Lehman Execs Have No One to Blame but Themselves

The U.S. bankruptcy-court examiner investigating the collapse of Lehman Brothers Holdings Inc. issued a stinging report Friday that accused senior executives of freewheeling accounting practices that led to the largest bankruptcy in U.S. history and sparked the worst financial crisis since the Great Depression.

The 2200-page report, authored by Anton Valukas, chairman of the Chicago-based law firm Jenner & Block LLP, also excoriated Wall Street investment banks, including JPMorgan Chase & Co. (NYSE: JPM) and Citigroup Inc. (NYSE: C) for finally pushing Lehman over the edge by demanding more collateral and changing guarantee agreements, Bloomberg News reported.

But the report says ultimate responsibility for its collapse can be attributed to a wrong-headed business model that rewarded excessive risk and encouraged leverage - problems that were brought to a head by the investment banks and government agencies.

Lehman's bankruptcy filing on Sept. 15, 2008 - the largest Chapter 11 filing in financial history - unleashed a crisis of confidence that threw financial markets worldwide into turmoil. 

The scathing report lambastes Lehman's executives, who "should have done more, done better."

Lehman "repeatedly exceeded its own internal risk limits and controls," and a series of judgment errors by its management led to the bank's demise, the report said.

Valukas blamed Lehman executives for conduct that "ranged from serious but non-culpable errors of business judgment to actionable balance sheet manipulation."  Their behavior multiplied the firm's problems, he alleged, eventually hurting its creditors and shareholders.

The report said former Chief Executive Richard Fuld was "at least grossly negligent in causing Lehman to file misleading periodic reports."

Specifically, the report alleges that when the credit squeeze caused investor confidence to falter in the fall of 2008, Lehman tried to stave off collapse by using an exotic accounting maneuver to paint a misleading picture of its financial condition.

Lehman used the accounting device, "Repo 105," to unload roughly $50 billion of toxic assets from its balance sheet at the end of the first and second quarters of 2008 instead of selling those assets at a loss, according to the report.

Accounting rules permitted Lehman to treat this transaction as sales instead of financing, "so that the assets could be removed from the balance sheet," the report said.

The examiner's report cited e-mails from Lehman's global financial controller, Martin Kelly, stating "the only purpose or motive for those transactions was reduction in the balance sheet," adding that "there was no substance to the transactions."

"In this way, unbeknownst to the investing public, rating agencies, government regulators, and Lehman's Board of Directors, Lehman reverse engineered the firm's net leverage ratio for public consumption," says the report.

The report said there was "sufficient evidence" that Fuld knew about the use of Repo 105 before signing off on quarterly financial reports that didn't mention using the accounting device.

The report also alleges that Ernst & Young, Lehman's financial auditor, didn't challenge or question the use of Repo 105.

Later, as Lehman reached the tipping point in September 2008, several factors helped to push Lehman over the brink in its final days, Valukas wrote.  Investment banks, including J.P. Morgan and Citibank, made demands for collateral and modified guarantee agreements that compromised Lehman's liquidity and pushed it into bankruptcy.

"The demands for collateral by Lehman's lenders had direct impact on Lehman's liquidity," Valukas wrote. "Lehman's available liquidity is central to the question of why Lehman failed."

Although Lehman's lenders had reasons to protect themselves as the investment bank's finances deteriorated, both JPMorgan and Citigroup may be sued to undo the guarantees they received from Lehman in the days before its bankruptcy and reverse the transfers of collateral under those agreements, the examiner said.

Additionally, the allegations of accounting manipulation and other abuses could influence pending criminal and civil investigations into Lehman's former executives. The Manhattan and Brooklyn U.S. attorney's offices are investigating whether they misled investors about the firm's finances before it filed for bankruptcy protection, and whether Lehman overvalued its real-estate assets, The Wall Street Journal reported, citing people familiar with the matter.

Both former CEO Fuld and Ernst & Young were quick to deny any culpability that might result from possible legal actions.

"Mr. Fuld did not know what these transactions were -- he didn't structure or negotiate them, nor was he aware of their accounting treatment," Fuld's lawyer, Patricia Hynes of Allen & Overy LLP Hynes, said in a statement obtained by CNNMoney.com.

A spokesman for Ernst & Young said in an email obtained by Bloomberg that it conducted its last audit of Lehman for the fiscal year ended Nov. 30, 2007 more than nine months before the Chapter 11 filing. 

Furthermore, "Lehman's financial statements for that year were fairly presented in accordance with generally accepted accounting principles [GAAP] and we remain of that view," Bloomberg reported.

Lehman CEO Bryan Marsal said in a separate e-mail to Bloomberg that he would "carefully evaluate" Valukas's report to assess how it might help "ongoing efforts to advance creditor interests."

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