Corporate governance is something that relates to the set of regulations, ethics or morals that governs the executives of a company in order to safeguard and promote the interest of its investors and shareholders in accordance with the social obligations imposed by the society. It is like a compass that shows the right direction to the navigating ship and takes it to the right direction.
Here in we'll study how and why weak corporate governance may be responsible for corporate failure, no matter how big and old the institution may be. One such example is that of Lehman Brothers which rose from ashes and ended up in dust; the 4th largest and one of the most powerful institutions of the world, ailing from poor corporate governance fallacies.
LEHMAN BROTHERS Inc.
The Lehman Brothers Inc. was founded by three brothers Henry, Emanuel & Mayer Lehman in 1850, having headquarters in United States and serving areas of investment & financial services across the world. Lehman Brothers Holding Inc. employed around 26,200 people and did its business in private banking, investment banking, fixed income sales, research, trading, investment management, private banking and equity. It was one of the biggest players of U.S Treasury securities market.
The firm had international headquarters in New York and regional headquarters in London & Tokyo with offices spread throughout the world.
THE LIFE-SPAN OF LEHMAN BROTHERS Inc:
Lehman Brothers started their business in 1855 as cotton traders in Southern United States. The business flourished and reached to new heights following the high market value of cotton. One of the three brothers (Henry) died due to yellow fever but the remaining two brothers focused on their business in commodity trading and brokerage operations. The Henry brothers shifted their base to New York following the concentration of cotton trading from south to New York. The firm survived the Civil War by shaking hands with John Durr and helped finance Alabama's reconstruction. Herbert became the member of board of New York cotton exchange and eventually a member of coffee exchange and finally member of New York Stock exchange by 1887.In 1906, the firm subvented two hundred new issues including F.W.Woolworth co., May department stores co., Gimbel brothers and etc.The company survived the Great Depression under the leadership of Robert Lehman, son of Philip Lehman and focused on the venture capital as the equity market was poor.In 1930 it helped funding the radio corporation of America.In 1969 Robert Lehman, the last Lehman successor passes away which created a void in the company. In 1970-72 the company saw difficult economic times and was at verge of sinking when Mr. Pete Peterson was called for the rescue.In 1975 it became the 4th largest investment bank of the country.After a decade Mr Peterson was ousted and Mr.Glucksman acquired his post.In early 90's Mr. Richard S. Fuld joined hands with Lehman and the company performed really well under his leadership. In 2003 it aggressively re-entered assets management, acquiring Crossroads and Newberger.In 2008 Lehman Brothers won the China Law Awards for debt market deal of the year and equity market deal of the year. The progress and life span of Lehman Brothers till 2007 was somewhat as depicted in the progress graph given below:
BANKRUPCY AT LEHMAN BROTHERS:
The fall started in 2007 with the start of the subprime mortgage crisis and the financial crisis of 2007-08.Aug 2007 saw the closure of BNC Mortgage resulting in a reduction of $27 million in the goodwill of Lehman. No doubt that the signs of storm were very much prevalent from 2005 itself.2008 brought with itself a huge lump of unparalleled losses due to the subprime mortgage crisis. In the 2nd Fiscal quarter Lehman incurred losses to the tune of $2.8 billion & Lehman sold off $6 bln of its assets. In the 1st half of 2008 itself Lehman's stock had fallen by 73% of its original value. On 11th sept, Lehman's stock fell by a further 40% with the executives waking up in a rush to search for a buyer for the fallen stocks now.
On 13th of September, 2008 Timothy F. Geithner, President, Federal Reserve Bank of NY called a meeting to express possibility of emergency liquidation of Lehman's assets. Talks were going on that Barklays and Bank of America would purchase Lehman but they declined. On 15th of September Lehman filed for CHAPTER 11 Bankruptcy with a bank debt of $613 billion, bond debt of $155 billion and $639 billion of assets. [1] This was the 2nd largest failure of an Investment bank in the history of corporate governance. On the same day Dow Jones recorded the largest drop in a single day after 11th September 2001 attack. It suffered the largest one day point loss, largest daily point gain & largest intra day range resulting into a perfect storm. [2]
ANALYSIS:
HOW WEAK CORPORATE GOVERNANCE RESULTED INTO THE DOWNFALL OF A CENTURY OLD INSTITUTION, AN EMPIRE OF $600 billion
There is not a single reason to account for the collapse of Lehman Brothers. It was partly the presence of loopholes in the financial regulatory system and the rest was the shaky corporate governance of the institution. The points are analyzed below:
The whole process started with the relaxed credit conditions in the financial market depending on which the financial institutions started taking advantage and increased their financial leverage ratio. This resulted in the insufficiency of capital & increased their vulnerability to financial shocks in spite the fact that the institutions were not having enough of financial cushions to absorb these shocks. This resulted in the increase of the debt ratio of the top five financial institutions of US, i.e., Lehman Brothers; bear Sterns, Merrill Lynch, Goldman Sachs & Morgan Stanley from 63.8% of GDP to 113.8% in 2007. The market situation was somewhat as described by the cycle given below:
HIGH LEV. RATIO, MORE RISK TO SHOCKS
INSUF. CAPITAL, POOR MARKET CONDITIONS
HENCE TIGHT MARKET
EASY CREDIT CONDTNS IN THE MARKET BY POLICY M
All the five investment banks met their fate. Lehman was liquidated, Bear Sterns & Merrill Lynch was sold at highly downtrodden prices, and Goldman Sachs & Morgan Stanley was commercialized. [3]
If we analyze this situation, we can see that the management of Lehman Brothers increased their leverage ratio in boom times, by pumping itself on debts and ignoring clear warnings from the US housing markets. It clearly ignored the bearish sentiments of financial advisors and commentators that the market bottom is near. It held less than a dollar in reserve behind every $ 30 of its liabilities. Whereas the fundamentals of Corporate Governance say that you should never make commitments when you are not having enough capital as shock cushions to fulfill them. It was just too much of risk. The market trend changed, as it always changes, every bull market is followed by the bear market and reached capitulation. People started panicking and sold their stocks at the lowest prices, followed by a further decline and it all crashed in a go like a fragile structure.
2. The second reason that weakened the strength of Lehman Brothers was the reliance on inaccurate credit ratings. Joseph Stieglitz commented on this,
"I believe that the rating agencies were one of the major culprits. They were the party that converted the securities from F-rated to A-rated. The banks could not have done what they did without the complicity of the rating agencies."
Although this contributed to the down fall of Lehman but there was nothing good corporate governance inside the company could have helped as the whole framework & the policy structure had loopholes. Rather there was a need for better regulations by authorities and a strict compliance of a stronger corporate governance framework regulating the institutions and companies. So we shift to the next cause.
The third and the strongest reason behind the fall of Lehman was the avoidance of regulatory framework. It completely breached the corporate governance by doing so. It took the help of many Structured Investment Vehicles which acted in the same manner as off-balance sheet vehicles in Enron to alter the extent of liabilities on its balance sheet. These entities helped Lehman show that it complied with the credit requirements and also gave a false impression that the firm was earning huge profits to keep its share value steady.
Lehman had a huge amount of poisonous real estate assets which was deteriorating in value day by day burdening the balance sheet .By the time they woke up and tried selling it, it was already too late. Joseph Stieglitz, the Nobel Prize winning economist at Columbia University said on this,
"It's unconscionable what they did or more accurately what they dint do." [4]
The other practice was naked short selling attacks, which helped greatly in market manipulations. Richard Fuld, the CEO of Lehman brothers said in his hearings on the bankruptcy of Lehman,
"Factors like lack of confidence, naked short selling attacks and false rumors contributed to the fall of Lehman". [5]
But I feel it wasn't the lack of confidence, instead it was the overconfidence which did not stop the executives from risking so high. Naked shorting was banned by SEC in 2008.The practice unfairly allowed the prices to fall downwards so that short sellers may benefit from the drop. It was the weakness at the part of SEC that it couldn't prevent the short selling attacks on Bear Stearns, Merril Lynch & especially Lehman Brothers, the institution that raised capital for 150 years for the best companies of US economy. Many experts agree that the fall of institutions like Lehman Brothers was the success of short sellers like David Einhorn & group whose naked short selling attacks resulted into market cornering, a market fraud which pulled down the best structures of economy.
5. LACK OF COMMUNICATION AND COMMON SENSE AT THE PART OF EXECUTIVES:
There was a gap of communication between the people working as the heart and soul of Lehman and the chairman. It seems everybody tried to sail his own ship in his own cabin, away from the realities of outside world. The sailor of the ship was not connected to the members on boar and tried taking every decision single handedly without the involvement of others. A good corporate governance would have made things better connected, well communicated and more realistic so that the executives would have realized the ground realities and the impact of their actions on the falling rates of the stocks. It seems they never knew that it wasn't their money which they were handling; it belonged to the share holders and stake holders so they had an inherent responsibility to handle it for shareholder's interest maximization.
Every time I think about this topic, one question haunts me, i.e. how could Mr. Fuld and his management be so ruthless when they knew that the value of the stock was falling soo steeply day by day? Were they sleeping on their desks for one year or were they waiting for a miracle to take place? It was a sheer lack of common sense that they saw the best & most brilliant traders & risk takers of Lehman leaving the institution and din't do anything to retain them.
Till the end the management was under the presumption that US govt. would rescue Lehman Brothers and under this misconception it rejected the offer of $18 per share by Korea Development Bank in august 2008 and instead engaged itself in more risky & unnecessary trading.
CONCLUSION:
POOR CORPORATE GOVERNANCE FRAMEWORK & WEAK REGULATION
The regulatory framework was not advanced enough to coordinate with the financial innovation taking place at the time. The repealing of Glass-Steagall Act by President Clinton kind of removed the barrier between investment banks and commercial banks because of which the investment guys had a direct access on the limitless supply of depositor's money.
The laws governing the shadow banking institutions like Lehman Brothers were not stringent enough. The requirement of capital in proverbial vault was very relaxed as compared to what they borrow & lend which resulted into high financial leverage.
BREACH OF CORPORATE GOVERNANCE BY EXECUTIVES (LACK OF RESPONSIBILITY)
The financial Institutions were promising a way too ahead of their capacities breaching the core fundamentals of corporate governance.
The relaxation of net capital rule in 2004 by SEC increased the level of debt taken by FI's. The irresponsible and uncalculative approach by the executives resulted in big lump of debt which the institution could not bear and the 1st thing that good corporate governance teaches is the highest level of responsibility and a calculative approach.
To add to its woes, as against the common perception & expectation, there was no government support given to Lehman. This was the only Investment bank which did not receive any aid from the govt.Till the end of the episode, everybody thought that the US treasury wouldn't let the whole structure fall with a debt of $650 billion, the fourth largest bank of the world cant fail like this. But the fact is they did!
The treasury secretary, Henry Merritt Paulson declared that there will be no bailouts this weekend for Lehman as bailouts result in the weakening of the compliance of companies with the corporate governance framework. But I often think why such discrimination with Lehman? Why no bailouts for Lehman when there were bailouts for the rest of the falling institutions even a week before Lehman's fall? It wasn't the bailouts that were making the compliance weak; instead it was the weak framework which did not make the compliance so stringent. It was not just about the poor corporate governance of Lehman. If it would have been so, then why all the financial institutions of USA were failing?
