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The Biggest Bankruptcy in the US History

The failure of Lehman Brothers in 2008 was the largest case of bankruptcy in US history. But the failure was the beginning of a series of events that were yet to be unfolded. The news and negative effects of the bankruptcy rippled through the market. The Dow Jones Industrial Average declined by more than 500 points by the end of the trading session of the day (Mamun & Johnson, 2012). Tremendous research has been done on the failure of Lehman Brothers including the causes of failures and whether it could have been prevented. A devastating report in March 2010 recounted in minute detail the practices carried out by Lehman Brothers, an institution founded in 1850 that declared bankruptcy on September 15, 2008. Notably, the executives were accused of gross negligence in their duty of disclosure (Morin & Muax, 2011, p. 38). This also sheds light on unethical practices that were either directly exercised by top managers or were supervised under their watch. Also, many blame accounting standards and techniques and how they are used to portray financial statements as not what they are, but how management wants them to portray. These practices leave open windows of opportunities for those whose intentions are to misuse their position, whether it is for personal reasons or short-term gains of the organization. In case of the Lehman it seems that it was more of the latter. Lehman failed to disclose various transactions in the notes to their financial statements. This may be due to negligence of accountants and auditors that leads many to argue for the reexamination of Generally Accepted Accounting Standards (Jeffers, 2010).

Many also blame the techniques that are currently used to predict firms financial distress. The numerous bankruptcies and financial difficulties that US banks went through in 2008, including the events that analysts failed to predict, indicated shortcomings in financial analysis techniques (Morin & Maux, 2011). This will also be discussed throughout the paper.

How Lehman Used Repo 105

Even though repo 105 is a legal procedure, Lehman used it as follows, according to Wilchins and DaSilva (2010). First, they bought government bonds from another bank using its Lehman Brothers Special Financing Unit in the United States. Just before the end of the quarter, the US unit transferred bonds to London affiliate, knows as Lehman Brothers International.

Then, the London affiliate gave assets to its counterparty and received cash and agreed to buy the assets back at a later time at a higher price, at least 105 percent of the price. The money that was received was used to cover and pay off a large amount of the liabilities. The reduction in assets and liabilities showed healthier quarterly financial statements and corresponding ratios, appearing much better to regulators, investors, and the general public. At the beginning of the next quarter and with healthy-looking statements, Lehman went on to borrow more at other lending institutions. Only then, Lehman repurchased the securities from the London affiliate at 105 percent of the original price. Having done so, the financial statements would have gone back to the previous inferior position.

Did Lehman Violate the Sarbans-Oxely Act?

Kourabi et al., (2011) explains that the Sarbanes-Oxley Act was enacted into law in 2002 and in response to the collapse of Enron and WorldCom, following the discovery of many accounting scandals.

The Act is designed to restore investors confidence, to enhance the reliability and accuracy of the financial reporting, to improve the corporate governance system, to improve the content and timeliness of the disclosure requirements, to strengthen the role of the independent directors, and to improve the internal control practices and procedures (p. 43).

Jeffers (2011) notes that even though repo 105 is a legal procedure, but if the procedure is used to taint the fair financial position of the company with the full knowledge of CFOs and CEOs, the executives are subject to severe financial penalties and imprisonments. In the case of Lehman, the executives were fully aware that the Repo 105 was being used to mislead the statements. From all accounts, it appeared that the senior management knew of the Repo 105 transactions and nevertheless, they certified the accuracy of the statements knowing that they were inappropriate. As a result, these executives were fully aware that the financial statements were misleading and did not fairly present the true position of the company (p. 53). Hence, those Lehman executives were subjected to criminal and financial liability. With top managers being fully aware, an accounting scandal was in the making and the Sarbanes-Oxley Act was violated.

Complex Structure

Steinberg and Snowdon (2009) blame the Lehman bankruptcy on the complex structure of the organization along with numerous other issues leading to the bankruptcy. Lehman Brothers was conducting business in global scope having about 3000 legal entities which made the situation incredibly complicated. Any organization that experiences exponential growth on the same scale as Lehman must have a similar degree of complexity. The complexity dedicated to the expansion and growth, and the expansion and growth contributed to the complexity. It works both ways as one would not be materialized with the absence of the other.

Prevention

Morin and Maux (2011) analyze the financial statements of 2005 to 2007 in order to establish whether the failure of Lehman Brothers could have been predicted. In doing so, they mention that most analysis are centered on balance sheet that portrays the financial structure of

the company and the state of its solvency/liquidity. Income statements are also of great importance. However, the statements of cash flows are mostly ignored by analysts. The statement of cash flows, which illustrates a companys capacity to transform its results into cash, has been virtually ignored by analysts, who tend to focus instead on the balance sheet and the income statement (p. 40). The question in the Lehman Brothers case remains: beyond the lies that were generally hidden by the top management, how could investors or auditors not detect such warning signs? Morin and Maux (2011) examine financial statements over the three years leading to the bankruptcy to show that such warning signs were indeed detectable. The reason that the bankruptcy was failed to be detected was that the statement of cash flows were not given equal weighs in comparison to other financial statements.

Although Lehman Brothers had $7.286 billion in cash and cash equivalents on November 30, 2007, an analysis of its statement of cash flows signals major dysfunctions in working capital management. This is particularly striking for the financial instruments: over a three-year period, they generated net negative cash flows of

$161.657 billion (p. 40).

The shortcoming in predicating a disaster by analysis is so clear that many may believe that analysts either did not just understand the statements or were blinded by the superficial performance. It is also possible that holding to the minimum of standards, they simply turned a blind eye to the warning signs. In any event, having negative cash flows must have rang a bell about the horrible health of the organization, and it must have hinted analysts about the superficiality of the balance sheet and income statement.

Furthermore, Morin and Maux (2011) drew a conclusion that the 2005-2007 statements of cash flow of Lehman Brothers were reliable predictors of the coming bankruptcy. They

mention the following signs of distress to be completely detectable in Lehmans financial statements.

1. Chronic inability to generate cash from operating activities (p. 52).

2. Massive and systematic investment in working capital items and even more intensive investments in financial tools and instruments.
3. Systematic use of external financing to offset operating deficits, in which it mainly included long-term debt.
4. Steady deterioration of cash flows over three years leading to the crisis.

Steinberg and Snowdon (2009), members of the Lehman tax department, maintain that they were also aware of the trouble ahead. Early in 2008, they anticipated and started planning that they were going record net operating losses for US tax purposes for the 2008 taxable year.

Steinberg and Snowdon (2009) note that they were focused on providing tax advice for the disposition of assets, deleveraging of the balance sheet and in structuring potential capital transactions while also attempting to ensure the preservation of the historic and current tax attributes such as foreign tax credit and tax net operating loss carry forwards of the company. There were various signs of disaster looming in the near future even though the tax team was kept in the dark about the dire situation. Since they did not know the depth of the trouble the question in their mind was if Lehman was to be absorbed by another financial institution, or perhaps mass layoffs, but no thoughts on filing for bankruptcy. However, due to unethical use of accounting standards, Lehman posted net positive results and growth between 2005 and 2007. This may be the only reason these signs of distress were not visible in the income statement. Analysts made recommendations and predictions based on Lehmans estimated earnings per share. They therefore had their eyes riveted to the statement of income, which may explain why Lehmans cash flow situation did not cause any apparent concern (Morin and Maux, 2011, p. 52).

However, when the analysis is made based on the statements of cash flow, the financial deterioration of the company is completely visible. The analysis signals major dysfunction in working capital management. This is particularly striking for the financial instruments which generated, over a three-year period, net negative cash flows of $161.657 billion (p. 52). What is surprising is that the systematic payment of dividends that went on despite sizable cash deficits was completely unnoticed by the auditors in assessing financial statements. What is even more shocking is the financing of the dividends that was done through long-term loans, which by itself indicates a dysfunctional cash management.

All these finding, can bring one to a conclusive result, that the failure of Lehman could have been predicted and prevented.

Recommendations Going Forward

One can learn many lessons from a failure, especially when the failure is the biggest of an institution in the US history. Modifying accounting practices and adding new methods of predicting the disaster are two are two lessons to be named. Caplan et al., (2010) examined the failure of Lehman and have suggested a few recommendations for going forward.

Avoiding Unachievable Business Strategy

Caplan et al., (2010) mention that in 2006, Lehman made a deliberate decision in pursuing a higher-growth business strategy. To achieve their goal they switched from a low-risk brokerage model to capital-intensive banking model that required them to buy assets and store them as opposed to acquiring assets to primarily moving them to a third party. Having to keep the assets internalized the risk and returns of the investments.The mismatch between short-term debt and long-term, illiquid investments required Lehman to continuously roll over its debt, creating significant business risk. Lehman

borrowed hundreds of billions of dollars on a daily basis. Since market confidence in a companys viability and debt-servicing ability is critical for it to access funds of this magnitude, it was imperative for Lehman to maintain good credit ratings (p. 24).

In order to pursue this high growth trend they had no other option but to aggressively target a high growth rate in revenues. But they also had to target an even faster growth in its balance sheet and total capital base. This unreachable target led them to hold $700 billion in assets in 2007 on equity of $25 billion with $675 billion in liabilities (Caplan et al., 2010). This unfeasible strategy at the time also brought along higher risk because most of assets were long term and highly illiquid. Commercial real estate, private equity, and leveraged loans were just to name a few. As the subprime crisis unfolded Lehman had to act quickly, and that meant liquidating a vast amount of its illiquid assets in housing mortgages. Negative perception of the market caused the assets to be bought as even a lower price. Looking back at the events unfolding and the strategy that Lehman chose, one may conclude that pursuing the company strategy at any cost was absolutely wrong. There is a cost to any strategy and Lehman must have forgone its high-growth strategy if its cost outweighed the benefits and was deemed as unfeasible at the time.

Case Study#2/Assignment#7 Carefully read the case study title: "The Bankruptcy of Lehman Brothers: Causes of Failure & Recommendations Going Forward" and develop the summary of the study. Discuss the way Lehman Brothers Camouflage its' true picture. The Bankruptcy of Lehman Brothers: Causes of Failure & Recommendations Going Forward Article in Social Science Research - August 2013 DOI: 10.2139/asm.2016892