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.

[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.

¶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

¶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).

¶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:

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).

¶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).

¶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.

¶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

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).