Written By: Steven Winter – Corporate Finance
On September 15, 2008, Lehman Brothers, until then the fourth-largest investment bank in the United States, filed for bankruptcy. It was the first company of its size to fail in the history of the United States. The aftermath of the collapse was economic turmoil that wiped nearly $12 trillion out of the system and resulted in the loss of more than six million jobs. At the time of the collapse, Lehman had $639 billion in assets and $619 billion in debt, making its bankruptcy filing the largest ever in the history of the world.
Before the collapse, Lehman was in the category of institutions deemed to be too big to fail. No one would believe that there would come a time when the investment bank would go belly up, forcing all of its stakeholders to pack. While the US Federal Reserve’s decision to let Lehman sink sealed its fate, the bank had already dug its own grave through poor corporate governance.
What are the corporate-governance lessons every organization should learn from the fall of Lehman Brothers?
Whistleblower and compliance strategies
In every organization, it is the role of the board, and in particular the independent directors, to conduct oversight duties. For the board to be able to perform its role, the organization must have in place strong whistleblower and compliance policies and programs to encourage reporting. In best practice, the policies should help identify risk, fraud and illegal activities in the organization. In the case of Lehman Brothers, the board of directors claimed to have been duped by the management and therefore was not aware of some of the practices that led to the collapse.
A report by the Public Company Accounting Oversight Board shows that the independent directors of Lehman relied on the audit opinion of the company’s independent auditors and did not bother to develop other independent sources of information. The outcome was the problem growing out of proportion leading to the eventual collapse. While the majority of the senior managers turned a blind eye to the brewing trouble, there were a few that foresaw the approaching disaster. According to a Lehman’s bankruptcy examiner report, Matthew Lee, the vice president of the bank’s financial division, was aware of the accounting improprieties that were taking place and had tried to alert his superior about the fishy Repo 105 transactions used by the bank.
However, under a robust whistleblower and compliance system, the best approach would have been to report directly to the audit committee. The question arises as to why most individuals with such information shy away from reporting to higher authorities. First, most organizations do not have a policy to protect and reward the employee who provides legitimate information. In most cases the reporting is known to jeopardize the reporter’s career and can in extreme cases lead to employment termination. In the case of Lehman, Lee was laid off in less than a month after reporting.
If the independent directors and the audit committee are to receive information from lower-level executives, they must be ready to establish a whistleblower system that encourages reporting. Independent directors must take charge of the system, and the resources to fulfill their responsibilities must be provided. The Financial Crisis Inquiry Report recommends that the system for accounting, auditing and risks complaints be independently administered—meaning that they should go directly to the auditing committee. The whistleblower’s identity should be protected, and they should be allowed to use their personal counsel and form entities for further protection.
Remuneration and incentive systems
While Lehman’s top management was turning a blind eye to the whistleblowers, it was encouraging irresponsible risk-taking by offering bonuses during high returns. The result was an improvement in short-term profits and an accumulation of risk that was to bring down the entire institution later. The practice encouraged the use of high levels of financial leverage to increase returns, hence exposing the firm to greater risk.
According to a report by the International Institute of Finance, compensations incentives should be based on performance in line with long-term profitability and shareholders’ interests. The firm should ensure that the incentives do not induce risk-taking in excess of its risk appetite. It is recommended that payouts of compensation incentives be based on risk-adjusted profits and coincide with risk time horizons.
Every organization today should embrace the improvement of their whistleblower programs and the review of incentive systems as the first steps to ensuring accountability, fairness, independence and transparency. Top management should be made accountable through independent audits, and employees should be encouraged to report suspicious incidents by offering them protection and rewards.