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Lehman Inc Financial Fraud Case Study
Investment Funds In Canada (FIN-3004)
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Running Head: LEHMAN BROTHERS INC FINANCIAL FRAUD CASE STUDY 1
Lehman Brothers Inc. Financial Fraud Case study Student’s Name Professor’s Name Course Title Date
TABLE OF CONTENTS............................................................... ...........
2.3 Fraudulent financial reporting.........................................................................
- TABLE OF CONTENTS............................................................... ...........
- Abstract................................................................................................
- Background............................................................................................
- 1 Introduction.......................................................................................
- 1 Lehman Brothers case background..............................................................
- 1 Past cases of fraud.................................................................................
- 1 Discussion of the key facts and issues..........................................................
- 1 Lehman’s business decisions and operations prior to the collapse..........................
- 1 Analysis of the facts and issues..................................................................
- 1 Causes of action arising from Lehman’s financial condition and failure...................
- 2 Literature review.................................................................................
- 2 Theoretical framework ...........................................................................
- 2 Fraud................................................................................................
- 2 The Literature on the Fraud Triangle............................................................
- 2.2 Pressure to Commit Occupational Fraud............................................................
- 2.2 Opportunity to Commit Occupational Fraud........................................................
- 2.2 The Rationalisation of Occupational Fraud.........................................................
- Financial Fraud......................................................................................
- 2.3 Misappropriation of assets...............................................................................
- 2.3 Overstating revenues......................................................................................
- 2.3 Understating expenses....................................................................................
- 3 Preventive measures...................................................................................
- 4 Recommendation......................................................................................
- 5 Conclusion.............................................................................................
- References..................................................................................................
- Appendices.................................................................................................
Abstract................................................................................................
The 2008 global financial meltdown saw most of the top worldwide financial institutions fall into bankruptcy and liquidation. The incident affected most of firms that either experienced a drop in returns or liquidation. The failure of Lehman Brothers in the middle of the global financial crisis was the most significant catastrophe to hit the financial industry in the U. On September 15, 2008, the fourth largest investment bank in the U., Lehman Brothers (holding over $600 billion in assets) filed for Chapter 11 bankruptcy protection, the largest bankruptcy filing in the U history. This had raised concerns and questions by many famous players and experts and players in international banking community. Lehman progressively turned to Repo 105 to reduce its reported net leverage and manage its balance sheet after a burden of huge volume of illiquid assets that it could not readily sell. The acquisition of illiquid assets became the subject for investigation relating to the valuation and liquidity issues. While Lehman’s risk decisions lay within the business judgment rule and did not give rise to debatable claims, those decisions were labeled in review by many experts as poor judgment. Hence, there is the urgent need for regulators of financial institutions to remove the gaps in their financial regulatory framework that allow complex, large, unified firms like Lehman to operate without robust consolidated supervision.
case, the company as well as their accounting firm Arthur Anderson systematically produced fraudulent financial reports and got involved in corrupt accounting by hiding liabilities and debts as well as misrepresenting earnings (Roger 2010). When the depth of the deception materialized to the public, creditors and investors retreated, forcing the company into bankruptcy in December 2001. The company frequently used accounting gimmicks at the end of each quarter to make its finances seem less shaky than they actually were. After the fall of Lehman Brothers, other banks followed suit and this is believed to be the beginning of the 2008 global financial crisis (Bloomberg BusinessWeek, 2009.) One exciting fact is that most of these big companies caught in financial report fraud cases have been audited by the Big Four auditing firms: KPMG, Deloitte Touche Tohmatsu PricewaterhouseCoopers, and Ernst & Young (Wikipedia 2012). This raises eyebrows on how it has been possible to cheat and scam the ones who should be there to assure the reliability of the records. Or could there be something behind the scenes? Although big companies are the ones ending up in the news, small firms experience unethical behavior and fraud evenly as much. Implementing an internal control system is assumed to be one of the best ways to preventing fraud. Many theory books write about the concept of the fraud triangle - motive, opportunity and rationalization – representing the three corners (Harrison, et, 2011, 236). All the three corners of the triangle exist in which there is a high possibility for a person to commit fraud which will be discussed later. Introduction The 2008 global financial crisis saw most of the leading financial institutions in the globe crush into liquidation and bankruptcy (Mensah, 2012; Murphy, 2008). Those which were not liquidated either experienced plummeting returns and their particular operations or filed for
voluntary bankruptcy. The Lehman Brothers bankruptcy scandal in the midst of the global financial crisis was the leading catastrophe to ever hit the U financial industry (Morin & Muax, 2011). Lehman Brothers being the leader in the industry had assets worth over $600 billion (D’Arcy, 2009). Apart from the well-known Enron failure in the early 2000, the failure of Lehman Brothers was the largest unit financial institution to have collapsed with assets so big (Jeffers, 2011). The leading US investment bank suffered massive losses within the month of September. The stock price fell by 73% of its value in the first half of September and by the mid of September 2008, lost about $3 billion in their effort to dispose of a majority of their shares in one of their subsidiaries (Mauz and Morin, 2011). Prior to their liquidation, the global crisis pressed the bank to close its leading subprime lender (BNC Mortgages) in 23 locations (Wilchins and DaSilva, 2010). The losses were so sequential such that Lehman Brothers filed for voluntary bankruptcy at the US Bankruptcy Court by September 15th 2008 (Murphy, 2008). The voluntary bankruptcy was necessitated by the failed attempt for a possible mergers and government bail-out coupled with some acquisition attempt by companies such as Barclays bank and many others. To explain for the possible causes of the Lehman’s failure, many financial analysts have advanced series of practical and academic arguments aimed at unearthing the exact causes of the melt-down. Others have also conducted research purposely to account for Lehman’s failure (Albrecht et, 2004).
1 Lehman Brothers case background..............................................................
Lehman Brothers (“Lehman”) was founded in 1850 by German immigrants Henry Lehman and his brothers, Mayer and Emanuel. While Lehman flourished over the prevailing decades, it had to undergo many challenges: the Russian debt default of 1998, the Great Depressions of the 1930s, the two World Wars, amongst others. However, regardless of
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the 1999 study of 200 financial statement frauds by the COSO (Committee of Sponsoring Organizations) of the Treadway Commission from 1987 to 1997 revealed that “senior management” is the most likely group to commit financial statement fraud (KuTenk 2000, 2009).The examination conducted on Lehman’s bankruptcy identified claims against Lehman’s external auditor, Ernst & Young for their failure to challenge or question inadequate or improper disclosures in Lehman’s financial statements (Valukas, 2010). According to the Public Company Accounting Oversight Board, “an external auditor is accountable to plan and perform the audit to acquire reasonable assurance on whether the financial statements are free of material misstatement, whether caused by fraud or error” (CAQ, 2010). Lartey (2012) observes that auditors need to establish a high level of objectivity and independence when reviewing financial statements. This objectivity and independence was completely lost in the case of Lehman’s external audit. According to Cooper (2005), in the six years before Enron's collapse, ASIC's American counterpart, the SEC, projected that investors lost US$100 billion owing to misleading, faulty, or fraudulent audits. It was confirmed that those linked with the Enron fiasco, including its auditor, Arthur Andersen, had been shredding thousands of pages of incriminating papers (Scott and Scott LLP, 2008). Improper adjustment to financial statements as well as deceptive accounting is common financial reporting frauds that auditors appear to usually cover up. For example, WorldCom, whose accounts were audited by the “so-called” professional auditors, experienced a more terrible loss of 17,000 jobs, having inflated profits by approximately US$4 billion through improper adjustments and deceptive accounting to the financial statements (Cooper, 2005). It is obvious from the collapse of Lehman Brothers that many auditors seem to be involved in financial statement frauds. In the case of Dynegy in which $300 million bank loan was masked
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to look like cash flow, through a sequence of complicated trades, the complex nature of the trades would have required considerable detective work on the part of the auditor (Ziff Davis Media Inc, 2004).
1 Past cases of fraud.................................................................................
WorldCom Currently known as MCI Inc., WorldCom was founded in 1983 as a LDDS (Long Distance Discount Service). The telecommunications company experienced fast growth in the 1990s mainly due to many large acquisitions. The company became WorldCom Inc. in 1995 following the acquisition of Williams Telecommunications Group Inc. for $2 billion (foxnews). In 1998, the company completed its largest corporate merger to date, acquiring MCI Communications Inc. for $40 billion. The company also merged with CompuServe Corp. and Brooks Fiber Properties Inc. in 1998 and WorldCom and Sprint Corp. decided to merge in 1999; however, in 2002 the merge was obstructed and blocked by U regulators fearing the company was becoming too large (CBS News, 2012). The 65 acquisitions that had already taken place made the company very competitive. At the height of its success, WorldCom’s stock was trading beyond $64 per share (Fox News, 2012). However, the company’s rapid growth and profits were halted when fraudulent financial reporting was finally uncovered. During an internal audit in early 2002 it was revealed that WorldCom had made numerous transfers that were not in accordance with GAAP (generally accepted accounting principles) (money.cnn). Shortly after the internal audit in March 2002, the SEC requested credentials from WorldCom in connection to these transfers. It was discovered that throughout
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of Tyco’s products charged to the commercial sector (tycofis.co). However, its main focus remained on high-tech research and development. Tyco has been involved in several acquisitions over the years. The first famous acquisitions were those of Wormald International Ltd. in 1990, Simplex Technologies in 1974, and Grinnell Fire Protection Systems in 1976. Following these, Tyco was involved in a fast period of large acquisition, with Thorn Security in 1996, AMP in 1999, and ADT in 1997 (tycofis.co). In the middle of continued expansion and growth, a corporate scandal at Tyco arose. In 2002, CEO Dennis Kozlowski, CFO Mark Swartz, and general counsel Mark Belnick were accused on charges of conspiracy and fraud. They were alleged of conning investors out of hundreds of millions of dollars that they had paid themselves in unauthorized compensation and bonuses since 1992. In total, around $170 million had been taken by the three (lawyershop). Although the firm had an employee loan program in place at the time, these personal loans were never approved and were kept off the financial statements of Tyco. Thus, they were not considered an asset on the company’s balance sheet. Combined, Swartz and Kozlowski had also sold $430 million worth of company stock without informing investors (The New York Times, 2012). They were both for guilty of conspiracy, fraud, and grand larceny charges in June of 2005 (The New York Times, 2012). Dennis Kozlowski was sentenced to 25 years in prison and fined $70 million, while Mark Swartz was sentenced to 8 years in prison and fined $35 million (The New York Times, 2012). Belnick, who was alleged to have failed to disclose $14 million worth of loans, was acquitted on criminal charges, but paid $100,000 in civil charges for his role in the scandal.
Adelphia Communications Corporation The 2002 fraud case of Adelphia Communications Corporation involves both misappropriation of assets and fraudulent financial reporting. This case involves almost entirely
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the founding family of the company committing the fraud. Adelphia was founded by John Rigas in 1952 in Pennsylvania. Adelphia remained entirely in the hands of the Rigas family until 1986, when it went public. By that time, Adelphia had 370 full-time worker and over 250, subscribers (Msnbc News, 2004).). Even after going public, John and his less-educated three sons, James, Michael, and Timothy held the top executive positions at Adelphia. John served as Chairman, ivy CEO and President; Michael served as Executive Vice President of Operation and Secretary; Timothy served as Executive Vice President, Chief Accounting Officer, CFO, and Treasurer; and James served as Executive Vice President of Strategic Planning. The Rigas appeared reliable and competent, but they had long been tricking investors. When it was revealed in March 2002 that between 1991 and 2001 they had intentionally excluded $2 billion in bank debt from the financial statements, the whole situation unwound (sec/news, 2012). It was discovered that Adelphia lacked the highest operating cash margins in the cable industry at 56%. The debt did not appear as a liability on the company’s balance sheet because it was hidden in the accounting records of off-balance sheet affiliates (sec, 2012). It was also revealed that Adelphia had funded the Rigases’ $150 million purchases of the Buffalo Sabres, and the purchase of 17 “company cars” intended for personal use totaling almost $12 million. As stated in the complaint SEC vs. Adelphia Communications Corporation, the company “inflated earnings to meet Wall Street's expectations, forged operations statistics, and concealed transparent self-dealing by the family that founded and controlled Adelphia, the Rigas Family” (sec, 2012). The company collapsed after the $2 billion exclusion was revealed. By 2002, before its termination, Adelphia was the sixth largest cable company in the U. but it forced to file Chapter 11 bankruptcy shortly after the fraud was reported.
1 Discussion of the key facts and issues..........................................................
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and managing its exposure to market and credit risks resulting from trading activities, Lehman entered into derivative transactions on its behalf and that of its clients (Valukas, 2010). According to Valukas (2010), Lehman held over 900,000 derivatives positions globally as of May and August, 2008 with a net value of around $21 billion as of May 31, 2008; making up a rather small percentage of Lehman’s total assets (approximately 3%). Valukas (2010) also argues that the term derivative is a contract between two or more parties often referred to as a “financial contract.” Lehman experienced a drop of $17 billion in CDOs (Collateralized Debt Obligations) in financial year 2008, compared with the $16 billion and $25 billion generated in financial years 2006 and 2007 correspondingly (Valukas, 2010). Although the 2008 decline is not as severe as is generally consistent with the decline in the global CDO market, many contend that it contributed considerably to the collapse of Lehman. Notwithstanding the billions of dollars worth of CDOs that Lehman originated from 2006 to 2007, Lehman accounted for just 3% of the total value of new CDO issuances; and their CDO portfolio was subjected to the disruptions in the credit markets and deteriorating value of mortgages and mortgage‐linked securities that occurred in 2007 and 2008 (Valukas, 2010). As the market declined, Lehman was not able to sell subordinate pieces of securitizations, and many of Lehman’s CDO positions were such pieces. For instance, of the $431 billion of CDOs originated in 2006‐2007, more than half had experienced events of default by November 2008, with increasing numbers of defaults over time (Valukas, 2010). Krugman (2010, cited in Swedberg, 2010 ) established that "in the years before the crisis, regulators did not expand the rules for banks to cover the growing 'shadow' banking system, comprising of institutions like Lehman Brothers that performed bank-like functions although they did not offer conventional bank deposits." The financial crisis that broke out after Lehman's fall on September 15 made
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some of Lehman’s executives realize very quickly that something else had to be done than just attend to individual cases. In June 2008, Lehman was able to raise approximately $6 billion in capital and took steps to improve its liquidity position, but efforts in raising additional capital in the weeks leading up to its failure proved insufficient (Bernanke, 2010). Lehman's high degree of leverage - the ratio of total assets to shareholders equity - was 31 in 2007, and its huge portfolio of mortgage securities made it progressively vulnerable to deteriorating market conditions. Lehman's bankruptcy was many times more multifaceted than Enron's failure in 2001 as it was deeply plumbed into the global financial system**.** According to Bernanke, "almost every large financial institution in the globe in momentous danger of going bankrupt" (Bernanke, 2009, cited in Swedberg, 2010).The following section analyzes some of the causes of Lehman’s collapse, with a particular emphasis on the implications of the bankruptcy on the international banking system.
1 Analysis of the facts and issues..................................................................
The collapse of Lehman has made headline news in several newspapers and journals. Several industry practitioners and authors have undertaken much research just to establish “what caused the failure of Lehman Brothers.” This section examines the facts and issues relating to the collapse of Lehman Brothers. What financial fraud factors that made Lehman Brothers go bankrupt and how could its bankruptcy have such a huge impact on the financial system? How could this event turn an economic crisis of some severity into a complete financial panic? These and many other questions are the emphasis of this section.
1 Causes of action arising from Lehman’s financial condition and failure...................
In recent years, there has been a sequence of publications on what caused the failure of Lehman Brothers. While some blamed Lehman’s CEO Dick Fuld for his overconfidence in
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U which led to more than 9,000 banks failing during the great depression years of 1930- (Laroche, 2010). Various experts have blamed these failures on the so-called unethical actions arising from the amalgamation of investment and commercial banking. In their paper, Altınkılıç, et al. (2007) observed that investment banks’ governance has responded to the deregulation of commercial bank entry into investment banking by virtue of the repeal of the Glass-Steagall Act. Competing with commercial banks was a huge undertaking for Lehman; therefore the easiest way to compete was to use high amounts of leverage, thus taking on more risk. For an investment bank, the processing and absorption of risk is a distinctive intermediation function comparable to a commercial bank engaged in lending (Boot, 2008). A risky state for any bank is to lose liquidity. Like all banks, Lehman was a reversed pyramid balanced on a splinter of cash. Even though it had a massive asset base, Lehman did not have enough by way of liquidity. Believing that Lehman did not have sufficient liquidity at hand, other banks declined to trade with it, so they moved to protect their own interests by pulling Lehman's lines of credit (D’Arcy, 2009). Many blamed Lehman’s failure on insufficient liquidity to meet current obligations and inability to retain the confidence of counterparties and lenders (Valukas, 2010). Lehman’s available liquidity is fundamental to the question of why Lehman failed. Liquidity offers firms the ability to convert assets into cash without complexity, thus ensuring that investment decisions are maintained and short‐term obligations are satisfied.
The firm also stated that it had boosted its liquidity pool to a projected $45 billion, decreased gross assets by $147 billion, reduced its exposure to commercial and residential mortgages by 20%, and cut down leverage from a factor of 32 to approximately 25” (Valukas, 2010). Valukas (2010) noted that there was a crisis of confidence since the confidence of lenders
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reduced on two successive quarters with massive reported losses, $2 billion in second quarter 2008 and $3 billion in third quarter of 2008. Lehman’s accounting system was a failure. The “Repo 105 transactions” used by the firm was described by its own accounting personnel as an “accounting gimmick, ”as it was a lazy way of managing the firm’s balance sheet (Valukas, 2010).This action of accounting improprieties created a deceptive portrayal of Lehman’s true financial health. Amazingly, Lehman’s external auditor, Ernst & Young took virtually no action to scrutinize the “Repo 105” allegations; and did not take any step to “challenge or question the non‐disclosure by Lehman of its use of $50 billion of temporary, off‐balance sheet transactions” (Valukas, 2010).
This unethical conduct by Lehman’s auditor justifies Stern Stewart’s (2002) conclusion that accounting is no longer counting what counts and those in charge have not been wise or strong enough to resist their ploys and to make the auditors’ definition of earnings into a reliable measure of value. Many experts attribute that many companies’ fail and experience financial crises because of disclosure fraud, accounting fraud, and accounting manipulation, that were kept under cover; and auditors failed to warn the society and shareholders. Financial statement fraud also played a key role in the collapse of Lehman because some senior officers overlooked and certified misleading financial statements. For example, in the case of Crazy Eddie Company’s frauds, the auditors were rushed and did not have time to complete most of their procedures (Kranacher, 2010). Lehman was greatly exposed to the US real-estate market, having been the major underwriter of property loans in 2007, by which Lehman had over $60 billion invested in CRE (commercial real estate) and was very big in subprime loans, mortgages - to risky homebuyers (D’Arcy, 2009). Lehman had vast exposure to innovative yet arcane investments such as CDOs (collateralized debt obligations) and CDS (credit default swaps).
Lehman Inc Financial Fraud Case Study
Course: Investment Funds In Canada (FIN-3004)
University: Lambton College of Applied Arts and Technology
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