In November 2008, Richard Fuld was called to testify before a US Congressional committee investigating the sudden collapse of Lehman Brothers, the investment bank he had headed for many years. Its deep involvement in the markets for asset-backed securities - bonds developed from what were called 'subprime mortgages and derivatives contracts associated with them had brought the company to a crisis two months before. When US government refused to bail it out, credit markets around the world seized up, accelerating the growing slump of the world economy. The text day, perhaps realizing the mistake of allowing Lehman Brothers to fail, the US Treasury pumped money into the American Insurance Group (AIG), a company that had become the biggest player in in a gigantic global market for credit default swaps - tradable securities that initially served as insurance against corporate borrowers, individual mortgage-holders and the banks who lent to them being unable to meet their commitments. As credit dried up around the world, almost any credit default swap might have to pay out. There was insufficient money to pay them all at once. The US Treasury saved AIG, but it proved too little and too late to prevent a string of calamities of varying degrees of severity in other countries.

By the end of November, several major commercial banks in a variety of countries had, in effect, been nationalised. Citigroup, the world's largest bank had been propped up with new equity supplied by US taxpayers, and the entire banking system of whole country - Iceland - was on its knees. Investments made by Icelandic banks - especially in the retail sector across Europe - were threatened as other banks refused to lend the retailers money to pay their suppliers for merchandise in the run-up to the buy Christmas sales.

The problems in the system were not entirely o Lehman Brothers' making of course. It had been only one of many intermediaries in the complex web of transactions that collapsed in on itself that month. In the preceding months, Britain had been forced to nationalise a mortgage lender, Northern Rock, after other banks had lost confidence in its ability to repay loans it had taken from other banks to fund its activities. America's biggest stock broker, the venerable Merrill Lynch, had been encouraged into a takeover by Bank of America, the country's second largest commercial bank. On the Wall Street, the model of investment banking that had dominated capital markets -from mergers and acquisitions advice, to stock and bond trading, commodities futures and lending to the burgeoning hedge fund industry - had come an end. After Lehman filed for bankruptcy, banks turned themselves into commercial banks, subjecting themselves to a needed to stay afloat directly from the Federal Reserve, America's central banking system.

With regard to unethical accounting, Lehman's case is not vastly different from Enron. Enron's directors managed to show a favourable financial position in financial statements by concealing losses (on converting debt into positive cash flows) through the use of off-balance sheet finance - the special purpose entities. At Lehman Brothers, use of 'REPO 105' helped to raise significant amount of cash flows without affecting the liabilities side of the balance sheet. REPO 105, is the short-form for 'sale and repurchase' agreement; Lehman could borrow funds on short-term through REPO, showing it as 'asset sale' and reducing the debt levels. Lehman failed to report these transactions. However, thanks to creative accounting the underlying assets never left the Lehman's balance sheet. Lehman brothers failed to disclose these transactions in their true form. When asked by the court examiner, Flud denied "any recollection of Lehman's use of Repo 105 transactions".

The legislators wanted to hear from Fuld just what he had done to earn the $500 million he had taken home from Lehman Brother over the last nine years. (It was not that much, he protested, something closer to $250 million.) But they also wanted to know: How did the board of directors - the people charged with watching over the policies and practices of the company known as Lehman Brothers Holdings Inc. - how had they so completely failed in their duties to the shareholders, that is the owners of the business they had pledged to serve? How had they failed to see that the business had gone bad, that symbol of the banking crisis - that it had afflicted with global financial system, spreading the discomfort throughout the world economy? Were they simply a sleep on the job? And what of the directors of all the other banks, brokers and businesses now threating the wealth of their shareholder, the jobs of their employees, the pensions of their retired workers and of all those whose savings were locked up in other pension funds that invested in stock, deft and property markets now threatened with one of the greatest collapses of value in the modern history of finance? How could these smart people get things so catastrophically wrong?

This was not, to be sure, the first time that directors of public companies had presided over massive destruction of value, despite widespread use of mechanisms of corporate governance - ranging from auditors to credit rating agencies, voluntary codes of conduct to stringent laws on liability and listing requirements of stock exchange - to prevent just that. In the first few years of the twenty-first century, the Italian dairy company Parmalat failed under allegations of fraud and misdealing, and Ahold, a Dutch supermarket group reeled under a scandal of false accounting. In America, the names of Enron Worldcom, once amount the largest and most respected companies in the country, became synonymous with corporate greed, arrogance, fraud and deception. 

Questions

1.    What does agency theory tell us about these cases?

 2.    How is stakeholder theory relevant to the above cases?

 3.    Discuss the root causes of failure of Lehman brothers?

 

4.    What approaches might the Lehman Board or the US government have used to prevent a disaster?

a.    Which are external to the company?

b.    Which are internal to the company?

 

5.    To whom were they responsible; to whom were they not responsible?

 6.    Why, in your view, do bank directors not seem to have learnt lessons from previous collapses?

Answer rating: 100% (QA)

1 Agency theory in the context of these cases highlights the principalagent relationship between shareholders principals and executives or managers agents of these companies It suggests that conflicts ... View the full answer