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In 2010, Richard Fuld, the former CEO of Lehman Brothers, told a congressional committee that he had "absolutely no recollection whatsoever of hearing anything" about Repo 105 at the time of the transactions. Lehman's demise, he claimed, was caused by "uncontrollable market forces" and the U.S. government's unwillingness to rescue the firm. Of course, Henry Paulson, the U.S. Treasury Secretary in 2008, had tried in vain to get Fuld to accept a buyer offering a reasonable price; Fuld had been holding out for more in spite of the financial condition of Lehman. It is stunning that a man who had been allowed to reach such a pristine and lofty office in the business world would not even permit himself to acknowledge any contributory role in the downfall of the organization he had run. Such an attitude alone seems worthy of a prison sentence (and the return of his salary and bonuses); how he and his "team" had manipulated the books to make the bank look wealthier than it was would seem to make such a sentence inevitable.

However, as of March 15, 2011, no high-profile executives involved in the finacial crisis of 2008 had been successfully prosecuted. In Feburary of the same year, for example, a federal criminal investigation of former Countrywide Financial Corp. Chief Executive Angelo Mozilo had been, according to The New York Times, "closed without charges." Regarding "the battered real-estate portfolio and an accounting move known as Repo 105," the paper reported that SEC officials were growing more worried in the early months of 2011 that "they could lose a court battle if they bring civil charges that allege Lehman investors were duped by company executives. The key stumbling block: The accounting move, while controversial, isn't necessarily illegal." This is an extremely important point, for it means that FASB, the non-profit quasi-regulatory body that promulgates generally accepted accounting principles (GAAP) in the United States, is too permissive--too accommodating of how executives of publicly-held corporations want to value assets and liabilities.

Punctum saliens, the means by which accounting standards are determined is too susceptible to influence from CPA firms and their clients, the public corporations being audited.  The structural conflict of interest existing between the "independent" auditors and their clients is magnified to the extent that either of the two parties have inordinate influence on FASB.  Even if a government agency such as the SEC were to set the regulations, there would still be the risk that the accounting firms and/or public corporations could gain leverage over the regulators, in what is called regulatory capture. The root problem behind both allowing the conflict of interest and being too accommodating in terms of GAAP is that Americans, and thus the values in American culture, are too conducive to business--meaning not sufficiently realistic concerning the possibility of greed and any resulting harm. An examination of why the Lehman executives could manipulate their books unfairly and yet legally points to this proclivity manifested through a too-flawed and friendly accounting regulatory system.

The New York Times reports that in March of the same year in which Richard Fuld testified before Congress to disavow any responsibility in the failure of the bank he had run, "the Repo 105 transactions were condemned by court-appointed examiner Anton R. Valukas, who said in a report that they enabled Lehman to 'paint a misleading picture of its financial condition.' . . . In the transactions, Lehman swapped fixed-income assets for cash shortly before the securities firm reported quarterly results, promising to buy back the securities later. The cash was used to pay down the company's debts. Emails sent by executives at the company referred to Repo 105 as a 'drug' and 'basically window dressing.'" Valukas concluded there were "colorable," or credible, legal claims against Ernst & Young, Fuld and former Lehman finance chiefs Ian Lowitt, Erin Callan and Christopher O'Meara. Indeed, when he was the Attorney General of New York, Andrew Cuomo criticized the Repo 105 transactions as a "house-of-cards business model, designed to hide billions in liabilities in the years before Lehman collapsed."  The implication is that Fuld and his subordinate managers had committed fraud.

Even so, Ernst & Young "had concluded that the accounting in the Repo 105 transactions was acceptable."  In a statement, Ernst & Young "said," we stand "behind our work on the Lehman audit and our opinion that Lehman's financial statements were fairly stated in accordance with the U.S. accounting standards that existed at the time." (italics added) Fairness, in other words, depends solely on whether the books of a company are in line with the accounting standards, rather than on whether the values recorded on the books reflect the values of the underlying assets and liabilities. In terms of the repos at Lehman, The New York Times reports that SEC officials generally concluded that "the transactions were consistent with accounting standards." Successfully prosecuting former Lehman execcutives for making misleading statements about the bank's financial condition is an uphill battle, according to the paper, because the executives relied on legal and accounting opinions. Furthermore, in his report, Valukas wrote that he didn't find "sufficient evidence to support a colorable claim for breach of fiduciary duty in connection with any of Lehman's valuations." Also, SEC officials were not "convinced that Lehman shareholders suffered material harm, since executives were trading one type of highly liquid asset for another." However, the apparently lower debt levels might have influenced existing and potential investors in their decision-making regarding their level of exposure from investing in Lehman. In other words, their risk was being deliberately understated by Lehman's management. Even if particular investors were not actually harmed, showing an apparent lower risk than would be the case without the repos (and cost valuations on the real estate investments) was not in the investors' interest. Moreover, it just isn't fair, even if it is legal because it is allowed by GAAP. The problem, in other words, extends from Fuld and his sycophants at Lehman to the FASB.

The wrench in the works with my thesis is the fact that there are indeed different ways in which an asset or liability can be valued fairly. There are different viable assumptions, for example, regarding whether an asset should be valued at cost or market. Each assumption has a downside. Showing a real estate investment at cost, for instance, has the downside that the market-value of the asset, if significantly lower, is not shown. That is, the transactions-value of the asset at the time is ignored. Even if the firm intends to hold the asset, the lower market value would determine what the firm could do with that asset in covering for any needed debt payments. On the other hand, if market values fluctuate substantially, changes in an asset's value may not make much difference to the underlying value of the asset, and thus to the firm, especially if the firm intends to hold the asset long term.  To the extent that speculators can artificially push up or short an asset's market price, the latter does not reflect the underlying, or fundamental, value of the asset or even the real supply and demand (e.g., oil price hikes in the wake of the Libyan disruptions in 2011). Unfortunately, the companies being regulated and the accounting firms they hire can use such authentic debates to open GAAP up wider than a sloppy whore so they can have their way with her in order to look better than they are. That such selfishness, deceitfulness and greed can be accommodated by GAAP, and thus the FASB, and ultimately the American electorates, is the real problem, and unfortunately there is not an easy solution because the basic problem lies in values and assumptions held by a population.

As useful as flexibility is in accommodating different assumptions and plans regarding assets and liabilities, the refusal of FASB to fortify its sanctioned accounting methods with conditions so investors are not misled--a refusal that I contend is from inordinate influence from the regulated and their public accountants--means that managers running publicly-held companies like Lehman Brothers are enabled to do practically-speaking whatever they want to show the public (and the owners) only the asset values and debt levels that they want. Allowing only cost to value real estate, for instance, could be conditioned not on whether the firm intends to hold the asset (a subjective matter that a manager could manipulate and even falsify), but rather on the extent of difference in percentage terms between the market value and cost. An accounting breed of relativism unchecked allows for and enables greed. Lest we want to succumb to such decadence, fairly stated ought not be tied to conforms to GAAP if the latter is too tolerant. The regulated will always prefer relativism in regulation.  Even if GAAP is tightened, fairly stated ought not to be determined solely in terms of those standards. Additionally, CPA firms ought to be on the look out for fraud or misleading practices even if they are allowed by the FASB's standards.  The latter are means rather than ends in themselves. According to Kant, beings of a rational nature must be treated as ends in themselves (as well as means). GAAP are not rational beings.

Beyond changes in GAAP and what CPA firms are charged to look at, the friendliness of the FASB to the business world, or at the very least the extent of the organization's accommodation, should convince the American people and government officials that more government regulatory involvement is warranted. While some government regulators could come from industry to contribute their technical knowledge, they should be checked by superiors who have a healthy skepticism of business and a salient regard, or value, for the public interest. Ultimately, it is up to the American people, operating through our elected officials and the related governmental agencies, to stand up to the temptation to have regulation esssentially by the regulatees. However, this requires esteeming values that are sufficiently realistic concerning the role that greed and selfishness can play in those of us who run the world of business. Power as well as money can be intoxicating, especially in high doses. Lest the value of economic liberty blind us to this subterranean all-too-human propensity, we as a society could pay more attention to the societal blind spot of structural or institutional conflicts of interest implicit in the very design of some of our most important regulatory systems.
Source: http://online.wsj.com/article/SB10001424052748703597804576194871565429108.html

Click to add a Comment or Question (or View Posted Comments) on business ethics at Lehman Brothers.


On greed, see related essay, "Godliness and Greed": http://thewordenreport.blogspot.com/2011/02/godliness-greed-how-effective-is.html

On Lehman's corporate governance, see: http://thewordenreport.blogspot.com/2011/02/godliness-greed-how-effective-is.html

In an executive meeting at Lehman in the summer of 2008, Skip McGee told Richard Fuld and the other top executives that the market was demanding “that we hold ourselves accountable.”  Essentially, he was pushing for Gregory’s outster.  What strikes me is what he didn’t say–namely, something like, “the stockholders are holding us accountable!”  Had he said this, Fuld might have laughed. Of course, Richard Fuld was a major stockholder, so he might have viewed it as “holding myself accountable to myself.”  Given the inherent ethical conflict of interest in such a statement, I don’t think we can rely on corporate governance as a check on excessive managerial risk-taking when executives hold a substantial share of the stock.  Therefore, in including stock options in executive compensation to align executives' incentives with medium and long-term firm performance, boards should add institutional safeguards or accountability mechanisms to corporate governance. In business-speak, there is a cost incurred that boards may not be aware of in aligning executive compensation (and firm ownership) with future profitability.

I believe the Lehman example demonstrates how corporate governance can fail rather clearly.According to a report by Anton R. Valukas, an examiner for the bank, Lehman used “materially misleading” accounting gimmicks involving repos to mask the perilous state of the bank’s financial condition. According to the report, Lehman utilized what amounts to financial engineering in order to temporarily shuffle $50 billion of troubled assets off the bank's books in the months before its collapse in September of 2008. The intent here was to conceal the bank's dependence on leverage, or borrowed money. Lehmans’ senior managers appear to have structured transactions such that they would sell securities at the end of a quarter, only to buy them back again days later. These assets were mostly illiquid real estate holdings, meaning that they were hard to sell in normal transactions. The effect of the accounting flash-of-hand was to artificially and temporarily lower the bank’s debt levels to hit certain targets, making the firm look healthier than it really was.

Lehman's managers managed to “shed” about $39 billion from the bank's balance sheet at the end of the fourth quarter of 2007, $49 billion in the first quarter of 2008 and $50 billion in the second quarter. At that time, Lehman managers sought to reassure the public that the bank's finances were fine. Herbert McDade, a senior exec at Lehmans, wrote, “I am very aware … it is another drug we r on,” in an April 2008 e-mail cited by the examiner’s report. Senior Lehman executives, as well as the bank’s accountants at Ernst & Young, were aware of the moves, according to Mr. Valukas.  In certifying the “actionable balance sheet manipulation,” Richard Fuld was “at least grossly negligent.” Other executives named in the examiner’s report in connection with the use of the accounting tool include three former Lehman chief financial officers: Christopher O’Meara, Erin Callan and Ian Lowitt.  Notably, Lehman’s directors were not aware of the accounting engineering.  That not even the board’s audit committee was aware is telling from the standpoint of corporate governance–especially if the report is correct in its claim that the bank’s public accountants from Ernst & Young were in the loop.

The Lehmans case suggests that board audit committees ought not to rely exclusively on their public accountants.  The structural conflict of interest wherein CPA firms rely on the firms they audit for continued business was not obviated or solved after the Arthur Andersen case.  Years before that case (and computers), “as per comptroller, discrepancy resolved” was a regular “tick mark” on green CPA audit sheets. I can still remember the actual tick mark I used (a check with a line through the stem) as a young public accountant at one of the Big Eight.  We were so big.  Senior audit managers simply included the tick mark without any fanfare in going over the standard tick-marks in training. During audits, the tick-mark was simply thought of as a technical matter. New auditors fresh out of college would have no basis to question the check-mark because ethical considerations do not enter in when a technical language of business normalizes all practices. Accordingly, the conflict of interest issue was essentially below the radar when I was a public accountant.  It is difficult to spot something as sticking out from among the normal that is treated as typical. I suspect the partners in the firms knew of the obvious conflict of interst in "as per controller, discrepancy resolved," but I don’t know whether the tick-mark was intentionally portrayed as simply one technical matter among others in "how to do an audit."  Therefore, transparency had to come from outside of the industry–from the media in the wake of a major scandal--not from a government too involved with industry's lobbyists. One might wonder where (or whether) we can expect corporate governance reform.

In general terms, corporate senior managements have much too much leverage over stockholders and the boards that are meant to oversee the management.  Proposed reforms from the White House do not make a dent.  For example, requiring a “non-binding” stockholder vote on executive compensation strikes me as a declaration of surrender to the titans.  “Non-binding.”  Why waste our representatives’ time with such window-dressing designed to look like it is correcting for another kind of window-dressing.  Everyone, it would seem, is busy polishing windows and nobody has guts enough to come up with structural reforms with teeth.  No one is willing to take the drugs away from the children playing will millions and sometimes billions of dollars.  We, and our governments, are enablers, and we settle for far too little…then we are surprised when the kids are caught with their fat ruddy hands in the cookie jar again. Ultimately, we, the American People, are to blame…and as Lehmans shows, our financial system and economy may hang in the balance.

Sources:
Andrew Sorkin’s Too Big to Fail
 http://www.nytimes.com/2010/03/12/business/12lehman.html

See also: http://money.cnn.com/2010/03/12/news/companies/lehman_examiner/index.htm?hpt=T1