UNITED STATES BANKRUPTCY COURT SOUTHERN DISTRICT … 3.pdf · united states bankruptcy court...

UNITEDSTATESBANKRUPTCYCOURTSOUTHERNDISTRICTOFNEWYORK

x InreLEHMANBROTHERSHOLDINGSINC.,etal., Debtors.

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Chapter11CaseNo.0813555(JMP)(JointlyAdministered)

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REPORTOFANTONR.VALUKAS,EXAMINER

March11,2010

Jenner&BlockLLP353N.ClarkStreetChicago,IL6065434563122229350919ThirdAvenue37thFloorNewYork,NY1002239082128911600CounseltotheExaminer

VOLUME3OF9

Section III.A.4: Repo 105

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EXAMINERSREPORT

TABLEOFCONTENTS

(SHORTFORM)

VOLUME1

Introduction,SectionsI&II:ExecutiveSummary&ProceduralBackground

Introduction...................................................................................................................................2

I. ExecutiveSummaryoftheExaminersConclusions ......................................................15

A. WhyDidLehmanFail?AreThereColorableCausesofActionThatAriseFromItsFinancialConditionandFailure?.....................................................15

B. AreThereAdministrativeClaimsorColorableClaimsForPreferencesorVoidableTransfers?......................................................................................................24

C. DoColorableClaimsAriseFromTransfersofLBHIAffiliateAssetsToBarclays,orFromtheLehmanALITransaction? ....................................................26

II. ProceduralBackgroundandNatureoftheExamination ..............................................28

A. TheExaminersAuthority ...........................................................................................28

B. DocumentCollectionandReview..............................................................................30

C. SystemsAccess..............................................................................................................33

D. WitnessInterviewProcess...........................................................................................35

E. CooperationandCoordinationWiththeGovernmentandParties ......................37

SectionIII.A.1:Risk

III. ExaminersConclusions......................................................................................................43

A. WhyDidLehmanFail?AreThereColorableCausesofActionThatAriseFromItsFinancialConditionandFailure?.....................................................43

1. BusinessandRiskManagement..........................................................................43

a) ExecutiveSummary .......................................................................................43

ii

b) Facts..................................................................................................................58

c) Analysis .........................................................................................................163

VOLUME2

SectionIII.A.2:Valuation

2. Valuation ..............................................................................................................203

a) ExecutiveSummary .....................................................................................203

b) OverviewofValuationofLehmansCommercialRealEstatePortfolio .........................................................................................................215

c) SeniorManagementsInvolvementinValuation....................................241

d) ExaminersAnalysisoftheValuationofLehmansCommercialBook................................................................................................................266

e) ExaminersAnalysisoftheValuationofLehmansPrincipalTransactionsGroup......................................................................................285

f) ExaminersAnalysisoftheValuationofLehmansArchstonePositions.........................................................................................................356

g) ExaminersAnalysisoftheValuationofLehmansResidentialWholeLoansPortfolio .................................................................................494

h) ExaminersAnalysisoftheValuationofLehmansRMBSPortfolio .........................................................................................................527

i) ExaminersAnalysisoftheValuationofLehmansCDOs ....................538

j) ExaminersAnalysisoftheValuationofLehmansDerivativesPositions.........................................................................................................568

k) ExaminersAnalysisoftheValuationofLehmansCorporateDebtPositions ...............................................................................................583

l) ExaminersAnalysisoftheValuationofLehmansCorporateEquitiesPositions .........................................................................................594

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SectionIII.A.3:Survival

3. LehmansSurvivalStrategiesandEfforts........................................................609

a) IntroductiontoLehmansSurvivalStrategiesandEfforts.....................609

b) LehmansActionsin2008PriortotheNearCollapseofBearStearns............................................................................................................622

c) ActionsandEffortsFollowingtheNearCollapseofBearStearns .......631

VOLUME3

SectionIII.A.4:Repo105

4. Repo105................................................................................................................732

a) Repo105ExecutiveSummary.................................................................732

b) Introduction ..................................................................................................750

c) WhytheExaminerInvestigatedLehmansUseofRepo105Transactions ..................................................................................................764

d) ATypicalRepo105Transaction ................................................................765

e) ManagingBalanceSheetandLeverage ....................................................800

f) ThePurposeofLehmansRepo105ProgramWastoReverseEngineerPubliclyReportedFinancialResults.........................................853

g) TheMaterialityofLehmansRepo105Practice ......................................884

h) KnowledgeofLehmansRepo105ProgramattheHighestLevelsoftheFirm .....................................................................................................914

i) Ernst&YoungsKnowledgeofLehmansRepo105Program..............948

j) TheExaminersConclusions ......................................................................962

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VOLUME4

SectionIII.A.5:SecuredLenders

5. PotentialClaimsAgainstLehmansSecuredLenders .................................1066

a) IntroductionandExecutiveSummary....................................................1066

b) LehmansDealingsWithJPMorgan ........................................................1084

c) LehmansDealingsWithCitigroup.........................................................1224

d) LehmansDealingsWithHSBC ...............................................................1303

e) LehmansDealingsWithBankofAmerica ............................................1375

f) LehmansDealingsWithBankofNewYorkMellon............................1376

g) LehmansDealingsWithStandardBank................................................1382

h) LehmansDealingsWiththeFederalReserveBankofNewYork .....1385

i) LehmansLiquidityPool...........................................................................1401

SectionIII.A.6:Government

6. TheInteractionBetweenLehmanandtheGovernment..............................1482

a) Introduction ................................................................................................1482

b) TheSECsOversightofLehman ..............................................................1484

c) TheFRBNYsOversightofLehman ........................................................1494

d) TheFederalReservesOversightofLehman .........................................1502

e) TheTreasuryDepartmentsOversightofLehman ...............................1505

f) TheRelationshipoftheSECandFRBNYinMonitoringLehmansLiquidity....................................................................................1507

g) TheGovernmentsPreparationfortheLehmanWeekendMeetingsattheFRBNY .............................................................................1516

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h) OntheEveningofFriday,September12,2008,theGovernmentConvenedaMeetingoftheMajorWallStreetFirmsinanAttempttoFacilitatetheRescueofLehman ..........................................1523

i) LehmansBankruptcyFiling ....................................................................1535

VOLUME5

SectionIII.B:AvoidanceActions

B. AreThereAdministrativeClaimsorColorableClaimsforPreferencesorVoidableTransfers....................................................................................................1544

1. ExecutiveSummary ..........................................................................................1544

2. ExaminersInvestigationofPossibleAdministrativeClaimsAgainstLBHI(FirstBullet) .............................................................................................1546

3. ExaminersInvestigationofPossibleAvoidanceActions(Third,FourthandEighthBullets)...............................................................................1570

4. ExaminersInvestigationofPossibleBreachesofFiduciaryDutybyLBHIAffiliateDirectorsandOfficers(FifthBullet) .....................................1894

5. ExaminersAnalysisofLehmansForeignExchangeTransactions(SecondBullet) ...................................................................................................1912

6. ExaminersReviewofIntercompanyTransactionsWithinThirtyDaysofLBHIsBankruptcyFiling(SeventhBullet).....................................1938

7. ExaminersAnalysisofLehmansDebttoFreddieMac..............................1951

SectionIII.C:BarclaysTransaction

C. DoColorableClaimsAriseFromTransfersofLBHIAffiliateAssetstoBarclays,orFromtheLehmanALITransaction? ................................................1961

1. ExecutiveSummary ..........................................................................................1961

2. Facts .....................................................................................................................1965

3. WhetherAssetsofLBHIAffiliatesWereTransferredtoBarclays .............1997

4. LehmanALITransaction..................................................................................2055

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5. Conclusions ........................................................................................................2063

6. BarclaysTransaction .........................................................................................2103

UNITEDSTATESBANKRUPTCYCOURTSOUTHERNDISTRICTOFNEWYORK

x InreLEHMANBROTHERSHOLDINGSINC.,etal., Debtors.

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Chapter11CaseNo.0813555(JMP)(JointlyAdministered)

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REPORTOFEXAMINERANTONR.VALUKAS

SectionIII.A.4:Repo105

727

TABLEOFCONTENTS

4. Repo105................................................................................................................732 a) Repo105ExecutiveSummary.................................................................732 b) Introduction ..................................................................................................750 c) WhytheExaminerInvestigatedLehmansUseofRepo105

Transactions ..................................................................................................764 d) ATypicalRepo105Transaction ................................................................765

(1) TheGenesisofLehmansRepo105Programin2001 ......................765 (2) Repo105TransactionsVersusOrdinaryRepoTransactions .........766

(a) LehmansAccountingTreatmentofRepo105TransactionsVersusOrdinaryRepoTransactions .................. 768

(b) LehmansAccountingPolicyforRepo105Transactions........ 775 (c) TheAccountingPurposeoftheLargerHaircut ....................... 777 (d) LehmanDidNotRecordaCashBorrowingbut

RecordedaDerivativeAssetinaRepo105Transaction......... 781 (3) AnatomyofRepo105TransactionsandtheLinklatersTrue

SaleOpinionLetter ...............................................................................782 (4) TypesofSecuritiesUsedinRepo105Transactions .........................793 (5) ProductControllersManuallyBookedRepo105

Transactions ...........................................................................................797 e) ManagingBalanceSheetandLeverage ....................................................800

(1) LehmanManagementsFocusinLate2007onReducingtheFirmsReportedLeverage....................................................................802 (a) LehmansCalculationofNetLeverage ..................................... 804

(2) ByJanuary2008,LehmanDecidedtoCutitsNetLeverageinHalftoWinBacktheConfidenceoftheMarket,LendersandInvestors .................................................................................................805 (a) BartMcDade,asNewlyAppointedBalanceSheetCzar,

AdvisedtheExecutiveCommitteeinMarch2008toCapLehmansUseofRepo105Transactions ................................... 809

(b) McDadeBecamePresidentandCOOonJune12,2008andAuthorizedtheReductionofRepo105Usage.................. 819

(3) TheMarketsIncreasedScrutinyoftheLeverageofInvestmentBanks..................................................................................822 (a) TheCostofDeleveraging ............................................................ 825

728

(4) StickyInventoryandFIDsBalanceSheetBreachesHamperedLehmansAbilitytoManageItsNetLeverage.............828

(5) DeleveragingResultedinIntensePressureatQuarterEndtoMeetBalanceSheetTargetsforReportingPurposes .......................843

(6) LehmansEarningsCallsandPressReleaseStatementsRegardingLeverage..............................................................................845 (a) AnalystsStatementsRegardingLehmansLeverage ............. 850

f) ThePurposeofLehmansRepo105ProgramWastoReverseEngineerPubliclyReportedFinancialResults.........................................853 (1) LehmanDidNotDiscloseItsAccountingTreatmentForor

UseofRepo105TransactionsinItsForms10Kand10Q.............853 (a) LehmansOutsideDisclosureCounselWasUnawareof

LehmansRepo105Program ...................................................... 855 (2) LehmansRepo105PracticeImprovedtheFirmsPublic

BalanceSheetProfileatQuarterEnd.................................................856 (a) ContemporaneousDocumentsConfirmThatLehman

UndertookRepo105TransactionstoReduceItsBalanceSheetandReverseEngineerItsLeverage.................................. 859

(b) WitnessStatementstotheExaminerRegardingtheTruePurposeofLehmansRepo105Practice.................................... 867

(3) QuarterEndSpikesinLehmansRepo105UsageAlsoSuggesttheTruePurposeofLehmansRepo105PracticeWasBalanceSheetManipulation .......................................................870

(4) Repo105TransactionsServedNoBusinessPurposeOtherThanBalanceSheetReduction ............................................................877 (a) Repo105TransactionsCameataHigherCostThan

OrdinaryRepoTransactions ....................................................... 877 (b) WitnessesAlsoStatedThatFinancingWasNottheReal

MotiveforUndertakingRepo105Transactions ...................... 882 g) TheMaterialityofLehmansRepo105Practice ......................................884

(1) TheRepo105ProgramExposedLehmantoPotentialReputationalRisk..............................................................................884

(2) LehmansRepo105PracticeHadaMaterialImpactonLehmansNetLeverageRatio .............................................................888 (a) LehmanSignificantlyExpandedItsRepo105Practicein

Late2007andEarly2008 ............................................................. 890

729

(3) BalanceSheetTargetsforFIDBusinessesWereUnsustainableWithouttheUseofRepo105Transactions .............899

(4) RatingAgenciesAdvisedtheExaminerthatLehmansAccountingTreatmentandUseofRepo105TransactionstoManageItsNetLeverageRatioWouldHaveBeenRelevantInformation ............................................................................................902

(5) GovernmentRegulatorsHadNoKnowledgeofLehmansRepo105Program.................................................................................910 (a) OfficialsfromtheFederalReserveBankWouldHave

WantedtoKnowaboutLehmansUseofRepo105Transactions................................................................................... 910

(b) SecuritiesandExchangeCommissionCSEMonitorsWereUnawareofLehmansRepo105Program ...................... 913

h) KnowledgeofLehmansRepo105ProgramattheHighestLevelsoftheFirm .....................................................................................................914 (1) RichardFuld,FormerChiefExecutiveOfficer .................................917 (2) LehmansFormerChiefFinancialOfficers .......................................921

(a) ChrisOMeara,FormerChiefFinancialOfficer ....................... 921 (b) ErinCallan,FormerChiefFinancialOfficer ............................. 930 (c) IanLowitt,FormerChiefFinancialOfficer............................... 937

(3) LehmansBoardofDirectors...............................................................945 i) Ernst&YoungsKnowledgeofLehmansRepo105Program..............948

(1) Ernst&YoungsComfortwithLehmansRepo105AccountingPolicy .................................................................................948

(2) TheNettingGrid ...............................................................................951 (a) QuarterlyReviewandAudit....................................................... 953

(3) Ernst&YoungWouldNotOpineontheMaterialityofLehmansRepo105Usage ...................................................................954

(4) MatthewLeesStatementsRegardingRepo105toErnst&Young......................................................................................................956

(5) AccountingMotivatedTransactions..................................................962 j) TheExaminersConclusions ......................................................................962

(1) Materiality ..............................................................................................963 (a) WhetherLehmansRepo105TransactionsTechnically

CompliedwithSFAS140DoesNotImpactWhetheraColorableClaimExists ................................................................. 964

730

(2) DisclosureRequirementsandAnalysis .............................................967 (a) DisclosureObligations:RegulationSKandtheMD&A....... 968 (b) DutytoDisclose ............................................................................ 972 (c) LehmansPublicFilings............................................................... 973

(i) SummaryofLehmans2000through2007PublicFilings.................................................................................... 974

(ii) Lehmans2007Form10K,FirstQuarter2008Form10Q,andSecondQuarter2008Form10Q..................... 977 a. TreatmentofRepoTransactionsandSFAS140....... 978 b. NetLeverage................................................................. 980 c. Derivatives .................................................................... 981 d. AReaderofLehmansForms10Kand10Q

WouldNotHaveBeenAbletoAscertainThatLehmanEngagedinTemporarySalesUsingLiquidSecurities........................................................... 984

(d) ConclusionsRegardingLehmansFailuretoDisclose ............ 985 (3) ColorableClaims...................................................................................990 (4) FiduciaryDutyClaims .........................................................................991

(a) BreachofFiduciaryDutyClaimsAgainstBoardofDirectors ......................................................................................... 991

(b) BreachofFiduciaryDutyClaimsAgainstSpecificLehmanOfficers............................................................................ 992 (i) RichardFuld......................................................................... 996

a. ThereIsSufficientEvidencetoSupportaFindingBytheTrierofFactThatFuldWasatLeastGrosslyNegligentinCausingLehmantoFileMisleadingPeriodicReports............................... 997

(ii) ChrisOMeara.................................................................... 1002 a. ThereIsSufficientEvidenceToSupporta

ColorableClaimThatOMearaWasatLeastGrosslyNegligentinAllowingLehmantoFileMisleadingFinancialStatementsandEngageinMaterialVolumesofRepo105Transactions.......... 1007

b. ThereIsSufficientEvidenceToSupportaColorableClaimThatOMearaBreachedHisFiduciaryDutiesbyFailingtoInformthe

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BoardandHisSuperiorsofLehmansRepo105Practice......................................................................... 1009

(iii) ErinCallan.......................................................................... 1013 a. ThereIsSufficientEvidenceToSupporta

FindingBytheTrierofFactThatCallanBreachedHerFiduciaryDutiesbyCausingLehmantoMakeMateriallyMisleadingStatements ................................................................... 1017

b. ThereIsSufficientEvidencetoSupportaColorableClaimThatCallanBreachedHerFiduciaryDutyofCarebyFailingtoInformtheBoardofDirectorsofLehmansRepo105Program....................................................................... 1019

(iv) IanLowitt ........................................................................... 1021 (c) Remedies ...................................................................................... 1024

(5) MalpracticeClaimsAgainstErnst&Young ...................................1027 (a) BackgroundandLegalStandards ............................................ 1028

(i) ProfessionalStandards ..................................................... 1028 (ii) CommonLawStandards ................................................. 1031

(b) ThereIsSufficientEvidencetoSupportaColorableClaimThatErnst&YoungWasNegligent ............................. 1032 (i) MalpracticeinFailuretoAdviseAuditCommittee

ofRepo105ActivityandLeesAllegations................... 1033 (ii) Lehmans2008Forms10Q.............................................. 1040 (iii) Lehmans2007Form10K................................................ 1048 (iv) EffectonPriorFilings ....................................................... 1050 (v) CausationandDamages................................................... 1051

(c) PossibleDefenses ........................................................................ 1053

732

4. Repo105

a) Repo105ExecutiveSummary

Lehman employed offbalance sheetdevices, knownwithinLehman as Repo

105andRepo108transactions,totemporarilyremovesecurities inventoryfrom its

balance sheet, usually for a period of seven to ten days, and to create amaterially

misleadingpictureofthefirmsfinancialcondition in late2007and2008.2847 Repo105

transactions were nearly identical to standard repurchase and resale (repo)

transactions that Lehman (and other investment banks) used to secure shortterm

financing,with a critical difference: Lehman accounted forRepo 105 transactions as

sales as opposed to financing transactions based upon the overcollateralization or

higherthannormalhaircutinaRepo105transaction.2848 ByrecharacterizingtheRepo

105transactionasasale,Lehmanremovedtheinventoryfromitsbalancesheet.2849

2847Unlessotherwisenoted,theReportusesthetermRepo105torefertobothRepo105andRepo108transactions.Lehmantreatedthetwotransactionsidenticallyunderthesameinternalaccountingpolicyandbothtransactionssharedthesameanatomy.TheydifferedonlyinthatRepo105transactionsutilizedfixed income securities and required a minimum five percent overcollateralization amount (i.e., aminimumof$105worthofsecurities inexchangefor$100cashborrowed)whileRepo108transactionsutilized equities securities and required aminimum eightpercent overcollateralization amount (i.e., aminimumof$108worthofsecuritiesinexchangefor$100cashborrowed).2848Sale and repurchase agreements (repos) are agreementswhere one party transfers an asset orsecuritytoanotherpartyascollateralforashorttermborrowingofcash,whilesimultaneouslyagreeingto repay the cash and take back the collateral at a specificpoint in time. When the repo transactionmatures,theborrowerrepaysthefundsplusanagreeduponinterestrateandtakesbackitscollateral.Asexplained inSection III.A.4.d.2.cof theReport,overcollateralizationamounts,orhaircuts, inRepo105transactionswerehigherthanthetypicalhaircutappliedtoordinaryreposusingsimilarsecurities.2849LehmanBrothersHoldingsInc.,AccountingPolicyManualRepo105andRepo108(Feb.13,2008),atp. 2 [LBEXDOCID 3213297]; ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS ANDEXTINGUISHMENTSOFLIABILITIES, Statement of FinancialAccounting StandardsNo. 140, 2, 98 (Fin.AccountingStandardsBd.2000)(SFAS140).TheaccountingforaRepo105transactionbeganwiththe

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LehmanregularlyincreaseditsuseofRepo105transactionsinthedayspriorto

reporting periods to reduce its publicly reported net leverage and balance sheet.2850

Lehmans periodic reports did not disclose the cash borrowing from the Repo 105

transactioni.e.,althoughLehmanhadineffectborrowedtensofbillionsofdollarsin

thesetransactions,Lehmandidnotdisclosetheknownobligationtorepaythedebt.2851

Lehman used the cash from the Repo 105 transaction to pay down other liabilities,

thereby reducingboth the total liabilities and the total assets reportedon itsbalance

sheetandloweringitsleverageratios.2852Thus,LehmansRepo105practiceconsistedof

a twostepprocess: (1)undertakingRepo105 transactions followedby (2) theuseofsameentriesasanordinaryrepo;additionalentrieswerethenmadetorecharacterizetheRepo105fromasecuredfinancingtoasaleofaninventorysecurity.2850SeeSectionsIII.A.4.f.24andIII.A.4.g.2ofthisReport.2851SeeSectionsIII.A.4.d.2.dandIII.A.4.j.2.cofthisReport.2852ExaminersInterviewofMartinKelly,Oct.1,2009,atp.7(statingthatincomingcashfromRepo105transactionswasusedtopaybusinessexpenses);ExaminersInterviewofEdwardGrieb,Oct.2,2009,atpp. 1314 (stating that cash received in Repo 105 transactionswas used to pay off other liabilities);ExaminersInterviewofMatthewLee,July1,2009,atp.14(explainingthatinorderforLehmantorealizethebenefittoitsleverageratiosasaresultofRepo105transactions,thefirmhadtousethecashreceivedtopayoffadifferentliability);emailfromAnurajBismal,Lehman,toMarieStewart,Lehman,etal.(Dec.5,2007)[LBEXDOCID3223384](statingtheeffectofRepo105onnetleverageratio,whichcouldonlybeimpactedifLehmanusedRepo105cashtopaydowndifferentliabilities).GiventhatLehmanundertook$38.6billion,$49.1billion,and$50.38billionofRepo105transactionsatquarterendfourthquarter2007,firstquarter2008,andsecondquarter2008,respectively,Lehmansdisclosuresofitscashholdingsateachquarterend furtherstrengthens thewitnessstatementsandotherevidence thatLehmanused theRepo105cashborrowingforotherbusinesspurposes,includingtopaydownothershorttermliabilities. SeeLehmanBrothersHoldingsInc.,AnnualReportfor2007asofNov.30,2007(Form10K)(filedonJan.29,2008),atp.86(LBHI200710K)(reportingthatLehmanhad$7.286billionincashandcashequivalentsonNovember30,2007);LehmanBrothersHoldingsInc.,QuarterlyReportasofFeb.29,2008(Form10Q)(filedonApr.9,2008),atp.5(LBHI10Q(filedApr.9,2008))(reportingthatLehmanhad$7.564billionincashandcashequivalentsonFebruary29,2008);LehmanBrothersHoldingsInc.,QuarterlyReportasofMay31,2008(Form10Q)(filedonJuly10,2008),atp.5(LBHI10Q(filedJuly10,2008))(reportingthatLehmanhad$6.513billionincashandcashequivalentsonMay31,2008).WhileLehmansRepo105transactionsspikedatquarterends,Lehmansordinary repobalancesdroppedoffsignificantlyduringthesametimeperiods.SeeDuff&Phelps,Repo105BalanceSheetAccountingEntryandLeverageRatiosSummary(Oct.2,2009),atp.5.

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Repo105 cashborrowings topaydown liabilities, thereby reducing leverage. A few

daysafterthenewquarterbegan,Lehmanwouldborrowthenecessaryfundstorepay

thecashborrowingplusinterest,repurchasethesecurities,andrestoretheassetstoits

balancesheet.2853

LehmanneverpubliclydiscloseditsuseofRepo105transactions,itsaccounting

treatmentforthesetransactions,theconsiderableescalationofitstotalRepo105usage

in late2007and into2008,or thematerial impact these transactionshadon the firms

publiclyreportednetleverageratio.2854AccordingtoformerGlobalFinancialController

MartinKelly, a careful review of Lehmans Forms 10K and 10Qwould not reveal

2853Duff& Phelps,Repo 105 Balance SheetAccounting Entry and LeverageRatios Summary (Oct. 2,2009),atp.4;seealsoLehmanBrothersHoldingsInc.,AccountingPolicyManualRepo105andRepo108(Feb.13,2008),atp.2[LBEXDOCID3213297].2854ExaminersInterviewofMarieStewart,Sept.2,2009,atp.15;ExaminersInterviewofMartinKelly,Oct.1,2009,atp.9;ExaminersInterviewofEdwardGrieb,Oct.2,2009,atp.14;ExaminersInterviewofMatthewLee,July1,2009,atp.15;seealsoSectionsIII.A.4.f.1andIII.A.4.j.2.cdofthisReport(discussingLehmansForms10Kand10Q).InitsForms10Kand10Q,Lehmandefineditsnetleverageratioasnetassetsdividedby tangibleequitycapital. Lehmandefinednetassetsas totalassetsexcluding: (1)cashandsecuritiessegregatedandondepositforregulatoryandotherpurposes;(2)securitiesreceivedascollateral;(3)securitiespurchasesunderagreementstoresell;(4)securitiesborrowed;and(5)identifiableintangibleassetsandgoodwill.LBHI200710K,atp.63;LBHI10Q(filedApr.9,2008),atp.72;LBHI10Q (filed July10,2008),atp. 88. Lehman calculated tangible equity capitalby including stockholdersequityandjuniorsubordinatednotesandexcludingidentifiableintangibleassetsandgoodwill.SeeLBHI200710K(Nov.30,2007),atp.63;LBHI10Q(filedApr.9,2008),atp.72;LBHI10Q(filedJuly10,2008),atp.88.Incontrast,Lehmansleverageratiowasgenerallycomputedbysimplydividingtotalassetsbystockholdersequity. TheExaminersconclusion thatLehmanneverdisclosed itsRepo105practicewas confirmed by severalLehmanwitnesses, including two formerGlobal FinancialControllerswhooversawthepreparationoftheForms10Kand10Q.ExaminersInterviewofMartinKelly,Oct.1,2009,atp.9;Examiners InterviewofEdwardGrieb,Oct.2,2009,atp.14.; see alsoSection III.A.4.j.2of thisReport, infra(containingExaminersanalysisofLehmansForm10KandForm10Qdisclosures). ThisReportdoesnotreachthequestionwhetherLehmansRepo105transactionstechnicallycompliedwiththe relevant financialaccounting standard,SFAS140. As set forthbelow, theanswer to thatquestiondoesnot impactwhether there is sufficient evidence to supporta colorable claim regardingLehmansfailure todisclose itsRepo 105practice andwhether that failure rendered the firmsperiodic reportsmateriallymisleading.

735

Lehmans use of Repo 105 transactions.2855 Lehman failed to disclose its Repo 105

practice even though Kelly believed that the only purpose or motive for the

transactionswas reduction inbalance sheet; felt thattherewasno substance to the

transactions; and expressed concerns with Lehmans Repo 105 program to two

consecutiveLehmanChiefFinancialOfficersErinCallanand IanLowittadvising

themthatthelackofeconomicsubstancetoRepo105transactionsmeantreputational

risktoLehmanifthefirmsuseofthetransactionsbecameknowntothepublic.2856In

additiontoitsmaterialomissions,Lehmanaffirmativelymisrepresentedinitsfinancial

statementsthatthefirmtreatedallrepotransactionsasfinancingtransactionsi.e.,not

salesforfinancialreportingpurposes.2857

Startinginmid2007,Lehmanfacedacrisis:marketobserversbegandemanding

that investmentbanksreducetheir leverage.2858 The inabilitytoreduce leveragecould

leadtoaratingsdowngrade,whichwouldhavehadanimmediate,tangiblemonetary

impactonLehman.2859 InaSeptember2007email comparingLehmansnet leverage

2855ExaminersInterviewofMartinKelly,Oct.1,2009,atp.9.2856Id.atpp.710.2857TheNotestoLehmansConsolidatedFinancialStatementsforeachperiodstatedthatLehmantreated[r]epurchaseandresaleagreementsascollateralizedagreementsandfinancingsforfinancialreportingpurposes.SeeLBHI200710K,atp.97;LBHI10Q(filedApr.9,2008),atp.13;LBHI10Q(filedJuly10,2008), atp. 16. TheNotes further stated that Other secured borrowingsprincipally reflect transfersaccountedforasfinancingsratherthansalesunderSFAS140.LBHI200710K,atp.97;LBHI10Q(filedApr.9,2008),atp.13;LBHI10Q(filedJuly10,2008),atp.16.2858Examiners Interview of Michael McGarvey, Sept. 11, 2009, at pp. 56; Mark Jickling, AvertingFinancialCrisis,CRSReportforCongress,at79(Mar.10,2008,updatedonOct.8,2008).2859Adowngradeinanissuerscreditratinghasasignificantnegativeimpactonthefinancialpositionofacompany likeLehman. See,e.g.,emailfromIanT.Lowitt,Lehman,toHerbertH.(Bart)McDadeIII,

736

ratiotoBearStearns,PaoloTonucci,LehmansGlobalTreasurer,wrotethatLehmans

net leverage calculation was intended to reflect themethodology employedbyS&P

who were most interested and focused on leverage.2860 In midtolate 2007, top

Lehmanexecutivesfromacrossthefirmfeltpressuretoreducethefirms leveragefor

quarterlyandannualreports.2861InresponsetoTonuccisSeptember2007email,Ryan

Traversari,SeniorVicePresident forExternalReporting,wrote that thequestionof

netleverageratiohascomeupmultipletimesinthe20secondsthatIvebeenhere

largely from [thenCFO] OMeara, Freidheim, Lowitt, Corporate Strategy, Investor

Relationsandthelike.2862

ByJanuary2008,LehmanCEOFuldorderedafirmwidedeleveragingstrategy,

hoping to reduce the firms positions in commercial and residential real estate and

Lehman (June30,2008) [LBHI_SEC07940_643543] (Onenotchdowngraderequires1.7bn;and2notchrequires 3.4 bn of additional margin posting.). Counterparties may respond to a downgrade bydemandingthattheissuerpostadditionalcashcollateraltosecureitsobligations.SeeAmadouN.R.Sy,The Systemic Regulation of Credit Rating Agencies and Rated Markets 89 (Intl Monetary Fund,Working Paper, 2009) (noting that brokerdealers may use credit ratings to determine acceptablecounterparties, aswell as collateral levels foroutstanding credit exposure); email from IanT.Lowitt,Lehman, toEricFelder,Lehman (July 5,2008) [LBEXDOCID 071263] (stating that adowngrade willaffectlinesandwillingnessofcounterpartiestofundsecured). SomeofLehmansderivativecontractshadbuiltintriggerspermitting counterparties to requireadditional cash collateral in the eventofadowngrade.SeealsoLehman,GlobalTreasuryDowngradeEffectonCashCapitalFacilities(June3,2008)[LBHI_SEC07940_513314](attachedtoemailfromAmberishRatanghayra,Lehman,toPaoloR.Tonucci,Lehman,etal.(June3,2008)[LBHI_SEC07940_513312]);seealsoAppendix13,Survival,atpp.13.2860EmailfromPaoloR.Tonucci,Lehman,toMarieStewart,Lehman,etal.(Sept.10,2007)[LBEXDOCID1695576].2861Email from IanT.Lowitt,Lehman, toGerardReilly,Lehman, et al. (Sept. 7, 2007) [LBEXDOCID1357178]; email from Ryan Traversari, Lehman, to Paolo R. Tonucci, Lehman, et al. (Sept. 11, 2007)[LBEXDOCID1695576];seeSectionsIII.A.4.e.13,6ofthisReport(discussingimportanceofnetleverageforpublicperceptionofLehmanandforreportingpurposes)2862Email fromRyanTraversari,Lehman, toPaoloR.Tonucci,Lehman (Sept.11,2007) [LBEXDOCID1695576].

737

leveraged loans in particular by half.2863 In the words of one internal Lehman

presentation,Reducingleverageisnecessarytoremoverefinancingriskandwinback

theconfidenceofthemarket,lenders,andinvestors.2864

Fuld recalled that Lehman had to improve its net leverage ratio by selling

inventory because there was a perception issue with raising equity.2865 Selling

inventory,however,proveddifficultinlate2007andinto2008because,startinginmid

2007,many of Lehmans inventory positions had grown increasingly sticky i.e.,

difficulttosellwithoutincurringsubstantiallosses.Moreover,sellingstickyinventory

atreducedpricescouldhaveledtoalossofmarketconfidenceinLehmansvaluations

forinventoryremainingonthefirmsbalancesheetsincefiresalepricingwouldreveal

thatLehmanhadalotofairin[its]marks.2866

In light of these factors, Lehman relied at an increasing pace on Repo 105

transactionsateachquarterendinlate2007andearly2008.Lehmansexpansionofits

Repo 105 program mitigated, in part, the adverse impact its increasingly

sticky/illiquid inventory comprisedmostlyof the leveraged loansand residential

and commercial real estatepositionsFuldwanted to exitwashavingon the firms

2863ExaminersInterviewofRichardS.Fuld,Jr.,Sept.25,2009,atpp.2627.2864Erin Callan, Lehman, Lehman Brothers Leverage Analysis (Apr. 7, 2008), at p. 1 [LBEXDOCID1401225].2865ExaminersInterviewofRichardS.Fuld,Jr.,Sept.25,2009,atp.27.AccordingtoFuld,ifLehmanhadraised equity, itwould have improved net leverage, butwould not have fixed Lehmans underlyingproblem.Id.FuldstatedthathewantedLehmantoimproveitsnetleveragebysellingassets.Id.2866ExaminersInterviewofTreasurySecretaryTimothyF.Geithner,Nov.24,2009,atpp.78.

738

publiclyreportednetleverageandnetbalancesheet.2867Anearly2007documentfrom

LehmansarchivesconcludingthatRepo105offersalowcostwaytooffsetthebalance

sheetand leverage impactofcurrentmarketconditions, furtherstated that[e]xiting

largeCMBSpositions inRealEstateandsubprime loans inMortgagesbeforequarter

endwould incur large lossesdue to the steepdiscounts that theywouldhave tobe

offeredatandcarrysubstantialreputationriskinthemarket. . . .ARepo105increase

would help avoid thiswithout negatively impacting our leverage ratios.2868 While

Lehmandid notutilizeRepo 105 transactions for selling sticky inventory, the firms

expanded use of Repo 105 transactions at quarterend impacted Lehmans publicly

reportednetleverageratio.2869

2867SeeSectionIII.A.4.e.4ofthisReport(discussingstickyinventory).Theconceptofnetbalancesheetisused interchangeablywithnetassets in thisReport. Thenetassetcalculationbeginswithtotalassets as reported for GAAP purposes in Lehmans Forms 10K and 10Q. From there, Lehmansubtractedcertainassets toarriveatnetassets: (i)cashandsecuritiessegregatedandondeposit forregulatoryandotherpurposes;(ii)collateralizedlendingagreements(e.g.,securitiesLehmanisholdingascollateralforaloanmadetoathirdparty);and(iii)identifiableintangibleassetsandgoodwill.SeeLBHI200710K,atpp.30,61.2868JosephGentile, Lehman, Proposed Repo 105/108 Target Increase for 2007 (Feb. 10, 2007), at p. 1[LBEXDOCID 2489498] (attached to email from JosephGentile, Lehman, to EdwardGrieb, Lehman(Feb.10,2007)[LBEXDOCID2600714]).2869Asdiscussed infraatpp.84346,LehmanattemptedtomovelessliquidinventoryintotheRepo105program, butwas unable to findwilling counterparties. As discussed in Section III.A.4.d.2.a of thisReport,atthemomentofaRepo105transaction,Lehmanreduced its inventoryassetsbutreceivedcash,therebyhavinganetneutraleffectontotalassets.BecauseLehmandidnotreflectthecashborrowingonits balance sheet as a liability (as it did in ordinary repo transactions), at themoment of a Repo 105transaction,thetransactionalsohadanetneutraleffectontotal liabilities. Lehman,however,usedthecash borrowing inRepo 105 transactions topaydifferent shortterm liabilities, thereby reducing bothtotalassetsand total liabilities. Byengaging inRepo105 transactionsandusing thecashborrowings,Lehmanreduceditsreportedleverageratios.

739

In thisway,unbeknownst to the investingpublic,ratingagencies,Government

regulators,andLehmansBoardofDirectors,Lehmanreverseengineeredthefirmsnet

leverageratioforpublicconsumption.Notably,duringLehmans2008earningscallsin

whichittouteditsleveragereduction,analystsfrequentlyinquiredaboutthemeansby

whichLehmanwas reducing its leverage.2870 AlthoughCFOCallan toldanalysts that

Lehmanwastrying togivethegroupagreatamountoftransparencyonthebalance

sheet, she reported thatLehmanwas reducing its leverage through the sale of less

liquidassetcategoriesbutsaidnothingaboutthefirmsuseofRepo105transactions.2871

Despite thebeliefofLehmanpersonnel thatnoneof the firmspeer investment

banks still used similar accountingmethods for repo transactions to arrive at their

leverage numbers, to which Lehmans reported net leverage was compared, Lehman

temporarilyreduceditsnetbalancesheetatquarterendthrough itsRepo105practice

byapproximately$38.6billioninfourthquarter2007,$49.1billioninfirstquarter2008,

and$50.38billioninsecondquarter2008.2872

2870SeeSectionIII.A.4.e.6ofthisReport.2871See Final Transcript of Lehman BrothersHoldings Inc. FirstQuarter 2008 EarningsCall (Mar. 18,2008), at p. 13 [LBHI_SEC07940_7277784]; see also Final Transcript of Lehman BrothersHoldings Inc.Fourth Quarter 2007 Earnings Call (Dec. 13, 2007), at p. 7 [LBHI_SEC07940_7222291]; Transcript ofLehmanBrothersHoldingsInc.PreliminarySecondQuarter2008EarningsCall(June9,2008),atpp.34,12[LBHI_SEC07940_2554480].2872NumerousLehmanwitnessesand internalLehman emails stated thatbyDecember2007,Lehmanpersonnel believed that Lehman was the last of its peer investment banks to use Repo 105typetransactions. The Examiner has not verifiedwhether otherCSE firms at one time used this type oftransactionbut laterceased. MartinKelly (formerGlobalFinancialController),AnurajBismal (formerSeniorVicePresidentBalanceSheetGroup),MarieStewart(formerGlobalHeadofAccountingPolicy),andMichaelMcGarvey(FIDFinance)saidthattheybelievedLehmanwastheonlyCSEfirmengagingin

740

LehmanfirstintroduceditsRepo105programinapproximately2001.2873Unable

tofindaUnitedStateslawfirmthatwouldprovideitwithanopinionletterpermitting

thetruesaleaccountingtreatmentunderUnitedStateslaw,LehmanconducteditsRepo

105programunder the aegis of an opinion letter theLinklaters law firm inLondon

wrote for LBIE, Lehmans European brokerdealer in London, under English law.2874

Accordingly, ifUnitedStatesbasedLehmanentities suchasLBIandLBSFwished to

engageinaRepo105transaction,theytransferredtheirsecuritiesinventorytoLBIEin

orderforLBIEtoconductthetransactionontheirbehalf.2875

While not referenced or incorporated into Lehmans internal Repo 105

AccountingPolicy,seniorLehmanmanagementsetlimitsonthetotalamountbywhich

Repo105typetransactionsby late2007. ExaminersInterviewofMarieStewart,Sept.2,2009,atp.14;Examiners Interview ofMichaelMcGarvey, Sept. 11, 2009, at p. 11; Examiners Interview ofAnurajBismal,Sept.16,2009,atp.7;ExaminersInterviewofMartinKelly,Oct.2,2009,atp.8.InaDecember2007email,Bismalwrote:[W]aschattingwithexlehmanemployee[CarlosLo]atMerrillyesterdayheis in their balance sheet group he toldme that theydo notuse repo 105, towhichMarie Stewartreplied,Thenthatmeanswearetheonlyone leftwhodoes. EmailfromMarieStewart,Lehman,toAnurajBismal,Lehman,etal.(Dec.5,2007)[LBEXDOCID3223386].InaJanuary2008email,McGarveywrote: By thewaywe are now the only large firm on the street that usesRepo 105. Email fromMichaelMcGarvey,Lehman,toClementBernard,Lehman(Jan.30,2008)[LBEXDOCID2796630]. InaMay2008email toOMeara (thenChiefRiskOfficer),RyanTraversari (SeniorVicePresidentExternalReporting)reported thatCitigroupand JPMorganlikelydonotdoRepo105andRepo108whichareUKbased specific transactions on opinions received by LEH from Linklaters. Thiswould be anotherreasonwhy LEHs daily balance sheet is larger intramonth then atmonthend. Email fromRyanTraversari,Lehman,toChristopherM.OMeara,Lehman,etal.(May16,2008)[LBEXDOCID574498].Insum, itwaswidelybelievedwithinLehmanby late2007that itwastheonlyfirmusingRepo105typetransactionstoreducebalancesheetandimpactthefirmsnetleverageratio.2873SeeSectionIII.A.4.d.1ofthisReport.2874SeeSectionIII.A.4.d.3ofthisReportandAppendix17,Repo105Appendix.2875AsexplainedinSectionIII.A.4.d.3ofthisReport,UnitedStatesbasedLehmanentitiesengagedonlyinRepo105,andnotinRepo108transactions.RegardlessofwhichLehmanentitytransferredsecuritiesineitheraRepo105orRepo108transaction,thebalancesheetandleveragereductionbenefitwasfirmwide,asLehmanranitsbusinessonaconsolidatedbasis.

741

thefirmcouldreduceitsbalancesheetonanygivendayusingRepo105transactions.2876

In July 2006, the limit was set at 1x leverage for Repo 105 transactions, or $17

billion.2877 Combinedwitha$5billion limitforRepo108transactions,Lehmansfirm

wide cap on combinedRepo 105/108 transactionswas $22 billion in the summer of

2006.2878AsofJanuary2008,thefirmwidecaponcombinedRepo105/108transactions

at quarterend was $25 billion, though in fact, Lehman exceeded the cap by

approximately$25billioninfirstandsecondquarter2008.2879Beginninginmid2007

theverytimethatthemarketbegantoparticularlyfocusoninvestmentbanksleverage

Lehman breached its internal limit on Repo 105 activity at every quarterend,

2876Examiners InterviewofPaoloR.Tonucci,Sept.16,2009,atp.27;Examiners InterviewofEdwardGrieb,Oct.2,2009,atp.8.2877Lehman,GlobalBalanceSheet,OverviewofRepo105(FID)/108(Equities)(July2006),atp.2[LBEXWGM748489].WhenquestionedaboutthecalculationoftheRepo105limitsetoutintheGlobalBalanceSheet Overview Presentation, former Lehman Financial Controller Ed Grieb could not recall thecalculationofthelimitorwhetherthe1xleverageor$17billiondefinitionreferredtooneofLehmansleverageratiosor,rather,totangibleequitycapital.ExaminersInterviewofEdwardGrieb,Oct.2,2009,atp.9. LehmansForm10QfromthesameperiodastheGlobalBalanceSheetOverviewPresentationshowsthatLehmanstangibleequitycapitalwas$17.4billionandthatthefirmsnetleverageratiowas13.8,suggestingthatthesettingofLehmansRepo105limitmayhavebeentiedtotangibleequitycapital.LehmanBrothersHoldingsInc.,QuarterlyReportasofMay31,2006(Form10Q)(filedonJuly10,2006),at p. 58 (LBHI 10Q (filed July 10, 2006)). TheGlobal Balance SheetOverview Presentation itselfsuggested that tangibleequity is theappropriatemeasureof leverage. Lehman,GlobalBalanceSheet,OverviewofRepo105(FID)/Repo108Equities(July2006),atp.5[LBEXWGM748489];seealsoDuff&Phelps,Repo105/108Usagevs.LimitComment(Oct.16,2009),atp.1.Theconclusionthat1xleveragemeans that theRepo105 limitwas1x the tangibleequitymetric isalsosupportedby the fact that thedenominatorofLehmansnet leverageratio is tangibleequity. Duff&Phelps,Repo105/108Usagevs.LimitComment (Oct.16,2009),atp.1&n.4. Thesettingof theRepo105 limitat1x tangibleequityimpliesthatLehmanmanagementauthorizedRepo105usagetoreduceLehmansnetleverageratiobyuptoonemultiple,or1.0.Id.atp.2.2878Lehman,GlobalBalanceSheet,OverviewofRepo105(FID)/108(Equities)(July2006),atp.2[LBEXWGM748489].2879Email from Sigrid Stabenow, Lehman, toClement Bernard, Lehman, et al. (Jan. 25, 2008) [LBEXDOCID1853428](requestingthatRepo105limitof$20billionbeexpandedto$23billion).

742

temporarilyremovingasmuchas$50.38billioninsecuritiesinventoryfromitsbalance

sheetinsecondquarter2008.2880

LehmandramaticallyrampedupitsuseofRepo105transactionsinlate2007and

early 2008 despite concerns about the practice expressed by Lehman officers and

personnel. InanApril2008emailasking ifhewas familiarwith theuseofRepo105

transactions to reduce net balance sheet, Bart McDade, Lehmans former Head of

Equities(20052008)andPresidentandChiefOperatingOfficer(JuneSeptember2008),

replied:Iamveryaware . . .itisanotherdrugweron.2881 Aweekearlier,McDade

hadrecommendedtoLehmansExecutiveCommitteethatthefirmsetacapontheuse

ofRepo105transactions.2882 AseniormemberofLehmansFinanceGroupconsidered

LehmansRepo105program tobebalancesheetwindowdressing thatwasbased

on legal technicalities.2883 Other former Lehman employees characterizedRepo 105

2880Lehman,TotalRepo105/108Trend(Feb.20,2008)[LBHI_SEC07940_1957956](statingtotalRepo105usageforAugust30,2007,closeofthirdquarter2007,was$36.4billion);Lehman,TotalRepo105&Repo108Report (Dec.5,2007) [LBEXDOCID3219746] (attached to email fromAnurajBismal,Lehman, toMarieStewart,Lehman,etal.(Dec.5,2007)[LBEXDOCID3223384]andstatingthattotalfirmwideRepo105usageonNov.30,2007was$38.634billion);Lehman,TotalRepo105&Repo108Report (June11,2008)[LBEXDOCID2078195](attachedtoemailfromKristieWong,Lehman,toMartinKelly,Lehman(June11,2008)[LBEXDOCID2325872]andstatingthattotalfirmwideRepo105usageonFeb.29,2008was$49.102billionandonMay30,2008was$50.383billion).Notethatin2008,May31wasaSaturday.Assetforthbelow,theExaminerconcludesthattheevidencesupportstheexistenceofcolorableclaimsarising fromLehmans failure todisclose itsRepo105practiceand the impact these transactionshadonLehmanspubliclyreportednetleverageandbalancesheet.2881Email fromHerbertH. (Bart)McDade III,Lehman, toHyungLee,Lehman (Apr. 3, 2008) [LBEXDOCID1570783].2882ExaminersInterviewofHerbertH.(Bart)McDadeIII,Jan.28,2010,atpp.34.2883EmailfromMichaelMcGarvey,Lehman,toJormenVallecillo,Lehman(July2,2008)[LBEXDOCID3379145].

743

transactions as an accounting gimmick and a lazyway ofmanaging the balance

sheet.2884

Inaddition to the firmwidecapon totalRepo105usage,managementcreated

two related rules looselyknownwithinLehmanas (1) the80/20orcontinualuse

ruleand(2)the120%rule.2885Theserulesprescribed,respectively,aminimallevelof

continualuseofRepo105transactionsthroughoutthequarterandamaximumvolume

of Repo 105 transactions at quarterend.2886 Former Financial Controller Ed Grieb

described the purpose of the rules: tomake sure there was a legitimate business

purposeforRepo105transactions.2887

Lehmandidnotactuallyfollowtheseselfimposedrules.Thatisnotsurprising,

sincenowitnesswasabletoprovidearationalbusinessexplanationforthearbitrary1x

leverage,continualuse,and120%rules. IfRepo105transactionsmadegoodbusiness

2884ExaminersInterviewofMurtazaBhallo,Sept.14,2009;ExaminersInterviewofMarieStewart,Sept.2,2009,atp.7.2885ExaminersInterviewofEdwardGrieb,Oct.2,2009,atp.13;Lehman,GlobalBalanceSheetOverviewofRepo105(FID)/108(Equities)(July2006),atp.2[LBEXWGM748489](Repo105transactionsmustbeexecutedonacontinualbasisandremaininforcethroughoutthemonth.Tomeetthisrequirement,theamountoutstandingatany timeshouldbemaintainedatapproximately80%of theamountatmonthend.[perChrisOMearaandEdGrieb.]);emailfromMichaelMcGarvey,Lehman,toKentaroUmezaki,Lehman,etal.(Aug.17,2007)[LBEXDOCID1635769](Theguidelineformonthendusageofrepo105isthatitshouldnotexceed120%ofyourdailyaverage.).2886See Lehman,Global Balance SheetOverview of Repo 105 (FID)/108 (Equities) (July 2006), at p. 2[LBEXWGM748489](Repo105transactionsmustbeexecutedonacontinualbasisandremaininforcethroughout the month. To meet this requirement, the amount outstanding at any time should bemaintainedatapproximately80%oftheamountatmonthend.[perChrisOMearaandEdGrieb.]);email fromMichaelMcGarvey, Lehman, to Kentaro Umezaki, Lehman, et al. (Aug. 17, 2007) [LBEXDOCID1635769](Theguidelineformonthendusageofrepo105isthatitshouldnotexceed120%ofyourdailyaverage.).2887ExaminersInterviewofEdwardGrieb,Oct.2,2009,atp.13.

744

senseontheirown,therewouldbenoapparentreasontoarbitrarilyrestricttheamount

ofsuch transactions to1x leverageor to impose intramonth limits toensure that the

amount of the transactions at reportingperiodsdid not spike tomore than 120% of

averageusage. Noreason,that is,excepttokeepthetransactionsundertheradar,by

limitingtheirtotalandtheamountofaquarterendspike.

Lehmans Fixed Income Division (FID), in particular, employed Repo 105

transactions to reach quarterend balance sheet targets set by senior Lehman

management in connection with the firmwide effort to reduce net leverage. For

example,fourdayspriortothecloseoffiscalyear2007,JerryRizzieriwasinsearchofa

way tomeethisbalance sheet target andwrote toMitchellKing: Canyou imagine

whatthiswouldbelikewithout105?2888WhenFIDsbalancesheetwasabovetargetin

thedaysleadinguptothecloseofthefirstquarter2008,aseniorfinancialofficerwithin

thatdivisionwarned that thedivisionwaslookingat sellingwhateverwe canand

alsodoing somemore repo105.2889 Similarly, theheadof theLiquidMarketsgroup

within FIDwrote at the same quarterend regarding the groups balance sheet: We

2888 Email from Jerry Rizzieri, Lehman, to Mitchell King, Lehman (Nov. 26, 2007) [LBEXDOCID3232804].2889EmailfromClementBernard,Lehman,toMartinPotts,Lehman,etal.(Feb.28,2008)[LBEXDOCID1854189].

745

haveadesperatesituationandIneedanother2billionfromyou,eitherthroughRepo

105oroutrightsales.Costisirrelevant,weneedtodoit.2890

Lehmans reliance upon Repo 105 transactions for quarterend balance sheet

relief continued intoLehmans secondquarter 2008. In an email titled Q2balance

sheetanddatedMay21,2008 tendaysbeforeLehmanssecondquarterclose the

head of the LiquidMarkets groupwrote: Do asmuch as you can inRepo 105 in

response to the question Do u thkwe can be flexible beyond $3bn in 105?2891 In

anotherMay21,2008email,theheadofLiquidMarketsasked:Arewegoingtomake

the FID Europe [balance sheet] target, which elicited the response: V close . . .

anythingthatmovesisgetting105d.2892

Several additional contemporaneous emails retrieved from Lehman archives

succinctlysetforthLehmanspurposeforundertakingRepo105transactions:

[T]hefirmhasafunctioncalledrepo105wherebyyoucanrepoapositionforaweekanditisregardedasatruesaletogetridofnetbalancesheet.2893

Wehave beenusingRepo 105 in thepast to reduce balance sheet at thequarterend.2894

2890Email from Kaushik Amin, Lehman, to Kieran Higgins, Lehman (Feb. 28, 2008) [LBEXDOCID3234351].2891Email fromKaushikAmin,Lehman, toThomasSiegmund,Lehman (May21,2008) [LBEXDOCID756545].2892Email from Kieran Higgins, Lehman, to Kaushik Amin, Lehman (May 21, 2008) [LBEXDOCID3234382].2893EmailfromAnthonyJawad,Lehman,toAndreaLeonardelli,Lehman(Feb.29,2008)[LBEXDOCID224902].2894Email from RaymondChan, Lehman, to PaulMitrokostas, Lehman, et al. (July 15, 2008) [LBEXDOCID3384937].

746

Whenpressed to identifyany legitimatebusinesspurpose forLehmansuseof

Repo 105 transactions, certain witnesses noted the secured shortterm financing

afforded by the transactions. While one outcome ofRepo 105 transactionswas that

Lehman received financing in exchange for collateral whichwas not reflected in

Lehmansperiodic reportsasaborrowingor liabilityaRepo105 transactionwasa

moreexpensivewayforLehmantosecuresuchshorttermfinancingascomparedtoan

ordinary repo transaction. Lehman had the ability to conduct an ordinary repo

transactionusingthesamesecuritiesandwithsubstantiallythesamecounterpartiesas

inRepo105transactions,atalowercost.2895Assuch,thesamewitnesseswhoidentified

afinancingpurposeforRepo105transactions,aswellasseveralotherformerLehman

personnel,uniformlyacknowledgedthattheoverarchinggoalofRepo105transactions

was to meet net balance sheet targets i.e., reduce the net asset component (the

numerator) of the net leverage ratio calculation in connection with the filing of

Lehmans financial statements. While the Examiner found a large number of

contemporaneous documents that talk about the use of Repo 105 transactions to

manage the balance sheet andmeet leverage targets, few, if any, contemporaneous

documentsdescribe anyotherpurpose for those transactions. Repo 105 transactions

werenotusedforabusinesspurpose,butinsteadforanaccountingpurpose:toreduce

Lehmanspubliclyreportednetleverageandnetbalancesheet.

2895ExaminersInterviewofJohnFeraca,Oct.9,2009,atp.6.

747

As set forthmore fullybelow, theExaminerconcludes thata fact findercould

findthatLehmansfailuretodiscloseitsuseofRepo105transactionstoimpactitsbalance

sheet at a timewhen both themarket and seniorLehmanmanagementwere keenly

focusedon the reductionofLehmans firmwidenet leverageandbalance sheet,and

particularly in light of the specific volumes atwhich Lehman undertook Repo 105

transactionsatquarterendinfourthquarter2007,firstquarter2008,andsecondquarter

2008,materiallymisrepresentedLehmanstruefinancialcondition.

AtrieroffactcouldfindthatLehmansuseoftensofbillionsofdollarsofRepo

105transactionsatquarterendinlate2007andearly2008renderedthefirmsfinancial

statementsandrelateddisclosuresmateriallymisleading. Indeed,auditwalkthrough

paperspreparedbyLehmansoutsideauditor,Ernst&Young,2896regardingtheprocess

forreopeningoradjustingaclosedbalancesheetstated:Materialityisusuallydefined

asany item individually,or in theaggregate, thatmovesnet leverageby0.1ormore

(typically$1.8billion).2897 Repo105movednet leveragenotby tenths,butbywhole

points.2898

2896Ernst&YoungrefersonlytoErnst&YoungLLP(i.e.,Ernst&YoungNorthAmerica)unlessstatedotherwise.2897Ernst&Young,LBHI/LBIWalkthroughTemplateforBalanceSheetCloseProcess(Nov.30,2007),atp.14[EYLELBHICORPGAMX07033384];seealsoSectionIII.A.4.g,whichdiscussesandanalyzesthematerialityofRepo105transactions.2898SeeSectionIII.A.4.g.2ofthisReport;emailfromAnurajBismal,Lehman,toMarieStewart,Lehman,etal.(Dec.5,2007)[LBEXDOCID3223384](statingthatLehmanwouldbeatnet leverageof18.0x[vssay16.3x]withoutrepo105/8).

748

Lehmans publicly reported net leverage ratio forNovember 30, 2007 (fourth

quarter2007),February29,2008(firstquarter2008),andMay31,2008(secondquarter

2008)was16.1x,15.4xand12.1x,respectively.2899 Without thebalancesheetbenefitof

Repo105 transactions,Lehmansnet leverageratios for thesameperiodswouldhave

been17.8x,17.3xand13.9x,respectively:2900

Date Repo105Usage

ReportedNetLeverage

LeverageWithoutRepo

105

Difference

Q42007 $38.6B2901 16.12902 17.82903 1.7Q12008 $49.1B2904 15.42905 17.32906 1.9Q22008 $50.38B2907 12.12908 13.92909 1.8

2899LBHI200710K,atp.64;LBHI10Q(filedApr.9,2008),atp.72;LBHI10Q(filedJuly10,2008),atp.89.2900Duff& Phelps,Repo 105 Balance SheetAccounting Entry and LeverageRatios Summary (Oct. 2,2009),atp.8;seealsoSectionIII.A.4.g.2oftheReport(discussingimpactofLehmansRepo105practiceonLehmansnetleverageratio).2901Lehman, Total Repo 105/108 Trend (Feb. 20, 2008) [LBHI_SEC07940_1957956] (stating that fourthquarter2007Repo105usagewas$38.634billion); see alsoLehman,GlobalConsolidatedBalanceSheet(Final) (Nov. 30, 2007) [LBEXDOCID 3439086] (stating that fourth quarter 2007Repo 105 usagewas$38.634billion). Notethatmany internalLehmandocuments,suchastheGlobalConsolidatedBalanceSheet,usedaRepo105heading to refer tobothRepo105andRepo108usage. Insuchdocuments,Repo108usagemaybedisaggregatedfromtheRepo105usagebyidentifyingthelineitemforEquities.Repo105transactionsusingEquitiesinventorywereactuallyRepo108transactions.2902SeeLBHI200710K,atpp.29,64.2903Duff& Phelps,Repo 105 Balance SheetAccounting Entry and LeverageRatios Summary (Oct. 2,2009),atp.8.2904Lehman,TotalRepo105&Repo108Report(June11,2008)[LBEXDOCID2078195](statingthatfirmwideRepo105usagewas$49.102billionatcloseoffirstquarter2008,Feb.29,2008).2905SeeLBHI10Q(filedApr.9,2008),atp.72.2906Duff& Phelps,Repo 105 Balance SheetAccounting Entry and LeverageRatios Summary (Oct. 2,2009),atp.8.2907Lehman,TotalRepo105&Repo108Report(June11,2008)[LBEXDOCID2078195](statingthatfirmwideRepo105usagewas$50.3834billionatcloseofsecondquarter2008,May30,2008).NotethatMay31in2008wasaSaturday.2908SeeLBHI10Q(filedJuly10,2008),atp.89.2909Duff& Phelps,Repo 105 Balance SheetAccounting Entry and LeverageRatios Summary (Oct. 2,2009),atp.8.

749

Lehmans directors, the rating agencies, and Government regulators all of

whomwere unaware of Lehmans use ofRepo 105 transactions have advised the

Examiner thatLehmansRepo105usagewasmaterialor significant information that

theywouldhavewantedtoknow.2910TheExaminerconcludesthatsufficientevidence

exists for a trier of fact to find that Lehmans quarterend Repo 105 practice was

materialandshouldhavebeendisclosed.2911

Because Lehman treated Repo 105 transactions as sales rather than financing

transactions,accounting rulesdidnot requireLehman to record the liabilitiesarising

from the cash borrowings inRepo 105 transactions. Nevertheless, there is sufficient

evidencetosupportadeterminationthatdisclosureoftheobligationtorepurchasethe

securitiesandrepaythecashborrowingwasrequiredintheManagementsDiscussion

andAnalysis(MD&A)sectionofLehmanspubliclyfiledfinancialstatementsbecause

therepurchasewasaknowneventthatwasreasonablylikelytooccurandwouldhave

hadamaterialeffectonthecompanysfinancialconditionorresultsofoperations.2912A

trieroffactcouldfurtherfindthatbyfailingtodisclosethetensofbillionsofdollarsof

Repo105transactionsandcashborrowings,LehmansdisclosuresintheLiquidityand

2910See Sections III.A.4.g.45 and III.A.4.h.3 of this Report (discussing rating agencies, GovernmentregulatorsandLehmanBoardofDirectors).2911See Sections III.A.4.j.2.ad of this Report (explaining disclosure requirements and providingExaminersconclusionsregardingLehmansdisclosures).2912SeeSectionIII.A.4.j.2ofthisReport(discussingandanalyzingdisclosurerequirements).

750

Capital Resources Section of the MD&A were deficient.2913 In addition, Lehmans

description of its net leveragewasmisleading because it omitteddisclosing that the

ratiowasreducedbymeansoftemporary,accountingmotivatedtransactions.2914

TheExaminerconcludes that there issufficientevidence tosupportacolorable

claimthat:(1)certainofLehmansofficersbreachedtheirfiduciarydutiesbyexposing

Lehman topotential liability for filingmateriallymisleadingperiodic reports and (2)

Ernst&Young, the firms outside auditor,was professionally negligent in allowing

those reports to go unchallenged. The Examiner concludes that colorable claims of

breachoffiduciarydutyexistagainstRichardFuld,ChrisOMeara,ErinCallan,andIan

Lowitt, and that a colorable claim of professionalmalpractice exists against Ernst&

Young.2915

b) Introduction

Sale and repurchase agreements (repos) are agreements inwhich one party

transfersassetstoanotherpartyascollateralforashorttermborrowingofcash,while

simultaneouslyagreeingtorepaythecashandtakebackthecollateralataspecificpoint

intime.2916Whentherepotransactionmatures,theborrowerrepaysthefundsplusan

2913SeeSectionIII.A.4.j.2ofthisReport(discussingandanalyzingdisclosurerequirements).2914SeeSections4.g.2and4.j.2.coftheReport(discussingimpactofRepo105practiceonnetleverageratioandLehmanspublicfilings,respectively).2915SeeSectionsIII.A.4.j.4.bandIII.A.4.j.5ofthisReport(discussingevidencesupportingcolorableclaimsagainstcertainLehmanofficersandErnst&Young).2916See ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS OFLIABILITIES,StatementofFinancialAccountingStandardsNo.140,96 (Fin.AccountingStandardsBd.2000) (Government securities dealers, banks, other financial institutions and corporate investors

751

agreed upon interest rate or other charge and takes back its collateral. Repo

transactions are widely used by financial institutions and are a legitimate tool for

raisingshorttermfunding.

Likeotherlargeinvestmentbanks,Lehmanengaged,onadailybasis,intensof

billions ofdollars of repo transactions in itsnormal course ofbusiness for financing

purposes (ordinary repoor traditional repo transactions).Lehman accounted for

theseordinaryrepotransactionsasfinancingtransactions.2917Accordingly,inLehmans

traditionalrepotransactions:

The transferred securities inventory remained on Lehmans balance sheetduringthetermoftherepo.

Because the inventory remained onLehmans balance sheet, the incomingborrowedcashincreasedLehmanstotalassets.

Total liabilities also increased because Lehman recorded a correspondingliabilityrepresentingitsobligationtorepaytheborrowedcash.

While simplified and for illustrative purposes only, the five illustrations that

follow demonstrate the impact of an ordinary repo transaction and a Repo 105

transactiononLehmansbalancesheetandleverageratios.

commonlyuserepurchaseagreements toobtainoruseshortterm funds. Under thoseagreements, thetransferor (repo party) transfers a security to a transferee (repo counterparty or reverse party) inexchangeforcashandconcurrentlyagreestoreacquirethatsecurityatafuturedateforanamountequaltothecashexchangedplusastipulatedinterestfactor.).2917Lehman reported in its Forms 10Q and 10K that it treated repurchase (repo) transactions asfinancingtransactionsforaccountingandreportingpurposes. SeeLBHI200710K,atp.97;LBHI10Q(filedApr.9,2008),atp.13;LBHI10Q(filedJuly10,2008),atp.16.

752

Illustration1

AssumethissimplifiedbalancesheetforLehman:

Assets(inmillions) Liabilities Cash 7,500 ShortTermBorrowings 200,000FinancialInstruments 350,000 CollateralizedFinancings 325,000CollateralizedAgreements 350,000 LongTermBorrowings 150,000Receivables 20,000 Payables 98,000Other 72,500 StockholdersEquity 27,000 Total 800,000 800,000 GrossLeverage2918 30 NetLeverage2919 17

Illustration2,below,showstheimpactofanordinaryrepoonLehmansbalance

sheetandleverageratios.

2918Grossleverage,forillustrativepurposesinthissetofexamplesonly,iscalculatedastotalassetsdividedbystockholdersequity.2919For illustrativepurposes inthissetofexamplesonly,asimplifieddefinitionofnet leverage isused: netleverage=(totalassetscollateralizedagreements)dividedbystockholdersequity.

753

Illustration2

IfLehmanexecutes$50billionoftypicalrepotransactionswith$50billion

of its financial instruments, those instruments remain on the balance sheet;

Lehman receivesa$50billion cashborrowing, increasing its cashposition;and

Lehmanrecords$50billionofadditionalcollateralizedfinancingliabilities;atthe

momentoftherepotransactions,totalbalancesheetandleverageincrease:

Assets(inmillions) Liabilities Cash 57,500 ShortTermBorrowings 200,000FinancialInstruments 350,000 CollateralizedFinancings 375,000CollateralizedAgreements 350,000 LongTermBorrowings 150,000Receivables 20,000 Payables 98,000Other 72,500 StockholdersEquity 27,000 Total 850,000 850,000 GrossLeverage 31 NetLeverage 19

Illustration3,below,showstheimpactofanordinaryrepofollowedbytheuseof

thecashborrowingtopaydownliabilities.

754

Illustration3

AssumingLehmanweretousethe$50billioncashborrowingfromtypical

repo transactions to pay off current liabilities, the effect on the balance sheet

wouldbeneutralnonet increase in totalassets/liabilities,andno effectupon

leverage:2920


Although Lehman publicly reported that it treated all repo transactions as

financing transactions for accounting purposes,2921 Lehman booked Repo 105

transactions as salesunder the FinancialAccounting StandardsBoards Statement of

2920ThisisnottosuggestthatLehmanregularlyusedthefundsreceivedinatypicalrepotransactiontopaydownliabilities.IntheNotestoitsConsolidatedFinancialStatements,forexample,LehmanstatedWeentersecuredborrowingand lending transactions to finance inventorypositions,obtainsecuritiesforsettlementandmeetclientsneeds.SeeLBHI200710K,atp.110.2921SeeLBHI200710K,atp.97(statingthatLehmantreatsrepotransactionsasfinancingtransactionsforreportingpurposes);LBHI10Q(filedApr.9,2008),atp.13(same);LBHI10Q(filedJuly10,2008),atp.16(same);seealsoLehman,GlobalBalanceSheetOverviewofRepo105(FID)/108(Equities)(July2006),atp. 1 [LBEXWGM 748489] (Repo transactions are normally recorded on the balance sheet asfinancings.).

755

Financial Accounting Standards No. 140 (SFAS 140), Accounting for Transfers and

ServicingofFinancialAssetsandExtinguishmentsofLiabilities.2922

SFAS140governs, inpart,whentorecognizeatransferofassetsasafinancing

transactionor,alternatively,asasale.2923AlthoughSFAS140moreoftenisdiscussedin

the context of securitization transactions, a particular provision of SFAS 140

specifically SFAS 140.98 permits the transferor of assets in a repo agreement to

accountfortherepotransactionasasalewithaforwardpurchasecommitmentifthe

transaction satisfies certain criteria.2924 Asanaccountingmatter,and consistentwith

Lehmanspublicly reported statements, thevastmajority of repo transactionsdonot

satisfySFAS140scriteria to recharacterize the repo transactionasasaleand thereby

movethetransferredinventoryoffbalancesheet.2925

2922AsdiscussedmorefullyatSectionIII.A.4.d.2.coftheReport,the105and108descriptionsrefertothehaircutnecessaryforLehmantoaccountforthetransactionasasaleunderSFAS140. Lehmanutilized treasuries, agencies, and other government securities in Repo 105 transactions and utilizedequitiessecuritiesinRepo108transactions.SeeSectionIII.A.4.d.4ofthisReport.2923ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS OFLIABILITIES,StatementofFinancialAccountingStandardsNo.140,2,98 (Fin.AccountingStandardsBd.2000)(SFAS140).IssuedinJune2009andeffectiveasofthebeginningofeachreportingentitysfirst annual reportingperiod that begins afterNovember 15, 2009, SFAS 160 and SFAS 167 amendedcertainaspectsofSFAS140. SeeACCOUNTINGFORTRANSFERSOFFINANCIALASSETS,ANAMENDMENTOFFASB STATEMENT NO. 140, Statement of Financial Accounting Standards No. 166 (Fin. AccountingStandards Bd. 2009); AMENDMENTS TO FASB INTERPRETATION NO. 46(R), Statement of FinancialAccountingStandardsNo.167(Fin.AccountingStandardsBd.2009).2924See SFAS 140, 98; see also Section III.A.4.j.2.c.ii.a of thisReport (discussingLehmansdisclosuresregardingsecuritizationactivitiesandSFAS140).2925Paragraph 208ofSFAS 140notes that sale treatment for repo transactions isunusual. Specifically,Paragraph 208 provides, [P]articipants in the very large markets for repurchase agreements andsecuritieslendingtransactionsare,forthemostpart,unaccustomedtotreatingthosetransactionsassales,anda change to sale treatmentwouldhave a substantial impacton their reported financialposition.SFAS140,208.

756

The recharacterization of a repo transaction from a financing or borrowing

transactiontoasaletransactionpursuanttoSFAS140leadstoseveralconsequences:

The transferred securities inventory arederecognized, i.e., considered soldandremoved from the transferors/sellersbalancesheetduring the termofthe repo even though the transferor/seller is required to repurchase theinventoryatafuturedate.2926

Additionally, when a repo transaction is recharacterized as a sale, thetransferor/seller does not record a liability representing its obligation torepay the borrowed funds.2927 In other words, the borrowing is notreflectedon thebalance sheet, even though the economic substanceof thetransaction isaborrowing,and thus, the transferors total liabilitiesdonotincrease.2928

Although the transferors inventory decreases, at the moment of thetransaction the transferors total assets remain unchanged because thetransferorreceivescashborrowingsinexchangeforthesecuritiesinventory.

Consequently, Lehmans Repo 105 transactions removed securities inventory

from Lehmans balance sheet for the duration of the repo typically seven to ten

days.2929 At themomentof theRepo105 transaction,Lehmanreceivedcash.2930 Thus,

2926SeeSFAS140,11.a(Uponcompletionofatransferoffinancialassetsthatsatisfiestheconditionstobe accounted for as a sale (paragraph9), the transferor shall:a.Derecognizeall assets sold.); see alsoAppendixE:GlossaryofSFAS140(Derecognize:Removepreviouslyrecognizedassetsorliabilitiesfromthestatementoffinancialposition.).2927SeeSFAS140,98(Ifthecriteriainparagraph9aremet,includingthecriterioninparagraph9(c)(1),the transferor shall account for the repurchase agreement as a sale of financial assets and a forwardrepurchase commitment,and the transferee shallaccount for theagreementasapurchaseof financialassetsandaforwardresalecommitment.).2928Id.2929ExaminersInterviewofTejalJoshi,Sept.15,2009,atp.4;ExaminersInterviewofMarkGavin,Sept.24, 2009, at p. 4; Examiners Interview of John Feraca,Oct. 9, 2009, at p. 5; Examiners Interview ofMatthewLee,July1,2009,atp.13.2930Lehman,GlobalBalanceSheetOverviewofRepo105(FID)/108(Equities)(July2006),atp.1[LBEXWGM 748489]; Examiners Interview of Edward Grieb, Oct. 2, 2009, at pp. 1314 (stating that cashreceivedinRepo105transactionswasusedtopayoffotherliabilities);ExaminersInterviewofMatthewLee,July1,2009,atp.14(explainingthatinorderforLehmantorealizethebenefittoitsleverageratiosas

757

althoughLehmanreduceditsinventory,theincomingcashresultedinnochangetothe

volumeofLehmanstotalassets.2931 BecauseLehmanbookedRepo105transactionsas

salesunderSFAS140,ratherthanasfinancings,itdidnotrecordanyliabilitiesarising

from the obligation to repay the shortterm funding secured by a Repo 105

transaction.2932Consequently,asdemonstratedinIllustration4,below,Lehmanwasalso

abletoborrowtensofbillionsofdollarswithoutdisclosingtheborrowing.

a resultofRepo105 transactions, the firmhad touse thecash received topayoffadifferent liability);Duff&Phelps,ExplanationofRepo105AccountingLedgerEntriesandTradingSystemOutput(Jan.5,2010), at p. 2. In addition, as explained in Letter from Linklaters, to Lehman Brothers International(Europe),re:RepurchaseTransactionsunderaGlobalMasterRepurchaseAgreement(May21,2006),2.4[LBEXLBIE000001],SectionIII.A.4.d.2.aofthisReportandAppendix17,Repo105Appendix,duringthetermof theRepo105 transactionas ina typical repo transactionLehman continued to receive theincomestreamarisingfromthetransferredsecuritiesduringthetermofthetransaction.2931Duff& Phelps,Repo 105 Balance SheetAccounting Entry and LeverageRatios Summary (Oct. 2,2009),atp.3;ExaminersInterviewofEdwardGrieb,Oct.2,2009,atp.1314(statingLehmanusedRepo105cashborrowingtopayother liabilities);ExaminersInterviewofMatthewLee,July1,2009,atp.14(explaining that inorder forLehman torealize thebenefit to its leverageratiosasaresultofRepo105transactions,thefirmhadtousethecashreceivedtopayoffadifferentliability).2932Duff& Phelps,Repo 105 Balance SheetAccounting Entry and LeverageRatios Summary (Oct. 2,2009),atpp.34.

758

Illustration4

IfLehmanexecutes$50billionofRepo105transactions,ratherthantypical

repos, the transaction is recharacterized as a sale and $50 billion of financial

instruments, considered sold, are removed from the balance sheet;2933 Lehman

receives $50 billion in cash, exchanging one form of asset for another, so total

assetsareunchanged;Lehmanrecordsnoliabilitytoreturnthecashborrowingso

liabilitieslikewiseremainunchanged;atthemomentoftheRepo105transactions,

leverageisunaffected:


2933Asdiscussed ingreaterdetail inSectionIII.A.4.d.2.dofthisReport,Lehmancreateda$5derivativeassetforevery$105worthofsecuritiesremovedfromitsbalancesheetinaRepo105transaction.Forthesakeofsimplification,Illustrations3and4donotincludethe$5derivative.

759

Lehman used the borrowed funds from Repo 105 transactions to pay down

shorttermliabilitiessuchasordinaryrepotransactions,asinIllustration5,below.2934By

doingso,Lehmanreduceditstotalassets,therebyreducingitsleverageratios.

2934ExaminersInterviewofMartinKelly,Oct.1,2009,atp.7(statingthatincomingcashfromRepo105transactionswasusedtopaybusinessexpenses);ExaminersInterviewofEdwardGrieb,Oct.2,2009,atpp. 1314 (stating that cash received in Repo 105 transactionswas used to pay off other liabilities);ExaminersInterviewofMatthewLee,July1,2009,atp.14(explainingthatinorderforLehmantorealizethebenefittoitsleverageratiosasaresultofRepo105transactions,thefirmhadtousethecashreceivedtopayoffadifferentliability);seeemailfromAnurajBismal,Lehman,toMarieStewart,Lehman,etal.(Dec.5,2007)[LBEXDOCID3223384](statingthatLehmanwouldhaveanetleverageof18.0xinsteadof16.3x without Repo 105, which indicates that Lehman used Repo 105 cash to pay down differentliabilities). Given that Lehman undertook $38.6 billion, $49.1 billion, and $50.38 billion of Repo 105transactionsatquarterendfourthquarter2007,firstquarter2008,andsecondquarter2008,respectively,Lehmansdisclosuresofitscashholdingsateachquarterendfurtherstrengthensthetestimonyandotherevidence that Lehman used the cash borrowing fromRepo 105 transactions to pay down shorttermliabilities. See LBHI 2007 10K, at p. 86 (reporting that Lehman had $7.286 billion in cash and cashequivalentsonNovember30,2007);LBHI10Q (filedApr.9,2008),atp.5 (reporting thatLehmanhad$7.564billionincashandcashequivalentsonFebruary29,2008);LBHI10Q(filedJuly10,2008),atp.5(reporting that Lehman had $6.513 billion in cash and cash equivalents onMay 31, 2008). WhileLehmansRepo105 transactionsspikedatquarterends,Lehmansordinary repobalancesdroppedoffsignificantlyduringthesametimeperiods.Duff&Phelps,Repo105BalanceSheetAccountingEntryandLeverageRatiosSummary(Oct.2,2009),atp.5.

760

Illustration5

In a Repo 105 transaction, Lehman uses the cash it generates to reduce

traditionalborrowings,suchasordinaryrepos(collateralizedfinancingsinthe

examplebelow).ByapplyingthecashfromaRepo105transactiontopaydown

liabilitiessuchasordinaryrepos,Lehmanreducesitsbalancesheetandleverage.


When theRepo105 transactionmatured,Lehmanborrowed funds torepay the

Repo 105 cash borrowing plus interest and the previously transferred securities

inventoryreturned toLehmansbalancesheetassecurities inventory.2935 Accordingly,

totalassetsandtotalliabilitiesincreased.

Although it is undisputed that Lehman received cash as part of Repo 105

transactions, thedocuments andwitness testimony reveal that the financingLehman2935Lehman,GlobalBalanceSheetOverviewofRepo105(FID)/108(Equities)(July2006),atp.1[LBEXWGM748489];Duff&Phelps,Repo105BalanceSheetAccountingEntryandLeverageRatiosSummary(Oct.2,2009),atp.4;Duff&Phelps,ExplanationofRepo105AccountingLedgerEntriesandTradingSystemOutput(Jan.5,2010),atp.5.

761

receivedunderaRepo105transactionwasnottherealorprimarypurposeforentering

intoRepo105transactions.Lehmancouldhaveobtainedthesamefinancingatalower

cost by engaging in ordinary repo transactions with substantially the same

counterpartiesusingthesameassetsinvolvedinRepo105transactions.2936

LehmansprimarymotiveforundertakingtensofbillionsofdollarsinRepo105

transactions at or near each quarterend in late 2007 and 2008 was to temporarily

removethesecuritiesinventoryinvolvedfromitsbalancesheetinordertoreportlower

leverage and net leverage ratios than Lehman actually had.2937 Numerouswitnesses

told the Examiner that Lehmansmotive for undertaking aRepo 105 transaction, as

opposedtoanordinaryrepo,turnedsolelyonLehmansneedtomanagethefirmwide

balancesheetandeffectthepubliclydisclosedleverage.2938

2936ExaminersInterviewofJohnFeraca,Oct.9,2009,atp.6.2937Leverageistherelationshipofacompanystotalassetstostockholdersequity.LBHI200710K,atp.30. Lehmanbelieved thatnet leveragebasedonnetassetsand tangibleequitycapitalwasamoremeaningfulmeasureofleverage.SeeLBHI200710K,atpp.30,63.Lehmandefinednetleverageratioasnetassetsdividedbytangibleequitycapital.Id.Lehmansnetassetcalculationbeginswithtotalassets as reported for GAAP purposes in Lehmans Forms 10K and 10Q. From there, Lehmansubtracted certain assets in order to arrive at net assets: (i) cash and securities segregated and ondepositforregulatoryandotherpurposes;(ii)collateralizedlendingagreements(i.e.,securitiesLehmanis holding as collateral for a loanmade to a thirdparty); and (iii) identifiable intangible assets andgoodwill.Seeid.atp.30.2938Examiners InterviewofTejal Joshi,Sept.15,2009,atpp.4,6 (stating thatRepo105allowedus totreat tradesofpositions thatwouldbe financing trades as true sales instead and that atquarterendtherewasamadscrambletomeetbalancesheettargetsthroughuseofRepo105);ExaminersInterviewofPaoloR.Tonucci,Sept.16,2009,atp.27(statingthatattheendofreportingperiods,LehmandeployedRepo105transactionstonetdownitsbalancesheet);ExaminersInterviewofMarkGavin,Sept.24,2009,atp.4(statingpurposeofRepo105transactionswasbalancesheetmanagement);ExaminersInterviewofMartinKelly,Oct.1,2009,atp.7([T]heonlypurposeormotiveforthe[Repo105transactions]wasreductioninbalancesheet.);ExaminersInterviewofEdwardGrieb,Oct.2,2009,atp.11(statingRepo105 transactionswereused to bring balance sheet in linewith targets);Examiners Interview of JohnFeraca,Oct.9,2009,atpp.6,10(ItwasuniversallyacceptedthroughouttheentireinstitutionthatRepo

762

From2001,whenLehmanfirstbeganusingRepo105transactions,2939untilearly

tomid2007, Lehman engaged in a relatively consistent volume of Repo 105

transactions,includingatquarterend,generallywithinarangeofbetween$20and$25

billion.2940 Lehman alsomaintained internal rules based on seniormanagements

judgment,ratherthananyaccountingrequirementlimitingthetotalfirmwideuseof

Repo105transactionsto$22billion,laterincreasedto$25billion.2941

In midtolate 2007, however, Lehman increased dramatically the volume of

firmwideRepo105transactionsatquarterend.Byfirstquarter2008,thedollarvalue

105wasused forbalancesheetreliefatquarterend);Examiners Interviewof JosephGentile,Oct.21,2009,atp.6 (stating thatRepo105wasabalancesheetmanagementmechanism,a tool thatcouldbeusedtoreduceLehmansnetbalancesheet);ExaminersInterviewofClementBernard,Oct.23,2009,atp.7(Repo105wasamechanismFIDreliedontogetitsbalancesheetdown);ExaminersInterviewofMatthewLee,July1,2009,atp.15(statingRepo105transactionsdrivenbymanagementsimperativetoreverseengineerleverageratio).2939ThoughRepo105 started in2001,Lehmandidnot initiateRepo108 transactions,used forequitiessecurities,untilMay2006.SeeLehman,GlobalBalanceSheetOverviewofRepo105(FID)/108(Equities)(July2006),atp.4[LBEXWGM748489].2940Id. (showing Repo 105 monthend trend between January 2005 and May 2006 of betweenapproximately $11 billion and $21 billion); Joseph Gentile, Lehman, Proposed Repo 105/108 TargetIncreasefor2007(Feb.10,2007),atp.1[LBEXDOCID2489498](attachedtoemailfromJosephGentile,Lehman,toEdwardGrieb,Lehman(Feb.10,2007)[LBEXDOCID2600714]andshowingdailytotalRepo105usage forDecember1,2006 throughFebruary2,2007remainedbetweenapproximately$14billionand$24billion).2941See,e.g.,Lehman,GlobalBalanceSheetOverviewofRepo105(FID)/108(Equities)(July2006),atp.2[LBEXWGM 748489] (setting Repo 105 limit at $17 billion and Repo 108 limit at $5 billion); JosephGentile,Lehman,ProposedRepo105/108TargetIncreasefor2007(Feb.10,2007),atp.1[LBEXDOCID2489498] (attached to email from JosephGentile, Lehman, to EdwardGrieb, Lehman (Feb. 10, 2007)[LBEXDOCID 2600714] and proposing to increase $22 billion combined Repo 105/108 limit to $25billion);emailfromSigridStabenow,Lehman,toClementBernard,Lehman,etal.(Jan.25,2008)[LBEXDOCID1853428] (requesting thatRepo105 limitof$20billionbeexpanded to$23billion);ExaminersInterviewofAndrewJ.Morton,Sept.21,2009,atpp.4,22(statingRepo105limitsestablishedatinceptionof program in 2001); Examiners Interview of Edward Grieb, Oct. 2, 2009, at pp. 910; ExaminersInterviewofJohnFeraca,Oct.9,2009,atp.10;ExaminersInterviewofJosephGentile,Oct.21,2009,atp.7.TheRepo105limitwasamanagementdecision,wasnotbasedonaccountingrules,andwasnotpartofLehmansinternalRepo105AccountingPolicy.

763

of assets that Lehman temporarily removed from its balance sheet at quarterend

through Repo 105 transactions was $49 billion.2942 Lehman escalated its Repo 105

activitydespite itsunderstandingthat itspeer investmentbankstowhomLehmans

leveragewascompareddidnotusesimilardevices.2943

Lehman greatly expanded its Repo 105 program at a time when market

observers increased their focus on the leverage of investment banks and Lehman

management placed increased pressure on the businesseswithin the firm to reduce

theirnetassets. CEOFuldnoted thatmarketplaceperceptionsofLehmanprecluded

Lehmanfromimprovingitsnetleverageratiobymeansofraisingequity.2944Moreover,

as Lehmans inventory grew increasingly illiquid, it became difficult to sellwithout

reducing prices and incurring losses or calling into question Lehmans marks for

inventoryremainingonitsbalancesheet.2945

2942SeeLehman,TotalRepo105&Repo108Report(June11,2008)[LBEXDOCID2078195](attachedtoemailfromKristieWong,Lehman,toMartinKelly,Lehman(June11,2008)[LBEXDOCID2325872]andshowingtotalfirmwideRepo105usageatMay30,2008).2943Examiners Interview ofMarie Stewart, Sept. 2, 2009, at p. 14; Examiners Interview ofMichaelMcGarvey, Sept. 11, 2009, at p. 11; Examiners Interview of Anuraj Bismal, Sept. 16, 2009, at p. 7;ExaminersInterviewofMartinKelly,Oct.1,2009,atp.7;ExaminersInterviewofMatthewLee,July1,2009,atp.14;seealsoemailfromAnurajBismal,Lehman,toMarieStewart,Lehman,etal.(Dec.5,2007)[LBEXDOCID3223386];emailfromMichaelMcGarvey,Lehman,toClementBernard,Lehman(Jan.30,2008) [LBEXDOCID 2796630]; email from Ryan Traversari, Lehman, to Christopher M. OMeara,Lehman,etal.(May16,2008)[LBEXDOCID574498];emailfromMichaelMcGarvey,Lehman,toJormenVallecillo,Lehman(July2,2008)[LBEXDOCID3379145].2944ExaminersInterviewofRichardS.Fuld,Jr.,Sept.25,2009,atp.27.2945SeeSectionIII.A.4.e.34ofthisReport.

764

c) WhytheExaminerInvestigatedLehmansUseofRepo105Transactions

As part of the Examiners investigation of internal Lehman audits of risk

management controls, theExaminerbecameawareofLehmansRepo105offbalance

sheet effect. As the Examiner obtained a critical mass of information regarding

Lehmans use of these transactions and the firms motive in undertaking them at

increasingvolumesinlate2007and2008,itbecameapparentthatLehmansuseofRepo

105 transactions intersected with several issues involved in the Examiners

investigation, including thedirective that theExaminer investigatewhether thereare

colorableclaimsforbreachoffiduciarydutiesbyofficersanddirectors.2946Asdescribed

infra, theExaminerconcludes thatacolorableclaimofbreachof fiduciarydutyexists

against certainLehman officers namely,RichardFuld,ChrisOMeara,ErinCallan,

andIanLowitt.

The Examiner further concludes that a colorable claim of professional

malpracticeexistsagainstErnst&Young.2947

2946OrderDirectingAppointmentofanExaminerPursuanttoSection1104(c)(2)oftheBankruptcyCode,DocketNo.0813555(JMP),InreLehmanBrothersHoldingsInc.,No.0813555,atp.3(Bankr.S.D.N.Y.Jan.16,2009).2947 Ernst & Youngs conduct in connection with Lehmans failure to disclose its use of Repo 105transactions fallswithin theCourts January 16, 2009directive that theExaminer perform thedutiesspecifiedinsections1106(a)(3)and(4)oftheBankruptcyCode. Id.at5. Sections1106(a)(3)and(4)oftheBankruptcyCodeprovidethattheExaminershallinvestigatetheacts,conduct,assets,liabilitiesandfinancialconditionofthedebtor[and]theoperationofthedebtorsbusinessandfileastatementofanyinvestigation . . . including any fact ascertained pertaining to fraud, dishonesty, incompetence,misconduct,mismanagement,orirregularityinthemanagementoftheaffairsofthedebtor,ortoacauseofactionavailabletotheestate.11U.S.C.1106(2006).

765

d) ATypicalRepo105Transaction

(1) TheGenesisofLehmansRepo105Programin2001

Lehman initiated itsRepo105programsometime in2001,soonafterSFAS140

tookeffectinSeptember2000.2948Atthattime

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LOCAL BANKRUPTCY RULES - United States Courts