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Sunday, February 20, 2011

Lehman Bros: Insufficient Accountability in Corporate Governance

In an executive meeting at Lehman in the summer of 2008, Skip McGee told Richard Fuld and the other top executives that the market was demanding “that we hold ourselves accountable.”  Essentially, he was pushing for Gregory’s outster.  What strikes me is what he didn’t say–namely, something like, “the stockholders are holding us accountable!”  Had he said this, Fuld might have laughed. Of course, Richard Fuld was a major stockholder, so he might have viewed it as “holding myself accountable to myself.”  Given the inherent ethical conflict of interest in such a statement, I don’t think we can rely on corporate governance as a check on excessive managerial risk-taking when executives hold a substantial share of the stock.  Therefore, in including stock options in executive compensation to align executives' incentives with medium and long-term firm performance, boards should add institutional safeguards or accountability mechanisms to corporate governance. In business-speak, there is a cost incurred that boards may not be aware of in aligning executive compensation (and firm ownership) with future profitability.

I believe the Lehman example demonstrates how corporate governance can fail rather clearly.According to a report by Anton R. Valukas, an examiner for the bank, Lehman used “materially misleading” accounting gimmicks involving repos to mask the perilous state of the bank’s financial condition. According to the report, Lehman utilized what amounts to financial engineering in order to temporarily shuffle $50 billion of troubled assets off the bank's books in the months before its collapse in September of 2008. The intent here was to conceal the bank's dependence on leverage, or borrowed money. Lehmans’ senior managers appear to have structured transactions such that they would sell securities at the end of a quarter, only to buy them back again days later. These assets were mostly illiquid real estate holdings, meaning that they were hard to sell in normal transactions. The effect of the accounting flash-of-hand was to artificially and temporarily lower the bank’s debt levels to hit certain targets, making the firm look healthier than it really was.

Lehman's managers managed to “shed” about $39 billion from the bank's balance sheet at the end of the fourth quarter of 2007, $49 billion in the first quarter of 2008 and $50 billion in the second quarter. At that time, Lehman managers sought to reassure the public that the bank's finances were fine. Herbert McDade, a senior exec at Lehmans, wrote, “I am very aware … it is another drug we r on,” in an April 2008 e-mail cited by the examiner’s report. Senior Lehman executives, as well as the bank’s accountants at Ernst & Young, were aware of the moves, according to Mr. Valukas.  In certifying the “actionable balance sheet manipulation,” Richard Fuld was “at least grossly negligent.” Other executives named in the examiner’s report in connection with the use of the accounting tool include three former Lehman chief financial officers: Christopher O’Meara, Erin Callan and Ian Lowitt.  Notably, Lehman’s directors were not aware of the accounting engineering.  That not even the board’s audit committee was aware is telling from the standpoint of corporate governance–especially if the report is correct in its claim that the bank’s public accountants from Ernst & Young were in the loop.

The Lehmans case suggests that board audit committees ought not to rely exclusively on their public accountants.  The structural conflict of interest wherein CPA firms rely on the firms they audit for continued business was not obviated or solved after the Arthur Andersen case.  Years before that case (and computers), “as per comptroller, discrepancy resolved” was a regular “tick mark” on green CPA audit sheets. I can still remember the actual tick mark I used (a check with a line through the stem) as a young public accountant at one of the Big Eight.  We were so big.  Senior audit managers simply included the tick mark without any fanfare in going over the standard tick-marks in training. During audits, the tick-mark was simply thought of as a technical matter. New auditors fresh out of college would have no basis to question the check-mark because ethical considerations do not enter in when a technical language of business normalizes all practices. Accordingly, the conflict of interest issue was essentially below the radar when I was a public accountant.  It is difficult to spot something as sticking out from among the normal that is treated as typical. I suspect the partners in the firms knew of the obvious conflict of interst in "as per controller, discrepancy resolved," but I don’t know whether the tick-mark was intentionally portrayed as simply one technical matter among others in "how to do an audit."  Therefore, transparency had to come from outside of the industry–from the media in the wake of a major scandal--not from a government too involved with industry's lobbyists. One might wonder where (or whether) we can expect corporate governance reform.

In general terms, corporate senior managements have much too much leverage over stockholders and the boards that are meant to oversee the management.  Proposed reforms from the White House do not make a dent.  For example, requiring a “non-binding” stockholder vote on executive compensation strikes me as a declaration of surrender to the titans.  “Non-binding.”  Why waste our representatives’ time with such window-dressing designed to look like it is correcting for another kind of window-dressing.  Everyone, it would seem, is busy polishing windows and nobody has guts enough to come up with structural reforms with teeth.  No one is willing to take the drugs away from the children playing will millions and sometimes billions of dollars.  We, and our governments, are enablers, and we settle for far too little…then we are surprised when the kids are caught with their fat ruddy hands in the cookie jar again. Ultimately, we, the American People, are to blame…and as Lehmans shows, our financial system and economy may hang in the balance.

Andrew Sorkin’s Too Big to Fail

See also: http://money.cnn.com/2010/03/12/news/companies/lehman_examiner/index.htm?hpt=T1