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.57 And confidence plummeted on two consecutive quarters with huge reported losses, $2.8 billion in second quarter 200858 and $3.9 billion in third quarter 2008,59 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,"60 "much the same as that undertaken when a defendant moves to dismiss a complaint for failure to state a claim."61 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.62

¶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"63 and a "lazy way of managing the balance sheet as opposed to legitimately meeting balance sheet targets at quarter end."64 Lehman used Repo 105 "to reduce balance sheet at the quarter‐end."65

¶In 2007‐08, Lehman knew that net leverage numbers were critical to the rating agencies and to counterparty confidence.66 Its ability to deleverage by selling assets was severely limited by the illiquidity and depressed prices of the assets it had accumulated.67 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.68 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.69

¶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)."70 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 B71 16.172 17.873 1.7 Q1 2008 $49.1 B74 15.475 17.376 1.9 Q2 2008 $50.4 B77 12.178 13.979 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.80 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.81

¶In May 2008, a Lehman Senior Vice President, Matthew Lee, wrote a letter to management alleging accounting improprieties;82 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.83 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.84 Ernst & Young took virtually no action to investigate the Repo 105 allegations.85 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.86

¶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.87

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.88

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.89

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.90

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.91 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.92

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.

[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.93

¶The Examiner has identified colorable claims that there were a limited number of preferential transfers.94

¶The Examiner has determined that there are a limited number of colorable claims for avoidance actions against JPMorgan95 and Citibank.96

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.97

¶The Examiner concludes that a limited amount of assets of LBHI Affiliates other than LBI were improperly transferred to Barclays.98

¶The Examiner concludes that the transfer of capital stock to ALI served a legitimate purpose and that there was no impropriety in those transactions.99

¶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").100 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.]"101 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[.]"

¶On January 19, 2009, the U.S. Trustee appointed Anton R. Valukas as Examiner.102 The Court approved the appointment on January 20, 2009.103 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. 2004.104 On February 17, 2009, the Court approved the Examiner's Preliminary Work Plan.105 On February 25, 2009, the Court authorized the Examiner to employ Duff & Phelps, LLC as his financial advisors.106

¶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.107 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.