The Lehman Brothers Meltdown

question 80

Essay

The Lehman Brothers Meltdown
Even though regulations are needed to promote appropriate business practices, they may also produce a false sense of security. Regulatory agencies often are coopted by those they are supposed to be regulating due to an inherent conflict of interest. The objectivity of regulators can be skewed by the prospect of future employment in the firms they are responsible for policing. No matter how extensive, regulations are likely to fail to achieve their intended purpose in the absence of effective regulators.

Consider the 2008 credit crisis that shook Wall Street to its core. On September 15, 2008, Lehman Brothers Holdings announced that it had filed for bankruptcy. Lehman's board of directors decided to opt for court protection after attempts to find a buyer for the entire firm collapsed. With assets of $639 billion and liabilities of $613 billion, Lehman is the largest bankruptcy in history in terms of assets. The next biggest bankruptcies were WorldCom and Enron, with $126 billion and $81 billion in assets, respectively.

In the months leading up to Lehman’s demise, there were widespread suspicions that the book value of the firm’s assets far exceeded their true market value and that a revaluation of these assets was needed. However, little was known about Lehman’s aggressive use of repurchase agreements or repos. Repos are widely used short-term financing contracts in which one party agrees to sell securities to another party (a so-called counterparty), with the obligation to buy them back, often the next day. Because the transactions are so short-term in nature, the securities serving as collateral continue to be shown on the borrower’s balance sheet. The cash received as a result of the repo would increase the borrower’s cash balances and be offset by a liability reflecting the obligation to repay the loan. Consequently, the borrower’s balance sheet would not change as a result of the short-term loan.

In early 2010, a report compiled by bank examiners indicated how Lehman manipulated its financial statements, with government regulators, the investing public, credit rating agencies, and Lehman’s board of directors being totally unaware of the accounting tricks. Lehman departed from common accounting practices by booking these repos as sales of securities rather than as short-term loans. By treating the repos as a sale of securities (rather than a loan), the securities serving as collateral for the repo were removed from the books, and the proceeds generated by the repo were booked as if they had been used to pay off an equivalent amount of liabilities. The resulting reduction in liabilities gave the appearance that the firm was less levered than it actually was despite the firm’s continuing obligation to buy back the securities. Since the repos were undertaken just prior to the end of a calendar quarter, their financial statements looked better than they actually were.

The firm’s outside auditing firm, Ernst & Young, was aware of the moves but continued to pronounce the firm’s financial statements to be in accordance with generally accepted accounting principles. The SEC, the recipient of the firm’s annual and quarterly financial statements, failed to catch the ruse. In the weeks before the firm’s demise, the Federal Reserve had embedded its own experts within the firm and they too failed to uncover Lehman’s accounting chicanery. Passed in 2002, Sarbanes-Oxley, which had been billed as legislation that would prevent any recurrence of Enron-style accounting tricks, also failed to prevent Lehman from “cooking its books.” As required by the Sarbanes-Oxley Act, Richard S. Fuld, Lehman’s chief executive at the time, certified the accuracy of the firm’s financial statements submitted to the SEC.

When all else failed, market forces uncovered the charade. It was the much maligned “short-seller” who uncovered Lehman’s scam. Although not understanding the extent to which the firm’s financial statements were inaccurate, speculators borrowed Lehman stock and sold it in anticipation of buying it back at a lower price and returning it to its original owners. In doing so, they effectively forced the long-insolvent firm into bankruptcy. Without short-sellers forcing the issue, it is unclear how long Lehman could have continued the sham.

A Federal Judge Reprimands Hedge Funds in their Effort to Control CSX

Investors seeking to influence a firm’s decision making often try to accumulate voting shares. Such investors may attempt to acquire shares without attracting the attention of other investors, who could bid up the price of the shares and make it increasingly expensive to accumulate the stock. To avoid alerting other investors, certain derivative contracts called “cash settled equity swaps” allegedly have been used to gain access indirectly to a firm’s voting shares without having to satisfy 13(D) prenotification requirements.

Using an investment bank as a counterparty, a hedge fund could enter into a contract obligating the investment bank to give dividends paid on and any appreciation of the stock of a target firm to the hedge fund in exchange for an interest payment made by the hedge fund. The amount of the interest paid is usually based on the London Interbank Offer Rate (LIBOR) plus a markup reflecting the perceived risk of the underlying stock. The investment bank usually hedges or defrays risk associated with its obligation to the hedge fund by buying stock in the target firm. In some equity swaps, the hedge fund has the right to purchase the underlying shares from the counterparty.

Upon taking possession of the shares, the hedge fund would disclose ownership of the shares. Since the hedge fund does not actually own the shares prior to taking possession, it does not have the right to vote the shares and technically does not have to disclose ownership under Section 13(D). However, to gain significant influence, the hedge fund can choose to take possession of these shares immediately prior to a board election or a proxy contest. To avoid the appearance of collusion, many investment banks have refused to deliver shares under these circumstances or to vote in proxy contests.

In an effort to surprise a firm’s board, several hedge funds may act together by each buying up to 4.9 percent of the voting shares of a target firm, without signing any agreement to act in concert. Each fund could also enter into an equity swap for up to 4.9 percent of the target firm’s shares. The funds together could effectively gain control of a combined 19.6 percent of the firm’s stock (i.e., each fund would own 4.9 percent of the target firm’s shares and have the right to acquire via an equity swap another 4.9 percent). The hedge funds could subsequently vote their shares in the same way with neither fund disclosing their ownership stakes until immediately before an election.

The Children’s Investment Fund (TCI), a large European hedge fund, acquired 4.1 percent of the voting shares of CSX, the third largest U.S. railroad in 2007. In April 2008, TCI submitted its own candidates for the CSX board of directors’ election to be held in June of that year. CSX accused TCI and another hedge fund, 3G Capital Partners, of violating disclosure laws by coordinating their accumulation of CSX shares through cash-financed equity swap agreements. The two hedge funds owned outright a combined 8.1 percent of CSX stock and had access to an additional 11.5 percent of CSX shares through cash-settled equity swaps.

In June 2008, the SEC ruled in favor of the hedge funds, arguing that cash-settled equity swaps do not convey voting rights to the swap party over shares acquired by its counterparty to hedge their equity swaps. Shortly after the SEC’s ruling, a federal judge concluded that the two hedge funds had deliberately avoided the intent of the disclosure laws. However, the federal ruling came after the board election and could not reverse the results in which TCI was able to elect a number of directors to the CSX board. Nevertheless, the ruling by the federal court established a strong precedent limiting future efforts to use equity swaps as a means of circumventing federal disclosure requirements.
-What criteria might have been used to prove collusion between TCI and 3G in the absence of signed agreements to coordinate their efforts to accumulate CSX voting shares?

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