Lehman Brothers – Corporate Governance Report

Teemu Kämppä, Sylvia Ruohonen & Nelli-Maria Sarasmaa

Aalto University
Business School
Corporate Governance
Supervised: Prof. Ikäheimo, Seppo
18.5.2018
SOURCES

Literature

1. Aguilera, Ruth V. et al: An Organizational Approach to Comparative Corporate

Governance: Costs, Contingencies, and Complementarities. Organization Science Vol. 19
No. 3, May-June 2008 pp. 475-492
2. Bebchuk, Lucian A – Fried, Jesse M.: Pay Without Performance: Overview of the Issues.
Harvard Law School – University of California at Berkley. Journal of Applied Corporate
Finance, Volume 17 number 4, 2005.
3. Bebchuk, Lucian A. – Cohen, Alma – Spamann, Holger: The Wages of Failure: Executive
Compensation at Bear Stearns and Lehman 2000-2008. Harvard Law School Cambridge.
Discussion Paper No. 657 revised 02/2010.
4. Bishop, Matthew – Green, Michael. The Road From Ruin: How to Revive Capitalism and
Put America Back on Top. Crown Business, New York, 2010. 1st edition.
5. Boatright, John R.: Rent Seeking in a Market with Morality: Solving a Puzzle About
Corporate Social Responsibility. Journal of Business Ethics (2009) 88: 541-552. Springer,
2009.
6. Chincarini, Ludwig B.: The Crisis of Crowding: Quant Copycats, Ugly Models, and the
New Crash Normal. Bloomberg Press, 2012
7. Hermalin, Benjamin E. – Weisbach, Michael S.: Boards of Directors as an Endogenously
Determined Institution: A Survey of the Economic Literature. FRBNY Economic Policy
Review April 2003.
8. Jeffers, Agatha E.: How Lehman Brothers Used Repo 105 to Manipulate Their Financial
Statements. Montclair State University. Journal of Leadership, Accountability and Ethics
vol. 8(5) 2011
9. Krambia-Kapardis, Maria: Corporate Fraud and Corruption – A Holistic Approach to
Preventing Financial Crises. Palgrave MacMillan, 2016.
10. Kirkpatrick, Grant: The Corporate Governance Lessons from the Financial Crisis. OECD
2009. Financial Market Trends. Pre-publication version for Vol. 2009/1.
11. Muolo, Paul – Padilla, Matthew: Chain of Blame: How Wall Street Caused the Mortgage
and Credit Crisis. John Wiley & Sons, Incorporated, 2008.
12. Presley, Theresa J. – Jones, Bryce: Lehman Brothers: The Case Against Self-Regulation.
Journal of Leadership, Accountability and Ethics vol. 11(2) 2014.
13. Remorov, Rodion: Stock Price and Trading Volume during Market Crashes. International
Journal of Marketing Studies; Vol. 6, No. 1:2014. Canadian Center of Science and
Education.
14. Roe, Mark J: The Institutions of Corporate Governance. Discussion Paper No. 488. 08/2004.
Harvard, John M. Olin Center for Law, Economics, and Business.
15. Sikka, Prem: Financial Crisis and the Silence of the Auditors. Working Paper No. WP
09/04. University of Essex, Essex Business School

i
 16. Valukas, Anton R: Bankruptcy examiner’s report on Lehman Brothers Holdings Inc.
Sections I & II: Introduction, Executive Summary & Procedural Background. United States
Bankruptcy Court Southern District of New York.
(https://web.stanford.edu/~jbulow/Lehmandocs/VOLUME%201.pdf, 28.4.2018)
17. Valukas, Anton R: Bankruptcy examiner’s report on Lehman Brothers Holdings Inc. Section
III.A.4: Repo 105. United States Bankruptcy Court Southern District of New York.
(https://web.stanford.edu/~jbulow/Lehmandocs/VOLUME%203.pdf)
18. Van Essen, Marc – Otten, Jordan – Carberry, Edward, J.: Assessing Managerial Power
Theory: a Meta-Analytic Apporach to Understanding the Determinants of CEO
Compensation. Utrecht University – Erasmus University. Journal of Management, Vol. 41
No. 1, Jan. 2015.
19. Wiggins, Rosalind Z. – Bennett, Rosalind L. – Metrick, Andrew: The Lehman Brothers
Bankruptcy D: The Role of Ernst & Young. Yale Program of Financial Stability Case Study
2014-3D-V1. Revised March 10 2015. Yale School of Management

Others

1. Amadeo, K.: What Is the Dodd-Frank Wall Street Reform Act? [online] The Balance. March
15, 2018. Available at: https://www.thebalance.com/dodd-frank-wall-street-reform-act-
3305688 [Accessed 17 May 2018].
2. Baily, M. and Klein, A.: The Impact of the Dodd-Frank Act on Financial Stability and
Economic Growth. [online] Brookings.edu. October 24, 2004. Available at:
https://www.brookings.edu/wp-content/uploads/2016/06/Baily-Klein-PPTF-1.pdf [Accessed
17 May 2018].
3. Basel Committee on Banking Supervision: Guidelines, Corporate Governance Principles for
Banks. Available online: https://www.bis.org/bcbs/publ/d328.htm
4. Berman, Dennis, K.: Where was Lehman's board? The Wall Street Journal. Sep 15, 2008
4:45 pm ET. Available online: https://blogs.wsj.com/deals/2008/09/15/where-was-lehmans-
board/
5. Hallman, Ben: Four Years Since Lehman Brothers, ‘Too Big To Fail’ Banks, Now Even
Bigger, Fight Reform. Huffington Post 2012. News.
(www.huffingtonpost.com/2012/09/15/lehman-brothers-collapse_n_1885489.html)
6. Bowes, Simon: Lehman Brothers former CEO blames bad regulations for banks collapse.
The Guardian. 28.5.2015, 20:39. Available online:
https://www.theguardian.com/business/2015/may/28/lehman-brothers-former-ceo-blames-
bad-regulations-for-banks-collapse (17.5.2018)
7. Carney, John: The Sec Rule That Broke the Wall Street. CNBC. Published 1:16 PM ET
Wed, 21 March 2012. Updated 1:42 PM ET Wed, 21 March 2012.
8. Cohen, Lauren. – Fazzini, Andrea. – Malloy, Christopher: Hiring Cheerleaders: Board
Appointments of "Independent" Directors. Available online:
http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.182.5333&rep=rep1&type=pdf
9. Kelly, Kate. How Godlman Won Big On Mortgage Meltdown; A Team’s Bearish Bets
Netted Firm Billions; A Nudge From the CFO. Wall Street Journal, Eastern edition; N.Y. 14
Dec 2017: A.1.
10. Einhorn, David: Private Profits and Socialized Risk. Grant’s Spring Investment Conference
April 8, 2008. Public speech. (www.tilsonfunds.com/Einhorn-4-08.pdf)

ii
11. Finanssivalvonta. Uusi vakavaraisuuskehikko Basel II on hyväksytty. [online]
Finanssivalvonta. 29.6.2004. Available at:
http://www.finanssivalvonta.fi/fi/Tiedotteet/Arkisto/Ratan_lehdistotiedotteet/Pages/16_2004
.aspx [Accessed 17 May 2018].
12. Hermalin, Benjamin. Weisbach, Michael: Boards of Directors as an Endogenously
determined Institution: A Survey of the Economic Literature. FRBNY Economic Policy
Review. April 2003.
13. Indiviglio, D.: Is the SEC to Blame for Lehman's Failure?. [online] The Atlantic. April 20,
2010. Available at: https://www.theatlantic.com/business/archive/2010/04/is-the-sec-to-
blame-for-lehmans-failure/39236/ [Accessed 16 May 2018].
14. Investopedia Staff: Basel III. Available online:
https://www.investopedia.com/terms/b/basell-iii.asp
15. Investopedia Staff: The Collapse of Lehman Brothers: A case study. Investopedia 11 Dec.
2017. (https://www.investopedia.com/articles/economics/09/lehman-brothers-collapse.asp)
16. Larcker, David, F. Tayan, Brian: Lehman Brothers: Peeking Under the Board Façade.
Standford Closer Look Series, June 4, 2010.
17. Sorkin, Andrew R.: A Partnership Solution for Investment Banks? The New York Times
Aug. 20 2008. DealBook. (https://dealbook.nytimes.com/2008/08/20/a-partnership-solution-
for-investment-banks)
18. Tobak, Steve: The Financial Crisisfor Dummies. Moneywatch, The CBSNews. March 26,
2010, 2:51 PM. (https://www.cbsnews.com/news/the-financial-crisis-for-dummies/)
19. Weil, Gotshal & Manges LLP: Public Company Advisory Group: Requirements for Public
Company Boards. Available online:
https://www.weil.com/~/media/files/pdfs/150154_pcag_board_requirements_chart_2015_v2
1.pdf
20. Wolff, Richard: Lehman Brothers: Financially and Morally Bankrupt. The Guardian 12. Dec
2011. News. (https://www.theguardian.com/commentisfree/cifamerica/2011/dec/12/lehman-
brothers-bankrupt)

iii
CONTENTS

I. Abstract ............................................................................................................................................. 1

1. Introduction ...................................................................................................................................... 3

1.1 Historical Background .............................................................................................................. 10

1.2 Introduction to the Key Issues in Inner Corporate Governance Institutions ............................ 12

2. Board of Directors .......................................................................................................................... 13

2.1 Independency of Board Members ............................................................................................ 13

2.2 Lehman Brothers Board of Director ......................................................................................... 14

2.3 Implications of the crisis: Basel Committee on Banking Supervision Guidelines and Principles
and Basel III ................................................................................................................................... 16

2.4. Intermediary conclusion .......................................................................................................... 17

3. Compensation Schemes ................................................................................................................. 19

4. Risk Management .......................................................................................................................... 24

4.1 Main internal issues .................................................................................................................. 24

4.2 External factors......................................................................................................................... 26

4.3. Intermediary conclusion .......................................................................................................... 27

5. Fallout ............................................................................................................................................ 28

6. Conclusion ..................................................................................................................................... 30

iv
I. ABSTRACT

In this essay on Lehman Brothers the context of financial crisis is outlined around Lehman Brother’s
collapse in 2008 to understand better the external reasons, why the corporate governance practices
were arranged in Lehman Brothers as they were and why their failure together with the collapse of
the housing markets in the US in 2007 lead to the collapse of the fourth largest investment bank. The
main events in Lehman Brothers business that affect to the collapse of the company are shown in
figure 1. These events will be discussed later in this essay.

The main discoveries of this essay are that the corporate governance practices of Lehman Brothers
cannot be separately analysed from their complementing nature, instead the practices should be
bundled together to assess their combined ability to achieve effective governance.1 Additionally, the
failures of the internal corporate governance practices must be considered together with the outside
corporate governance in view of so called legitimacy of corporate governance. Corporate governance
institutions do have the internal effects of preventing agency problems and stabilizing corporations,
but there also exists the legitimacy dimension, where the institutions are tested regarding how well
they govern the firm so that it is legitimate in its society and politically. The players outside the
corporation can affect the corporation: if corporate arrangements appear unfair, then the outsiders can
intervene through political institutions. They can ban some arrangements, raise the costs of others,
and subsidize others. These actions deeply affect the institutions of corporate governance.2

As a result, the fundamental finding of this essay is that the main identified corporate governance
issues in Lehman Brothers of faulty risk management, compensation schemes and board of director
activity, were a consequence of historical development, political pressure, failure of regulators and
watchdogs like credit rating agencies and auditors. Of these factors the political pressure has been
brought up as a prime culprit as the reason why Lehman Brothers, unlike other investment banks in
the same situation in the financial crisis, was not bailed out. Instead the Federal Reserve decided to
let Lehman Brothers to fail in order to give the public and regulators a stimulus to begin the
strengthening of the financial sector through troubled asset relief program and eventually, to introduce
stricter regulation to control investment banks that had until then been largely free to operate as they
pleased. Such freedom from external regulation had resulted in complex financial structured securities

1
Aguilera et al. 2008, p. 476
2
Roe. 2004, p. 4, 17

1
and increased risk-taking activities, which meant that the investment banks outmanoeuvred the
watchdogs creating an unsustainable growth in the housing markets.

We can now put the events that occurred in the financial markets in a timeline to further illustrate
how the credit bubble was created in a chronological order and how Lehman reacted to the changing
financial markets to adapt to the changes.

2007
2006 subrpim
1889 Lehman e
expansion launches mortgag 2008 Lehman
to aggressive e market Bear Brothers file
investment growth crisis Sterns for
banking strategy begins collapse bankruptcy

Survive 2007 2007 2008 Fall Sept.

great beats BNC and of stock 18th
depression Bear LLC shut value Bailout
Sterns as down to
the Congress
biggest
underwri
ter of
MBSs

Figure 1: Timeline of main events affecting to bankruptcy of Lehman Brothers

2
1. INTRODUCTION

A good description in layman terms of what happened with Lehman Brothers Holding Inc. (Lehman)
in the housing market crash is given in the following quote from a press release, as well as, a
description of the public feeling after the collapse. The public was, and still is, demanding the rooting
out of the guilty parties, issues in corporate governance and economy that were to blame for the
downfall of the investment bank.

“Blame for the collapse is still being debated. People bought homes they couldn’t afford,
peddled by lenders who knew — or should have known — that the loans were destined to fail.
Wall Street sucked up these loans and sold them off in bundles to investors, sometimes while
making bets against those same products. “
Huffington Post, Ben Hallman3

What happened to Lehman then in financial numbers? First, Lehman had been for a long-time a
success story and on Jan. 2008, Lehman reported record revenues of close to $60 billion and record
earnings in excess of $4 billion for its fiscal year 2007 (see figure 2). Lehman’s stock was valued at
$65,73 per share giving Lehman a market capitalisation of over $30 billion in Jan. 2008. Nevertheless,
on Sept. 2008, Lehman’s stock had plummeted and closed under $4, losing almost 95% of its value
from Jan. On 15th Sept. the decline in trade volume of Lehman’s stock lead to the decrease of the
stock value,4 but essentially, illiquidity forced Lehman to file for the largest bankruptcy in the
history.5

3
Hallman. 2012 (https://www.huffingtonpost.com/2012/09/15/lehman-brothers-collapse_n_1885489.html)
4
Remorov. 2014, p. 27
5
Valukas. 2010, p. 2. Sections I & II: Introduction, Executive Summary & Procedural Background

3
Figure 2: Monthly stock price of Lehman Brothers Inc.6

The fall of Lehman marked an important point of economic history as the bankruptcy of Lehman, the
fourth-largest investment bank, had ripple effects across the banking world and was a major
contributing factor ushering the financial crisis of 2008. The importance of corporate governance in
financial industry was consequently brought to the attention of the public. Investment banks’ high
level of inter-connectedness within the economy was the root of the discussion in the media, where
the question of whether banks should be “too-big-to-fail” or not was asked.

The reasons why Lehman collapsed are multifaceted. However, if holistic approach regarding the
responsibilities of an organization to all its stakeholders is taken, it has been argued that corporate
financial scandals occur because the prevailing corporate culture focuses only on profits; transparency
and accountability, trust, and business ethics lacking.7 As Bart McDade – COO and President, tasked
with largely running Lehman and saving it as the then CEO Richard S. Fuld was side-lined, said in a
meeting during the crisis: “Right now this firm needs some adult risk supervision” and “we have to
clean up twenty-four months of reckless growth with little regard for risk management”.8

6
Remorov. 2014, p. 24. Used source for the table: Bloomberg
7
Krambia-Kapardis. 2016, p. 7
8
McDonald – Robinson. 2009, p. 305-306

4
The prime culprit behind the collapse of Lehman was the excessive risk taking undertook by Lehman
during the U.S. housing boom, which eventually proved to be a colossal market bubble. During the
housing boom Lehman acquired several mortgage lenders, including subprime lender BNC Mortgage
and Aurora Loan Services, of which the later specialized in Alt-A loans. In 2007 Lehman underwrote
more mortgage-backed securities than any other firm, accumulating a $85 billion portfolio, or four
times its shareholder’s equity. Lehman’s high degree of leverage and its huge portfolio of mortgage
securities made it extremely vulnerable to deteriorating housing market conditions. As the subprime
mortgage market crisis began in 2007 in the U.S., the soaring delinquency rates led to a rapid
devaluation of financial instruments i.e. mortgage-backed securities including bundled loan
portfolios, derivatives and credit default swaps. This lead to mistrust in these securities that halted
the markets, which in turn meant that banks, such as Lehman, who were heavily invested in these
assets faced a liquidity crisis.9

The subprime game was not only played by Lehman, but by several major investment banks. These
included companies such as Bear Stearns, Citigroup, Lehman Brothers, Merrill Lynch and Swiss
investment banker Credit Suisse10, as well as, government sponsored enterprises (GSEs) Fannie Mae
and Freddie Mac. However, Lehman made a deadly mistake as it made a deliberate decision to double
down, when the first signs of subprime residential mortgage business crisis emerged, additionally,
failing to accurately take notice of the spill over effect that would later on materialize on the
commercial estate markets as well. By hoping to profit from a counter-cyclical strategy Lehman
significantly and repeatedly exceeded its own internal risk limits and controls in the hope of snapping
up bargains and without fully realizing how bad the real estate situation would come.11 Therefore,
Lehman was in a sense the consequence of a deteriorating economic climate.

Nevertheless, the financial plight of Lehman, and the consequences to Lehman’s creditors and
shareholders, was exacerbated by Lehman’s executives, whose conduct ranged from serious but non-
culpable errors of business judgement to actionable balance sheet manipulation; by the investment
bank business model, which rewarded excessive risk taking and leverage; and by Government
agencies, who by their own admission might better have anticipated or mitigated the outcome.12 The
executives’ creed to increase their own compensation profits, even by the means of corruption, was

9
Investopedia Staff. 2017 Available online: https://www.investopedia.com/articles/economics/09/lehman-brothers-
collapse.asp (17.5.2018)
10
Muolo – Padilla. 2008, p. 7
11
Chincarini. 2012, see Chapter 11: The Lehman Bankruptcy. A Chronology of the Gorilla’s Death
12
Valukas. 2010, p. 3. Sections I & II: Introduction, Executive Summary & Procedural Background

5
also noted by the press after the collapse of Lehman. Subsequently, in the aftermath, the blame was
naturally first directed at the executives handling the daily operative decisions of Lehman.

“Lehman Brothers' bankruptcy has revealed multiple layers of ramifying corruption and theft
among global banks in the US and elsewhere…. Of course, Lehman Brothers' top bank
executives rewarded themselves stupendously while directing Lehman Brothers into collapse.”
The Guardian, Richard Wolff13

After the fall of Lehman, there were also high political stakes involved to find answers and to give
the public a target face to blame. The former CEO and chairman of Lehman, Richard Fuld, was as a
result questioned by the Congress on his oversight of Lehman. At the conference, however, Fuld
brought his view on the causes of Lehman’s downfall. Fuld blamed, firstly, the government for
pushing non-qualified ownership as the government aimed to fulfil the idea of the American dream.
The aggravating factors being low interest rates and easy access to credit for homeowners. Credit
bubble indicators were also plainly visible. Secondly, Lehman’s stock was strongly shorted by hedge
funds like Greenlight Capital and Goldman Sachs (4 billion$ profit).14 The sizeable short-position of
Goldman Sachs also cancelled out their own subprime mortgage losses and this fact has spurred the
rumours of conspiracies that it was in the interest of Goldman Sachs that Lehman was allowed to fail
and that the former Goldman employee Paulson heading the SEC were biased in their decision.15

The story of David Einhorn, Greenlight Capital hedge fund manager, had a very opposite perspective,
where he explained the short position of Lehman’s stock with mistakes within Lehman. The issues
identified by Einhorn were, firstly, failed volatility models that lead to excessive leverage ratio 30-1.
Secondly, the management payment incentives to maximize employee compensation through
leveraging. At the same time the shareholders of investment banks got only incremental returns on
the equity, even though the banks were taking high risks. One reason for this expressed by Einhorn
is the bank’s sophisticated investor relations (IR). Thirdly, the risk models used at Lehman were
flawed, particularly, Value-at-Risk (VAR) concept gave false security to the management and
watchdogs and proved catastrophic in a major event like the housing market crash. Fourthly, the
watchdogs, especially, credit rating agencies (CRAs) and Securities Exchange Commission (SEC)

13
Wolff. 2011. (https://www.theguardian.com/commentisfree/cifamerica/2011/dec/12/lehman-brothers-bankrupt)
14
Bowers. 2015. (https://www.theguardian.com/business/2015/may/28/lehman-brothers-former-ceo-blames-bad-
regulations-for-banks-collapse) & Kelly. 2007
15
Bishop – Green. 2010, p. 66-67

6
failed to monitor and control Lehman. Rating agencies did not adequately monitor Lehman’s
exposure by observing the failing risk controls and hedging. On the other hand, SEC issued a rule on
Alternative Net Capital Requirements for Broker-Dealers That Are Part Consolidated Supervised
Entities, which in hindsight proved catastrophic as it allowed brokers to enable lower capital
requirements to engage in increasingly risky activities. Fifthly, Einhorn blames the bailouts for
exacerbating the credit bubble as it reinforces the excessive risk taking and leverage. The argument
is that the reluctance of the government to allow a collapse of a single significant player in the
derivative markets, due to the systemic risks involved, in effect meant that the government’s message
was that dealing with anyone in the “too-big-to-fail” group was not a matter of creditworthiness at
all. An entertaining illustration is given by Einhorn by comparing Coke and Water to the bailout
systems. While Coke gives a sugar rush stimulation and quenches thirst, water purifies the body and
is healthier in the long-term. Similarly, bailouts give immediate relief, while allowing the fall of a
too-big-to-fail company improves the healthiness of the markets. Lastly, Einhorn points out that in
Lehman the management was charismatic and had almost cult-like status, who without control had
left the company too exposed for the financial crisis and upkept performance smoothing.16 Einhorn
sums nicely the whole context around Lehman concisely in the following extract:

“I was going to point out that we were developing a system of very large, highly levered,
undercapitalized, financial institutions including the investment banks, some of the large money
center banks, the insurance companies with large derivatives books and the GSEs. I planned to
speculate that regulators believe all of these are too big to fail and would bail them out, if
necessary. The owners, employees and creditors of these institutions are rewarded when they
succeed, but it is all of us, the taxpayers, who are left on the hook if they fail. This is called
private profits and socialized risk. Heads, I win. Tails, you lose. It is a reverse-Robin Hood
system.”17
Einhorn, David. Greenlight Capital

As already became clear from Einhorns’ speech, there has been made the claim that due to the nature
of the political atmosphere at the time of Lehman’s collapse, the Federal Reserve allowed Lehman to
fail. The ulterior motive for such biased decision was to use the Lehman as a means to an end. The
aim was to convince the politicians and the public that a large financial bailout was necessary to force
new regulation of the financial markets, which was in dire need to diminish the effects of the financial

16
Einhorn. 2008 p 1-9
17
Einhorn. 2008, p. 7

7
crisis. Although this decision can be debated in regards its validity, it might have had an effect on
preventing even deeper recession as resuscitating measures were launched such as the troubled assets
relief program (TARP).

CRAs had also an important role in the financial crisis as they assigned ratings to the securities traded
by investment banks, in addition to, rating the investment banks themselves. CRAs not only failed to
reduce the investment banks’ ratings due to the swelling of the balance sheet and high risks included
in the assets, but also did even illegally in some cases assign inaccurate ratings on the MBSs, which
in turn misguided the other investors. A major problem was that the investment banks paid for these
ratings, which cause a conflict of interest. Moreover, there were technical problems with the
computation models and misuse of these ratings as investors relied on them too heavily without
complete understanding of how the ratings were calculated. This meant that the corporate governance
framework was not complemented appropriately by CRAs, which mislead investors through poor
credit assessments.18 As investors realised this, they lost confidence in ratings and securitised
products more generally.19

In the financial crisis a big part of the problems was also the accounting rules that allowed banks to
inflate the value of their assets, thereby making accounting creative fiction that resulted in sludge
assets in the balance sheets.20 The accounting practices are even more inflammable considering the
high leverage ratio, where only incremental drops in the value of assets could wipe out the entire
value of equity and making the company insolvent. The auditing practices do require that the audited
entity has the ability to continue operational for the foreseeable future. Auditing standards also require
auditors to perform audit procedures, whereby evidence is accumulated to ensure that the events up
to the date of the auditor’s report that need adjustment or disclosing are identified. At the same time
the external auditing firms received considerable income from all distressed banks creating a conflict
of interest. In the financial crisis 2008 misuse of off-balance sheet entities and fair valuation of assets
were a problem. Lehman used f.ex. repurchase agreements (Repo 105) as an accounting gimmick to
remove risky assets from its balance sheet and to decrease the leverage ratio was lowered. This
misleading accounting practice occurred usually just before quarterly reports as a form of window
dressing.21 In Repo 105 Lehman obtained loans from financial institutions and held the obligation to

18
Kirkpatrick. 2009, p. 24-25
19
Ibid. p. 25
20
Sikka. 2009, p. 4
21
Jeffers. 2011, p. 45-46

8
buy back the collateral. After the financial statements were issued, Lehman would use the cash from
the loans to buy back the troubled assets at 105% of their value (hence Repo “105”). Repo 105 was
possible due to the loophole, where the accounting principles were unclear concerning when then
control of assets have been surrendered in sense of a sale and when not in sense of borrowing.22
Hence, the management of Lehman broke its fiduciary duty towards the owners of the firm. Ernst &
Young (EY) served as Lehman’s independent auditor from 2001 until the Lehman’s bankruptcy. EY
became aware of the Repo 105 practice and the examiner in Lehman’s bankruptcy proceedings stated
that EY was professionally negligent in allowing the misleading periodic reports to go
unchallenged.23 Instead, EY never applied professional scepticism to inquire about the unusual
situations and transactions, even though that the usage of Repo 105 was an unusually expensive way
to raise funds and that other investment banks had ceased to utilize such mechanism.24 There was
even a “Whistle-blower Letter” from the Senior Vice President, Matthew Lee, sent to EY and
Lehman’s senior managers concerning suspicions on accounting errors and other irregularities, which
lead to a meeting between EY and Lee, where Repo 105 was discussed. Despite the whistleblowing,
EY did never disclose the allegations regarding Repo 105 made by Lee to the audit committee, or the
full board.25

The ownership structure of Lehman also seems to have earned little attention in case studies
concerning Lehman. The question is that how much the highly diffused ownership structure of
Lehman affected the weak corporate governance structures. A New York Times article had made same
kind of a remark. There the author has noticed firstly the historical development of how the
investment banks became diffusedly owned from being partnership companies as they listed in the
stock exchange, when the prohibition of these entities for listing was lifted in 1970s. The question
next is whether the massive losses would have ensued, if the managing directors would have owned
it all. In the article an interesting remark is made that Goldman Sachs being the bank who largely
anticipated and avoided the problems with subprime securities also had most partnership-like
attributes.26 The conclusion that can be drawn from this is that although partnership structure has its
own limitations and issues and might not be a preferential solution, we can infer that the shareholders

22
Jeffers. 2011, p. 50
23
Valukas. 2010, p. 750. Section III.A.4: Repo 105
24
Wiggins – Bennett – Metrick. 2014, p. 11
25
Ibid. p. 11
26
Sorkin. 2008.Available online: https://dealbook.nytimes.com/2008/08/20/a-partnership-solution-for-investment-banks/
(17.5.2018)

9
of Lehman were too inactive either because of diffused ownership or because of the lack of
understanding the complex financial sector.

1.1 Historical Background

To begin with, the regulatory framework on investment banks was relatively weak before the crisis
of 2008 and the banks were only loosely guided by the SEC and could only voluntarily become
regulated under the Consolidated Supervised Entities (CSE) program.27 In this kind of surroundings,
there was less protection for consumers and significantly greater amount of operational freedom for
the investment banks. Investment banks were neither monitored by certain individual institutions
which in its part encouraged banks to operate somewhat recklessly. It should be noted here, that in
turn commercial banks were more regulated by Glass-Steagal Act and Federal Government. Here, for
instance, the leverage ratio was limited to 10:1, while similar but higher limitations were only
recommendations for investment banks.

Before the crisis, there was a rather strong political atmosphere influencing in the background which
was basically the governmental aim to provide houses and the "American dream" also for those who
were not necessarily solvent. One by one, those rules and regulations intended to ensure that lenders
didn't write bad loans were ultimately removed.28 For this 'housing' purpose, Fanny Mae and Freddy
Mac, government sponsored-enterprises, were important in providing these mortgages for the
ordinary people and operating in the secondary mortgage market. The ultimate purpose of these
institutions was to expand the secondary mortgage market by securitizing mortgages in the form of
mortgage-backed securities (MBS). Fanny Mae and Freddy Mac bought the mortgages from
commercial banks as they were willing to sell because holding loans is risky due to the possible
default risk.29 Fannie and Freddy assumed the credit risk and attached it to the securitized mortgages
pools and sold them to the investors.30 Fannie and Freddy enabled banks to grant more loans and
furthermore, the loans could be sold further to the investors in order to get outsiders into the mortgage
market and more money moving. While the regulatory environment was rather accommodating and
allowed non-financial companies to enjoy access to the housing markets, it led to compressed margins

27
The SEC RuleThat Broke Wall Street. Available online: https://www.cnbc.com/id/46808453 (17.52018)
28
The Financial Crisis for Dummies. Available online: https://www.cbsnews.com/news/the-financial-crisis-for-dummies/
(17.5.2018)
29
Chincarini, 2012. Chapter: The Basic Business (chapter name, pages not available).
30
Ibid., Chapter: Where is the risk?

10
in traditional banking.31 Therefore, banks were forced to develop new sources of revenue and new
financial assets such as collateralized debt obligation (CDO) and derivatives based on mortgages
which were not regulated. Bankers found creative ways of getting all those risky loans off their
balance sheets and packed and sold them further to investors and institutions all over the world. This
kind of "monkey business" was enabled by the credit rating agencies as described above.32 Also, the
exemption of over-the-counter derivatives, such as credit-default swaps, from regulation was a clear
catalyst for the movement of these risky financial instruments.33

As many mortgages had been granted without adequate assessment to non-qualified people, some
parties defaulted. This caused freezing in the market, because no one wanted to buy those risky
financial entities. The mistrust spread and the financial crisis was ready. Lehman had no assets to
cover its day-to-day business because its treasury was empty as all it had was tied to those risky
financial instruments and it had to declare bankruptcy in 2008.

Lehman Brothers was not the only investment bank that had difficulties surviving the crisis, although
some of them were bailed out by the U.S. government Federal Reserve like, Goldman Sachs. Why
was Lehman not saved? Answer to this question lies most likely in the politics behind. It can be
possible, that already after saving some investment banks there was possibly a pressure not to spend
any more money on such institution which had been somewhat reckless in its business. Also, it could
have been a wakeup call for the decision makers, that more regulation is needed and that the situation
could not go on anymore. Another interesting issue regarding Lehman's bankruptcy is, that as there
were several big investment institutions involved in this risky business, it ultimately means that if one
fails, they all will fail eventually. When it comes to corporate governance, could the situation have
been different, and Lehman be saved if it had organized and taken better care of its corporate
governance issues, for instance, if risk exposure had been limited? Perhaps not. Although, if Lehman
had been the first one to fall there could have been a possibility of the absence of the political pressure
not to save any more investment firms.

31
Kirkpatric 2009. p. 5
32
The Financial Crisis for Dummies. Available online: https://www.cbsnews.com/news/the-financial-crisis-for-dummies/
(17.5.2018)
33
Ibid.

11
1.2 Introduction to the Key Issues in Inner Corporate Governance Institutions

One of the key matters that emerged in the Lehman crisis was the weak structure and operation of
corporate governance organizations inside the company. The corporate governance structures failed
to safeguard the company from excessive risk taking, which eventually lead to Lehman’s bankruptcy.
These internal failures remained well hidden and were ignored until the downturn. The key areas,
where the corporate governance failed, were board of directors, remuneration schemes and corporate
risk management. Additionally, there were also external controls that failed as has been discussed
above: regulations regarding financial markets and institutions, CRAs, industry culture and possible
competition by rival companies as well as auditors had their part in the mess.

12
2. BOARD OF DIRECTORS

Lehman Brothers crisis is sometimes being viewed as a model example of how the board of directors
failed to fulfil its task as a major player in the field of corporate governance. There were several
factors present which made the investment company to fail, but the sloppy work of directors was
distinctly one of those issues. In this chapter we focus on the issues with the Lehman Brothers board
of directors at the time of the crisis: what did the board do wrong and why?

Board of directors is an economic institution which is meant to address organisational problems in

different organizations. In theory, board helps to solve the agency problem which essentially, refers
to an inherent problem in companies with shareholders: board is to control and oversee the CEO in
order to protect shareholders interests.34 In practice and in the best-case scenario, board is an actively
participating organ in governing a company: it speaks out its ideas and views as well as brings in
experience due to its members' educational and professional backgrounds. In general, boards tasks
include arranging AGM, appointing CEO and preparing financial statements. Also, board is usually
regarded to oversee the company strategy. The most important tasks include evaluating company
CEO, making decisions on compensation arrangements and deciding on dividend policy. Board of
directors is mandatory for every public company and is usually elected by shareholders or according
special bylaws of the company.

2.1 Independency of Board Members

In US, both the New York Stock Exchange (NYSE) and Nasdaq rules set qualifications for independent
directors. Most of board members in a listed company should be independent which according to
NYSE requires:

"Independent director is one who board affirmatively determines has no material relationship with
company either directly or as a partner, shareholder or officer of an organization that has a
relationship with the company".

These requirements also include, that the director is not independent if he/she has received more than
$120 000 from the company during any twelve-month period within the last three years.35

34
Hermalin - Weisbach. 2003, p. 1
35
Hermalin – Weisbach. 2003, p.4

13
In Nasdaq Marketplace Rule 4200(a) (15) "independent director" is defined as follows:

"Independent director" means a person other than an executive officer or employee of the
company or any other individual having a relationship which, in the opinion of the issuer's board
of directors, would interfere with the exercise of independent judgement in carrying out the
responsibilities of a director."

On the other hand, we can ask whether these requirements are sufficient to ensure the board members
actual independency and this issue has been addressed also in academic literature. In the light of some
studies, it seems customary for companies to appoint such independent directors who are somewhat
overly sympathetic to management but also meet the requirements of independency.36 Also, despite
formal independency, there might be some corporate structures or practices which CEOs can use to
have an influence on directors. CEO might for example, be a member of a nomination committee and
thereby able to influence director or executive appointments.37 Moreover, CEO's can benefit directors
in other ways, like granting them additional charitable compensation on top of their fees, which is not
prohibited but limited to some extent.38

2.2 Lehman Brothers Board of Directors

In case of Lehman Brothers, there were 10 directors which seems to be quite normal number of
directors. Four of them was over 75 years old as the average age was 68. Altogether, nine of them
was already retired. When considering these structural features of the Lehman board, it is quite normal
and also very close to the board of Goldman Sachs.39

None of the directors was currently working in the field of finance, and overall only two of them
(dependent directors) had direct experience from financial-service industry.40 It has also been
mentioned in some articles, that although some of the members had worked in finance-services the

36
Cohen - Fazzini – Malloy. Hiring Cheerleaders: Board Appointments of "Independent" Directors, p. 22
37
These issues have been adduced by Bebchuk and Fried 2006 in their study Pay Without Performance: The Unfulfilled
Promise of Executive Compensation. See, for example p.26.
38
Ibid., p.28-29
39
Larcker – Tayan. 2010. p.1
40
Larcker – Tayan. 2010. p.1

14
business area in question had been quite different then than what it had become in 2008; back in those
days the risks of e.g. derivatives and default swaps were rather unknown, which made the expertise
of the members somewhat outdated.41 In addition, the directors had a very diverse backgrounds as
one of them was a theatre producer and another a navy rear admiral. Eight of the directors was
independent according to the NYSE standards. Directors received compensation which included
equity as well as base salary.

Fuld, the CEO, was also a member of the board as a chairman which could essentially lead to a
situation where he wasn't monitored properly, and he was able to effect on board operation. In this
type of situation, the conflict between shareholders interest and management is well presented;
agency problem seems to be realized and the board was perhaps not operating as a balancing force
nor did it advocate shareholders interest as it should have. This board structure combined with Fuld's
alleged difficult character could be one rather important feature in Lehman Brothers collapse. Several
articles have mentioned that Fuld was a defiant, blunt and even aggressive personality. He used to
isolate from others and made it clear for everyone that he knew what he was doing, and it was
unnecessary to oversee his work. This partially lead to a company culture of silence and ignorance
where the directors were not able nor interested in challenging Fuld's views or policy. On the other
hand, Fuld was regarded as the embodiment of Lehman Brothers success for instance, Lehman
revenues grew almost 600 per cent between 1994-2006 from $2.7 billion to $19.2 billion while Fuld
was CEO and maybe this was the reason why controlling was not held important.

Lehman Brothers had five committees: Audit, Compensation and Benefits, Nominating and
Governance, Finance and Risks as well as Executive committee. Interesting thing here is, that the
Finance and Risk committee met only twice in years 2006 and 200742 although, we might expect that
specific committee to have been the most important one for Lehman Brothers in its last years.43
However, from this fact we might be able to deduct, that the financial risks that Lehman faced had
not been addressed at all or they were simply largely ignored by those who should have been
interested. All other committees met more than five times a year, and no peculiarities regarding those
have been brought up.

41
Berman. 2008. Available online: https://blogs.wsj.com/deals/2008/09/15/where-was-lehmans-board/ (17.5.2018)
42
Ibid.
43
Larcker – Tayan. 2010. p.1

15
Considering the Lehman’s misleading financial statements some criticism should be directed on the
Audit Committee and Finance and Risk Committee. The issue why the audit committee did not react
to such malpractice can be found from the aforesaid lack of EY’s disclosing of information and that
none of the members, other than the chair were deemed financial experts and none of the members
had experience in financial services, investment services, or banking that would have assisted in
understanding the financial decisions at Lehman. The same lack of expertise was repeated in the
Finance and Risk Committee, and the only experienced chair of the committee responded to the
bankruptcy examiner’s questions regarding Repo 105 that a 50 $billion transactions was in his mind
significant, although he would consider a 4-5% tip in leverage significant. In addition, the board were
never informed of certain limits on stress tests, decision in Executive Committee to remove limits on
transactions on single transactions designed to limit risk exposure nor on the manipulation of risk
management system that was presented to the board.44 To sum up, the board and committee was
largely kept in dark considering risk exposure and build up of members who lacked gravely the
appropriate competence to sit in the board. Moreover, the power within the board was centralized in
the CEO/Chairman and the inability of Fuld to recognize balance sheet impairment may have been
related to his long tenure as CEO.

Although, the structural attributes might not give us anything on why Lehman failed, looking at the
subjective features of individual directors like quality of professional background and engagement
and activity in board responsibilities might explain something. As mentioned above, there seemed to
be a lack of financial expertise on the board as well as current business experience.45 Did the directors
have a complete understanding of the business they were involved? And why were they involved in
the first place?

2.3 Implications of the crisis: Basel Committee on Banking Supervision Guidelines and
Principles and Basel III

Third Basel Accord (Basel III) is an international regulatory framework which was enacted for
improving regulation, supervision and risk management in banking sector.46 It was formed by the
Basel Committee on Banking Supervision as a response to the financial crisis of 2007-09 and applies
to all internationally active banks. More importantly, regarding board of directors, guidelines on

44
Valukas. 2010, p. 946-957. Section III.A.4: Repo 105 & Presley – Jones. 2014, p. 15
45
Larcker – Tayan. 2010. p.1
46
Investopedia: Basel III. Available online: https://www.investopedia.com/terms/b/basell-iii.asp

16
Corporate Governance Principles from 2010, revised in 2015, are essential. These guidelines include
for instance, principles on board responsibilities, board qualifications and composition as well as
boards structure and practices directed especially for banks. The revised guidelines expand guidance
on roles of board in overseeing the implementation of effective risk management systems as well as
the importance of board's collective competence and individual director's obligation to dedicate
sufficient time on their mandates and keep abreast of developments on the banking industry.47

According to these guidelines the board is responsible for the bank, including approving and
overseeing management’s implementation of the bank’s strategic objectives, governance framework
and corporate culture. It should also oversee the risk governance framework of the company. The
guidelines further require that the board members should remain both collectively and individually
qualified for their positions which also covers understanding of the company's area of business and
the importance of their role in oversight and corporate governance. The board should be able to
exercise objective judgement about the affairs of the company. 48 Also, there should be a clear and
rigorous process for selecting board members as well as a set of minimum qualifications for the
members. However, these requirements and rules on directors are quite general in nature and only
few specific obligations are established. Are they enough to fix the issues Lehman had in its board's
conduct and create enough strong and clear guidelines to follow?

2.4. Intermediary conclusion

Though we cannot scrutinise the actual day-to-day operation of the Lehman Brothers board of
directors, in the light of the structure of the board and the known facts, the board did not seem to be
too active on their mandates. In the light of these issues it seems clear, that Lehman Brothers board
of directors did not operate actively enough to fight the agency problem.

Firstly, the company culture did not encourage directors to challenge the CEO nor to seize those
problematic issues. Secondly, it can also be said that clearly the directors lacked the required level of
expertise in such a complicated field of business Lehman was operating. Some have even said, that
the directors were not interested in their mandates in the first place and were too busy dealing with
other commitments to attend with full intensity. Maybe the appointment of such inept directors was

47
Basel Committee on Banking Supervision: Guidelines, Corporate Governance Principles for Banks. p. 8-13. Available
online: https://www.bis.org/bcbs/publ/d328.htm
48
Ibid., p. 13

17
something that Fuld wanted in the first place. This kind of structuring of board enabled him to operate
in peace without too much monitoring. It should also be mentioned, even briefly, that because Fuld
was the CEO and the chairman of the board, he was probably one member of the nomination
committee and therefore, able to have a word on the nominations of directors.

One interesting issue and also widely studied area is director stock ownership and its link to improved
company outcomes. Some studies have found this positive link to exist, but we can also ask, what
level of ownership is enough to give incentives enough. This issue was also addressed by Bebchuk
and Fried already in 2004. The 27 000 employees of Lehman owned a rather small portion (about
30%) of its shares,49 and we can ask whether these proportions were too small to give the directors
financial incentives to act in the best possible way and to control Fuld. Maybe not, though it is difficult
to say without specific numbers on directors owned shares. Another interesting point possibly
influencing corporate governance was rather diffused shareholders. The biggest shareholders own
only 5-7 percentages of the company shares, which means that there are no such shareholders with
major ownings and with excess power. Could this have affected in a way that shareholders were not
able to oversee management as possibly as in case of bigger more dominant shareholders? Also, due
to these regulatory bodies, like Basel III and its guidelines which were enacted after the crisis, it is
evident that there were certain common issues regarding board of directors which had to be addressed.

49
Lehman Brothers former CEO blames bad regulations for banks collapse. Available online:
https://www.theguardian.com/business/2015/may/28/lehman-brothers-former-ceo-blames-bad-regulations-for-banks-
collapse (17.5.2018)

18
3. COMPENSATION SCHEMES

In the case of Lehman an often-taken viewpoint is that the executives’ pay arrangements gave the
executives excessive risk-taking incentives and fixing the pay schemes would prevent such behaviour
in the future. The legislation and regulation in connection with the relief projects in the aftermath of
the financial crisis demanded the elimination of compensation structures that provided risk-taking
incentives. On the other hand, there were opposing views according to which the losses suffered by
the executives when the stock prices of Lehman fell would have implied that such incentives cannot
be justified and instead the risk-taking was a consequence of making mistakes, excessive optimism,
failure to perceive risks or even hubris.50

However, research by Bebchuk et al. has concluded that the executives’ losses from the collapse
cannot be viewed as to exclude the possibility of excessive risk-taking incentives being present with
the compensation structures. Instead, the fact that the executives took large amounts of performance-
based compensation off the table based on short-term results show that they had undesirable
incentives to seek improvements in short-term results even at the cost of an excessive elevation of the
risk of large losses at some uncertain point in the future.51

The analysis by Bebchuk et al. concludes that the design of the performance-based compensation
used in Lehman and Bear Stearns did not produce a tight alignment of executives’ interests with long-
term shareholder value. Rather, the design provided substantial opportunities to take large amounts
of compensation based on short-term gain off the table and to retain it even after the bankruptcy of
Lehman. In addition, the cashing out of large amounts of shares and options by the executives
throughout the period provided the executives with incentives to place significant weight on the effect
of their decisions on short-term stock prices. The message that can be taken from the analysis is that
the executives had incentives to run the firms in a way that involved an excessive probability of large
losses at some uncertain date and that these concerns should not be dismissed, but rather taken
seriously.52

Bebchuk et al. provide several resolutions to the incentive problem, where the short-term incentives
are connected to long-term objectives. Firstly, in performance-based bonus plans clawback provisions

50
Bebchuk – Cohen – Spamann. 2010, p. 1-2, 9
51
Ibid. p. 4
52
Ibid. p. 24-25

19
and bonus bank provisions should be considered. Secondly, substantial limitation on unloading in
equity-based compensations should be introduced. In Lehman such limitations were permitted only
five years after vesting, but in case of long serving executives it might not sufficiently preventative.
Another option is to require executives to retain a substantial fraction of the shares and options
awarded to them until their retirement. This approach was followed by Goldman Sachs, which we
have earlier already found to survive the financial crisis well. Other alternative is to limit the
executives’ possibilities to cash out only a rather limited fraction annually.53

The official view of executive compensation is that of arm’s length contracting, where the board of
directors set pay arrangements solely on the basis of shareholder interests. However, compensation
practices that are not readily understood under arm’s length contracting view have been identified.54
The next obvious question to put forward is why such compensation structures were in place in
Lehman. One important aspect is provided by managerial power theory that indicates that managerial
influence over the design of pay arrangements can produce such considerable distortions in the
payment arrangements. The managers influence can lead into compensation schemes that weaken
managers’ incentives to increase firm value and even create incentives to take actions that reduce
long-term value.55
In executive compensation the board of directors have an important role to set and oversee the firm’s
policies for compensating management. In studies concerning the relationships between board of
directors’ composition, ownership structure and CEO pay the founding has been that firms with
weaker governance structures tend to pay their CEOs excessively. As has been argued earlier the
board of directors in Lehman consisted of outsiders that were appointed during the long tenure of the
CEO Fuld and on whose appointment, Fuld has had a strong impact. The board of directors in Lehman
was also inactive in sense that the factors that denominate inactivity were often checked in Lehman’s
board of directors. Out of these factors that actualized in Lehman were the facts that the board
members were busy in sense that they had other responsibilities distracting their oversight over
Lehman, the board also consisted of aged members and the board size was large. Additionally, Fuld
had served a long time in Lehman and was likely to have a tremendous bargaining power in the board
of directors that he himself chaired.56 Since Fuld as CEO had a say on the directors who were
recruited, they came to Lehman with a reservoir of good will toward the CEO, which also contributed

53
Bebchuk – Cohen – Spamann. 2010, p. 25-26
54
Bebchuk. 2004, p. 11
55
Bebchuk. 2004, p. 8
56
Hermalin – Weisbach. 2003, p. 16

20
to the board members incentives towards the CEO, rather than towards the shareholders, which made
the agency problem of the board even more considerable. In addition to Lehman having relatively
weak and ineffectual board of directors vis-à-vis the CEO, the diffused ownership structure of
Lehman further increased the managers’ influence over their compensation. In empirical studies it
has been found that there is a negative correlation between the equity ownership of the largest
shareholder and the amount of CEO compensation. Therefore, the lack of concentration in the
ownership structure in Lehman can be linked to the absence of shareholders monitoring the CEO and
the board, which in turn lead to rent-seeking behaviour.57

The influence that the Lehman management had on their own compensation structure, where they are
excessively compensated without performance can be linked to rent-seeking, coined by Gordon
Tullock. The standard economic analysis of rent-seeking activities is that they create no productivity
but instead only harm the society by redistributing existing resources.58 An economic rent is
commonly defined as a return on a resource in excess of the owner’s opportunity cost or the difference
between the return on a resource and its next best use. The fact that the executives are paid excessively
diverts resources that could have been allocated in better use and amounts to a wasteful rent-seeking.
Therefore, paying excessively could be regarded as contrary to corporate social responsibility.
However, the charge that an activity is not socially responsible is easier to make than the charge of
rent seeking, and hence rent seeking is not very useful concept in posing questions of corporate social
responsibility.59

If we then take a view of the statistics of how the top 5 executives were compensated in Lehman, we
can find support for the claim that the executives were compensated excessively. In the figure 2 we
can see that Lehman provided their top executives with large bonuses during the years 2000-2007 on
basis of the banks’ high earnings and stock price increases during those years (see f.ex. figure 1).

57
Bebchuk. 2005, p. 15
58
Boatright. 2009, p. 541
59
Ibid. p. 550

21
 Total Cash Flows from Bonuses and
Equity Sales 2000-2008
CEO Executives 2-5
Bonus $61 557 166 $102 407 231
Sales of stock $461 173 614 $389 315 896
Stock remaining $0 $0
Total $522 730 780 $491 723 127
Total top-5 $1 014 453 907

Figure 3. Cash bonuses

In addition, from the figure 3 it is clear that the top executives received substantial net cash proceeds
from sales of their companies’ shares.

Lehman chose to provide their top executives with large bonuses during
the years 2000-2007 on the basis of the banks’ high earnings and stock price increases during
those years. Based on such short-terms results, the firms awarded especially large bonuses during
the 2004-2006 period. (page 12  table X)
As Table 2 shows, during the years 2000-2008, the banks’ top executives received
substantial net cash proceeds from sales of their companies’ shares, including from the exercise
of options. (page 15, table 2) A noteworthy feature of the pattern displayed in Table 2 is the
regularity with which the members of the top executive teams were unloading equity positions. At
both Bear Stearns and Lehman, the CEOs and the 2-5 executives obtained net cash flows from
unloading shares and options in each of the years 2000-2008. This pattern, of course, meant that
executives had incentives to place some weight on short-term stock market prices throughout the
period. It is also interesting to note that most executives were able to sell more shares during the
period 2000-2007 than they held at the end in 2008. (page 16, table lisää)

In any event, the members of the top teams were all long-serving executives who
became free each year to unload the equity incentives awarded them five years earlier, and the
patterns displayed in the preceding table indicate that they made regular and substantial use of
this freedom, unloading previously granted incentives as they were receiving new ones. (Table 3,
page 18)
Before concluding, it would be worth comparing the cash flows derived by the executives
with the value of the executives’ holdings in their banks at the beginning of the period 2000-
2008. Such comparison would provide us with the executives’ net payoffs for this period. (page 20,
TABE UUSI JOKU PUUTTUU)
Cash bonuses during 2000-2008 based on performance for the top executives (2-5 officers) were at
Lehman $102 407 231 which was rather sizable amount. Compared to Bear Stearns the executives
received $239 337 166 respectively. Salaries of the top executives during that same period was $17.5
million. Lehman CEO took home about $61 million in that same period. These bonuses were huge
especially large during 2004-2006 but for the year 2007 bonuses were not awarded at all60 as we can

60
Bebchuk - Cohen - Spamann. 2010. p.11-13

22
expect. Fuld, the chairman of the board and CEO held, directly or indirectly, 10.8 million shares as
of January, 2008.61

61
Ibid., p.8

23
4. RISK MANAGEMENT

To the 2006 The Lehman Brothers risk management system was very respected, and regulators
thought that the risk framework was as regulated. In public the company told that their risk
management was a “meaningful constraint on its risk taking”. However, Lehman began to dismantle
the risk management framework at the same time as the new growth strategy was put into practice.
After the implementation of the more aggressive growth strategy Lehman began to exceed the risk
limits it had established. During the next two years Lehman ignored all the risk management that they
had before, the procedures, numbers of risk metrics, specialists’ comments and limits. 62

4.1 Main internal issues

Everything since 1999 when Lehman Brothers wanted to improve risk management and hired
Madelyn Antoncic to be head of risk policy. In 2002, the same person became a chief risk officer
(CRO). In this position, she was until 2007, after which she was transferred to head of financial
market policy relations. With the help of the board, she planned world-class risk function. This
function combined talented people, boundaries, integrated ways, and validated information. By these
practices were intended to maintain organized balance of risk. As for the CRO, Antoncic was able to
understand risk analysis and business. She felt that understanding these two was crucial to a
successful risk structure. Antoncic was director of Lehman's Global Risk Management Division
(GRMD). The figure 4 helps to follow up the events in risk management.63

Figure 4: The timeline in risk managements point of view

62
Wiggins, R. and Metrick, A. 2014. p.1-3
63
Wiggins, R. and Metrick, A. 2014. p.3

24
Globo The Risk Management Division had its own independent and global role in the company. The
role was significant and by 2007 GRMD had 398 people in risk management. Growth was significant,
as in 2005 there were only 156 people. Lehman noticed the importance of this division and felt that
risk management was one of the company's core competences and an essential part of the control
system. Division worked in harmony with the business. Risk management directors act as guides
rather than police.64

In 2006, however, decisions were made that led to the destruction of the Lehman brothers. It all started
with a new business strategy that focused on stronger growth. This new plant category was put into
practice and the company invested in new real estate and used more leveraged loans. Prior to 2006,
leverage loans were acquired and transferred to third parties, for example through securities, but with
the new strategy they were "deposited" as an own investment. In this way, the company shift from
low-risk brokerage to a high-risk capital-intensive bank model. The risk that was taken earlier was
moderate, but from mid-2006 the risk appetite grew. As seen in the figure 5. Usually the growth was
0.2 to 0.3 billion, comparing to last year, but growth was expected to increase by one billion in 2006,
so from 2.3 billion to 3.3 billion.65

Figure 5: Average Monthly Risk Usage Total Firm66

64
Wiggins, R. and Metrick, A. 2014. p.4
65
Wiggins, R. and Metrick, A. 2014. p.7-8
66
Wiggins, R. and Metrick, A. 2014. p.9

25
Antoncic tried to negotiate, to lower the risk and to limit risky transactions. Eventually, development
led to the transfer of Antoncic, which was mentioned earlier. This happened on 2007. Antoncic was
replaced by a deal maker who had no professional risk management experience. Also, the real estate
crisis got worse, but Lehman did not care about this, but continued the action in accordance with its
new strategy.67

4.2 External factors

At least as long as Lehman Brothers' risk was headed by Antoncic, Lehman tried to do the right and
conscientious action. In 2004, it joined the CSE under SEC. This CSE, or Consolidated Supervised
Entity, was set up for Lehman and other similar companies so they would not be in Basel II's eyesight.
CSE main focus was to provided voluntary supervision for the five largest investment bank
conglomerates. Basel II came into force in December 2006. 68

Basel II included three pillars. The first pillar defined minimum capital requirements for credit,
market and operational risks. The purpose of this pillar was to get the minimum capital requirements
to better reflect the real risks the banks had. The Pillar also offered methods to calculate the Minimum
Capital Requirement even if the risk management system had not been so advanced. Pillar 2nd
required a supervisor and a supervised overall estimate to ensure capital adequacy to cover all relevant
risks. The emphasis was on the anticipation of capital plans and the importance of the capital
management process. The third pillar sought to strengthen the market discipline by emphasizing the
transparency of bank reporting. It also required banks to publish more information.69

Lehman was subject to some requirements. It had to meet certain capital requirements and maintain
an internal control and risk management system with certain financial indicators. These indicators
were, for example, capital, leverage, liquidity, risk management and stress tests. This information
was provided to SEC. This happened in 2005, when everything was still fine and within the
framework of the regulations. After Lehman's bankruptcy, however, it has been criticized and
considered how closely the agency followed Lehman's development. SEC was heavily criticized for

67
Wiggins, R. and Metrick, A. 2014. p.9
68
Wiggins, R. and Metrick, A. 2014. p.11
69
Finannsivalvonta. 2004.

26
not doing anything. At the time of the crisis, the SEC quickly ended the CSE program and admitted
that it did not work. But no one knows or knows what SEC could have done.70

4.3. Intermediary conclusion

All in all, everything could have gone well. Lehman's problems were not due to risk management,
but to the fact that the risk management department was not listened to. Antoncic was the right person
to lead Lehman Brothers' Risk Division. The situation was good, after a change of moderation in the
field, At the same time, management closed the risk monitoring and these risks eventually led to the
destruction of the company.

Although nobody else can blame Lehman's bankruptcy in principle, as a company itself. But the looks
are still turning to the supervisory authorities as well. Lehman Brothers, however, was part of CSE
and was under voluntary control, so did not anyone watch them? What was the purpose of the CSE
if it was not within the bounds of companies to remain in the monitoring and risk anticipation?
Lehman's bankruptcy investigator Anton Valukas, however, said in 2010 that the SEC, which
manages CSE, knew that the amounts Lehman reported were not correct and that Lehman exceeded
teir risk limit. In addition, SEC should have also known about Lehman's manipulation of the balance
sheet.71 And so the SEC should have done something about it.

Lehman Brothers' risk management was unsuccessful because the internal department did not have
the means to prevent the risk limits being exceeded. Another failure was the lack of external control.
All this was due solely to the wrong choices and decisions of the leaders.

70
Wiggins, R. and Metrick, A. 2014. p.12
71
Indiviglio. 2010.

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5. FALLOUT

The bankruptcy of Lehman Brothers in 2008 affected many issues. It all started with the Emergency
Economic Stabilization Act of 2008, which was released on October 3, 2008. Lehman Brothers had
indeed sought corporate restructuring in September of that year. This emergency law was set up to
rescue the US financial system. This led to the emergence of the TARP or The Troubled Asset Relief
Program. TARP authorized expenditures of $ 700 billion. TARP enabled toxic assets and equity
purchases from financial institutions to strengthen the financial sector. The United States also started
their Zero Interest-Rate Policy (ZIRP). This included the central bank maintaining a 0 percent
nominal rate. This was continued until 2014, after which inflation, unemployment began to ease and
GDP growth. Also quantitative easing was introduced to facilitate economic conditions.

The Troubled Asset Relief Program continued until 2010, when a new Consumer Protection Act,
known as Dodd-Frank, was published. This reduced the amount authorized to $ 475 billion. This new
act made significant changes to US financial regulation. The results have shown that Dodd-Frank has
improved financial stability and consumer protection.72 As a result of the Act, the Consumer Financial
Protection Bureau (CFPB) was created to protect consumers, for example from predatory pricing. For
example, the purpose was to prevent home brokers from receiving higher rates or higher interest
rates.73

There are things about Dodd Frank that can secure the financial sector. One of its influences is that it
blocks the exploitation of customers by banks and other actors. The rule of law prohibits the use and
ownership of the hedge funds from the banks if they use them for their own profit. Banks were given
seven years to get rid of hedge funds. This Act also hedge funds in daylight. As the crisis in 2008 was
due to the fact that no one knew what the derivatives contained. It is also intended to see the financial
sector and look at the overall picture. This includes just the hedge funds. All of this is overseen by
the Financial Stability Oversight Council.74

Act also has decided that risk-sensitive derivatives should be regulated. All the most dangerous
derivatives, such as credit default swaps, are regulated. Thus, the risks come to the attention of
political decision-makers before the crisis. However, Dodd-Frank left to the authorities the

72
Baily and Klein, 2014
73
Amadeo, 2018.
74
Amadeo, 2018.

28
establishment of Clearinghouse. This brings the trading of derivatives to the public. Dodd-Frank also
created the SEC's Office of Credit Ratings. This role is to oversee credit rating agencies. This was
created because people had previously trusted agencies, such as Moody, and did not realize that debt
was in danger of not being repaid. The task of the SEC is therefore to control these and, if necessary,
dismantle the agency that gives the wrong ratings.75

There are also some everyday things that are meant to protect the consumer. These include regulation
of credit cards, loans and bonds. The Consumer Financial Protection Bureau therefore monitors
creditors, credit and debit cards. It seeks to protect and educate borrowers so they understand the risky
mortgage loans. Inspection of insurance companies was also introduced and a Federal Insurance
Office was established under the Treasury Department. It identifies risk-taking insurers and ensures
that insurance is affordable and also available to those who are minorities and other underserved
communities.76

Although Fed did work with the Treasury during the financial crisis, Dodd-Frank also renewed its
operations. Emergency loans issued by the Fed during the crisis were reviewed and can be reviewed
as long as the Dodd-Frank Wall Street Reform Act is in force. This Act was implemented during
Barack Obama, and now with the new president, ideas for changing and abolishing this Act have
emerged. However, this Act is at least currently in force and has been in force for 10 years now.77

75
Amadeo, 2018.
76
Amadeo, 2018.
77
Amadeo, 2018.

29
6. CONCLUSION

Finally, we conclude, that the financial crisis was greatly caused by issues and faults in corporate
governance arrangements. In this report we have pointed out certain structures and arrangements
which did not serve their purpose in safeguarding investment companies from excessive risk taking.
Most importantly, the risk management systems failed on many levels: senior management was not
informed properly and were not prepared to compose a risk management strategy nor suitable metrics
to monitor implementation. After all, it is boards responsibility to manage risks and oversee those
directions executing risk strategy.

Remuneration systems have not in several cases been closely related to the strategy and risk appetite
of the company and its long-term interests. Therefore, as the risk policy management is a clear duty
of a board and the deficiencies in Lehman board were severe, the board was one of the biggest
weaknesses leading the company to fail. Board was not competent to fulfil its task and it was not
provided the information it would have needed to make considered decisions and plans. Sometimes,
even false information was provided. Also, the incentive system was distorted, which should have
been overseen by the board as well.78 Moreover, accounting standards and regulatory requirements
have also proven insufficient leading the relevant standard setters to take a review.

The reasons behind inactive and incapable board was at least partially because Lehman Brothers was
rather CEO-centred enterprise. Fuld had chosen such directors in order to act in his own way. It could
also have been possible, that Fuld was become somehow blind for the swelling of the balance sheets
and the risks attached to it because he had been the CEO of Lehman Brothers more than 10 years.

Failure of Lehman Brothers was a very multifaceted issue with many corporate governance
arrangements and structures being bundled together. In this connection, is important to observe the
whole context and the environment as well as the business area where Lehman operated. On the other
hand, when taking into account other operators on that specific market, Lehman Brothers was not
even the worst "villain" as its leverage was only 31 while Fannie May's leverage was 68 and Bear
Stearns 34.79 Ultimately, behind the bail out there were both corporate governance issues and political
reasons.

78
Kirkpatrick. 2009, p. 17
79
Chincarini. 2006. Chapter: The Wall Street Club

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