Lehman Brothers Incorporation Limited

Background and Success Story

Discuss about the Lehman Brothers Incorporation Limited.

Lehman Brothers is an incorporation having its welcome prints in the year 1850. It was founded by Henry Lehman, a German immigrant, in 1844. The business was started as a small store providing small items of necessity like utensils, grocery items, goods etc. Six years later, the business was joined by Emanuel Lehman and Mayer Lehman, and the three Lehman Brothers started working as a common entity in the year 1850 and named the business – Lehman Brothers. (Fineman, 2008)

The firm played a major role in the upliftment of cotton and coffee market. It also accepted an offer to work as Government’s agent for dealing in commodities market. Till the end of 19^th Century, Lehman Brothers found its core business area and had begun to conquer the market as a leading and emerging business tycoon.

In the beginning of 20^th Century, the firm had its partnerships and MOUs with many companies like Sears, Roebuck & co., Woolworth co., Gimbel Brothers Inc., May Department Store and RH Mary & co. (Adu-Gyamfi, 2015). These partnerships could evident the interest of Lehman Brothers in the upliftment of retail business.

Steadily but not slowly, Lehman Brothers started showing its mastery in the stock and commodities market. The introduction of Private Placement is the gift of Lehman Brothers. This was as a result of a great downfall in the stock market during the Great Depression of 1929. Lehman Brothers started the concept of privately placing the shares to the relatives, companies etc. This concept proved very helpful in boosting the value of the business in global market.

Lehman Brothers marked its footprints in the Investment Banking in the year 1994 by opening several offices and recruiting various employees. The firm also merged with the fourth largest Investment Bank of the time-Kuhn Loeb & Co. The market was introduced with another major merger of the time which was the merger of E.F. Hutton & co. with Shearson Lehman which proved very helpful in the formation of Lehman Brothers Investment Bank. The result was due to failure of the merger of E.F. Hutton & co. with Shearson Lehman. The Investment banking business was named Lehman Brothers Incorporation Limited and it had its IPO in 1994. (Adu-Gyamfi, 2015)

The firm’s major revenue generating source was mortgage backed securities. It initiated its major business in subprime mortgage market. Subprime Mortgage Securities are the securities having low credit worthiness and therefore an individual doesn’t get credit on the basis of these securities. Lehman Brothers started providing credit on the basis of these securities. Though, the business was very risky but it had huge revenue generating capacities which taken the firm to new levels of success. In 2007, the firm became the leading underwriter of mortgage securities and a leader in stock market as well.

Partnerships and MOUs

The major reasons for collapse of Lehman Brothers could be categorized into four major parts.   First reason was a downfall in the housing prices. Lehman Brothers had its major investment in subprime mortgage securities. Subprime Mortgage securities have low credit worthiness and these securities contribute the major part of the assets of the Lehman business. Due to overinvestment in such risky securities, the business earned huge revenues initially but had its huge downfall also since the housing prices had a great decline. The overall downfall in the economic market was the reason for such heavy downfall in the housing prices.  The value of the assets of the business fell sharply and the business debt to assets ratio started increasing crossing the highest ratio acceptable by the American Government. There were several other financing institutions which crossed the highest debt to assets ratio acceptable by American Government and Lehman business was one of them.

Second reason was the investment in Repo105 and Repo108 securities. Repo105 meant lending cash by mortgage of securities having value more than 5% of the credit extended and Repo108 meant lending cash by mortgage of securities having value more than 8% of the credit extended. This decision was very judicious on the part of the financial officers of the business as Repo securities extended credit to credit worthy clients only and the securities taken from the clients were able to generate enough cash to compensate any failure. Though, the decision was a prudent one considering the situation of market but the shortfall was in the treatment of the securities. Lehman Brothers treated the securities received during Repo transaction as sales and used cash to discharge the liabilities. The Repo securities were used to window dress the financial position of the business in the market.

The third reason is the incapability of the managers to oversee the future conditions and inefficient risk management strategies. The CEO of Lehman Brothers at the time of its bankruptcy had earned billions of dollars from the business but could not nurture the growth and prosperity. The CFO and CEO are mainly responsible to oversee the future potential of a business and to recommend preventive and corrective actions so that the future inefficiencies could be overcome. The bankruptcy had led to retrenchment of a number of employees who lost their source of earning and living. The firm could have provided proper and regular methods to the employees so that they could make themselves prepared for the worst outcomes. They were the most innocent people who had to bear the foolishness of some handful of senior employees. The auditors on the other hand were also ignorant about the financial repercussions of the activities undertaken by the business to make its financial position look better to the stakeholders. The audit work, despite of being in hands of such efficient and reputed audit firm could not fulfill its responsibilities.   

Introduction of Private Placement

The fourth and the last reason which finally resulted in the bankruptcy of Lehman Brothers Incorporation Limited was the lack of support from American Government. Initially, the Korea Development Bank agreed to take over the business but it could not be materialized due to some problems with the regulators. Again, Barclays Bank agreed for a take-over but it was disapproved by the US government which eventually marked an end of Lehman Brothers.

The firm’s collapse had a major impact on the prices of global stock market indices. There was worldwide devastating effect on the bankruptcy and this phenomenon had been marked as one of the biggest downfalls in the stock market. After the filing of bankruptcy by the Lehman brothers, The Reserve Primary Fund, which was considered one of the largest money market mutual funds, lost its share price. “This phenomenon was referred as Breaking the Buck.” (Tymkiw, 2012). Apart from that, above 75 such administration cases were recorded. There were a number of such studies which reveal the condition of market after the collapse of Lehman Brothers. (Ranjeen, 2015). No market was left untouched by the devastation. The US market, the Chinese market etc. were adversely affected. One such instance supporting the statement was shown by the 4.4% drop of New York Dow Jones Industrial Average. This was the largest drop of that time (Duncan, 2012). The European market was also part of same. There was 3.92% fall in FTSE Index, 3.78% fall in Paris CAC and 3.6% fall in NASDAQ Composite. These all recorded the biggest fall in the market after the 2001 attack in US. Even the Asian countries were not left. Major countries like India, Taiwan, and Singapore etc. witnessed constant declines in stock and commodities market. Further, Japan, Hongkong and South Korea faced biggest fall of their histories. (Adu-Gyamfi, 2015)

All the above mentioned events show that the collapse of Lehman Brothers was not a failure of single company or a single market or a single country’s economy. This failure was a massive failure of the overall investment market which could be witnessed worldwide. The effect of such failure took a number of years to vanish from the market. The big businessmen especially the Investment Bankers started taking the adherence policies of their Governments too seriously. The Auditors responsibilities took a major turning point. In the Lehman’s case, the auditors were seriously accused of their gross ignorance and lack of due diligence and prudence. The auditors are expected to perform their services according to the prescribed standards of work and they cannot change their actions from the quality standards prescribed by various regulatory and administrative boards. The senior employees also held an important role in the failure of Lehman Brothers. The employees and workers of any company is responsible for the upliftment of the company’s status. The foolish behavior of workers and short sightedness of senior employees could lead to a dangerous result to a company. The roles of employees were increased by enactment of various Corporate Governance measures. Thus, a global impact was witnessed by the world due to failure of a handful of people.

The auditor’s roles and liabilities are mentioned in the International Standards on Auditing (ISA) by the International Auditing and Assurance Board (IAASB). These standards set a framework of work by the auditors while performing audit and assurance services to their clients.

The auditors are the watchdogs of the business concerns. They are expected to provide their opinion on the financial prudency as well as competencies of a business. The centre work of an auditor is to provide an unbiased opinion on the financial statements of the business and to assure the stakeholders regarding full disclosure of all material transactions.

The Lehman Brothers Incorporation limited was audited by Ernst and Young, a reputed audit firm having global recognition. “Ernst and Young” is considered one of the Big Four Audit firms all over the world. Having recorded its perfection in various audit work various time, this audit firm underperformed in the Lehman Brothers’ case. The shortcomings of Lehman’s business were not even pointed out by such an expert audit firm. There were many audit inefficiencies like the treatment of Repo transactions should have been bought to the notice of stakeholders by the auditors and the auditors should have qualified their report. The accounting inefficiencies like the Repo transactions being shown as sales and not made part of liabilities was a major concern. Further, there was improper disclosure of such transactions and the stakeholders were unaware of the transactions. But nothing was pinned by the auditors. The auditors considered trusting the business managers’ vision when it was about the adherence of accounting standards. Though the standard for not clear, but the auditors should have understood that the standard was formed for the betterment of general and not the specific. They must have rejected the owner’s way of showing things and stood by the Boards.

Further, the International accounting standard for Repurchase transactions had a major loophole. It did not provide a benchmark for the treatment of such transactions and Lehmans took advantage of such loophole and was defended by the auditors. The International accounting standards were revised after the collapse. The International accounting standards Board (IASB) and Financial Accounting Standards Board (FASB) met in April 2010 and had their discussion regarding the question to overcome such loophole for accounting of repo transactions.

However, the auditors were expected to see the facts in the light of its duties to the stakeholders and not as a follower of the accounting and auditing standards. The auditors, in such cases, need to show utmost professionalism and serious work and not support such business devastations blindfolded.

Initiating Major Business in Subprime Mortgage Market

The revised accounting standard on accounting for repo transactions was issued in June, 2014 (via Update No. 2014-11), “Transfers and Servicing (Topic 860): Repurchase-to-Maturity Transactions, Repurchase Financings, and Disclosures”. (FASB, 2014)

According to the guideline, the repurchase transactions will not be accounted as sales. Earlier, the transfer of a financial asset could be combined with the repurchase financing and both are accounted as a forward agreement. This treatment resulted in window dressing of Balance Sheets by many investors. (FASB, 2014). With the revised format, the Generally Accepted Accounting Standards were aligned with the International standards of reporting popularly known as IFRS. Therefore, the auditors are required to comply with the new guidelines and show greater professionalism and prudence in providing the audit and assurance services especially while auditing such a huge and globally renowned institution.

The audit and role of auditors had never been into such a limelight before. The Association of Chartered Accountants (ACCA) has assessed an auditor’s role in the downfall of a business concern. ACCA has firm belief that the auditors bring value to business and the expanding economies. This is done by the trust of stakeholder which is reflected by the governing structure of corporate reporting. ACCA have met several time to see the case for the role of audit and that how it can extended to meet stakeholder expectations more efficiently. (ACCA, 2011).

 The auditors were always expected to show professional competency but the global financial crisis led to a series of inquiry into the roles and liabilities of auditors. This is evident from the European Commissions’ Green paper on auditing, the UK Economic affairs Committee’s inquiry, the US Public Company Accounting Oversight Board’s examinations etc. All of these highly emphasized that the auditors should not be a blind follower of the standards formulated.  The major recommendations which came forward post global financial crisis inquiries are:-

• The big four audit firms should be assigned the task of auditing of Big concerns. The reason behind such decision is that if one of the big firms fail to perform the required services then the other will need to choose from the remaining ones and not to get confused about the suitability of various audit firms.
• The auditors should perform the audit services keeping in mind the requirement of the stakeholders and the society because in case of failure there can be legal action against the auditor by the stakeholders.
• The auditor should perform non-audit services keeping in the mind the required independence on the part of auditors. The huge consultancy prices should not attract the auditors as the auditor is expected to perform their duties independently and any relation to the business may hamper its scope of duties and independent examination.
• The points mentioned in Sarbanes Oxley Act, 2008 should be clearly understood to see the motive of the enactment. The enactment was a result of a series of financial crunches like Enron and Worlcom and is seen as a major industrial turnaround.
• The auditors should not stick to one company our concern for a longer period of time as this may seriously hamper the independence as well as the audit scope and duties. The longer duration of audit engagements not only satisfies the client regarding strictness in audit policies but it also make the auditor reluctant to see any irregular transactions or activities and he prejudices the nature of work of his clients.
• The Going Concern assumption of the business should be clearly overviewed because after the global financial crisis, a number of financial institutions were getting indulged in window dressing their financial position by using various monetary and non-monetary measures. The going concern assumption may not be there in some cases as the financial statements must be showing highly valued assets but the actual valuation and position would be much lower. Thus, the auditors’ responsibilities regarding the going concern has increased.

ACCA, 2011. Audit under fire: a review of the post-financial crisis inquiries. [Online] Avail able at: https://www.accaglobal.com/content/dam/acca/global/PDF-technical/audit-publications/pol-af-auf.pdf[Accessed 17 January 2017].

Adu-Gyamfi, M., 2015. The A nalysis of the Collapse of Lehman Brothers. [Online] Avail able at: file:///C:/Users/user/Downloads/SSRN-id2771615.pdf[Accessed 17 January 2017].

Duncan, S., 2012. Causes of  Collapse: The Failure of Lehman Brother Holdings, Inc.. [Online] Available at: www.ssrn.com/abstract=2192284[Accessed 17 January 2017].

FASB, 2014. FASB IMPROVES FINANCIAL REPORTING OF REPURCHASE AGREEMENTS. [Online] Avail able at: https://fasb.org/cs/ContentServer?c=FASBContent_C&pagename=FASB%2FFASBContent_C%2FNewsPage&cid=1176164127256[Accessed 17 January 2017].

Fineman, J. &. O. Y., 2008. Lehman Brothers’ Corporate History and Chronology. [Online] Available at: www.bloomberg.com/apps/news?pid=newsarchive&sid=a63mWc3ILITo[Accessed 17 January 2017].

PricewaterhouseCoopers, 2009. Lehman Brothers’ Bankruptcy: Lessons Learned for. [Online] Available at: www.pwc.com/jg/en/events/lessons-learned-for-the-survivors.pdf[Accessed 17 January 2017].

Ranjeen, K. &. S. S., 2015. The effects of Lehman Brothers’ bankruptcy on the. [Online] Available at: www.web.b.ebscohost.com/ehost/pdfviewer/pdfviewer?vid=4&sid=2eba05al-c490-4989-90ab-32a8b33fd375%40sessionmgr102&hid=116 [Accessed 17 January 2017].

Tymkiw, C., 2012. Pioneers of money market funds cleared of fraud. [Online] Availa ble at: www.buzz.money.cnn.com/tag/reserve-primary-fund-cleared-of-fraud.pdf [Accessed 17 January 2017].