation of their fiduciary duties instead of all compensation paid to them while they were in violation of their duties).Show full note

1025 1026

¶While the most common remedies for breach of fiduciary duty are in equity, a plaintiff's recovery is not limited to disgorgement or other remedies that may be traced directly to the breach.³⁸⁹⁶³⁸⁹⁶ See, e.g., Cinerama, Inc. v. Technicolor, Inc., 663 A.2d 1156, 1166 (Del. 1995) (citations omitted) ("[T]he measure of damages for any breach of fiduciary duty, under an entire fairness standard of review, is 'not necessarily limited to the difference between the price offered and the 'true' value as determined under the appraisal proceedings.' . . . [T]he [Court of Chancery] 'may fashion any form of equitable and monetary relief as may be appropriate, including rescissory damages.'"); Weinberger v. UOP, Inc., 457 A.2d 701, 714 (Del. 1983) ("Under such circumstances [involving a breach of fiduciary duty], the [court's] powers are complete to fashion any form of equitable and monetary relief as may be appropriate, including rescissory damages."); Harman v. Masoneilan Int'l, Inc., 442 A.2d 487, 500 (Del. 1982) ("[T]he relief available in equity for tortious conduct by one standing in a fiduciary relation with another is necessarily broad and flexible.").Show full note Indeed, Delaware courts have wide latitude to craft damage remedies to compensate a party with respect to whom a defendant breached a fiduciary duty.³⁸⁹⁷³⁸⁹⁷ See Weinberger v UOP, Inc., 457 A.2d 701, 714 (Del. 1983) ("[T]he Chancellor's powers are complete to fashion any form of equitable and monetary relief as may be appropriate, including rescissory damages."). Another remedy that may be available to a party asserting a breach of fiduciary duty would be compensatory damages, which would attempt to rectify any financial harm caused to the beneficiary by a fiduciary's breach of his duties.³⁸⁹⁸³⁸⁹⁸ See, e.g., Noerr v. Greenwood, No. 14320‐NC, 2002 WL 31720734, at *5 (Del. Ch. Nov. 22, 2002) (granting class certification to a claim requesting primarily compensatory damages based on a breach of fiduciary duty); Painewebber R & D Partners II, L.P. v. Centocor, Inc., No. 14405, 1999 WL 160123, at *15 (Del. Ch. Mar. 15, 1999) (approving settlement agreement including compensatory damages for alleged breaches of fiduciary duty); see also Thorpe, 676 A.2d at 445 (holding that Delaware case law did not only require that the defendant not profit from disloyal conduct but that the beneficiary of the duty also suffer harm as a result of the breach and, therefore, damages could be appropriate if proven); cf. In re JP Morgan Chase & Co. S'Holder Litig., 906 A.2d 766, 772 (Del. 2006) (denying plaintiff's claim for compensatory damages not because compensatory damages were inapplicable to a claim for breach of fiduciary duty but because the requested damages could not be connected to the alleged breach).Show full note The Restatement of Torts supports the contention that, in the case of a breach of fiduciary duty, compensatory damages may be awarded.³⁸⁹⁹³⁸⁹⁹ RESTATEMENT (SECOND) OF TORTS § 874 cmt. b (1979) ("The remedy of a beneficiary against a defaulting or negligent trustee is ordinarily in equity; the remedy of a principal against an agent is ordinarily at law. However, irrespective of this, the beneficiary is entitled to tort damages for harm caused by the breach of duty arising from the relation. . . ."). A party seeking compensatory damages would have to prove damages and causation in order to be successful.³⁹⁰⁰³⁹⁰⁰ See LNC Invs., Inc. v. First Fidelity Bank, N.A., N.J., 173 F.3d 454, 465 (2d Cir. 1999) ("[W]here damages are sought for breach of fiduciary duty under New York law, the plaintiff must demonstrate that the defendantʹs conduct proximately caused injury in order to establish liability."); Am. Fed. Group, Ltd v. Rothenberg, 136 F.3d 897, 908 n.7 (2d Cir. 1998) (stating that in breach of fiduciary duty cases where the remedy sought is damages to compensate for loss, the usual damages‐causation rule for tort cases applies).Show full note

1027

¶In the event that Lehman is eventually subject to liability as a consequence of the actions of one or more of its officers, those officers may be liable to Lehman accordingly.

Malpractice Claims Against Ernst & Young

¶The Examiner concludes that sufficient evidence exists to support colorable claims against Ernst & Young LLP ("Ernst & Young") for professional malpractice arising from Ernst & Young's failure to follow professional standards of care with respect to communications with Lehman's Audit Committee, investigation of a whistleblower claim, and audits and reviews of Lehman's public filings.³⁹⁰¹³⁹⁰¹ The Examiner consulted with an industry expert, Gary L. Holstrum, PhD, CPA, to assist in the analysis of professional auditing standards. Dr. Holstrum earned a PhD in accounting from the University of Iowa's School of Business. He recently served as an Associate Chief Auditor and Director of Research, and has been a consultant to the Office of Chief Auditor, at the Public Company Accounting Oversight Board. He has been a professor of accountancy at several universities, including the University of Southern California, the University of Texas at Austin, the University of Florida, and the University of South Florida. In 2009, Dr. Holstrum received the Distinguished Service in Auditing Award from the Auditing Section of the American Accounting Association. Dr. Holstrum's experience, including publications and service on the Auditing Standards Board, is more fully described in his resume, Appendix 17, Repo 105 Appendix. Dr. Holstrum concurs with the findings in this Section of the Report, and in his opinion, a valid claim for professional malpractice can be raised on these facts. The Examiner met with counsel for Ernst & Young to discuss the colorable claims identified in this Section, and counsel presented several arguments as to why Ernst & Young did not commit malpractice. Following that presentation, the Examiner discussed Ernst & Young's presentations with Dr. Holstrum, and Dr. Holstrum's opinion as to the existence of colorable claims did not change.Show full note

1028

Background and Legal Standards

Professional Standards

¶One of the primary responsibilities of an external auditor is to express an opinion whether the company's financial statements are presented fairly, in all material respects, in accordance with Generally Accepted Accounting Principles ("GAAP"). Professional standards have been established to ensure that external auditors fulfill their obligations when auditing and reviewing financial statements and other information contained in SEC filings. Those standards are known as generally accepted auditing standards, or "GAAS." GAAS consists of authoritative standards, originally established by the American Institute of Certified Public Accountants ("AICPA"), which auditors must comply with when they conduct audits and reviews.

¶The Sarbanes‐Oxley Act of 2002 authorized the Public Accounting Oversight Board ("PCAOB") to establish auditing and related professional practice standards to be used by registered public accounting firms.³⁹⁰²³⁹⁰² See Pub. L. No. 107‐204, § 103(a)‐(d), 2002 U.S.C.C.A.N. (116 Stat), 745, 755‐57 (codified at 15 U.S.C. § 73213 (2006)). PCAOB Rule 3100, Compliance with Auditing and Related Professional Practice Standards, issued by the PCAOB and approved by the SEC, requires registered public accounting firms to comply with all applicable auditing and related professional practice standards of the PCAOB in their engagements relating to documents filed with the SEC, including audits of annual financial statements and reviews of interim financial information of public companies.³⁹⁰³³⁹⁰³ See Order Approving Proposed Rule Relating to Compliance with Auditing and Related Professional Practice Standards, Exchange Act Release No. 48,730, 81 SEC Docket 1509 (Oct. 31, 2003). The PCAOB adopted as interim auditing standards the generally accepted auditing standards described in the AICPA's Auditing Standards Board ("ASB") Statement on Auditing Standards No. 95, Generally Accepted Auditing Standards, in existence on April 16, 2003.³⁹⁰⁴³⁹⁰⁴ See Order Regarding Section 103(A)(3)(B) of the Sarbanes‐Oxley Act of 2002, Securities Act Release No. 8222, Exchange Act Release No. 47,745, 80 SEC Docket 142 (Apr. 25, 2003). Ernst & Young is registered with and regulated by the PCAOB, and Ernst & Young's audits and reviews for public companies such as Lehman are subject to the PCAOB's auditing standards. The PCAOB Auditing Standards, which are applicable to the Ernst & Young annual audit and interim review engagements of Lehman during the periods addressed in this Report, are shown in the "Standards" section of the PCAOB web site (www.pcaob.org). The PCAOB adopted as its "Interim Auditing Standards" only those SASs issued by the ASB that were issued before April 16, 2003. After that date, the PCAOB issued its own additional Auditing Standards and revisions of the Interim Auditing Standards as it deemed appropriate, subject to its due process requirements, including approval by the SEC. Any SAS issued by the ASB after April 16, 2003 (essentially after SAS No. 101) did not and does not become a PCAOB Auditing Standard, applicable to audits of public companies (and, consequently, is not shown on the PCAOB web site).Show full note

1029

¶GAAS consists of ten standards (three general standards, three fieldwork standards, and four reporting standards) that are further interpreted and defined in "Statements on Auditing Standards" or "SASs" which are referred to by reference to "AU" sections.³⁹⁰⁵³⁹⁰⁵ CODIFICATION OF ACCOUNTING STANDARDS AND PROCEDURES, Statement on Auditing Standards No. 95, AU § 150.02 (Am. Inst. of Certified Pub. Accountants 2002). The AU standards adopted by the PCAOB are available at http://www.pcaobus.org/Standards/Interim_Standards/Auditing_Standards/ index.aspx. They are referenced by the applicable section and paragraph number for the remainder of this Section of the Report.Show full note Among the ten auditing standards are the following:

● Due professional care is to be exercised in the performance of the audit and the preparation of the report.

1030

● A sufficient understanding of internal control is to be obtained to plan the audit and to determine the nature, timing, and extent of tests to be performed.

● Sufficient competent evidential matter is to be obtained through inspection, observation, inquiries, and confirmations to afford a reasonable basis for an opinion regarding the financial statements under audit.

● The auditor's report must state whether the financial statements are presented in accordance with GAAP.

● Informative disclosures in the financial statements are to be regarded as reasonably adequate unless otherwise stated in the report.

● The report shall contain either an expression of opinion regarding the financial statements, taken as a whole, or an assertion to the effect that an opinion cannot be expressed. When an overall opinion cannot be expressed, the reasons therefore should be stated.

¶See AU § 150.02.

¶The objective of an auditor's "review" of quarterly financial information is to provide a basis for reporting whether the reviewer is aware of material modifications that should be made to the information to conform with GAAP. See AU § 722.07. A review includes obtaining sufficient knowledge of the entity's business and its internal control as it relates to the preparation of both annual and interim financial information to: (1) identify the types of potential material misstatements in the interim financial information and consider the likelihood of their occurrence; and (2) select the inquiries and analytical procedures that will provide the accountant with a basis for communicating whether he or she is aware of any material modifications that should be made to the interim financial information for it to conform with GAAP. See AU § 722.09. In the course of reviewing interim financial information, auditors are required to make inquiries of members of management who have responsibility for financial and accounting matters concerning, among other things, significant transactions occurring or recognized in the last several days of the interim period. See AU § 722.18(c).

1031

Common Law Standards

¶To state a claim of auditor malpractice under New York law,³⁹⁰⁶³⁹⁰⁶ Lehman's engagement letter with Ernst & Young does not contain a choice‐of‐law provision, but New York law would likely apply to a malpractice action given that Lehman was headquartered in New York and most of Ernst & Young's audit work was centered in New York. See AIG v. Greenberg, 965 A.2d 763, 817‐22 (Del. Ch. 2009) (New York law governed malpractice and breach of contract claims against auditor where auditing work was performed primarily in New York and audited client was headquartered in New York). The engagement letter for the 2007 audit contains a mandatory arbitration clause, see Letter from Ernst & Young to Christopher M. O'Meara, Lehman, re: 2007 audit services (May 15, 2007), at ¶ 33 [EY‐LE‐KEYPERS 2641786] ("Engagement Letter (May 15, 2007)"), and such clauses are generally adhered to in bankruptcy proceedings in this jurisdiction. See In re Refco, Inc. Sec. Litig., Nos. 07 MDL 1992(GEL), 07 Civ. 11604(GEL), 2008 WL 2185676, at *5 (S.D.N.Y. May 21, 2008) (holding that the trustee was bound by arbitration clause in engagement letters between debtor and auditing firm); In re Hagerstown Fiber Ltd. P'Ship, 277 B.R. 181, 206 (Bankr. S.D.N.Y. 2002) ("If the debtor agreed in a pre‐ petition contract to arbitrate a dispute, the trustee, suing as successor to the debtor, is likewise bound by the arbitration clause."). Lehman and Ernst & Young had not yet signed the 2008 engagement letter, but the 2007 engagement letter states that Ernst & Young will continue to provide audit services in later years pursuant to the terms of the 2007 agreement unless terminated by Lehman or Ernst & Young. Engagement Letter (May 15, 2007) at ¶ 9 [EY‐LE‐KEYPERS 2641786].Show full note a client must allege the existence of a duty, a breach of that duty, proximate causation, and damages.³⁹⁰⁷³⁹⁰⁷ See VTech Holdings, Ltd. v. Pricewaterhouse Coopers, LLP, 348 F. Supp 2d 255, 262 (S.D.N.Y. 2004). Generally, breaches of duty are demonstrated by a showing that the auditor departed from accepted standards of practice and that this departure was the proximate cause of plaintiff's injury.³⁹⁰⁸³⁹⁰⁸ Id.; Hous. Works, Inc. v. Turner, 179 F. Supp 2d 177, 215 (S.D.N.Y. 2001). In determining whether an auditor has deviated from accepted standards, courts and tribunals routinely look to the recognized and accepted professional standards for accountants and auditors, generally measured by GAAP and GAAS.³⁹⁰⁹³⁹⁰⁹ See, e.g., Cumis Ins. Soc'y Inc. v. Tooke, 739 N.Y.S.2d 489, 493 (App. Div. 2002). As discussed in Section III.A.4.j.5.a.i of the Examiner's Report, the PCAOB standards incorporate GAAS and must be followed for all audits and reviews of public companies by public accounting firms, which in turn must be registered with the PCAOB.

1032

There Is Sufficient Evidence to Support a Colorable Claim That Ernst & Young Was Negligent

¶The Examiner finds that sufficient evidence exists to support at least three colorable claims that could be asserted against Ernst & Young relating to Lehman's Repo 105 activities and reporting: (1) negligence in connection with the investigation into whistleblower Matthew Lee's claims concerning $50 billion in Repo 105 activities at the end of the second quarter 2008, including failing to conduct an adequate inquiry into the allegations prior to the filing of Lehman's Form 10‐Q, and failing to properly inform management and the Audit Committee of Lee's allegations; (2) at least with respect to Lehman's first quarter and second quarter 2008 Forms 10‐Q, if not with respect to earlier filings, negligence by failing to take proper action when Ernst & Young was made aware that the financial information may be materially misleading because of the failure to disclose the effect of the timing and volume of Lehman's Repo 105 activities (which had a material effect on interim financial statement items), and failing to take proper action with respect to materially misleading statements contained in the MD&A sections of the Forms 10‐Q for these quarters; and (3) at least with respect to Lehman's 2007 Form 10‐K, if not with respect to earlier Forms 10‐K, negligence by failing to take proper action when Ernst & Young was made aware that the financial statements may be materially misleading because of the failure to disclose the effect of the timing and volume of Lehman's Repo 105 activities (which had a material effect on financial statement items), and failing to take proper action with respect to materially misleading statements contained in the MD&A sections of the Form 10‐K.³⁹¹⁰³⁹¹⁰ Professional negligence claims may also be presented as breach‐of‐contract claims, although a similar liability standard would be applied under either cause of action. In addition, if Lehman were subject to a securities fraud claim and sought to allocate fault to Ernst & Young, Lehman would likely need to demonstrate scienter on the part of Ernst & Young, rather than mere negligence. Rothman v. Gregor, 220 F.3d 81, 98 (2d Cir. 2000) (securities fraud complaint alleged accounting firm had violated various GAAP provisions; those allegations, without corresponding fraudulent intent, were insufficient to state claim); Decker v. Massey‐Ferguson, Ltd., 681 F.2d 111, 120‐21 (2d Cir. 1982) (assuming accountantʹs recklessness could satisfy scienter requirement of securities fraud action, such recklessness must be conduct that is ʺhighly unreasonableʺ and represents ʺan extreme departure from the standards of ordinary careʺ). The Examiner has not analyzed whether any of the actions or inaction of Ernst & Young could amount to recklessness sufficient to satisfy the more demanding standard of scienter.Show full note

1033

Malpractice in Failure to Advise Audit Committee of Repo 105 Activity and Lee's Allegations

¶The Examiner concludes that sufficient evidence exists to support a colorable claim for malpractice³⁹¹¹³⁹¹¹ Based on these facts, the Examiner also considered whether there also is a colorable claim against Ernst & Young for aiding and abetting breaches of fiduciary duty. The Examiner concluded that there is not sufficient, credible evidence identified at this time to support a claim. That said, however, with further discovery, such a claim may be uncovered. against Ernst & Young arising from Ernst & Young's failure to apprise the Audit Committee of Matthew Lee's allegations relating to Lehman's extensive quarter‐end Repo 105 activity:

1034

● In May/June 2008, the Chairman of the Audit Committee and internal audit requested that Ernst & Young assist with the investigation into allegations made by Lee in a May 16, 2008 letter.³⁹¹²³⁹¹² Examiner's Interview of Thomas Cruikshank, Oct. 8, 2009, at p. 7; Examiner's Interview of Thomas Cruikshank, Jan. 20, 2010, at p. 3; Examiner's Interview of Roger Berlind, Dec. 18, 2009, at p. 3; Examiner's Interview of Michael L. Ainslie, Dec. 22, 2009, at p. 2; Examiner's Interview of Sir Christopher Gent, Jan. 20, 2010, at p. 2; Examiner's Interview of Beth Rudofker, Dec. 15, 2009, at p. 5.

● Lee's letter alleged a number of possible accounting irregularities, including balance sheet substantiation discrepancies, valuation issues, and the lack of competence and independence of Lehman's internal audit department.³⁹¹³³⁹¹³ Letter from Matthew Lee, Lehman, to Martin Kelly, Lehman, et al. (May 16, 2008) [EY‐LE‐LBHI‐ KEYPERS 5826885]. Lee's letter contained the following six allegations: (1) on the last day of each month, Lehman's books and records contained approximately $5 billion of net assets in excess of what was managed on the last day of the month, thereby suggesting that the firm's senior management was not in control of its assets to be able to present full, fair, and accurate financial statements to the public; (2) Lehman had "tens of billions of dollars of unsubstantiated balances, which may or may not be 'bad' or non‐performing assets or real liabilities"; (3) Lehman had tens of billions of dollars of illiquid inventory and did not value its inventory in a "fully realistic or reasonable" way; (4) given Lehman's rapid growth and increased number of accounts and entities, it had not invested sufficiently in financial systems and personnel to cope with the balance sheet; (5) the India Finance office lacked sufficient knowledgeable management, resulting in the real possibility of potential misstatements of material facts being distributed by that office; and (6) certain senior level internal audit personnel were not qualified to "properly exercise the audit functions they are entrusted to manage."Show full note Lee's letter did not mention Repo 105 transactions.

● As part of the investigation, William Schlich (Ernst & Young Audit Partner) and Hillary Hansen (another Ernst & Young partner) met with Lee on June 12, 2008, and during that meeting, Lee raised an additional allegation not contained in his letter; specifically, he advised Schlich and Hansen that at the end of the second quarter 2008, Lehman moved $50 billion in assets off its balance sheet using Repo 105 transactions, only to move those assets back onto the balance sheet a few days later.³⁹¹⁴³⁹¹⁴ Examiner's Interview of Ernst & Young, Nov. 3, 2009, at p. 14 (statement of Hillary Hansen); Examiner's Interview of Matthew Lee, July 1 and July 10, 2009, at p. 17; see also Hillary Hansen, Ernst & Young, Notes from meeting with Matthew Lee, June 12, 2009, at p. 1 [EY‐LE‐LBHI‐KEYPERS 5826869]. Although Schlich stated that he had no recollection of Lee's Repo 105 assertions, those assertions were prominent in Hansen's contemporaneous notes of the meeting with Lee and

1035

Schlich, and Hansen specifically recalled conferring with Schlich about Lee's Repo 105 allegations.³⁹¹⁵³⁹¹⁵ Examiner's Interview of Ernst & Young, Nov. 3, 2009 at p. 14 (statement of Hillary Hansen); Id. at p. 16 (statement of William Schlich); Examiner's Interview of Ernst & Young, Oct. 9, 2009, at p. 5 (statement of William Schlich).

● The next day – on June 13, 2008 – Schlich met with the Audit Committee and participated in an update to the committee on the Lee investigation.³⁹¹⁶³⁹¹⁶ Examinerʹs Interview of Roger Berlind, Dec. 18, 2009, at p. 4; Examinerʹs Interview of Michael L. Ainslie, Dec. 22, 2009, at p. 2; Examiner's Interview of Sir Christopher Gent, Jan. 20, 2010, at p. 2.; see also Lehman Brothers Holdings Inc., Minutes of Meeting of Audit Committee (June 13, 2008) [LBEX‐AM 003759]. Schlich did not inform the Audit Committee about the Repo 105 claims made by Lee, even though the Audit Committee asked to be told about each allegation.³⁹¹⁷³⁹¹⁷ Examinerʹs Interview of Roger Berlind, Dec. 18, 2009, at pp. 2, 4; Examinerʹs Interview of Michael L. Ainslie, Dec. 22, 2009, at pp. 2, 3; Examiner's Interview of Sir Christopher Gent, Jan. 20, 2010, at p. 2; Examiner's Interview of Thomas Cruikshank, Jan. 20, 2010, at p. 3; Examinerʹs Interview of Beth Rudofker, Dec. 15, 2009, at p. 7; see also Lehman Brothers Holdings Inc., Minutes of Meeting of Audit Committee (June 13, 2008) [LBEX‐AM 003759].Show full note

● On July 8, 2008, the Audit Committee met with Schlich, Kelly, Lowitt, and Beth Rudofker to review the second quarter MD&A and financial statements.³⁹¹⁸³⁹¹⁸ Lehman Brothers Holdings Inc., Minutes of Meeting of Audit Committee (July 8, 2008) at p. 2 [LBEX‐ AM 003831]. At that meeting, Schlich did not raise any issues concerning the adequacy of the disclosures or financial statements, and stated that Ernst & Young would issue an unqualified review report.³⁹¹⁹³⁹¹⁹ Id.

● On July 10, 2008, Ernst & Young issued an unqualified review report in connection with the issuance of Lehman's Form 10‐Q.³⁹²⁰³⁹²⁰ LBHI 10‐Q (filed July 10, 2008), at p. 53.

● On July 22, 2008, Schlich again remained silent as to Lee's Repo 105 allegation at an Audit Committee meeting, where internal audit presented the results of the investigation into each of the claims made by Lee in his May 16, 2008 letter to management.³⁹²¹³⁹²¹ Employee Letter Review, Presentation to the Audit Committee (July 22, 2008) [LBEX‐AM 067664]; Examiner's Interview of Thomas Cruikshank, Jan. 20, 2010, at pp. 2, 3; Examiner's Interview of Michael L. Ainslie, Dec. 22, 2009, at p. 3; Examiner's Interview of Roger Berlind, Dec. 18, 2009, at pp. 3‐4; Examiner's Interview of Sir Christopher Gent, Jan. 20, 2010, at pp. 2‐3; Examiner's Interview of Beth Rudofker, Dec. 15, 2009, at p. 7.Show full note At that meeting, the Audit Committee was told that "[c]orporate audit has largely completed an evaluation of [Lee's] observations in partnership with Financial Control and Ernst and Young."³⁹²²³⁹²² Employee Letter Review, Presentation to the Audit Committee (July 22, 2008), at p. 2 [LBEX‐AM 067664]; see also Lehman Brothers Holdings Inc., Minutes of Meeting of Audit Committee (July 22, 2008), at pp. 4‐5 [LBEX‐AM 003861].

1036

¶There is sufficient evidence to support a colorable claim that Ernst & Young failed to exercise due professional care by failing to notify the Audit Committee of Lee's allegations about end‐of‐quarter Repo 105 transactions as a means to manipulate publicly reported balance sheet reductions.³⁹²³³⁹²³ On two occasions during the course of the examination, the Examiner offered Ernst & Young the opportunity to provide the Examiner with a presentation, narrative, or explanation regarding the business purpose of Lehman's Repo 105 transactions. Ernst & Young declined that invitation. See, e.g., AU § 316.79 ("Whenever the auditor has determined that there is evidence that fraud may exist, that matter should be brought to the attention of an appropriate level of management. This is appropriate even if the matter might be considered inconsequential, . . . Fraud involving senior management and fraud . . . that causes a material misstatement of the financial statements should be reported directly to the audit committee"); AU § 317 (if auditor becomes aware of possible violations of laws or regulations which may have a direct or indirect effect on the financial statements, he or she must make inquiries, perform additional tests, and inform management and the audit committee of the issue).³⁹²⁴³⁹²⁴ See also In re Allou Distribs., Inc., 395 B.R. 246, 272‐73 (Bankr. E.D.N.Y. 2008) (finding that plaintiff sufficiently pled that auditing firm committed malpractice by failing to report suspicious circumstances and material discrepancies to the audit committee); Springer, Exchange Act Release No. 44858, 75 S.E.C. Docket 2095 (Sept. 27, 2001) (finding, in addition to other auditing violations, that an accountant had violated Section 10A of the Securities Exchange Act and engaged in professional misconduct by failing toShow full note

1037

¶Moreover, in addition to its duty to report a determination that there is evidence that fraud "may" have occurred, Ernst & Young was required to discuss with the Audit Committee the quality of Lehman's accounting principles as applied to financial reporting, see AU § 380.11, which would include moving $30‐$50 billion temporarily off the balance sheet at quarter‐end through overseas "true sale" legal opinions that could not be obtained in the United States. Indeed, AU Section 380.11 states that auditors should discuss accounting policies, unusual transactions, the clarity and completeness of the financial statements, and unusual transactions with the audit committee. Specifically, that standard states that an auditor:

¶notify the client's audit committee that he had detected information indicating that the client had reported $1.3 million in false revenues in its quarterly report). Section 10A(b) of the Securities Exchange Act of 1934, 15 US.C. § 78j‐1(b), provides that:

If, in the course of conducting an audit pursuant to this title to which subsection (a) applies, the registered public accounting firm detects or otherwise becomes aware of information indicating that an illegal act (whether or not perceived to have a material effect on the financial statements of the issuer) has or may have occurred, the firm shall, in accordance with generally accepted auditing standards, as may be modified or supplemented from time to time by the Commission— (A) (i) determine whether it is likely that an illegal act has occurred; and (ii) if so, determine and consider the possible effect of the illegal act on the financial statements of the issuer, including any contingent monetary effects, such as fines, penalties, and damages; and (B) as soon as practicable, inform the appropriate level of the management of the issuer and assure that the audit committee of the issuer, or the board of directors of the issuer in the absence of such a committee, is adequately informed with respect to illegal acts that have been detected or have otherwise come to the attention of such firm in the course of the audit, unless the illegal act is clearly inconsequential.

1038

should discuss with the audit committee the auditorʹs judgments about the quality, not just the acceptability, of the entityʹs accounting principles as applied in its financial reporting. . . The discussion . . . should include such matters as the consistency of the entityʹs accounting policies and their application, and the clarity and completeness of the entityʹs financial statements, which include related disclosures. The discussion should also include items that have a significant impact on the representational faithfulness, verifiability, and neutrality of the accounting information included in the financial statements. Examples of items that may have such an impact are the following:

¶‐ Selection of new or changes to accounting policies

¶‐ Estimates, judgments, and uncertainties

¶‐ Unusual transactions

‐ Accounting policies relating to significant financial statement items, including the timing of transactions and the period in which they are recorded.

¶See AU § 380.11. Contrary to that standard, Ernst & Young never communicated anything about the Repo 105 transactions to Lehman's Audit Committee members – let alone discuss the substantial and increasing volumes at quarter end.³⁹²⁵³⁹²⁵ Examiner'sInterview of Thomas Cruikshank, Jan. 20, 2010, at pp. 1‐2.; Examiner's Interview of Michael L. Ainslie, Dec. 22, 2009, at p. 3; Examiner's Interview of Roger Berlind, Dec. 18, 2009, at pp. 3, 4; Examiner's Interview of Sir Christopher Gent, Jan. 20, 2010, at pp. 3, 4; see also Lehman Brothers Holdings Inc., Minutes of Meeting of Audit Committee (June 13, 2008) [LBEX‐AM 003759]; Lehman Brothers Holdings Inc., Minutes of Meeting of Audit Committee (July 8, 2008) [LBEX‐AM 003831]; Lehman Brothers Holdings Inc., Minutes of Meeting of Audit Committee (July 22, 2008) [LBEX‐AM 003861]. The Examiner reviewed Ernst & Young's work papers for the 2007 year‐end audit and 2008 quarterly reviews and found no reference to any communication with the Audit Committee about Repo 105. The Examiner also reviewed relevant documents, dated from January 1, 2007 through September 15, 2008, from the e‐ mail accounts and desk files of 43 mid‐to‐senior‐level auditors at Ernst & Young, and uncovered no communications with or references to communications with Lehman's Audit Committee regarding Repo 105. Ernst & Young does not dispute the fact that it did not discuss Lee's Repo 105 allegations with the Audit Committee.Show full note

1039

¶The Examiner therefore concludes that Ernst & Young's failure to discuss these matters with the Audit Committee gives rise to a colorable claim of malpractice, particularly in light of: (1) the failure to disclose in public filings the use of Repo 105 transactions to reduce the balance sheet items that were used to calculate Lehman's net leverage ratio; (2) the impact of the Repo 105 transactions on Lehman's net leverage ratio;3926 (3) Lehman's emphasis to the public of the importance of its net leverage ratio; (4) the sheer size and timing of the end‐of‐quarter activity that Lee highlighted to Ernst & Young ($50 billion); and (5) the Audit Committee's explicit request to be apprised of all of Lee's allegations.

¶3926 GAAS requires an auditor to understand its client's business, and therefore, Ernst & Young had a duty to understand the importance of net leverage ratios to Lehman and the investing public. See AU § 722.10 (auditor/reviewer has responsibility of becoming sufficiently knowledgeable about client's business to allow auditor to identify the types of potential material misstatements and to select inquiries and analytical procedures that will provide the auditor with a basis for communicating whether he or she is aware of any material modifications that should be made for such financial information to conform with GAAP). Here there is no question that Ernst & Young had a full understanding of the net leverage ratio. Ernst & Young's documents contain calculations of materiality with respect to net leverage ratios, and Ernst & Young reviewed financial statements and other public disclosures emphasizing the importance of the ratio. See, e.g., Ernst & Young, LBHI/LBI Walkthrough Template for Balance Sheet Close Process (Nov. 30, 2007) at p. 14 [EY‐LE‐LBHI‐CORP‐GAMX‐07‐033384] (stating that, with respect to reopening a closed balance sheet, "[m]ateriality is usually defined as any item individually, or in the aggregate, that moves net leverage by 0.1 or more (typically $1.8 billion)" and that "[n]et leverage is an important ratio analyzed by the rating agencies and included in Lehman's earnings release"); e‐mail from William Schlich, Ernst & Young, to Carmine DiSibio, Ernst & Young, et al. (June 5, 2008) [EY‐LE‐LBHI‐ KEYPERS 0853883] (noting that Lehman's game plan for combating the release of its second quarter loss is to emphasize its capital raise and "significant de‐levering of the balance sheet"); e‐mail from William Schlich, Ernst & Young, to Ryan Traversari, Lehman, et al. (June 14, 2008) [LBEX‐DOCID 2374461] (providing Schlich's comments on the attached draft version of the second quarter 2008 preliminary earnings call speech); Transcript of Lehman Brothers Holdings Inc. Second Quarter 2008 Preliminary Earnings Call [Draft] (June 16, 2008), at p. 15 [LBEX‐DOCID 2046258] (noting that "deleveraging and de‐ risking the balance sheet was an important goal this quarter" and that net leverage as of May 31 had been reduced from 15.4x to 12.0x).

1040

Lehman's 2008 Forms 10‐Q

¶The Examiner also finds that sufficient evidence exists to support colorable claims for malpractice against Ernst & Young arising from Ernst & Young's review of Lehman's first and second quarter Form 10‐Q financial statements and MD&A sections.³⁹²⁷³⁹²⁷ For purposes of this analysis, the Examiner does not reach the issue of whether the treatment of the Repo 105 transactions as sales under SFAS 140 is proper. However, as discussed in Section III.A.4.j.2, there is sufficient evidence to support a determination by the trier of fact that the notes to the financial statements and other written disclosures presented a misleading picture of Lehman's financial condition by failing to disclose the effect of the volume and timing of Lehman's Repo 105 activity.Show full note

¶Sufficient evidence exists to support a finding that the financial statements in both quarters of 2008 were misleading because: (1) the notes stated that Lehman treated repos as collateralized agreements and financings, as opposed to disclosing that a significant volume of repo transactions were treated as sales (and thus were "off balance sheet"); and (2) the notes referred to the transfer of certain financial assets as sales pursuant to SFAS 140, but only with respect to securitization activities, without anywhere disclosing Lehman's Repo 105 activity.³⁹²⁸³⁹²⁸ See Section III.A.4.j.2.c.ii of the Examiner's Report.

¶Although a review of interim financial statements is "substantially less in scope than an audit," see AU § 722.09, the SEC requires a registrant such as Lehman to engage an independent accountant to review its interim financial information before the registrant files its Form 10‐Q.³⁹²⁹³⁹²⁹ See Rule 10‐01(d) of Regulation S‐X, 17 C.F.R. § 210.10‐01(d) (2009). The SEC further requires that an accountant's review report be filed with the interim financial information if the entity states that the interim financial information has been reviewed by an independent public accountant.³⁹³⁰³⁹³⁰ Id. Ernst & Young filed such review reports in connection with both of Lehman's Forms 10‐Q in 2008.³⁹³¹³⁹³¹ See LBHI 10‐Q (filed April 9, 2008), at 42; LBHI 10‐Q (filed July 10, 2008), at 53.

1041

¶An auditor can, of course, be liable for violating professional standards in connection with the preparation of interim financial reports.³⁹³²³⁹³² See, e.g., William Iselin & Co., Inc. v. Landau, 522 N.E.2d 21, 23 (N.Y. 1988) (regardless of whether the activity is characterized as an "audit" or a "review," the accountant owes the party contracting for the services a duty to exercise due care in the performance of professional accounting services); Collins v. Esserman & Pelter, 681 N.Y.S.2d 399, 401 (App. Div. 1998) ("Even with respect to a review . . . the accountant is obligated to exercise due care in the performance of the engagement."); Kantor, Geisler & Oppenheimer, P.A., PCAOB Release No. 105‐2007‐009 (Dec. 14, 2007) (finding that accounting firm violated Section 10A(b) of the Exchange Act and PCAOB standards in quarterly review when, upon learning information indicating that an illegal act may have occurred, the firm failed to address appropriately the threshold question of whether it was likely that an illegal act had occurred).Show full note Auditing and related professional practice standards applicable to the Examiner's finding of a colorable claim against Ernst & Young in the context of Ernst & Young's 2008 quarterly reviews of the notes to Lehman's quarterly financial statements include:

● AU Section 722.41‐43 applies in situations where the auditor is aware that the interim financials contain inadequate disclosures or do not conform to GAAP in other ways. In those instances, the auditor should issue a modified review report that describes the inadequacies or non‐GAAP compliant matters. The auditing standards define conformance with GAAP to mean not only that the accounting principles applied have general acceptance, but also to mean that the "financial statements, including the related notes, are informative of matters that may affect their use, understanding, and interpretation." See AU § 411.04 (addressing the meaning of "present fairly in conformity with [GAAP]").³⁹³³³⁹³³ See also AU § 431.02 (under GAAP, financial statements should contain "adequate disclosure of material matters. . . [regarding] form, arrangement, and content of the financial statements and their appended notes, including, for example, the terminology used, the amount of detail given, the

1042

● AU Section 722.07 relating to "Interim Financial Information" states that the objective of a review of interim financials is to provide the accountant with a basis for communicating whether the accountant is aware of any material modifications that should be made to the interim financial information for it to conform with GAAP.

● AU Section 722.07 states that an interim review typically does not require the auditor to perform tests of or obtain evidence that corroborates the financial information, but that the review instead principally consists of performing analytical procedures and making inquiries of persons responsible for accounting and financial matters.³⁹³⁴³⁹³⁴ Note that the standard goes on to require that when the reviewer becomes aware that the interim financial information may not be in conformity with GAAP in all material respects (which includes adequacy of disclosure), the reviewer is required to make additional inquiries and perform other procedures to corroborate the financial information. See AU § 722.22, infra.

● AU Section 722.10 charges the auditor with the responsibility of becoming sufficiently knowledgeable about the entity's business to allow the auditor to identify the types of potential material misstatements and to select the inquiries and analytical procedures that will provide the accountant with a basis for communicating whether he or she is aware of any material modifications that should be made to the interim financial information for it to conform with GAAP.

● AU Section 722.18(c) provides that an auditor engaged in an interim review should inquire of management about significant transactions occurring or recognized in the last several days of the interim period.

● AU Section 722.18(c) states that an auditor engaged in an interim review should inquire of management about allegations of fraud or suspected fraud affecting the entity, for example, received in communications from employees, former employees, analysts, regulators, short sellers, or others.

● AU Section 722.18(c) provides that an auditor engaged in an interim review should inquire of management about unusual or complex situations that may have an effect on the interim financial information.

¶classification of items in the statements, and the bases of amounts set forth. An independent auditor considers whether a particular matter should be disclosed in light of the circumstances and facts of which he is aware at the time").

1043

¶● AU Section 722.22 specifies that if a reviewer of interim financial information becomes aware of information leading the reviewer to believe that the interim financial information may not be in conformity with GAAP in all material respects, the reviewer should make additional inquiries and perform other procedures that the reviewer considers appropriate to provide a basis for communicating whether the reviewer is aware of any material modifications that should be made to the interim financial information. The standards set forth the following example: "[I]f the accountant's interim review procedures lead him or her to question whether a significant sales transaction is recorded in conformity with [GAAP], the accountant should perform additional procedures, such as discussing the terms of the transaction with senior marketing and accounting personnel, reading the sales contract, or both, to resolve his or her questions." ● AU Section 722.26 states that if an "inadequate disclosure" is brought to the auditor's attention during an interim review, the auditor should evaluate matters such as the nature, cause, amount, and materiality of the "likely misstatement." Footnote 18 of AU Section 722.26 reminds the reviewer of the requirements concerning adequacy of disclosure that are contained in Rule

¶10‐01 of Regulation S‐X, including that "[t]he interim financial information shall include disclosures either on the face of the financial statements or in accompanying footnotes sufficient so as to make the interim information presented not misleading. . . ." ● AU Section 722.28 provides that a reviewer should not issue a review report if the reviewer has not completed the necessary review procedures or if the client does not provide the reviewer with the written representations the reviewer believes are necessary to achieve the objective of an interim review. ● AU Section 722.28‐31 states that if the auditor performing the review becomes aware of matters that cause him or her to believe that material modifications should be made to make the interim information conform with

¶GAAP (which includes adequacy of disclosure) such matters should be communicated to management, and if management does not respond appropriately, then the auditor should inform the audit committee. If the audit committee does not respond appropriately, then the auditor should consider whether to resign from the review engagement and as the entity's auditor. ● AU Section 722.32 states that if the auditor becomes aware of information indicating that fraud or an illegal act has or may have occurred, the auditor

1044

must also determine his or her responsibilities under AU Section 316, Consideration of Fraud in a Financial Statement Audit, AU Section 317, Illegal Acts by Clients, and Section 10A of the Securities Exchange Act of 1934.

● AU Section 722.34 incorporates AU Section 380, which concerns communications with those charged with governance.³⁹³⁵³⁹³⁵ See Section III.A.4.j.5.b.i. of this Report, which discusses the requirements of AU Section 380.

● AU Section 722.36 provides that if the accountant has identified matters to be communicated to "those charged with governance," the accountant should attempt to make such communications to the audit committee, or at least to the chair of the audit committee, and a representative of management before the entity files its interim financial information with a regulatory agency.

¶These and other professional standards are also incorporated into Ernst & Young's engagement letter with Lehman:

"If we determine that there is evidence that fraud or possible illegal acts may have occurred, we will bring such matters to the attention of an appropriate level of management. If we become aware of fraud involving senior management or fraud (whether by senior management or other employees) that causes a material misstatement of the consolidated financial statements, we will report this matter directly to the Audit Committee. We will ensure that the Audit Committee is adequately informed of illegal acts that come to our attention unless they are clearly inconsequential. . . ."³⁹³⁶³⁹³⁶ Letter from Ernst & Young to Christopher M. O'Meara, Lehman, re: 2007 audit services (May 15, 2007), at ¶ 9 [EY‐LE‐KEYPERS 2641786] (emphasis added).

¶The Examiner concludes that sufficient evidence exists to support a colorable claim that Ernst & Young should have made appropriate inquiries of management and performed analytical procedures concerning significant transactions that occurred at the ends of the quarters in 2008 and analyzed their impact upon the financial statements, including the footnotes. Particularly after Lee alerted Ernst & Young to $50 billion in Repo 105 transactions prior to the filing of the second quarter Form 10‐Q, Ernst & Young should have reported to senior management and the Audit Committee that Lehman was using Repo 105 transactions to temporarily and artificially reduce balance sheet and its net leverage ratio for reporting purposes, without disclosing the practice to the public.³⁹³⁷³⁹³⁷ Before issuing its first and second quarter 2008 review reports, Ernst & Young obtained standard written representations from Lehman management stating that management was not aware of fraud or alleged fraud, and also disclosing transfers involving qualifying special purpose entities that were treated as sales under SFAS 140. See Letter from Richard S. Fuld, Jr., Lehman, et al. to Ernst & Young, re: Lehman Management Representations (Apr. 9, 2008), at pp. 2, 6‐7 [EY‐SEC‐LBHI‐GAMX‐1Q08 002679]; Letter from Richard S. Fuld, Jr., Lehman, et al. to Ernst & Young, re: Lehman Management Representations (July 9, 2008), at pp. 2, 6‐7 [EY‐SEC‐LBHI‐WP‐2Q 000277]. Ernst & Young cannot, however, rely on these letters as a defense to its failure to act on Lee's allegations, given that, among other things, Lee presented his allegations directly to Ernst & Young (and outside the presence of management).Show full note

1045

¶Sufficient evidence exists to support a colorable claim that Ernst & Young knew or should have known that the notes to the financial statements were false and misleading because, among other things, those notes describe all repos as "financings," which Ernst & Young knew was not the case, and those notes did not disclose the Repo 105 transactions. Ernst & Young had a professional obligation to communicate the issue to both senior management and the Audit Committee and to recommend corrections of the Forms 10‐Q, and also to either issue modified review reports noting the materially inadequate disclosures, or to withhold its review reports altogether.

¶There is also sufficient evidence to support the existence of a colorable claim against Ernst & Young for malpractice in connection with the misleading statements concerning Lehman's net leverage ratio contained in the MD&A sections of Lehman's two 2008 Forms 10‐Q. Sufficient evidence exists to find that those disclosures were materially inadequate and misleading because Lehman did not disclose the fact that the reported assets, net assets, leverage ratio and the reduction in the net leverage ratio were materially affected by temporary Repo 105 transactions.

1046

¶Auditors have a far more limited responsibility for disclosures and "other information" in filings accompanying financial statements, as opposed to the financial statements and accompanying footnotes, but the standards require the auditor to "read the other information [e.g., the MD&A] and consider whether such information, or the manner of its presentation, is materially inconsistent with information, or the manner of its presentation, appearing in the financial statements." See AU § 550.04. In addition, AU Section 550.05 states that if the auditor "becomes aware of information that he believes is a material misstatement of fact that is not a material inconsistency, . . . he should discuss the matter with the client. . . . If the auditor concludes he has a valid basis for concern, he should propose that the client consult with some other party whose advice might be useful to the client, such as the client's legal counsel".³⁹³⁸³⁹³⁸ Seegenerally AU § 312.10 (assessment of materiality involves both quantitative and qualitative considerations, including whether the omission of information would make it probable that the judgment of a reasonable person relying on the information would have been changed or influenced). If the misstatement is not resolved, then the auditor should consider actions such as notifying the client in writing of his or her views. See AU § 550.06.³⁹³⁹³⁹³⁹ Further, the standards state that "if the accountant concludes that there is a material inconsistency, or becomes aware of information that he or she believes is a material misstatement of fact, the action taken will depend on his or her judgment under the circumstances." See AU § 722.18(f) (cross‐referencing to AU § 550.04‐06) (emphasis added). In addition, as discussed in Section III.A.4.j.2.a of this Report, there is an SEC requirement that companies disclose "known trends" in MD&A sections.Show full note Here, Ernst & Young did none of those things.

1047

¶There is sufficient evidence for a trier of fact to conclude that Ernst & Young should have insisted on proper disclosures of Repo 105 transactions in the interim information that it reviewed or withheld an unmodified review report because the interim information disclosures were materially inadequate and misleading. Furthermore, the MD&A information implied that Lehman had achieved desirable net leverage numbers by balance sheet reductions, without disclosing that those net numbers would have been significantly higher but for the Repo 105 transactions. There is credible evidence that Ernst & Young was aware of Lehman's Repo 105 policy as early as 2001,³⁹⁴⁰³⁹⁴⁰ Examiner's Interview of Ernst & Young, Repo 105, Oct. 16, 2009, at pp. 4‐5 (statement of William Schlich); Examiner's Interview of John Feraca, Oct. 9, 2009, at p. 7. that Ernst & Young was aware of over $29 billion in Repo 105 transactions in 2007 when it received the Netting Grid,³⁹⁴¹³⁹⁴¹ Lehman, Accounting Policy Review Balance Sheet Netting and Other Adjustments [Draft] (Nov. 2007), at p. 26 [LBEX‐DOCID 3213271] (stating total amount of Repo 105 for Feb. 28, 2007 was $29.258 billion), attached to e‐mail from Margaret Sear, Lehman, to Jerry Gruner, Ernst & Young, et al. (Nov. 6, 2007) [LBEX‐DOCID 3235499]. and that Ernst & Young was on notice as to the $50 billion in such transactions by no later than June 2008.³⁹⁴²³⁹⁴² See Sections III.A.4.i.4 and III.A.4.j.5.b.i of this Report, which discuss Lee's statements to Ernst & Young. Ernst & Young was aware of the importance in Lehman's industry of the net leverage number, as those numbers were being touted by Lehman in the press and investor calls.³⁹⁴³³⁹⁴³ See Section III.A.4.e.6 of this Report. Given those facts, the Examiner finds that sufficient evidence exists to support a colorable claim against Ernst & Young in connection with its reviews of Lehman's interim financial information and its responsibilities regarding Lehman's MD&A information in both quarters of 2008.

1048

Lehman's 2007 Form 10‐K

¶Lehman's 2007 Form 10‐K contained essentially the same statements as those in its later 2008 Forms 10‐Q. In its 2007 Form 10‐K, Lehman represented that it treated repurchase agreements as financings (i.e., not as sales) even though Repo 105 transactions were treated as sales. In Note 1 to Lehman's Consolidated Financial Statements, Lehman stated that Lehman treated "[r]epurchase and resale agreements" as "collateralized agreements and financings for financial reporting purpose" which Lehman described were "collateralized primarily by government and government agency securities."³⁹⁴⁴³⁹⁴⁴ LBHI 2007 10‐K, at p. 97. This disclosure is under the heading "Collateralized Lending Agreements and Financings." In addition, Lehman stated that "[o]ther secured borrowings principally reflect transfers accounted for as financings rather than sales under SFAS 140."³⁹⁴⁵³⁹⁴⁵ Id. Lehman disclosed that it recognized the transfer of financial assets as sales pursuant to SFAS 140 – but it said so only with respect to "securitization activities."³⁹⁴⁶³⁹⁴⁶ Id. at p. 96. "Securitization activities" is a separate heading in the Note.

1049

¶There is also sufficient evidence for a trier of fact to conclude that Ernst & Young knew or should have known that that those statements were materially misleading and failed to provide necessary disclosures concerning Lehman's use of Repo 105 transactions. Therefore, the Examiner finds sufficient evidence to support a colorable claim of malpractice against Ernst & Young in connection with its 2007 audit of Lehman.³⁹⁴⁷³⁹⁴⁷ While the issue concerning the lack of disclosure with respect to Lehman's Repo 105 activity goes back to earlier periods, the Examiner's investigation of potential claims against Ernst & Young has focused on the late 2007 and early 2008 critical period because of the increasing volume of Repo 105 transactions, the emphasis on reducing net leverage, and Lehman's public touting of its deleveraging during that time.Show full note

¶The financial statements accompanying the 2007 Form 10‐K were audited – as opposed to "reviewed" – by Ernst & Young and thus higher standards and requirements of professional care applied. For example, while quarterly reviews require the auditor to perform analytical procedures and make inquiries of management, among many other things, year‐end audits mandate that the auditor perform tests, gather corroborating evidence that supports the financial statements, obtain reasonable assurance about whether the financial statements are free of material misstatements, and provide a positive opinion regarding whether the financial statements are fairly presented in conformity with GAAP. See, e.g., AU §§ 310, 311, 326.

¶Accordingly, in performing its 2007 year‐end audit, Ernst & Young was required to look at the data underlying the financial statements. Such an audit should have revealed that a significant volume of Lehman's repo activity was not treated as financings, but instead was reported as sales. In addition, the MD&A section to Lehman's 2007 Form 10‐K discussed the net leverage ratio without disclosing the role that Repo 105 transactions played in that calculation. Ernst & Young's failure to require proper disclosures in the MD&A section and in footnotes to the financial statements constitutes sufficient evidence to find a colorable claim of malpractice.

1050

Effect on Prior Filings

¶Finally, while Ernst & Young should have required proper disclosures in the 2007 Form 10‐K and 2008 first quarter Form 10‐Q prior to those filings, Ernst & Young also had a duty, upon learning in June 2008 of Lee's allegations concerning Repo 105 transactions, to revisit the earlier filings. The auditor's responsibilities in such situations is addressed in AU Section 561.04‐06, which states that when an auditor becomes aware that facts may have existed at the date of a previously issued audit report which might have affected the report had the auditor then been aware of such facts, the auditor should investigate whether the new information is reliable and existed at the time of the original report and whether the new information indicates that the previously issued opinion is incorrect and should not be relied on. If the previously issued audit report is incorrect, the auditor should consider action to prevent future reliance on the prior reports.

1051

Causation and Damages

¶One measure of damages in an audit malpractice action against Ernst & Young would be the recovery of fees Lehman paid to Ernst & Young in connection with the 2007 audit and/or the 2008 reviews.³⁹⁴⁸³⁹⁴⁸ See, e.g., Stanley L. Bloch, Inc. v. Klein, 258 N.Y.S.2d 501, 508 (Sup. Ct. 1965) (holding that measure of damages for professional negligence of accountant in issuing balance sheet containing substantial errors was accounting and auditing fees paid to accountant for year of service immediately prior to issuance of balance sheet and accounting and auditing fees necessitated by review thereof). It also is possible that the estate could recover additional damages beyond fees paid to Ernst & Young if it is shown that Lehman suffered damages that could have been avoided had Ernst & Young adhered to professional accounting standards. For example, had Ernst & Young fulfilled its obligation to advise the Audit Committee of the extent and significance of Repo 105 activities, the Audit Committee may have insisted on measures to actually and substantially reduce leverage or to take other remedial or strategic steps that might have led to a different outcome.³⁹⁴⁹³⁹⁴⁹ See, e.g., Bd. of Trs. of Cmty. Coll. Dist. No. 508, County of Cook v. Coopers & Lybrand LLP, 775 N.E.2d 55, 63 (Ill. App. 2002) (applying Illinois law, holding that auditor's failure to detect treasurer's violation of investment policy during audits could be the proximate cause of damages caused by investments made after the audit, where members of the board testified that they would have ended those investment practices had auditor detected them), revʹd on other grounds, 803 N.E.2d 460 (Ill. 2003); Plan Comm. v. PricewaterhouseCoopers, 335 B.R. 234, 249‐51 (D.D.C. 2005) (creditors committee adequately alleged damages against debtor's auditing firm under District of Columbia law, where committee asserted that malpractice proximately caused debtor's insolvency and bankruptcy and specifically alleged that the board would have taken actions to avoid insolvency if it had been "timely alerted by appropriately audited financial statements to the fact that [company] was performing significantly worse than was presented in the negligently audited financial statements"), dismissed on other grounds, No. 02‐01487 (TFH), 2007 WL 119917 (D.D.C. Apr. 20, 2007).Show full note Ernst & Young, in turn, may have a compelling argument that such a measure of damages is too speculative.³⁹⁵⁰³⁹⁵⁰ See VTech Holdings Ltd. v. Pricewaterhouse Coopers 348 F. Supp 2d 255, 267 (S.D.N.Y. 2004) (buyer of wired business could recover lost profits and consequential damages under New York law on accountant malpractice claim only if they were capable of being measured based on reliable factors).

1052

¶In addition, the estate may be able to seek compensation from Ernst & Young for fees and expenses that the estate incurred or will incur as a result of Ernst & Young's malpractice. For example, if an accountant's negligence in the preparation or certification of financial statements results in litigation against the accountant's client brought by purchasers of the client's securities, the client may be able to recover the expenses of the litigation and the amount of any judgment or reasonable settlement.³⁹⁵¹³⁹⁵¹ A plaintiff generally is entitled to "actual out‐of‐pocket costs" that "flow as a natural and continuous consequence" from or are otherwise "proximately caused" by the defendantʹs breach of its legal duties. Crowley v. Chait, Civ. No. 85‐2441 (HAA), 2004 U.S. Dist. LEXIS 27238, at *39 (D.N.J. Aug. 25, 2005); Baker Hughes Oilfield Operation, Inc. v. Seabulk Tankers, Inc., No. Civ.A. 03‐1230, 2004 WL 1290576, at *1 (E.D. La. June 8, 2004) (Baker I); Keywell Corp. v. Piper & Marbury LLP, No. 96‐CV‐0660E (SC), 1999 WL 66700, at *5 (W.D.N.Y. Feb. 11, 1999). Among the expenses that could be considered to flow from the breach of a legal duty are those incurred to repair harm to the plaintiff caused by the defendant's breach. See, e.g. World Radio Labs., Inc. v. Coopers & Lybrand, 557 N.W.2d 1, 15 (Neb. 1996) (holding that client was entitled to recover damages for accounting fees paid to second auditing firm as a result of defendant auditing firm's negligence).Show full note

1053

Possible Defenses

¶The Examiner recognizes that Ernst & Young may have valid defenses to these claims. As a general matter, the question of whether an auditor committed malpractice is a fact‐intensive inquiry and requires the testimony and opinion of experts in the field. Indeed, many of the auditing standards set forth above do not impose bright line rules, but instead provide general guidance and principles. Ernst & Young likely would submit expert testimony in support of its view that it adhered fully to its professional responsibilities in its reviews and audits of Lehman's financial statements, and may take the position that some of the professional standards cited above apply only where an auditor has a subjective belief that a disclosure or other information is materially inaccurate. Ernst & Young also may take the position that preparation of financial statements is the responsibility of management – and not of the outside auditor.

¶The Examiner concludes that there is sufficient basis for claims to be submitted to a trier of fact, who will have to evaluate those claims in light of any defenses raised by Ernst & Young.

Notes not linked in the text

These notes appear in the source but the pipeline could not place their reference in the body. They are listed here so nothing is lost.

²⁹¹⁸ Gross leverage, for illustrative purposes in this set of examples only, is calculated as total assets divided by stockholders' equity.
²⁹¹⁹ For illustrative purposes in this set of examples only, a simplified definition of net leverage is used: net leverage = (total assets – collateralized agreements) divided by stockholders' equity.
³¹⁹⁵ Joseph Gentile, Lehman, Proposed Repo 105/108 Target Increase for 2007 (Feb. 10, 2007) [LBEX‐ DOCID 2489498] (attached to e‐mail from Joseph Gentile, Lehman, to Edward Grieb, Lehman (Feb. 10, 2007) [LBEX‐DOCID 2600714]); see also e‐mail from Kaushik Amin, Lehman, to Herbert H. (Bart) McDade III, Lehman (June 3, 2008) [LBEX‐DOCID 574610] (stating that Liquid Markets division within FID made "Herculean" efforts to reduce its balance sheet $25 billion lower than its actual balance sheet target near the quarter‐end in second quarter 2008 in order to compensate for other businesses within FID that were unable to meet their targets and transmitting report [LBEX‐DOCID 522198] showing Liquid Markets conducted over $42 billion in Repo 105 transactions at close of second quarter 2008 and over $39 billion in Repo 105 transactions at close of first quarter 2008).