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UNITEDSTATESBANKRUPTCYCOURT

SOUTHERNDISTRICTOFNEWYORK

x
:
Inre : Chapter11CaseNo.
:
LEHMANBROTHERSHOLDINGSINC., : 0813555(JMP)
etal., :
: (JointlyAdministered)
Debtors. :
x

REPORTOF
ANTONR.VALUKAS,EXAMINER


Jenner&BlockLLP
353N.ClarkStreet
Chicago,IL606543456
3122229350

919ThirdAvenue
37thFloor
NewYork,NY100223908
2128911600

March11,2010 CounseltotheExaminer

VOLUME1OF9

SectionsI&II:Introduction,ExecutiveSummary&ProceduralBackground

SectionIII.A.1:Risk

EXAMINERSREPORT

TABLEOFCONTENTS

VOLUME1

Introduction,SectionsI&II:ExecutiveSummary&ProceduralBackground

Introduction ...................................................................................................................................2
I. ExecutiveSummaryofTheExaminersConclusions ......................................................15
A. WhyDidLehmanFail?AreThereColorableCausesofActionThatArise
FromItsFinancialConditionandFailure?..................................................................15
B. AreThereAdministrativeClaimsorColorableClaimsForPreferencesor
VoidableTransfers? ........................................................................................................24
C. DoColorableClaimsAriseFromTransfersofLBHIAffiliateAssetsto
Barclays,orFromtheLehmanALITransaction?.......................................................26
II. ProceduralBackgroundandNatureoftheExamination................................................28
A. TheExaminersAuthority .............................................................................................28
B. DocumentCollectionandReview ................................................................................30
C. SystemsAccess ................................................................................................................33
D. WitnessInterviewProcess .............................................................................................35
E. CooperationandCoordinationWiththeGovernmentandParties ........................37

SectionIII.A.1:Risk

III.ExaminersConclusions .......................................................................................................43
A. WhyDidLehmanFail?AreThereColorableCausesofActionThatArise
FromItsFinancialConditionandFailure?..................................................................43
1. BusinessandRiskManagement .............................................................................43
a) ExecutiveSummary............................................................................................43
(1)TheExaminerDoesNotFindColorableClaimsThatLehmans
SeniorOfficersBreachedTheirFiduciaryDutyofCareby
FailingtoObserveLehmansRiskManagementPoliciesand
Procedures......................................................................................................47

(2)TheExaminerDoesNotFindColorableClaimsThatLehmans
SeniorOfficersBreachedTheirFiduciaryDutytoInformthe
BoardofDirectorsConcerningTheLevelofRiskLehmanHad
Assumed.........................................................................................................52
(3)TheExaminerDoesNotFindColorableClaimsThatLehmans
DirectorsBreachedTheirFiduciaryDutybyFailingtoMonitor
LehmansRiskTakingActivities................................................................54
b) Facts.......................................................................................................................58
(1)FromMovingtoStorage:LehmanExpandsItsPrincipal
Investments....................................................................................................58
(a)LehmansChangedBusinessStrategy .................................................59
(b)TheIncreasedRiskFromLehmansChangedBusiness
Strategy.....................................................................................................62
(c) ApplicationofRiskControlstoChangedBusinessStrategy ...........65
(i) StressTestingExclusions ................................................................66
(ii) RiskAppetiteLimitIncreaseForFiscal2007...............................70
(iii)DecisionNotToEnforceSingleTransactionLimit.....................73
(d)TheBoardsApprovalofLehmansGrowthStrategy .......................76
(2)LehmanDoublesDown:LehmanContinuesItsGrowthStrategy
DespitetheOnsetoftheSubprimeCrisis..................................................78
(a)LehmansResidentialMortgageBusiness...........................................82
(i) LehmanDecidestoCurtailSubprimeOriginationsbut
ContinuestoPursueAltAOriginations ..................................82
(ii) TheMarch20,2007BoardMeeting...............................................90
(b)TheExplosioninLehmansLeveragedLoanBusiness .....................95
(i) RelaxationofRiskControlstoAccommodateGrowthof
LehmansLeveragedLoansBusiness ...........................................97
(c) InternalOppositiontoGrowthofLeveragedLoansBusiness .......100
(d)GrowthofLehmansCommercialRealEstateBusinessatthe
StartoftheSubprimeCrisis.................................................................103
(i) RelaxationofRiskControlstoAccommodateGrowthof
LehmansCommercialRealEstateBusiness..............................105
(ii) InternalOppositiontoGrowthofCommercialReal
EstateBusiness ...............................................................................107
(iii)Archstone ........................................................................................108

ii

a. LehmansCommitment............................................................108
b. RiskManagementofLehmansArchstone
Commitment..............................................................................112
(e) NagioffsReplacementofGelbandasHeadofFID .........................114
(f) TheBoardofDirectorsAwarenessofLehmansIncreasing
RiskProfile .............................................................................................116
(3)EarlyWarnings:RiskLimitOverages,FundingConcerns,and
theDeepeningSubprimeCrisis ................................................................117
(a)NagioffandKirkTrytoLimitLehmansHighYieldBusiness......119
(b)JulyAugust2007ConcernsRegardingLehmansAbilityto
FundItsCommitments ........................................................................123
(c) LehmanDelaystheArchstoneClosing .............................................128
(d)LehmanIncreasestheRiskAppetiteLimittoAccommodate
theAdditionalRiskAttributabletotheArchstone
Transaction.............................................................................................131
(e) CashCapitalConcerns .........................................................................134
(f) LehmansTerminationofItsResidentialMortgage
Originations ...........................................................................................138
(g)September,October,andNovember2007MeetingsofBoard
ofDirectors.............................................................................................139
(i) RiskAppetiteDisclosures.............................................................139
(ii) LeveragedLoanDisclosures ........................................................144
(iii)LeverageRatiosandBalanceSheetDisclosures........................147
(iv)LiquidityandCapitalDisclosures...............................................148
(4)LateReactions:LehmanSlowlyExitsItsIlliquidRealEstate
Investments..................................................................................................150
(a)Fiscal2008RiskAppetiteLimitIncrease ...........................................152
(b)January2008MeetingofBoardofDirectors .....................................154
(c) ExecutiveTurnover...............................................................................156
(d)CommercialRealEstateSellOff:TooLittle,TooLate ...................157
(e) LehmansCompensationPractices.....................................................161

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c) Analysis ..............................................................................................................163
(1)TheExaminerDoesNotFindColorableClaimsThatLehmans
SeniorOfficersBreachedTheirFiduciaryDutyofCareby
FailingtoObserveLehmansRiskManagementPoliciesand
Procedures....................................................................................................164
(a)LegalStandard.......................................................................................164
(b)Background............................................................................................166
(i) CountercyclicalGrowthStrategywithRespectto
ResidentialMortgageOrigination...............................................171
(ii) LehmansConcentrationofRiskinItsCommercialReal
EstateBusiness ...............................................................................172
(iii)ConcentratedInvestmentsinLeveragedLoans ........................175
(iv)FirmWideRiskAppetiteExcesses..............................................179
(v) FirmWideBalanceSheetLimits .................................................181
(vi)StressTesting ..................................................................................181
(vii)Summary:OfficersDutyofCare ..............................................182
(2)TheExaminerDoesNotFindColorableClaimsThatLehmans
SeniorOfficersBreachedTheirFiduciaryDutytoInformthe
BoardofDirectorsConcerningtheLevelofRiskLehmanHad
Assumed.......................................................................................................183
(3)TheExaminerDoesNotFindColorableClaimsThatLehmans
DirectorsBreachedTheirFiduciaryDutybyFailingtoMonitor
LehmansRiskTakingActivities..............................................................188
(a)LehmansDirectorsareProtectedFromDutyofCare
LiabilitybytheExculpatoryClauseandtheBusiness
JudgmentRule.......................................................................................188
(b)LehmansDirectorsDidNotViolateTheirDutyofLoyalty ..........190
(c) LehmansDirectorsDidNotViolateTheirDutytoMonitor .........191
(i) ApplicationofCaremarktoRiskOversight:InreCitigroup
Inc. ....................................................................................................191
(ii) ApplicationofCaremarkandCitigrouptoLehmans
Directors ..........................................................................................193

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VOLUME2

SectionIII.A.2:Valuation

2. Valuation ..................................................................................................................203
a) ExecutiveSummary..........................................................................................203
(1)ScopeofExamination .................................................................................210
(2)SummaryofApplicableLegalStandards................................................212
(3)SummaryofFindingsandConclusions...................................................214
b) OverviewofValuationofLehmansCommercialRealEstate
Portfolio ..............................................................................................................215
(1)OverviewofLehmansCREPortfolio......................................................217
(a)SummaryofPortfolio ...........................................................................217
(b)OverviewofValuationofCREPortfolio ...........................................220
(i) GREGLeaders ................................................................................220
(ii) ParticipantsintheValuationProcess .........................................220
(c) ChangesintheCREPortfoliofrom2006through2008...................223
(d)PerfectStormImpactonCREValuationin2008..........................227
(2)OutsideReviewofLehmansCREValuationProcess...........................232
(a)SEC ..........................................................................................................233
(b)Ernst&Young .......................................................................................237
c) SeniorManagementsInvolvementinValuation.........................................241
(1)SeniorManagementsGeneralRoleWithRespecttoCRE
Valuation ......................................................................................................243
(2)SeniorManagementsInvolvementinValuationintheSecond
Quarterof2008 ............................................................................................245
(3)SeniorManagementsInvolvementinValuationintheThird
Quarterof2008 ............................................................................................247
(a)SeniorManagementsAccount ...........................................................248
(b)PaulHughsonsAccount .....................................................................253
(c) OtherAccounts......................................................................................254
(4)ExaminersFindingsandConclusionsWithRespecttoSenior
ManagementsInvolvementinCREValuation ......................................265
d) ExaminersAnalysisoftheValuationofLehmansCommercial
Book ....................................................................................................................266
(1)ExecutiveSummary....................................................................................266

(2)LehmansValuationProcessforitsCommercialBook .........................270
(3)ExaminersFindingsandConclusionsastotheReasonableness
ofLehmansValuationofItsCommercialBook.....................................274
(a)AsoftheSecondQuarterof2008 .......................................................274
(b)AsoftheThirdQuarterof2008 ..........................................................282
e) ExaminersAnalysisoftheValuationofLehmansPrincipal
TransactionsGroup ..........................................................................................285
(1)ExecutiveSummary....................................................................................285
(2)OverviewofLehmansPTGPortfolio......................................................292
(3)EvolutionofLehmansPTGPortfolioFrom2005Through2008.........296
(4)LehmansValuationProcessforItsPTGPortfolio.................................303
(a)TheRoleofTriMontintheValuationProcessforLehmans
PTGPortfolio .........................................................................................306
(i) LehmansIssueswithTriMontsData ........................................311
(ii) LehmanChangedItsValuationMethodologyforItsPTG
PortfolioinLate2007.....................................................................312
(b)TheRoleofLehmansPTGBusinessDeskintheValuation
ProcessforLehmansPTGPortfolio ..................................................319
(c) TheRoleofLehmansProductControlGroupinPrice
TestingtheValuationofLehmansPTGPortfolio ...........................321
(d)TheInfluenceofLehmansPTGBusinessDeskuponthe
PriceTestingFunctionofLehmansProductControlGroup.........326
(5)TheExaminersFindingsandConclusionsastothe
ReasonablenessofLehmansValuationofPTGPortfolio.....................329
(a)LehmanDidNotMarkPTGAssetstoMarketBasedYield ...........331
(b)TheEffectofNotMarkingtoMarketBasedYield...........................337
(i) EffectofCap*105NotMarkingtoMarketBasedYield .........337
(ii) EffectofIRRModelsNotMarkingtoMarketBased
Yield .................................................................................................342
(iii)EffectofProductControlPriceTestingNotMarkingto
MarketBasedYield .......................................................................349
(iv)EffectofModifyingTriMontsDataintheThirdQuarter
of2008..............................................................................................351
(c) ExaminersFindingsandConclusionsastotheEffectofNot
MarkingLehmansPTGPortfoliotoMarketBasedYield ..............353

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f) ExaminersAnalysisoftheValuationofLehmansArchstone
Positions .............................................................................................................356
(1)ExecutiveSummary....................................................................................356
(2)LehmansAcquisitionofArchstone.........................................................364
(a)BackgroundonArchstone ...................................................................364
(b)AcquisitionofArchstone .....................................................................365
(i) AnalystReaction ............................................................................367
(ii) LehmansSyndicationEfforts ......................................................370
(iii)BridgeandPermanentEquityatClosing...................................374
(iv)CapitalStructureatClosing .........................................................375
(v) PriceFlex .........................................................................................377
(vi)Standard&PoorsCreditRating .................................................380
(3)LehmansValuationofArchstone ............................................................382
(a)ValuationBetweenCommitmentandClosing .................................386
(b)ValuationasoftheClosingDate ........................................................388
(c) ValuationasoftheFourthQuarterof2007.......................................390
(d)ValuationIssuesDuringtheFirstQuarterof2008...........................391
(i) BarronsArticle ..............................................................................391
a. ArchstonesResponsetotheBarronsArticle.......................392
b. LehmansResponsetotheBarronsArticle ..........................394
(ii) January2008ArchstoneUpdate ..................................................396
(iii)ValuationasofFebruary29,2008................................................399
(iv)FirstQuarter2008EarningsCallandLenders
DiscussionRegardingModifyingtheArchstoneStrategy ......401
(e) ValuationIssuesDuringtheSecondQuarterof2008......................402
(i) March2008ArchstoneUpdate ....................................................402
(ii) March2008Valuation ...................................................................404
(iii)April2008DowngradebyS&P....................................................407
(iv)EinhornSpeechinApril2008.......................................................407
(v) May2008Valuation.......................................................................408
(vi)SecondQuarter2008EarningsConferenceCall........................411
a. PreparationandLehmansMethodsofAnalyzing
ReasonablenessofValuationsPriortotheCall ....................411

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b. DiscussionDuringtheSecondQuarter2008Earnings
Call ..............................................................................................412
(vii)LehmansRevisedPlantoSellArchstonePositions................414
(f) ValuationIssuesDuringtheThirdQuarterof2008.........................416
(i) DiscussionAmongLendersinJuly2008....................................417
(ii) August2008Valuation..................................................................417
(g)ProductControlsReviewofArchstoneValuations........................418
(4)ExaminersAnalysisofLehmansValuationProcessforits
ArchstonePositions ....................................................................................419
(a)DiscountedCashFlowValuationMethod ........................................421
(i) RentGrowth ...................................................................................422
a. NetOperatingIncome..............................................................426
b. SensitivityAnalysis...................................................................429
(ii)ExitCapitalizationRate..................................................................431
(iii)ExitPlatformValue .......................................................................433
(iv)DiscountRate..................................................................................436
(b)SumofthePartsMethod .....................................................................438
(c) ComparableCompanyMethod ..........................................................440
(i) PotentialOvervaluationBasedonPrimaryComparable
Companies ......................................................................................445
(5)ExaminersAnalysisoftheReasonablenessofLehmans
ValuationofitsArchstonePositionsonaQuarterlyBasis ...................446
(a)ReasonablenessasoftheFourthQuarterof2007.............................446
(b)ReasonablenessasoftheFirstQuarterof2008.................................449
(i) BarronsArticle ..............................................................................450
(ii) DiscussionsAmongArchstone,TishmanandLenders ...........458
(iii)LehmansValuationDuringtheFirstQuarterof2008.............459
(iv)SumoftheParts .............................................................................460
(v)DCFMethod ....................................................................................464
(vi)ExaminersFindingsandConclusionsastothe
ReasonablenessofLehmansArchstoneValuationasof
theEndoftheFirstQuarterof2008 ............................................466
(c) ReasonablenessasoftheSecondQuarterof2008............................468
(i)SecondQuarterEarningsCall ........................................................469

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(ii)SumoftheParts ..............................................................................476
(iii)DCFModel......................................................................................477
(iv)RentGrowth ...................................................................................478
(v)ExitCapitalizationRate..................................................................479
(vi)QuantificationofChangesinAssumptions ...............................480
(vii)ExaminersFindingsandConclusionsastothe
ReasonablenessofLehmansArchstoneValuationasof
theEndoftheSecondQuarterof2008 .......................................481
(d)ReasonablenessasoftheThirdQuarterof2008...............................484
(i)SumoftheParts................................................................................487
(ii)DCFModel.......................................................................................488
(iii)RentGrowth ...................................................................................489
(iv)ExitCapitalizationRate.................................................................490
(v)QuantificationofChangesinAssumptions ................................491
(vi)ExaminersFindingsandConclusionsastothe
ReasonablenessofLehmansArchstoneValuationasof
theEndoftheThirdQuarterof2008 ..........................................492
g) ExaminersAnalysisoftheValuationofLehmansResidential
WholeLoansPortfolio......................................................................................494
(1)ResidentialWholeLoansOverview .........................................................494
(2)LehmansU.S.ResidentialWholeLoansin2008 ...................................497
(3)LehmansValuationProcessforitsResidentialWholeLoans..............501
(a)LehmansMay2008PriceTesting ......................................................504
(b)LehmansAugust2008PriceTesting .................................................515
(4)ExaminersIndependentValuationofLehmansResidential
WholeLoansPortfolio................................................................................520
(5)ExaminersFindingsandConclusionsWithRespecttothe
ReasonablenessofLehmansValuationofItsResidentialWhole
LoansPortfolio ............................................................................................525
(h)ExaminersAnalysisoftheValuationofLehmansRMBSPortfolio ........527
(i) ExaminersAnalysisoftheValuationofLehmansCDOs .........................538
(1)LehmansPriceTestingProcessforCDOs ..............................................543
(2)PriceTestingResultsfortheSecondandThirdQuarters2008 ............551
(a)LehmansPriceTestingofitsCeagoCDOs.......................................553

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(3)ExaminersReviewofLehmansLargestU.S.ABS/CRECDO
Positions .......................................................................................................562
(4)ExaminersFindingsandConclusionsWithRespecttothe
ReasonablenessofLehmansValuationofitsCDOs .............................567
(j) ExaminersAnalysisoftheValuationofLehmansDerivatives
Positions .............................................................................................................568
(1)OverviewofLehmansDerivativesPositions.........................................568
(2)LehmansUseofCreditSupportAnnexestoMitigate
DerivativesRisk ..........................................................................................574
(3)LehmansPriceTestingofitsDerivativesPositions ..............................578
(k)ExaminersAnalysisoftheValuationofLehmansCorporateDebt
Positions .............................................................................................................583
(1)OverviewofLehmansCorporateDebtPositions .................................583
(2)LehmansPriceTestingofitsCorporateDebtPositions.......................585
(3)ExaminersFindingsandConclusionsWithRespecttothe
ValuationofLehmansCorporateDebtPositions..................................589
(a)RelianceonNonTrades.......................................................................590
(b)QualityControlErrorsMismatchedCompanies ..........................591
(c)NoTestingofInternalCreditRating ..................................................592
(l) ExaminersAnalysisoftheValuationofLehmansCorporate
EquitiesPositions ..............................................................................................594
(1)OverviewofLehmansCorporateEquitiesPositions............................594
(2)LehmansValuationProcessforitsCorporateEquitiesPositions.......596
(3)ExaminersFindingsandConclusionsWithRespecttothe
ValuationofLehmansCorporateEquitiesPositions............................599
(a)ImpairedDebtwithNoEquityMarkDown.....................................601
(b)StaticMarks............................................................................................603

VOLUME2(CONT.)

SectionIII.A.3:Survival

3. LehmansSurvivalStrategiesandEfforts ...........................................................609
a) IntroductiontoLehmansSurvivalStrategiesandEfforts..........................609
(1)ExaminersConclusions .............................................................................609
(2)IntroductiontoLehmansSurvivalStrategies ........................................612

b) LehmansActionsin2008PriortotheNearCollapseofBearStearns......622
(1)RejectionofCapitalInvestmentInquiries ...............................................623
(a)KIAOffer................................................................................................624
(b)KDBMakesItsInitialApproach.........................................................625
(c) ICDsInitialApproach .........................................................................626
(2)DivergentViews..........................................................................................627
(a)CompetitorsRaiseCapital ...................................................................627
(b)InternalWarningsRegardingCapital................................................629
c) ActionsandEffortsFollowingtheNearCollapseofBearStearns ............631
(1)LehmansAttempttoIncreaseLiquidity.................................................633
(2)LehmansAttempttoReduceitsBalanceSheet .....................................634
(3)LehmanSellsStocktoPrivateandPublicInvestors ..............................638
(4)SpinCo ..........................................................................................................640
(a)EvolutionofSpinCo..............................................................................642
(b)ExecutionIssues ....................................................................................644
(i) EquityHole .....................................................................................645
(ii) OutsideFinancingforSpinCo......................................................649
(iii)SECIssues .......................................................................................653
a. AuditingandAccountingIssues ............................................653
b. TaxFreeStatus ..........................................................................658
(iv)ValuationofAssets ........................................................................659
(c) BarclaysSpinCo ...............................................................................661
(5)PotentialStrategicPartners........................................................................662
(a)BuffettandBerkshireHathaway ........................................................664
(i) March2008......................................................................................664
(ii) LastDitchEffortwithBuffett.......................................................667
(b)KDB .........................................................................................................668
(i) DiscussionsBegin ..........................................................................668
(ii) DiscussionsResume:SecondRoundofTalksbetween
KDBandLehman...........................................................................673
(iii)ThirdRoundofTalksbetweenKDBandLehman....................677
(iv)KDBsSeptember9,2008Announcement..................................681
(c) MetLife....................................................................................................687
(d)ICD ..........................................................................................................691

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(e) BankofAmerica....................................................................................694
(i) InitialDiscussionsintheSummerof2008 .................................694
(ii) TalksResumeinSeptember .........................................................696
(f) Barclays...................................................................................................703
(6)GovernmentCommunications..................................................................711
(a)TreasuryDinner ....................................................................................712
(b)ShortSales ..............................................................................................713
(c) PossibilityofFederalAssistance.........................................................716
(7)LehmansBankruptcy ................................................................................718

VOLUME3

SectionIII.A.4:Repo105

4. Repo105 ...................................................................................................................732
a) Repo105ExecutiveSummary......................................................................732
b) Introduction .......................................................................................................750
c) WhytheExaminerInvestigatedLehmansUseofRepo105
Transactions .......................................................................................................764
d) ATypicalRepo105Transaction .....................................................................765
(1)TheGenesisofLehmansRepo105Programin2001 ............................765
(2)Repo105TransactionsVersusOrdinaryRepoTransactions ...............766
(a)LehmansAccountingTreatmentofRepo105Transactions
VersusOrdinaryRepoTransactions ..................................................768
(b)LehmansAccountingPolicyforRepo105Transactions................775
(c) TheAccountingPurposeoftheLargerHaircut ...............................777
(d)LehmanDidNotRecordaCashBorrowingbutRecordeda
DerivativeAssetinaRepo105Transaction......................................781
(3)AnatomyofRepo105TransactionsandtheLinklatersTrueSale
OpinionLetter .............................................................................................782
(4)TypesofSecuritiesUsedinRepo105Transactions ...............................793
(5)ProductControllersManuallyBookedRepo105Transactions ...........797
e) ManagingBalanceSheetandLeverage .........................................................800
(1)LehmanManagementsFocusinLate2007onReducingthe
FirmsReportedLeverage..........................................................................802
(a)LehmansCalculationofNetLeverage .............................................804

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(2)ByJanuary2008,LehmanDecidedtoCutitsNetLeveragein
HalftoWinBacktheConfidenceoftheMarket,Lendersand
Investors .......................................................................................................805
(a)BartMcDade,asNewlyAppointedBalanceSheetCzar,
AdvisedtheExecutiveCommitteeinMarch2008toCap
LehmansUseofRepo105Transactions ...........................................809
(b)McDadeBecamePresidentandCOOonJune12,2008and
AuthorizedtheReductionofRepo105Usage..................................819
(3)TheMarketsIncreasedScrutinyoftheLeverageofInvestment
Banks.............................................................................................................822
(a)TheCostofDeleveraging ....................................................................825
(4)StickyInventoryandFIDsBalanceSheetBreachesHampered
LehmansAbilitytoManageItsNetLeverage .......................................828
(5)DeleveragingResultedinIntensePressureatQuarterEndto
MeetBalanceSheetTargetsforReportingPurposes .............................843
(6)LehmansEarningsCallsandPressReleaseStatements
RegardingLeverage....................................................................................845
(a)AnalystsStatementsRegardingLehmansLeverage .....................850
f) ThePurposeofLehmansRepo105ProgramWastoReverse
EngineerPubliclyReportedFinancialResults..............................................853
(1)LehmanDidNotDiscloseItsAccountingTreatmentFororUse
ofRepo105TransactionsinItsForms10Kand10Q...........................853
(a)LehmansOutsideDisclosureCounselWasUnawareof
LehmansRepo105Program ..............................................................855
(2)LehmansRepo105PracticeImprovedtheFirmsPublicBalance
SheetProfileatQuarterEnd .....................................................................856
(a)ContemporaneousDocumentsConfirmThatLehman
UndertookRepo105TransactionstoReduceItsBalance
SheetandReverseEngineerItsLeverage..........................................859
(b)WitnessStatementstotheExaminerRegardingtheTrue
PurposeofLehmansRepo105Practice ............................................867
(3)QuarterEndSpikesinLehmansRepo105UsageAlsoSuggest
theTruePurposeofLehmansRepo105PracticeWasBalance
SheetManipulation.....................................................................................870
(4)Repo105TransactionsServedNoBusinessPurposeOtherThan
BalanceSheetReduction ............................................................................877

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(a)Repo105TransactionsCameataHigherCostthanOrdinary
RepoTransactions.................................................................................877
(b)WitnessesAlsoStatedThatFinancingWasNottheReal
MotiveforUndertakingRepo105Transactions...............................882
g) TheMaterialityofLehmansRepo105Practice ...........................................884
(1)TheRepo105ProgramExposedLehmantoPotential
ReputationalRisk....................................................................................884
(2)LehmansRepo105PracticeHadaMaterialImpacton
LehmansNetLeverageRatio ...................................................................888
(a)LehmanSignificantlyExpandedItsRepo105PracticeinLate
2007andEarly2008 ..............................................................................890
(3)BalanceSheetTargetsforFIDBusinessesWereUnsustainable
WithouttheUseofRepo105Transactions .............................................899
(4)RatingAgenciesAdvisedtheExaminerthatLehmans
AccountingTreatmentandUseofRepo105Transactionsto
ManageItsNetLeverageRatioWouldHaveBeenRelevant
Information ..................................................................................................902
(5)GovernmentRegulatorsHadNoKnowledgeofLehmansRepo
105Program .................................................................................................910
(a)OfficialsfromtheFederalReserveBankWouldHave
WantedtoKnowaboutLehmansUseofRepo105
Transactions ...........................................................................................910
(b)SecuritiesandExchangeCommissionCSEMonitorsWere
UnawareofLehmansRepo105Program.........................................913
h) KnowledgeofLehmansRepo105ProgramattheHighestLevelsof
theFirm ..............................................................................................................914
(1)RichardFuld,FormerChiefExecutiveOfficer .......................................917
(2)LehmansFormerChiefFinancialOfficers .............................................921
(a)ChrisOMeara,FormerChiefFinancialOfficer ...............................921
(b)ErinCallan,FormerChiefFinancialOfficer......................................930
(c) IanLowitt,FormerChiefFinancialOfficer .......................................937
(3)LehmansBoardofDirectors.....................................................................945
i) Ernst&YoungsKnowledgeofLehmansRepo105Program ..................948
(1)Ernst&YoungsComfortwithLehmansRepo105Accounting
Policy.............................................................................................................948
(2)TheNettingGrid .....................................................................................951

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(a)QuarterlyReviewandAudit...............................................................953
(3)Ernst&YoungWouldNotOpineontheMaterialityof
LehmansRepo105Usage .........................................................................954
(4)MatthewLeesStatementsRegardingRepo105toErnst&
Young............................................................................................................956
(5)AccountingMotivatedTransactions........................................................962
j) TheExaminersConclusions ...........................................................................962
(1)Materiality ....................................................................................................963
(a)WhetherLehmansRepo105TransactionsTechnically
CompliedwithSFAS140DoesNotImpactWhethera
ColorableClaimExists .........................................................................964
(2)DisclosureRequirementsandAnalysis ...................................................967
(a)DisclosureObligations:RegulationSKandtheMD&A ...............968
(b)DutytoDisclose ....................................................................................972
(c) LehmansPublicFilings .......................................................................973
(i) SummaryofLehmans2000through2007PublicFilings........974
(ii) Lehmans2007Form10K,FirstQuarter2008Form10
Q,andSecondQuarter2008Form10Q.....................................977
a. TreatmentofRepoTransactionsandSFAS140....................978
b. NetLeverage..............................................................................980
c. Derivatives .................................................................................981
d. AReaderofLehmansForms10Kand10QWould
NotHaveBeenAbletoAscertainThatLehman
EngagedinTemporarySalesUsingLiquidSecurities ........984
(d)ConclusionsRegardingLehmansFailuretoDisclose ....................985
(3)ColorableClaims.........................................................................................990
(4)FiduciaryDutyClaims ...............................................................................991
(a)BreachofFiduciaryDutyClaimsagainstBoardofDirectors ........991
(b)BreachofFiduciaryDutyClaimsagainstSpecificLehman
Officers....................................................................................................992
(i) RichardFuld ...................................................................................996
a. ThereIsSufficientEvidencetoSupportaFindingBy
theTrierofFactThatFuldWasatLeastGrossly
NegligentinCausingLehmantoFileMisleading
PeriodicReports ........................................................................997

xv

(ii) ChrisOMeara ..............................................................................1002


a. ThereIsSufficientEvidenceToSupportaColorable
ClaimThatOMearaWasatLeastGrosslyNegligent
inAllowingLehmantoFileMisleadingFinancial
StatementsandEngageinMaterialVolumesofRepo
105Transactions ......................................................................1007
b. ThereIsSufficientEvidenceToSupportaColorable
ClaimThatOMearaBreachedHisFiduciaryDuties
byFailingtoInformtheBoardandHisSuperiorsof
LehmansRepo105Practice ..................................................1009
(iii)ErinCallan ....................................................................................1013
a. ThereIsSufficientEvidenceToSupportaFindingBy
theTrierofFactThatCallanBreachedHerFiduciary
DutiesbyCausingLehmantoMakeMaterially
MisleadingStatements ...........................................................1017
b. ThereIsSufficientEvidencetoSupportaColorable
ClaimThatCallanBreachedHerFiduciaryDutyof
CarebyFailingtoInformtheBoardofDirectorsof
LehmansRepo105Program ................................................1019
(iv)IanLowitt ......................................................................................1021
(c) Remedies ..............................................................................................1024
(5)MalpracticeClaimsAgainstErnst&Young .........................................1027
(a)BackgroundandLegalStandards ....................................................1028
(i) ProfessionalStandards................................................................1028
(ii) CommonLawStandards ............................................................1031
(b)ThereIsSufficientEvidencetoSupportaColorableClaim
ThatErnst&YoungWasNegligent.................................................1032
(i) MalpracticeinFailuretoAdviseAuditCommitteeof
Repo105ActivityandLeesAllegations..................................1033
(ii) Lehmans2008Forms10Q ........................................................1040
(iii)Lehmans2007Form10K ..........................................................1048
(iv)EffectonPriorFilings ..................................................................1050
(v) CausationandDamages .............................................................1051
(c) PossibleDefenses ................................................................................1053

xvi

VOLUME4

SectionIII.A.5:SecuredLenders

5. PotentialClaimsAgainstLehmansSecuredLenders.....................................1066
a) IntroductionandExecutiveSummary.........................................................1066
(1)JPMorgan....................................................................................................1068
(2)Citibank ......................................................................................................1073
(3)HSBC...........................................................................................................1077
(4)OtherLenders ............................................................................................1080
(5)TheFederalReserveBankofNewYork................................................1081
(6)LehmansLiquidityPool..........................................................................1082
b) LehmansDealingsWithJPMorgan .............................................................1084
(1)Facts.............................................................................................................1084
(a)OverviewofJPMorganLehmanRelationship ...............................1084
(b)TripartyRepoPriorto2008 ...............................................................1089
(c) JPMorganRestructuresItsApproachtoTripartyRisk .................1094
(d)LehmanBeginsPostingAdditionalCollateral ...............................1101
(e) JPMorganConcernOverLehmanCollateralinAugust2008 ......1105
(f) TheAugustAgreements ....................................................................1113
(g)BackgroundtotheSeptember9CollateralRequestand
SeptemberAgreements ......................................................................1125
(h)September9CallsBetweenStevenBlackandRichardFuld ........1138
(i) SeptemberAgreements ......................................................................1143
(j) DailyLiquidityPoolUpdatesFromLehmantoJPMorgan ..........1156
(k)September11CollateralRequestPursuanttotheSeptember
Agreements ..........................................................................................1158
(l) AdditionalValuationAnalysesbyJPMorganBeginning
September11........................................................................................1165
(m)LehmanRequestsforReturnofCollateral.....................................1168
(2)AnalysisofPotentialClaims ...................................................................1172
(a)TheEvidenceDoesNotSupportaColorableClaimAgainst
JPMorganforEconomicDuress........................................................1173
(i) LegalBackground:EconomicDuress .......................................1173

xvii

(ii) ThereIsNoAvailableEvidenceofanExpressUnlawful
ThreatMadebyJPMorganinConnectionWiththe
FormationoftheSeptemberAgreements ................................1174
(iii)TheAvailableEvidenceSuggestsJPMorganDidNot
HaveanImproperPurpose ........................................................1178
(iv)ThereWasaDegreeofNegotiationOvertheTermsof
theSeptemberAgreements ........................................................1181
(b)ThereIsInsufficientEvidencetoSupportaColorableClaim
ThattheSeptemberAgreementsAreInvalidforLackof
Consideration ......................................................................................1183
(c)ThereisSufficientEvidencetoSupporttheExistenceofa
Technical,ButNotColorable,ClaimThattheSeptember
AgreementsAreInvalidforLackofAuthority ..............................1186
(i) TonucciMayHaveActedWithApparentAuthority.............1190
(ii) ThereIsSubstantialEvidenceThatLehmanRatifiedthe
SeptemberAgreements ...............................................................1193
(d)ThereIsInsufficientEvidencetoSupportaColorableClaim
ThatJPMorganFraudulentlyInducedtheSeptember
Agreements ..........................................................................................1198
(e) ThereIsInsufficientEvidencetoSupportaColorableClaim
forBreachofContractoftheSeptemberAgreementsBased
onJPMorgansRefusaltoReturnCollateral ...................................1200
(i) LegalBackground:ContractualObligationsUnder
SeptemberAgreements ...............................................................1200
(ii) ThereWasNoWrittenNoticeforCollateralReturn ..............1208
(f) ThereIsEvidencetoSupportaColorable,ButNotStrong,
ClaimThatJPMorganBreachedtheImpliedCovenantof
GoodFaithandFairDealingbyDemandingExcessive
CollateralinSeptember2008.............................................................1210
(i) LegalStandardsGoverningImpliedCovenantofGood
FaithandFairDealing.................................................................1211
(ii) ThereIsSufficientEvidenceToSupportaColorable,But
NotaStrong,ClaimThatJPMorganViolatedtheImplied
CovenantbyDemandingExcessiveCollateral .......................1214
(iii)ATrierofFactWillLikelyHavetoResolveaWaiver
Defense ..........................................................................................1220
c) LehmansDealingsWithCitigroup..............................................................1224

xviii

(1)Facts.............................................................................................................1224
(a)CitigroupProvidedContinuousLinkedSettlementService
andOtherClearingandSettlementOperationstoLehman .........1224
(i) BackgroundInformationontheContinuousLinked
SettlementServiceCitiProvidedtoLehman...........................1224
(ii) OtherClearingandSettlementServicesThatCiti
ProvidedtoLehman....................................................................1227
(iii)CitisClearingandSettlementExposuretoLehman,
Generally .......................................................................................1229
(iv)TheTermsofLehmansCLSAgreementwithCiti .................1231
(b)LehmanProvideda$2BillionCashDepositwithCition
June12,2008ToSupportitsClearingNeeds..................................1233
(i) TheMarketEnvironmentandOtherCircumstances
SurroundingCitisRequestforthe$2BillionCash
DepositonJune12 .......................................................................1235
(ii) ThePartiesDidNotSharetheSameUnderstandingof
theTermsofthe$2BillionCashDeposit .................................1242
a. WhatLehmanUnderstoodtheTermsoftheDeposit
ToBe..........................................................................................1243
b. WhatCitiUnderstoodtheTermsoftheDepositToBe.....1245
c. TheExactTermsoftheComfortDepositAre
UnknownBecausetheTermsWereNotReducedto
Writing......................................................................................1250
(iii)CitiKnewtheComfortDepositwasIncludedin
LehmansLiquidityPool ............................................................1250
(c) CollateralPledgeDiscussionsBetweenLehmanandCiti
BeganinJune2008andContinuedUntilSeptember2008 ...........1251
(i) TheUnexecutedPledgeAgreement:thePartiesAgreed
toNegotiatetheTermsbutNotExecutetheAgreement
UntilItWasNeeded ....................................................................1251
(ii) CitiHadDifficultyPricingtheCollateralOfferedby
LehmanasaSubstitutefortheCashDeposit ..........................1254
(iii)TheGuarantyAmendmentWasSignedinaFireDrill
onSeptember9,2008...................................................................1261
a. EventsPriortotheSigningoftheSeptember9
GuarantyAmendmentfromCitisPerspective ..................1263

xix

b. EventsPriortotheSigningoftheSeptember9
GuarantyAmendmentfromLehmansPerspective..........1265
c. NegotiationsBetweenLehmanandCitiPersonnel
RegardingWhichLehmanEntitiesWereToBeAdded
totheParentGuarantybytheSeptember9Guaranty
Amendment .............................................................................1268
(iv)September12,2008:ALehmanCollateralAccountatCiti
wasActivatedAfterTwoMonthsofDiscussion,and
LehmanSignedanAmendmenttotheDirectCustodial
ServicesAgreement .....................................................................1273
(d)LehmansClearingEnvironmentatCitiDuringtheWeekof
September8,2008................................................................................1276
(i) CitiRequiredLehmanToOperateUnderLower
DaylightOverdraftLimits ..........................................................1276
(ii) LehmanDepositedAmountsinExcessofthe$2Billion
DepositatVariousTimesin2008WithCiti.............................1279
(iii)CitiEndeavoredToHelpLehmaninSeptember2008,
PriortotheBankruptcyFiling ...................................................1281
(iv)LehmansAccountsatCitiClosedonFridaySeptember
12WithFundsinExcessofthe$2BillionDeposit..................1284
(e) CitisParticipationinLehmanWeekendEvents........................1285
(f) CitisActionsTowardLehmanAfterLehmanFiledfor
BankruptcyProtection........................................................................1287
(i) CitiContinuedtoProvideCLSServicesforLehman,But
NotinanEntirelyUninterruptedManner...............................1287
(ii) PriortoLehmansBankruptcyFiling,CitiSetOffa
PortionoftheCashDeposit .......................................................1290
(2)AnalysisofPotentialColorableClaims .................................................1291
(a)ValidityoftheSeptember9GuarantyAmendment......................1291
(i) EconomicDuress..........................................................................1291
a. LegalFramework ....................................................................1292
b. TheEvidenceDoesNotSupporttheExistenceofa
ColorableClaimAgainstCitiforEconomicDuress ..........1293
(ii) TheFailureofConsideration......................................................1297
a. LegalFramework ....................................................................1298

xx

b. TheEvidenceDoesNotSupporttheExistenceofa
ColorableClaimAgainstCitiforFailureof
Consideration ..........................................................................1298
(b)BreachoftheDutyofGoodFaithandFairDealingin
ConnectionWiththeCLSServicesAgreement ..............................1300
(i) TheEvidenceDoesNotSupporttheExistenceofa
ColorableClaimAgainstCitiforBreachoftheDutyof
GoodFaithandFairDealinginConnectionWiththe
CLSServicesAgreement.............................................................1301
d) LehmansDealingsWithHSBC ....................................................................1303
(1)OverviewofHSBCsRelationshipWithLehman ................................1305
(a)HSBCProvidedCRESTClearingandSettlementServicesto
Lehman .................................................................................................1306
(b)OverviewoftheOperativeAgreements..........................................1309
(2)TheExaminersInvestigationofParticularTransactions ...................1311
(a)HSBCCancelleda$1BillionIntradayCreditFacility ...................1311
(b)LehmanMaintaineda$1BillionSegregatedDepositwith
HSBC.....................................................................................................1312
(c) LehmanDeposited$750MillionwithHSBConJune24...............1314
(d)LehmanCommitted$25MilliononAugust15toHSBCs
SyndicatedLendingFacility ..............................................................1315
(e) LehmanPledged$6MilliontoHSBCasCollateralforLetters
ofCredit................................................................................................1317
(f) OtherSignificantExposures ..............................................................1318
(3)HSBCRequiredLehmantoProvideApproximately$1Billionin
CollateralWhileQuietlyEndingTheirRelationship...........................1319
(a)HSBCDeterminedtoEndItsRelationshipwithLehman.............1319
(b)HSBCDemandedCollateralforIntradayCredit ...........................1322
(c) HSBCAgreedToAccommodateLehmanatQuarterEnd ...........1325
(d)LehmanDepositedtheCashCollateralWithHSBC......................1326
(e) LehmanNegotiatedNewTermsandExecutedtheCash
Deeds ....................................................................................................1327
(i) LehmanSecuredConcessionsintheU.K.CashDeeds..........1327
(ii) LehmanExecutedtheHongKongCashDeedLateon
September12 ................................................................................1329

xxi

(f) HSBCandLBHIStipulatedToSetoffandReturnSomeofthe
FundsCoveredbytheU.K.CashDeeds .........................................1332
(4)OtherIssuesStemmingfromHSBCsCollateralDemand..................1333
(a)LehmanIncludedtheDepositsCoveredbytheCashDeeds
inItsReportedLiquidityPool...........................................................1333
(b)HSBCConsideredWithholdingPaymentsorRequiring
PrefundingofTradesintheAsiaPacificRegionPriorto
LehmansBankruptcy ........................................................................1336
(5)TheEvidenceDoesNotSupporttheExistenceofColorable
ClaimsArisingFromHSBCsDemandThatLehmanProvide
CashCollateralandExecuteCashDeedsinOrderforHSBCto
ContinueProvidingClearingandSettlementServices .......................1336
(a)TheParametersoftheExaminersAnalysis....................................1336
(b)TheFactsProvideLittletoNoSupportforInvalidatingthe
U.K.CashDeeds..................................................................................1339
(i) AnalyticalFramework ................................................................1339
a. EnglishLawGovernsContractClaimsArisingfrom
theU.K.CashDeeds ...............................................................1339
b. EnglishContractLawTreatsDeedsDifferentlyfrom
OtherContracts .......................................................................1340
(ii) TheEvidenceDoesNotSupporttheExistenceofa
ColorableClaimThattheU.K.CashDeedsAreInvalid
forWantofConsideration ..........................................................1341
(iii)TheEvidenceDoesNotSupporttheExistenceofa
ColorableClaimforEconomicDuressBecausethe
CRESTAgreementAllowedHSBCToCeaseClearing
andSettlementatItsAbsoluteDiscretion................................1343
a. ElementsofEconomicDuress...............................................1343
b. ApplicationtoLehmanFacts ................................................1344
c. OtherTransactionsDoNotGiveRisetoEconomic
DuressClaims..........................................................................1346
(iv)TheEvidenceDoesNotSupporttheExistenceofa
ColorableClaimthatHSBCViolatedaDutyofGood
FaithandFairDealingbyDemandingCashCollateral .........1348
a. EnglishLawDoesNotRecognizeaPrincipleofGood
FaithandFairDealingofGeneralApplication ..................1349

xxii

b. ApplicationtoLehmanFacts ................................................1349
(v) TheEvidenceDoesNotSupporttheExistenceofa
ColorableClaimthatHSBCViolatedtheNotice
ProvisionoftheCRESTAgreement ..........................................1352
a. ConstructionofTerms............................................................1352
b. ApplicationtoLehmanFacts ................................................1353
(vi)TheCashDeedsWereNotContractsofAdhesionor
StandardFormContracts............................................................1355
a. CharacteristicsofStandardFormContractsor
ContractsofAdhesion............................................................1355
b. ApplicationtoLehmanFacts ................................................1355
(c) OtherPotentialTheoriesofLiability................................................1357
(i) EnglishLawGovernstheRemainingPotentialClaims
EvenThoughTheyAreNotCoveredbytheChoiceof
LawProvisionoftheCashDeeds..............................................1357
a. AnalyticalFramework............................................................1357
b. ApplicationtoRemainingPotentialClaims........................1359
(ii) TheEvidenceDoesNotSupportTheExistenceOfa
ColorableClaimForUnjustEnrichmentBecause
LehmanConveyedaBenefitonHSBCPursuantto
LehmansValidContractualObligations.................................1360
a. ElementsofUnjustEnrichment ............................................1361
b. ApplicationtoLehmanFacts ................................................1362
(iii)TheEvidenceDoesNotSupportaColorableClaimThat
HSBCBreachedaFiduciaryDutytoLehmanBecause
HSBCandLehmanWereSophisticatedPartiesina
RelationshipGovernedbyanAgreementThatLimited
HSBCsObligations .....................................................................1363
a. ElementsofBreachofFiduciaryDutyand
Misappropriation ....................................................................1364
b. ApplicationtoLehmanFacts ................................................1365
(iv)TheEvidenceDoesNotSupportaColorableClaimthat
HSBCsDemandforCollateralTortiouslyInterfered
WithLehmansOtherBusinessorContractsBecause
HSBCWasActingToProtectItsOwnEconomic
Interests .........................................................................................1367

xxiii

a. ElementsofTortiousInterference ........................................1368
b. ApplicationtoLehmanFacts ................................................1369
(v) TheEvidenceDoesNotSupportaFindingthatHSBC
FraudulentlyorNegligentlyMisrepresentedItsPlanto
Withdraw ......................................................................................1371
a. ElementsofFraudandMisrepresentation ..........................1371
b. ApplicationtoLehmanFacts ................................................1373
e) LehmansDealingsWithBankofAmerica .................................................1375
f) LehmansDealingswithBankofNewYorkMellon .................................1376
(1)BNYMDemandsandReceivesaCollateralDeposit ...........................1377
(2)TheDepositIsSignificantBecauseofInternalLehmanConcerns
AboutIncludingItinItsPool..................................................................1379
g) LehmansDealingsWithStandardBank.....................................................1382
h) LehmansDealingsWiththeFederalReserveBankofNewYork ..........1385
(1)TheFRBNYSupervisesDepositTakingInstitutionsandAssists
inManagingMonetaryPolicy,butLacksAuthorityToRegulate
InvestmentBankHoldingCompanies...................................................1385
(2)InResponsetotheBearStearnsNearCollapse,theFRBNY
CreatedaVarietyofFacilitiesToBackstoptheLiquidityof
BrokerDealers;Lehman,InTurn,DrewonTheseFacilities..............1387
(a)ThePrimaryDealerCreditFacility ..................................................1387
(b)TheMarketGreetedtheCreationofthePDCFasaPositive
StepTowardBackstoppingBrokerDealerLiquidity,andas
ShoringUpLehmansLiquidity .......................................................1390
(c) InAdditiontoaLiquidityBackstop,LehmanViewedthe
PDCFasanOutletforItsIlliquidPositions ....................................1392
(d)LehmanWasReluctanttoDrawonthePDCFBecauseofa
PerceivedStigmaAttachedtoBorrowingfromtheFacility .....1396
(e) LehmanAccessedthePDCFTenTimesin2008;Lehmans
UseofthePDCFWasConcentratedinPeriodsImmediately
AftertheBearStearnsNearCollapse,andImmediatelyAfter
LBHIFiledforBankruptcy ................................................................1398
(3)OtherFRBNYLiquidityFacilities ...........................................................1400
(a)TheTermSecuredLendingFacility .................................................1400
(b)OpenMarketsOperations..................................................................1401
i) LehmansLiquidityPool................................................................................1401

xxiv

(1)IntroductionandExecutiveSummary...................................................1401
(2)TheImportanceofLiquiditytoBrokerDealersandInvestment
BankHoldingCompaniesGenerally .....................................................1406
(3)LehmansLiquidityPool..........................................................................1408
(a)ThePurposeandCompositionofLehmansLiquidityPool ........1408
(b)LehmanTestedItsLiquidityPoolandSharedtheResultsof
TheseTestswithRatingAgencies ....................................................1413
(c) MarketParticipantsFormedFavorableOpinionsof
LehmansLiquidityontheBasisofLehmans
RepresentationsAboutItsLiquidityPool .......................................1415
(4)LehmansClearingBanksSoughtCollateralPledgesandCash
DepositsToSecureIntradayCreditRisk;LehmanIncludedThis
CollateralinItsLiquidityPool................................................................1417
(a)LehmanPledgedCLOsandOtherSecuritiestoJPMorgan
ThroughouttheSummerof2008toMeetTripartyRepo
MarginRequirements.........................................................................1417
(b)TheSecuritiesPostedtoMeetJPMorgansMargin
RequirementsWereIncludedinLehmansLiquidityPool ..........1422
(c) OnJune12,2008,LehmanTransferred$2BilliontoCitias
ComfortforContinuingCLSSettlement .....................................1424
(d)TheCitiComfortDepositWasIncludedinLehmans
LiquidityPool ......................................................................................1430
(e) OnAugust25,2008,LehmanExecutedaSecurityAgreement
withBankofAmerica,GrantingtheBankaSecurityInterest
ina$500MillionDeposit ...................................................................1433
(f) LBHIandJPMorganExecutedanAmendmenttotheJune
2000ClearanceAgreement,aSecurityAgreementanda
HoldingCompanyGuaranty,allDatedAugust26,2008 .............1436
(g)LehmanAssetsSubjecttotheAugustSecurityAgreement
WereIncludedinLehmansLiquidityPool ....................................1439
(h)September2,2008:LehmanTransferredJustUnder$1Billion
toHSBCtoContinueClearingOperations,andEncumbered
ThiswithCashDeedsExecutedonSeptember9and
September12........................................................................................1441
(i) TheHSBCDepositWasRepresentedasLiquidandWas
IncludedinLBHIsLiquidityPool ...................................................1446

xxv

(j) LehmanandJPMorganExecutedAnotherRoundofSecurity
DocumentationDatedSeptember9,2008;LehmanMade$3.6
Billionand$5BillionPledgestoJPMorganSubjecttothe
TermsofTheseAgreements ..............................................................1446
(k)LehmanMadeaDeposittoBankofNewYorkMellonto
CoverIntradayExposure,andIncludedThatDepositinIts
LiquidityPool ......................................................................................1448
(l) TheCumulativeImpactofLehmansInclusionofClearing
BankCollateralandDepositsinItsLiquidityPool........................1450
(5)DisclosuresConcerningtheInclusionofClearingBank
CollateralinLehmansLiquidityPool...................................................1454
(a)LehmanDidNotDiscloseonItsJune16,2008Second
QuarterEarningsCallThatItWasIncludingthe$2Billion
CitiComfortDepositinItsLiquidityPool ..................................1454
(b)LehmanDidNotDiscloseinItsSecondQuarter200810Q,
FiledJuly10,2008,ThatItWasIncludingBoththe$2Billion
CitibankComfortDepositandApproximately$5.5Billion
ofSecuritiesCollateralPledgedtoJPMorganinItsLiquidity
Pool........................................................................................................1455
(c) LehmanDidNotDiscloseOnItsSeptember10,2008
EarningsCallThataSubstantialPortionofItsLiquidityPool
WasEncumberedbyClearingBankPledges .................................1457
(d)SeniorExecutivesDidNotDisclosetotheBoardofDirectors
attheSeptember9,2008FinanceCommitteeMeetingthe
FactThataSubstantialPortionofItsLiquidityPoolWas
EncumberedbyClearingBankPledges ..........................................1460
(e) LehmanOfficersDidNotDisclosetotheBoardofDirectors
ThatItsLiquidityPositionWasSubstantiallyImpairedby
CollateralHeldatClearingBanksUntiltheEveningof
September14,2008..............................................................................1464
(f) LowittsViewsonIncludingClearingBankCollateralinthe
LiquidityPool ......................................................................................1466
(6)RatingAgenciesWereUnawareThatLehmanWasIncluding
ClearingBankCollateralinItsLiquidityPool .....................................1467
(a)Fitch.......................................................................................................1467
(b)Standard&Poors ...............................................................................1468
(c) Moodys................................................................................................1469

xxvi

(7)TheFRBNYDidNotViewtheClearingBankCollateralinthe
LiquidityPoolasUnencumbered.......................................................1469
(8)TheSEC,LehmansPrimaryRegulator,WasUnawareofthe
ExtenttoWhichLehmanWasIncludingClearingBank
CollateralinItsLiquidityPool;totheExtentItWasAware,the
SECDidNotViewThisPracticeasProper ...........................................1472
(9)CertainLehmanCounselWereAwareThatAgreementswithIts
ClearingBanksWereStructuredtoIncludeClearingBank
CollateralinItsLiquidityPool,butDisclaimedKnowledge
ConcerningWhatAssetsWereAppropriateorInappropriatefor
theLiquidityPool .....................................................................................1476
(10)LehmansAuditorsMonitoredLehmansLiquidityPool,but
ViewedtheCompositionofthePoolasaRegulatoryIssue...............1478
(11)ThereIsInsufficientEvidenceToSupportaDetermination
ThatAnyOfficerorDirectorBreachedaFiduciaryDutyin
ConnectionWiththePublicDisclosureofLehmansLiquidity
Pool..............................................................................................................1479

VOLUME4(CONT.)

SectionIII.A.6:Government

6. TheInteractionBetweenLehmanandtheGovernment .................................1482
a) Introduction .....................................................................................................1482
b) TheSECsOversightofLehman ...................................................................1484
(1)TheCSEProgram ......................................................................................1484
(2)LehmansParticipationintheCSEProgram ........................................1487
(3)TheSEC/OIGFindings .............................................................................1490
(4)TheViewFromtheTop ...........................................................................1492
c) TheFRBNYsOversightofLehman .............................................................1494
d) TheFederalReservesOversightofLehman ..............................................1502
e) TheTreasuryDepartmentsOversightofLehman ....................................1505
f) TheRelationshipoftheSECandFRBNYinMonitoringLehmans
Liquidity ...........................................................................................................1507
(1)TheSECPerformedOnlyLimitedMonitoringofLehmans
LiquidityPool ............................................................................................1508

xxvii

(2)TheSECandFRBNYDidNotAlwaysShareInformationAbout
Lehman .......................................................................................................1511
g) TheGovernmentsPreparationfortheLehmanWeekend
MeetingsattheFRBNY ..................................................................................1516
h) OntheEveningofFriday,September12,2008,theGovernment
ConvenedaMeetingoftheMajorWallStreetFirmsinanAttempt
toFacilitatetheRescueofLehman ...............................................................1523
i) LehmansBankruptcyFiling .........................................................................1535

VOLUME5

SectionIII.B:AvoidanceActions

B. AreThereAdministrativeClaimsorColorableClaimsforPreferencesor
VoidableTransfers ......................................................................................................1544
1. ExecutiveSummary..............................................................................................1544
2. ExaminersInvestigationofPossibleAdministrativeClaimsAgainst
LBHI(FirstBullet) .................................................................................................1546
a) Summary ..........................................................................................................1546
b) Introduction .....................................................................................................1547
c) LehmansCashManagementSystem ..........................................................1549
(1)LBHIsRoleasCentralBanker................................................................1550
(2)GlobalCashandCollateralManagement .............................................1551
(3)LehmansExternalandVirtualBankAccounts....................................1554
(4)BankAccountReconciliations.................................................................1560
d) EffectoftheBankruptcyontheCashManagementSystem.....................1562
e) CashTransfersGivingRisetoAdministrativeClaims..............................1564
(1)CashTransfersfromLBHIAffiliatestoLBHI.......................................1565
(2)CashReceivedbyLBHIonBehalfofLBHIAffiliates..........................1566
(3)OtherRelevantTransactions ...................................................................1568
3. ExaminersInvestigationofPossibleAvoidanceActions(Third,Fourth
andEighthBullets)................................................................................................1570
a) Summary ..........................................................................................................1570
b) LBHISolvencyAnalysis.................................................................................1570
(1)Introduction ...............................................................................................1570
(2)MarketBasedValuationAnalysis ..........................................................1573

xxviii

(a)BasisforUtilizationofaMarketBasedValuationAnalysis.........1573
(b)MarketValueofAssetsApproach....................................................1577
(i) ImpliedAssetValue ....................................................................1578
(ii) SmallEquityCushion..................................................................1580
(iii)LimitationsoftheMarketBasedApproach.............................1581
a. ApplicationofRetrojection....................................................1583
b. TheApplicationofCurrentAwareness...........................1584
(3)Conclusion .................................................................................................1587
c) LBHIAffiliateSolvencyAnalysis .................................................................1587
(1)Summary ....................................................................................................1587
(2)DescriptionoftheExaminersAnalysis.................................................1595
(3)DebtorbyDebtorAnalysis .....................................................................1610
(a)LehmanCommercialPaperInc.........................................................1610
(b)CESAviation,CESAviationVLLC,CESAviationIX ..................1615
(c) LBSpecialFinancing...........................................................................1618
(d)LBCommodityServices.....................................................................1622
(e) LuxembourgResidentialPropertiesLoanFinanceS.A.R.L..........1627
(f) LBOTCDerivatives............................................................................1628
(g)LB745LLC...........................................................................................1629
(h)LBDerivativeProducts ......................................................................1631
(i) LBFinancialProducts.........................................................................1633
(j) LBCommercialCorporation .............................................................1635
(k)BNCMortgageLLC ............................................................................1638
(l) EastDoverLimited .............................................................................1638
(m)LehmanScottishFinance ..................................................................1640
(n)PAMIStatlerArms..............................................................................1641
d) UnreasonablySmallCapital ..........................................................................1642
(1)Summary ....................................................................................................1645
(2)AnalysisoftheUnreasonablySmallCapitalTest ............................1648
(a)SummaryofLegalStandard..............................................................1648
(b)LehmansCountercyclicalStrategy..................................................1650
(c) LehmansRepoBookandLiquidityRisk........................................1654
(i) BearStearnsDemonstratestheLiquidityRiskAssociated
WithRepoFinancing...................................................................1656

xxix

(ii) QualityandTenorofLehmansRepoBook.............................1658
(d)DeleveragingtoWinBackMarketConfidence ..........................1662
(e) BeginningintheThirdQuarterof2008,LehmanCouldHave
ReasonablyAnticipatedaLossofConfidenceWhichWould
HaveTriggeredItsLiquidityRisk....................................................1665
(f) LehmanWasNotSufficientlyPreparedtoAbsorba
LiquidityCrisisMarkedbyaSuddenLossofNon
Government,NonAgencyRepoFunding ......................................1674
(i) LehmansLiquidityPool ............................................................1675
(ii) LiquidityStressTests ..................................................................1678
(iii)OtherCapitalAdequacyMetrics...............................................1687
a. CashCapitalSurplus ..............................................................1687
b. EquityAdequacyFramework ...............................................1688
c. CSECapitalRatio ....................................................................1690
(g)LBHIAffiliateUnreasonablySmallCapitalAnalysis................1692
e) InsiderPreferencesAgainstLBHI(ThirdBullet) .......................................1694
(1)Summary ....................................................................................................1694
(2)LegalSummary .........................................................................................1696
(3)SourcesofPotentialPreferentialActivity..............................................1698
(4)DeterminationsandAssumptionsonSection547(b)Elements .........1705
(5)ScopeofDefensesUnderSection547(c) ................................................1710
(6)FindingsforLBSF......................................................................................1713
(7)FindingsforLBCS .....................................................................................1718
(8)FindingsforLCPI......................................................................................1722
f) PreferencesAgainstNonLBHILehmanAffiliates(FourthBullet).........1730
g) AvoidanceAnalysisofLBHIandLBHIAffiliatesAgainstFinancial
ParticipantsandPreChapter11Lenders(FourthandEighth
Bullets) ..............................................................................................................1731
(1)Summary ....................................................................................................1731
(2)APBAnalysis .............................................................................................1734
(3)CashDisbursementAnalysis ..................................................................1737
(4)PledgedCollateralAccountsAnalysis...................................................1738
(5)AvoidanceAnalysisforCertainPreChapter11Lendersand
FinancialParticipants ...............................................................................1739
(a)JPMorganAvoidanceAnalysis .........................................................1739

xxx

(i) Background...................................................................................1739
(ii) AvoidabilityoftheSeptemberAgreementsand
TransfersinConnectionwiththeSeptemberAgreements....1742
a. AvoidabilityoftheSeptemberGuarantyasa
ConstructiveFraudulentObligation ....................................1743
1. ThereIsEvidenceToSupportAFindingThat
LBHIIncurredanObligationWithinthe
ApplicableLookBackPeriodsWhenitExecuted
theSeptemberGuaranty ..................................................1743
2. ThereIsEvidenceToSupportAFindingThat
LBHIReceivedLessThanReasonablyEquivalent
ValueorDidNotReceiveFairConsiderationin
ExchangeforGrantingJPMorgantheSeptember
Guaranty.............................................................................1744
3. InsolvencyasofSeptember10,2008 ..............................1757
4. UndercapitalizationasofSeptember10,2008 ..............1758
b. DefensestoAvoidabilityoftheSeptemberGuaranty.......1758
1. ApplicabilityoftheGoodFaithDefenseofSection
548(c)oftheBankruptcyCodeandSection279of
theN.Y.DebtorCreditorLawtotheSeptember
Guaranty.............................................................................1758
2. ApplicabilityoftheSafeHarborProvisionstothe
SeptemberGuaranty.........................................................1762
c. AvoidabilityofTransfersofCollateralinConnection
withtheSeptemberGuaranty ...............................................1767
1. LBHIsCollateralTransfersandPostPetition
Setoffs..................................................................................1767
2. ApplicationOfTheSafeHarborsToThe$8.6
BillionCashCollateralTransfers ....................................1776
3. ThereIsEvidenceToSupportPotentialStateLaw
ClaimsAvailabletoLBHIPursuanttoSection541
toAvoidtheTransfersInConnectionwiththe
SeptemberGuaranty.........................................................1781
4. TotheExtenttheSeptemberGuarantyProvided
foraGuarantyofNonProtectedContract
Obligations,OrtotheExtentJPMorgan
LiquidatedCollateralPursuanttoNonProtected

xxxi

ContractExposure,aColorableBasisExiststhat
theSafeHarborProvisionsarenotApplicable ............1787
(iii)AvoidabilityoftheAugustAgreementsandTransfersin
ConnectionwiththeAugustAgreements................................1794
a. AvoidabilityoftheAugustGuarantyasa
ConstructiveFraudulentObligation ....................................1794
1. LBHIIncurredanObligationWithinthe
ApplicableLookBackPeriodsWhenitExecuted
theAugustGuaranty........................................................1794
2. ThereIsEvidenceThatLBHIReceivedLessThan
ReasonablyEquivalentValueorDidNotReceive
FairConsiderationinExchangeforGranting
JPMorgantheAugustGuaranty .....................................1795
3. InsolvencyasofAugust29,2008....................................1797
4. UndercapitalizationandInabilitytoPayDebtsas
TheyComeDueasofAugust29,2008 ..........................1797
b. DefensestoAvoidabilityoftheAugustGuaranty.............1797
c. AvoidabilityofTransfersofCollateralinConnection
WiththeAugustGuaranty ....................................................1798
(iv)AvoidabilityoftheAugustandtheSeptemberSecurity
AgreementsAndCollateralTransfersPursuantto
Section548(a)(1)(A) .....................................................................1801
(v) AvoidabilityoftheTransfersofCollateralinConnection
withtheSeptemberGuarantyPursuanttoSection547(b)
oftheBankruptcyCode ..............................................................1806
(vi)AvoidabilityofObligationsofLBHItoFundsManaged
byJPMorgan .................................................................................1813
(b)CitiAvoidanceAnalysis ....................................................................1817
(i) Background...................................................................................1817
(ii) Avoidabilityofthe$2BillionDeposit ......................................1821
(iii)AvoidabilityoftheAmendedGuaranty ..................................1821
(iv)Avoidabilityofthe$500MillionTransferFromanLBHI
AccounttoanLBIAccount ........................................................1827
(c) FRBNYAvoidanceAnalysis..............................................................1829
(d)HSBCAvoidanceAnalysis ................................................................1830
(i) Background...................................................................................1830

xxxii

(ii) TheU.K.CashDeedTransactions.............................................1832
(iii)TheHongKongCashDepositTransactions............................1833
(iv)September9,2009Stipulation ....................................................1834
(v) AvoidabilityoftheJanuary4,2008Guaranty .........................1835
(vi)AvoidabilityoftheHongKongCashDeedTransactions......1836
(vii)AvoidabilityoftheU.K.CashDeed.........................................1836
(viii)AvoidabilityoftheTransferoftheRemaining
Collateral .......................................................................................1837
(e) StandardBankAvoidanceAnalysis.................................................1837
(f) BNYMAvoidanceAnalysis...............................................................1839
(g)BofAAvoidanceAnalysis..................................................................1840
(h)CMEAvoidanceAnalysis..................................................................1841
(i) Summary.......................................................................................1841
(ii) Background...................................................................................1843
a. EnergyDerivatives .................................................................1851
b. FXDerivatives .........................................................................1852
c. InterestRateDerivatives........................................................1852
d. EquityDerivatives ..................................................................1853
e. AgriculturalDerivatives ........................................................1854
(iii)DefensestoAvoidabilityofClaims...........................................1855
a. ApplicabilityofCEAPreemption.........................................1855
b. ApplicabilityofSelfRegulatoryOrganization
Immunity..................................................................................1862
c. ApplicabilityoftheSafeHarborProvisionsofthe
BankruptcyCode ....................................................................1870
h) AvoidanceAnalysisofLBHIAffiliatePaymentstoInsider
Employees(FourthBullet) .............................................................................1871
(1)Summary ....................................................................................................1871
(2)Methodology..............................................................................................1873
(3)ApplicableLegalStandards.....................................................................1874
(4)Findings ......................................................................................................1882
(a)LBHIAffiliateSeverancePayments .................................................1882
(b)LBHIAffiliateBonusPayments ........................................................1887
(c)LBHIsAssumptionsofLimitedPartnershipInterests ..................1889

xxxiii

4. ExaminersInvestigationofPossibleBreachesofFiduciaryDutyby
LBHIAffiliateDirectorsandOfficers(FifthBullet) .........................................1894
a) FiduciaryDutyStandardforaWhollyOwnedAffiliateSubsidiary
underDelawareLaw ......................................................................................1896
b) FiduciaryDutyStandardforaWhollyOwnedAffiliateSubsidiary
underNewYorkLaw.....................................................................................1902
(1)LCPIsBackgroundandOfficersandDirectors ..................................1905
(a)DutyofCare.........................................................................................1907
(b)DutytoMonitor ..................................................................................1909
c) BreachofFiduciaryDutyforAidingorAbettingUnderDelaware
Law....................................................................................................................1911
5. ExaminersAnalysisofLehmansForeignExchangeTransactions
(SecondBullet).......................................................................................................1912
a) Summary ..........................................................................................................1912
b) ForeignExchangeatLehman ........................................................................1913
c) ForeignExchangeTransactionsDuringtheStubPeriod ..........................1923
6. ExaminersReviewofIntercompanyTransactionsWithinThirtyDays
ofLBHIsBankruptcyFiling(SeventhBullet) ..................................................1938
a) Summary ..........................................................................................................1938
b) Discussion ........................................................................................................1939
c) Analysis ............................................................................................................1942
d) AnalysisofOverallNetIntercompanyDataforthe2007and2008
PeriodsofAnalysis .........................................................................................1942
(1)LBHI ............................................................................................................1942
(2)LBIE.............................................................................................................1945
(3)LBSF ............................................................................................................1947
e) AnalysisofNetDailyIntercompanyDataforthe2007and2008
PeriodsofAnalysis .........................................................................................1949
7. ExaminersAnalysisofLehmansDebttoFreddieMac .................................1951

xxxiv

VOLUME5(CONT.)

SectionIII.C:BarclaysTransaction

C. DoColorableClaimsAriseFromTransfersofLBHIAffiliateAssetsto
Barclays,orFromtheLehmanALITransaction?...................................................1961
1. ExecutiveSummary..............................................................................................1961
a) PurposeofInvestigation ................................................................................1961
(1)BarclaysSaleTransaction.........................................................................1961
(2)LehmanALITransaction .........................................................................1963
b) SummaryofConclusions...............................................................................1963
(1)BarclaysTransaction.................................................................................1963
(2)LehmanALITransaction .........................................................................1965
2. Facts.........................................................................................................................1965
a) LehmanBusinessesandAssets.....................................................................1965
(1)LBHIAffiliateOperatingCompanies ....................................................1970
(a)LBCS......................................................................................................1970
(b)LBCC .....................................................................................................1972
(c) LCPI ......................................................................................................1975
(d)LBSF ......................................................................................................1978
(e) LOTC.....................................................................................................1980
(f) LBDPandLBFP...................................................................................1981
(g)LBF ........................................................................................................1984
(h)BNC .......................................................................................................1986
(2)LBHIAffiliateSinglePurposeEntities...................................................1987
(a)LB745....................................................................................................1987
(b)CESAviationEntities .........................................................................1987
(c) PAMIStatler ........................................................................................1988
(d)EastDover ............................................................................................1988
(e) ScottishFinance ...................................................................................1989
(f) LuxembourgS.A.R.L. .........................................................................1989
(g)Navigator .............................................................................................1990
(3)SaleTransaction.........................................................................................1991
3. WhetherAssetsofLBHIAffiliatesWereTransferredtoBarclays.................1997
a) AnalysisofSecuritiesTransferredtoBarclays ...........................................1998

xxxv

(1)SecuritiesTransferredtoBarclays ..........................................................1999
(a)LehmansSecuritiesTradingRecordsandSystems ......................2005
(i) General ..........................................................................................2005
(ii) GFSSystemAssessment .............................................................2008
a. ComparisonofGFSDatatoLehmans10QFilings ..........2009
b. ComparisonofGFSDatatoLehmansGeneralLedger ....2009
c. ReliabilityofSeptember12Data...........................................2010
(iii)GFSDataExtractedbyExaminer ..............................................2010
(2)AnalysisofGFSData................................................................................2012
(a)CUSIPsNotAssociatedWithLBHIAffiliateEntities....................2014
(b)CUSIPsAssociatedSolelyWithanLBHIAffiliateEntity .............2015
(c) CUSIPsAssociatedWithBothLBIandLBHIAffiliate
Entities ..................................................................................................2016
(i) CUSIPsAssociatedWithSubordinatedEntities .....................2016
(ii) SecuritiesFinancingTransactions .............................................2021
(iii)AlternativeAnalyses ...................................................................2024
(d)817CUSIPsWithNoGFSData .........................................................2025
(i) September19,2008GFSDataset................................................2026
(ii) SearchbyISINNumberandProductID..................................2027
(iii)TMSSourceSystem .....................................................................2027
(iv)AdditionalDataSources .............................................................2028
b) AnalysisofTangibleAssetTransfers...........................................................2030
(1)LB745..........................................................................................................2033
(2)LBCS............................................................................................................2035
(3)LCPI ............................................................................................................2036
(4)LBSF ............................................................................................................2038
(5)CES ..............................................................................................................2039
(6)CESV ..........................................................................................................2041
(7)CESIX .........................................................................................................2042
c) AnalysisofIntangibleAssetTransfers ........................................................2044
(1)CustomerInformationAssets .................................................................2045
(2)ProprietarySoftware ................................................................................2051
(3)AssembledWorkforce ..............................................................................2054
4. LehmanALITransaction .....................................................................................2055

xxxvi

5. Conclusions............................................................................................................2063
a) Summary ..........................................................................................................2063
b) ColorableClaimsArisingfromTransferofLBHIAssets..........................2064
(1)ThereAreNoColorableClaimsAgainstBarclaysArisingfrom
TransferofLBHIAffiliateSecurities ......................................................2064
(2)ThereAreColorable,LimitedClaimsAgainstBarclaysArising
fromTransferofLBHIAffiliateOfficeEquipmentandLBCS
CustomerInformation..............................................................................2076
(a)BankruptcyCodeClaims ...................................................................2077
(i) Section542.....................................................................................2077
(ii) Section548.....................................................................................2081
(b)CommonLawClaims.........................................................................2083
(i) RecoveryofChattel .....................................................................2083
(ii) Conversion....................................................................................2086
(iii)UnjustEnrichment.......................................................................2088
(iv)TradeSecretMisappropriation ..................................................2090
(v) UnfairCompetition .....................................................................2092
(vi)TortiousInterferenceWithEmploymentRelations................2094
(3)ClaimsAgainstLBHIAffiliateOfficersandDirectors ........................2096
(a)DutyofCare.........................................................................................2098
(b)DutyofGoodFaith .............................................................................2100
(c) DutytoMonitor ..................................................................................2101
c) LehmanALITransaction ...............................................................................2103
6. BarclaysTransaction.............................................................................................2103
a) PreBankruptcyNegotiations........................................................................2104
(1)BarclaysInterestinaTransactionInvolvingLehman ........................2104
(2)NegotiationsBeforeSeptember15 .........................................................2110
b) LBHIBankruptcy ............................................................................................2116
(1)LBHIFilesChapter11 ..............................................................................2116
(2)PostPetitionClearingandFinancing ....................................................2116
c) NegotiationsLeadingtoAPA .......................................................................2124
(1)Participants ................................................................................................2127
(2)StructureofTransaction...........................................................................2129

xxxvii

(3)NegotiationsRegardingSecuritiesPositionstobePurchasedby
Barclays.......................................................................................................2131
(a)OnSeptember15and16,LehmanandBarclaysReview
LehmansSecuritiesPositionsandMarks .......................................2131
(b)BarclaysAgreestoPurchaseLongSecuritiesPositions
WithaBookValueofApproximately$70Billion ......................2138
(4)NegotiationsRegardingContractCureandEmployee
CompensationLiabilities .........................................................................2143
(a)ContractCureCosts............................................................................2143
(b)CompensationLiabilities ...................................................................2147
d) ConsiderationandApprovalofTransactionDescribedinAPAby
LBHIandLBIBoardsofDirectors................................................................2153
e) TransactionDescribedtotheCourtonSeptember17 ...............................2155
(1)SaleMotion ................................................................................................2155
(2)September17SaleProceduresHearing .................................................2157
f) BetweenSeptember17and19,theSecuritiesPositionsBeing
AcquiredbyBarclaysChange .......................................................................2160
(1)TheReplacementTransaction .............................................................2160
(2)$15.8BillionRepo......................................................................................2170
(3)September19AgreementtoTransferAdditionalAssets....................2175
(a)Excess15c33Assets ...........................................................................2178
(b)AdditionalSecurities ..........................................................................2182
(c) OCCMargin.........................................................................................2184
g) TheCourtsConsiderationandApprovaloftheProposed
Transaction.......................................................................................................2188
(1)September19,2008SaleHearing ............................................................2188
(2)TheSaleOrder ...........................................................................................2192
h) TransactionClosing ........................................................................................2194
(1)JPMorgan/BarclaysDisputes...................................................................2194
(2)TheCommitteesRole ..............................................................................2197
(3)December2008SettlementBetweenTrustee,Barclaysand
JPMorgan....................................................................................................2208

xxxviii
EXAMINERS REPORT

TABLE OF APPENDICES

VOLUME6

Tab1 LegalIssues

VOLUME7

Tab2 Glossary,Acronyms&Abbreviations

Tab3 KeyIndividuals

Tab4 WitnessInterviewList

Tab5 DocumentCollection&Review

Tab6 LehmanSystems

Tab7 Bibliography

VOLUME8

Tab8 RiskManagementOrganizationandControls

Tab9 RiskAppetiteandVaRUsageVersusLimitsChart

Tab10 CalculationofCertainIncreasesinRiskAppetiteLimits

Tab11 Compensation

Tab12 ValuationArchstone

Tab13 SurvivalStrategiesSupplement

Tab14 ValuationCDO

Tab15 NarrativeofSeptember4Through15,2008

Tab16 ValuationResidentialWholeLoans

i
Tab17 Repo105

Tab18 SummaryofLehmanCollateralatJPMorgan

Tab19 LehmansDealingswithBankofAmerica

KnowledgeofSeniorLehmanExecutivesRegardingThe
Tab20
InclusionofClearingBankCollateralintheLiquidityPool

Tab21 LBHISolvencyAnalysis

Tab22 PreferencesAgainstLBHIandOtherLehmanEntities

VOLUME9

AnalysisofAPB,JournalEntry,CashDisbursement,and
Tab23
JPMorganCollateral

Tab24 ForeignExchangeTransactions

IntercompanyTransactionsOccurringWithinThirtyDaysBefore
Tab25
Bankruptcy

Tab26 CUSIPswithBlankLegalEntityIdentifiers

Tab27 CUSIPsNotAssociatedwithanLBHIAffiliate

Tab28 CUSIPsAssociatedSolelywithanLBHIAffiliate

Tab29 CUSIPsAssociatedwithBothLBIandLBHIAffiliates

Tab30 CUSIPsAssociatedwithSubordinatedEntities

CUSIPsAssociatedwithLBHIAffiliatesNotDeliveredtoLBIina
Tab31
FinancingTrade

Tab32 September19,2008GFSDataset

Tab33 SummaryBalanceSheetsofLBHIAffiliates

Tab34 TangibleAssetBalanceSheetVariations

ii

UNITEDSTATESBANKRUPTCYCOURT
SOUTHERNDISTRICTOFNEWYORK

x
:
Inre : Chapter11CaseNo.
:
LEHMANBROTHERSHOLDINGSINC., : 0813555(JMP)
etal., :
: (JointlyAdministered)
Debtors. :
x

REPORTOF
EXAMINERANTONR.VALUKAS

Introduction

SectionsI&II:ExecutiveSummary&ProceduralBackground

TABLEOFCONTENTS

Introduction ...................................................................................................................................2
I. ExecutiveSummaryofTheExaminersConclusions.....................................................15
A. WhyDidLehmanFail?AreThereColorableCausesofActionThat
AriseFromItsFinancialConditionandFailure?.....................................................15
B. AreThereAdministrativeClaimsorColorableClaimsForPreferencesor
VoidableTransfers?......................................................................................................24
C. DoColorableClaimsAriseFromTransfersofLBHIAffiliateAssetsto
Barclays,orFromtheLehmanALITransaction? ....................................................26
II. ProceduralBackgroundandNatureoftheExamination ..............................................28
A. TheExaminersAuthority ...........................................................................................28
B. DocumentCollectionandReview..............................................................................30
C. SystemsAccess..............................................................................................................33
D. WitnessInterviewProcess...........................................................................................35
E. CooperationandCoordinationWiththeGovernmentandParties ......................37

INTRODUCTION

OnJanuary29,2008, Lehman BrothersHoldingsInc. (LBHI1) reportedrecord

revenues of nearly $60 billion and record earnings in excess of $4 billion for its fiscal

yearendingNovember30,2007.2DuringJanuary2008,Lehmansstocktradedashigh

as $65.73 per share and averaged in the high to midfifties,3 implying a market

capitalizationofover$30billion.4Lessthaneightmonthslater,onSeptember12,2008,

Lehmansstockclosedunder$4,adeclineofnearly95%fromitsJanuary2008value.5

OnSeptember15,2008,LBHIsoughtChapter11protection,6inthelargestbankruptcy

proceedingeverfiled.7

TherearemanyreasonsLehmanfailed,andtheresponsibilityisshared.Lehman

was more the consequence than the cause of a deteriorating economic climate.

1Thereareasignificantnumberofacronyms,abbreviationsandotherspecializedtermsusedthroughout

this Report. To avoid the necessity of defining terms repeatedly, the Report will generally use them
without definition; the reader should consult the Glossary attached as Appendix 2. Except where the
specificidentityofanentityisrelevantandsetout,thisReportwilluseLehmantorefercollectivelyto
LehmanBrothersHoldingsInc.(LBHI)andallofitsaffiliatesandsubsidiaries.
2LehmanBrothersHoldingsInc.(LBHI),AnnualReportfor2007asofNov.30,2007(Form10K)(filed

Jan.29,2008),atp.29(LBHI200710K).LBHIwastheholdingcompanyforhundredsofindividual
corporate entities, twentytwo of which are currently Chapter 11 debtors in jointly administered
proceedings.
3 Morningstar Document Research Co., LBHI Historic Stock Prices, Jan. 1, 2008 through Sept. 15, 2008,

[LBEXEXM00000114](printedfromwww.10kwizard.com)(lastvisitedFeb.3,2010).
4LBHI,QuarterlyReportasofFeb.29,2008(Form10Q)(filedonApr.9,2008),atp.1(LBHI10QApr.

9,2008)(554millioncommonequitysharesoutstandingtimes$55=approximately$30billion).
5Morningstar Document Research Co., LBHI Historic Stock Prices (Jan. 1, 2008 through Sept. 15,

,2008)[LBEXEXM00000114](printedfromwww.10kwizard.com)(lastvisitedFeb.3,2010).
6Voluntary Petition (Chapter 11), Docket No. 1, Lehman Brothers Holdings Inc., No. 0813555 (Bankr.

S.D.N.Y.Sept.15,2008).
7Yalman Onaran & John Helyar, Fuld Sought Buffet Offer He Refused as Lehman Sank (Update 1),

Bloomberg.com(Nov.10,2008),atp.2.
2

Lehmans financial plight, and the consequences to Lehmans creditors and

shareholders, was exacerbated by Lehman executives, whose conduct ranged from

serious but nonculpable errors of business judgment to actionable balance sheet

manipulation;bytheinvestmentbankbusiness model, which rewardedexcessive risk

takingandleverage;andbyGovernmentagencies,whobytheirownadmissionmight

betterhaveanticipatedormitigatedtheoutcome.

Lehmansbusinessmodelwasnotunique;allofthemajorinvestmentbanksthat

existed at the time followed some variation of a highrisk, highleverage model that

required the confidence of counterparties to sustain. Lehman maintained

approximately $700 billion of assets, and corresponding liabilities, on capital of

approximately $25 billion.8 But the assets were predominantly longterm, while the

liabilities werelargelyshortterm.9Lehmanfundeditselfthroughtheshorttermrepo

marketsandhadtoborrowtensorhundredsofbillionsofdollarsinthosemarketseach

dayfromcounterpartiestobeabletoopenforbusiness.10Confidencewascritical.The

momentthatrepocounterpartiesweretoloseconfidenceinLehmananddeclinetoroll

overitsdailyfunding,Lehmanwouldbeunabletofunditselfandcontinuetooperate.

8LBHI200710K,atp.29;LBHI10QApr.9,2008,atpp.56.

9ExaminersInterviewofPaoloR.Tonucci,Sept.16,2009,atp.8.

10ExaminersInterviewofPaoloR.Tonucci,Sept.16,2009,atpp.4,8(Lehmanfinancedthemajorityofits

balancesheetintheshorttermrepomarket,morethan$200billionadayin2008;Lehmanwasrelianton
shorttermsecuredfinancingtoconductitsdailyoperations);ExaminersInterviewofRaymondAbary,
Mar.12,2009.
3

Sotoowiththeotherinvestmentbanks,hadtheycontinuedbusinessasusual.Itisno

coincidencethatnomajorinvestmentbankstillexistswiththatmodel.11

In 2006, Lehman made the deliberate decision to embark upon an aggressive

growth strategy, to take on significantly greater risk, and to substantially increase

leverage on its capital.12 In 2007, as the subprime residential mortgage business

progressedfromproblemtocrisis,Lehmanwasslowtorecognizethedevelopingstorm

and its spillover effect upon commercial real estate and other business lines. Rather

than pull back, Lehman made the conscious decision to double down, hoping to

profit from a countercyclical strategy.13 As it did so, Lehman significantly and

repeatedlyexceededitsowninternalrisklimitsandcontrols.14

With the implosion and near collapse of Bear Stearns in March 2008, it became

clearthatLehmansgrowthstrategyhadbeenflawed,somuchsothatitsverysurvival

11Bank of America, Press Release, Bank of America Buys Merrill Lynch Creating Unique Financial
Services Firm (Sept. 15, 2008) (announcing its acquisition of Merrill Lynch); Morgan Stanley, Press
Release,MorganStanleyandCititoFormIndustryLeadingWealthManagementBusinessThroughJoint
Venture(Jan.13,2009)(announcingjointventurewithCitisSmithBarneyGrouptoformMorganStanley
Smith Barney); Federal Reserve, Press Release, Sept. 21, 2008 (announcing that the Federal Reserve
grantedtheapplicationsbyGoldmanSachsandMorganStanley,thelasttwomajorinvestmentbanks,to
become bank holding companies); Goldman Sachs, Press Release, Sept. 21, 2008 (announcing that
GoldmanSachswillbecomeabankholdingcompanyandwillberegulatedbytheFederalReserve).
12SeeDavidGoldfarb,Lehman,GlobalStrategyOffsite(Mar.2006)[LBEXDOCID2489987].

13ExaminersInterviewofDr.HenryKaufman,May19,2009,atp.9(ataMarch20,2007Boardmeeting,

managementadvisedthatvirtuallyallsubprimeoriginatorshavecutbackontheiroperationsorgone
out of business, but, despite that fact, it was managements view that the current distressed
environmentprovidessubstantialopportunitiesasinthelate1990s).
14Duff & Phelps, High Yield Total Usage Versus Limits (Nov. 19, 2009), at pp. 49 (showing that

Lehmans monthly average risk appetite exceeded its limit by $41 million in July 2007, $62 million in
August 2007, $608 million in September 2007, $670 million in October 2007, $508 million in November
2007,$562millioninDecember2007,$708millioninJanuary2008,and$578millioninFebruary2008).
4

wasinjeopardy.15ThemarketswereshakenbyBearsdemise,andLehmanwaswidely

considered to be the next bank that might fail.16 Confidence was eroding. Lehman

pursuedanumberofstrategiestoavoiddemise.

Buttobuyitselfmoretime,tomaintainthatcriticalconfidence,Lehmanpainted

amisleadingpictureofitsfinancialcondition.

Lehmanrequiredfavorableratingsfromtheprincipalratingagenciestomaintain

investor and counterparty confidence; and while the rating agencies looked at many

thingsinarrivingattheirconclusions,itwasclearandcleartoLehmanthatitsnet

leverage and liquidity numbers were of critical importance.17 Indeed, Lehmans CEO

RichardS.Fuld,Jr.,toldtheExaminerthattheratingagencieswereparticularlyfocused

on net leverage;18 Lehman knew it had to report favorable net leverage numbers to

15ExaminersInterviewofHenryM.Paulson,Jr.,June25,2009,atp.11(formerSecretaryoftheTreasury

PaulsonstatedthatafterBearStearnsnearcollapsehewaslessoptimisticaboutLehmanschancesthan
Fuld,andheinformedFuldthatLehmanneededtoraisecapital,findastrategicpartnerorsellthefirm).
16ExaminersInterviewofTimothyF.Geithner,Nov.24,2009,atp.2(formerPresidentoftheFRBNYand

currentTreasurySecretaryGeithnerbelievedthatafterBearStearnsnearcollapse,Lehmanwasthemost
vulnerableinvestmentbank);ExaminersInterviewofBenS.Bernanke,Dec.22,2009,atp.3(Chairmanof
the Federal Reserve Bernanke believed that, after Bear Stearns, Lehman was the next most vulnerable
bank); Examiners Interview of Henry M. Paulson, Jr., June 25, 2009, at p. 2 (Paulson thought Lehman
could be next to fail after Bear Stearns); Examiners Interview of Christopher Cox, Jan. 8, 2010, at p. 8
(formerChairmanoftheSECCoxsaidthatafterBearStearnscollapsedLehmanwastheSECsnumber
onefocus.Lehmanhadsuffereddiminutionofvalueandhadtroubledassets).
17Erin M. Callan, Lehman Brothers Leverage Analysis (Apr. 7, 2008), at p. 1 [LBEXDOCID 1401225]

(Reducingleverage[i]snecessarytoremoverefinancingriskandwinbacktheconfidenceofthemarket,
lenders, and investors.); Examiners Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at p. 8 (rating
agencieslookedatnetleverage);ExaminersInterviewofMichaelMcGarvey,Sept.11,2009,atp.5(senior
managementmadeaconcertedefforttomanageandreducethebalancesheetwithaviewtowardsthe
ratingagencies);ExaminersInterviewofEileenA.Fahey,Fitch,Sept.17,2009,atp.6;Standard&Poors
RatingsDirect, LiquidityManagement In Times OfStress: How The MajorBrokerDealersFare(Nov.8,
2007),atp.3[LBHI_SEC07940_439424].
18ExaminersInterviewofRichardS.Fuld,Jr.,Sept.25,2009,atp.7.

maintain its ratings and confidence. So at the end of the second quarter of 2008, as

Lehman was forced to announce a quarterly loss of $2.8 billion resulting from a

combinationofwritedownsonassets,salesofassetsatlosses,decreasingrevenues,and

losses on hedges it sought to cushion the bad news by trumpeting that it had

significantlyreduceditsnetleverageratiotolessthan12.5,thatithadreducedthenet

assetsonitsbalancesheetby$60billion,andthatithadastrongandrobustliquidity

pool.19

Lehmandidnotdisclose,however,thatithadbeenusinganaccountingdevice

(known within Lehman as Repo 105) to manage its balance sheet by temporarily

removing approximately $50 billion of assets from the balance sheet at the end of the

firstandsecondquartersof2008.20Inanordinaryrepo,Lehmanraisedcashbyselling

assetswithasimultaneousobligationtorepurchasethemthenextdayorseveraldays

later; such transactions were accounted for as financings, and the assets remained on

Lehmansbalancesheet.InaRepo105transaction,Lehmandidexactlythesamething,

but because the assets were 105% or more of the cash received, accounting rules

permittedthetransactionstobetreatedassalesratherthanfinancings,sothattheassets

19FinalTranscriptofLehmanBrothersHoldingsInc.SecondQuarterPreliminaryEarningsCall(June9,

2008),atpp.78.
20LBHI200710K,atp.63;LBHI10QApr.9,2008,atp.72;LehmanBrothersHoldingsInc.,Quarterly

Report as of May 31, 2008 (Form 10Q) (filed on July 10, 2008), at p. 88 (LBHI 10Q July 10, 2008);
ExaminersInterviewofMartinKelly,Oct.1,2009;ExaminersInterviewofEdGrieb,Oct.2,2009.
6

could be removed from the balance sheet.21 With Repo 105 transactions, Lehmans

reportednetleveragewas12.1attheendofthesecondquarterof2008;butifLehman

hadusedordinaryrepos,netleveragewouldhavetohavebeenreportedat13.9.22

Contemporaneous Lehman emails describe the function called repo 105

wherebyyoucanrepoapositionforaweekanditisregardedasatruesaletogetridof

netbalancesheet.23LehmanusedRepo105fornoarticulatedbusinesspurposeexcept

to reduce balance sheet at the quarterend.24 Rather than sell assets at a loss, [a]

Repo 105 increase would help avoid this without negatively impacting our leverage

ratios.25 Lehmans Global Financial Controller confirmed that the only purpose or

motivefor[Repo105]transactionswasreductioninthebalancesheetandthatthere

wasnosubstancetothetransactions.26

Lehman did not disclose its use or the significant magnitude of its use of

Repo105totheGovernment,totheratingagencies,toitsinvestors,ortoitsownBoard

21SeeSectionIII.A.4(discussingRepo105).

22LBHI 10Q July 10, 2008, at p. 89; Duff & Phelps, Repo 105 Balance Sheet Accounting Entry and
LeverageRatiosSummary(Oct.2,2009),atp.7.SeealsoSectionI.AofthisReport,whichdiscussesnet
leverage.
23 Email from Anthony Jawad, Lehman, to Andrea Leonardelli, Lehman (Feb. 29, 2008) [LBEXDOCID

224902].
24EmailfromRaymondChan,Lehman,toPaulMitrokostas,Lehman,etal.(Jul.15,2008)[LBEXDOCID

3384937].
25JosephGentile,Lehman,ProposedRepo105/108TargetIncreasefor2007(Feb.10,2007),atp.1[LBEX

DOCID2489498],attachedtoemailfromJosephGentile,Lehman,toEdGrieb,Lehman(Feb.10,2007)
[LBEXDOCID2600714].
26ExaminersInterviewofMartinKelly,Oct.1,2009,atp.9.

ofDirectors.27Lehmansauditors,Ernst&Young,wereawareofbutdidnotquestion

LehmansuseandnondisclosureoftheRepo105accountingtransactions.28

In midMarch 2008, after the Bear Stearns near collapse, teams of Government

monitors from the Securities and Exchange Commission (SEC) and the Federal

Reserve Bank of New York (FRBNY) were dispatched to and took up residence at

Lehman,29tomonitorLehmansfinancialconditionwithparticularfocusonliquidity.30

27LehmandidnotdiscloseitsuseofRepo105inpublicfilings.ExaminersInterviewofEdGrieb,Oct.2,

2009, at p. 14; Examiners Interview of Marie Stewart, Sept. 2, 2009, at p. 15; Examiners Interview of
MatthewLee,July1,2009,atp.16.LehmandidnotdiscloseitsuseofRepo105toratingagencies.See
Lehman,S&PRatingsQ22008Update(June5,2008)[S&PExaminer000946](Lehmandidnotdiscloseits
useofRepo105toStandard&Poorsinitsratingspresentation);Lehman,FitchRatingsQ22008Update
(June3,2008)[LBHI_SEC07940_513239](LehmansimilarlydidnotdiscloseitsuseofRepo105toFitchas
part of its presentation where Lehman touted its balance sheet reduction). The Examiner interviewed
representatives from the three leading ratings agencies, Fitch, S&P and Moodys, and none had
knowledgeofLehmansuseofRepo105/108transactions,eitherbynameorbydescription.Examiners
InterviewofEileenA.Fahey,Sept.17,2009,atp.7;ExaminersInterviewofDianeHinton,Sept.22,2009,
atp.6;ExaminersInterviewofPeterE.Nerby,Oct.8,2009,atp.5.Lehmandidnotdiscloseitsuseof
Repo105 toGovernment regulators. Examiners Interview ofRonald S. Marcus,Nov.4, 2009, at p. 11;
Examiners Interview of Timothy F. Geithner, Nov. 24, 2009, at p. 5; Examiners Interview of Jan H.
Voigts,Oct.1,2009.LehmandidnotdiscloseitsuseofRepo105toitsBoardofDirectors.Examiners
Interview of Dr. Henry Kaufman, Sept. 2, 2009, at p. 21; Examiners Interview of Jerry A. Grundhofer,
Sept.16,2009,atp.10;ExaminersInterviewofRolandHernandez,Oct.2,2009;ExaminersInterviewof
SirChristopherGent,Oct.21,2009,atp.22;ExaminersInterviewofRogerBerlind,Dec.18,2009,atp.4.
28Examiners Interview of Ernst & Young, Repo 105 session, Oct. 16, 2009, at pp. 89 (statement of

WilliamSchlich);ExaminersInterviewofErnst&Young,Nov.3,2009,atpp.1415(statementofHillary
Hansen).
29ExaminersInterviewofMatthewEichner,Nov.23,2009,atp.5(EichnertoldtheExaminerthatafter

Bear Stearns nearly collapsed, the SEC had monitors onsite at Lehman almost all the time. Eichner
also told the Examiner that the FRBNY had people in residence with actual offices at Lehman);
Examiners Interview of Jan H. Voigts, Aug. 25, 2009, at p. 1 (Voigtsmonitored Lehmans liquidity
position,embeddedonsitewiththefirm,fromMarch16,2008throughmidSeptember,2008).
30ExaminersInterviewofTimothyF.Geithner,Nov.24,2009,atp.4(afterBearStearnsnearlycollapsed,

GeithnermetwithLehmanandotherinvestmentbanksaboutmovingthebankstoamoreconservative
place regarding capital and liquidity. Geithner indicated that his primary concern was Lehmans
funding structure. He told the Examiner that he was consumed with figuring out how to make
Lehmangetmoreconservativelyfunded).
8

Lehman publicly asserted throughout 2008 that it had a liquidity pool sufficient to

weatheranyforeseeableeconomicdownturn.31

ButLehmandidnot publiclydisclosethat byJune2008 significantcomponents

ofitsreportedliquiditypoolhadbecomedifficulttomonetize.32AslateasSeptember

10, 2008, Lehman publicly announced that its liquidity pool was approximately $40

billion;33 but a substantial portion of that total was in fact encumbered or otherwise

illiquid.34 From June on, Lehman continued to include in its reported liquidity

substantial amounts of cash and securities it had placed as comfort deposits with

various clearing banks; Lehman had a technical right to recall those deposits, but its

abilitytocontinueitsusualclearingbusinesswiththosebankshaditdone sowasfar

fromclear.35ByAugust,substantialamountsofcomfortdepositshadbecomeactual

31FinalTranscript of Lehman Brothers Holdings Inc. Second Quarter 2008 Preliminary Earnings Call
(June, 9, 2008), at p. 8 (Lehmans liquidity pool reported at $45 billion); Final Transcript of Lehman
BrothersHoldingsInc.SecondQuarter2008EarningsCall(June16,2008),atp.6(Lehmansliquiditypool
reported at $45 billion); Final Transcript of Lehman Brothers Holdings Inc. Third Quarter 2008
PreliminaryEarningsCall(Sept.10,2008),atp.10(Lehmansliquiditypoolreportedat$42billion).
32Lehman,LiquidityPoolTableListingCollateralandAbilitytoMonetize(Sept.12,2008)[LBEXWGM

784607](listing$30.1billionofassetsaslowabilitytomonetize).
33FinalTranscriptofLehmanBrothersHoldingsInc.ThirdQuarter2008PreliminaryEarningsCall(Sept.

10,2008),atp.10.
34Examiners Interview of Paolo R. Tonucci, Sept. 16, 2009, at p. 19 (Lehman included $2 billion that it

pledged to Citibank as a comfort deposit in its liquidity pool); Security Agreement between LBHI and
Bank of America, N.A. (Aug. 25, 2008) [LBEXDOCID 000584] (providing for a $500 million security
depositfromLehmantoBofA);Lehman,LiquidityPoolTableListingCollateralandAbilitytoMonetize
(Sept.9,2008),atp.2[LBHI_SEC07940_557815](showingthe$500millionBofAdepositintheliquidity
pool); Lehman, Liquidity Update (Sept. 10, 2008), at p. 3 ($1 billion in Lehmans liquidity pool was
earmarkedtoHSBCandlistedasLowabilitytomonetize.).
35SeeSectionIII.A.5(discussingpotentialclaimsagainstsecuredlenders).

pledges.36 By September 12, two days after it publicly reported a $41 billion liquidity

pool,thepoolactuallycontainedlessthan$2billionofreadilymonetizableassets.37

Months earlier, on June 9, 2008, Lehman preannounced its second quarter

resultsandreportedalossof$2.8billion,itsfirsteverlosssincegoingpublicin1994.38

Despite that announcement, Lehman was able to raise $6 billion of new capital in a

publicofferingonJune12,2008.39ButLehmanknewthatnewcapitalwasnotenough.

TreasurySecretaryHenryM.Paulson,Jr.,privatelytoldFuldthatifLehmanwasforced

to report further losses in the third quarter without having a buyer or a definitive

survivalplaninplace,Lehmansexistencewouldbeinjeopardy.40

OnSeptember 10, 2008, Lehmanannouncedthat itwasprojectinga$3.9billion

loss for the third quarter of 2008.41 Although Lehman had explored options over the

summer, it had no buyer in place; its only announced survival plan was to spin off

36Id.

37See Lehman, Liquidity Pool Table Listing Collateral and Ability to Monetize (Sept. 12, 2008) [LBEX

WGM 784607] (listing $1.4 billion of assets as high ability to monetize and $934 million of assets as
midabilitytomonetize).
38Lehman Brothers Holdings Inc., Press Releases (Mar. 14, 2007, June 12, 2007, Sept. 18, 2007, Dec. 13,

2007,Mar.18,2008andJune9,2008).
39Lehman Brothers Holdings Inc., Press Release (June 12, 2008); Lehman Brothers Holdings Inc., Press

Release(June16,2008).
40Fulddoesnotrecallthatwarning.ExaminersInterviewofRichardS.Fuld,Jr.,Sept.30,2009,atp.3,

butPaulsontoldtheExaminerthatheconsistentlycommunicatedtoFuldhowdireLehmanssituation
wasandthathepointedlyurgedFuldtofindabuyerafterLehmanannounceda$2.8billionlossforthe
secondquarterof2008,ExaminersInterviewofHenryM.Paulson,June25,2009,atpp.1115.
41FinalTranscriptofLehmanBrothersHoldingsInc.ThirdQuarter2008PreliminaryEarningsCall(Sept.

10, 2008), at p. 8; Lehman Brothers Holdings Inc., Press Release (Sept. 10, 2008), at p. 1
[LBHI_SEC07940_042866].
10

troubledassetsinto a separateentity.SecretaryPaulsonsprediction turned outto be

rightitwasnotenough.

BythecloseoftradingonSeptember12,2008,Lehmansstockpricehaddeclined

to$3.65pershare,a94%dropfromthe$62.19January2,2008price.42

70.00 $62.19
60.00
50.00
40.00 $31.75
Lehman Stock Price $27.50
30.00
$20.96
20.00
$7.79 $7.25
10.00 $3.65
0.00
2-Jan-08 17-Mar-08 10-Jun-08 1-Jul-08 9-Sep-08 10-Sep-08 12-Sep-08
Landmark Dates

Over the weekend of September 1214, an intensive series of meetings was

conducted by and among Treasury Secretary Paulson, FRBNY President Timothy F.

Geithner,SECChairmanChristopherCox,andthechiefexecutivesofleadingfinancial

institutions.43 Secretary Paulson began the meetings by stating the Government was

there to do all it could but that it could not fund a solution.44 The Governments

42Morningstar DocumentResearch Co.,LBHI Historic StockPrices (Jan.1, 2008 throughSept. 15,2008)

[LBEXEXM00000114](printedfromwww.10kwizard.com)(lastvisitedonFeb.3,2010).
43Examiners Interview of Henry M. Paulson, Jr., June 25, 2009, at p. 15; Examiners Interview of

ChristopherCox,Jan.8,2010,atpp.1517;ExaminersInterviewofThomasC.Baxter,Jr.,May20,2009at
p.9.
44ExaminersInterviewofHenryM.Paulson,Jr.,June25,2009,atpp.1516(PaulsontoldtheExaminer

that these meetings were part of the Governments attempt to pull a rabbit out of a hat and save
Lehman); Examiners Interview of Thomas C. Baxter, Jr., May 20, 2009 at pp. 910 (FRBNY General
Counsel Baxter told the Examiner thatPaulson explained to the group that the purpose ofthe meeting
wastwofold(1)toattempttofacilitatetheacquisitionofLehman;and(2)inthealternative,toresolve
theconsequencesofLehmansfailure).
11

analysiswasthatitdidnothavethelegalauthoritytomakeadirectcapitalinvestment

in Lehman, and Lehmans assets were insufficient to support a loan large enough to

avoidLehmanscollapse.45

It appeared by early September 14 that a deal had been reached with Barclays

whichwouldsaveLehmanfromcollapse.46Butlaterthatday,thedealfellapartwhen

thepartieslearnedthattheFinancialServicesAuthority(FSA),theUnitedKingdoms

bankregulator,refusedtowaiveU.K.shareholderapprovalrequirements.47

Lehmannolongerhadsufficientliquiditytofunditsdailyoperations.48Onthe

eveningofSeptember14,SECChairmanCoxphonedtheLehmanBoardandconveyed

the Governments strong suggestion that Lehman act before the markets opened in

45ExaminersInterviewofHenryM.Paulson,Jr.,June25,2009,atpp.1617(PaulsontoldtheExaminer

thatheconcludedthattheFederalGovernmentlackedauthoritytoinjectcapitalintoLehman,evenvia
an exigent circumstances loan from the Federal Reserve, because Lehman was not an institution
perceived to have capital and able to provide a guarantee.); Chairman of the Federal Reserve Ben S.
Bernanke,SpeechattheKansasCityFederalBankConferenceinJacksonHole,Wyoming(Aug.21,2009)
([T]he companysavailable collateralfell well short of theamount needed tosecure a FederalReserve
loan of sufficient size to meet its funding needs.); Examiners Interview of Ben S. Bernanke, Dec. 22,
2009,atp.2(Lehmansassetsandsecuritiesfellconsiderablyshortoftheobligationsthatwouldbecome
due).
46ExaminersInterviewofRichardS.Fuld,Jr.,Apr.28,2009,atp.9(FuldtoldtheExaminerthatonthe

morning of September 14, 2008, he woke up thinking he had a transaction in place with Barclays);
LehmanBrothersHoldingsInc.,MinutesofMeetingofBoardofDirectors(Sept.13,2008),atp.1[LBEX
AM003927003931](TheLehmanBoardmetat5:00p.m.todiscussapotentialdealwithBarclays).
47Examiners Interview of Henry M. Paulson, Jr., June 25, 2009, at pp. 1920; Examiners Interview of

RichardFuld,Jr.,Apr.28,2009,at9.InawrittenstatementtotheExaminer,theFSAsaidthatitnever
received a formal request to waive the shareholderapproval requirement. According to the FSAs
statement,theFSAhadseriousconcernsaboutthelackofprecedentforsuchwaivers.TheFSAwasalso
concernedaboutLehmansliquidityandfunding.FSA,StatementoftheFinancialServicesAuthorityto
theExaminer(Jan.20,2010),atpp.8,10.
48Lehman, Liquidity of Lehman Brothers [Draft] (Oct. 7, 2008), at p. 9 [LBHI_SEC07940_844701] (LBIE

facedacashshortageof$4.5billiononSeptember15,2008).
12

Asia.49 On September 15, 2008, at 1:45 a.m., LBHI filed for Chapter 11 bankruptcy

protection.50

Sortingoutwhetherandtheextenttowhichthefinancialupheavalthatfollowed

was the direct result of the Lehman bankruptcy filing is beyond the scope of the

Examinersinvestigation.Butthoseeventshelpputintocontextthesignificanceofthe

Lehman filing. The Dow Jones index plunged 504 points on September 15.51 On

September 16, AIG was on the verge of collapse; the Government intervened with a

financial bailout package that ultimately cost about $182 billion.52 On September 16,

2008,thePrimaryFund,a$62billionmoneymarketfund,announcedthatbecauseof

thelossitsufferedonitsexposuretoLehmanithadbrokenthebuck,i.e.,itsshare

49ExaminersInterviewofChristopherCox,Jan.8,2010,atpp.1617(CoxcalledLehmansBoardtourge

that Lehman take whatever action it decided upon as soon as possible, before the markets opened.
Duringthecall,Coxrelated,FRBNYGeneralCounselThomasC.Baxter,Jr.,addedthatithadbeenmade
clearinthemeetingsearlierthatdaythattheactionshouldbethatLehmandeclarebankruptcy.Cox
told the Examiner that the SEC was not offering guidance or trying to influence the fiduciary
responsibilitiesof[Lehmans]directors.).
50VoluntaryPetition(Chapter11),DocketNo.1,LehmanBrothersHoldingsInc.,CaseNo.0813555(Bankr.

S.D.N.Y.Sept.15,2008);DocketActivityReport,LehmanBrothersHoldingsInc.,CaseNo.0813555(Bankr.
S.D.N.Y.Sept.15,2008).
51AlexandraTwin,StocksGetPummeled,CNNMoney.com,Sept.21,2008,atp.1(statingWallStreetsees

worst day in 7 years with Dow down 504 points . . . ), available at


http://money.cnn.com/2008/09/15/markets/markets_newyork2/index.htm(lastvisitedJan.28,2010).
52SewellChan,BernankeWantsanAuditofFedsBailoutofAIG,N.Y.Times,Jan.19,2010(statingthatthe

FRBNYandTreasuryDepartmentmadeabout$182billionavailabletoAIG).

13

pricehadfallentolessthan$1pershare.53OnOctober3,2008,Congresspasseda$700

billionTroubledAssetReliefProgram(TARP)rescuepackage.54

Inhisrecentreconfirmationhearings,FederalReserveChairmanBenBernanke,

speaking of the overall economic crisis, candidly conceded that there were mistakes

madeallaroundandweshouldhavedonemore.55Lehmanshouldhavedonemore,

donebetter.Someofthesefailingsweresimplyerrorsofjudgmentwhichdonotgive

risetocolorablecausesofaction;somegobeyondandareindeedcolorable.

* * *

PartIofthisReportprovidesanexecutivesummaryoftheExaminersfindings

andconclusions.

PartIIdiscussestheproceduralbackgroundoftheExaminersappointment,the

Examiners authority, and the manner in which the Examiner conducted his

investigation.

PartIIIdetailsthefactsandanalysison the topics assignedby theCourt tothe

ExaminerandcontainstheExaminersanalysisandconclusions.

53SeeMarkus K. Brunnermeier, Deciphering the Liquidity and Credit Crunch 20072008, 23 J. Econ.
Perspectives, Winter 2009, at 87 (2009); NewYorkFed.org, Financial Turmoil Timeline,
http://www.newyorkfed.org/research/global_economy/Crisis_Timeline.pdf(lastvisitedJan.26,2010).
54DavidM.Herszenhorn,ACuriousCoalitionOpposedBailoutBill,N.Y.Times,Oct.3,2008,atp.1.

55Edmund L. Andrews, Bernanke Says Fed Should Have Done More, N.Y. Times, Dec. 4, 2009, at p. 1.

TheofficialtranscriptofChairmanBenS.BernankesConfirmationHearingBeforetheSenateCommittee
on Banking, Housing, and Urban Affairs, Dec. 3, 2009, was not available at the time this Report was
released.
14

I. EXECUTIVESUMMARYOFTHEEXAMINERSCONCLUSIONS

TheOrderappointingtheExaminer(theExaminerOrder)assignstenspecific

bulletedtopicsfortheExaminertoinvestigate;inaddition,theExaminerOrderdirects

the Examiner to perform the duties specified in Section 1106(a)(3) and (4) of the

BankruptcyCode,thatis,tofileastatementof. . .anyfactascertained pertaining to

fraud, dishonesty, incompetence, misconduct, mismanagement, or irregularity in the

managementoftheaffairsofthedebtor,ortoacauseofactionavailabletotheestate.56

Becausethetenbulletedtopicssetoutatpages34oftheExaminerOrderoverlap,the

Examiner has grouped theminto threesubstantiveareas:(A)WhyDid Lehman Fail?

Are There Colorable Causes of Action That Arise From Its Financial Condition and

Failure?(B)AreThereAdministrativeClaimsorColorableClaimsforPreferencesor

Voidable Transfers? and (C) Are There Colorable Claims Arising Out of the Barclays

SaleTransaction?

A. WhyDidLehmanFail?AreThereColorableCausesofActionThatArise
FromItsFinancialConditionandFailure?

Section(A)addressesthefifth,eighthandtenthbulletsoftheExaminerOrder:

[Bullet10]TheeventsthatoccurredfromSeptember4,2008throughSeptember15,2008
orpriortheretothatmayhaveresultedincommencementoftheLBHIChapter11case.

[Bullet5]Whethertherearecolorableclaimsforbreachoffiduciarydutiesand/oraiding
or abetting any such breaches against the officers and directors of LBCC and/or other
DebtorsarisinginconnectionwiththefinancialconditionoftheLehmanenterpriseprior
tothecommencementoftheLBHIChapter11caseonSeptember15,2008.

56OrderDirectingAppointmentofanExaminerPursuanttoSection1104(c)(2)oftheBankruptcyCode,at

pp.35,DocketNo.2569,LehmanBrothersHoldingsInc.,CaseNo.0813555(Bankr.S.D.N.Y.Jan.16,2009).
15

[Bullet8]Thetransactionsandtransfers,includingbutnotlimitedtothepledgingor
grantingofcollateralsecurityinterestamongthedebtorsandthepreChapter11lenders
and/orfinancialparticipantsincludingbut notlimitedto,JPMorgan Chase,Citigroup,
Inc.,BankofAmerica,theFederalReserveBankofNewYorkandothers.

Lehmanfailedbecauseitwasunabletoretaintheconfidenceofitslendersand

counterparties and because it did not have sufficient liquidity to meet its current

obligations. Lehman was unable to maintain confidence because a series of business

decisions had left it with heavy concentrations of illiquid assets with deteriorating

valuessuchasresidentialandcommercialrealestate.Confidencewasfurthereroded

whenitbecamepublicthatattemptstoformstrategicpartnershipstobolsteritsstability

had failed.57 And confidence plummeted on two consecutive quarters with huge

reported losses, $2.8 billion in second quarter 200858 and $3.9 billion in third quarter

2008,59withoutnewsofanydefinitivesurvivalplan.

ThebusinessdecisionsthatbroughtLehmantoitscrisisofconfidencemayhave

beeninerrorbutwerelargelywithinthebusinessjudgmentrule.Butthedecisionnot

todisclosetheeffectsofthosejudgmentsdoesgiverisetocolorableclaimsagainstthe

57SeeLehmanBrothersHoldingsInc.,MinutesofMeetingoftheBoardofDirectors(Mar.31,2008)

(LehmanapproachedWarrenE.Buffettaboutapotential$3.5billionprivateinvestment,butdiscussions
werepreliminaryanddidnotresultinanyagreementonterms)[LBEXAM003597604];Examiners
InterviewofRichardS.Fuld,Jr.,May6,2009,atp.11(FuldtoldtheExaminerthatKDBspressreleaseon
Sept.9,2008,announcingthatnegotiationsbetweenKDBandLehmanaboutastrategicpartnershiphad
ended,triggeredLehmansdecisiontoannouncethirdquarterearningsearly.AccordingtoFuld,
LehmansstockdroppedsignificantlyafterKDBsannouncementandshortsellerswerekickingthe
daylightsoutofLehman);MorningstarDocumentResearchCo.,LBHIHistoricStockPrices(Jan.1,2008
throughSept.15,2008)[LBEXEXM000001](printedfromwww.10kwizard.com)(lastvisitedonFeb.3,
2010(Lehmansstockfell45%afterKDBsannouncement).
58LehmanBrothersHoldingsInc.,PressRelease(June9,2008).

59LehmanBrothersHoldingsInc.,PressRelease(Sept.10,2008).

16

senior officers who oversaw and certified misleading financial statements Lehmans

CEORichardS.Fuld,Jr.,anditsCFOsChristopherOMeara,ErinM.CallanandIanT.

Lowitt. There are colorable claims against Lehmans external auditor Ernst & Young

for, among other things, its failure to question and challenge improper or inadequate

disclosuresinthosefinancialstatements.

The Examiner Order does not contain a definition of what constitutes a

colorableclaim.TheSecondCircuithasdescribedcolorableclaimsasonesthaton

appropriate proof would support a recovery,60 much the same as that undertaken

when a defendant moves to dismiss a complaint for failure to state a claim.61 But

under such a standard, the Examiner would find colorable claims wherever bare

allegationsmightsurviveamotiontodismiss.Becausehehasconductedanextensive

factual investigation, the Examiner believes it is more appropriate to use a higher

thresholdstandard,andinthisReportacolorableclaimisoneforwhichtheExaminer

hasfoundthatthereissufficientcredibleevidencetosupportafindingbyatrieroffact.

TheExaminerisnottheultimatedecisionmaker;whetherclaimsareinfactvalidwill

beforthetriersoffacttowhomclaimsarepresented.Theidentificationofaclaimby

the Examiner as colorable does not preclude the existence of defenses and is not a

60InreSTNEnters.,779F.2d901,905(2dCir.1985).

61InreKDIHoldings,Inc.,277B.R.493,508(Bankr.S.D.N.Y.1999)(quotingInreAmericasHobbyCenter,

223B.R.275,281(Bankr.S.D.N.Y.1998)),accordInreAdelphiaCommcnsCorp.,330B.R.364,376(Bankr.
S.D.N.Y.2005).
17

prediction as to how a court or a jury may resolve any contested legal, factual, or

credibilityissues.62

AlthoughRepo105transactionsmaynothavebeeninherentlyimproper,thereis

a colorable claim that their sole function as employed by Lehman was balance sheet

manipulation.LehmansownaccountingpersonneldescribedRepo105transactionsas

anaccountinggimmick63andalazywayofmanagingthebalancesheetasopposed

tolegitimatelymeetingbalancesheettargetsatquarterend.64LehmanusedRepo105

toreducebalancesheetatthequarterend.65

In 200708, Lehman knew that net leverage numbers were critical to the rating

agenciesandtocounterpartyconfidence.66Itsabilitytodeleveragebysellingassetswas

severely limited by the illiquidity and depressed prices of the assets it had

accumulated.67 Against this backdrop, Lehman turned to Repo 105 transactions to

62Foramorecompleteanalysisofthelawrelatingtothecolorableclaimstandard,seeAppendix1.The

Examinerisnottheultimatedecisionmakeronanycolorableclaim;hesimplyisdirectedtoidentifythe
existenceofsuchclaims.WhiletheExaminerhasevaluatedtheattimesconflictingevidencetomakehis
determinationsastopotentialcolorableclaims,itisneithernecessarynorappropriatefortheExaminerto
make credibility assessments or resolve conflicting evidence; that will be the responsibility of a trier of
factwhenandifthoseclaimsarelitigated.
63ExaminersInterviewofMurtazaBhallo,Sept.14,2009,atp.3.

64ExaminersInterviewofMarieStewart,Sept.2,2009,atp.7.

65EmailfromRaymondChan,Lehman,toPaulMitrokostas,Lehman,etal.(July15,2008)[LBEXDOCID

3384937].
66Examiners Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at p. 8 (rating agencies looked at net

leverage); Examiners Interview of Michael McGarvey, Sept. 11, 2009, at p. 2; Examiners Interview of
AnurajBismal,Sept.16,2009,atpp.56(BismaltoldtheExaminerthatmeetingleverageratiotargetswas
themostcriticalissue(averyhottopic)forseniormanagementbytheendof2007).
67ExaminersInterviewofTimothyF.Geithner,Nov.24,2009,atpp.78(Startinginmid2007,manyof

Lehmans inventory positions had grown increasingly sticky i.e., difficult to sell without incurring
18

temporarily remove $50 billion of assets from its balance sheet at first and second

quarter ends in 2008 so that it could report significantly lower net leverage numbers

than reality.68 Lehman did so despite its understanding that none of its peers used

similar accounting at that time to arrive at their leverage numbers, to which Lehman

wouldbecompared.69

Lehmandefinedmateriality,forpurposesofreopeningaclosedbalancesheet,as

any item individually, or in the aggregate, that moves net leverage by 0.1 or more

(typically$1.8billion).70LehmansuseofRepo105movednetleveragenotbytenths

butbywholepoints:

substantial losses. Moreover, selling sticky inventory at reduced prices could also have led to loss of
marketconfidenceinLehmansvaluationsforinventoryremainingonthefirmsbalancesheet).
68Lehman,SpreadsheetSummarizingTotalRepo105&Repo108(May30,2008)[LBEXDOCID2078195]

(totalRepo105firmwideonFeb.29,2008was$49.102billionandonMay30,2008was$50.383billion).
69ExaminersInterviewofMartinKelly,Oct.1,2009,atp.8(KellytoldtheExaminerthatLehmanwasthe

last of the CSE firms to continue using Repo 105type transactions to manage its balance sheet by late
2007);ExaminersInterviewofMarieStewart,Sept.2,2009,atp.4(StewartbelievedthatLehmanwasthe
lastofitspeergroupusingRepo105transactionsbyDecember2007).
70Ernst&Young,WalkthroughTemplate:BalanceSheetCloseProcess(Nov.30,2007),atp.14[EYSEC

LBHICORPGAMX07033384].

19

Date Repo105 Reported Net Difference


Usage Net Leverage
Leverage Without
Repo105
Q42007 $38.6B71 16.172 17.873 1.7
Q12008 $49.1B74 15.475 17.376 1.9
Q22008 $50.4B77 12.178 13.979 1.8

Lehmansfailuretodisclosetheuseofanaccountingdevicetosignificantlyand

temporarily lower leverage, at the same time that it affirmatively represented those

lowleveragenumberstoinvestorsaspositivenews,createdamisleadingportrayalof

Lehmanstruefinancialhealth.80Colorableclaimsexistagainsttheseniorofficerswho

were responsible for balance sheet management and financial disclosure, who signed

and certified Lehmans financial statements and who failed to disclose Lehmans use

andextentofRepo105transactionstomanageitsbalancesheet.81

71Lehman,SpreadsheetofTotalRepo105/108Trend[LBHI_SEC07940_1957956](listingtotaluseofRepo

105/108forthefourthquarterof2007as$38.634billion).
72SeeLBHI200710K,atp.29.

73SeeSectionIII.A.4(discussingRepo105/108); Duff&Phelps,Repo105BalanceSheetAccountingEntry

andLeverageRatiosSummary(Oct.2,2009),atp.8.
74Lehman,SpreadsheetofTotalRepo105/108Trend[LBHI_SEC07940_1658543].

75LBHI10QApr.9,2008,atp.72.

76SeeSectionIII.A.4(discussingRepo105/108); Duff&Phelps,Repo105BalanceSheetAccountingEntry

andLeverageRatiosSummary(Oct.2,2009),atp.8.
77Lehman,SpreadsheetofTotalRepo105/108Trend[LBHI_SEC07940_1658543].

78LBHI10QJuly10,2008,atp.89.

79SeeSectionIII.A.4(discussingRepo105/108); Duff&Phelps,Repo105BalanceSheetAccountingEntry

andLeverageRatiosSummary(Oct.2,2009),atp.8.
80Examiners Interview of Matthew Lee, July 1, 2009, at p. 15 ([Lehman] was telling the public they

reducedthebalancesheet,butnottellingthemtheyweredoingsobyunartfulmeans.Lehmanhad
waymoreleveragethanpeoplethought;itwasjustoutof[thepublics]sight).
81SeeSectionIII.A.4(discussingRepo105/108).

20

In May 2008, a Lehman Senior Vice President, Matthew Lee, wrote a letter to

management alleging accounting improprieties;82 in the course of investigating the

allegations,Ernst&YoungwasadvisedbyLeeonJune12,2008thatLehmanused$50

billion of Repo 105 transactions to temporarily move assets off balance sheet and

quarterend.83ThenextdayonJune13,2008Ernst&YoungmetwiththeLehman

BoardAuditCommitteebutdidnotadviseitaboutLeesassertions,despiteanexpress

direction from the Committee to advise on all allegations raised by Lee.84 Ernst &

YoungtookvirtuallynoactiontoinvestigatetheRepo105allegations.85Ernst&Young

took no steps to question or challenge the nondisclosure by Lehman of its use of $50

billionoftemporary,offbalancesheettransactions.ColorableclaimsexistthatErnst&

Youngdidnotmeetprofessionalstandards,bothininvestigatingLeesallegationsand

inconnectionwithitsauditandreviewofLehmansfinancialstatements.86

82LetterfromMatthewLee,SeniorVicePresident,Lehman,toMartinKelly,Controller,Lehman,etal.,re:

possibleaccountingimproprieties(May16,2008),atpp.13[EYLELBHIKEYPERS5826885].
83Examiners Interview of Ernst & Youngs Hillary Hansen, Nov. 3, 2009 at p. 14; email from Beth
Rudofker,Lehman,toWilliamSchlich,Ernst&Young(June5,2008)[EYSECLBHIML000001000142],
forwarding May 21, 2008 email from Matthew Lee regarding second request for balance sheet
substantiation.
84Examiners Interview of Roger Berlind, Dec. 18, 2009, at p. 2; Examiners Interview of Michael L.

Ainslie, Dec. 22, 2009, at pp. 23; Examiners Interview of Sir Christopher Gent, Jan. 20, 2010, at p. 2;
Examiners Interview of Thomas Cruikshank, Jan. 20, 2010, at p. 3; Examiners Interview of Beth
Rudofker, Dec. 15, 2009, at pp. 67; see also Lehman Brothers Holdings Inc., Minutes of the Audit
Committee(June13,2008)[LBEXAM00375960].
85Examiners Interview of Ernst & Youngs Hillary Hansen, Nov. 3, 2009, at p. 15 (Hansen told the

ExaminerthatshedidnofurtherfollowupspecificallyonRepo105/108becauseE&Ywasinthemidstof
collectingallthedata,anditsinvestigationwasnotfinalized).
86SeeSectionIII.A.4(discussingRepo105/108).

21

Inthesectionsthatfollow,thisreportwilldescribeindetailthefactsandanalysis

thatsupporttheExaminersconclusions.Thatdetailwillincludethebasesnotonlyfor

thecolorable claimsthattheExaminer has found,butalso for thosetheExaminer has

consideredbutnotfound.TheExaminerbelievesitisappropriatetosetforththefacts

andanalysisoncolorableclaimsthathehasnotfoundinequaldetail,sothattheparties

canunderstandtheprocessthatledtothoseconclusions.TheissuesthattheExaminer

investigated were framed by the Examiner Order itself, by suggestions made by the

parties and Government agencies with whom the Examiner has had extensive

coordination, and by the natural course of investigation, where a new path (such as

Repo105)wasuncoveredinthecourseoftheinvestigation.

TheReportbeginswithadiscussionofthebusinessdecisionsthatLehmanmade

well before the bankruptcy, and the risk management issues raised by those business

decisions. Ultimately, the Examiner concludes that while certain of Lehmans risk

decisions can be described in retrospect as poor judgment, they were within the

businessjudgmentruleanddonotgiverisetocolorableclaims.Butthosejudgments,

andthefactsrelatedtothem,provideimportantcontextfortheothersubjectsonwhich

the Examiner has found colorable claims. For example, after saddling itself with an

enormous volume of illiquid assets that it could not readily sell, Lehman increasingly

turned to Repo 105 to manage its balance sheet and reduce its reported net leverage.

22

Lehmans acquisition of illiquid assets is also the predicate for the liquidity and

valuationissuesinvestigatedbytheExaminer.

Accordingly, the report will detail the following subjects that the Examiner has

explored:

1. Business and Risk Management The Examiner has explored this subject
because it is central to the question of how and why Lehman amassed the
assets that ultimately it could not monetize in time to maintain liquidity,
acceptable leverage and confidence. The Examiner explored Lehmans
reactiontothesubprimelendingcrisisandothereconomiceventstoanalyze
whetherLehmansofficersanddirectorsfulfilledtheirfiduciaryduties.The
ExaminerconcludesthatsomeofLehmansmanagementsdecisionscanbe
questioned in retrospect, but none fall outside the business judgment rule;
theExaminerfindsnocolorableclaims.87

2. Valuation The Examiner has explored this subject because it is central to


the question of Lehmans solvency and to whether Lehmans financial
statements were accurately stated. The Examiner concludes that Lehmans
valuation procedures may have been wanting and that certain valuations
mayhavebeenunreasonableforpurposesofabankruptcysolvencyanalysis.
The Examiners conclusion that valuations were unreasonable for solvency
analysis does not necessarily mean that individuals acted with sufficient
scienter to support claims for breach of fiduciary duty, and the Examiner
doesnotfindsufficientcredibleevidencetosupportcolorableclaims.88

3. SurvivalTheExaminerhasexploredthissubjectbecauseitiscentraltothe
questionwhethertheofficersanddirectorsdischargedtheirfiduciaryduties.
TheExaminerfindsnocolorableclaims.89

4. Repo105TheExaminerhasexploredthissubjectafteruncoveringtheissue
in the course of his investigation. The Examiner finds there are colorable
claims against Richard Fuld, Jr., Christopher OMeara, Erin Callan, and Ian
Lowittinconnectionwiththeirfailuretodisclosetheuseofthepracticeand

87SeeSectionIII.A.1(discussingLehmansriskmanagement).

88SeeSectionIII.A.2(discussingLehmansvaluation).

89SeeSectionIII.A.3(discussingLehmanssurvival).

23

against Ernst & Young for its failure to meet professional standards in
connectionwiththatlackofdisclosure.90

5. Secured Lenders The Examiner has explored this subject because it was
specificallyassignedaspartofthe Examiner Orderandbecausethesubject
wasaddressedinmultiplecommunicationswiththeparties.TheExaminer
finds colorable claims against JPMorgan Chase (Chase) and CitiBank in
connection with modifications of guaranty agreements and demands for
collateral in the final days of Lehmans existence.91 The demands for
collateral by Lehmans Lenders had direct impact on Lehmans liquidity
pool;LehmansavailableliquidityiscentraltothequestionofwhyLehman
failed.

6. Lehmans Interaction With Government Agencies As part of the


Examinersoverallinvestigation,itwasnecessarytoconsidertheinteraction
between Lehman and the Government agencies who regulated and
monitoredLehman;forexample,LehmanofficerssuggestedtotheExaminer
that he should consider, in the course of determining whether they had
breachedanyfiduciaryduties,thecompletenessofthedisclosurestheymade
totheGovernment.92

B. AreThereAdministrativeClaimsorColorableClaimsForPreferencesor
VoidableTransfers?

Section(B)addressesthefirst,second,third,fourth,seventhandeighthbulletsof

theExaminerOrder:

[Bullet 1] Whether LBCC [Lehman Brothers Commercial Corporation] or any other


entity that currently is an LBHI Chapter 11 debtor subsidiary or affiliate (LBHI
Affiliate(s)) has any administrative claims against LBHI resulting from LBHIs cash

90SeeSectionIII.A.4(discussingRepo105/108).Afterreachingthetentativeconclusionthattheseclaims

existed,theExaminercontactedcounselforeach,advisedthemofthebasisforthepotentialfinding,and
invitedeachofthemtopresentanyadditionalfactsormaterialsthatmightbearonthefinalconclusion.
The Examiner had individual, facetoface meetings with each and carefully considered the materials
raised by each. While the Examiner was directed to credible facts and arguments that might form the
basis for successful defenses, the Examiner concluded in all cases that these possible defenses do not
changehisnowfinalconclusionthatthereissufficientcredibleevidencefromwhichatrieroffactcould
findabreachofdutyafterweighingthecredibleevidenceonbothsidesoftheissue.
91SeeSectionIII.A.5(discussingpotentialclaimsagainstLehmanssecuredlenders).

92SeeSectionIII.A.6(discussingthegovernmentsrole).

24

sweeps of cash balances, if any, from September 15, 2008, the commencement date of
LBHIsChapter11case,throughthedatethatsuchapplicableLBHIaffiliatecommenced
itsChapter11case.

[Bullet2]Allvoluntaryandinvoluntarytransfersto,andtransactionswith,affiliates,
insidersandcreditorsofLBCCoritsaffiliates,inrespectofforeignexchangetransactions
and other assets that were in the possession or control of LBHI Affiliates at any time
commencingonSeptember15,2008throughthedaythateachLBHIAffiliatecommenced
itsChapter11case.

[Bullet3]WhetheranyLBHIAffiliatehascolorableclaimsagainstLBHIforpotentially
insiderpreferencesarisingundertheBankruptcyCodeorstatelaw.

[Bullet4]WhetheranyLBHIAffiliatehascolorableclaimsagainstLBHIoranyother
entities for potentially voidable transfers or incurrences of debt, under the Bankruptcy
Codeorotherwiseapplicablelaw.

[Bullet 7] The intercompany accounts and transfers among LBHI and its direct and
indirectsubsidiaries,includingbutnotlimitedto:LBI,LBIE,LehmanBrothersSpecial
Finance(LBSF)andLBCC,duringthe30dayperiodprecedingthecommencementof
theChapter11casesbyeachdebtoronSeptember15,2008orthereafterorsuchlonger
periodastheExaminerdeemsrelevanttotheInvestigation.

[Bullet8]Thetransactionsandtransfers,includingbutnotlimitedtothepledgingor
grantingofcollateralsecurityinterestamongthedebtorsandthepreChapter11lenders
and/orfinancialparticipantsincluding butnotlimited to,JPMorgan Chase,Citigroup,
Inc.,BankofAmerica,theFederalReserveBankofNewYorkandothers

The Examiner has identified approximately $60 million of administrative

claims.93

TheExaminerhasidentifiedcolorableclaimsthattherewerealimitednumberof

preferentialtransfers.94

93SeeSectionIII.B.2(discussingpossibleadministrativeclaims).

94SeeSectionIII.B.3(discussingpossibleavoidanceactions).

25

TheExaminerhasdeterminedthattherearealimitednumberofcolorableclaims

foravoidanceactionsagainstJPMorgan95andCitibank.96

C. DoColorableClaimsAriseFromTransfersofLBHIAffiliateAssetsto
Barclays,orFromtheLehmanALITransaction?

Section(C)addressesthesixthandninthbulletsoftheExaminerOrder:

[Bullet6]WhetherassetsofanyLBHIAffiliates(otherthanLehmanBrothers,Inc.)were
transferred to Barclays Capital Inc. as a result of the sale to Barclays Capital Inc. that
wasapprovedbyorderoftheBankruptcyCourtenteredSeptember20,2008,andwhether
consequences to any LBHI Affiliate as a result of the consummation of the transaction
createdcolorablecausesofactionthatinuretothebenefitofthecreditorsofsuchLBHI
subsidiaryoraffiliate.

[Bullet 9] The transfer of the capital stock of certain subsidiaries of LBI on or about
September19,2008toLehmanALIInc.

In the course of reviewing whether affiliates other than LBI were adversely

impactedbytheBarclayssale,theExaminerreviewedthefactsrelatedtothetransferof

LBIassetsinthepostfilingsaletoBarclays.Becausetheissuesrelatedtothesaleare

thesubjectofactive,pendinglitigationfiledbytheDebtors,onwhichdiscoveryisfar

fromcomplete,theExaminerexpressesnoviewonthemeritsofthatlitigationandwill

limithimselftosettingoutthefactualrecordhehasdevelopedontheissues.97

95The Examiner notified counsel for JPMorgan of his tentative conclusion and counsel made a
presentation in response. The Examiner carefully considered that presentation but concludes that a
colorableclaimexists.
96SeeSectionIII.B.3(discussingpossibleavoidanceactions).

97SeeSectionIII.C(discussingtheBarclayssaletransaction).

26

TheExaminerconcludesthatalimitedamountofassetsofLBHIAffiliatesother

thanLBIwereimproperlytransferredtoBarclays.98

The Examiner concludes that the transfer of capital stock to ALI served a

legitimatepurposeandthattherewasnoimproprietyinthosetransactions.99

98SeeSectionIII.C(discussingtheBarclayssaletransaction).

99SeeSectionIII.C(discussingtheExaminersconclusionsregardingtheLehmanALItransaction).

27

II. PROCEDURALBACKGROUNDANDNATUREOFTHEEXAMINATION

A. TheExaminersAuthority

On January 16, 2009, the United States Bankruptcy Court for the Southern

District of New York entered an order directing the U.S. Trustee to nominate an

Examiner, and outlining the subject matter of the Examiners investigation (the

Examiner Order).100 The Examiner Order lists ten bulleted topics that the Examiner

was to investigateand,further, mandatesthat the Examiner shall perform theduties

specified in sections 1106(a)(3) and (4) of the Bankruptcy Code [unless otherwise

ordered.]101 Under 11 U.S.C. 1106(a)(3), the Examiner is to investigate the acts,

conduct, assets, liabilities, and financial condition of the debtor, the operation of the

debtorsbusinessandthedesirabilityofthecontinuanceofsuchbusiness,andanyother

matterrelevanttothecaseortotheformulationofaplan[unlessorderedotherwise.]

Under 11 U.S.C. 1106(a)(4), the Examiner must, inter alia, file a statement of any

investigation conducted . . . including any fact ascertained pertaining to fraud,

dishonesty, incompetence, misconduct, mismanagement, or irregularity in the

managementoftheaffairsofthedebtor,ortoacauseofactionavailabletotheestate[.]

100OrderDirectingAppointmentofanExaminerPursuanttoSection1104(c)(2)oftheBankruptcyCode,

atpp.35,DocketNo.2569,InreLehmanBrothersHoldingInc.,etal.,CaseNo.0813555(Bankr.S.D.N.Y.
Jan.16,2009).
101Id.atp.5.

28

OnJanuary19,2009,theU.S.TrusteeappointedAntonR.ValukasasExaminer.102

TheCourtapprovedtheappointmentonJanuary20,2009.103 OnFebruary11,2009,the

CourtapprovedtheExaminersrequesttoemployJenner&BlockLLPascounseland

provided the Examiner with authority to issue subpoenas under Fed. R. Bankr. P.

2004.104 On February 17, 2009, the Court approved the Examiners Preliminary Work

Plan.105 On February 25, 2009, the Court authorized the Examiner to employ Duff &

Phelps,LLCashisfinancialadvisors.106

Despite the complexity of Lehmans bankruptcy and the broad scope of the

Examiners investigation, the time available for the examination was limited by the

practicalneedsofthebankruptcyproceeding.TheExaminerinitiallytargetedtheweek

ofFebruary1,2010tosubmithisreporttotheCourtinordertoassurethatthereport

would be available prior to the March 15, 2010 deadline of the Debtors exclusivity

102NoticeofAppointmentofExaminer,DocketNo.2570,InreLehmanBrothersHoldingsInc.,CaseNo.08

13555(Bankr.S.D.N.Y.Jan.19,2009).
103OrderApprovingAppointmentofExaminer,DocketNo.2583,InreLehmanBrothersHoldingsInc.,Case

No.0813555(Bankr.S.D.N.Y.Jan.20,2009).
104OrderAuthorizingtheExaminertoRetainandEmployJenner&BlockLLPasHisCounselNuncPro

Tunc as of January 19, 2009, Docket No. 2803, In re Lehman Brothers Holdings Inc., Case No. 0813555
(Bankr. S.D.N.Y. Feb. 11, 2009); and Order Granting Examiners Motion Directing the Production of
Documents and Authorizing the Examinations of the Debtors Current and Former Officers, Directors
andEmployees,andOtherPersonsandEntities,DocketNo.2804,InreLehmanBrothersHoldingsInc.,Case
No.0813555(Bankr.S.D.N.Y.Feb.11,2009).
105OrderApprovingthePreliminaryWorkPlanofAntonR.Valukas,Examiner,DocketNo.2855,Inre

LehmanBrothersHoldingsInc.,CaseNo.0813555(Bankr.S.D.N.Y.Feb.17,2009).
106OrderAuthorizingtheExaminertoRetainandEmployDuff&PhelpsLLCasHisFinancialAdvisors

NuncProTuncasofFebruary6,2009,DocketNo.2924,InreLehmanBrothersHoldingsInc.,CaseNo.08
13555(Bankr.S.D.N.Y.Feb.17,2009).
29

periodtoproposeaplanofreorganization.107EventhoughtheDebtorshavesuggested

that they may not file a plan by that date, the Examiner determined that all parties

wouldbebetterservedifheadheredtohisselfimposedFebruary2010schedule.

B. DocumentCollectionandReview

The available universe of Lehman email and other electronically stored

documentsisestimatedatthreepetabytesofdataroughlytheequivalentof350billion

pages. The Examiner carefully selected a group of document custodians and search

termsdesignedtoculloutthemostpromisingsubsetofLehmanelectronicmaterialsfor

review.Inaddition,theExaminerrequestedandreceivedhardcopydocumentsfrom

Lehman and both electronic and hard copy documents from numerous third parties

and Government agencies, including the Department of the Treasury, the SEC, the

Federal Reserve, FRBNY, the Office of Thrift Supervision, the SIPA Trustee, Ernst &

Young, JPMorgan, Barclays, Bank of America, HSBC, Citibank, Fitch, Moodys, S&P,

andothers.108

Intotal,theExaminercollectedinexcessoffivemilliondocuments,estimatedto

comprisemorethan40,000,000pages.Allofthesedocumentshavebeenconvertedto

107Order Granting Debtors Motion, Pursuant to Section 1121(d) of the Bankruptcy Code, Requesting

Second Extension of Exclusive Periods for the Filing of and Solicitation of Acceptances for Chapter 11
Plans, Docket No.4449, In re Lehman Brothers Holdings Inc., CaseNo.0813555 (Bankr.S.D.N.Y.July 20,
2009).
108See Appendix 5 for full details of custodians, search request, search terms and related document

metrics. Although a handful of subpoenas were threatened and in a few cases served, ultimately the
Examinerreceivednearlyallrequesteddocumentsvoluntarily.Intheinterestoftimeandefficiency,the
Examiner did not, except where significant deficiencies were apparent, challenge the completeness of
productionorthewithholdingofdocumentsuponclaimsofprivilege.
30

electronic form and are maintained on two computerized databases, Stratify and

CaseLogistix.TheStratifydatabase,whichishousedandmaintainedonserversbythe

Debtors professionals, Alvarez & Marsal, contains approximately four and a half

millionuniquedocuments,andconsistsofcollectedLehmanemailsandattachments;

theCaseLogistixdatabase,whichishousedandmaintainedbytheExaminerscounsel,

Jenner & Block, contains approximately seven hundred thousand unique documents,

primarilyconsistingofthirdpartyproductions.

Documents were reviewed on at least two levels. First level review was

conductedbylawyerstrainedtoidentifydocumentsofpossibleinterestandtocodethe

substantiveareastowhichthedocumentspertained;thosesoidentifiedweresubjected

tofurtherandmorecarefulreviewbylawyersorfinancialadvisorsespeciallyimmersed

intheearmarkedsubjects.Inordertoreducethecostofreview,theExaminersought

andobtainedtheCourtsapprovaltoretaincontractattorneys.109Agroupofmorethan

70contractattorneys,supplementedbyJenner&Blockattorneys,conductedfirstlevel

reviews. All second level (and beyond) reviews were performed by Jenner & Block

attorneysorDuff&Phelpsprofessionals.

109OrderAuthorizingtheExaminertoRetainCertainContractAttorneystoPerformSpecificDocument

ReviewTasksNuncProTuncasofApril15,2009,DocketNo.3577,InreLehmanBrothersHoldingsInc.,
CaseNo.0813555(Bankr.S.D.N.Y.May15,2009);OrderAuthorizingtheExaminertoRetainAdditional
Contract Attorneys to Perform Specific Document Review Tasks Nunc Pro Tunc as of May 11, 2009,
DocketNo.3750,InreLehmanBrothersHoldingsInc.,CaseNo.0813555(Bankr.S.D.N.Y.June3,2009);and
OrderAuthorizingtheExaminertoRetainAdditionalContractAttorneystoPerformSpecificDocument
ReviewTasksNuncProTuncasofJune11,2009,DocketNo.4428,InreLehmanBrothersHoldingsInc.,Case
No.0813555(Bankr.S.D.N.Y.July16,2009).
31

TheExaminerestimatesthathehasreviewedapproximately34,000,000pagesof

documentsinthecourseofhisinvestigation.TheentirebodyofemailintheStratify

database4,439,924documents,approximately26millionpageshasbeenreviewed.110

Approximately340,000oftheCaseLogistixdocumentsroughlyeightmillionpages

havebeenreviewed.111AlthoughalargenumberoftheCaseLogistixdocumentswere

not reviewed, that database is fully searchable, and the Examiner is reasonably

confident that the repeated and focused searches applied against that database have

discoveredmostifnotallofthemostrelevantdocuments.112

In most cases, documents were produced to the Examiner under stipulated

protective orders, which are described in Appendix 5. Subject to those orders, the

document databases createdbytheExaminerremainaresourcefor theestateandthe

parties. The database includes computerized tagging which will allow persons

interested in making their own searches to narrow and focus search requests. The

Examiner will work with the parties and the Court to resolve logistical and

110OnJanuary30,2010,theExaminerreceivedabout55,500uniqueemailsfromtheDebtorsresponsive

tolongoutstandingrequeststhathadnotearlierbeenproducedduetoadatatransferissue.Earlierthat
week, the Examiner received 30,000 pages of documents from Ernst & Young responsive to long
outstanding requests that had not earlier been produced because a single custodians files had
inadvertently not been included. Despite the lateness of the receipt of these documents, the Examiner
wasabletocompletereviewofthembydeployingateamoflawyerstothetask.
111The Examiner is able to count documents loaded in the two databases with precision, but page

numbersareestimates.Onaverage,theemailandattachmentsintheStratifydatabasearesixpagesper
document; the documents in the CaseLogistix database tend to be larger, averaging 23 pages per
document.
112AsubstantialnumberofadditionaldocumentswereproducedinthependingBarclayssalelitigation

in the weeks before this Report was due. Given the ongoing nature of that litigation and the Courts
concurrencethattheExaminerneednotexpressconclusionsonthesestillinactivelitigationissues,those
documentshavenotbeenreviewedexceptonalimited,focusedbasis.
32

confidentiality issues so that the databases can become an asset available to all

interestedparties.

C. SystemsAccess

Answering the questions posed by the Examiner Order necessarily required an

extensiveinvestigationandreviewofLehmansoperating,trading,valuation,financial,

accounting and other data systems. Interrogating those systems proved particularly

challenging, first because the vast majority of the systems had been transferred and

wereunderthecontrolofBarclays;bythetimeoftheExaminersappointment,Barclays

had integrated its own proprietary and confidential data into some of the systems, so

Barclays had legitimate concerns about granting access to those systems. Although it

took some time, Barclays was cooperative and those issues were for the most part

resolved.

The second challenge was moredaunting. Atthe timeofitsbankruptcyfiling,

Lehmanmaintainedapatchworkofover2,600softwaresystemsandapplications.The

Examiner,inconsultationwithhisfinancialadvisors,decidedearlyonthatitwouldnot

becosteffectivetoundertaketheenormouseffortandexpensethatwouldberequired

to learn and access each of these 2,600 systems. Rather, the Examiner directed his

financial advisors to identify and acquire an indepth understanding of the most

promisingofthesystems.

33

The Examinersfinancialadvisorsultimately requestedaccess to 96 ofthe most

relevantsystems.113Theprocessofidentifyingthosepresenteditownchallenges.Many

of Lehmans systems were arcane, outdated or nonstandard. Becoming proficient

enough to use the systems required training in some cases, study in others, and trial

and error experimentation in others. In numerous instances, the Examiners

professionalswouldrequestaccesstoaparticularsystem,expendthetimenecessaryto

learn how to use the system and only then discover that access to two or three

additionalsystemswasrequiredtoanswerthenecessaryquestions.Lehmanssystems

were highly interdependent, but their relationships were difficult to decipher and not

welldocumented.Ittookextraordinaryefforttountanglethesesystemstoobtainthe

necessaryinformation.

BecausesomesystemswereincurrentusebyBarclaysinitsoperations,Barclays

limitedaccessto79oftherequested96systemstoreadonly.Readonlyaccessmade

thereviewandorganizationofdatamoredifficult.Andinsomecases,readonlyaccess

wasseverelyrestricted.Forsomesystems,theabilitytoquerythedataandsearchfora

particulartransactionwaslimitedtocertainparameters.Forothers,theExaminerwas

denieddirectaccessaltogether,requiringtheneedtorequestthatsearchesbedoneby

Barclaysstechnologypersonnel,whowouldthenforwardfindingstotheExaminer.

113SeeAppendix6.

34

Finally, the accessibility of data was complicated by the fact that the filing of a

bankruptcypetitionbyLehmancamewithvirtuallynoadvancepreparation.Thefiling

did not occur at the close of a month or a quarter when Lehman would prepare

reconciliations and summaries of its financial data. Recordkeeping quickly fell into

disarray upon Lehmans hurried filing. Reconstructing data during this period has

provenachallengenotonlyfortheExaminerbutforallwhomustrelyuponthisdatain

LehmansChapter11proceedings.

Intheend,theExaminersfinancialadvisorsweregenerallyabletogetsufficient

datatoinformandsupporttheExaminersReport,buttheremaybeareas,specifically

noted where appropriate in the text below, where data limitations need to be

considered.

D. WitnessInterviewProcess

Shortly after his appointment, the Examiner spoke with examiners from other

large bankruptcy proceedings, including WorldCom, SemCrude and Refco, and

obtainedtheiradviceonbestpractices.Oneofthesuggestionsmadewasthatwherever

possible interviews be conducted informally, without requiring that the witness be

sworn andwithout transcripts. Thereare obviousprosandcons totheuseofsworn,

transcribed interviews. On the plus side, oath and transcription make citations to

testimony more certain; on the minus side, the formality of oath and transcription

inevitably takes moretime,createsadditionalexpenseandmakessomewitnesses less

35

willingtogivefullcooperation;moreover,thecreationoftranscribedstatementsmight

have impacted pending Government investigations. Balancing these factors, the

Examinerdecidedtouseinformalinterviewswhereverpossibleandthatturnedoutto

be possible inall cases.Toassureaccuracy,allinterviews wereconducted byat least

twoattorneys,oneofwhomwasassignedtokeepcarefulnotes.Flashsummarieswere

prepared as soon as possible, usually the day of the interview, and reviewed by all

lawyerspresentwhilerecollectionsremainedsharp;andfullsummariesweremadeand

reviewedassoonaspracticalafterthat.

In the vast majority of cases, the interviewees were represented by counsel.

Nevertheless,theExamineradvisedeachintervieweethatheisaneutralfactfinderand

that he and his professionals should not be deemed to represent the witness nor any

point of view. Consistent with that neutrality, prior to each interview the Examiner

provided advance notice of the topicsheintendedtocover andadvancecopiesof the

documentsheanticipatedshowingthewitness.TheExaminerdidsoinordertomake

the interview as efficient as possible and to permit the witness to refresh recollection

beforetheinterviewratherthanonthefly.Eachwitnesswasencouragedtoadvisethe

Examiner if he or she believed it was appropriate to correct or supplement the

informationgivenduringtheinterview.

Inall,theExaminerhasinterviewedmorethan250individuals.Therewasonly

one individual the Examiner sought to interview but could not. The Examiner

36

requestedaninterviewwithHectorSants,chiefexecutiveoftheUKsFinancialServices

Authority(FSA),todiscusstheFSAsinvolvementintheeventsofLehmanWeekend

and the Barclays transaction. The FSA considered the request, but did not make Mr.

Sants available for an interview. However, the FSA did provide detailed, written

answerstospecificquestionsthatwouldhavebeenposedtoMr.Sants.

AfulllistofthepersonsinterviewedbytheExaminerissetoutinAppendix4.

E. CooperationandCoordinationWiththeGovernmentandParties

The Examiner received extraordinary cooperation, both from parties and non

parties,withoutwhichthecompletionofthisReportwouldhavetakenfarmoretime.

AlthoughtheDebtorsprofessionals and personnel wereandare extremely busywith

the daytoday requirements of Lehmans liquidation, they remained responsive to

almostdailyrequestsforinformationfromtheExaminerandhisprofessionals.Many

parties,suchastheDebtors,provideddocumentstotheExamineronanexpeditedbasis

withouttakingthetimeforprivilegereview,subjecttoclawbackagreements.

Shortlyafterhisappointment,theExaminermetwithandestablishedaregular

line of contact with the SIPA Trustee to share documents, interview summaries and

otherinformationtoavoidduplicationofeffort.TheExaminermetwiththeSECand

three United States Attorney Offices (New Jersey, Eastern District of New York,

SouthernDistrictofNewYork)toestablishprotocolsforclearingproposedinterviews

37

so as not to interfere with any ongoing investigations. And the Examiner met with

interestedpartiestoobtaintheirguidanceandthoughts.

Throughout the course of the investigation, the Examiner conducted regular,

weeklycallswiththeSECandU.S.Attorneystoupdatethemondevelopmentsandto

describesignificantdocumentsandtheresultsofinterviews.TheExaminerhaslikewise

madedocumentsandtheresultsofinterviewsavailabletotheSIPATrustee.

* * * * * * * * * * *

TheReportnowcontinueswiththedetail.

38

UNITEDSTATESBANKRUPTCYCOURT
SOUTHERNDISTRICTOFNEWYORK

x
:
Inre : Chapter11CaseNo.
:
LEHMANBROTHERSHOLDINGSINC., : 0813555(JMP)
etal., :
: (JointlyAdministered)
Debtors. :
x

REPORTOF
EXAMINERANTONR.VALUKAS

Section III.A.1: Risk

TABLEOFCONTENTS

III. ExaminersConclusions......................................................................................................43
A. WhyDidLehmanFail?AreThereColorableCausesofActionThat
AriseFromItsFinancialConditionandFailure?.....................................................43
1. BusinessandRiskManagement..........................................................................43
a) ExecutiveSummary .......................................................................................43
(1) TheExaminerDoesNotFindColorableClaimsThat
LehmansSeniorOfficersBreachedTheirFiduciaryDutyof
CarebyFailingtoObserveLehmansRiskManagement
PoliciesandProcedures .........................................................................47
(2) TheExaminerDoesNotFindColorableClaimsThat
LehmansSeniorOfficersBreachedTheirFiduciaryDutyto
InformtheBoardofDirectorsConcerningtheLevelofRisk
LehmanHadAssumed ..........................................................................52
(3) TheExaminerDoesNotFindColorableClaimsThat
LehmansDirectorsBreachedTheirFiduciaryDutyby
FailingtoMonitorLehmansRiskTakingActivities.........................54
b) Facts..................................................................................................................58
(1) FromMovingtoStorage:LehmanExpandsItsPrincipal
Investments..............................................................................................58
(a) LehmansChangedBusinessStrategy......................................... 59
(b) TheIncreasedRiskFromLehmansChangedBusiness
Strategy............................................................................................. 62
(c) ApplicationofRiskControlstoChangedBusiness
Strategy............................................................................................. 65
(i) StressTestingExclusions ..................................................... 66
(ii) RiskAppetiteLimitIncreaseForFiscal2007 .................... 70
(iii) DecisionNotToEnforceSingleTransactionLimit .......... 73
(d) TheBoardsApprovalofLehmansGrowthStrategy............... 76
(2) LehmanDoublesDown:LehmanContinuesItsGrowth
StrategyDespitetheOnsetoftheSubprimeCrisis ............................78
(a) LehmansResidentialMortgageBusiness................................... 82
(i) LehmanDecidestoCurtailSubprimeOriginations
butContinuetoPursueAltAOriginations .................. 82
(ii) TheMarch20,2007BoardMeeting .................................... 90

39

(b) TheExplosioninLehmansLeveragedLoanBusiness ............. 95


(i) RelaxationofRiskControlstoAccommodate
GrowthofLehmansLeveragedLoansBusiness ............. 97
(c) InternalOppositiontoGrowthofLeveragedLoans
Business .......................................................................................... 100
(d) GrowthofLehmansCommercialRealEstateBusinessat
TheStartoftheSubprimeCrisis................................................. 103
(i) RelaxationofRiskControlstoAccommodate
GrowthofLehmansCommercialRealEstate
Business ................................................................................ 105
(ii) InternalOppositiontoGrowthofCommercialReal
EstateBusiness..................................................................... 107
(iii) Archstone ............................................................................. 108
a. LehmansCommitment............................................... 108
b. RiskManagementofLehmansArchstone
Commitment................................................................. 112
(e) NagioffsReplacementofGelbandasHeadofFID................. 114
(f) TheBoardofDirectorsAwarenessofLehmans
IncreasingRiskProfile ................................................................. 116
(3) EarlyWarnings:RiskLimitOverages,FundingConcerns,
andtheDeepeningSubprimeCrisis ..................................................117
(a) NagioffandKirkTrytoLimitLehmansHighYield
Business .......................................................................................... 119
(b) JulyAugust2007ConcernsRegardingLehmansAbility
toFundItsCommitments............................................................ 123
(c) LehmanDelaystheArchstoneClosing ..................................... 128
(d) LehmanIncreasestheRiskAppetiteLimitto
AccommodatetheAdditionalRiskAttributabletothe
ArchstoneTransaction ................................................................. 131
(e) CashCapitalConcerns ................................................................. 134
(f) LehmansTerminationofItsResidentialMortgage
Originations ................................................................................... 138
(g) September,October,andNovember2007Meetingsof
BoardofDirectors......................................................................... 139
(i) RiskAppetiteDisclosures .................................................. 139
(ii) LeveragedLoanDisclosures.............................................. 144

40

(iii) LeverageRatiosandBalanceSheetDisclosures ............. 147


(iv) LiquidityandCapitalDisclosures .................................... 148
(4) LateReactions:LehmanSlowlyExitsItsIlliquidRealEstate
Investments............................................................................................150
(a) Fiscal2008RiskAppetiteLimitIncrease................................... 152
(b) January2008MeetingofBoardofDirectors............................. 154
(c) ExecutiveTurnover ...................................................................... 156
(d) CommercialRealEstateSellOff:TooLittle,TooLate ........... 157
(e) LehmansCompensationPractices ............................................ 161
c) Analysis .........................................................................................................163
(1) TheExaminerDoesNotFindColorableClaimsThat
LehmansSeniorOfficersBreachedTheirFiduciaryDutyof
CarebyFailingtoObserveLehmansRiskManagement
PoliciesandProcedures .......................................................................164
(a) LegalStandard .............................................................................. 164
(b) Background.................................................................................... 166
(i) CountercyclicalGrowthStrategywithRespectto
ResidentialMortgageOrigination .................................... 171
(ii) LehmansConcentrationofRiskinItsCommercial
RealEstateBusiness ............................................................ 172
(iii) ConcentratedInvestmentsinLeveragedLoans ............. 175
(iv) FirmWideRiskAppetiteExcesses................................... 179
(v) FirmWideBalanceSheetLimits....................................... 181
(vi) StressTesting ....................................................................... 181
(vii) Summary:OfficersDutyofCare .................................... 182
(2) TheExaminerDoesNotFindColorableClaimsThat
LehmansSeniorOfficersBreachedTheirFiduciaryDutyto
InformtheBoardofDirectorsConcerningtheLevelofRisk
LehmanHadAssumed ........................................................................183
(3) TheExaminerDoesNotFindColorableClaimsThat
LehmansDirectorsBreachedTheirFiduciaryDutyby
FailingtoMonitorLehmansRiskTakingActivities.......................188
(a) LehmansDirectorsareProtectedFromDutyofCare
LiabilitybytheExculpatoryClauseandtheBusiness
JudgmentRule............................................................................... 188

41

(b) LehmansDirectorsDidNotViolateTheirDutyof
Loyalty............................................................................................ 190
(c) LehmansDirectorsDidNotViolateTheirDutyto
Monitor........................................................................................... 191
(i) ApplicationofCaremarktoRiskOversight:Inre
CitigroupInc.......................................................................... 191
(ii) ApplicationofCaremarkandCitigrouptoLehmans
Directors ............................................................................... 193

42

III. EXAMINERSCONCLUSIONS

A. WhyDidLehmanFail?AreThereColorableCausesofActionThatArise
FromItsFinancialConditionandFailure?

1. BusinessandRiskManagement

a) ExecutiveSummary

In2006,Lehmanadoptedamore aggressivebusinessstrategybyexpanding its

investments in potentially highly profitable lines of business that also carried much

more risk than Lehmans traditional investment banking activities. Through the first

halfof2007,Lehmanfocusedonmakingprincipalinvestmentscommittingitsown

capital in commercial real estate (CRE), leveraged lending, and private equitylike

investments. These investments were considerably riskier for Lehman than its other

businesslinesbecauseLehmanwasacquiringpotentiallyilliquidassetsthatitmightbe

unabletosellinadownturn.114

Lehmancontinuedandevenintensifiedthishighriskstrategyaftertheonsetof

the subprime residential mortgage crisis in late 2006. As some Lehman officers

described it, Lehman shifted from focusing almost exclusively on the moving

business a business strategy of originating assets primarily for securitization or

syndication and distribution to others to the storage business which entailed

making longerterm investments using Lehmans own balance sheet.115 Lehman

114See Tobias Adrian, Federal Reserve Bank of New York, and Hyun Song Shin, Princeton University,

FinancialIntermediaries,FinancialStabilityandMonetaryPolicy(Aug.5,2008),atp.13.
115SeeSectionIII.A.1.bofthisReport.

43

continued to pursue commercial real estate and leveraged loan transactions

aggressivelyuntilJuly2007.116

While the decision to shift into longterm investments was voluntary, market

events pushed Lehman ever further from moving to storage. Lehmans primary

mortgage origination subsidiaries, BNC Mortgage Inc. (BNC) and Aurora Loan

Services, LLC (Aurora), continued to originate subprime and other nonprime

mortgages to a greater extent than other mortgage originators, many of whom had

recentlygoneoutofbusiness,orwouldsoondoso.117BNCsandAurorascontinued

mortgage originations increased the volume of illiquid assets on Lehmans balance

sheet albeit unintentionally because Lehman became unable to securitize and

distributethesemortgagestothirdparties.118

Lehmanscontinuedpursuitofthisaggressivegrowthstrategy,evenintheface

of the subprime crisis, was based on two important calculations by Lehmans

management.First,likesomeothermarketparticipants,nottomentiongovernmental

officials,Lehmansmanagementbelievedthatthesubprimecrisiswouldnotspreadto

116SeeSectionIII.A.1.bofthisReport.

117Lehman, Update on Lehman Brothers Subprime Mortgage Origination Business Presentation to


LehmanBoardofDirectors(Mar.20,2007),atp.5[LBHI_SEC07940_025839].
118Lehman,SecuritizedProducts,MBS:NonInvestmentGradeRetainedInterests(Jan.16,2007),atp.1

[LBEXDOCID839039];Lehman,UpdateonLehmanBrothersSubprimeMortgageOriginationBusiness
Presentation to Lehman Board of Directors [Draft] (Mar. 18, 2007), at p. 14 [LBEXDOCID 610173]
(Limited ability to sell below Investment Grade risk profitably in current environment); Examiners
InterviewofMatthewMiller,Sept.24,2009,atp.2.

44

other markets and to the economy generally.119 Second, Lehmans management

believedthatwhileotherfinancialinstitutionswereretrenchingandreducingtheirrisk

profile, Lehman had the opportunity to pick up ground and improve its competitive

position. Lehman had benefited from a similar countercyclical growth strategy

during prior market dislocations, and its management believed it could similarly

benefitfromthesubprimelendingcrisis.120Lehmanmiscalculated.AsLehmansChief

ExecutiveOfficer(CEO)RichardS.Fuld,Jr.lateradmitted,Lehmanunderestimated

both the severity of the subprime crisis and the extent of the contagion to Lehmans

otherbusinesslines.121

The Examiner investigated Lehmans adoption and implementation of this

aggressive countercyclical business strategy for several reasons. First, the potentially

illiquidassetsLehmanacquiredplayedasignificantroleinLehmansultimatefinancial

failure. Lehmans losses were largely concentrated in its commercial real estate

portfolio and in certain less liquid aspects of its residential mortgage origination and

securitization business. Similarly, Lehmans liquidity was compromised by its

119E.g.,ExaminersInterviewofRichardS.Fuld,Jr.,Sept.25,2009,atpp.16,24;ExaminersInterviewof

JosephGregory,Nov.13,2009,atp.7;ExaminersInterviewofTreasurySecretaryTimothyF.Geithner,
Nov.24,2009,atp.3.
120SeeSectionIII.A.1.bofthisReport.

121Examiners Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at pp. 16, 24; Examiners Interview of

RichardMcKinney,Aug.27,2009,atpp.2,9;RichardS.Fuld,Jr.,Lehman,NotesforSeniorManagement
Speech(June16,2008),atpp.56[LBEXDOCID529241],attachedtoemailfromTaimurHyat,Lehman,
toHerbertH.(Bart)McDadeIII,Lehman,etal.(June25,2008)[LBEXDOCID556064].

45

accumulation of assets that it could not sell, including not only the commercial and

residentialrealestateassets,butalso,toalesserextent,theleveragedloanpositions.

Second, emails written by Lehman risk management personnel suggest that

Lehmanseniormanagementdisregardeditsriskmanagers,itsriskpolicies,anditsrisk

limits.122 Press reports prior to Lehmans bankruptcy stated that in 2007 Lehman had

removed Madelyn Antoncic, Lehmans Chief Risk Officer (CRO), and Michael

Gelband, head of its Fixed Income Division (FID), because of their opposition to

managementsgrowingaccumulationofriskyandilliquidinvestments.123Andexternal

monitors of Lehmans affairs, such as the Office of Thrift Supervision (OTS) and

Moodys Investor Services (Moodys), also raised serious questions about Lehmans

riskmanagement,particularlywithrespecttoitscommercialrealestateinvestments.124

122See,e.g.,emailfromKentaroUmezaki,Lehman,toHerbertH.(Bart)McDadeIII,Lehman,etal.(Sept.

10,2008)[LBEXDOCID1718043](notinghistoryof`endaroundsonriskdecisions,riskmanagements
lackofauthorityandlackofauthorityoverbalancesheetandinabilitytoenforcerisklimits);emailfrom
VincentDiMassimo,Lehman,toChristopherM.OMeara,Lehman(Sept.1,2008)[LBEXDOCID203219]
(whateverriskgovernanceprocesswehadinplacewasultimatelynoteffectiveinprotectingthefirm[.]
RiskAppetitemeasureswerenoteffectiveinestablishingclearenoughwarningsignalsthattheFirmwas
taking on too much risk relative to capital. . . . The [Risk Management] function lacked sufficient
authority within the Firm. Decisionmaking was dominated by the business. . . .); email from Satu
Parikh, Lehman, to Michael Gelband, Lehman, Sept. 15, 2008 [LBEXDOCID 882447] (I am shocked at
thepoorriskmgmtatthehighestlevels,andIdontthinkitstartedwithArchstone.Itisallunbelievable
and I think there needs to be an investigation into the broader issue of malfeasance. Mgmt gambled
recklesslywiththousandsofjobsandshareholderwealth....).
123See, e.g., Yalman Onaran, Lehman FaultFinding Points to Last Man Fuld as Shares Languish,

Bloomberg.com,July22,2008.
124SeeOfficeofThriftSupervision,ReportofExamination,LehmanBrothersHoldingsInc.(asofMay31,

2008),atp.2[LBEXOTS000392](findingthatLehmandidnotemploysoundriskmanagementpractices
initscommercialrealestatebusiness);emailfromStephenLax,Lehman,toErinM.Callan,Lehman,et
al.(June9,2008)[LBEXDOCID017840](forwardingtextofMoodysreleaseannouncingdowngradeof
Lehman ratings outlook: The rating action also reflects Moodys concerns over risk management

46

Accordingly,theExaminerinvestigated(1)whethertherearecolorableclaimsfor

breach of the duty of care against Lehmans officers for the manner in which they

administeredLehmansriskmanagementsysteminconnectionwiththeacquisitionof

these illiquid assets; (2) whether there are colorable claims for breach of the duty of

goodfaithandcandoragainstLehmansofficersforfailingfullytoinformtheBoardof

Directors(theBoard)125oftheextentoftheriskandilliquiditythatLehmanassumed

throughthenewstrategy;and(3)whethertherearecolorableclaimsagainstLehmans

directorsforbreachoftheirdutytomonitorLehmansriskmanagement.

TheExaminer concludesthat the conduct of Lehmans officers,whilesubjectto

questioninretrospect,fallswithinthebusinessjudgmentruleanddoesnotgiveriseto

colorableclaims.TheExaminerconcludesthatLehmansdirectorsdidnotbreachtheir

dutytomonitorLehmansrisks.

(1) TheExaminerDoesNotFindColorableClaimsThatLehmans
SeniorOfficersBreachedTheirFiduciaryDutyofCareby
FailingtoObserveLehmansRiskManagementPoliciesand
Procedures

Delaware law, which governs a Delaware corporation such as Lehman, sets a

high bar for establishing a breach of the fiduciary duty of care.126 Officers and

directors business decisions are generally protected from personal liability by the

decisionsthatresultedinelevatedrealestateexposuresandthesubsequentineffectivenessofhedgesto
mitigatetheseexposures).
125ReferencestotheBoardinthisSectionoftheReportrefertoLehmansoutsidedirectors,nottoFuld,

whowasCEOandChairmanoftheBoard.
126ForadetaileddiscussionofDelawarecorporatefiduciarylaw,seeAppendix1.

47

businessjudgmentrule,andevenifthebusinessjudgmentruledoesnotapply,thereis

no liability unless the officer or director was grossly negligent. In the duty of care

context gross negligence has been defined as reckless indifference to or a deliberate

disregardofthewholebodyofstockholdersoractionswhicharewithouttheboundsof

reason.127

The proof necessary to defeat the business judgment rule and establish gross

negligence is particularly high with respect to risk management and financial

transactions. Banking is inherently risky and prone to financial losses caused by

unforeseenchangesinthemarkets.128 Profitabilitydependslargelyonthefirmsability

toevaluatetherisksofpotential investmentsandbalance themagainsttheirpotential

gains.129 Consequently, to establish a colorable claim that Lehman officers breached

their fiduciary duty by mismanaging business risk, the evidence must show that

Lehmans senior management was reckless or irrational in managing the risks

associated with the principal investment strategy that Lehman pursued during 2006

and2007.130

Lehmanhadsophisticatedpolicies,procedures,andmetricsinplacetoestimate

therisk that thefirmcouldassumewithoutjeopardizing itsabilityto achievea target

127McPaddenv.Sidhu,964A.2d1262,1274(Del.Ch.2008)(quotingBenihanaofTokyo,Inc.v.Benihana,Inc.,

891A.2d150,192(Del.Ch.2005)).
128SeeInreCitigroupInc.SholderDerivativeLitig.,964A.2d106,126(Del.Ch.2009).

129Seeid.

130SeeAppendix1,LegalIssues.

48

rateofreturn,andtoapprisemanagementandtheBoardwhetherLehmanwaswithin

various risk limits.131 Lehman also used an array of stress tests to determine the

potential financial consequences of an economic shock to its portfolio of assets and

investments.132 Lehman had an extensive staff that was devoted solely to risk

management.133

Theserisklimitsandstresstests,however,didnotimposelegalrequirementson

managementorpreventmanagementandtheBoardfromexceedingthoselimitsifthey

chosetodoso.134Theroleoftherisklimitsandstresstestswastocausemanagementto

consider whether a particular investment or a broad business strategy was worth the

riskitcarried.135Inaddition,Lehmanuseditsriskmanagementsystemtopromoteits

capabilities to investors, rating agencies, and regulators.136 Lehmans management

always retained the discretion to use its judgment to decide whether to pursue

particularstrategiesortransactions.137

TheExaminerdidfindthatinpursuingitsaggressivegrowthstrategy,Lehmans

managementchosetodisregardoroverrulethefirmsriskcontrolsonaregularbasis.

ThequestionwhetherthereisacolorableclaimthatLehmansseniorofficersbreached

131SeegenerallyAppendix1,LegalIssues.

132AppendixNo.8,RiskManagementOrganizationandControls.

133Id.

134Id.

135Seeid.

136Id.

137Seeid.

49

their fiduciary duty of care focuses on facts relating to Lehmans acquisition of

potentially illiquid investments in 2007 and the manner in which management used

Lehmans risk management system as part of its process of making investment

decisions:

Lehmans management decided to exceed risk limits with respect to


Lehmans principal investments, namely, the concentration limits on
Lehmans leveraged loan and commercial real estate businesses, including
the single transaction limits on the leveraged loans. These limits were
designed to ensure that Lehmans investments were properly limited and
diversified by business line and by counterparty. Lehman took highly
concentrated risks in these two business lines, and, partly as a result of
marketconditions,ultimatelyexceededitsrisklimitsbymarginsof70%asto
commercialrealestateandby100%astoleveragedloans.138

Lehmansmanagementexcludedcertainriskyprincipalinvestmentsfromits
stresstests.AlthoughLehmanconductedstresstestsonamonthlybasisand
reportedtheresultsofthesestresstestsperiodicallyto regulatorsandtoits
BoardofDirectors,thestresstestsexcludedLehmanscommercialrealestate
investments, its private equity investments, and, for a time, its leveraged
loancommitments.Thus,Lehmansmanagementdidnothavearegularand
systematicmeansofanalyzingtheamountofcatastrophiclossthatthefirm
couldsufferfromtheseincreasinglylargeandilliquidinvestments.139

Lehmandidnotstrictlyapplyitsbalancesheetlimits,whichweredesigned
tocontaintheoverallriskofthefirmandmaintainthefirmsleverageratio
withintherangerequiredbythecreditratingagencies,butinsteaddecided
to exceed those limits. To mitigate the apparent effect of these overages,
LehmanusedRepo105transactionstotakeassetstemporarilyoffthebalance
sheet before the ends of reporting periods. (The Repo 105 transactions are
discussedinSectionIII.A.4ofthisReport.)140

Lehmans management decided to treat primary firmwide risk limit the


risk appetite limit as a soft guideline, notwithstanding Lehmans

138AppendixNo.9,comparingriskappetiteandVaRusageversuslimits.

139SeeSectionIII.A.1.bofthisReport.

140Seeid.

50

representations to the Securities Exchange Commission (SEC) and the


Board that the risk appetitelimit wasa meaningful constrainton Lehmans
risktaking.141 Lehman managements decision not to enforce the risk
appetitelimitwasapparentinseveralways:

Between December 2006 and December 2007, Lehman raised its firm
wideriskappetitelimitthreetimes,goingfrom$2.3to$4.0billion.142

BetweenMayandAugust2007,Lehmanomittedsomeofitslargestrisks
from its risk usage calculation. The primary omitted risk was a $2.3
billion bridge equity position in the ArchstoneSmith Real Estate
Investment Trust (Archstone or Archstone REIT) real estate
transaction, an extraordinarily large and risky commitment. Had
Lehmans management promptly included that risk in its usage
calculation,itwouldhavebeenimmediatelyapparentthatLehmanwas
overitsrisklimits.143

After Lehman did include the Archstone risk in the firms risk appetite
usage, Lehman continued to exceed the limit for several more months.
Rather than aggressively reduce Lehmans balance sheet in response to
these indicators of excessive risktaking, Lehman raised its firmwide
risklimitagain.144

Although these decisions by Lehmans management ultimately proved to be

unwise, the Examiner finds insufficient evidence to support a determination that

Lehmans senior officers conduct with respect to risk management was outside the

businessjudgmentruleorrecklessorirrational.145

141 E.g., SEC, Lehman Monthly Risk Review Meeting Notes (July 19, 2007), at p. 5 [LBEXSEC 007363]

(Jeff [Goodman] told us that . . . VaR is just one measure that Lehman uses, and is more of a speed
bump/warningsignthatatrue,hardlimitthatrolefallstoRA[(i.e.riskappetite)].[.]Hesaidthat
Madelyn[Antoncic],Dave[Goldfarb],andtheexecutivecommitteetendtolookmoreatRA.Asanaside,
MadelyncameinafterJeffsexplanationandgavevirtuallythesamespeech);seealsoSectionIII.A.1.bof
thisReport.
142SeeSectionIII.A.1.bofthisReport.

143Seeid.

144Seeid.

145SeeSectionIII.A.1.cofthisReport.

51

Based upon their considerable business experience and successful track record,

Lehmansseniormanagersdecidedtoplaceahigherpriorityonincreasingprofitsthan

on keeping the firms risk level within the limits arising from its risk management

policies and metrics. Lehmans senior managers were confident making business

judgmentsbasedontheirunderstandingofthemarkets,anddidnotfeelconstrainedby

the quantitative metrics generated by Lehmans risk management system. These

decisions raise questions about the role of risk management in a complex financial

institution,buttheydonotgiverisetoacolorableclaimofthebreachofthefiduciary

dutyofcaregiventhehighbartoliabilityestablishedbyDelawarelaw.

(2) TheExaminerDoesNotFindColorableClaimsThatLehmans
SeniorOfficersBreachedTheirFiduciaryDutytoInformthe
BoardofDirectorsConcerningtheLevelofRiskLehmanHad
Assumed

The Examiner finds insufficient evidence to support a determination that

Lehmans senior managers breached their fiduciary duty of candor, which required

them to provide the Board with material reports concerning Lehmans risk and

liquidity.146

Thefactualissuesrelevanttothedutyofcandorarethesameriskmanagement

issues relevant to the duty of care. Lehmans officers did not disclose certain

146Appendix No. 1, Legal Issues; In re Amer. Intl Group, Inc., 965 A.2d 763, 80607 (Del. Ch. 2009) (In

colloquial terms, a fraud on the board has long been a fiduciary violation under our law and typically
involvesthefailureofinsiderstocomecleantotheindependentdirectorsabout...informationthatthe
insidersfearwillbeusedbytheindependentdirectorstotakeactionscontrarytotheinsiderswishes).

52

information concerning the amount or duration of the firmwide risk limit overages,

their decisions to exceed certain concentration limits, or the limitations in the firms

stresstesting.NordidLehmansofficersdisclosethatLehmansoriginationsofAltA

mortgagesmortgagesthatwereconsideredriskierthantypicalprimemortgagesbut

notsoriskyastobecategorizedassubprimewereexposingthefirmtosubprime

mortgage risk, even as Lehman was curtailing originations of loans actually

denominated as subprime. Lehmans directors generally said that if such risk

management issues were significant and longlasting, they would have liked to have

receivedmoreinformationaboutthem,butwouldnotnecessarilyhavetakenactionasa

result.147

However,theExaminerfoundthatLehmansmanagementdidinformtheBoard,

clearly and on more than one occasion, that it was taking increased business risk in

ordertogrowthefirmaggressively;thattheincreasedbusinessriskresultedinhigher

risk usage metrics and ultimately firmwide risk limit overages; and that market

conditions after July 2007 were hampering the firms liquidity.148 Lehmans

management also informed the Board, accurately, that the subprime mortgage crisis

147ExaminersInterviewofRogerS.Berlind,May8,2009,atp.4;ExaminersInterviewofMarshaJohnson

Evans, May 22, 2009, at p. 6; Examiners Interview of Roland A. Hernandez, Oct. 2, 2009, at p. 10;
Examiners Interview of John D. Macomber, Sept. 25, 2009, at p. 17; Examiners Interview of Henry
Kaufman,May19,2009,atp.17;ExaminersInterviewofSirChristopherGent,Oct.21,2009,atpp.1416;
ExaminersInterviewofMichaelAinslie,Sept.22,2009,atpp.34.ForinformationconcerningtheBoard
meetings where these general topics were discussed, the directors statements to the Examiner about
thosemeetings,andthedirectorsstatementsaboutthematerialityofthesefacts,seeSectionIII.A.1.bof
thisReport.
148SectionsIII.A.1.bofthisReport.

53

was constricting profitability and that management was tightening origination

standardsandtakingotherstepstoaddressthatcrisis.149

These disclosures were not so incomplete as to lead to the conclusion that

LehmansmanagementmisledtheBoardofDirectors.NordidLehmansofficershave

a legal duty to disclose additional details to the Board. Lehmans risk limits and

controls were designed primarily for managements internal use in making business

decisions concerning the core issue faced by any financial institution: what business

riskstotakeandwhatbusinessriskstodecline.150Whiletheoverallriskmanagementof

the firm is an appropriate topic for board consideration, the daytoday decisions are

primarilytheresponsibilityofofficers,notdirectors.151

(3) TheExaminerDoesNotFindColorableClaimsThatLehmans
DirectorsBreachedTheirFiduciaryDutybyFailingtoMonitor
LehmansRiskTakingActivities

Lehmans corporate charter and related aspects of Delaware law protect its

directors from personal liability based upon their business decisions. As a result, the

directorscannotbeheldliableforabreachofthedutyofcare;ratherthedirectorscan

be liable for inadequately monitoring Lehmans affairs only if their failure to monitor

wassoegregiousastorisetothelevelofabreachofthedutyofloyaltyorthedutyof

149SectionIII.A.1.bofthisReport.

150SeeAppendixNo.8,RiskManagementOrganizationandControls.

151See17C.F.R.240.15c31e&15c34(2007)(requiringLehmantosubmitacomprehensivedescription

of its internal risk management control system to the SEC); NYSE, Inc., Listed Company Manual
303A(7)(c)(iii)(D)&cmt.(2010)(requiringauditcommitteeofboardtodiscusspolicieswithrespectto
riskassessmentandriskmanagementwhilenotingthatitisthejoboftheCEOandseniormanagement
toassessandmanagethecompanysexposuretorisk).

54

good faith. The Delaware courts have called this type of claim referred to as a

Caremark claim possibly the most difficult theory in corporation law upon which a

plaintiffmighthopetowinajudgment.152

The conduct typically evaluated in Caremark claims has been the failure to

monitormanagersunlawfulconduct.Incontrasthere,aclaimthatthedirectorsfailed

to satisfy their duty to monitor the extent of risk assumed by management and its

compliancewithcorporateriskpolicieswouldrequireproofthatthedirectorsfailedto

monitor managers judgment as to internal procedures that were not legally binding.

The business judgment rule applies with particular force to such a claim because the

questionofhowmuchriskaninvestmentbankcanreasonablyassumegoestothecore

ofitsbusiness.153

The Examiner finds insufficient evidence of a breach of fiduciary duty by any

Lehmandirector.ThedirectorsreceivedreportsconcerningLehmansbusinessandthe

levelandnatureofitsrisktakingateveryBoardmeeting.Althoughthesereportsnoted

the elevated levels of risk to Lehmans business beginning in late 2006, management

informedthedirectorsthattheincreasedrisktakingwaspartofadeliberatestrategyto

grow the firm. The directors continued to receive such reports throughout 2007, and

wererepeatedlyinformedaboutdevelopmentsinthesubprimemarketsandthecredit

marketsgenerally.Managementassuredthedirectorsthatitwastakingprudentsteps

152InreCaremarkIntlInc.DerivativeLitig.,698A.2d959,967(Del.Ch.1996).

153InreCitigroupInc.SholderLitig.,964A.2d106,126(Del.Ch.2009).

55

toaddresstheserisksbutthatmanagementsawtheunfoldingcrisisasanopportunity

topursueacountercyclicalgrowthstrategy.Managementsreportstothedirectorsdid

notcontainredflagsimposingonthedirectorsadutytoinquirefurther.154

Delawarelawpermitsdirectorstorelyonmanagementsreportsandimmunizes

the directors from personal liability when they do so.155 Consequently, there is

insufficient evidence to establish a colorable claim that Lehmans directors breached

theirdutytomonitorLehmansmanagementofitsrisks.

*****

Although the Examiner does not find colorable claims against Lehmans senior

officers or directors concerning Lehmans risk management, a complete discussion of

thefactsdiscoveredbytheExaminersinvestigationofriskmanagementisimportantin

two fundamental respects. First, the Examiner sets out the facts in detail so that the

Court and the parties have the basis for the Examiners conclusion that Lehman

managementsdecisionswithrespecttoriskanditscountercyclicalgrowthstrategydo

notgiverisetocolorableclaims.

154See,e.g.,LehmanBrothersHoldingsInc.,MinutesofMeetingoftheBoardofDirectors(June19,2007)

[LBHI_SEC07940_026267];Lehman,LehmanBoardofDirectorsMaterialsforJune19,2007BoardMeeting
(June19,2007)[LBHI_SEC07940_026214];LehmanBrothersHoldingsInc.,MinutesofMeetingofBoard
ofDirectors(Sept.11,2007)[LBHI_SEC07940_026364];Lehman,LehmanBoardofDirectorsMaterialsfor
Sept. 11, 2007 Board Meeting (Sept. 7, 2007) [LBHI_SEC07940_026282]; Lehman Brothers Holdings Inc.,
Minutes of Meeting of Board of Directors (Oct. 15, 2007), at p. 6 [LBHI_SEC07940_026407]; Lehman,
Lehman Board of Directors Materials for Oct. 15, 2007 Board Meeting (Oct. 11, 2007)
[LBHI_SEC07940_026371].
155SeeDEL.CODEANN.tit.8,141(e)(2009).

56

Second,thesefactsshowhowLehmansapproachtoriskultimatelycreatedthe

conditionsthatledLehmanstopmanagerstouseRepo105transactionsasdiscussedin

Section III.A.4 of this Report. Lehmans aggressive growth strategy also provides

context for several other issues discussed in this Report, including issues concerning

Lehmansliquiditypoolandassetvaluations.Lehmansgrowthstrategyresultedina

dramaticgrowthofLehmansbalancesheet:

Allfiguresin($Billions) Q406 Q107 Q207 Q307 Q407 Q108 Q208


ReportedNetAssets156 268.936 300.797 337.667 357.102 372.959 396.673 327.774

Lehmansnetassetsincreasedbyalmost$128billionor48%inalittleoverayearfrom

thefourthquarterof2006throughthefirstquarterof2008.

This increase in Lehmans net assets was primarily attributable to the

accumulationofpotentiallyilliquidassetsthatcouldnoteasilybesoldinadownturn.

By one measure, Lehmans holdings of less liquid assets more than doubled during

thesametimeperiodincreasingfrom$86.9billionattheendofthefourthquarterof

2006to$174.6billionattheendofthefirstquarterof2008.157

156Lehmandefinednetassetsastotalassetsexcluding:(1)cashandsecuritiessegregatedandondeposit

for regulatory and other purposes; (2) securities received as collateral; (3) securities purchases under
agreementstoresell;(4)securitiesborrowed;and(5)identifiableintangibleassetsandgoodwill.Lehman
Brothers Holdings Inc., Annual Report for 2007 10K as of Nov. 30, 2007 (Form 10K) (filed on Jan. 29,
2008),atp.63.
157Lehman Brothers Holdings Inc., Lehman Brothers Fact Book Q2 2008 (June 13, 2009), at p. 16

[LBHI_SEC07940_593047]. Lehmans public filings include a different quantification of Lehmans less


liquidassets. According to these sources, Lehmans less liquidasset holdings almost quadrupled from
the third quarter of 2006 until the first quarter of 2008, with a particularly sudden spike in the fourth
quarterof2007.LehmanBrothersHoldingsInc.,QuarterlyReportasofAug.31,2006(Form10Q)(filed
on Oct. 10, 2006), at pp. 16, 7172 (LBHI 10Q (filed Oct 10, 2006)); Lehman Brothers Holdings Inc.,

57

To explainthebusinessand riskdecisions thatledLehman management down

thispath,thefollowingportionsofthisSectionoftheReportdescribe:

1. Lehmansdecisionin2006totakemoreprincipalrisk;

2. The dramatic growth in Lehmans principal investments and in its balance


sheet during the first half of Lehmans fiscal 2007, culminating in the
acquisitionofArchstone,towhichLehmancommittedinMay2007;

3. Itbecameapparentduring2007thatLehmansbalancesheethadgrowntoo
large,andthatLehmanhadtakenontoomuchrisk;

4. How, even after it became apparent that Lehmans growth strategy had
exposed the firm to financial peril, Lehman still acted without sufficient
urgencytodeleverage.

b) Facts

(1) FromMovingtoStorage:LehmanExpandsItsPrincipal
Investments

During the course of 2006, Lehmans management and Board made the

deliberate business decision to increase the firms risk profile generally, andto take

moreriskspecificallywithrespecttoprincipalinvestmentswiththefirmscapital.This

new strategy was directed by Lehmans highest officers primarily Fuld, Joseph

AnnualReportfor2006asofNov.30,2006(Form10K)(filedonFeb.13,2007),atpp.6667(LBHI2006
10K);LehmanBrothersHoldingsInc.,QuarterlyReportasofFeb.28,2007(Form10Q)(filedonApr.9,
2007), at pp. 15, 19, 60 (LBHI 10Q (filed Apr. 9, 2007)); Lehman Brothers Holdings Inc., Quarterly
ReportasofMay31,2007(Form10Q)(filedonJuly10,2007),atpp.17,22,64(LBHI10Q(filedJuly10,
2007));LehmanBrothersHoldingsInc.,QuarterlyReportasofAug.31,2007(Form10Q)(filedonOct.
10, 2007), at pp. 18, 23, 67 (LBHI 10Q (filed Oct. 10, 2007)); Lehman Brothers Holdings Inc., Annual
Reportfor2007asofNov.30,2007(Form10K)(filedonJan.29,2008),atpp.6162,104(LBHI200710
K);LehmanBrothersHoldingsInc.,QuarterlyReportasofFeb.29,2008(Form10Q)(filedonApr.9,
2008),atpp.21,27,55,71(LBHI10Q(filedApr.9,2008));LehmanBrothersHoldingsInc.,Quarterly
ReportasofMay31,2008(Form10Q)(filedonJuly10,2008),atpp.26,29(LBHI10Q(filedJuly10,
2008));seealsoSectionIII.A.1.b.4ofthisReport.

58

Gregory(LehmansPresidentandChiefOperatingOfficer),andHughE.(Skip)McGee

III(GlobalHeadofInvestmentBanking)aftersignificantinternaldebate.

ThisSectionoftheReportdescribestheprincipalinvestmentstrategyadoptedby

Lehman in 2006; explains the risks that this strategy posed to the firm; describes how

Lehmans risk controls were applied (or not) to the new strategy; and explains the

Boardsunderstandingof,andagreementwith,thenewstrategy.

(a) LehmansChangedBusinessStrategy

In2006,Lehmanmadeasignificantchangeinitsbusinessstrategyfromalower

risk brokerage model to a higher risk, capitalintensive banking model. Historically,

Lehman described itself as being primarily in the moving business, not the storage

business.158Lehman,forthemostpart,didnotuseitsbalancesheettoacquireassetsfor

its own investment; rather, Lehman acquired assets such as commercial and

residential real estate mortgages primarily to move them by securitization or

syndicationanddistributiontothirdparties.

During2006,Lehmansmanagementdecidedtoemphasizethestoragebusiness

using Lehmans balance sheet to acquire assets for longerterm investment.159 Fuld

believed that other banks were using their balance sheets to make more proprietary

investments, that these investments were highly profitable relative to theirrisk inthe

158ExaminersInterviewofPaulShotton,June5,2009,atp.12.

159Id.atp.2.

59

thenbuoyanteconomicenvironment,andthatLehmanwasmissingoutonsignificant

opportunitiestodothesame.160

Lehmans management primarily focused on expanding three specific areas of

principalinvestment:commercialrealestate;leveragedloans;andprivateequity.

Commercial real estate investments were considered a strong candidate for

expansion because those investments had historically been a strength of the firm.161

MarkA.Walsh,LehmansheadoftheGlobalRealEstateGroup(GREG),wasoneof

themostsuccessfulandtrustedoperatorsatthefirm;managementbelievedthatWalsh

could investLehmans capital wisely and could distribute any excess risk to other

investors.162 The firm was even willing to make commercial real estate bridge equity

investmentstakingpotentiallyriskierequitypiecesofrealestateinvestmentsonthe

theory that the bridge equity, though riskier than the debt, could quickly be resold to

third parties at a profit.163 Lehman was well paid for bridge equity in the commercial

160Examiners Interview of Richard S. Fuld Jr., Sept. 25, 2009, at pp. 1012 (Fuld said that Lehman
expandedintotheleveragedlending,bridgeequityandprincipalinvestingtogainwalletshare.Fuld
wantedtousethe8020ruletogetthewalletshareofLehmanstopclients.The8020rulesaysthatthe
top20%ofthefirmsclientswillprovide80%ofthefirmsearnings.);ExaminersInterviewofJeremyM.
Isaacs,Oct.1,2009,atp.6.
161ExaminersInterviewofPaulA.Hughson,Oct.28,2009,atp.3.

162ExaminersInterviewofRogerNagioff,Sept.30,2009,atp.14;ExaminersInterviewofMarkWalsh,

Oct. 21, 2009, at pp. 45; email from Jeffrey Goodman, Lehman, to Mark A. Walsh, Lehman (Sept. 19,
2006)[LBEXDOCID1368068].
163ExaminersInterviewofMarkA.Walsh,Oct.21,2009,atp.6.

60

real estate business, and management believed that Walshs distribution network

minimizedtheriskthatthefirmwouldbeunabletosellit.164

The business strategy to expand the leveraged loan business was somewhat

different. Lehmans management recognized that leveraged loans in their own right,

including the bridge equity components of those transactions, were risky relative to

their profitability.165 But Fuld, Gregory, and McGee in particular believed that if

Lehman made loans to private equity sponsors as part of major M&A transactions,

Lehmanwouldbuildlongtermclientrelationshipswiththesponsorsandperhapswith

other institutions involved in the transaction.166Fuld, Gregory, and McGee believed

thateverydollarthatLehmanmadefromaleveragedloanwouldleadtofivedollarsof

followonprofitsinthefuture.167

The firms aggressive growth strategy was apparent in various firmwide

presentationsgivenbyseniormanagementandincertainhighlevelbusinessandrisk

takingdecisionsmadeduring2006andattheoutsetofthe2007fiscalyear.AsDavid

Goldfarb (then Lehmans Global Head of Strategic Partnerships, Principal Investing,

164Lehman,FIDOffsitePresentationandNotes(Sept.28,2006),atp.10[LBEXDOCID2042292,2068495],

attachedtoemailfromMichaelGelband,Lehman,toRichardS.Fuld,Jr.,Lehman,etal.(Sept.26,2006)
[LBEXDOCID2384245].
165Examiners Interview of Kentaro Umezaki, June 25, 2009, at pp. 10, 13; Examiners Interview of

MichaelGelband,Aug.12,2009,atp.6;ExaminersInterviewofAlexKirk,Jan.12,2010,atp.6.
166ExaminersInterviewofHughE(Skip)McGeeIII,Aug.12,2009,atpp.78;ExaminersInterviewof

JosephGregory,Nov.13,2009,atp.3;accordExaminersInterviewofRichardS.Fuld,Jr.,Sept.25,2009,
atp.12.
167ExaminersInterviewofJosephGregory,Nov.13,2009,atp.3;ExaminersInterviewofAlexKirk,Jan.

12,2010,atp.7.

61

and Risk) put it, Lehman was pursuing 13% annual growth in revenues, and to

support this revenue growth [Lehman was] targeting an even faster increase in the

firmsbalancesheet,totalcapitalbaseandriskappetiteeachofwhich[was]projected

to increase by 15% per year.168 Goldfarb noted that Lehman had been pedal to the

metalingrowthmodefortheprevioustwoyears,butplannedtocontinuethatgoing

forward.169Thatyear,FuldandGelband(thenheadofFID)alsogavepresentationsin

whichtheydiscussedLehmansaggressivegrowthstrategy.170

(b) TheIncreasedRiskFromLehmansChangedBusiness
Strategy

ThebusinessstrategythatLehmanpursuedbeginningin2006wasriskyinlight

ofthefirmshighleverageandsmallequitybase.Commercialrealestateinvestments,

leveragedloansandotherprincipalinvestmentsconsumedmorecapital,entailedmore

risk,andwerelessliquidthanLehmanstraditionallinesofbusiness.171

The lack of liquidity increased the risk to the firm in several ways. Having a

largevolumeofilliquidassetsmadeitmuchmoredifficultforthefirmtoaccomplish

168DavidGoldfarb,Lehman,GlobalStrategyOffsitePresentation(Mar.2006),atpp.3031[LBEXDOCID

1342496],attachedtoemailfromChristopherM.OMeara,Lehman,toJacquelineRoncagliolo,Lehman
(Apr.3,2006)[LBEXDOCID1357100].
169Id.atp.10.

170ExaminersInterviewofRichardS.Fuld,Jr.,Sept.25,2009,atp.11;Lehman,FIDOffsitePresentation

and Notes (Sept. 28, 2006) [LBEXDOCID 2042292, 2068495], attached to email from Michael Gelband,
Lehman,toRichardS.Fuld,Jr.,Lehman,etal.(Sept.26,2006)[LBEXDOCID2384245].
171 Less liquid investments were Level 3. Level 1 assets have readily available markets to provide

pricesandliquidity,suchasexchangetradedequities.Level2assetshaveobservableeventstoprovide
pricing, such as comparable sales. Level 3 assets have no readily available pricing mechanism and
thereforearelessliquidthanLevel1and2assets.

62

threeimportantgoalsinadifficultfinancialenvironment:toraisecash;tohedgerisks;

ortosellassetstoreducetheleverageinitsbalancesheet.

When a financial institution suffers losses, it often needs to raise cash to fund

itself.172 But illiquid investments are difficult to use for that purpose because they

cannotbesoldquickly.173Whenilliquidinvestmentsaresoldinadifficultmarket,the

seller often takes a much larger loss on the sale than on a liquid asset.174 Similarly,

illiquidassetsaremoredifficulttouseascollateralforborrowing.175Theyoftencannot

beusedintherepomarket,whichwasacrucialsourceoffundingforinvestmentbanks

such as Lehman.176 If a borrower pledges illiquid assets as collateral, there will be a

largerhaircut,thatis,adiscountfromthemarketvalueofthepledgedcollateral,than

forliquidassets.177

172SeeLehman,CapitalAdequacyReview(Sept.11,2008),atp.1[LBEXDOCID012124].

173See Tobias Adrian, Federal Reserve Bank of New York, and Hyun Song Shin, Princeton University,

FinancialIntermediaries,FinancialStabilityandMonetaryPolicy(Aug.5,2008),atp.13.
174MartinOehmke,PuttingtheBrakesonCollateralLiquidations,ColumbiaBusinessSchoolIdeasatWork,

July28,2009,
http://www4.gsb.columbia.edu/ideasatwork/feature/731624/Putting+the+Brakes+on+Collateral+Liquidati
ons(lastvisitedonFeb.1,2010).
175Id.; see alsoMoodys Investor Services, Press Release: Moodys Text: ChangesLehman Outlook From

StableToNegative(June9,2008).
176Examiners Interview of Anuraj Bismal, Sept. 16, 2009, at p. 10; Lehman, Accounting Policy Manual

(Sept.9,2006)[LBEXDOCID3213287],attachedtoemailfromMarieStewart,Lehman,toMartinKelly,
Lehman,etal.(Dec.5,2007)[LBEXDOCID3223385].
177See Lehman, Update on Risk, Liquidity and Capital Adequacy Presentation (Aug. 17, 2007), at p. 48

[LBEXDOCID 2031705] (Lehmans funding framework took account of the inability to fund illiquid
assetsthroughtherepomarket;thereforethefirmalwaysfundedilliquidholdingswithlongtermassets
andliabilities).

63

Financial institutions generally engage in transactions designed to hedge their

risks.178Butilliquidinvestmentsaretypicallymoredifficulttohedge.179Infact,Lehman

decidednottotrytohedgeitsprincipalinvestmentriskstothesameextentasitsother

exposures for precisely this reason its senior officers believed that hedges on these

investmentswouldnotworkandcouldevenbackfire,aggravatinginsteadofmitigating

Lehmanslossesinadownturn.180Asaresult,Lehmanacquiredalargevolumeofun

hedgedassetsthatultimatelycausedLehmansignificantlosses.181

Inadifficultfinancialenvironment,italsoisimportantforfinancialinstitutions

to be able to reduce their leverage and risk profile.182 The more highly leveraged the

institutionis,themoreimportantitisfortheinstitutiontobeginreducingleverageas

soonasmarketconditionsturnagainstit.Butiftheneedtoreduceleverageforcesthe

sale of illiquid assets at a loss, it has a double impact; in addition to the loss, the

178Cf. Examiners Interview of Alex Kirk, Jan. 12, 2010, at p. 9; Examiners Interview of Roger Nagioff,

Sept.30,2009,atpp.3,13.
179Cf.ExaminersInterviewofRogerNagioff,Sept.30,2009,atpp.3,13.

180Examiners Interview of Roger Nagioff, Sept. 30, 2009, at pp. 3, 13; Examiners Interview of Roger

Berlind, May 8, 2009, at p. 7; Examiners Interview of Fred S. Orlan, Sept. 21, 2009, at p. 6; Examiners
Interview of Paul Shotton, June 5, 2009, at pp. 78; Examiners Interview of Kentaro Umezaki, June 25,
2009,atp.17;Lehman,2ndQuarter2007Review:CreditFacilitationGroup(June2007),atpp.12[LBEX
DOCID 514908]; Lehman, Leveraged Finance Risk Presentation (June 2007), at p. 12 [LBEXDOCID
3283752];emailfromChristopherM.OMeara,Lehman,toIanT.Lowitt,Lehman(Sept.27,2007)[LBEX
DOCID 193218]; email from Jeffrey Goodman, Lehman, to Christopher M. OMeara, Lehman (Oct. 1,
2007) [LBEXDOCID 201866]; email from Jeffrey Goodman, Lehman, to Paul Shotton, Lehman, et al.
(Mar. 19, 2008) [LBEXDOCID 335666]; Andrew J. Morton, Lehman, Hedging Fixed Incomes Portfolio
Presentation (Aug. 8, 2008), at pp. 2, 3, 8, 11 [LBEXDOCID 011869], attached to email from Thomas
Odenthal,Lehman,toAndrewJ.Morton,Lehman,etal.(Aug.6,2008)[LBEXDOCID069824].
181Examiners Interview of Roger Nagioff, Sept. 30, 2009, at pp. 3, 13; Examiners Interview of Paul

Shotton,June5,2009,atpp.78.
182Cf.ExaminersInterviewofTreasurySecretaryTimothyF.Geithner,Nov.24,2009,atpp.78.

64

perception can be that there is air in the valuation of the other illiquid assets that

remainonthebalancesheet,exacerbatingtheriskofalossofconfidenceinthefirms

future.183

During the declining market of 200708, Lehman suffered from all these

problems.Lehmanhaddifficultysellingstickyassetsandwasunabletoreduceits

balancesheetquicklythroughtypicalmeans.Instead,Lehmanexpandedthevolumeof

Repo 105 transactions that misleadingly and temporarily reduced its balance sheet

solelyforthepurposeofthefirmspublicfinancialreports.184

(c) ApplicationofRiskControlstoChangedBusiness
Strategy

Lehmans principal investments in illiquid assets presented new and increased

formsofrisktothefirm,butLehmansmanagementdidnotrecalibratethefirmspre

existing risk controls to ensure that its new investments were properly evaluated,

monitoredandlimited.Ifanything,tofacilitatethenewinvestmentstrategy,Lehmans

management relaxed its controls in several ultimately fateful ways, discussed below.

Lehmans senior officerstook this tack notwithstanding their periodic statements to

183Id.;seeMoodysInvestorServices,PressRelease:MoodysText:ChangesLehmanOutlookFromStable

ToNegative(June9,2008).
184SeeSectionIII.A.4ofthisReport.

65

LehmansBoard,theratingagencies,andtheSECthatitsriskmanagementsystemwas

arigorousindependentcheckontherisksundertakenbyitsbusinesslines.185

(i) StressTestingExclusions

One of Lehmans major risk controls was stress testing. Historically, Lehmans

stress testing had not been designed to encompass the risks posed to the firm by

principal investments in real estate and private equity, because those positions

previouslymadeupasmallportionofLehmansportfolio.186Lehmandidnotreviseits

stresstestingtoaddressitsevolvingbusinessstrategy.

Lehman was required by the SEC187 to conduct some form of regular stress

testing on its portfolio to quantify the catastrophic loss it could suffer over a defined

period of time.188 Lehman ran a series of stress tests based on13 or 14 different

scenarios.189Someofthescenarioswerehistoricalevents,suchasthe1987stockmarket

185MadelynAntoncic,RiskManagementPresentationtoStandard&Poors[Draft](Aug.17,2007),atp.5

[LBEXDOCID 342851] (Global Risk Management Division is independent of the trading areas),
attached to email from Lisa Rathgeber, Lehman, to Jeffrey Goodman, Lehman, et al. (Aug. 15, 2007)
[LBEXDOCID305205];SECDivisionofMarketRegulation,LehmanBrothersConsolidatedSupervised
Entity Market and Credit Risk Review (June 2005), at pp. 34 [LBEXDOCID 2125011] (saying Risk
Management was independent of Lehmans business units), attached to email from Michelle Danis,
SEC, to David Oman, Lehman, et al. (Apr. 21, 2006) [LBEXDOCID 2068428]; Lehman, Risk Update
Presentation to Lehman Board of Directors (July 18, 2006), at pp. 5, 8 [LBEXDOCID 2125293] (saying
Lehmans risk approach applie[d] analytical rigor overlaid with sound practical judgment; Lehman,
Risk Management Update Presentation to Lehman Board of Directors (Apr. 15, 2008), at pp. 12
[LBHI_SEC07940_02790929](sayingLehmanprovidedanindependentviewofrisk).
186ExaminersInterviewofPaulShotton,Oct.16,2009,atp.2.

187Seeinfra,SectionIII.A.6.

188ExaminersInterviewoftheSecuritiesandExchangeCommission,Aug.24,2009,atp.13.

189See, e.g., Lehman, Stress Test Report for March 31, 2006 [LBEXDOCID 2078161], attached to email

fromSandeepGarg,Lehman,toPatrickWhalen,Lehman,etal.(Apr.24,2006)[LBEXDOCID2118206];
Lehman,StressTestReportforFebruary28,2007[LBEXDOCID632363],attachedtoemailfromMelda

66

crash or the 1998 Russian financial crisis, while other scenarios were hypothesized by

Lehmans risk managers.190 Lehmans management represented to its external

constituents that regular and comprehensive stress tests were performed to evaluate

the potential P&L impact on the Firms portfolio of abnormal yet plausible market

conditions.191 Stress testing was designed to measure tail riska one in ten year

typeevent.

When Lehman first adopted stress testing in about 2005, it applied the testing

only to its tradable instruments such as stocks, bonds, and other securities; it did not

include its untraded assets such as its commercial real estate or private equity

investments.192 Because these assets did not trade freely, they were not considered

susceptible to stress testing over a shortterm scenario.193 And since Lehman did not

thenhavesignificantinvestmentsintheseareas,excludingthemfromthestresstesting

Elagoz,Lehman,toPaulShotton,Lehman,etal.(Mar.9,2007)[LBEXDOCID630356];StressTestReport
forOctober31,2007[LBEXDOCID632432],attachedtoemailfromJeffreyGoodman,Lehman,toCherie
Gooley, Lehman (Dec. 19, 2007) [LBEXDOCID 665513]; Stress Test Report for Apr. 30, 2008 [LBEX
DOCID3296803],attachedtoemailfromMarkWeber,Lehman,toCherieGooley,Lehman,etal.(May
28,2008)[LBEXDOCID3302270].
190Lehman, Risk Management Presentation to Fitch (Apr. 7, 2006), at p. 47 [LBEXDOCID 691768];

Lehman,Risk,Liquidity,Capital,andBalanceSheetUpdatePresentationtoFinanceandRiskCommittee
ofLehmanBoardofDirectors(Sept.11,2007),atp.28[LBEXAM067167].
191E.g., Madelyn Antoncic, Lehman, Risk Management Presentation to Standard & Poors [Draft] (Aug.

17,2007),atpp.3839[LBEXDOCID342851],attachedtoemailfromLisaRathgeber,Lehman,toJeffrey
Goodman,Lehman,etal.(Aug.15,2007)[LBEXDOCID305205].
192Examiners Interview of Paul Shotton, Oct. 16, 2009, at pp. 56; Examiners Interview of Jeffrey

Goodman,Aug.28,2009.
193ExaminersInterviewofJeffreyGoodman,Aug.28,2009.

67

did not undermine the usefulness of the results.194 The SEC was aware of this

exclusion.195

Atvariouspointsin2006and2007,Lehmansriskmanagersconsideredwhether

toincludeprincipalinvestmentsinLehmansstresstesting.196Aninternalauditadvised

that Lehman address the main risks in the Firms portfolio, including illiquidity

andconcentrationrisk.197ButLehmandidnottakesignificantstepstoincludethese

privateequitypositionsinthestresstestinguntil2008,eventhoughtheseinvestments

becameanincreasinglylargeportionofLehmansriskprofile.198

Until late 2007, Lehmans stress testing also excluded its leveraged loan

commitments i.e., the leveraged loans that Lehman had committed to fund in the

future,buthadnotyetclosed.199Thisexclusionappearstohavebeeninadvertent.200

194ExaminersInterviewofPaulShotton,Oct.16,2009,atpp.56.

195Examiners Interview of Matthew Eichner, Nov. 23, 2009, at p. 12; Examiners Interview of Paul
Shotton,Oct.16,2009,atp.6.
196EmailfromMarcHenn,Lehman,toMariaTurner,Lehman,(Mar.2,2007)[LBEXDOCID264992];e

mail from Melda Elagoz, Lehman, to Jeffrey Goodman, Lehman, et al. (June 11, 2007) [LBEXDOCID
384503];Lehman,2006CompetitorAnalysisKeyConsiderations(Dec.1,2006)[LBEXDOCID2110930],
attachedtoemailfromMireyNadler,Lehman,toFredSteinberg,Lehman(Dec.1,2006)[LBEXDOCID
2042308];emailfromGerardReilly,Lehman,toChristopherM.OMeara,Lehman(May17,2006)[LBEX
DOCID1342418];emailfromJamesBallentine,Lehman,toMichaelGelband,Lehman,etal.(Jan.4,2007)
[LBEXDOCID384818].
197Lehman,InternalVaRAuditReport[Draft](Feb.26,2007),atp.3[LBEXDOCID232917],attachedto

emailfromLisaRathgeber,Lehman,toPaulShotton,Lehman(Feb.26,2007)[LBEXDOCID232916].
198ExaminersInterviewofChristopherM.OMeara,Aug.14,2009,atp.25.

199Examiners Interview of Roger Nagioff, Sept. 30, 2009, at pp. 1011; Examiners Interview of Paul

Shotton,Oct.16,2009,atp.4;emailfromMeldaElagoz,Lehman,toJefferyGoodman,Lehman(July16,
2007)[LBEXDOCID385103];emailfromJefferyGoodman,Lehman,toStephenLax,Lehman,etal.(Nov.
14,2007)[LBEXDOCID297400].
200Examiners Interview of Roger Nagioff, Sept. 30, 2009, at pp. 1011; Examiners Interview of Paul

Shotton,Oct.16,2009,atp.4.

68

Because Lehmans stress testing did not include its real estate investments, its

private equity investments or, during a crucial time period, its leveraged loan

commitments,Lehmansmanagementpursueditstransitionfromthemovingbusiness

to the storage business without the benefit of regular stress testing on the primary

businesslinesthatwerethesubjectofthisstrategicchange.Forexample,asdescribed

below, Lehman entered into a series of large and risky commercial real estate

transactionsinthefirsthalfof2007withoutstresstestingtheparticulartransactionsand

withoutconductingregularstresstestingonLehmansaggregatecommercialrealestate

book.201

This exclusion was significant. Experimental stress tests conducted in 2008

showedthatalargeproportionofLehmanstailriskperhapsevenalargemajorityof

its overall tail risk lay with the businesses that were previously excluded from the

stress testing. One stress test posited maximum potential losses of $9.4 billion,

including$7.4billioninlossesonthepreviouslyexcludedrealestateandprivateequity

positions,andonly$2billiononthepreviouslyincludedtradingpositions.202Another

stresstestshowedtotallossesof$13.4billion,ofwhich$2.5billionwasattributableto

201SeeSectionIII.A.1.bofthisReport.

202Lehman, Stress Test Report (June 30, 2008), at p. 3 [LBEXDOCID 3326829], attached to email from

NancyMalik,Lehman,toPaulShotton,Lehman,etal.(June30,2008)[LBEXDOCID3301915];Lehman,
PrivateEquityandRealEstateStresses,GlobalMarketRiskManagementpresentation(June30,2008),at
pp.34[LBEXDOCID3301916]attachedtoemailfromNancyMalik,Lehman,toPaulShotton,Lehman,
etal.(June30,2008)[LBEXDOCID3301915].

69

the firms included positions, and $10.9 billion was attributable to the excluded

positions.203

Butthesestresstestswereconductedlongaftertheseassetshadbeenacquired,

andtheywereneversharedwithLehmansseniormanagement.204Foramoredetailed

discussionofLehmansstresstesting,seeAppendix8,RiskManagementOrganization

andControls.

(ii) RiskAppetiteLimitIncreaseForFiscal2007

Lehmanhadaseriesofriskappetitelimitsthatitconsideredthecenterofits

approach to risk.205 Risk appetite was a measure that aggregated the market risk,

credit risk, and event risk faced by Lehman.206 Lehman had an elaborate set of

proceduresdesignedtocalculatetheriskappetiteusageineachofitsbusinesslines,

each of its divisions,and for the firm asa whole.207 These risk appetite usage figures

werecalculatedeveryday.208

203Lehman, Stress Test Report (June 30, 2008), at p. 1 [LBEXDOCID 384227] attached to email from

NancyMalik,Lehman,toPaulShotton,Lehman,etal.(Sept.2,2008)[LBEXDOCID385413].
204ExaminersInterviewofMarkWeber,Aug.11,2009,atp.14;ExaminersInterviewofChristopherM.

OMeara,Sept.23,2009,atp.19.
205See,e.g.,JaredPedowitz,BMRMMarketRiskManagementWalkthroughTemplate(Nov.30,2007),at

p.9 [EYLELBHIKEYPERS 1015089]; Madelyn Antoncic, Lehman, Risk Management Presentation to


Standard&Poors [Draft](Aug.17,2007),at p.23 [LBEXDOCID342851],attached to email fromLisa
Rathgeber,Lehman,toJeffreyGoodman,Lehman,etal.(Aug.15,2007)[LBEXDOCID305205].
206Madelyn Antoncic, Lehman, Risk Management Presentation to Standard & Poors [Draft] (Aug. 17,

2007), at p. 21 [LBEXDOCID 342851], attached to email from Lisa Rathgeber, Lehman, to Jeffrey
Goodman,Lehman,etal.(Aug.15,2007)[LBEXDOCID305205].
207SEC Division of Market Regulation, Lehman Brothers Consolidated Supervised Entity Market and

CreditRiskReview(2005),atpp.45[LBEXDOCID2125011].
208See, e.g., email from Jenny Peng, Lehman, to David Goldfarb, Lehman, et al. (Oct. 12, 2007) [LBEX

DOCID 152049] (containing summary Daily Risk Appetite and VaR Report for Oct. 10, 2007), and

70

Atthebeginningofeachyear,Lehmansetnumericallimitsontheriskappetite

usageitwaswillingtotakeforeachsuchbusinessunitandforthefirmasawhole.209

ManagementpresentedthefirmwidelimittotheBoard.210

Under Lehmans limit policy, lowerlevel limits applicable to a single business

line or geographic area were relatively soft and could be exceeded based on

appropriate authority.211 Lehmans higherlevel limits were harder and required

greaterauthorizationiftheywereexceeded.212Thefirmwideriskappetitelimitwasthe

hardestofall,andifitwasexceeded,theRiskCommitteeofthefirmwasrequired

toconsiderthepropercourseofactiontotake.213TheRiskCommitteewascomposedof

the Executive Committee of the firm, the Chief Risk Officer (CRO), and the Chief

FinancialOfficer(CFO).Whileonewitnesssaidthattheonlypermissiblereactionto

attachedspreadsheet(Oct.12,2007)[LBEXDOCID150128](containingdailyriskappetitereport,global
riskappetitereportorganizedbyrisktype,anddailyVaRreport).
209SEC Division of Market Regulation, Lehman Brothers Consolidated Supervised Entity Market and

Credit Risk Review (2005), at pp. 45 [LBEXDOCID 2125011]. See Appendix 8, Risk Management
OrganizationandControls(discussingriskappetitelimits).RiskappetitemeasuredtheamountLehman
couldloseinagiveyearandstillachieveanacceptablelevelofnetprofit.
210Itisnotclearwhetherthepresentationwasforratificationandapprovalorsimplyforinformation.See

e.g.,Lehman,2008FinancialPlanSummaryPresentationtoLehmanBoardofDirectors(June29,2008),at
p.11[LBHI_SEC07940_027374].
211Lehman,MarketRiskManagementLimitPolicyManual(Oct.2006),atp.2[LBHI_SEC07940_767665),

attached to email from Christopher M. OMeara to Kristi Michelle Reynolds (Apr. 7, 2008)
[LBHI_SEC07940_767661].
212Lehman Brothers Global Risk Management, Second Quarter 2008 Report (July 21, 2008), at p. 29

[LBEXDOCID738522],attachedtoemailfromElizabethAgosto,Lehman,toJeffreyGoodman,Lehman,
etal.(July21,2008)[LBEXDOCID670132].
213E.g.,SEC,LehmanMonthlyRiskReviewMeetingNotes(July19,2007),atp.5[LBEXSEC007363];SEC

Division of Market Regulation, Lehman Brothers Consolidated Supervised Entity Market and Credit
RiskReview(2005),atp.6[LBEXDOCID2125011].

71

exceeding the firmwide limit was immediately reducing the risk faced by the firm,214

most Lehman personnel said that senior management could cure a limit excess by

grantingatemporaryreprievefromthelimitorbyincreasingthelimit.215Aswiththe

stresstests,managementdescribedtheriskappetitelimitstoregulators,ratingagencies

andtheBoardasameaningfulcontrolthatLehmanusedtomanageitsrisktaking.216

At the end of 2006, Lehman dramatically increased its risk appetite limits

applicabletofiscal2007.Thefirmwidelimitincreasedfrom$2.3billionto$3.3billion,

and subsidiary limits also increased significantly, particularly insofar as the principal

investingbusinesseswereconcerned.217

These increases in the risk appetite limits were somewhat controversial. The

CROatthetime,MadelynAntoncic,arguedforasignificantlylowerincreaseto$2.6or

$2.7 billion, and the much higher $3.3 billion figure was apparently the result of a

214ExaminersInterviewofKentaroUmezaki,June25,2009,atp.5.

215E.g.,ExaminersInterviewofMadelynAntoncic,Oct.6,2009,atp.7;ExaminersInterviewwithDavid

Goldfarb,Sept.21,2009,atp.5;ExaminersInterviewofPaulShotton,June5,2009,atpp.1011(saying
thatthefirmwideriskappetitelimitwasahardlimit,thebreachofwhichhadtobecuredbyeither
reducingthefirmsoverallriskorraisingthelimit).
216MadelynAntoncic,RiskManagementPresentationtoStandard&Poors[Draft](Aug.17,2007),atp.

23 [LBEXDOCID 342851], attached to email from Lisa Rathgeber, Lehman, to Jeffrey Goodman,
Lehman, et al. (Aug. 15, 2007) [LBEXDOCID 305205]; SEC Division of Market Regulation, Lehman
BrothersConsolidatedSupervisedEntityMarketandCreditRiskReview(June2005),atpp.45[LBEX
DOCID2125011],attachedtoemailfromMichelleDanis,SEC,toDavidOman,Lehman,etal.(Apr.21,
2006)[LBEXDOCID2068428];Lehman,RiskUpdatePresentationtoLehmanBoardofDirectors(July18,
2007),atpp.1112[LBEXDOCID2125293].
217LehmanBrothers,2007RiskAppetiteLimit(Jan.7,2007),atp.1[LBEXDOCID158938],attachmentto

email from Robert Azerad, Lehman, to Madelyn Antoncic, Lehman (Jan. 11, 2007) [LBEXDOCID
158331].

72

compromise with other senior managers.218 Moreover, to justify the increased limit

amount, Lehman changed the way that it calculated the limit; had Lehman used the

samemethodtocalculatethe2007limitthatithadusedtocalculatethe2006limit,the

2007limitwouldhavebeenseveralhundredmilliondollarslower.219

Increasingthefirmwidelimitto$3.3billionfacilitatedarapidexpansionofthe

firms risk profile between 2006 and 2007. As described below,within the first few

monthsoffiscal2007,Lehmanquicklyusedthefullamountofthenew$3.3billionrisk

appetite limit and then some. In late 2007 and early 2008, Lehman relaxed its risk

appetitelimitsinseveralotherways,whicharedescribedbelow.Foramoredetailed

discussion of Lehmans risk appetite limits, see Appendix 8, Risk Management

OrganizationandControls.

(iii) DecisionNotToEnforceSingleTransactionLimit

In 2006, to facilitate the planned expansion of the leveraged loan business,

Lehmans Executive Committee decided to be more flexible with respect to the firms

single transaction limit.220 The single transaction limit was actually two limits one

limit applicable to the notional amount of the expected leveraged loan and a second

218Examiners Interview of Madelyn Antoncic, Mar. 27, 2009, at p. 13; email from David Goldfarb,
Lehman, to Madelyn Antoncic, Lehman, et al. (Nov. 2, 2006) [LBEXDOCID 2125677]; email from
MadelynAntoncic,Lehman,toChristopherM.OMeara,Lehman(Nov.2,2006)[LBEXDOCID2125679];
email from Christopher M. OMeara, Lehman, to Madelyn Antoncic, Lehman (Nov. 2, 2006) [LBEX
DOCID2125680].
219Lehman, 2007 Financial Plan Presentation to Finance and Risk Committee of the Board of Directors

(Jan.30,2007),atpp.2122[LBEXAM067099].
220ExaminersInterviewofAlexKirk,Jan.12,2010,atpp.78.

73

limit applicable to a calculated amount that Lehman was at risk of losing on the

leveraged loan. The limits were partly a function of Lehmans equity. Lehman had

previouslyagreedwiththeratingagenciesthatitwouldadoptasingletransactionlimit

akintolimitspreviouslyadoptedbycommercialbanks.221

AlthoughLehmansExecutiveCommitteealwaysretainedthefreedomtowaive

the single transaction limit as to any individual transaction, Lehman informed its

external constituents that this prerogative would be exercised only in rare

circumstances.222

Inlate2006,Lehmansmanagementdecidednottoenforcethesingletransaction

limit because it had cost Lehman significant opportunities.223 Because Lehman had a

dramatically smaller equity base than its commercial banking competitors, and a

somewhat smaller equity base even than its investment banking competitors, Lehman

had a lower single transaction limit than its competitors, which forced it to forgo or

limititsparticipationinanumberofbigdeals.224Lehmansmanagementdecidedthat

221Appendix8,RiskManagementOrganizationandControls.

222Madelyn Antoncic, Lehman, Standard Risk Management Presentation (Undated), at p. 21 [LBEX

DOCID 194031], attached to email from Paul Shotton, Lehman, to Christopher M. OMeara, Lehman
(Feb. 20, 2008) [LBEXDOCID 214223]; Madelyn Antoncic, Lehman, Standard Risk Management
Presentation,atp.21[LBEXDOCID194031].
223ExaminersInterviewofAlexKirk,Jan.12,2010,atpp.78;Lehman,AppendixtoFinancialSponsors

Strategies (Including Lending Capacity Solutions) Presentation to the Executive Committee (Aug. 3,
2006),atp.6[LBEXDOCID1343776],attachedtoemailfromBlairSieff,Lehman,toMadelynAntoncic,
Lehman,etal.(Aug.2,2006)[LBEXDOCID1360977].
224Lehman, Appendix to Financial Sponsors Strategies (including Lending Capacity Solutions)

PresentationtotheExecutiveCommittee(Aug.3,2006),atpp.3,6[LBEXDOCID1343776],attachedtoe
mail from Blair Sieff, Lehman, to Madelyn Antoncic, Lehman, et al. (Aug. 2, 2006) [LBEXDOCID

74

inthefuture,itwouldparticipateinsuchdealswithoutregardtothesingletransaction

limit.225Moreover,Lehmandidnotapplythesingletransactionlimittoitscommercial

real estate deals, even though some of its risk managers advocated for this broader

applicationofthelimit.226

Likethedecisiontoincreasethefirmwideriskappetitelimit,thedecisionnotto

enforce the single transaction limit was controversial within Lehmans management.

Alex Kirk, then head of Lehmans Credit Business, had primary responsibility for the

leveraged loan business, thought that the single transaction limit was an important

methodoflimitingthefirmsriskonitsleveragedloans.227Antoncicalsothoughtthat

the firm should continue to abide by the single transaction limit in part because the

substantive terms of the leveraged loans were increasingly lopsided in favor of the

private equity sponsors and unfavorable for the lending banks.228 Although Antoncic

1360977];Lehman,FinancialSponsorsStrategies(includingLendingCapacitySolutions)Presentationto
the Executive Committee (Aug. 3, 2006), at pp. 1011 (LBEXDOCID 1343775], attached to email from
BlairSieff,Lehman,toMadelynAntoncic,Lehman,etal.(Aug.2,2006)([LBEXDOICD1360977].
225EmailfromJoeLi,Lehman,toPaulMitrokostas,Lehman(Aug.30,2007)[LBEXDOCID2547330];Joe

Li,Lehman,STLBacktestingExcelSpreadsheet(July25,2007)[LBEXDOCID2506462],attachedtoemail
from Joe Li, Lehman, to Fred S. Orlan, Lehman, et al. (July 25, 2007) [LBEXDOCID 2563167]; accord
ExaminersInterviewofAlexKirk,Jan.12,2010,atpp.78.
226Cf. Examiners Interview of Madelyn Antoncic, Oct. 6, 2009, at p. 12; email from Jeffrey Goodman,

Lehman,toZevKlasewitz,Lehman(Jan.17,2007)[LBEXDOCID794864];emailfromJeffreyGoodman,
Lehman,toZevKlasewitz,Lehman(Feb.12,2007)[LBEXDOCID794879].
227ExaminersInterviewofAlexKirk,Jan.12,2010,atpp.78.

228ExaminersInterviewofMadelynAntoncic,Mar.27,2009,atp.9.

75

thoughtthefirmshouldabidebythesingletransactionlimit,229KirkandAntoncicwere

overruledbyFuld,Gregory,andMcGee.230

(d) TheBoardsApprovalofLehmansGrowthStrategy

Lehmans Board fully embraced Lehmans growth strategy. In a January 2007

Board meeting, the directors were informed of the large increase in the risk appetite

limit for fiscal 2007, and of the firms intention to expand its footprint in principal

investments,andtheyagreedwithLehmansseniorofficersthatLehmanneededtotake

moreriskinordertocompete.231AllofthedirectorstoldtheExaminerthattheyagreed

withLehmansgrowthstrategyatthetimeitwasundertaken.232.

AlthoughtheperiodicmaterialsthattheFinanceandRiskCommittee233received

aboutthefirmsstresstestingdisclosedthattestswereconductedonthefirmstrading

portfolio and We subject both our trading and our counterparty portfolio to stress

229Id.;ExaminersInterviewofAlexKirk,Jan.12,2010,atpp.68.

230ExaminersInterviewofAlexKirk,Jan.12,2010,atpp.78;ExaminersInterviewofMadelynAntoncic,

Mar.27,2009,atp.9.
231Examiners Interview of Sir. Christopher Gent, Oct. 21, 2009, at pp. 78; Examiners Interview of

ThomasCruikshank,Oct.8,2009,atpp.23;ExaminersInterviewofRolandA.Hernandez,Oct.2,2009;
ExaminersInterviewofJohnD.Macomber,Sept.28,2009,atp.12;ExaminersInterviewofMichaelL.
Ainslie, Sept. 22, 2009, at p. 8; Examiners Interview of Marsha Johnson Evans, May 22, 2009, at p. 12;
ExaminersInterviewofDr.HenryKaufman,May19,2009,atpp.78,14;ExaminersInterviewofRoger
Berlind,May8,2009,atpp.67;ExaminersInterviewofJohnF.Akers,Apr.22,2009,atp.9.
232Id.

233The Board had a Finance and Risk Committee that generally met twice a year and received more

detailedinformationthanthefullBoardonthesetopics.Dr.HenryKaufman,formermanagingdirector
ofSalmonBrothers,wastheheadoftheFinanceandRiskCommittee.

76

tests,234managementdidnotinformtheFinanceandRiskCommitteethatmanyofthe

firms commercial real estate and private equity investments were excluded from the

firmsstresstests.235

The omission was noted on January 29, 2008, when the Finance and Risk

Committeereceivedmaterialsstatingthatrealestateownedandprivateequitywere

excluded from the stress testing.236 No member of the Board who was asked by the

Examiner about the issue recalled noticing this revised disclosure, and no member

recalledLehmansofficersexplainingitorotherwisebringingittotheattentionofthe

Board.237Somedirectorswerenotconcernedabouttheexclusionoftheseinvestments

from the stress testing, saying that the exclusions appeared reasonable at the time.238

234Lehman Brothers Holdings Inc., Risk, Liquidity, Capital and Balance Sheet Update Presentation to

FinanceandRiskCommitteeofLehmanBoardofDirectors(Sept.11,2007),atp.28[LBEXAM067167
233].
235Examiners Interview of Paul Shotton, Oct. 16, 2009, at p. 5; see also Lehman Brothers Holdings Inc.,

Risk, Liquidity, Capital and Balance Sheet Update Presentation to Finance and Risk Committee of
LehmanBoardofDirectors(Sept.11,2007),atp.29[LBEXAM067167233].
236 Lehman, 2008 Financial Plan Presentation to Lehman Finance and Risk Committee of the Board of

Directors(Jan.29,2008),atp.19[LBHI_SEC07940_068559].
237Cf.ExaminersInterviewofJerryA.Grundhofer,Sept.16,2009,atp.7;ExaminersInterviewofRoland

A.Hernandez,Oct.2,2009;ExaminersInterviewofJohnD.Macomber,Sept.25,2009,atp.4;Examiners
Interview ofDr. Henry Kaufman, Sept. 2,2009,at p. 11; contraExaminers Interview of Christopher M.
OMeara,Sept.23,2009,atp.18.
238 Examiners Interview of Dr. Henry Kaufman, Sept. 2, 2009, at pp. 23, 1011 (Despite [these]

exclusions, [Kaufman] was not concerned with the result to the stress tests.); Examiners Interview of
JerryA.Grundhofer,Sept.16,2009,atp.7(sayingtheexclusionlookedreasonableandthatitwouldbe
hardfor[Grundhofer]tobelieveLehmanwasnotfollowingthestandardforconductingstresstests.);see
Examiners Interview of Sir Christopher Gent, Oct. 21, 2009, at pp. 1314 (saying he did not find stress
testshelpfulandthoughtsomeassetsmightbeexcluded).

77

However,onedirectorsaidthatiftheexclusionwasmaterial,hewouldhavewantedto

knowaboutit.239

The Board also was not told that Lehmans management had decided not to

applythesingletransactionlimitstoitsleveragedloans.AlthoughtheExaminerhas

found no evidence that before 2008, Lehmans management had represented to the

Board that any single transaction limit had been adopted,240 some directors said that

concentration limits were important protections for the firm, and they would have

wantedtoknowaboutsignificantexcessesaboveconcentrationlimits.241

In sum, during the second half of 2006, Lehman began to pursue a more

aggressive principal investment strategy, and it relaxed several risk limits to facilitate

thatstrategy.

(2) LehmanDoublesDown:LehmanContinuesItsGrowth
StrategyDespitetheOnsetoftheSubprimeCrisis

Late in the second half of 2006, the first signs of weakness in the subprime

residential mortgage market were apparent.242 For example, delinquency rates on

subprimeloans,whichhadhoverednear10%in2004and2005,reached13%bytheend

239 ExaminersInterviewofJohnD.Macomber,Sept.25,2009,atp.11.
240See,e.g.,Lehman,RiskUpdatePresentationtoLehmanBoardofDirectors(July18,2006)[LBEXWGM

986315](notmentioningsingletransactionlimit);butseeLehman,RiskManagementUpdatePresentation
toLehmanBoardofDirectors(Apr.15,2008),atp.1[LBHI_SEC07940_027909](WehaveanoverallRisk
Appetitelimitwhichissupplementedby...singletransaction,countryandotherconcentrationlimits.).
241Examiners Interview of Dr. Henry Kaufman, Sept. 2, 2009, at p. 6; Examiners Interview of John

Macomber,Sept.25,2009,atpp.6,17.
242BankforInternationalSettlements,77thAnnualReport(June24,2007),atp.109.

78

of 2006.243 In addition, after peaking in mid2006, housing prices began to decline

steeply.244Thisdeclineinpricesthreatenedthesubprimemortgagemarketbecausethe

markets health depended on continued price appreciation in housing.245 As a result,

beginninginNovember2006,significantwideningofspreadsonnoninvestmentgrade

tranches of home equity loans was evident.246 By the spring of 2007, the crisis had

advancedtothepointthatseveralmajorsubprimelendershadgonebankruptorbeen

acquiredbystrongerpartners.247

Lehmans management saw the subprime crisis as an opportunity to pick up

groundonitscompetitors.248Lehmansmanagementadoptedacountercyclicalgrowth

243Id.

244Standard & Poors, Press Release: Home Price Declines Worsen As We Enter the Fourth Quarter of

2008 According to the S&P/CaseShiller Home Price Indices (Dec. 30, 2008), at p. 1 (available at
http://www2.standardandpoors.com/spf/pdf/index/CSHomePrice_Release_123062.pdf); see also Vikas
Bajaj,HomePricesFallinMoreThanHalfofNationsBiggestMarkets,N.Y.Times,Feb.16,2007,atp.C1.
245GaryGorton,Information,Liquidityandthe(Ongoing)Panicof20072(NIBRWorkingPaperNo.w14649,

2009);seealsoGaryGorton&AndrewMetrick,SecuritizedBankingandtheRunonRepo5(YaleIntlCenter
forFinance,WorkingPaperNo.0914,2009).
246BankforInternationalSettlements,77thAnnualReport(June24,2007),atp.109.

247Id.atpp.10910.

248Lehman,2008FinancialPlanSummaryPresentationtoLehmanBoardofDirectors(Jan.24,2008),atp.

5[LBHI_SEC07940_027374](Currentenvironmentpresentsauniquelongtermgrowthopportunityfor
the Firm.... The Firms competitors, with the notable exceptions of Goldman Sachs and JP Morgan
Chase, have sustained large losses, weakening their competitive positions.... This presents an
opportunity for the Firm to pursue a countercyclical growth strategy, similar to what it did during the
20012002downturn,toimproveitscompetitivepositionand,overtime,generatesuperiorreturnsforour
shareholders.);seealsoLehman,UpdateonLehmanBrothersSubprimeMortgageOriginationBusiness
PresentationtoLehmanBoardofDirectors(Mar.20,2007),atp.10[LBHI_SEC07940_025834](Mostof
large subprime independents have gone out of business, have been sold or are selling.... Current
distressed environment provides substantial opportunities, as in late 1990s); Lehman, Notes for
Presentation for the Fixed Income Division OffsiteMeeting (Sept. 26,2006), at pp. 1012 [LBEXDOCID
1715601](statingthatLehmanviewedthe2006growthstrategyasacountercyclicalopportunitytogrow
business),attachedtoemailfromLesleyOramasScala,Lehman,toMichaelGelband,Lehman(Sept.26,
2006)[LBEXDOCID1945744].

79

strategy.249Lehmansmanagementbelievedthatthesubprimecrisiswouldnotspread

totheeconomygenerally,oreventothecommercialrealestatemarket,whereLehman

wasamajorplayer.250Inpastrecessionsandfinancialcrises,Lehmanhadsuccessfully

takenonmoreriskwhileitscompetitorsretrenched.251

During the first half of 2007, Lehman continued its growth strategy. Although

Lehmansmanagementdecidedtocurtailitsresidentialmortgageoriginationbusiness,

it did so less dramatically than many of its competitors in that business, several of

whichwentoutofbusiness.252

Lehman, along with other market participants and government regulators,

underestimated the severity of the subprime mortgage crisis;253 the subprime crisis

impaired Lehmans ability to securitize and sell residential mortgages and forced the

firm to retain an increasingly large volume of residential mortgagerelated risk on its

249Id.

250Id.

251Id.

252Lehman, Update on Lehman Brothers Subprime Mortgage Origination Business Presentation to


LehmanBoardofDirectors(Mar.20,2007),atpp.5,10[LBHI_SEC07940_025834];emailfromDimitrios
Kritikos,Lehman,toJeffreyGoodman,Lehman(Feb.2,2007)[LBEXDOCID566140](Whiletherestof
the industry is tightening credit and increasing prices in these areas, we are moving in the opposite
direction.).
253Examiners Interview of Treasury Secretary Timothy F. Geithner, Nov. 24, 2009, at p. 3; Examiners

InterviewofRichardS.Fuld,Jr.,Sept.25,2009,atpp.16,24;ExaminersInterviewofRichardMcKinney,
Aug. 27, 2009, at pp. 2, 9; Richard S. Fuld, Jr., Lehman, Notes for Senior Management Speech (June 16,
2008), at pp. 56 [LBEXDOCID 529241], attached to email from Taimur Hyat, Lehman, to Herbert H.
McDadeIII,Lehman,etal.(June25,2008)[LBEXDOCID556064].

80

ownbalancesheet.254Atthesametime,duringthefirsttwoquartersof2007,Lehman

continued to grow its leveraged loan, commercial real estate, energy, and principal

investments businesses.255 Lehmans growth strategy culminated in the acquisition of

the Archstone REIT in late May 2007.256 Together, these transactions continued the

ongoing increase in the size of Lehmans balance sheet, with a particularly strong

concentrationinassetsthatcouldnoteasilybesoldinacrisis.Beginninginthefourth

quarterof2006,FIDsbusinessesconsistentlyexceededtheirlimitseventhoughreturns

on assets and earnings were decreasing.257 By February 2007, FID had a serious

balancesheetissue.258

ThisSectionoftheExaminersReportdiscussesLehmansactionswithrespectto

each of these business lines separately below. This Section also discusses the major

personnelmoveduringthefirsthalfof2007thereplacementofMichaelGelbandwith

Roger Nagioff as the head of FID. Finally, this section discusses the extent to which

254Lehman,SecuritizedProducts,MBS:NonInvestmentGradeRetainedInterests(Jan.16,2007),atpp.1,

3 [LBEXDOCID 839039], attached to email from James Guarino, Lehman, to Richard McKinney,
Lehman,etal.(Jan.16,2007)[LBEXDOCID865925].
255SeeSectionIII.A.1.b.1ofthisReport.

256SeeSectionIII.A.1.b.2.dofthisReport.

257Lehman,FixedIncomeDivisionBalanceSheetManagement(Apr.2007),atp.2[LBEXDOCID787297],

attachedtoemailfromKieronKeating,Lehman,toDavidN.Sherr,Lehman,etal.(June6,2007)[LBEX
DOCID808850];LehmanBalanceSheetandDisclosureScorecardForTradeDateApr.21,2008(Apr.22,
2008),atp.3[LBEXDOCID3187588],attachedtoemailfromTalLitvin,Lehman,toHerbertH.McDade
III,Lehman,etal.(Apr.22,2008)[LBEXDOCID3187333].
258EmailfromJosephGentile,Lehman,toMichaelGelband,Lehman,etal.(Feb.21,2007)[LBEXDOCID

810934].

81

Lehmans officers informed the Board of Directors of the continuing expansion of

Lehmansbalancesheetandrisktaking.

(a) LehmansResidentialMortgageBusiness

(i) LehmanDecidestoCurtailSubprimeOriginationsbut
ContinuetoPursueAltAOriginations

Inthesecondhalfof2006,Lehmanbegantoseethefirstcracksinthesubprime

mortgage market.259 Lehman reacted to these signs by tightening its origination

standards,particularlywithrespecttosubprimemortgages,260butLehmancontinuedto

pursue growth in its mortgage origination business generally, particularly through its

AltA originator, Aurora.261 AltA loans are a somewhat loosely defined category

between prime and subprime that are designed for borrowers with good credit

records who do not meet standard guidelines for documentation requirements.262

259Examiners Interview of Thomas L. Wind, Apr. 21, 2009, at p. 8; Examiners Interview of Susan
Harrison, Apr. 28, 2009, at pp. 2, 5; Examiners Interview of Marie Jean Burruel, Apr. 28, 2009, at p. 5;
Dimitrios Kritikos, Lehman, BNC Risk Review December 2006 (Jan. 20, 2007), at p. 50 [LBEXDOCID
251077];DimitriosKritikos,Lehman,RiskReview:AuroraandBNCFebruary2007(Mar.19,2007),atp.
10[LBEXDOCID188325].
260Dimitrios Kritikos, Lehman, BNC Risk Review December 2006 (Jan. 20, 2007), at p. 6 [LBEXDOCID

251077];Lehman,MaterialsPreparedforOfficeofThriftSupervisionSafetyandSoundness/Compliance
Examination2007(Aug.13,2007),atpp.1315[LBEXDOCID538654];Lehman,PresentationtoMoodys
[Draft] (Oct. 16, 2007), at pp.1215 [LEHFINRAEMAIL00088455]; Lehman, Presentation to Radian:
MortgageOperationsReview(July24,2007),atpp.1517[LBEXDOCID839141];ExaminersInterviewof
MarieJeanBurruel,Apr.28,2009,atpp.810;ExaminersInterviewofDimitriosKritikos,Apr.16,2009,at
p.8.
261DimitriosKritikos,Lehman,AuroraLoanServicesRiskReviewJanuary2008(Feb.7,2008),atpp.10,

12[LBEXDOCID394711].
262SaundraF.Braunstein,DirectorofDivisionofConsumerandCommunityAffairs,BoardofGovernors

oftheFederalReserve,TestimonyBeforeU.S.HouseofRepresentativesCommitteeonFinancialServices,
Subcommittee on Financial Institutions and Consumer Credit (Mar. 27, 2007); see also Lehman, Product
Definitions of AltA, Mortgage Maker, and Subprime (Oct. 17, 2007), at p. 1 [LBEXDOCID 537902];

82

Although Lehmans AltA mortgages were never as risky as subprime mortgages, its

AltAmortgagesbecameincreasinglyriskytowardstheendof2006andthebeginning

of2007.263ThisportionoftheReportdescribesthoseevents.

Lehman considered its residential mortgage securitization business to be a

distribution business.264 Lehman had a vertically integrated residential mortgage

businessinwhichBNCoriginatedsubprimeloansandAuroraoriginatedAltAloans,

and Lehman itself securitized pools of those mortgages into residential mortgage

backed securities (RMBS).265 BNC and Aurora were part of Lehmans Mortgage

CapitalDivision,whichoriginatedresidentialmortgages,whileFIDwasresponsiblefor

securitizing the mortgages.266 By selling the RMBS to investors, Lehman shifted the

risks of the underlying mortgages to the investors.267 Lehman, however, bore the risk

thatitwouldnotbeabletosecuritizethemortgagesorselltheRMBS.268Themortgages

Cynthia Angell & Clare D. Rowley, Federal Deposit Insurance Corp., FDIC Outlook (Second Quarter
2006)(lastupdatedMar.21,2007)
(http://www.fdic.gov/bank/analytical/regional/ro20062q/na/2006_summer04.html)
263Email from Dimitrios Kritikos, Lehman, to Jeffrey Goodman, Lehman (Jan. 31, 2007) [LBEXDOCID

380035]; Dimitrios Kritikos, Lehman, Selected trends from Aurora Risk Review (Feb. 2, 2007), at p. 2
[LBEXDOCID537846];ExaminersInterviewofDimitriosKritikos,July29&30,2009,atpp.12,1415.
264Madelyn Antoncic, Lehman, 2007 Bondholder Meeting Presentation (Oct. 18, 2007), at p. 6 [LBEX

DOCID 244792]; Lehman, Presentation to Standard and Poors, Lehman Brothers Securitized Products
Business(Oct.7,2005),atp.2[LBEXDOCID095356];Lehman,StrategicandFinancialReview(Jan.18,
2008),atp.9[LBEXDOCID1412341];ExaminersInterviewofRichardMcKinney,Aug.27,2009,atp.5.
265VikasShilpiekandula,Lehman,AnOverviewoftheResidentialMortgageMarket(Oct.25,2007),atp.

2[LBEXDOCID894664].
266ExaminersInterviewofDavidN.Sherr,May6,2009,atp.4.

267Lehman,SecuritizedProducts,MBS:NonInvestmentGradeRetainedInterests(Jan.16,2007),atp.1

[LBEXDOCID839039].
268Id.;Lehman, Presentation to Standard and Poors, Lehman Brothers Securitized Products Business

(Oct.7,2005),atpp.9,10[LBEXDOCID095356].

83

thatLehmancouldnotshifttothirdpartyinvestorsthroughsecuritizationwereknown

asretainedinterests.269

Bylate2006,Lehmansnoninvestmentgraderetainedinterestsbegantoincrease

sharply;investorsweregrowingincreasinglycautiousaboutpurchasingRMBSbonds

backed by subprime mortgages, and as a result the [Lehman residential mortgage

trading] desk [was] struggling to sell residuals and [noninvestment grade] bonds.270

Lehmans diminished ability to shift the mortgagebased risk to investors meant that

the formerly profitable moving business could become a moneylosing storage

business.271

At the same time, Lehmans mortgage business experienced other troubling

trends,includingsharpincreasesinrepurchaserequests,risesindelinquencyratesand

a spike in firstpayment defaults.272 By the fourth quarter of 2006, Lehmans internal

researchreportsweresuggestingthatinvestorsinRMBSbonds,andparticularlythose

backedbysubprimemortgages,wouldbecomeincreasinglyriskaverse,andsubprime

backedRMBSbondswouldbeatheightenedriskofaratingagencydowngrade.273

269Lehman,SecuritizedProducts,MBS:NonInvestmentGradeRetainedInterests(Jan.16,2007),atp.25

[LBEXDOCID839039];seealsoLBHI_SEC07940_58117410Q(filedApr.9,2008),atpp.20,55.
270Lehman,SecuritizedProducts,MBS:NonInvestmentGradeRetainedInterests(Jan.16,2007),atp.13

[LBEXDOCID839039].
271Id.atp.1.

272ExaminersInterviewofSusanHarrison,Apr.28,2009,atpp.2,5;DimitriosKritikos,Lehman,BNC

RiskReviewDecember2006(Jan.20,2007),atp.50[LBEXDOCID251077];DimitriosKritikos,Lehman,
RiskReview:AuroraandBNCFebruary2007(Mar.19,2007),atp.10[LBEXDOCID188325].
273Srinivas Modukuri, Lehman, Securitized Products Outlook for 2007: Bracing for a Credit Downturn

(Dec.2006),atpp.8,19[LBEXDOCID245013].

84

Because ofthesetrends,Lehman tightenedits subprimelendingoperations. In

about August 2006, Lehman replaced BNCs CEO and also created a new executive

position (filled by Thomas L. Wind) to oversee both BNC and Aurora operations.274

Wind and new BNC CEO Steven Skolnik initiated changes to BNCs underwriting

guidelinesandproductmix.275Thesechangesincludedreductioninthesizeofoneof

BNCs leading lending programs, known as 80/20, in which BNC extended two

separateloanstobringtheborrowersloantovalueratioto100%basedonlyonincome

dataasstatedbytheborrower.276Productionunderthe80/20programdroppedbytwo

thirds from 2005 to 2006, and BNC discontinued the program entirely in late March

2007.277Yeteveninearly2007,BNCwasoriginatingasubstantialquantityofsubprime

mortgages (about $750 million worth during the month of February 2007, for

274ExaminersInterviewofThomasL.Wind,Apr.21,2009,atpp.3,8;ExaminersInterviewofDimitrios

Kritikos,July2930,2009,atpp.89;ExaminersInterviewofRichardMcKinney,Aug.27,2009,atpp.56;
ExaminersInterviewofLanaFranksHarber,Sept.23,2009,atp.6;Lehman,PresentationtotheOfficeof
ThriftSupervision,LehmanBrothersBank,FSB:Safety&Soundness/ComplianceExamination2007(Aug.
7, 2007), at p. 5 [LBEXDOCID 1693347]; Lehman, Update on Lehman Brothers Subprime Mortgage
Origination Business Presentation to Lehman Board of Directors (Mar. 20, 2007), at p. 6
[LBHI_SEC07940_025834].
275ExaminersInterviewofThomasL.Wind,Apr.21,2009,atpp.6,78.

276Dimitrios Kritikos, Lehman, BNC Risk Review December 2006 (Jan. 20, 2007), at p. 6 [LBEXDOCID

251077];ExaminersInterviewofMarieJeanBurruel,Apr.28,2009,atpp.810.
277Lehman, Materials Prepared for Office of Thrift Supervision Safety and Soundness/Compliance

Examination 2007 (Aug. 13, 2007), at p. 13 [LBEXDOCID 538654]; Lehman, Presentation to Moodys
[Draft] (Oct. 16, 2007), at p. 12 [LEHFINRAEMAIL00088444]; Lehman, Presentation to Radian:
Mortgage Operations Review (July 24, 2007), at p. 14 [LBEXDOCID 839141]; Examiners Interview of
MarieJeanBurruel,Apr.28,2009,atpp.810;ExaminersInterviewofDimitriosKritikos,Apr.16,2009,at
p.8.

85

example).278 Lehman did not discontinue subprime lending (as Lehman defined it)

throughBNCuntilitsclosureofBNConAugust22,2007.279

Lehman executives had different recollections concerning whether managers

withinFIDhadadvocatedanearlierandmorerapidreductioninLehmanssubprime

mortgageoriginations.280CertainFIDexecutivesnotedthatLehmanmanagersfromthe

Mortgage Capital Division wished to continue aggressive origination and that

MortgageCapitalsviewprevailed,whileothersinMortgageCapitaldidnotrecallthe

disagreement or maintained that FID could have reduced originations itself if it

wished.281

278Dimitrios Kritikos, Lehman, Risk Review: Aurora and BNC February 2007 (Mar. 19, 2007), at p. 6

[LBEXDOCID188325].
279ExaminersInterviewofLanaFranksHarber,Sept.23,2009,atp.12;ExaminersInterviewofTheodore

P. Janulis, Sept. 25, 2009, at p. 3; Examiners Interview of Marie Jean Burruel, Apr. 28, 2009, at p. 10;
Lehman Brothers Holdings Inc., Press Release: Lehman Brothers Announces Closure of BNC Mortgage
(Aug. 22, 2007) [LBEXDOCID 880148]; Lehman, Subprime(r) (Sept. 4, 2007), at p. 14 [LBEXDOCID
894656];emailfromEdwardGrieb,Lehman,toChristopherM.OMeara,Lehman(Aug.22,2007)[LBEX
DOCID197143];emailfromTashaPelio,Lehman,toJasjit(Jesse)Bhattal,Lehman,etal.(Aug.22,2007)
[LBEXDOCID176893].
280ExaminersInterviewofKentaroUmezaki,June25,2009,atpp.2,15;ExaminersInterviewofMichael

Gelband,Aug.12,2009,atpp.2,1012;ExaminersInterviewofLanaFranksHarber,Sept.23,2009,atpp.
4,6;ExaminersInterviewofTheodoreP.Janulis,Sept.25,2009,atpp.3,5.
CompareExaminersInterviewofKentaroUmezaki,June25,2009,atpp.2,15(statingthathe,Gelband
281

and Sherr, wanted to scale back originations while Janulis did not); Examiners Interview of Michael
Gelband,Aug.12,2009,atp.11;(recallingthataslateas2007,herecommendedmanagingtheresidential
realestatebusinessmoreconservatively,andthatingeneral,MCDhadanincentivetocontinuetopush
fororiginationsbecauseitwasrewardedwhenitsoriginationvolumeswerehighandtheriskwasshifted
to the Securitized Products Group after the mortgages were originated.), with Examiners Interview of
DavidN.Sherr,Sept.25,2009,atpp.23,45(statingthathedidnotrecalladisputebetweenMCDand
FID over any proposed scaling back of originations, but that there was tension between FID and MCD
overthecontroloftheresidentialmortgageoriginationbusiness,);ExaminersInterviewofTheodoreP.
Janulis,Sept.25,2009,atpp.3,5(statingthathedidnotrecalladisagreementaboutwhetheroriginations
shouldbeslowedandthatFIDcouldhaveslowedoriginationvolumesifitwishedtodoso);Examiners
Interview of Lana Franks Harber, Sept. 23, 2009, at p. 6. (stating that she did not recall internal

86

EvenasLehmanwastighteningstandardsonitssubprimeoriginationsthrough

BNC, Lehman was also using its Aurora subsidiary to expand its AltA lending.282

Moreover,AurorasAltAlendingreachedborrowersoflessercreditqualitythanthose

whohistoricallyhadbeenconsideredAltAborrowers.283Thevehicleforthataspectof

the Aurora business plan was the Mortgage Maker product.284 As Mortgage Maker

expanded to more than half of Auroras AltA production by February 2007, many of

Auroras loans denominated as AltA came more and more to resemble the subprime

loans that Lehman was supposedly exiting by tightening origination standards at

BNC.285

By late January 2007, Lehmans residential mortgage analyst began to notice

disturbingtrendswithrespecttoAurorasMortgageMakerprogram:

presentations by Gelband questioning the continued viability of subprime residential lending); see also
ExaminersInterviewofJosephGregory,Nov.13,2009,atp.10(suggestingthatheagreedwithMCDs
viewandapprovedastrategyofcontinuingtooriginateresidentialmortgagesaggressively).
282ExaminersInterviewofCarlPeterson,May27,2009,atpp.68.

283Id.atpp.57.

284Id. at p. 5; Examiners Interview of Diane May, Apr. 16, 2009, at p. 5; Aurora Loan Services,

PresentationtoSecuritiesandExchangeCommission(Feb.67,2007),atp.2[LBEXDOCID357348].
285ExaminersInterviewofDavidN.Sherr,May6,2009,atp.8;ExaminersInterviewofJohnVedra,Apr.

15,2009,atp.8;ExaminersInterviewofDianeMay,Apr.16,2009,atp.5;DimitriosKritikos,Lehman,
Risk Review: Aurora and BNC February 2007 (Mar. 19, 2007), at p. 4 [LBEXDOCID 188325]; see also e
mail from Dimitrios Kritikos, Lehman, to Ken Linton, Lehman, et al. (Mar. 30, 2007) [LBEXDOCID
286265](notingthattheriskiersegmentsofMortgageMakerperformedthreetofivetimesworsethanthe
restofAurorasloans);RussellV.Brady,Aurora,ResponsetoLXSPerformanceIssues(Jan.24,2007),atp.
1 [LBEXDOCID 885450] (suggesting that Aurora needed to [d]etermine whether a segment of the
[Mortgage]Makerpopulationshouldbeservicedsimilartosubprime);emailfromRichardMcKinney,
Lehman, to Thomas L. Wind, Aurora, et al. (Feb. 12, 2007) [LBEXDOCID 1369758] (noting that the
performance of Lehmans LXS securitizations that consisted mostly of Mortgage Maker had worsened
versusitslargestcompetitorfor2006production,andstatingExpectedsubordinationlevelsare11.7%to
AAA loss coverage. This compares with 2025% for a typical subprime deal. That is, we are creating
worse performance than subprime, while the rating agencies assume our performance should be
substantiallybetter).

87

Looking at the trends on originations and linking them to first payment


defaults,thestoryisugly:ThelastfourmonthsAurorahasoriginatedthe
riskiest loans ever, with every month being riskier than the one before
theindustrymeanwhilehaspulledbackduringthattime.286

Atthesametime,otherparticipantsintheAltAindustrywerereportingdefaultrates

andlatepaymentdatathatindicatedthat[t]hecreditdeterioration[inAltA]hasbeen

almostparalleltotheoneofthesubprimemarket.287Thus,whileAurorasmortgages

werenotasriskyassubprimemortgages,Aurorasriskprofilewasincreasinginmuch

thesamewayastheriskinsubprimemortgages.

Asaresultofallthesefactors,Lehmansriskmanagerssometimesconsideredthe

Mortgage Maker loans to be distinct from AltA mortgages, and described Mortgage

MakerasAltB.288WhilethetermAltBwasnotanacceptedtermorcategorizationin

the business, Lehmans managers occasionally used it as a way of differentiating the

riskier mortgages in the Mortgage Maker program from what had more traditionally

beenconsideredAltAmortgages,thoughnotsoriskyastomeritthelabelsubprime.289

286Email from Dimitrios Kritikos, Lehman, to Jeffrey Goodman, Lehman (Jan. 31, 2007) [LBEXDOCID

380035].
287DimitriosKritikos,Lehman,RiskReview:AuroraandBNCFebruary2007[Draft](Mar.9,2007),atp.1

[LBEXDOCID538518].
288EmailfromDimitriosKritikos,Lehman,toJefferyGoodman,Lehman(Mar.12,2007)[LBEXDOCID

307101] (Auroras product is far from AltA anymore. The traditional AltA program is only 40% of
Auroras production); email from Dimitrios Kritikos, Lehman, to Charlie Lu, Lehman (Apr. 12, 2007)
[LBEXDOCID 566105] (MortgageMaker is NOT AltA); Dimitrios Kritikos, Lehman, Selected trends
fromAuroraRiskReviewFebruary2007(Feb.2,2007),atp.2[LBEXDOCID537846](Theproductmix
ofAuroraproductionhasshiftedsubstantiallyinthelast6monthsfromAltAtoMortgageMaker(Alt
B)).
289DimitriosKritikos,Lehman,SelectedtrendsfromAuroraRiskReviewFebruary2007(Feb.2,2007),at

p. 2 [LBEXDOCID 537846]; Examiners Interview of Dimitrios Kritikos, July 2930, 2009, at pp. 3, 18
(statingthatMortgageMakerloanswereneitherAltAnorsubprime).

88

To make matters worse, Lehmans risk managers saw indications that Lehman

wouldnotbeabletodistributetheriskonthemortgagesitwasoriginating.ByJanuary

2007,itwasapparentthatLehmansholdingofnoninvestmentgraderetainedinterests

insecuritizationshadbeenincreasing.290AndbyMarch2007,Lehmanwasnotingsharp

declinesinsecuritizationrevenue,291causingtheSecuritizedProductsGroupwithinFID

toexceeditsriskappetiteandVaRlimits.292

TorespondtotheserisksinitsAltAportfolio,inMarch2007Lehmanundertook

aseriesofchangesdesignedtomakeMortgageMakerloanslessavailabletoborrowers

with lower credit scores, or to borrowers who wished to take out loans at 100% of a

homesvalue.293AlthoughthevolumeofMortgageMakerloansoriginatedbyLehman

290Lehman,SecuritizedProducts,MBS:NonInvestmentGradeRetainedInterests(Jan.16,2007),atp.3

[LBEXDOCID839039].
291Lehman,MortgageUpdate1Q07,atp.9[LBHI_SEC07940_845984].

292See, e.g.,George Hansman, Lehman, Securitized Products Risk Appetite and VaR limit and overage

graphs(May17,2007)[LBEXDOCID861260];emailfromLehmanRisk,toLehmanRiskLimitExcesse
mailgroup(Mar.8,2007)[LBEXDOCID229930];emailfromLehmanRisk,toLehmanRiskLimitExcess
email group (Mar. 19, 2007) [LBEXDOCID 229944]; email from Lehman Risk, to Lehman Risk Limit
Excess email group (Mar. 22, 2007) [LBEXDOCID 229954]; email from Lehman Risk, to Lehman Risk
Limit Excess email group (Apr.9, 2007) [LBEXDOCID 790039]; email from Lehman Risk, to Lehman
Risk Limit Excess email group (Apr.16, 2007) [LBEXDOCID 790029]; email from Lehman Risk, to
LehmanRiskLimitExcessemailgroup(May29,2007)[LBEXDOCID790059];emailfromLehmanRisk,
to Lehman Risk Limit Excess email group (May30,2007) [LBEXDOCID 790060]; email from Lehman
Risk, to Lehman Risk Limit Excess email group (Sept. 5, 2007) [LBEXDOCID 230188]; email from
LehmanRisk,toLehmanRiskLimitExcessemailgroup(Oct.12,2007)[LBEXDOCID230789903];email
fromLehmanRisk,toLehmanRiskLimitExcessemailgroup(Oct.17,2007)[LBEXDOCID789908];e
mailfromLehmanRisk,toLehmanRiskLimitExcessemailgroup(Oct.18,2007)[LBEXDOCID789910];
email from Lehman Risk, to Lehman Risk Limit Excess email group (Oct. 19, 2007) [LBEXDOCID
789909]; email from Lehman Risk, to Lehman Risk Limit Excess email group (Oct. 22, 2007) [LBEX
DOCID 790089]; email from Lehman Risk, to Lehman Risk Limit Excess email group (Oct. 30, 2007)
[LBEXDOCID789916].
293Dimitrios Kritikos, Lehman, Risk Review: Aurora and BNC February 2007 (Mar. 19, 2007), at p. 3

[LBEXDOCID188325](summarizingunderwritingguidelinechangesatBNCandAurora).

89

declined following implementation of the March 2007 guideline changes, Lehman

continuedtooriginatesignificantvolumesofAltAmortgagesuntilAugust2007.294

(ii) TheMarch20,2007BoardMeeting

On March 20, 2007, the Mortgage Capital and Fixed Income Divisions gave a

presentation to Lehmans Board of Directors about the state of Lehmans residential

mortgage origination and securitization business in light of the deepening subprime

crisis.295 The presentation was given by David N. Sherr, the head of Lehmans

Securitized Products Group; Theodore P. Janulis, the head of the Mortgage Capital

Division; and Lana Franks Harber, Chief Administrative Officer (CAO) of the

MortgageCapitalDivision.296

Whilepreparingtogivethispresentation,Harberemailedoneofhercolleagues

to inform him about a conversation that she had with Lehmans President, Joseph

Gregory,aboutthepresentation:

BoardisnotsophisticatedaroundsubprimemarketJoedoesntwanttoo
muchdetail.HewantstocandidlytalkabouttheriskstoLehmanbutbe

294Dimitrios Kritikos, Lehman, Aurora Loan Services Risk Review January 2008 (Feb. 7, 2008), at p. 12

[LBEXDOCID394711].
295Lehman Brothers Holdings Inc., Minutes of Meeting ofBoard of Directors (Mar.20,2007),at pp.67

[LBHI_SEC07940_025779]; Lehman, Update on Lehman Brothers Subprime Mortgage Origination


BusinessPresentationtoLehmanBoardofDirectors(Mar.20,2007)[LBHI_SEC07940_025834].
296Lehman, Update on Lehman Brothers Subprime Mortgage Origination Business Presentation to

Lehman Board of Directors (Mar. 20, 2007) [LBHI_SEC07940_025834]; Examiners Interview of Lana
FranksHarber,Sept.23,2009,atp.2;ExaminersInterviewofTheodoreP.Janulis,Sept.25,2009,atp.2;
ExaminersInterviewofDavidN.Sherr,Sept.25,2009,atp.9.

90

optimisticandconstructivetalkabouttheopportunitiesthatthismarket
createsandhowweareuniquelypositionedtotakeadvantageofthem.297

Consistentwiththisdirection,theBoardpresentationemphasizedthatLehmans

managementconsideredthecrisisanopportunitytopursueacountercyclicalstrategy.298

TheMarch2007Boardpresentationfirstnotedthedifficultiesinthesubprimemarket,

includingthefactthatsevenofthetoptwentysubprimeoriginatorshadalreadybeen

soldtostrongerpartnersorgonebankruptandthatthebusinesswassignificantlyless

profitable than in past years because of lower origination volumes, lower sale and

securitization margins, and increased loan loss reserves.299 The presentation further

noted that in response to these market events, Lehman had improved BNCs risk and

credit profile, tightened its lending criteria, retained new management, and

significantlyreducedheadcount.300

The presentation concluded by highlighting managements belief that Lehman

hadsubstantialopportunities,asinlate1990stoimproveitscompetitiveposition.301

This countercyclical strategy was based on several stated premises. Most important,

LehmansmanagementbelievedthatthesubprimecrisiswouldpresentonlyaLimited

ContagionToOtherMarketsinparticular,Lehmansmanagementdidnotexpectthe

297Email from Lana Franks Harber, Lehman, to Steven Skolnik, BNC Mortgage, et al. (Mar. 9, 2007)

[LBEXDOCID 306198]; accord Examiners Interview of Lana Franks Harber, Sept. 23, 2009, at pp. 910;
ExaminersInterviewofTheodoreP.Janulis,Sept.25,2009,atp.6.
298Lehman, Update on Lehman Brothers Subprime Mortgage Origination Business Presentation to

LehmanBoardofDirectors(Mar.20,2007),atpp.1,10[LBHI_SEC07940_025834].
299Id.atpp.45.

300Id.atpp.67.

301Id.atp.10.

91

subprime crisis to have a significant impact on the [b]roader credit markets.302

Lehmansmanagementalsobelievedthatasubstantialpartof[the]subprimemarket

isheretostayandthat[p]rofitabilitywillreturnwhenenvironmentimproves.303In

sum,Lehmanmanagementthoughtthatthemarketwasnearingthebottomofthecycle

in spring and summer of 2007, and that Lehman would benefit from preserving the

optiontoexpandthebusinessinthefuture.304ManagementinformedtheBoardthatthe

down cycle in subprime presented substantial opportunities for Lehman, and that

management expected Lehman to be better positioned for profitable growth once the

industrycycleturned.305

The presentation did not discuss Auroras AltA mortgage originations at all,

notwithstanding the significant concerns that Lehmans residential mortgage analyst

hadrecentlyraisedaboutthatgroupofmortgages.306Instead,thepresentationgrouped

theAltAcategoryofmortgageswithprimeanddescribedPrime/AltAMortgagesas

follows: credit performance not problematic delinquencies are within expected

range.307 Anearlier draft oftheslideshowpresentedto the Board hadused theterm

AltA/AltB Mortgages above the words credit performance not problematic

302Id.atp.9.

303Id.atp.10.

304ExaminersInterviewofLanaFranksHarber,Sept.23,2009,atp.2;ExaminersInterviewofTheodore

P.Janulis,Sept.25,2009,atp.8;ExaminersInterviewofDavidN.Sherr,Sept.25,2009,atp.6.
305Lehman,UpdateonLehmanBrothersSubprimeOriginationBusinessPresentationtoLehmanBoard

ofDirectors(Mar.20,2007),atpp.1,10[LBHI_SEC07940_025834].
306Id.atpp.110.

307Id.atp.9.

92

delinquenciesarewithinexpectedrange,308butthisreferencetoAltBwasdeletedfrom

thefinalversionofthematerialsinfavorofPrime/AltAMortgages.309

Sherr,Janulis,andHarbertoldtheExaminerthattheydidnotincludeaspecific

referenceto Mortgage Maker or AltBintheir presentation becausethey believed that

the loans in the Mortgage Maker program were distinct from subprime mortgages,

whichwerethesubjectofthepresentation.310TheLehmanriskanalystwhohadstudied

the performance issues in Mortgage Maker told the Examiner that leaving Mortgage

Maker out of a presentation on subprime was proper given the differences between

what Lehman considered subprime (FICO scores below 620) and Mortgage Maker

(averageFICOscoreof691).311

After the Board presentation, Lehman continued to originate subprime and

especially AltA/AltB mortgage loans, thereby pursuing its countercyclical strategy,

andlikelyexacerbatingLehmansresidentialmortgagelosses.TheExaminersfinancial

advisors have estimated the losses from residential mortgage positions from the first

quarterof2007throughthethirdquarterof2008at$7.4billion.312

308Lehman,StateofLehmanBrothersSubprimeMortgageOriginationBusinessPresentationtoLehman

BoardofDirectors[Draft](Mar.15,2007),atp.12[LBEXDOCID2485576].
309Lehman,UpdateonLehmanBrothersSubprimeOriginationBusinessPresentationtoLehmanBoard

ofDirectors(Mar.20,2007),atp.9[LBHI_SEC07940_025834].
310ExaminersInterviewofLanaFranksHarber,Sept.23,2009,atp.3;ExaminersInterviewofTheodore

P.Janulis,Sept.25,2009,atpp.2,7;ExaminersInterviewofDavidN.Sherr,Sept.25,2009,atp.7.
311ExaminersInterviewofDimitriosKritikos,July2930,2009,atp.19.

312Lehman,MortgageUpdate1Q07(Apr.9,2007)[LBEXDOCID540069];Lehman,MortgageUpdate

2Q07(June8,2007)[LBEXDOCID505835];Lehman,MortgageUpdateJune07(Aug.9,2007)[LBEX
DOCID611902];Lehman,MortgageUpdateAugust07(Sept.25,2007)[LBEXDOCID505889];Lehman,

93

Theselossesweretemperedbyeffectivehedgingstrategiesthroughatleast2007

andintoearly2008.313Betweenthefirstquarterof2007andthethirdquarterof2008,

Lehmanhadagainof$2.96billiononitsresidentialmortgagecredithedges.314Ofthis

$2.96 billion gain, $2.623 billion was gained between the first quarter of 2007 and the

endofthefirstquarterof2008.315Forthesecondandthirdquartersof2008,however,

Lehman had essentially no gains on its hedges.316 As a result, during those quarters,

Lehmansufferedverysubstantiallossesonitsresidentialmortgagebusiness.317

Flash Mortgage Update November 07(Dec. 21, 2007) [LBEXDOCID 505890];Lehman, Flash
MortgageUpdateJanuary07(Feb.15,2008)[LBEXDOCID3237972];Lehman,FlashMortgageUpdate
March 07(Apr. 23,2008) [LBEXDOCID 2432630]; Lehman, Flash Mortgage Update Apr. 07(May
15,2008) [LBEXDOCID 1362958]; Lehman, Flash Mortgage Update May 07(June 11,2008) [LBEX
DOCID3238001];Lehman,SecuritizedProductsP&LJune2008(July11,2008)[LBEXDOCID505776];
Lehman,SecuritizedProductsP&LJuly2008(Aug.14,2008)[LBEXDOCID505778].
313ExaminersInterviewofKentaroUmezaki,June25,2009,atp.17;Lehman,MinutesofMeetingofthe

BoardofDirectors(Sept.11.2007),atp.6[LBHI_SEC07940_263264].
314Lehman,MortgageUpdate1Q07(Apr.9,2007)[LBEXDOCID540069];Lehman,MortgageUpdate

2Q07(June8,2007)[LBEXDOCID505835];Lehman,MortgageUpdateJune07(Aug.9,2007)[LBEX
DOCID611902];Lehman,MortgageUpdateAugust07(Sept.25,2007)[LBEXDOCID505889];Lehman,
Flash Mortgage Update November 07(Dec. 21, 2007) [LBEXDOCID 505890];Lehman, Flash
MortgageUpdateJanuary07(Feb.15,2008)[LBEXDOCID3237972];Lehman,FlashMortgageUpdate
March 07(Apr. 23,2008) [LBEXDOCID 2432630]; Lehman, Flash Mortgage Update Apr. 07(May
15,2008) [LBEXDOCID 1362958]; Lehman, Flash Mortgage Update May 07(June 11,2008) [LBEX
DOCID3238001];Lehman,SecuritizedProductsP&LJune2008(July11,2008)[LBEXDOCID505776];
Lehman,SecuritizedProductsP&LJuly2008(Aug.14,2008)[LBEXDOCID505778].
315Id.

316LBHI10Q(July10,2008),atp.67.

317 The Examiners financial advisors estimate that Lehmans secured losses from residential mortgages

exceeded$1billioninthesecondquarterandinexcessof$3.5billioninthethirdquarterof2008.

94

(b) TheExplosioninLehmansLeveragedLoanBusiness

During the first half of fiscal 2007, the high yield market was active,

notwithstandingtheonsetofthecrisisinthesubprimeresidentialmortgagemarket.318

Like other market actors during this period, Lehman participated in more leveraged

finance deals than ever before and entered into deals that were generally bigger than

the leveraged finance deals it had done in the past.319 Compared to its competitors,

Lehmanwasthemostaggressivelenderperdollarofshareholderequityinthefirsthalf

of2007.320

Lehmancontinueddownthispathdespitethefactthatthetermsofthesedeals

became less and less favorable over time from an investment banking perspective.

Because there was so much competition to finance these loans, sponsors were able to

negotiate terms that significantly increased the risk to the banks. For example,

according to some estimates, covenant light loans loans that did not include

previously standard covenants requiring the borrower to maintain certain levels of

collateral,cashflow,andpaymenttermsincreasedfromlessthan1%ofallleveraged

318Email from Roopali Hall, Lehman (Jan. 4, 2008) [LBHI_SEC07940_066187]; Lehman Loan Syndicate,

YearEndRecap(Jan.7,2008),atp.1[LBHI_SEC07940_066190].
319EmailfromEvetteSaldana,Lehman,toHYCCmembers,Lehman,etal.(June15,2007)[LBEXDOCID

494525];LehmanCreditFacilitationGroup,2ndQuarter2007Review(June2007),atp.1[LBEXDOCID
514908],attachmenttoemailfromEvetteSaldana,Lehman,toHYCCmembers,Lehman,etal.(June15,
2007)[LBEXDOCID494525].
320EmailfromEvetteSaldana,Lehman,toHYCCmembers,Lehman,etal.(June15,2007)[LBEXDOCID

494525];LehmanCreditFacilitationGroup,2ndQuarter2007Review(June2007),atp.6[LBEXDOCID
514908], attached to email from Evette Saldana, Lehman, to HYCC members, Lehman, et al. (June 15,
2007)[LBEXDOCID494525].

95

loans in 2004 to over 18% by 2007 industrywide.321 Lenders such as Lehman also

abandoned certain contractual protections (e.g., material adverse change provisions

(MACs),upfrontsyndication,andjointliability)thatwerepreviouslystandardinthe

leveragedloanindustry.322Insomedeals,Lehmanwastheonlypartytosignthelegal

documents, even though other banks were intended to commit to the loans; thus,

Lehman initially bore all the risk.323 As ofMarch 2007, the rating agenciesperceived

looseningof[Lehmans]riskstandardsparticularlyinleveragedlending....324The

Examiner has not investigated whether the contractual terms of Lehmans leveraged

lendingtransactionsweremoreaggressivethanthoseofitscompetitors.

Between December 2006 and June 2007, Lehman participated in more than 11

leveraged buyout deals that each exceeded $5 billion.325 By April 2007, Lehman had

approximately70highyieldcontingentcommitmentsinitspipelinearecordnumber

321Eric Felder, Lehman, Credit Outlook Presentation (Apr. 16, 2008), at p. 48 [LBHI_SEC07940_393578],

attached to email from Christopher Wichenbaugn, Lehman, to DCMNY, Lehman (Apr. 16, 2008)
[LBHI_SEC07940_393578]; Standard & Poors and LSTA, Leveraged Loan Index, August 2008 Review
(Sept.3,2008),atp.84[LBEXDOCID4404712],attachedtoemailfromKristenVigletta,Lehman(Sept.3,
2008)[LBEXDOCID4326914].
322ExaminersInterviewofMadelynAntoncic,Feb.25,2009,atp.4.

323Id.

324Lehman, Credit Ratings Strategy Presentation (Mar. 1, 2007), at p. 13 [LBEXDOCID 618355]; email

fromStephenLax,Lehman,toJamesP.Seery,Jr.Lehman,etal.(Apr.11,2008)[LBEXDOCID444768].
325EmailfromMiriamOh,Lehman,toPaulParker,Lehman,etal.(July5,2007)[LBEXDOCID3197652];

Lehman,BigLBOUpdate(July3,2007),atp.2[LBEXDOCID3183564].

96

for it.326 In June 2007, Lehmans lending pace had already doubled Lehmans 2006

recordsettingyearforhighgradeandhighyieldcombined.327

When the market started to slow, Lehman suddenly found itself with a huge

volume of commitments on its books and a risk profile that was well above its high

yield businesss risk appetite limits. At the end of the second quarter of 2007,

approximately $36 billion ofcontingentcommitmentsremainedonLehmansbooks.328

FIDwasalmost$20billionoveritsnetbalancesheetlimitforthequarter.329Relatedly,

as described below, Lehman soon vastly exceeded its risk appetite limits for the high

yieldbusiness.

(i) RelaxationofRiskControlstoAccommodateGrowth
ofLehmansLeveragedLoansBusiness

ToaccommodatethegrowthofLehmanshighyieldlendingactivities,Lehmans

managementdecidedtoloosenseveralofthefirmsriskcontrolsthatotherwisewould

havelimitedthefirmsabilitytoengageinmanyofthesedeals.Mostsignificantly,as

discussed above, Lehmans senior management approved a number of deals that

exceededthefirmssingletransactionlimit.

326EmailfromStephenLax,Lehman,toAlexKirk,Lehman,etal.(Apr.26,2007)[LBEXDOCID259369].

327Lehman Credit Facilitation Group, 2nd Quarter 2007 Review (June 2007), at p. 13 [LBEXDOCID
514908], attached to email from Evette Saldana, Lehman, to HYCC members, Lehman, et al. (June 15,
2007)[LBEXDOCID494525].
328AlexKirk,Lehman,LeveragedFinanceRiskPresentation(June2007)[LBEXDOCID158975],attached

toemailfromOliviaLua,Lehman,toChristopherM.OMeara,Lehman(June21,2007)[LBEXDOCID
158975].
329Lehman Brothers, Balance Sheet Trend Presentation (Apr. 2007), at pp. 46 [LBEXDOCID 251418],

attached to email from Kentaro Umezaki, Lehman, to Rebecca Miller, Lehman (May 3, 2007) [LBEX
DOCID346520].

97

Many of the leveraged loans that Lehman funded in 2006 and 2007 were way

overthelimit.330ByJuly2007,Lehmanhadcommittedtoapproximately30dealsthat

exceeded the preexisting $250 million loss threshold, nine deals that would have

exceededanewlyproposedlossthresholdof$400million,331fivedealsthatviolatedthe

notionallimitof$3.6billion,andfourdealsthatwouldhaveviolatedthenotionallimit

of$4.5billionthatwasproposedduringthefourthquarterof2007.332SomeofLehmans

commitmentsexceededthelossthresholdlimitbyafactorofsix.333Withrespectto24of

thelargesthighyielddealsinwhichLehmanparticipated,Lehmancommittedroughly

$10 billion more than the single transaction limit, if enforced, would have allowed.334

These figures arguably understate the extent to which Lehmans leveraged loans

exceededthesingletransactionlimit,sinceLehmanappliedthesingletransactionlimit

onlytotheamountoftheleveragedloanthatLehmanexpectedtofund,notthefull

amountofLehmanscommitment.335

Toaccommodatethegrowthofthehighyieldbusiness,Lehmansmanagement

alsorelaxedthehighyieldbusinesssriskappetitelimits.Despitehavingincreasedthe

330EmailfromJoeLi,Lehman,toPaulMitrokostas,Lehman(Aug.30,2007)[LBEXDOCID2547330].

331JoeLi,Lehman,STLBacktestingExcelSpreadsheet(July25,2007)[LBEXDOCID2506462],attachedto

emailfromJoeLi,Lehman,toFredS.Orlan,Lehman,etal.(July25,2007)[LBEXDOCID2563167].
332Id.

333Id.

334Lehman, Fixed Income Business Strategy, Single Transaction Limit Policy Proposed Improvements

(Sept.2007),atp.3[LBEXDOCID2563444].
335Lehman,PresentationtoLehmanExecutiveCommitteeonLeveragedFinanceRisk(Oct.16,2007),atp.

12[LBEXDOCID506033],attachedtoemailfromBlairSieff,Lehman,toStevenBerkenfeld,Lehman,et
al.(Oct.16,2007)[LBEXDOCID569915].

98

highyieldbusinesssriskappetitelimitatthebeginningof2006andagaininearly2007,

Lehmansincreasinglevelofhighyieldcommitmentscausedittoexceedthehighyield

businesssriskappetitelimitbysignificantamountsin2007and2008.336BylateApril

2007, Lehman had exceeded its newly increased high yield risk appetite limit,337 and

starting in late July, the high yield business usage consistently exceeded its limits.338

As Lehman funded more of its commitments, the leveraged loan exposure soon

doubledthelimitamount.339

Lehmans management made a conscious decision to exceed the risk appetite

limits on leveraged loans.340 Even though the risk appetite limits were divided into

subsidiarylimitsforthebusinesslinesofeachdivision,thelimitsforeachbusinessline

wereflexibleaslongastheaggregatenumbersrolledupwithinthedivisionallimit.341

One Lehman executive questioned whether the firm even had a high yield limit. In

April2007,KentaroUmezaki,HeadofFixedIncomeStrategy,emailedChristopherM.

OMeara, Lehman CFO at the time, and several others, expressing concern that in a

336Appendix:9,comparingriskappetiteandVaRusageversuslimits.

337Id.atp.3.

338Id.atp.4.

339Id.atp.49.

340Examiners Interview of Kentaro Umezaki, June 25, 2009, at p. 13; Examiners Interview of Jeffrey

Goodman,Aug.28,2009.
341ExaminersInterviewofMadelynAntoncic,Mar.27,2009,atp.12;ExaminersInterviewofMadelyn

Antoncic,Oct.6,2009,atp.7.

99

recentfirmwidemeeting,Fuldsentinconsistentmessagesbyencouraginggrowthat

thesametimeLehmanwasnearitsrisklimits.342UmezakinotedtoOMearaandothers:

the majorityof the tradingbusinessesfocusisonrevenues,withbalance


sheet, risk limit, capital or cost implications being a secondary concern.
Thefactthattheyhaventheardthatthoseitemsmatter[in]publicforums
from senior management recently reinforces this revenue oriented
behaviorimplicitly....Examplewhichwevedebatedforyears:waseven
atopicin[theTurnberrymeetingin]FLA:Doweordontwehavealimit
on how much HY LBO related lending/commitment exposure we can
have at any given time? There has been no real one firm outcome to
dateinmyopinion.ImnottheonlyonewhohasthisviewinFID.343

(c) InternalOppositiontoGrowthofLeveragedLoans
Business

LehmansFID,includingGelband,Kirk,andUmezaki,opposedanumberofthe

leveraged loan deals to which Lehman committed during this period, because they

believed that these individual deals were too risky to justify their limited returns.344

Despitetheopposition,theExecutiveCommitteedecidedtoproceedwithmanyofthe

deals.345

342Email from Kentaro Umezaki, Lehman, to Scott J. Freidheim, Lehman, et al. (Apr. 19, 2007) [LBEX

DOCID210193].
343Id.(emphasisadded);emailfromKentaroUmezaki,Lehman,toIanT.Lowitt,Lehman(Apr.18,2007)

[LBEXDOCID743931].
344Examiners Interview of Kentaro Umezaki, June 25, 2009, at p. 10; Examiners Interview of Michael

Gelband,Aug.12,2009,atpp.69;ExaminersInterviewofAlexKirk,Jan.12,2010,atp.2;emailfrom
EricFelder,Lehman,toMichaelGelband,Lehman,etal.(Aug.28,2008)[LBEXDOCID822513];seealsoe
mail from Steven Berkenfeld, Lehman, to Scott J. Freidheim, Lehman (May 11, 2007) [LBEXDOCID
1379290]; email from Bertrand Kan, Lehman, to Richard Atterbury, Lehman (Jan. 30, 2008) [LBEX
DOCID1379129].
345Examiners Interview of Kentaro Umezaki, June 25, 2009, at p. 3; Examiners Interview of Michael

Gelband,Aug.12,2009,atpp.79;ExaminersInterviewofAlexKirk,Jan.12,2010,atpp.2,7;Examiners
InterviewofPaulShotton,June5,2009,atpp.2,67;ExaminersInterviewofHughE.(Skip)McGeeIII,
Aug. 12, 2009, at p. 9; Examiners Interview of Fred S. Orlan, Sept. 21, 2009, at p. 4; email from Eric

100

Some of the opposition to Lehmans increase in leveraged lending was focused

onthebridgeequitycomponentofthosedeals.346SeveralformermembersofLehmans

senior management, including Nagioff, Antoncic, and Berkenfeld, expressed

reservations regarding the firms level of engagement in leveraged loan bridge equity

activities.347 The Examiner, however, also found that sponsors were aggressive in

demandingequitybridgecomponentstofinancing348andthattheInvestmentBanking

Division (IBD) was in favor of providing bridge equity because it believed that

Lehman needed to do so to stay competitive in the industry.349 Despite various

discussions among Lehmans management regarding whether the level of leveraged

loan bridge equity was acceptable and sustainable, Lehmans management never put

anylimitonthebusinesssleveragedloanbridgeequitycommitments.350

Felder,Lehman,toMichaelGelband,Lehman,etal.(Aug.28,2008)[LBEXDOCID822513];seealsoemail
from Steven Berkenfeld, Lehman, to LBEC Member, Lehman, et al. (May 11, 2007) [LBEXDOCID
1379290]; email from Larry Wieseneck, Lehman, to Alex Kirk, Lehman (Jan. 30, 2008) [LBEXDOCID
1379129].
346Email from Roger Nagioff, Lehman, to Madelyn Antoncic, Lehman, et al. (June 29, 2007) [LBEX

DOCID1467654);ExaminersInterviewofFredS.Orlan,Sept.21,2009,atp.7.
347Email from Roger Nagioff, Lehman, to David Goldfarb, Lehman (June 1, 2007) [LBEXDOCID

1581523];emailfromMadelynAntoncic,Lehman,toDavidGoldfarb,Lehman,etal.(June1,2007).
348Email from Steven Berkenfeld, Lehman, to Robert D. Redmond, Lehman (Sept. 23, 2007) [LBEX

DOCID1387569];emailfromAlexKirk,Lehman,to[xxxxxxx]@archwireless.net(May15,2007)[LBEX
DOCID 1379297] (phone number redacted); email from Steven Berkenfeld, Lehman, to LBEC Member,
Lehman,etal.(May11,2007)[LBEXDOCID1379291].
349ExaminersInterviewofFredS.Orlan,Sept.21,2009,atp.7.

350ExaminersInterviewofRogerNagioff,Sept.30,2009,atp.13;ExaminersInterviewofAlexKirk,Jan.

12,2010,atp.8;emailfromRobertD.Redmond,Lehman,toStevenBerkenfeld,Lehman,etal.(May19,
2007)[LBEXDOCID264270];emailfromAlexKirk,Lehman,toRobertD.Redmond,Lehman,etal.(May
21,2007)[LBEXDOCID174236];emailfromStevenBerkenfeld,Lehman,toDavidGoldfarb,Lehman,et
al.(June15,2007)[LBEXDOCID859026].

101

ByApril2007,theoverallsizeofthefirmsleveragedloancommitmentsbecame

controversial.351KirkandGelbandbecameconcernedaboutLehmansoverallexposure.

InApril2007,KirkemailedGelband:

Asaheadsupourriskofmandatedcommitsisupto6mmabptripleour
previoushigh.AlsothecommitsarecominginfastandfuriousIexpect
us to be well north of 30B this quarter. This is also unprecedented. In
addition we are now seeing commitments that have crossed the risk
tolerancesowemayneedyourhelpwiththebankinsayingnotosome
keyclients.352

Ataboutthesametime,Berkenfeld,whowasheadoftheCommitmentCommitteethat

was charged with evaluating individual leveraged loans, noted in an email: The

frenzyofthelastmonthorsoconcernsmeandIdontlikebeingbroughtinatthevery

endandexpectedtomakethesedecisionsinlessthan48hours.353

Antoncic,theCRO,alsoopposedmanyofthetransactionsandtheoverallsizeof

the business. She recalled a conversation in which she told Berkenfeld and Goldfarb

thatthefirmsleveragedloanexposurewasgettingtoolargeandthatlimitshadtobe

imposed.354 When Berkenfeld replied that he liked all of the deals that Lehman was

considering, Antoncic responded that he could like one deal or another, but not all of

thematonce.355

351ExaminersInterviewofKentaroUmezaki,June25,2009,atp.10.

352EmailfromAlexKirk,Lehman,toMichaelGelband,Lehman(Apr.20,2007)[LBEXDOCID2763976].

353EmailfromStevenBerkenfeld,Lehman,toJeanFrancoisAstier,Lehman,et.al.(Mar.30,2007)[LBEX

DOCID351370].
354ExaminersInterviewofMadelynAntoncic,Mar.27,2009,atp.10.

355Id.

102

FuldbelievedthatFIDandGelbandwerenotopposedtoLehmanexpandingits

leveraged loan business.356 Fuld believed that FID simply did not want the leveraged

loansonitsownbalancesheet,becauseitreceivedcreditforonlyhalfoftheincome.357

In contrast, IBD received credit for half of the income but bore no risk.358 Fuld

consideredGelbandsconcernsanintramuralP+Lgrab,whichconcernedhim.359

(d) GrowthofLehmansCommercialRealEstateBusinessat
TheStartoftheSubprimeCrisis

AtthesametimethatLehmanwasrapidlygrowingitsleveragedloanbusiness,

Lehman also dramatically increased its commercial real estate transactions. Lehman

almostdoubledGREGsbalancesheetlimitfrom$36.5billioninthefirstquarter2007to

$60.5billioninthefirstquarter2008,withGREGregularlyexceedingitsbalancesheet

limits.360 For instance, GREG exceeded its balance sheet limit by approximately $600

million in the third quarter 2007 ($56.6 billion balance sheet usage); by approximately

$3.8 billion in the fourth quarter 2007 ($64.3 billion balance sheet usage); and by

approximately$5.2billioninthefirstquarter2008($65.7billionbalancesheetusage).361

356ExaminersInterviewofRichardS.Fuld,Jr.,Sept.25,2009,atpp.5,12,13.

357Id.atp.19.

358ExaminersInterviewofKentaroUmezaki,June25,2009,atp.10.

359ExaminersInterviewofRichardS.Fuld,Jr.,Sept.25,2009,atp.19.

360Lehman, FIDBalance Sheet Management Presentation (Sept. 2007), at p. 3 [LBEXDOCID 4553137],

attached to email from Janet Marrero,Lehman, toGerardReilly, Lehman (Oct. 8, 2007) [LBEXDOCID
4552976]; Lehman, FIDBalance Sheet Presentation (Jan. 17, 2008), at p. 3 [LBEXDOCID 3363221],
attached to email from Sigrid Stabenow, Lehman, to Erik Addington, Lehman (Jan. 31, 2008) [LBEX
DOCID3384762];Lehman,FixedIncomeQ3BalanceSheetTargets[LBEXDOCID1742006],attachedtoe
mailfromKevinHoran,Lehman,toClementBernard,Lehman(June27,2009)[LBEXDOCID1698861].
361Id.

103

In addition, between the second quarter of 2006 and the second quarter of 2007,

Lehmans real estate bridge equity positions in the United States increased tenfold,

from$116millionto$1.33billion,andthendoubledtomorethan$3billionbytheend

ofthesecondquarterof2008.362

GREGs balance sheet growth was largely the result of a series of large

transactions that Lehman concluded between May 2007 and November 2007. Each of

the following deals increased the balance sheet by over $1 billion in the respective

months:363

May2007,$2.0billionLehmanfinancingtoBroadwayPartnerstoacquirea
subportfolioofBeaconCapitalStrategicPartnersIII,LP.364

May2007,$1.3billionLehmanfinancingtoBroadwayRealEstatePartners
toacquire237ParkAvenue.365

June2007,$1.2billionLehmanfinancingtoApolloInvestmentCorp.fora
takeprivateofInnkeepersUSATrust;366

June 2007, $1.1 billion Lehman financing to Thomas Properties Group to


acquiretheEOPAustinportfolio;367

362Ari Koutouvides, Lehman, Global Real Estate Group Americas Portfolio Summary re the Second
Quarterof2007(Oct.24,2007),atp.2[LBEXDOCID2501404],attachedtoemailfromJonathanCohen,
Lehman, to Paul Higham, Lehman (Oct. 24, 2007) [LBEXDOCID 2558146]; Global Real Estate Group
AmericasPortfolioasofJune30,2008,atp.15[LBEXDOCID1419825].
363Theamountslistedwerelabeledas[m]ovementsontothebalancesheetfortherespectivemonths.

Unlessotherwisenotedinthesource,theseamountsarepresumedtobeamountsfundedinthatperiod.
SeeQuarterlyRealEstateRecapThirdQuarterandYearToDatePresentation(Nov.29,2007),atpp.118
25[LBEXDOCID3504242],attachedtoemailfromPaulHigham,Lehman,toDonaldE.Petrow,Lehman
(Nov.29,2007)[LBEXDOCID3625043].
364
Id.
365Id.

366Id.

367Id.

104

June 2007, $1.7 billion Lehman financing for the acquisition of Northern
Rockscommercialrealestateportfolio;368

July 2007, $1.5 billion Lehman financing to ProLogis to acquire the


Dermodyindustrialportfolio;369

July 2007, $2.9 billion Lehman financing for the acquisition of the Coeur
Defenseofficebuilding;370

August2007,$1.0billionLehmanfinancingfortheacquisitionofNorthern
Rockscommercialrealestateportfolio;371

October 2007, $1.5 billion Lehman financing to Blackstone for its


acquisitionofHiltonHotels;372and

October 2007, $5.4 billion Lehman financing for the acquisition of the
ArchstoneSmithTrust.373

BecauseLehmanencounteredsubsequentdifficultiesinsellingorsecuritizingportions

ofthesedeals,manyoftheabovetransactionsremainedamongthelargestexposureson

LehmansbalancesheetasLehmansfinancialconditiondeterioratedwellinto2008.374

(i) RelaxationofRiskControlstoAccommodateGrowth
ofLehmansCommercialRealEstateBusiness

Aswiththegrowthoftheleveragedloanbusiness,thegrowthofthecommercial

real estatebusinesswas facilitated firstby anincreaseintherisk limitsand then by a

decisiontoexceedthoselimits.InaMay9,2006emailtoUmezaki,PaulA.Hughson,

368Id.

369Id.

370Id.

371 Id.
372Lehman,CommercialmortgagesQ22008(Aug.6,2008),atpp.514[LBEXDOCID018868],attached

toemailfromGerardReilly,Lehman,toIanT.Lowitt,Lehman(Aug.7,2008)[LBEXDOCID011867].
373Id.

374Lehman,GlobalRealEstateGroupUpdate,atpp.211[LBEXDOCID019080](listingtop10risksasof

May31,2008).

105

GREGs Head of Credit Distribution, inquired as to how risk limits meshed with

GREGsplanstoexpandourbusinessinAsia,Europeandourbridgeequitybusiness

globally. I specifically wanted to focus on how we can grow Asia and bridge equity,

given the risk limits . . . .375 Several months later, in September 2006, in an email to

Walsh, Jeffrey Goodman, (seniormost risk manager for FID directly responsible for

GREG) stated that he wanted to followup on a conversation I had with [G]elband a

whilebackconcerningapush(fromGoldfarbetal)totakeonmoreriskinRE(double

yoursize?)andgetyourviewonwhatisrealistictoexpectandwhereyouseethisin

theapprovalprocessinternally.376

Lehmans risk appetite limit for the real estate business increased from $600

million in 2006 to $720 million in 2007.377 But the real estate business quickly felt

pressurefrommanagementtoexceeditsrecentlyincreasedlimit.InaJune2007email,

GoodmantoldAntoncicthatHughsonfelttrapped inthatRoger[Nagioff] and other

seniorfolkswant[ed]themtokeepgrowingthebizandhittingp/lbudgetsbutonthe

otherhandthey[were]over[balancesheet]limitsandrisklimits.378Goodmanadvised

375Email from Kentaro Umezaki, Lehman, to Paul A. Hughson, Lehman (May 9, 2006) [LBEXDOCID

1776281].
376Email from Jeffrey Goodman, Lehman, to Mark A. Walsh, Lehman (Sept. 19, 2006) [LBEXDOCID

1368068].
377Email from Paul A. Hughson, Lehman, to Thomas Pearson, Lehman, et al. (May 23, 2006) [LBEX

DOCID1776282];Lehman,RealEstate>>RiskAppetite/VaR>>SummaryCOB27Aug2007Monday
[LBEXDOCID2912096],attachedtoemailfromPatriciaLuken,Lehman,toPaulHigham,Lehman,etal.
[LBEXDOCID2880146].
378EmailfromJeffreyGoodman,Lehman,toMadelynAntoncic,Lehman(June29,2007)[LBEXDOCID

155724].

106

Hughson that Lehmans commercial real estate group [could not] keep adding deals

withoutaplantoreducetherisksomehow,andthatthereneededtobeadiscussion

withNagioffas[toaskwhetherhecould]cutriskinotherareas(HY?)tofreeupsome

roomor[whetherhewould]bewillingtositoutsomeopportunities.379Management

ultimatelydecidedthatGREGwouldnotbeheldtoanyriskappetitelimits.380

(ii) InternalOppositiontoGrowthofCommercialReal
EstateBusiness

As with the leveraged loan business, some Lehman executives voiced concerns

about the risk associated with Lehmans large concentration of commercial real estate

positionsonitsbalancesheet.But,againaswiththeleveragedloanbusiness,Lehmans

management decided to continue to grow the commercial real estate business

notwithstanding those warnings, because that was the strategic imperative of the

firm.381 For example, on May 7, 2007, Goodman emailed Antoncic about the

Archstone transaction discussed below and said that OMeara, then the CFO, ha[d]

significantconcernsregardingoverallsizeof[therealestate]bookandhowmuchofthe

firms equity [was] tied up in such bridge equity deals.382 Lehmans risk managers

were also concerned with the real estate bridge equity deals in which Lehman was

379Id.

380ExaminersInterviewofMarkWalsh,Oct.21,2009,atpp.45.WalshtoldtheExaminerthathewas

toldtodoublethecommercialrealestaterisk.Id.atp.5.
381ExaminersInterviewofPaulA.Hughson,Oct.28,2009,atp.3.

382Email from Jeffrey Goodman, Lehman, to Madelyn Antoncic, Lehman (May 7, 2007) [LBEXDOCID

154953].

107

participating.383Thebridgeequitypositionswereconsideredparticularlyriskybecause

Lehmansbalancesheetwouldbedirectlyaffectedbythedecliningmarketvaluesofthe

underlyingrealestateifthefirmfailedtosellitsbridgeequitypositionsasplanned.384

Nevertheless, by late 2007, Lehman acquired a number of substantial bridge

equity positions, both in the United States and overseas, including: $2.3 billion in

Archstone;385$574millioninProLogis/Dermodyportfolio;386475million($655million)

inCoeurDefense;387$221millioninEOPAustin;388and$195millionintheacquisitionof

the 200 Fifth Avenue building.389 As a result of these acquisitions, real estate bridge

equity went from a negligible business to a multibillion dollar exposure in

approximately18months.

(iii) Archstone

a. LehmansCommitment

The enormous growth of Lehmans commercial real estate balance sheet

culminated in Lehmans commitment to participate in an approximately $22 billion

383Id.;Examiners Interview of Madelyn Antoncic, Mar. 27, 2009, at pp. 89; email from Madelyn
Antoncic,Lehman,toRogerNagioff,Lehman,etal.(June29,2007)[LBEXDOCID1478403];emailfrom
PaulA.Hughson,Lehman,toThomasPearson,Lehman,etal.(May23,2006)[LBEXDOCID1776282].
384ExaminersInterviewofMadelynAntoncic,Mar.27,2009,atpp.89.

385Global Real Estate Group, Lehman, Updated Commitment Committee Memorandum for Archstone

(May22,2007)[LBEXDOCID1350952];Lehman,LehmanBrothersBridgeEquityPipeline(July3,2007)
[LBEXDOCID638275],attachedtoemailfromJeffreyGoodman,Lehman,toDonaldE.Petrow,Lehman,
etal.(July11,2007)[LBEXDOCID670845].
386Lehman,TopRealEstateRiskSummary(Dec.12,2007),atp.2[LBEXDOCID789172].

387Id.;QuarterlyRealEstateRecapThirdQuarterandYearToDatePresentation(Nov.29,2007),atp.124

[LBEXDOCID 3504242], attached to email from Paul Higham, Lehman, to Donald E. Petrow, Lehman
(Nov.29,2007)[LBEXDOCID3625043].
388Id.atp.3.

389Id.atp.4.

108

joint venture with Tishman Speyer for the acquisition of the publiclyheld Archstone

REIT.390Includingunitsunderconstruction,Archstoneownedover88,000apartments,

whichwerespreadacrossmorethan340communitieswithintheUnitedStates.391Mark

Walshwasthedrivingforcebehindthisdeal,butFuldandGregorystronglysupported

itaswell.392

OnMay2,2007,LehmanandTishmanSpeyerprovidedanonbindingletterto

acquire all outstanding shares of Archstone for $64 per share, subject to confirmatory

due diligence.393 After negotiating a price of $60.75 per share and executing a plan of

merger,394 the parties announced the deal publicly on May 29, 2007.395 The deal was

originallyscheduledtoclosebeforeAugust31.396

Lehmans Executive Committee required Walsh to find partners to reduce

Lehmansriskinthedeal.BankofAmericaCorporation(BofA)agreedtofundhalf

390Lehman,ArchstoneQ22008Update,atp.14[LBEXDOCID2929329],attachedtoemailfromLeonard

Cohen,Lehman,toPaulA.Hughson,Lehman(June12,2008)[LBEXDOCID2820780].
391ArchstoneSmithOperatingTrust,AnnualReportfor2006asofDecember31,2006(Form10K)(filed

onMar.1,2007),atp.6.
392Examiners Interview of Mark A. Walsh, Oct. 21, 2009, at pp. 810; Examiners Interview of Joseph

Gregory,Nov.13,2009,atpp.78;ExaminersInterviewofRichardS.Fuld,Jr.,Sept.25,2009,atpp.34.
393James L. Dixson, Lehman, Archstone Transaction Timeline (June 20, 2007), at. p. 2 [LBEXDOCID
2139993],attachedtoemailfromJamesL.Dixson,Lehman,toRobertAshmun,Lehman,etal.(June20,
2007)[LBEXDOCID2139994].
394Id.atp.5;AgreementandPlanofMergerAmongArchstoneSmithTrust,ArchstoneSmithOperating

Trust, River Holding, LP, River Acquisition (MD), LP, and River Trust Acquisition, LP (May 28,
2007)[TSREV00000460554].
395JamesL.Dixson,Lehman,ArchstoneTransactionTimeline(June20,2007),at.pp.5,6[LBEXDOCID

2139993],attachedtoemailfromJamesL.Dixson,Lehman,toRobertAshmun,Lehman,etal.(June20,
2007) [LBEXDOCID 2139994]; Agreement and Plan of Merger for ArchstoneSmith and River Holding
(May 28, 2007) [LBEXDOCID 1759937], attached to email from Kyle Krpata, Weil, Gotshal & Manges
LLP,toDavidE.Shapiro,Wachtell,Lipton,Rosen&Katz,etal.(May29,2007)[LBEXDOCID1870993].
396EmailfromChipHeflin,Lehman,toLoanSales,Lehman(May29,2007)[LBEXDOCID1488757].

109

of the floating rate bank loan and junior mezzanine loan, and to purchase half the

bridgeequity.397BarclaysCapitalInc.(Barclays)signedaparticipationagreementto

take15%ofthebridgeequityand15%ofthedebtintheArchstonedeal,andthen,on

July2,2007,amendedtheagreementtotake25%ofthedebt.398Barclayscommitments

came out of BofAs share of the debt and equity, and thus did not affect Lehmans

exposuretoArchstone.399

TheArchstonedealwasanenormouscommitmentbyLehman,bothintermsof

debt financing and equity. After bringing in BofA and Barclays, Lehman agreed to

makeapermanentequityinvestmentof$250million;agreedtopurchasebridgeequity

of approximately $2.3 billion; and also agreed to fund various debt tranches totaling

$8.5billion.400

397Compare Memorandum from Mark A. Walsh, Lehman, to Executive Committee of Lehman Board of

Directors, Re: Project Easy Living(May 22,2007) [LBEXDOCID1350952],attached to emailfromJulia


Atwood, Lehman, to HYCC Members, Lehman, et al. [LBEXDOCID 1341648] with Memorandum from
MarkA.Walsh,Lehman,toExec.CommitteeofLBHIBoardofDirectors,re:ProjectEasyLiving(May7,
2007), at pp. 1, 3 [LBEXDOCID 147230], attached to email from Mark A. Walsh, Lehman, to Steven
Berkenfeld, Lehman, et al. (May 8, 2007) [LBEXDOCID 141217]; Letter from Scott M. Weiner, Barclays
InvestmentHoldings,Inc.,toLehman,etal.,RedlineCommitmentLetterforArchstone(June11,2007)
[LBEXDOCID2073685];LetterfromScottM.Weiner,BarclaysInvestmentHoldings,Inc.,toLehman,et
al.,ExecutionCopyofCommitmentLetterforArchstone(June11,2007)[LBEXDOCID1451573].
398Id.

399ExaminersInterviewofMarkA.Walsh,Oct.21,2009.

400ProjectEasyLiving,TermSheet(Sponsor)(May28,2007),atp.1[LBEXDOCID1624529],attachedto

emailfromDavidHerman,Weil,Gotshal&MangesLLP,toAndrewDady,SchulteRoth&ZabelLLP,et
al.[LBEXDOCID1383842];ProjectEasyLiving,TermSheet(BridgeEquity)(May28,2007),atp.1[LBEX
DOCID1324526],attachedtoemailfromDavidHerman,Weil,Gotshal&MangesLLP,toAndrewDady,
Schulte Roth & Zabel LLP, et al. [LBEXDOCID 1383842]; River Holdings LP Senior Secured Facilities
CommitmentLetter(May28,2007),atp.1[LBEXDOCID2395952],attachedtoemailfromJulianChung,
Cadwalader,Wickersham&TaftLLP,etal.(May29,2007)[LBEXDOCID2268458].

110

At the time the deal was presented to the Executive Committee, Lehman

intendedtosellallArchstonedebtatclosing.401BecauseLehmanhadpriceflexonthe

Archstonedebt,Lehmanmanagementwasreasonablyconfidentthatitcoulddistribute

thedebtwithoutsufferingaloss.402Priceflexisamechanismthatfacilitatessyndication

orsaleofaloanbytheinitiallenderwithouttakingaloss.403Asamechanicalmatter,

price flex may permit the initial lender to increase the interest rate to attract other

lenders(inwhichcasetheborrowerisrequiredtopayitslendersahigherinterestrate),

orrequiretheborrowertoreimbursethedebtholdersforanylosstheymaysufferasa

result of syndicating or selling the debt to a third party at a price less than par.404

BecauseofthepriceflexontheArchstonedebt,theriskintheArchstonecommitment

washeavilyconcentratedinLehmansequityandbridgeequitycommitments.

Lehmanplannedtosell50%ofitsremainingmezzaninedebtandbridgeequity

positions within two to three weeks of closing (Lehman had already had two large

financial institutions express an interest), and the rest would be sold off over the six

401Lehman,EasyLivingTalkingPointsforExecutiveCommitteeandRatingAgencies(May18,2007),at

p. 2 [LBEXDOCID 200792], attached to email from Paolo R. Tonucci, Lehman, to Christopher M.


OMeara,Lehman,etal.(May18,2007)[LBEXDOCID215761].
402Id.

403 Standard & Poors, Guide to the Loan Market (Sept. 2009), at p. 8,
http://www2.standardandpoors.com/spf/pdf/fixedincome/LoanMarketGuide_2009_Final.pdf (last visited
(lastvisitedonFeb.1,2010);AliciaTaylor&AliciaSansone,THE HANDBOOKOF LOAN SYNDICATIONSAND
TRADING 175 (McGrawHill 2007); Steven M. Vavaria, Standard & Poors, Syndicated LoansA Rated
Market, at Last! (Feb. 12, 2002), http://leeds
faculty.colorado.edu/madigan/3020/Readings/Syndicated_LoansA_Rated_Market_At_Last.pdf (last
visitedonFeb.1,2010).
404Id.

111

months following closing.405 Insofar as Lehmans potential profits were concerned,

Lehmanforecastearningmorethan$1.3billionoveratenyearperiod,includingnearly

$1 billion on Lehmans investment and substantial origination and asset management

fees.406

b. RiskManagementofLehmansArchstone
Commitment

ArchstonewasrepeatedlyconsideredbyboththeCommitmentCommitteeand

ExecutiveCommittee.407Thesecommitteesmandatedsignificantalterationstothedeal

structure,including,mostimportantly,requiringWalshtobringinatleastonepartner

ultimatelyBofAtoreducethesizeofLehmanscommitment.408

Notwithstanding Archstones consideration by the senior management of the

firm, Lehmans risk managers said that they had minimal input in the decision to

acquire Archstone.409 As a result, despite the extraordinary size and risk of Lehmans

commitment to the transaction, Lehmans management did not conduct quantitative

405Lehman,EasyLivingTalkingPointsforExecutiveCommitteeandRatingAgencies(May18,2007),at

p. 2 [LBEXDOCID 200792], attached to email from Paolo R. Tonucci, Lehman, to Christopher M.


OMeara,Lehman,etal.(May18,2007)[LBEXDOCID215761].
406MemorandumfromMarkA.Walsh,Lehman,toExecutiveCommittee,Lehman,reProjectEasyLiving

(May7,2007),atp.3[LBEXDOCID147230],attachedtoemailfromMarkA.Walsh,Lehman,toSteven
Berkenfeld,Lehman,etal.(May8,2007)[LBEXDOCID141217].
407ExaminersInterviewofDavidS.Lazarus,Nov.18,2009,atpp.67;ExaminersInterviewofPaulA.

Hughson, Oct. 28, 2009, at p. 2; Examiners Interview of Lisa Beeson, Oct. 23, 2009, at p. 4; Examiners
InterviewofKennethCohen,Oct.20,2009,atpp.56.
408Examiners Interview of Steven Berkenfeld, Oct. 5 & 7, 2009, at pp. 1415; Examiners Interview of

RichardS.Fuld,Jr.,Sept.25,2009,atpp.2223.
409Examiners Interview of Jeffrey Goodman, Aug.28, 2009; Examiners Interview of Kentaro Umezaki,

June25,2009,atp.17;ExaminersInterviewofMadelynAntoncic,Feb.25,2009,atp.5.

112

analysesofLehmansexposureinadvanceoftheriskLehmanwasundertaking.410For

example, it does not appear that Lehman systematically analyzed the effect that the

commitmentwouldhaveonthe firmsriskappetitelevels,orconductedstresstesting

onthefirmsburgeoningcommercialrealestateexposures,inadvanceofcommittingto

the transaction. Because of the extraordinary size of the transaction, however

including especially an unprecedented bridge equity commitment it was clear from

the beginning that the Archstone commitment would cause Lehman to exceed its risk

appetitelimits.411

The Office of Thrift Supervision (OTS) criticized Lehmans decision to enter

into the Archstone transaction in excess of its risk appetite limits.412 During OTSs

yearlyreview of Lehman in 2007,the OTS noticed that Lehman had exceeded its risk

appetitelimitsandthattheArchstonedealwaslargelyresponsibleforthatoverage.413

Asaresult,in2008,OTSdecidedtoconductatargetedreviewofLehmanscommercial

real estate business. After that targeted review, OTS issued a negative report,

criticizing Lehman for being materially overexposed in the commercial real estate

market and for entering into the Archstone deal without sound risk management

410ExaminersInterviewofJeffreyGoodman,Aug.28,2009;ExaminersInterviewofMadelynAntoncic,

Mar.27,2009,atp.11.
411ExaminersInterviewofJeffreyGoodman,Aug.28,2009.

412Office of Thrift Supervision, Report of Examination, Lehman Brothers Holdings Inc. (Exam starting

July7,2008),atp.2[LBEXOTS000392].
413ExaminersInterviewofRonaldMarcus,Nov.4,2009,atpp.78.

113

practices.414ThereportconcludedthatLehmansbreachofrisklimits,causedlargelyby

theArchstonedeal,contributedtomajorfailingsintheriskmanagementprocess.415

Bycontrast,theSECtoldtheExaminerthatitwasawareoftheriskappetitelimit

excesses, and that it did not secondguess Lehmans business decisions so long as the

limitexcesseswereproperlyescalatedwithinLehmansmanagement.416

(e) NagioffsReplacementofGelbandasHeadofFID

OnMay1,2007,LehmanannouncedthatGelband,thethenactingGlobalHead

of FID, had decided to leave the Firm to pursue other interests, and that Roger

Nagioff would assume the top FID position at Lehman.417 Internally, Lehman

announced that the change was based on philosophical differences among Fuld,

Gregory,andGelbandastothedirectiontotaketogrowthebusiness.418

Gelband was removed from the position for several reasons, including that he

was not aggressive enough in growing the business in accordance with Fulds long

414ExaminersInterviewofRonaldS.Marcus,Nov.4,2009,atpp.78;accordOfficeofThriftSupervision,

ReportofExamination,LehmanBrothersHoldingsInc.(ExamstartingJuly7,2008),atp.2[LBEXOTS
000392].
415Office of Thrift Supervision, Report of Examination, Lehman Brothers Holdings Inc. (Exam starting

July7,2008),atp.2[LBEXOTS000392].
416ExaminersInterviewoftheSecuritiesandExchangeCommission,Aug.24,2009,atp.8.

417LehmanBrothersHoldingsInc.,PressRelease:LehmanBrothersNamesRogerB.NagioffGlobalHead

of Fixed Income (May 2, 2007), at p. 1 [LBEXDOCID 1470086], attached to email from Monique Wise,
Lehman,toJasjit(Jesse)Bhattal,Lehman,etal.(May1,2007)[LBEXDOCID1605828].
418Lehman Brothers, Talking Points & FAQs (May 1, 2007) [LBEXDOCID 1470087], attached to email

from Monique Wise, Lehman, to Jasjit (Jesse) Bhattal, Lehman, et al. (May 1, 2007) [LBEXDOCID
1605828].

114

term revenue targets.419 Fuld and Gregory also clashed with Gelband with respect to

growingthefirmsenergybusinessanditsleveragedloanbusiness.420

Fuld and Gregory chose Nagioff, then the CEO of Lehman Europe, to succeed

Gelband,eventhoughhehadnodirectexperienceinthefixedincomebusiness,andhe

lived in London, not New York.421 Nagioff decided to commute from London for a

portionofeachmonth.422

419ExaminersInterviewofJosephGregory,Nov.5,2009;ExaminersInterviewofRogerNagioff,Sept.30,

2009, at pp. 56 (stating that Gregory informed him that Gelband was forced out because he was not
willing to think creatively about growing Lehmans business and sharing his belief that Gelbands
opposition to the Eagle Energy deal was the last straw); Examiners Interview of Michael Gelband,
Aug. 12, 2009, at pp. 1516; contra Examiners Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at p. 18;
ExaminersInterviewofHerbertH.(Bart)McDadeIII,Jan.28,2010,atp.9.
420Examiners Interview of Michael Gelband, Aug. 12, 2009, at pp. 2, 7, 1516; Examiners Interview of

Joseph Gregory, Nov. 5, 2009; Examiners Interview of Roger Nagioff, Sept. 30, 2009, at pp. 56;
Examiners Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at p. 18; email from Michael Gelband,
Lehman to Richard S. Fuld, Jr., Lehman (Mar. 6, 2007) [LBEXDOCID 2762454] ([R]isk/reward is not
good here so Im trying to get out of as much illiquid risk as possible.... That is the strategy at the
momentthatallmymanagersarefollowing.Ineedtohavethembeinapositiontobeabletooperate
andcapitalizeifwegothroughaperiodofstress.).
421Examiners Interview of Roger Nagioff, Sept. 30, 2009, at pp. 56; Examiners Interview of Hugh E.

(Skip) McGee, Aug. 12, 2009, at p. 27 (McGee indicated that replacing Gelband with Nagioff was an
unusualideabecauseNagioffsexperiencewaswithEuropeanequitiesandMcDadewouldhavebeena
morelogicalchoicetoreplaceGelband.);ExaminersInterviewofKentaroUmezaki,June25,2009,atp.15
(Umezaki stated that many people, himself included, were surprised at Nagioffs promotion because
Nagioff had no background in fixed income and was not located in the United States at a time when
LehmanwasdealingwithaneconomiccrisislocatedprimarilywithintheUnitedStatesandfurtherthat
AlexKirkorAndrewJ.MortonwouldhavebeenmorelogicalselectionsbutthatGregoryhadindicated
thatNagioffwouldbegoodforthejobbecauseofhisabundanceofbusinessexperienceandawillingness
totakerisks.).
422Examiners Interview of Roger Nagioff, Sept. 30, 2009, at p. 6 (Nagioffs commute would ultimately

provetobeanunsustainablearrangement,asthestrainitcreatedonNagioffsfamilycausedhimtoleave
thecompanyinFebruary2008.).

115

(f) TheBoardofDirectorsAwarenessofLehmansIncreasing
RiskProfile

InaJune19,2007Boardmeeting,OMearapresentedthesecondquarterresults

to the Board.423 Lehmans management generally disclosed the firms increased risk

profile as well as the recently concluded Archstone deal. For example, OMeara

reportedthatthefirmwidequarterlyaverageriskappetiteusageforthesecondquarter

of2007was$2.6billionagainstalimitof$3.3billion,424andtheBoardhadanextended

discussion concerning the fact that the increased risk usage was spread across the

firm.425InJune2007,however,Lehmansdailyrisksystemsreflectedthatthefirmwas

almost at the $3.3billionriskappetitelimit, notincluding theArchstonetransaction

wellabovethe$2.6billionquarterlyaverage.426

TheinclusionoftheArchstonetransactionwascertaintoputLehmanwellover

both its firmwide risk appetite limit and its limit applicable to the real estate

business.427 While the Archstone transaction was discussed at the June meeting,428

423Lehman Brothers Holdings Inc., Minutes of Meeting of Board of Directors (June 19, 2007), at p. 3
[LBHI_SEC07940_026267].
424Id.; Lehman, Second Quarter 2007 Financial Information Presentation to Lehman Board of Directors

(June19,2007),atp.6[LBHI_SEC07940_026226].
425Lehman,SecondQuarter2007FinancialInformationPresentationtoLehmanBoardofDirectorswith

Weliksonsnotes(June19,2007),atp.6[WGM_LBEX_01165].
426See,e.g.,Lehman,DailyRiskAppetiteReport(June19,2007),atp.1[LBEXDOCID3296221],attached

toemailfromRuiLi,Lehman,toManhuaLeng,Lehman,etal.(June19,2007)[LBEXDOCID3295251].
427See,e.g., id.;Mark Weber, Lehman, Chart ShowingRisk Appetite Adjustment for Archstone (July 24,

2008) [LBEXDOCID 425705], attached to email from Mark Weber, Lehman, to PortfolioRisk Support,
Lehman,etal.(July24,2008)[LBEXDOCID265567].
428LehmansBoarddidnotconsiderorapprovetheArchstonetransactioninadvanceofthecommitment.

Examiners Interview of Sir Christopher Gent, Oct. 22, 2009, at p. 3; but cf. Examiners Interview of
MichaelL.Ainslie,Sept.22,2009,atp.8(statingthattheBoardneverformallyapprovedtheArchstone

116

Lehmans management did not inform the Board until October 15, 2007 that Lehman

hadexceededthefirmwideriskappetitelimitformorethanfourmonths.

(3) EarlyWarnings:RiskLimitOverages,FundingConcerns,and
theDeepeningSubprimeCrisis

FromMaytoAugust2007,thefinancialcrisisthathadpreviouslybeencontained

to the subprime residential mortgage market began to spread to other markets,

including the commercial real estate and credit markets, where Lehman was

particularly active. These concerns escalated in June and July 2007, when two Bear

Stearns hedge funds imploded, leading to panic in the credit markets and concerns

more generally that the subprime crisis would spill into the broader economy.429 SEC

Chairman Christopher Cox commented that [o]ur concerns are with any potential

systemicfallout.430

Asaconsequenceofthisgatheringstorm,inthefirsttwoweeksofJuly2007,S&P

placed$7.3billionofresidentialmortgagerelatedsecuritiesonnegativeratingswatch

and announced a review of collateralized debt obligations (CDOs) exposed to

residentialcollateral;Moodysdowngraded$5billionofsubprimemortgagebondsand

acquisition or even discussed the transaction prior to Lehmans commitment to the deal); Examiners
InterviewofJohnF.Akers,Apr.22,2009(same);ExaminersInterviewofRogerBerlind,May8,2009,at
p. 10 (same); Examiners Interview of Thomas Cruikshank, Oct. 8, 2009, at p. 3 (same); Examiners
Interview of Marsha Johnson Evans, May 22, 2009, at p. 14 (same); Examiners Interview of Sir
ChristopherGent,Oct.22,2009,atpp.1213(same);ExaminersInterviewofRolandA.Hernandez,Oct.
2, 2009 (same); Examiners Interview of Dr. Henry Kaufman, May 19, 2009, at p. 15 (same); Examiners
InterviewofJohnD.Macomber,Sept.25,2009,atp.13(same).
429Mark Pittman, Bear Stearns Mortgage Fund Collapse Sends Shock Through CDOs (Update 2), Bloomberg,

June21,2007.
430Id.

117

placed184mortgagebackedCDOtranchesondowngradereview;andFitchplaced33

classes of structured finance CDOs on credit watch negative.431 By the first week of

August2007,GermanysIKBannouncedmajorsubprimerelatedlossesandrequireda

bailout, American Home Mortgage filed for Chapter 11 bankruptcy, and the French

bank BNP Paribas froze redemptions on three of itsfunds, citing an inability to value

theminthecurrentmarket.432

Despitetheseevents,Lehmanwentforwardwithanumberoflargeinvestments,

somepreviouslycommitted,somenew,untilAugust2007,whenitdrasticallycutback

onitsleveragedlending,andlaterin2007,whenitstoppeddoingnewcommercialreal

estatedeals.

ThisSectiondiscussestheconcernsofLehmansmanagersaboutthestateofthe

marketsasearlyasAprilandMay2007andmanagementsactionswithrespecttothe

scale of its leveraged loan business. This Section also discusses the concerns among

someLehmanmanagersinJulyandAugust2007thatLehmanmightbeunabletofund

allofitsleveragedloanandrealestatecommitments,includingArchstone,andLehman

managers decision during this period not to increase the magnitude of Lehmans

macrohedgesonitsleveragedloanandcommercialrealestateportfolio.Finally,this

Section discusses managements decision to terminate its residential mortgage

originationsthroughBNCandAurora.

431BankforInternationalSettlements,78thAnnualReport(June30,2008),atp.95.

432Id.

118

(a) NagioffandKirkTrytoLimitLehmansHighYield
Business

Nagioff began to discuss rolling back the growth of the firms leveraged loan

business as soon as he became head of FID on May 2, 2007, but this decision was not

fully effectuated until August 2007, by which time Lehmans leveraged loan exposure

hadgrownto$35.8billionasaresultof$25.4billioninnewcommitments.433

NagiofflearnedaboutthesizeofLehmansleveragedloanexposuresfromKirk,

then Head of Global Credit Products.434 Lehmans leveraged loan business was so

gargantuantheexposuresjumpedoutat[him].435NagioffandKirkbelievedthatthis

was banker business, not broker business, which Lehman did not have the balance

sheettosupport.436Nagioffalsothoughtthatthechanceofasuddenmarketdownturn

washigh,andthatLehmanwasmakingrelativelysmallprofitsfortakingincreasingly

433Lehman, Business and Financial Review Q2 2008 (Aug. 5, 2008), at p. 14 [LBHI_SEC07940_659768];

Lehman,LoanPortfolioGroupWeeklyReview(June8,2007),atpp.38[LBEXDOCID146379];Lehman,
Loan Portfolio Group Weekly Review (June 15, 2007), at pp. 38 [LBEXDOCID 146375]; Lehman, Loan
Portfolio Group Weekly Review (June 22, 2007), at pp. 38 [LBEXDOCID 146376]; Lehman, Loan
Portfolio Group Weekly Review (June 29, 2007), at pp. 38 [LBEXDOCID 146377]; Lehman, Loan
PortfolioGroupWeeklyReview(July6,2007),atpp.38[LBEXDOCID146348];Lehman,LoanPortfolio
GroupWeeklyReview(July13,2007),atpp.38[LBEXDOCID146358];Lehman,LoanPortfolioGroup
Weekly Review (July 20, 2007), at p. 7 [LBEXDOCID 146339]; Lehman, Loan Portfolio Group Weekly
Review(July27,2007),atpp.38[LBEXDOCID146350];Lehman,LoanPortfolioGroupWeeklyReview
(Aug. 10, 2007), at pp. 38 [LBEXDOCID 146341]; email from Jeffrey Goodman, Lehman, to David N.
Sherr,Lehman,etal.(June22,2007)[LBEXDOCID237094].Thereissomeevidenceofinaccuraciesinthe
LPG reports. See, e.g., Gary J. Fox, Lehman, Lehman Brothers Top Exposure Report Lehman Papers
Compared to LPG Data (June 25, 2007) [LBEXDOCID 2461202], attached to email from Gary J. Fox,
Lehman, to Greg L. Smith, Lehman, et al. (June 26, 2009) [LBEXDOCID 2461203]. The calculation
excludesthecommitmenttoTXU.
434ExaminersInterviewofRogerNagioff,Sept.30,2009,atp.8.

435Id.atp.7.

436ExaminersInterviewofRogerNagioff,Sept.30,2009,atp.7.

119

large and illiquid risks.437 Nagioff was concerned because the tail risk of Lehmans

leveragedloanbusinesstotaledbillionsofdollars.438

Nagioff also had broader concerns about the state of the credit markets. These

concerns were shared by others outside Lehman and by several of Nagioffs senior

colleagues, who believed that Lehman was operating in a credit bubble.439 Months

later, Antoncic, for example, reflected back on the general consensus that the markets

were in trouble: every one saw the train wreck coming. 64k question is why didnt

anyonegetoutoftheway???440

Although Nagioffs concerns were shared by several others, Nagioff believed

thatitwouldbedifficulttocurtailLehmansleveragedloanbusiness,becauseMcGees

IBD,whichhadchampionedexpansionofthisbusinessfromthestart,hadtoauthorize

thechange.441Moreover,Lehmanhadmanydealsinthepipeline,andthosedealswere

supporting 100 bankers.442 To make matters worse,Kirk believed that Gelband had

been relieved of his position partly as a result of his opposition to the leveraged loan

437ExaminersInterviewofRogerNagioff,Sept.30,2009,atp.8;emailfromGaryMandelblatt,Lehman,

toRogerNagioff,Lehman,etal.(Nov.27,2007)[LBEXDOCID156264].
438ExaminersInterviewofRogerNagioff,Sept.30,2009,atp.10.

439Email from Steven Berkenfeld, Lehman, to Roger Nagioff, Lehman (May 10, 2007) [LBEXDOCID

140669]; email from Roger Nagioff, Lehman, to Ian T. Lowitt, Lehman (May 10, 2007) [LBEXDOCID
140666]; email from Christopher M. OMeara, Lehman, to Paulo R. Tonucci, Lehman (Apr. 6, 2007)
[LBEXDOCID 1349076]; emailfrom Christopher M. OMeara,Lehman, to Ian T. Lowitt,Lehman (July
21,2007)[LBEXDOCID211149].
440Email from Madelyn Antoncic, Lehman, to Jack Malvey, Lehman (Apr. 8, 2008)

[LBHI_SEC07940_212356].
441ExaminersInterviewofRogerNagioff,Sept.30,2009,atp.10.

442Id.

120

business;NagioffbelievedthathewouldonlygetonechancetoconvinceFuldthatthis

businesshadtobestopped.443

NagioffspoketoFuldonMay31,2007.NagiofftoldFuldthatLehmanwastoo

big in the leveraged lending business and could lose a lot of money in the tail risk.444

NagioffshowedFuldthenumbers,whichreflectedapossible$3.2billionlossundera

stress scenario that was computed specifically for the purpose of this meeting.445

Nagioff told Fuld that Lehman needed to reduce its forward commitments from $36

billionto$20billion,imposerulesontheamountofleverageinthedeals,anddevelopa

frameworkforlimitingandevaluatingthisbusiness.446

Fuldwassurprisedandconcernedbythetailriskintheleveragedloanpositions

and authorized Nagioff to present his analysis to the Executive Committee to get

authorization to move forward with a plan to limit the firms leveraged loan

exposures.447

443Email from Roger Nagioff, Lehman, to Alex Kirk, Lehman (May 31, 2007) [LBEXDOCID 173414];

ExaminersInterviewofRogerNagioff,Sept.30,2009,atp.11;ExaminersInterviewofAlexKirk,Jan.12,
2010, at p. 11 (Kirk stated that Nagioff thought that Gelband had been fired in part for opposing the
leveragedloansbusiness;thus,theyhadtomoveveryslowlyinobtainingauthoritytohaltthebusiness).
444ExaminersInterviewofRogerNagioff,Sept.30,2009,atp.11;emailfromJormenVallecillo,Lehman,

to Roger Nagioff, Lehman, et al. (June 8, 2007) [LBEXDOCID 1620669]; Alex Kirk, Lehman, Leveraged
FinanceRiskPresentation(June8,2007)[LBEXDOCID1416503].
445Examiners Interview of Roger Nagioff, Sept. 30, 2009, at pp. 1112; email from Jormen Vallecillo,

Lehman, to Roger Nagioff, Lehman, et al. (June 8, 2007) [LBEXDOCID 1620669]; Alex Kirk, Lehman,
LeveragedFinanceRiskPresentation(June8,2007),atp.10[LBEXDOCID1416503].
446ExaminersInterviewofRogerNagioff,Sept.30,2009,atp.12.

447Id.

121

Several weeks later, Nagioff discussed the leveraged loan exposure with the

Executive Committee. After that conversation, on June 28, 2007, Nagioff was

authorizedbyFuld,Gregory,andMcGeetoconductacrossfirminitiativetoreduce

commitments to $20 billion by the end of 2007.448 The crossfirm initiative entailed

developing more specific and effective limits on Lehmans high yield business

(including single transaction limits) and bridge equity, and developing a plan for

reducingtheexistingexposures.449

InthetwomonthsbetweenNagioffsconversationwithFuldonMay31andthe

slowdownofLehmansleveragedloancommitmentsinAugust2007,thefirmentered

intoanother$25.4billionincommitments.450Forexample,LehmanagreedonJune18,

2007tocommit$2.05billiontotheSequaCorpdeal;tocommit$3.3billiontotheHome

Depot Supply deal on July 19, 2007; to commit $2.4 billion to finance the Houghton

Mifflin deal; and to commit $2.14 billion to finance the Applebees deal on July 16,

448EmailfromStevenBerkenfeld,Lehman,toScottJ.Freidheim,Lehman(June26,2007)[LBEXDOCID

1819424];ExaminersInterviewofRogerNagioff,Sept.30,2009,atp.13.
449ExaminersInterviewofRogerNagioff,Sept.30,2009,atp.13.

450Lehman, Loan Portfolio Group Weekly Review (June 8, 2007), at pp. 38 [LBEXDOCID 146379];
Lehman, Loan Portfolio Group Weekly Review (June 15, 2007), at pp. 38 [LBEXDOCID 146375];
Lehman, Loan Portfolio Group Weekly Review (June 22, 2007), at pp. 38 [LBEXDOCID 146376];
Lehman,LoanPortfolioGroupWeeklyReview(July6,2007),atpp.38[LBEXDOCID146348];Lehman,
Loan Portfolio Group Weekly Review (July 13, 2007), at pp. 38 [LBEXDOCID 146358]; Lehman, Loan
PortfolioGroupWeeklyReview(July27,2007),atpp.38[LBEXDOCID146350];Lehman,LoanPortfolio
Group Weekly Review (Aug. 10, 2007), at pp. 38 [LBEXDOCID 146341]. The calculation excludes
LehmanscommitmenttoTXU.

122

2007.451Asaresult,FIDendedthequarterroughly$2billionoveritsnetbalancesheet

limit.452AsNagioffputit,ittooktimetostopthemachine;alotofdealswereinthe

pipeline or under negotiation, and Lehman did not believe that it could abruptly

terminatethosedeals.453

Nagioffwasconcernedthathiseffortsweretoolittletoolate:Sadlyinspiteof

killing BCE which was a 5!bn KKR disaster I am probably 3 months too late in the

job.a big deal got pulled today and others are being restructured down.we are

probably going to get punished for our stupidity.454 Two days later, Nagioff also

wrote: I now have the thing under control . . . if I had the job 6 months earlier we

wouldnotbewhereweare...letshopeitisonlyscratches.455

(b) JulyAugust2007ConcernsRegardingLehmansAbilityto
FundItsCommitments

ByJuly2007,aftertheBearStearnsfundsimplosion,someLehmanexecutives

were concerned that Lehman might not be able to fund all of its commitments.456 For

451Email from Lehman Risk, Lehman, to Risk Limit Excess, Lehman (July 16, 2007) [LBEXDOCID
230109]; Lehman, Loan Portfolio Group Weekly Review (July 20, 2007), at p. 7 [LBEXDOCID 146339];
Lehman, Loan Portfolio Group Weekly Review (July 27, 2007), at pp. 67 [LBEXDOCID 146350];
Appendix:9,comparingriskappetiteandVaRusageversuslimits.
452Lehman,2007BalanceSheetTargetsandUsageGlobal(Oct.17,2007)[LBEXDOCID278229].

453ExaminersInterviewofRogerNagioff,Sept.30,2009,atp.10;ExaminersInterviewofAlexKirk,Jan.

12,2009,atpp.23;accordExaminersInterviewofRichardS.Fuld,Jr.,Dec.9,2009,atpp.1011,1617.
454Email from Roger Nagioff, Lehman, to David Goldfarb, Lehman (June 26, 2007) [LBEXDOCID

1585157]. For a fuller discussion of the effort to reduce the firms high yield exposure, see Sections
III.A.1.b.3andIII.A.1.b.4ofthisReport.
455 Email from Roger Nagioff, Lehman, to David Goldfarb, Lehman (June 28, 2007) [LBEXDOCID

1585167].
456See,e.g.,emailfromPaoloR.Tonucci,Lehman,toSigridM.Stabenow,Lehman(Mar.14,2007)[LBEX

DOCID 1342697]; email from Christopher M. OMeara, Lehman, to Paolo R. Tonucci, Lehman (Apr. 6,

123

example, Lehman had a maximum cumulative outflow funding model designed to

ensurethatLehmanhadsufficientcashsourcestomeettheexpectedcashoutflowsina

stressedmarketenvironment.457Underthatmodel,inJuly2007,thefirms[L]iquidity

Pooloneyearforwardposition[was]short$(0.4)billion.458

The liquidity concerns were the result of several factors. First, as the credit

markets froze, Lehman was unable to distribute its risk in certain leveraged loan and

commercialrealestatedeals,includingArchstone,leavingitwithmoreexposurethanit

hadpreviouslyanticipated.459Inaddition,thefirmhadeffectivelybeenlockedoutof

thecapitalmarkets.460

When Nagioff learned about these concerns, he wrote Ian T. Lowitt, Lehmans

then CoCAO: Kirk and Ken [Umezaki] are panicky. Are they over reacting.461

2007)[LBEXDOCID1349076];Lehman,ChartShowingHighGradeandHighYieldLoanCommitments
(July 19, 2007) [LBEXDOCID 375444], attached to email from Nahill Younis, Lehman, to Kentaro
Umezaki,Lehman(July19,2007)[LBEXDOCID297877];emailfromKentaroUmezaki,Lehman,toIan
Lowitt, Lehman (July 20, 2007) [LBEXDOCID 717108]; email from Ian T. Lowitt, Lehman, to Kentaro
Umezaki, Lehman (July 20, 2007) [LBEXDOCID 717108]; email from Ian T. Lowitt, Lehman, to Paolo
Tonucci,Lehman,etal.(July11,2007)[LBEXDOCID1901826].
457Lehman, Liquidity Management At Lehman Brothers (July 2008), at p. 13 [LBEXDOCID 009007],

attached to email from Rowena T. Carreon, Lehman, to Robert Azerad, Lehman, et. al. (July 31, 2008)
[LBEXDOCID067762].
4583rd QuartertoDate MCO and Cumulative Outflow Analysis (July 11, 2007), at p. 1 [LBEXDOCID

1681748], attached to email from Nahill Younis, Lehman, to Paolo R. Tonucci, Lehman (July 11, 2007)
[LBEXDOCID1901826].
459Examiners Interview of Kentaro Umezaki, June 25, 2009, at p. 16; Examiners Interview of Roger

Nagioff,Sept.30,2009,atp.9;ExaminersInterviewofAlexKirk,Jan.12,2010,atp.12.
460Email from Nahill Younis, Lehman, to Paolo R. Tonucci, Lehman (July 11, 2007) [LBEXDOCID

1901826].
461EmailfromRogerNagioff,Lehman,toIanT.Lowitt,Lehman(July20,2007)[LBEXDOCID175649].

124

Lowittrespondedwithadetailedexplanationoftheproblemandhisviewoftherootof

theproblem:

Ifeverythinggoesasbadlyasitcouldsimultaneouslyitwillbeawful,but
at least at the moment a lot of people have money they are willing to
[l]end to us and if we close them quickly it will make a difference. I do
thinkweneedtogetona`warfooting.[James]Merliandtheguysonthe
desk are panicky and that is feeding back into fid and outside the firm.
Needpeopletobeconfident.Iwoulddescribemypositionbasedonwhat
I know today as anxious but not panicky. Also the discipline we had post
1998aboutfundingcompletelydissipatedwhichaddstothealarm.462

Nagioffresponded:Lastparagraphappliestofirmbroadly.463

Lowitt traced Lehmans difficulty in funding its commitments directly to its

failuretoabidebyitsrisklimits,asLowittwrotetoOMearainalateremailonJuly20,

2007: In case we ever forget; this is why one has concentration limits and overall

portfoliolimits.Marketsdoseizeup.464

Todealwiththeseconcernsonawarfooting,Lowitt,OMeara,Kirk,Umezaki,

and Paolo R. Tonucci, (Lehmans Global Treasurer), set up an AssetLiability

Committee(ALCO)sothatFIDandLehmansTreasuryDepartmentcouldmanage

[the firms] liquidity on a daily basis.465 Prior to the formation of ALCO, Lehmans

462EmailfromIanT.Lowitt,Lehman,toRogerNagioff,Lehman(July20,2007)[LBEXDOCID175646]

(emphasissupplied).
463EmailfromRogerNagioff,Lehman,toIanT.Lowitt,Lehman(July20,2007)[LBEXDOCID175646].

464Email fromIan Lowitt, Lehman, to Christopher M. OMeara, Lehman (July20, 2007) [LBEXDOCID

194066].
465EmailfromIanLowitt,Lehman,toRogerNagioff,Lehman(July20,2007)[LBEXDOCID175646];e

mail from Ian Lowitt, Lehman, to Herbert H. McDade III, Lehman, et al. (July 20, 2007) [LBEXDOCID
175646].

125

TreasuryDepartmentreliedonpipelinereportsfromthebusinesses.466ALCOconvened

frequentmeetingsfromAugust2007throughFebruary2008,467andbegantotrackand

monitor more closely the firms monthly projections for cash capital and maximum

cumulativeoutflow.

The cash capital model was a pillar of the firms funding framework.468 The

sourcesofcashcapitalwereequityanddebtwitharemaininglifeofgreaterthanone

year.469Thefirmalwaysfundedleveragedloansandcommercialrealestatewithcash

capital.470Althoughthefirmcouldfundloansandcommercialrealestateonasecured

basis, it assumed that secured finance would not be available under stressed market

466ExaminersInterviewofRogerNagioff,Sept.30,2009,atp.9.

467Seee.g.,Lehman,LBHICCProjections(July30,2007)[LBEXDOCID214312],attachedtoemailfrom

Paolo R. Tonucci, Lehman, to Christopher M. OMeara, Lehman (July 30, 2007) [LBEXDOCID 187182];
ALCOSummaryPackage(Aug.2,2007)[LBEXDOCID514844];ALCOSummaryPackage(Aug.7,2007)
[LBEXDOCID 514847]; ALCO Summary Package (Aug. 16, 2007) [LBEXDOCID 514851]; ALCO
SummaryPackage(Sept.4,2007)[LBEXDOCID514862];ALCOSummaryPackage(Sept.5,2007)[LBEX
DOCID 514863]; ALCO Summary Package (Sept. 6, 2007) [LBEXDOCID 514865]; ALCO Summary
Package(Sept.7,2007)[LBEXDOCID514866];ALCOSummaryPackage(Sept.10,2007)[LBEXDOCID
514867]; ALCO Summary Package (Sept. 12, 2007) [LBEXDOCID 514869]; ALCO Summary Package
(Sept.13,2007)[LBEXDOCID514870];ALCOSummaryPackage(Sept.14,2007)[LBEXDOCID514871];
ALCO Summary Package (Sept. 18, 2007) [LBEXDOCID 514873]; ALCO Summary Package (Sept. 21,
2007) [LBEXDOCID 514875]; ALCO Summary Package (Oct. 25, 2007) [LBEXDOCID 514887]; ALCO
SummaryPackage(Dec.4,2007)[LBEXDOCID104102];ALCOSummaryPackage(Feb.12,2008)[LBEX
DOCID104040].
468Lehman, Implications for the Funding Framework (Aug. 6, 2007), at p. 2 [LBEXDOCID 601971],

attached to email from Angelo Bello, Lehman, to Kentaro Umezaki, Lehman (Aug. 6, 2007) [LBEX
DOCID720559].
469Lehman,UpdateonRisk,Liquidity,andCapitalAdequacyPresentationtoStandardandPoors(Aug.

17,2007),atp.72[LBEXDOCID2031705],attachedtoemailfromShaunK.Butler,Lehman,toElizabeth
R.Besen,Lehman(Aug.28,2007)[LBEXDOCID2374876].
470Id.atp.67.

126

conditions.471Itwasthefirmspolicyalwaystohaveacashcapitalsurplusofatleast$2

billion.472

OnJuly30,2007,ALCOmembersexchangedananalysisshowingthatLehman

did not project having the usual surplus, and in fact projected large deficits of cash

capital.473Morespecifically,LehmansmonthendcashcapitalestimatesforSeptember,

October, and November of the same year were $11.4 billion, $14.5 billion and $9.4

billion.474 This meant that Lehman did not anticipate being able to fund its longterm

obligationswithlongtermassets.

Facedwiththisprospect,inearlyAugust2007,Kirk,LowittandNagioffdecided

toshutdowntheleveragedloanandcommercialrealestatebusinessesuntiltheendof

thethirdquarterof2007.TheyconvincedMcGeeandBerkenfeldtokill everything

fortherestofthequarter.475NagioffbelievedtheExecutiveCommitteeshouldnothave

approvedanylargedealsbeforetheendofthequarter,saying:Donotthinkanylarge

deal can get thru exec[utive committee] pre qtr end . . . this cannot be expressed

471Id.

472Lehman,Risk, Liquidity, Capital and Balance Sheet Update Presentation to the Finance and Risk
CommitteeofLehmanBoardofDirectorson(Sept.11,2007),atp.31[LBEXDOCID505941],attachedto
emailfromPaoloR.Tonucci,Lehman,toChristopherM.OMeara,Lehman,etal.(Sept.9,2007)[LBEX
DOCID552383].
473LBHI CC Projections (July 30, 2007), at p. 2 [LBEXDOCID 214312], attached to email from Paolo

Tonucci,Lehman,toChristopherM.OMeara,Lehman(July30,2007)[LBEXDOCID187182].
474Id.

475ExaminersInterviewofRogerNagioff,Sept.30,2009,atp.10.

127

publicly.476Kirkresponded:Good.Wewillneedskip[McGee]tokillasmuchstuffas

earlyaspossible.477

Ataboutthesametime,theleveragedloanmarketgenerallycollapsed,andnew

issuesslowedtoatrickleinthethirdquarter.478Lehmansleveragedloancommitments

thus halted in early August 2007, three months after Nagioff first concluded that

Lehmans exposure was already gargantuan, and two months after Nagioffs first

conversationwithFuldabouttheissue.

(c) LehmanDelaystheArchstoneClosing

Becauseofthefundingconcerns,LehmandelayedtheclosingonArchstonefrom

theoriginallyanticipatedAugust2007closingdatetoOctober5,2007.479Asthemarket

crisis escalated in June and July 2007, Lehman attempted to syndicate its Archstone

debt. But by late July 2007, the institutional market for commercial real estate was

virtuallyclosed,480andLehmansattemptsatsellingArchstonebridgeequitylargely

failed.481

476EmailfromRogerNagioff,Lehman,toAlexKirk,Lehman(Aug.7,2007)[LBEXDOCID173496].

477EmailfromAlexKirk,Lehman,toRogerNagioff,Lehman(Aug.7,2007)[LBEXDOCID173496].

478Lehman,LoanSyndicate/YearEndRecap(Jan.4,2008),atp.5.[LBHI_SEC07940_066190].

479EmailfromRandallB.Whitestone,Lehman,toStevenBerkenfeld,Lehman,etal.(Aug.5,2007)[LBEX

DOCID 988270]; ArchstoneSmith Trust, Press Release: ArchstoneSmith Amends Merger Agreement
With Tishman Speyer Partnership (Aug. 6, 2007) [LBEXDOCID 2140354]; email from Chip Heflin,
Lehman,toLoanSales4thFloor,Lehman(May29,2007)[LBEXDOCID1488757].
480EmailfromMarkWalsh,Lehman,toAlexKirk,Lehman,etal.(July27,2007)[LBEXDOCID174304].

481SeeAppendixgenerallyemailfromPaulA.Hughson,Lehman,toMarkA.Walsh,Lehman,etal.,(July

27, 2007) [LBEXDOCID 155079] (reflecting the fact that on July 27, 2007, D.E. Shaw informed Lehman
thatgiventheselloffinthereitmarketandthevolatilityofthecreditmarketsitsRiskCommitteehad
rejectedthedeal);emailfromJonathanCohen,Lehman,toChristopherM.OMeara,Lehman,etal.(July

128

In the midst of the market deterioration, an analyst at Citigroup issued an

analyst report entitled Archstone Smith Trust (ASN): Could the Buyers Cut Their

Losses and Walk Away?482 The report suggested that Lehman, BofA, and Barclays

mightbebetteroffwalkingawayfromtheArchstonedealandpayingthe$1.5billion

breakupfee,ratherthanclosingthedealatasignificantloss.483

WhilethereportandaWallStreetJournalarticlediscussingitwerewidelyread

atLehman,484Lehmanneverseriouslyconsideredwalkingawayfromthedeal.485One

reason Lehman was comfortable proceeding with the deal was that Lehman was

ultimatelyabletosellapproximately$2.09billioninArchstonedebttoFreddieMac,486

and another $7.1 billion of Archstone debt to Fannie Mae.487 During the same time

27, 2007) [LBEXDOCID 1904232] (showing that by July 2007, Lehman began to worry that the market
implosion might force Lehman to provide $9 billion in funding for the Archstone transaction, rather
thanthe$6.8billionithadpreviouslyassumedwouldbenecessary.).
482Jonathan Litt, Citigroup Global Markets Inc., Archstone Smith Trust (ASN): Could the Buyers Cut Their

LossesandWalkAway?(July26,2007)[LBEXDOCID1714588].
483Id.atpp.12.

484Seee.g.,emailfromWebsterNeighbor,Lehman,toPaulA.Hughson,Lehman(July31,2007)[LBEX

DOCID2500559];emailfromGerardReilly,Lehman,toChristopherM.OMeara,Lehman(Aug.1,2007)
[LBEXDOCID210156];emailfromStephenF.Rossi,Lehman,toAnnaYu,Lehman,etal.(Aug.1,2007)
[LBEXDOCID3271158].
485Examiners Interview of Lisa Beeson, Oct. 23, 2009, at p. 5; Examiners Interview of Mark A. Walsh,

Oct. 21, 2009, at p. 9; Examiners Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at p. 4; Examiners
InterviewofRogerNagioff,Sept.30,2009,atp.3;ExaminersInterviewofSirChristopherGent,Oct.21,
2009,atp.3;ExaminersInterviewofJohnD.Macomber,Sept.25,2009,atpp.1314.
486Freddie Mac, Holdco Term Sheet (Sept. 5, 2007) [LBEXDOCID 4452813]; Freddie Mac, Sellco Term

Sheet(Sept.5,2007)[LBEXDOCID4452811];Lehman,ProjectEasyLivingDebtFundingDetail(Oct.5,
2007),atp.1[LBEXDOCID598184].
487Examiners Interview of Mark A. Walsh, Oct. 22, 2009, at p. 9; Examiners Interview of Lisa Beeson,

Oct.23,2009,atp.8;LetterfromLehmanBrothersHoldingsInc.toFannieMaere:RateLockTerms(Sept.
17,2007),atp.1.[LBEXDOCID2704241].

129

period,however,Lehmananditspartnerswereabletosellonly$71millionofthedeals

$4.6billioninbridgeequity.488

The Archstone deal closed on October 5, 2007.489 As of October 12, 2007,

LehmanstotalArchstoneexposurewasapproximately$6billion,$2.39billionofwhich

was in the riskiest equity portions of the deal (permanent equity and bridge equity

portions):490

Permanentequity $250million

Bridgeequity $2.14billion

Mezzanineloan $240million

Termloan $2.47billion

Seniordebt $850million

WhenSecretaryoftheTreasuryHenryM.Paulson,Jr.learnedlatein2007thatLehman

had closed on Archstone, despite the shutdown in the securitization market, he

questioned the wisdom of the decision and the direction in which Lehman was

heading.491

488Lehman,ArchstoneSmithMultifamilyJVDebtandEquityRedemptionSchedule(Jan.3,2008),atp.1

[LBEXDOCID2502413],attachedtoemailfromKeithCyrus,Lehman,toPaulA.Hughson,Lehman,et
al.(Jan.1,2008)[LBEXDOCID2646616].
489Lehman,AcquisitionofArchstoneSmithTrustCorporateClosingDocumentsTableofContents(Oct.

5,2007),atp.2[LBEXWGM960404].
490Lehman, Lehman Expected Share ofReal Estate Commitments (Oct. 17, 2007), at p. 2 [LBEXDOCID

624620].
491ExaminersInterviewofHenryPaulson,June25,2009,atp.9.

130

(d) LehmanIncreasestheRiskAppetiteLimitto
AccommodatetheAdditionalRiskAttributabletothe
ArchstoneTransaction

TheriskinLehmansbookwasdramaticallyincreasingduring2007.492Lehmans

management reacted to the increasing risk appetite usage by increasing its limit

amounts.

Although Lehman ordinarily included the risk appetite usage attributable to a

transactionimmediatelyafterenteringintothecommitmentforthetransaction,Lehman

did not include the very substantial increase in risk appetite usage attributable to

Archstoneintheriskappetitecalculationforalmostthreemonths.493Atleastoneother

realestatebridgeequitytransaction,Dermody/ProLogis,alsowasnotincludedinrisk

appetiteuntilthatdate.494

492 Some of the increase in risk usage, of course, was the result of market volatility and its effect upon

existing assets; some was the result of decisions to close new deals. In any event, usage increased
dramaticallyin2007andlimitswereraisedaccordingly,from$3.3billionto$3.5billionto$4.0billion.See
email from Manhua Leng, Lehman, to Mynor Gonzalez, Lehman, et al. (Sept. 10, 2007) [LBEXDOCID
262797]; email from Christopher M. OMeara, Lehman, to David Goldfarb, Lehman (Aug. 15, 2007)
[LBEXDOCID211183];Lehman,MaterialforMarketRiskControlCommitteeMeeting(Jan.14,2008),at
p.33[LBEXDOCID271352],attachedtoemailfromMarkWeber,Lehman,toPaulShotton,Lehman,et
al. (Jan. 14, 2008) [LBEXDOCID 223263]. As revenues increased, the capacity for risk increased;
management calculated, albeit sometimes by adjusting the formula, that each increase was justified by
anticipated revenues. See email from Madelyn Antoncic, Lehman, to David Goldfarb, Lehman, et al.
(Aug.28,2007)[LBEXDOCID193203];seeAppendix10,showingthecalculationofLehmansincreased
$4.0billionriskappetitelimit.
493See email from Mark Weber, Lehman, to Jeffrey Goodman, Lehman (June 4, 2007) [LBEXDOCID

247960]; Mark Weber, Lehman, Chart Showing Risk Appetite Adjustment for Archstone (July 24, 2008)
[LBEXDOCID425705],attachedtoemailfromMarkWeber,Lehman,toPortfolioRiskSupport,Lehman,
et al. (July 24, 2008) [LBEXDOCID 265567]; see also email from Mark Weber, Lehman, to Laura M.
Vecchio,Lehman(July31,2008)[LBEXDOCID264849].
494Lehman,VaR/RiskAppetiteRestatements,(Nov.12,2007)atp.17[LBEXDOCID271334].

131

If Archstone (and the other transactions) had been included in the firms risk

appetiteusagefromtheArchstonecommitmentdateinlateMay2007,consistentwith

the firms usual practice, Lehman would have been over the firmwide risk appetite

limitformuchoftheinterveningperiod.495Lehmanwouldalsohavebeenovertherisk

appetite limits for FID and the real estate business by substantial margins.496 As the

summerof2007woreon,thevolatilityinthemarketsbegantoexacerbatethesituation,

andLehmansriskappetiteusageincreasedmarkedly,eventhoughLehmangenerally

stoppedenteringintomajornewcommitmentsafterthethirdquarterof2007.497

Archstone and Dermody/ProLogis were not included sooner in Lehmans risk

appetite usage calculation because Lehmans risk managers were trying to calculate a

stable usage amount for these bridge equity transactions. Initial calculations yielded

495Id.

496Id.

497Email from Jeffrey Goodman, Lehman, to Christopher M. OMeara, Lehman, et al. (Dec. 4, 2007)
[LBEXDOCID 251204]; email from Paul Shotton, Lehman, to Christopher M. OMeara, Lehman et al.
(Dec. 6, 2007) [LBEXDOCID 251204]; Examiners Interview of Mark Weber, Aug. 11, 2009, at p. 9;
Examiners Interview of David Goldfarb, Sept. 21, 2009, at p. 8; Examiners Interview of Madelyn
Antoncic,Oct.6,2009,atp.7;ExaminersInterviewofRichardS.Fuld,Jr.,Nov.19,2009,atp.13;butsee
Lehman, September 2007 Financial Information Presentation to Lehman Board of Directors with
ChristopherM.OMearashandwrittennotes(Oct.15,2007),atp.6[LEH_CMO_0000001](attributingthe
increase in risk appetite to increased market volatility as well as increased leveraged finance and
commercialrealestatepositions,particularlysincethemarketenvironmenthadpreventedthefirmfrom
sellingthoseassets);emailfromJoeLi,Lehman,toMadelynAntoncic,Lehman(Sept.11,2007)[LBEX
DOCID 157247] (stating that 50% of the recent VaR increase for Global Capital Products was due to
volatilityand50%wasfromtheoriginationbook);seealsoLehman,FirmwideRiskDriver(Oct.22,2007)
[LBEXDOCID 190147] (attributing the firms rising risk appetite and VaR usage figures primarily to
increasedcorrelationacrossdivisions).

132

varying risk appetite usage figures that Lehmans risk managers considered

unreasonable.498

Once these positions were officially included in risk appetite usage in August

2007,itbecamecleartoseniormanagementthatthefirmhadbeenexceedingthefirm

wideriskappetiteonapersistentbasisforsometime.499Thefirmsriskappetiteusage

startedtobediscussedmorewidelywithinthefirm.500

Lehmanraiseditsfirmwideriskappetitelimitfrom$3.3billionto$3.5billionon

September 7, 2007.501 Lehmans risk managers questioned whether Lehman truly had

increased risktaking capacity, however. Two weeks after the firm first included the

498ExaminersInterviewofJeffreyGoodman,Aug.28,2009;ExaminersInterviewofMarkWeber,Aug.

11, 2009, at p. 4; but cf. Examiners Interview of Madelyn Antoncic, Oct. 6, 2009, at p. 11 (reflecting
statementsthatshewasunawarethatthebridgeequityportionoftheArchstonedealhadbeenexcluded
from the firms risk measurementsand that she hit the roofwhen JeffreyGoodman told her that the
bridgeequityhadnotbeenincludedinthefirmsmetrics).
499ExaminersInterviewofJeffreyGoodman,Aug.28,2009;ExaminersInterviewofPaulShotton,June5,

2009,atp.19;AppendixNo.9,comparingriskappetiteandVaRusageversuslimits;emailfromMark
Weber, Lehman, to Laura M. Vecchio, Lehman (July 31, 2008) [LBEXDOCID 264849]; Mark Weber,
Lehman,ChartShowingRiskAppetiteAdjustmentforArchstone(July24,2008)[LBEXDOCID425705],
attached to email from Mark Weber, Lehman, to Portfolio Risk Support, Lehman, et al. (July 24, 2008)
[LBEXDOCID265567];emailfromMadelynAntoncic,Lehman,toDavidGoldfarb,Lehman,etal.(Aug.
14,2007)[LBEXDOCID211183].
500See Lehman, September 2007 Financial Information Presentation to Lehman Board of Directors (Oct.

15, 2007), at p. 6 [LBHI_SEC07940_026377]; Lehman Brothers Holdings Inc., Minutes of Meeting of the
FinanceandRiskCommitteeoftheBoardofDirectors(Sept.11,2007),atp.2[LBEXAM067018];Lehman
Brothers Holdings Inc., Minutes of Meeting of Board of Directors (Sept. 11, 2007), at p. 3
[LBHI_SEC07940_026364]; email from Madelyn Antoncic, Lehman, to David Goldfarb, Lehman, et al.
(Aug.14,2007)[LBEXDOCID211183].
501EmailfromManhuaLeng,Lehman,toMynorGonzalez,Lehman,etal.(Sept.10,2007)[LBEXDOCID

262797]; email from Christopher M. OMeara, Lehman, to David Goldfarb, Lehman (Aug. 15, 2007)
[LBEXDOCID211183].ButseeemailfromMadelynAntoncic,Lehman,toDavidGoldfarb,Lehman,et
al.(Aug.28,2007)[LBEXDOCID193203](showingthatAntoncicdidnotbelievethatthedecisiontoraise
the limit had been made we did not close the loop on this. Robert worked up some numbers but I
thinkweneedtorevisittheexpectedrevforQ4givenaslowdown).

133

Archstone and Dermody/ProLogis bridge equity positions in the firms risk appetite

usage calculation, Goldfarb emailed OMeara and Antoncic: I thought we increased

[risk]appetitetoreflectYTDperformance?502Antoncicrepliedthattheydidnotclose

the loop on this because of concerns related to a fourthquarter slowdown in

revenues.503Underthemethodologyforcalculatingtheriskappetitelimit,aslowdown

inrevenueswouldhavereducedLehmansabilitytotakerisk.Similarly,inanOctober

2007 CSE meeting, Goodman informed the SEC that Lehman had increased its risk

appetitelimit,butadmittedthattheyprobablyshouldnthaveraisedthelimitto$3.5b

when they did, given that they were almost there and there wasnt enough

headroom.504

(e) CashCapitalConcerns

ALCO continued to have serious concerns about Lehmans cash capital and

liquidity position. Until the final week of September2007, Lehman did not expect its

endingcashcapitalpositionsforthemonthsofSeptember,October,andNovemberto

meetthe$2billionminimumrequirement.505Theaverageendingcashcapitalpositions

502Email from David Goldfarb, Lehman, to Madelyn Antoncic, Lehman, et al. (Aug. 28, 2007) [LBEX

DOCID193203].
503Email from Madelyn Antoncic, Lehman, to David Goldfarb, Lehman, et al. (Aug. 28, 2007) [LBEX

DOCID193203].
504SEC,NotesfromLehmansMonthlyRiskReviewMeeting(Oct.19,2007),atp.6[LBEXSEC007438].

505Lehman, ALCO Summary Package (Sept. 4, 2007), at p. 2 [LBEXDOCID 514862]; Lehman, ALCO
Summary Package (Sept. 5, 2007), at p. 2 [LBEXDOCID 514863]; Lehman, ALCO Summary Package
(Sept.6,2007),atp.2[LBEXDOCID514865];Lehman,ALCOSummaryPackage(Sept.7,2007),atp.2
[LBEXDOCID514866];Lehman,ALCOSummaryPackage(Sept.10,2007),atp.2[LBEXDOCID514867];
Lehman, ALCO Summary Package (Sept. 11, 2007), at p. 2 [LBEXDOCID 514868]; Lehman, ALCO

134

for September, October, and November 2007 were projected to be $0.05 billion, $2.15

billion and$1.75billion respectively.506Thecommitteeprojectednegativemonth end

cashcapitalpositionsfortheremainderoftheyear.507

OnthedaythatArchstoneclosed,TonucciinformedOMearathatLehmanwas

looking at being $12 [billion] short [in equity]should not really be surprised.508

Moreover, the firms cash capital projections for the end of October went negative

immediatelyafterthefirmclosedonArchstone.509

A draft presentation on the firms equity adequacy dated October 2007 was

preparedfortheExecutiveCommitteeshortlyaftertheexchangebetweenOMearaand

Tonucci.510OMearawasslatedtobethepresenter.511Thepresentationconcludedthat

the firms capital adequacy over the last five to six quarters had materially

Summary Package (Sept. 12, 2007), at p. 3 [LBEXDOCID 514869]; Lehman, ALCO Summary Package
(Sept.13,2007),atp.3[LBEXDOCID514870];Lehman,ALCOSummaryPackage(Sept.14,2007),atp.3
[LBEXDOCID514871];Lehman,ALCOSummaryPackage(Sept.17,2007),atp.3[LBEXDOCID514872];
Lehman, ALCO Summary Package (Sept. 18, 2007), at p. 3 [LBEXDOCID 514873]; Lehman, ALCO
Summary Package (Sept. 19, 2007), at p. 3 [LBEXDOCID 514874]; Lehman, ALCO Summary Package
(Sept.21,2007),atp.3[LBEXDOCID514875];Lehman,ALCOSummaryPackage(Sept.24,2007),atp.3
[LBEXDOCID514876];Lehman,ALCOSummaryPackage(Sept.26,2007),atp.3[LBEXDOCID514877].
506Id.

507Id.

508Email from Paolo R. Tonucci, Lehman, to Christopher M. OMeara, Lehman (Oct. 5, 2007) [LBEX

DOCID1360792].
509Lehman,ALCOSummaryPackage(Sept.4,2007),atp.2[LBEXDOCID514881].

510Lehman,EquityAdequacyPresentationtoExecutiveCommittee[Draft](Oct.26,2007)[LBEXDOCID

1698460],attachedtoemailfromAriAxelrod,Lehman,toChristopherM.OMeara,Lehman,etal.(Oct.
26,2007)[LBEXDOCID1912826].
511Email fromAriAxelrod,Lehman, toChristopherM. OMeara,Lehman,et al. (Oct.26,2007)[LBEX

DOCID1902541].

135

deteriorated.512 Lehman was at the bottom of its peer range with respect to the

regulatory requirement of a minimum 10% total capital ratio imposed by the SEC.513

The equity adequacy framework illustrated how the firms capital position decreased

froma$7.2billionsurplusinthebeginningof2006toa$42milliondeficitattheendof

the third quarter of 2007.514 The Examiner was unable to find a final version of this

presentation,andwasunabletodetermineifthepresentationeverwasgiven.Fuldsaid

that he was notaware oftheinformationcontained inthe presentation, andif he had

been,hewouldhavebeenabletoresolvethesituation.515

The deterioration of Lehmanscapital was also apparent from the decline in its

total capital ratio from 18.2% in early 2006 to 10.5% in August 2007.516 The industry

highinAugust2007was18.7%.517FromAugusttoNovember2007,Lehmanpostedthe

lowesttotalcapitalratiointheindustry.518ThefirmwasatornearitsSECimposed10%

512Ari Axelrod, Lehman, Equity Adequacy Presentation Summary Page [Draft] (Oct. 25, 2007), at p. 1

[LBEXDOCID 1696067], attached to email from Ari Axelrod, Lehman, to Christopher M. OMeara,
Lehman,etal.(Oct.26,2007)[LBEXDOCID1902541].
513Lehman,EquityAdequacyPresentationtoExecutiveCommittee[Draft](Oct.26,2007),atp.1[LBEX

DOCID1698460],attachedtoemailfromAriAxelrod,Lehman,toChristopherM.OMeara,Lehman,et
al.(Oct.26,2007)[LBEXDOCID1912826].
514Id.

515ExaminersInterviewofRichardS.Fuld,Jr.,Dec.9,2009,atp.5.

516Lehman, Monthly CSE Capital Reports for SEC (Mar. 2006), at p. 1 [LBEXSEC 000303]; Lehman,

Equity Adequacy Presentation to Executive Committee [Draft] (Oct. 26, 2007), at p. 5 [LBEXDOCID
1698460],attachedtoemailfromAriAxelrod,Lehman,toChristopherM.OMeara,Lehman,etal.(Oct.
26,2007)[LBEXDOCID1912826].
517EmailfromAnnaYu,Lehman,toErinM.Callan,Lehman,etal.(Dec.9,2007)[LBEXDOCID3761740].

518Lehman,CSEMethodologyImpactSummary(Apr.4,2008),atp.2[LBEXDOCID382980].

136

requirementforsixmonthsin20072008.519Onthreeseparateoccasions,Lehmanhadat

leastaconcernthatthetotalcapitalratiowouldfallbelowthe10%requirement.520

TheSECexpectedLehmantonotifyitifthetotalcapitalratiofellbeloworwas

expectedtofallbelowthe10%requirement,butLehmandidnotdoso.521Tonuccitold

theSECthatLehmanwascomfortablewithlandingclosetothe10%limitattheend

oftheyeargivenhowdifficultitistoissuerightnow.522

ThedominantcausefortherapiddeclineinLehmansequitypositionwasashift

in the firms asset mix to illiquid assets, including high yield loans, real estate, and

principal investments.523 From November 2006 to August 2007, the firms illiquid

holdingsgrewby72%,whileTier1capitalgrewbyonly26%.524

519Lehman,CSEMethodologyImpactSummary(Apr.4,2008),atp.2[LBEXDOCID382980].

520EmailfromAnnaYu,Lehman,toPaoloR.Tonucci,Lehman(Oct.3,2007)[LBEXDOCID1654567];e

mail from Anna Yu, Lehman, to undisclosed recipients (Nov. 26, 2007) [LBEXDOCID 638715]; email
fromAnnaYu,Lehman,toGeorgesAssi,Lehman,etal.(Dec.7,2007)[LBEXDOCID307968].
52117 C.F.R. 240.15c31g(e) (1) (i);17 C.F.R. 240.17i8(a) (2)(2007); The Goldman Sachs Group Inc.,

QuarterlyReportasofMay31,2008(Form10Q)(filedonJuly7,2008),atp.90(GoldmanSachs10Q
(filedonJuly7,2008))(GoldmanSachsisrequiredtonotifytheSECintheeventthattheTotalCapital
Ratio falls below 10% or is expected to do so within the next month); Merrill Lynch & Co., Inc.,
QuarterlyReportasofJune27,2008(Form10Q)(filedonAug.5,2008),atp.108(MerrillLynch10Q
(filedonAug.5,2008))(MerrillLynchisrequiredtonotifytheSECintheeventthattheTotalCapital
Ratiofallsorisexpectedtofallbelow10%);ErikR.Sirri,SEC,TestimonyConcerningLessonsLearnedin
RiskManagementOversightatFederalFinancialRegulatorsBeforetheSubcommitteeonSecurities,Insurance
andInvestmentCommitteeonBanking,HousingandUrbanAffairs,UnitedStatesSenate,Mar.19,2009
(CSEs were also required to file an early warning notice with the SEC in the event that certain
minimum thresholds, including the 10% capital ratio, were breached or were likely to be breached);
ExaminersInterviewofMatthewEichner,Nov.23,2009,atp.13.
522SEC,NotesfromMonthlyRiskMeetingwithLehman(Nov.15,2007),atp.2[LBEXSEC007467].

523Lehman,EquityAdequacyPresentationtoExecutiveCommittee[Draft](Oct.26,2007),atp.7[LBEX

DOCID1698460],attachedtoemailfromAriAxelrod,Lehman,toChristopherM.OMeara,Lehman,et
al.(Oct.26,2007)[LBEXDOCID1912826].
524Id.atp.6.

137

Thereafter, Lehmans cash capital and equity adequacy position temporarily

improved.Theimprovementwastheresultofseveralfactors.Foronething,theSEC

changed the method of calculating the total capital ratio, and, as a result, Lehman

pickedupseveralpercentagepointsandsavedroughly$4billionincapitalchargeson

average every month.525 In addition, Lehman was able to sell some of its leveraged

loanpositions,therebyraisingcashcapitalandreducingitsilliquidholdings.526

(f) LehmansTerminationofItsResidentialMortgage
Originations

During this same period, midAugust 2007, Lehman decided to close BNC and

ceasesubprimeoriginationsentirely.527Theanticipatedturnintheresidentialmortgage

market still had not arrived, and management could not justify Lehmans continued

exposure to liability on the origination of subprime mortgages.528 In January 2008,

Lehmans Aurora subsidiary suspended its origination through wholesale and

525EmailfromAnnaYu,Lehman,toMartinKelly,Lehman,etal.(Feb.6,2008)[LBEXDOCID2799485].

526Lehman,ALCOSummaryPackage(Jan.31,2008),atp.2[LBEXDOCID527115].

527LehmanBrothersHoldingsInc.,PressRelease:LehmanBrothersAnnouncesClosureofBNCMortgage

(Aug. 22, 2007) [LBEXDOCID 880148]; Lehman, Subprime(r) (Sept. 6, 2007), at p. 14 [LBEXDOCID
894656];emailfromEdwardGrieb,Lehman,toChristopherM.OMeara,Lehman(Aug.22,2007)[LBEX
DOCID197143];emailfromTashaPelio,Lehman,toJasjit(Jesse)Bhattal,Lehman,etal.(Aug.22,2007)
[LBEXDOCID176893].
528ExaminersInterviewofLanaFranksHarber,Sept.23,2009,atpp.2,10,11;ExaminersInterviewof

DavidN.Sherr,Sept.25,2009,atpp.2,6,8.

138

correspondent channels, which represented the bulk of the program.529 Lehman had

curtailedtheflowofMortgageMakeroriginationsapproximatelyfivemonthsearlier.530

(g) September,October,andNovember2007Meetingsof
BoardofDirectors

Lehman had a series of Board meetings in the fall of 2007. At these meetings,

Lehmans management continued to report on the firms elevated risk profile and

concentrationofrealestateandleveragedloanrisk,butdidnotpresenttheBoardwith

additionalnegativeinformationconcerningthefirmsriskandliquidityprofile.

(i) RiskAppetiteDisclosures

AttheSeptember11,2007FinanceandRiskCommitteemeeting,theFinanceand

Risk Committee was shown a presentation disclosing that the firms average risk

appetite usage rose from $2.12 billion in November 2006 to $3.27 billion in August

2007.531Inthepresentation,theCommitteewasinformedthatwhileriskappetiteusage

had increased, Lehman still remained within its risk appetite limit.532 The Committee

529Lehman Brothers Holdings Inc., Press Release: Lehman Brothers Suspends Wholesale and
CorrespondentU.S.ResidentialMortgageOriginationActivities(Jan.17,2008)[LBEXDOCID156125].
530 Dimitrios Kritikos, Lehman, Aurora Loan Services Risk Review January 2008 (Feb. 7, 2008), at p.12

[LBEXDOCID394711].
531Lehman, Presentation on Risk, Liquidity, Capital and Balance Sheet Update to Finance and Risk

CommitteeofLehmanBoardofDirectors(Sept.11,2007),atp.2[LBEXAM067167].
532Lehman Brothers Holdings Inc., Minutes of Meeting of Financeand Risk Committee of the Board of

Directors(Sept.11,2007),atp.3[LBEXAM067018];Lehman,DailyRiskAppetiteReport(Sept.6,2007)
[LBEXDOCID1340197],attachedtoemailfromChristopherM.OMeara,Lehman,toDavidGoldfarb,
Lehman(Sept.7,2007)[LBEXDOCID1345985].

139

was informed of the recent increase in the risk appetite limit from $3.3 billion to $3.5

billion.533

AlthoughitwascorrectthatthefirmsmonthlyaverageriskappetiteforAugust

2007 was within the firms risk appetite limit, by the time of the meeting, Lehman

actuallywasoveritsnewlyincreasedlimitby$97million.534Additionally,Lehmanhad

been over the $3.5 billion limit each business day that month except for September 3,

2007.535ThereisnoevidencethattheBoardwasinformedthatArchstoneandatleast

one other bridge equity deal had been excluded from Lehmans risk appetite usage

calculation for almost three months, or that Lehman would have been over its risk

appetitelimitformuchoftheperiodsinceJune1,2007ifthosebridgeequitydealshad

beenincludedinthecalculationinatimelymanner.

When the full Board met again on October 15, 2007, OMeara disclosed that

Lehmanwasoveritsfirmwideriskappetitelimit.ButOMearadidnotwanttheBoard

to conclude that Lehman was out of bounds, so OMeara edited the standard chart

providedtotheBoardateachmeeting.536Previously,thatchartshowedthefirmsrisk

appetite usage and risk appetite limit in close proximity, so that the directors could

533 Lehman, Risk, Liquidity, Capital and Balance Sheet Update Presentation to Finance and Risk
Committee of Lehman Board of Directors with Weliksons handwritten notes (Sept. 11, 2007), at p. 25
[WGM_LBEX_02248].
534AppendixNo.9,comparingriskappetiteandVaRusageandlimits.

535Id.

536ExaminersInterviewofChristopherM.OMeara,Aug.14,2009,atp.11.

140

easily seehowmuchbelow(orabove) theusagewascomparedtothelimit.537Before

theOctober2007Boardmeeting,however,OMearadirectedthatthelimitinformation

be removed from the final version of the chart.538 He explained to the Examiner that

managementwasnottroubledbybeingoverthelimitandhepreferredtoexplainthe

overagetotheBoardorallyratherthanthroughwrittenmaterials.539

In addition, OMeara informed the Board that Lehmans average daily risk

appetite usage for the prior month was $3.7 billion, $200 million above the new risk

appetitelimit,540buthedidnotdisclosethatonthedayoftheBoardmeeting,Lehmans

daily risk appetite usage was $4.269 billion, 22% (or $769 million) above the new risk

appetite limit.541 Moreover, at this October meeting, OMeara also said he told the

Board that Lehman had a higher capacity the outside edge of the amount of risk

thatLehmancouldabsorbthanitsactualriskappetitelimitandthatthecapacitywas

atleast$4.0billion.542

537Lehman, Second Quarter Financial Information Presentation to Lehman Board of Directors (June 19,

2007), at p. 6 [LBHI_SEC07940_026226]; Lehman, Estimated Third Quarter Financial Information


PresentationtoLehmanBoardofDirectors(Sept.11,2007),atp.6[LBHI_SEC07940_026288].
538Lehman,PresentationtoLehmanBoardofDirectorsonSeptember2007FinancialInformation[Draft]

(Oct.8,2007),atp.6[LBEXDOCID510227];Lehman,FinalPresentationtoLehmanBoardofDirectorson
September 2007 Financial Information (Oct. 15, 2007), at p. 6 [LBHI_SEC07940_026377]; Examiners
InterviewofChristopherM.OMeara,Sept.23,2009,atp.4.
539Id.

540Lehman,PresentationtoLehmanBoardofDirectorsonSeptember2007FinancialInformation(Oct.15,

2007),atp.6[LBHI_SEC07940_026377].
541Lehman,DailyFirmwideRiskDriver(Oct.15,2007)[LBEXDOCID147304],attachedtoemailfrom

JeffreyGoodman,Lehman,toMadelynAntoncic,Lehman,etal.(Oct.14,2007)[LBEXDOCID155737].
542ExaminersInterviewofChristopherM.OMeara,Aug.14,2009,atpp.10,12.

141

OMearadidnotinformtheBoardthatLehmangenerallyhadbeeninexcessof

its firmwide risk appetite limit since entering into the Archstone transaction in late

May 2007; OMeara attributed Lehmans limit excesses to recent changes in market

conditionsspecifically, the inabilitytosecuritize or syndicaterisksthat Lehmanhad

previouslyexpectedtobeabletodistribute543butdidnotmentionotherfactorssuch

astheadditionofArchstoneandothernewdeals.544

Many of Lehmans directors told the Examiner that this information about the

extentanddurationofanyriskappetitelimitexcesswouldhavebeenhelpfulforthem

tohavereceived.545SomedirectorsdidnotrecallknowingthatLehmanhadeverbeen

in breach of its risk appetite limits.546 Although none of the directors said that they

wouldhavechangedtheirviewshadtheyreceivedthatinformation,theydidsaythat

543ExaminersInterviewofChristopherM.OMeara,Sept.23,2009,atpp.1415;Lehman,Presentationon

Risk, Liquidity, Capital and Balance Sheet Update to Financeand Risk Committee of Lehman Board of
Directors(Sept.11,2007),atp.2[LBEXAM067167];LehmanBrothersHoldingsInc.,MinutesofMeeting
ofBoardofDirectors(Oct.15,2007),atp.6[LBHI_SEC07940_026407].
544Lehman, September 2007 Financial Information Presentation to Lehman Board of Directors with

Christopher M. OMearas handwritten notes (Oct. 15, 2007), at p. 6 [LEH_CMO_0000001]; Lehman,


September 2007 Financial Information Presentation to Lehman Board of Directors with Jeffrey A.
Weliksonshandwrittennotes(Oct.15,2007),atp.6[WGM_LBEX_00540].
545Examiners Interview of Roger Berlind, May 8, 2009, at p. 4; Examiners Interview of Dr. Henry

Kaufman,May19,2009,atp.7;ExaminersInterviewofMarshaJohnsonEvans,May22,2009,atpp.79;
Examiners Interview of John D. Macomber, Sept. 25, 2009, at p. 3; Examiners Interview of Roland A.
Hernandez,Oct.2,2009.
546Examiners Interview of Roger Berlind, May 8, 2009, at p. 4; Examiners Interview of John D.

Macomber,Sept.25,2009,atp.17;ExaminersInterviewofMarshaJohnsonEvans,May22,2009,atp.9;
ExaminersInterviewofSirChristopherGent,Oct.21,2009,atp.14;ExaminersInterviewofRolandA.
Hernandez,Oct.2,2009,atp.10.

142

theywouldhavewantedtohaveaconversationwithmanagementaboutthereasonfor

thelimitoveragesandmanagementsstrategyforresolvingthem.547

Thefollowingchartillustratesthelagbetweenthebeginningoftheriskappetite

limitoveragesandthenotificationoftheBoard.Thestraightdottedlinerepresentsthe

firmwideriskappetitelimitandthejaggedsolidlinerepresentsthefirmwideusage:

547Examiners
Interview of Roger Berlind, May 8, 2009, at p. 4; Examiners Interview of John D.
Macomber,Sept.25,2009,atp.13;ExaminersInterviewofMarshaJohnsonEvans,May22,2009,atp.7;
ExaminersInterviewofSirChristopherGent,Oct.21,2009,atp.15;ExaminersInterviewofRolandA.
Hernandez,Oct.2,2009,atp.10;ExaminersInterviewofDr.HenryKaufman,May19,2009,atp.7.

143

FirmwideRiskAppetiteUsagevs.Limit
Q2 2007 Q3 2007 Q4 2007 Q1 2008

4.5
PeriodbetweenRAexcessand Boardnotification

4.0

3.5

3.0
$inBillions

2.5

2.0

1.5

1.0

0.5

0.0
Feb28,07 May31,07 Aug31,07 Nov30,07 Feb29,08

May29,2007 Aug13,2007 Sep11, 2007 Oct15,2007


Archstone Archstoneis Boardof Boardisfirst
agreement. addedintoRA.RA Directorsistold toldabout RA
waslater thatRA"remains excess.
RAexcesses retroactively withinthe
beginsoon updatedtoreflect establishedrisk
thereafter. thecommitment limits."
sinceJune1,2007.

FirmwideUsage FirmwideLimit

Source:LehmanRisk Summary
Note:Datesmayreflect actualdate,orthefirst businessdayaftertheevent.

(ii) LeveragedLoanDisclosures

Both the Finance and Risk Committee and the full Board were apprised of

Lehmansriskexposuretohighyieldbondsandleveragedloan.548OMearadiscussed

548LehmanBrothersHoldingsInc.,MinutesofMeetingofFinanceandRiskCommitteeofLehmanBoard

ofDirectors(Sept.11,2007),atpp.12[LBEXAM067018];Lehman,Risk,Liquidity,CapitalandBalance

144

withtheCommitteethecomprehensiveriskframeworkforhighyielddebtproducts

and referred to Lehmans extensive risk controls, spanning the approval process

through postclosing.549 OMeara told the Finance and Risk Committee that Lehman

had a disciplined approach to risk mitigation through syndication, outright sales, sale

through silent partner participation, and singlename and macro hedging.550 A chart

that accompanied his presentation shows that Lehmans macro hedges reduced

LehmansHYClosedLoanNetExposurebyapproximately20%.551

TheBoardwasnotinformedthatin2007Lehmansmanagershaddecidednotto

increase the size of its macro hedges on the leveraged loans exposure to cover the

remaining 80% of the closed loans or to cover any portion of Lehmans much greater

volume of commitments because these exposures were considered potentially not

capableofbeinghedged.552(Relatedly,thereisnoevidencethatmanagementdisclosed

the extent to which Lehmans commercial real estate investments were unhedged.)553

SheetUpdatePresentationtoFinanceandRiskCommitteeofLehmanBoardofDirectors(Sept.11,2007),
at p. 13 [LBEXAM 067167]; Lehman Brothers Holdings Inc., Minutes of Meeting of Board of Directors
(Sept.11,2007),atp.6[LBHI_SEC07940_026364].
549Lehman Brothers Holdings Inc., Minutes of Meeting of Financeand Risk Committee of the Board of

Directors(Sept.11,2007),atpp.23[LBEXAM067018].
550Lehman, Risk, Liquidity, Capital and Balance Sheet Update Presentation to Finance and Risk

CommitteeofLehmanBoardofDirectors(Sept.11,2007),atp.14[LBEXAM067167].
551Id.

552Examiners Interview of Paul Shotton, June 5, 2009, at pp. 78; Examiners Interview of Kentaro

Umezaki,June25,2009,atp.17;ExaminersInterviewofFredOrlan,Sept.21,2009,atp.6;Examiners
InterviewofRogerNagioff,Sept.30,2009,atp.13;ExaminersInterviewofAlexKirk,Jan.12,2010,atp.
9; Lehman Brothers Holdings Inc., Minutes of Meeting of Finance and Risk Committee of the Board of
Directors(Sept.11,2007),atpp.23[LBEXAM067018].
553ExaminersInterviewofMarshaJohnsonEvans,May22,2009,atpp.3,910;ExaminersInterviewof

RogerBerlind,May8,2009,atp.7.

145

Some members of Lehman management were concerned that hedging the leveraged

loanswouldbeineffectiveandcouldcreateadoublewhammysimultaneouslosses

ontheloansandthehedges.554

TheBoardwasnotinformedthattheriskappetiteusageofLehmansleveraged

loanbusinesswasalmostdoublethelimitapplicabletothatbusinessandthattheusage

had been over the limit almost continuously since July 19, 2007,555 or that Lehmans

management had approved at least 30 leveraged loans that exceeded Lehmans single

transactionlimit.556SomedirectorsbelievedthatthedecisiontoexceedLehmanshigh

yieldandsingletransactionlimitsshouldhavebeendisclosedtotheBoard.557

554ExaminersInterviewofRogerNagioff,Sept.30,2009,atpp.3,13;ExaminersInterviewofMadelyn

Antoncic,Mar.27,2009,atp.10.
555Lehman Brothers Holdings Inc., Minutes of Meeting of Board of Directors (Sept. 11. 2007), at p. 6

[LBHI_SEC07940_263264]; Lehman, Update on Liquidity, Leveraged Loan Commitments and Mortgage


PositionsPresentationtoLehmanBoardofDirectorswithWeliksonshandwrittennotes(Sept.11,2007)
[LBHI_SEC07940_026355]; Mynor Gonzalez, Lehman, Daily Risk Appetite and VaR Report (Sept. 11,
2007) [LBEXDOCID 3296330], attached to email from Mynor Gonzalez, Lehman, to Mark Weber,
Lehman (Sept. 12, 2007) [LBEXDOCID 3295527]; Appendix No. 9, comparing risk appetite and VaR
usageversuslimits.
556Lehman, Risk, Liquidity, Capital, and Balance Sheet Update Presentation to Finance and Risk

CommitteeofLehmanBoardofDirectors(Sept.11,2007)[LBEXAM067167];LehmanBrothersHoldings
Inc.,MinutesofMeetingoftheFinanceandRiskCommitteeofBoardofDirectors(Sept.11,2007)[LBEX
AM 067018]; email from Joe Li, Lehman, to Fred Orlan, Lehman, et al. (July 25, 2007) [LBEXDOCID
2563167].
557ExaminersInterviewofDr.HenryKaufman,Sept.2,2009,atp.6(notingimportanceofconcentration

limits); Examiners Interview of John D. Macomber, Sept. 25, 2009, at pp. 6, 17 (stating that significant
excessesoughttohavebeendisclosed).

146

(iii) LeverageRatiosandBalanceSheetDisclosures

AttheseSeptember11,2007meetings,OMearaalsoreportedtotheFinanceand

Risk Committee that Lehmans net leverage ratio was in line with Lehmans peers.558

Managementspresentationregardingthenetleveragemetricnoted:

In the past, leverage was the key measure of equity adequacy. Between
2003 and 2006 we significantly reduced leverage. Low leverage was
positively viewed by rating agencies and contributed to our 2005
upgrades. In 2006 and 2007, we worked with the regulatory and rating
agenciestoimplementmoreaccurateadequacymeasures.Asaresult,we
arecomfortablewithallowingourleveragetoincrease.559

Thenewadequacymeasuresincludedameasurementforequity,theCSEcapitalratios,

andLehmansinternalequityadequacyframework.560

OMeara did not disclose the firms use of Repo 105 transactions to manage its

net leverage ratio at this Board meeting or any other, and no director asked by the

Examinereverwasawareoftheseoffbalancesheettransactions.561

558Lehman, Risk, Liquidity, Capital and Balance Sheet Update Presentation to Finance and Risk
CommitteeofLehmanBoardofDirectorswithWeliksonsHandwrittenNotes(Sept.11,2007),atpp.2,30
[WGM_LBEX_0224702340];LehmanBrothersHoldingsInc.,FinanceandRiskCommitteeMinutes(Sept.
11,2007),atpp.23[LBEXAM067018].
559Lehman, Presentation on Risk, Liquidity, Capital and Balance Sheet Update to Finance and Risk

CommitteeofLehmanBoardofDirectors(Sept.11,2007),atp.50[LBEXAM067167].
560Id.atp.51.

561Examiners Interview of Roger Berlind, Dec. 18, 2009, at p. 4; Examiners Interview of Roland A.

Hernandez, Oct. 2, 2009, at p. 22; Examiners Interview of John D. Macomber, Sept. 25, 2009, at p. 20;
ExaminersInterviewofDr.HenryKaufman,Sept.2,2009,atp.21;ExaminersInterviewofMichaelL.
Ainslie, Dec. 22, 2009, at p. 4; Examiners Interview of Thomas Cruikshank, Oct. 8, 2009, at p. 2;
Examiners Interview of Sir. Christopher Gent, Jan. 20, 2010, at p. 4; Examiners Interview of Jerry A.
Grundhofer, Sept. 16, 2009, at p. 10; Lehman Brothers Holdings Inc., Minutes of the Board of Directors
(Sept.11,2007),atp.3[LBHI_SEC07940_026364];Lehman,BoardofDirectorsMaterialsforSept.11,2007
BoardMeeting(Sept.7,2007)[LBHI_SEC07940026282];LehmanBrothersHoldingsInc.,Minutesofthe
BoardofDirectors(Oct.15,2007),atp.6[LBHI_SEC07940_026407];Lehman,BoardofDirectorsMaterials
forOct.15,2007BoardMeeting(Oct.11,2007)[LBHI_SEC07940026371];LehmanBrothersHoldingsInc.,

147

(iv) LiquidityandCapitalDisclosures

Tonucci reported to the Boards Finance and Risk Committee that Lehman had

record levels of liquidity and cash capital surplus at the end of the third quarter of

2007.562HealsoreviewedLehmansliquiditypoolyeartodateandoverthelastfour

years, noting the conservative nature of the firms liquidity pool as compared to its

peers,which[had]beenrecognizedbytheleadingcreditratingagencies.563

The materials presented to the Board showed that Lehman had a third quarter

record liquidity pool of $36 billion (an increase from $25.7 billion at the end of the

second quarter 2007) and a cash capital position of $8.1 billion (an increase from $2.5

billion at the end of the second quarter) against a $2 billion policy minimum.564 The

materialsstatedthatLehmandidnotprojecttheneedtotapthecapitalmarketsbecause

Lehman had significant liquidity to fund these activities.565 Management similarly

emphasized to the full Board Lehmans conservative approach to funding its balance

Minutes of the Board of Directors (Nov. 8, 2007), at p. 6 [LBHI_SEC07940_026650]; Lehman, Board of


Directors Materials for Nov. 8, 2007 Board Meeting (Nov. 2, 2007) [LBHI_SEC07940026520]; see also
SectionIII.A.4ofthisReport.
562Lehman Brothers Holdings Inc., Minutes of Meeting of Financeand Risk Committee of the Board of

Directors(Sept.11,2007),atp.3[LBEXAM067018].
563Id.

564Lehman,UpdateonLiquidity,LeveragedLoanCommitmentsandMortgagePositionsPresentationto

Lehman Board of Directors with Weliksons handwritten notes (Sept. 11, 2007), at p. 1
[LBHI_SEC07940_026355]; Lehman, Risk, Liquidity, Capital and Balance Sheet Update Presentation to
FinanceandRiskCommitteeofLehmanBoardofDirectors(Sept.11,2007),atp.31[LBEXAM067167].
565Id.

148

sheetandstrongliquiditypool,butacknowledgedthatforthelasttwomonthsliquidity

hadbeenmorechallengingtomaintain.566

Management did not tell the Board or the Finance and Risk Committee about

ALCOsconcernsaboutLehmansabilitytofunditscommitments,orthatLehmanhad

nearly stopped entering into new deals in August 2007.567 Some directors said that if

anyofLehmansseniormanagementhadconcernsaboutthefirmsfundingorcapital

adequacy,thatisclearlysomethingtheywouldhavewantedtoknow.568

OnSeptember20,2007,LehmanissuedapressreleaseannouncingthatOMeara

wouldreplaceAntoncicasLehmansGlobalHeadofRiskManagement(orCRO)asof

December1,2007.569TheExaminerdidnotfindanyevidencetosuggestthatAntoncics

replacement was related to the risk limit or risk disclosure issues that had occurred

duringthepriorthreetofourmonths.However,theSECnoteditsconcernthattherisk

566Lehman Brothers Holdings Inc., Minutes of Meeting of Board of Directors (Sept. 11, 2007), at p. 5

[LBHI_SEC07940_026364].
567ExaminersInterviewofKentaroUmezaki,June25,2009,atpp.1617;ExaminersInterviewofRoger

Nagioff,Sept.30,2009,atpp.910;emailfromRogerNagioff,Lehman,toIanT.Lowitt,Lehman(July20,
2009)[LBEXDOCID175646];emailfromAlexKirk,Lehman,toRogerNagioff,Lehman(Aug.6,2007)
[LBEXDOCID173492];emailfromAlexKirk,Lehman,toRogerNagioff,Lehman(Aug.7,2007)[LBEX
DOCID173496].
568ExaminersInterviewofJohnD.Macomber,Sept.28,2009,atp.16;ExaminersInterviewofDr.Henry

Kaufman,Dec.22,2009(sayingitmighthavebeenappropriatetodiscloseliquidityconcernsiftheywere
morethanshortlived).
569Lehman Brothers Holdings Inc., Press Release: Lehman Brothers Announces Management Changes

(Sept.20,2007)[LBEXDOCID533362].

149

limit excesses occurred during a period when Lehmans CRO position was in

transition.570

(4) LateReactions:LehmanSlowlyExitsItsIlliquidRealEstate
Investments

Thelastquarterof2007andfirstquarterof2008fromSeptember2007through

February2008wasacrucialjunctureforLehman.Lehmansoverallbalancesheethad

grown by 37% during 2007,571 and much of the growth was concentrated in illiquid

holdingsthatLehmanwasalreadyunabletosellwithoutincurringsignificantlosses.572

As a result, without the accounting device of Repo 105 transactions, FID was already

welloveritsbalancesheetlimitofapproximately$230billionby$18billion.573Indeed,

Lehman had been over its risk limits for the prior six months.574 In hindsight, this

quarter may have been Lehmans final opportunity to take decisive action to improve

itsbalancesheetbeforethenearcollapseofBearStearnschangedtherulesoftheroad

forLehmanandallofitspeerinvestmentbanks.

BeforeBearStearnsnearcollapseinMarch2008,Lehmanhadtwobasicwaysof

reducing its leverage: (1) selling assets, to reduce the numerator in the net leverage

formula;or(2)raisingequity,toincreasethedenominatorinthenetleverageformula.

570SEC,NotesfromLehmansMonthlyRiskReviewmeeting(Oct.11,2007),atp.6[LBEXSEC007438].

571Lehman,2008FinancialPlanPresentationtoFinanceandRiskCommitteeofBoardofDirectors(Jan.

29,2008),atp.8[LBHI_SEC07940_068559].
572ExaminersInterviewofHerbertH.(Bart)McDadeIII,Sept.16,2009,atp.3;ExaminersInterviewof

TreasurySecretaryTimothyF.Geithner,Nov.24,2009,atp.7.
573AndrewJ.Morton,Notes:FirstSixtyDays(Apr.7,2008),atp.6[LBEXDOCID1734462].

574AppendixNo.9,comparingriskappetiteandVaRusageversuslimits.

150

But Lehman did not successfully take either of these tacks during the final quarter of

2007orthefirstquarterof2008:Lehmansnetbalancesheetwas$23.7billionhigherat

the end of the first quarter of 2008 than at the end of 2007.575 Lehman did not raise

substantialamountsofequityduringthisperiod.576

Lehmansfailuretosellassetssoonerwasbasedpartlyonitspreviousdecisionto

pursue a countercyclical growth strategy, which entailed a conscious acceptance of

greater risk even while Lehmans peer investment banks were curtailing their risk

taking.577 The countercyclical growth strategy continued to be reflected in Lehmans

strategyinthefirstquarterof2008.578

FuldtoldtheExaminerthathedecidedaftertheDecember2007holidayseason

to instruct his senior managers to reduce the firms balance sheet.579 However,

documentary evidence shows that Lehman did not aggressively begin to sell assets

untilthesecondquarterof2008.580

575LBHI10Q(filedonApr.9,2008),atp.70.

576Lehman,2008FinancialPlanPresentationtoFinanceandRiskCommitteeofBoardofDirectors(Jan.

29,2008),atp.16[LBHI_SEC07940_068559];ExaminersInterviewofRichardS.Fuld,Jr.,Sept.25,2009,at
pp.2527.
577See Lehman, 2008 Financial Plan Presentation to Finance and Risk Committee of Board of Directors

(Jan.29,2008),atp.6[LBHI_SEC07940_068559].
578Id.

579ExaminersInterviewofRichardS.Fuld,Jr.,Nov.19,2009,atp.2.

580Lehman, Commercial Real Estate Update (Mar. 25, 2008), at p. 3 [LBHI_SEC07940_127250]; Lehman,

Balance Sheet and Disclosure Scorecard For Trade Date April 21, 2008 (Apr. 22, 2008), at p. 3 [LBEX
DOCID3187588],attachedtoemailfromTalLitvin,Lehman,toHerbertH.(Bart)McDadeIII,Lehman,et
al.(Apr.22,2008)[LBEXDOCID3187333];emailfromGaryMandelblatt,Lehman,toAlexKirk,Lehman
(Jan.15,2008)[LBEXDOCID1600235];emailfromErinM.Callan,Lehman,toHerbertH.(Bart)McDade
III,Lehman,etal.(Apr.3,2008)[LBEXDOCID1538729];emailfromPaulA.Hughson,Lehman,toMark

151

Duringthefirstquarterof2008,FuldalsodecidedthatLehmanwouldnotraise

equity unless it could do so at a premium.581 While many of Lehmans competitors

enteredintostrategictransactionstoraiseequityinlate2007andearly2008,582Lehman

didnotwanttosignalweaknessbyraisingequityatadiscount,583and,unlikeitspeers,

had not yet suffered losses that might have signaled a more urgent need for such

action.

(a) Fiscal2008RiskAppetiteLimitIncrease

InOctober2007,thefirmwideriskappetiteusagecontinuedtoincrease,andfor

several days was more than $500 million over the limit; the limit excess peaked at

almost 22% of the limit amount.584Thelimitexcess waspartly the resultofLehmans

decision to enter into several significant commercial real estate and leveraged loan

transactionsinMay,June,andJuly2007,whichweregraduallybeingfundedandthus

Walsh,Lehman(Apr.1,2008)[LBEXDOCID1866761];Lehman,BalanceSheetandDisclosureScorecard
ForTradeDateAugust12,2008(Aug.13,2008),atp.7[LBEXSIPA006539].
581Examiners Interview of Richard S. Fuld, Jr., Sept. 25, 2009, at p. 8; Examiners Interview of Jeremy

Isaacs,Oct.1,2009,atp.3.
582See,e.g.,MerrillLynch&Co.,Inc.,AnnualReportfor2007asofDec.28,2007(Form10K)(filedonFeb.

25,2008),atp.23(MerrillLynch200710K)(statingthatMerrillLynchissued$6.2billionincommon
stockduringthefourthquarterof2007,and$6.6billionofmandatoryconvertiblepreferredstockduring
thefirstquarterof2008);MorganStanley,AnnualReportfor2007asofNov.30,2007(Form10K)(filed
on Jan. 29, 2008), at pp. 17879 (Morgan Stanley 2007 10K) (stating that Morgan Stanley sold equity
units to the Chinese Investment Corporation for approximately $5.579 billion in December 2007);
Citigroup Inc., Annual Report for 2007 as of Dec.31,2007 (Form 10K)(filed on Feb.22, 2008), at p.77
(Citigroup 2007 10K) (stating that Citigroup sold $7.5 billion of equity units to the Abu Dhabi
InvestmentAuthorityonDecember3,2007);UBSAG,AnnualReportfor2007asofDec.31,2007(Form
20F) (filed on Mar. 18, 2008), at pp. 27677 (UBS AG 2007 20F) (stating that UBS issued shares
correspondingtoapproximately13.4%ofthethencurrentsharecapitalonFebruary27,2008);seeSection
III.A.3ofthisReport.
583Email from David Goldfarb, Lehman, to Richard S. Fuld, Jr., Lehman, et al. (Jan. 9, 2008)

[LBHI_SEC07940_670045].
584AppendixNo.9,comparingriskappetiteandVaRusageversuslimits.

152

increasing Lehmans risk appetite usage; partly the result of Lehmans inability to

securitize or syndicate those and other transactions; and partly the result of increased

volatilityinthemarket.585

Lehmanincreasedthefirmwideriskappetitelimitforfiscal2008.Approvalfor

the increase was given on January 14, 2008, when Lehman raised the limit from $3.5

billionto$4billion,with[the]increase[being]backdatedtoDecember3,2007.586The

limitincreasehadtheeffectofeliminatinganyfirmwidelimitexcessesfromthatdate

forward.587

To arrive at the $4 billion risk appetite limit figure, Lehmans officers made

significantchangestothelimitcalculationascomparedtoprioryearscalculations.The

Examinersfinancialadvisors calculatethatif the same assumptionsusedfor the 2007

riskappetitelimithadbeenusedtodeterminethelimitfor2008,the2008limitwould

havebeenapproximately$2.5billionratherthan$4.0billion.588

The 2008 risk appetite limit also was based on a very aggressive projected

revenue figure. Lehmans projected revenues were the starting point for setting the

limit,andperhapsthesinglemostimportantinputtotheformula.Lehmanuseda$21

585SEC,NotesfromLehmansMonthlyRiskReviewMeeting(Aug.17,2007),atp.7[LBEXSEC007383];

emailfromJeffreyGoodman,Lehman,toChristopherM.OMeara,Lehman,etal.(Dec.4,2007)[LBEX
DOCID251204].
586Lehman,MaterialforMarketRiskControlCommitteeMeeting(Jan.14,2008),atp.33[LBEXDOCID

271352], attached to email from Mark Weber, Lehman, to Paul Shotton, Lehman, et al. (Jan. 14, 2008)
[LBEXDOCID223263].
587AppendixNo.9,comparingriskappetiteandVaRusageversuslimits.

588For a more detailed explanation of the changes in the risk appetite calculation, see Appendix 10,

describingcalculationofincreased$4.0billionriskappetitelimit.

153

billionprojectedrevenuefigureincalculatingthe$4billionlimitamount.589Despitethe

difficulties in the market, this amount constituted a 9% increase over 2007 revenues.

Contemporaneousexternalanalystreportsprojected2008revenuesofonlyabout$19.2

billion a figure that would have resulted in a much lower risk appetite limit for the

year.590

(b) January2008MeetingofBoardofDirectors

OnJanuary29,2008,theFinanceandRiskCommitteeandtheentireBoardmet.

Duringthesemeetings,managementdiscussedthedifficultmarket,butbelievedthatit

presentedopportunitiesforLehmantogrow.591LehmansseniorofficerstoldtheBoard:

[The market environment] presents an opportunity for the firm to pursue a

countercyclicalgrowthstrategy,similartowhatitdidduringthe20012002downturn,

to improve its competitive position and, over time, generate superior returns for our

shareholders.592

Management provided the Finance and Risk Committee with an overview of

LehmansnetassetsandleveragelevelsandtoldtheCommitteethatLehmansbalance

589Paolo R. Tonucci, Lehman, 2008 Financial Plan Presentation (Jan. 29, 2008), at p. 1
[LBHI_SEC07940_068559].
590E.g.,DouglasSipkin,WachoviaCapitalMarkets,L.L.C.,ToughYearAheadSowingSeedsforShare

Gains(Jan.15,2008),atp.1[LBEXDOCID095883];Appendix10,describingcalculationofincreased$4.0
billionriskappetitelimit.
591Lehman,2008FinancialPlanSummary(Jan.29,2009),atp.5[LBHI_SEC07940_027374].

592Id.

154

sheet continued to grow across almost all asset classes and businesses.593 At the full

Boardmeeting,KaufmanreportedtotheBoardonLehmansbalancesheetgrowthand

Lehmans year end increase in net leverage.594 Callan discussed Lehmans target

leverageratiowiththeBoardandsaidthatitwouldcomebackdown.595

At the Finance and Risk Committee meeting, management reviewed Lehmans

monthlystresstestsandscenarioanalyses.596Stresstestsindicatedaworstcaselossof

$3.2 billion.597 Management did not inform the Committee of a new Credit Crunch

scenario that was added to Lehmans portfolio of stress testing scenarios in October

2007 that predicted the worst loss of all the scenarios, with a loss of $3.99 billion

(althoughearlydraftsofthepresentationdidincludethescenario).598

At these January meetings, Lehmans management also recommended the new

risk appetite limit to the Board.599 The directors were generally not aware or did not

593Lehman Brothers Holdings Inc., Minutes of Meeting of Financeand Risk Committee of the Board of

Directors(Jan.29,2008),atpp.23[LBEXAM067022];Lehman,AdditionalMaterialsfortheFinanceand
RiskCommittee(Jan.29,2008),atp.3[LBEXAM067260].
594Lehman Brothers Holdings Inc., Minutes of Meeting of Board of Directors (Jan. 29, 2008), at p.3

(LBHI_SEC07940_027446].
595Id.atp.8;Lehman,December2007PresentationtoLehmanBoardwithWeliksonshandwrittennotes

(Jan.29,2008),atp.6[WGM_LBEX_00708].
596Lehman, 2008 Financial Plan Presentation to Finance and Risk Committee of the Board of Directors

(Jan.29,2008),atp.18[LBHI_SEC07940_068559].
597Id.atp.19.

598Lehman, Monthly Risk Review Package (Oct. 11, 2007), at p. 10 [LBEXSEC 007438] (noting Lehman

added a new stress test, called the Credit Crunch which is essentially Summer 2007); Lehman, 2008
Financial Plan Presentation to Lehman Board of Directors [Draft] (Jan. 2008), at p. 5 [LBEXDOCID
384192], attached to email from Mark Weber, Lehman, to Jennifer Bale, Lehman, et al. (Jan. 16, 2008)
[LBEXDOCID306708].
599Lehman,2008FinancialPlanSummary(Jan.29,2008),atp.11[LBHI_SEC07940_027374].

155

recallanydiscussionregardingtheadjustmentsoftheriskappetitecalculation.600Two

ofthedirectorssaidthattheywouldhavewantedtoknowaboutsignificantchangesin

the methodology.601 However, Lehmans managers told the Board that the $21 billion

revenueprojectionwasveryaggressive,andtheBoardhadanextendeddiscussionof

theimpactofpotentiallylowerrevenuesonLehmansbusiness.602

(c) ExecutiveTurnover

InJanuary2008,Nagioffdecidedforpersonalreasonstoresignasglobalheadof

FID.603 In addition, that month, Alex Kirk, cochief operating officer of FID since

October2007,leftLehman.KirkagreedwithFuldthathewouldleaveLehmanatabout

thesametime.604

600 Examiners Interview of Sir Christopher Gent, Oct. 21, 2009, at p. 16; Examiners Interview of Dr.

HenryKaufman,Sept.2,2009,atp.2;ExaminersInterviewofRolandA.Hernandez,Oct.2,2009,atp.
14;ExaminersInterviewofJohnD.Macomber,Sept.25,2009,atp.18.
601 Examiners Interview of Dr. Henry Kaufman, Sept. 2, 2009, at p. 2; Examiners Interview of John

Macomber,Sept.25,2009,atp.2.
602Jeffrey A. Welikson, Lehman,Notesfrom the 2008 Financial Plan Presentation (Jan. 29,2008), at p. 1

[WGM_LBEX_03249].
603Examiners Interview of Roger Nagioff, Sept.30, 2009, at p. 20; Examiners Interview of Richard S.

Fuld, Jr., Sept.25, 2009, at p.22 (Fuld indicated that Nagioffs decision to step down was entirely
voluntary and was the result of Nagioffs frustration with his commute from London); Examiners
InterviewofSirChristopherGent,Oct.21,2009,atp.5(Gentexplainedthat,basedonconversationswith
Nagioff,hebelievedNagioffsresignationwasentirelyduetothelogisticaldisruptionofNagioffsfamily
lifeonaccountofhiscommute);ExaminersInterviewofHughE.(Skip)McGeeIII,Aug.12,2009,atp.13
(McGee denied that Nagioffs resignation had anything to do with Lehmans cessation of residential
mortgage originations, and tied Nagioffs decision to the difficulty of Nagioffs commute); Examiners
InterviewofJohnF.Akers,Apr.22,2009,atp.2(AkersexpressedthebeliefthatNagioffleftvoluntarily
and that his departure was mutual between him and management, but also noted that along with the
commute from London, difficulty also arose because Nagioff failed to meet Fulds expectations);
Examiners Interview of EricFelder, May21, 2009, at p.6 (Felder indicated that Nagioff left Lehman
voluntarily).
604TranscriptofdepositiontestimonyofAlexKirk,InreLehmanBrothersHoldingsInc.,CaseNo.0813555,

Bankr.S.D.N.Y.,Aug.31,2009,atpp.78.

156

(d) CommercialRealEstateSellOff:TooLittle,TooLate

Although Lehman ultimately took aggressive action to reduce its balance sheet

andthusitsnetleverage,Lehmansmanagementdidnotmakeafirmwidedecisionto

reducethesefiguresuntilwellafterthebeginningoftheriskappetiteandbalancesheet

limitoveragesinmid2007.Moreover,evenafterLehmansseniorofficersdirectedthe

businesslinestoreducetheirbalancesheets,ittookseveralmonthsforthereductionto

be effectuated, particularly with respect to Lehmans illiquid holdings of commercial

realestateassets.

Although the firm persistently was over its balance sheet limits, and had been

overtheriskappetitelimitsinceaboutJune1,2007,thefirstwrittenindicationthatthe

RiskCommitteeconsideredtherisklimitoveragewasinOctober2007.605OnOctober2,

2007, OMeara noted in an email that the Risk Committee agreed to temporarily

approve the Risk Appetite limit overage, due to the unusual circumstances in the

marketplacetoday/recently,especiallyconcerningLeveragedFinanceandRealEstate

businesses.606 Thus, Lehmans management decided not to reduce its risk position

aggressivelyatthattime.

Later in October, in advance of a planned conversation with the Executive

Committee,OMearaproposedformulatingspecificrecommendationsaboutwhereto

605Email from Christopher M. OMeara, Lehman, to Paul Shotton, Lehman, et al. (Oct. 2, 2007) [LBEX

DOCID155020].
606Email from Christopher M. OMeara, Lehman, to Paul Shotton, Lehman, et al. (Oct. 2, 2007) [LBEX

DOCID155020].

157

make the cuts to bring down risk appetite.607 Goodman expressed a willingness to

takesomelossestoachievethisgoal.608InaNovember2007presentationtoFuld,the

commercial real estate group recommended reducing its global balance sheet by $15

billion.609

When Erin M. Callan became CFO on December 1, 2007, one of her objectives

wastoreducebalancesheet,particularlyintheareasofresidentialandcommercialreal

estate.610 Fuld decided during the December 2007 holiday season that it was time to

pursueanaggressivereductionofLehmansriskprofile.611

Lehman did not aggressively pursue these reductions for several months,

however. According to Callan, she had discussions with Fuld and Gregory about

reducing balance sheet in January and February 2008, but didnt get traction quickly

on it.612 Between the fourth quarter of 2007 and the first quarter of 2008, Lehmans

grossandnetassetsactuallyincreasedfrom$691billionto$786billion,andfrom$373

607EmailfromJeffreyGoodman,Lehman,toMarkWeber,Lehman,etal.(Oct.22,2007)[LBEXDOCID

318367].
608Id.

609GlobalRealEstateGroup,Lehman,GlobalRealEstateUpdate(Nov.6,2007),atpp.1,2[LBEXDOCID

514264],attachedtoemailfromJeffreyGoodman,Lehman,toMadelynAntoncic,Lehman,etal.(Nov.6,
2007)[LBEXDOCID531492];emailfromJonathanCohen,Lehman,toChristopherM.OMeara,Lehman,
et al. (Nov. 3, 2007) [LBEX DOCID 523669] (indicating that Fuld was the intended audience of the
presentation).
610ExaminersInterviewofErinM.Callan,Oct.23,2009,atpp.1013.

611ExaminersInterviewofRichardS.Fuld,Jr.,Dec.9,2009,atp.10.

612ExaminersInterviewofErinM.Callan,Oct.23,2009,atpp.1013.

158

billionto$397billion,respectively.613Inaddition,FIDexceededitsbalancesheetlimit

inthefourthquarterof2007by$11.17billion,withoveragesconcentratedinsecuritized

productsandrealestate.614Inthefirstquarterof2008,FIDwasoverthebalancesheet

limit by $18 billion with nearly 50% of the overages concentrated in securitized

products and real estate.615 Lehmans Treasurer at the time, Paolo Tonucci, was

comfortablewithFIDsbalancesheetoveragesinthefirstquarterof2008.616Attheend

ofthefirstquarterof2008,TonuccididnotrequireFIDtoselloffmoreassets.617

ItwasnotuntilFebruary26,2008thatGregoryinstructedWalshtogetbalance

sheetdownquickly,618andGREGsetouttoreduceitsglobalbalancesheetby$5billion

by March 18, 2008.619 Even after that, Callan told the Examiner that she pleaded with

Fuld and Gregory to reduce the balance sheet and finally persuaded them to add the

issue to the Executive Committees March 20, 2008 agenda after the near collapse of

613Lehman,Q22008Update(June18,2008),atp.5[LBEXDOCID1302959],attachedtoemailfromAnu

Jacob,Lehman,toDennisRodrigues,Lehman,etal.(July8,2008)[LBEXDOCID1326944].
614AndrewJ.Morton,Notes:FirstSixtyDays(Apr.7,2008),atp.6[LBEXDOCID1734462],attachedtoe

mailfromGaryMandelblatt,Lehman,toAndrewJ.Morton,Lehman,etal.(Apr.7,2008)[LBEXDOCID
1834937].
615Id.atp.4.

616Email from Clement Bernard, Lehman, to Andrew J. Morton, Lehman, et al. (Feb. 27, 2008) [LBEX

DOCID1849839].
617Id.

618Email from Mark A. Walsh, Lehman, to Andrew J. Morton, Lehman (Feb.26, 2008)

[LBHI_SEC07940_115814].
619EmailfromPaulA.Hughson,Lehman,toMarkGabbay,Lehman,etal.(Feb.27,2008)[LBEXDOCID

1869265] (discussing the schedule for the $5 billion reduction target); email from Paul A. Hughson,
Lehman,toMarkGabbay,Lehman,etal.(Mar.7,2008)[LBEXDOCID1723168](Hughsongivesupdate
on sales progress and asks for updates from others on their progress towards the $5 billion reduction
target).

159

Bear Stearns.620 McDade was made the firms balance sheet czar in midMarch and

was given authority to enforce firmwide balance sheet targets.621 Fuld intended to

reduceallofLehmanspositions,includingcommercialrealestateandleveragedloans

positions.622BalancesheetreductiontargetswerenotsentouttoLehmansbusinesses

untilaftertheExecutiveCommitteemeetingonMarch20,2008.623

OnMay13,2008,twoweeksbeforetheendofthesecondquarter,Callanurged

GregoryandFuldtodeliveronthebalancesheetreductionthisquarterandnotgive

anyroomtoFIDforslippage.624GREGsoverseasbusinessesinparticularwereslow

to reduce their positions in the first and second quarters of 2008,625 but GREGs U.S.

businessmetitsbalancesheetreductiontargets,despitecontinuingtoengageinsome

originations.626

SomewitnessesbelievedthatGREGwasnotaggressiveenoughinsellingoffits

portfolio, holding on to positions in a belief that the market would eventually

620ExaminersInterviewofErinM.Callan,Oct.23,2009,atpp.10,11.

621Id.atp.12;ExaminersInterviewofAndrewJ.Morton,Sept.21,2009,atp.11.

622ExaminersInterviewofRichardS.Fuld,Jr.,Sept.25,2009,atp.26.

623ExaminersInterviewofErinM.Callan,Oct.23,2009,atpp.1112.

624Email from Erin M. Callan, Lehman, to Joseph Gregory, Lehman, et al. (May 13, 2008)
[LBHI_SEC07940_034732].
625ExaminersInterviewofPaulA.Hughson,Oct.28,2009,atp.5;Lehman,BalanceSheetandDisclosure

ScorecardforTradeDateJune23,2008(June24,2008),atp.10[LBEXDOCID1742000],attachedtoemail
from Michael McGarvey, Lehman, to Paul Mitrokostas, Lehman, et al. (June 25, 2008) [LBEXDOCID
1856557]; email from Paul A. Hughson, Lehman, to Kentaro Umezaki, Lehman, et al. (Oct. 2, 2007)
[LBEXDOCID 1809381]; email from Paul A. Hughson, Lehman, to Jonathan Cohen, Lehman (July 20,
2007)[LBEXDOCID1426881].
626Examiners Interview of Mark A. Walsh, Oct. 21, 2009, at pp. 1011 (stating that he and Gregory

realizedatthetimethathaltingoriginationswasnotaseasyasflippingaswitch).

160

rebound.627 In one memorandum, Lehmans Head of Global Strategy expressed the

concernthattheteamresponsibleforsellingdownthesepositionsisthesameonethat

originated them.628 But several witnesses denied there was any incentive not to sell

down the portfolio because they knew that no one in GREG would be getting a 2008

bonus.629

RegardlessofthereasonsforLehmansslowreactiontoitsoversizedcommercial

realestateholdings,thefactremainsthatLehmansbalancesheetdidnotdeclineuntil

theendofthesecondquarterof2008,afterBearStearnshadalreadynearlycollapsed.

(e) LehmansCompensationPractices

TheExaminerconsidered,inthecourseofdeterminingwhethertheofficersand

directors of Lehman breached their fiduciary duties, the impact that Lehmans

compensationpracticesmayhavehadonLehmansconductsuchastheexpansioninto

potentiallyhighlyprofitable,butriskier,linesofbusiness,asdiscussedabove.

Lehmans compensation policy was designed, in theory, to penalize excessive

risktaking.Attimes,FIDbusinessesthatexceededbalancesheetlimitsandbreached

627ExaminersInterviewofErinM.Callan,Oct.23,2009,atp.13;ExaminersInterviewofMarkWeber,

Aug.11,2009,atpp.89.
628Memorandum from Timothy Lyons, Lehman, to David Goldfarb, Lehman, Strategic Imperatives for

theFirm(July3,2008),atp.1[LBEXDOCID1377945].
629ExaminersInterviewofDavidOReilly,Oct.26,2009,atp.3;ExaminersInterviewofMarkA.Walsh,

Oct. 21, 2009, at p. 11; Examiners Interview of Kenneth Cohen, Oct. 20, 2009, at p. 11; Examiners
InterviewofAndrewJ.Morton,Sept.21,2009,atpp.1920(MortonnotesthatWalshknewbyFebruary
2008 that he would receive only a straight salary for 2008, with no bonus, thus Walsh had no
compensationbased incentive to inflate his marks). For a more detailed discussion of the effect of
Lehmansofficerscompensationstructureontheincentivetotakerisks,seeAppendix11,Compensation.

161

risk limitsfaceddiminutionoftheircompensationpool.630Atothertimes,FIDused a

Compensation Scorecard that included riskweighted metrics such as return on risk

equity and return on net balance sheet to determine compensation pool allocations.631

The FID Compensation Committee assessed performance against VaR, balance sheet

usage,andriskappetite.632

But in practice, Lehman rewarded its employees based upon revenue with

minimal attention to risk factors in setting compensation. None of these riskrelated

adjustments was applied rigorously or consistently. Ken Umezaki, then Head of FID

Strategy,notedafterafirmwidespeechbyFuld:

[T]hemajorityofthetradingbusinessesfocusisonrevenues,withbalance
sheet,risklimit,capitalorcostimplicationsbeingasecondaryconcern.633

To calculate revenue for its compensation pool, Lehman included revenue not

yetrecognizedbutrecordedbasedonmarktomarketpositions.634Intheory,therefore,

traders and business units were incented to enter into transactions for shortterm

profits,evenifthosetransactionscreatedlongtermrisksforthefirm.635

630 Examiners Interview of Kentaro Umezaki, June 25, 2009, at pp. 89; Lehman, Global Consolidated
BalanceSheet(May31,2007)[LBEXDOCID276740];emailfromKentaroUmezaki,Lehman,toKaushik
Amin,Lehman,etal.(July10,2007)[LBEXDOCID252873].
631Lehman,2004FixedIncomeDivisionCompensationScorecard(Undated)[LBEXDOCID1748807].

632Lehman,COMPMETRICSExcelSpreadsheet(Undated),atpp.19[LBEXLL1054327];Lehman,2007

FIDForecastBudgetSupportExcelSpreadsheet(Undated),atpp.111[LBEXBARCMP0000001].
633 Email from Kentaro Umezaki, Lehman, to Scott J. Freidheim, Lehman, et al. (Apr. 19, 2007) [LBEX

DOCID318475].
634ExaminersInterviewofJohnD.Macomber,Sept.25,2009,atpp.5,22;ExaminersInterviewofJames

Emmert,Oct.9,2009,atp.23.
635 See Section III.A.1.b.1.2 of this Report. The Examiner finds that Lehmans assumption of ever

increasing business risk did not come from the bottom up but rather from the top down. Similarly

162

Lehmans marktomarket accounting also incented Lehman to value

investmentsatthehighendtogeneratehighernetrevenues.Lehmanhadprocedures

tocontrolsuchvaluations,however,andinpractice,theExaminerfoundnoevidenceto

supportafindingthatanyimpropervaluationsweretakentoaffectcompensation.

AmoredetaileddescriptionofLehmanscompensationpracticesmaybefound

atAppendix11.

c) Analysis

The Examiner investigated three potential claims in connection with Lehmans

managementofitsrisks:(1)whetheranyLehmanofficerbreachedthefiduciarydutyof

caretothefirmbyassumingexcessiveriskwithrespecttoLehmansinvestments,orby

failing to follow the firms risk management policies; (2) whether any Lehman officer

breachedthefiduciarydutyofgoodfaithandcandorbynotprovidingtheBoardwith

material information concerning risk issues; and (3) whether any Lehman director

breachedthefiduciarydutyofgoodfaithtomonitorLehmansriskmanagement.

LehmansseniorofficersFuldandGregoryinparticularhadsizeableholdingsofLehmanstockand
may have been more incented to increase Lehmans longterm stock price than to generate shortterm
revenues.

163

(1) TheExaminerDoesNotFindColorableClaimsThatLehmans
SeniorOfficersBreachedTheirFiduciaryDutyofCareby
FailingtoObserveLehmansRiskManagementPoliciesand
Procedures

(a) LegalStandard

To assert a colorable duty of care claim concerning corporate conduct, the

plaintiff must first overcome the protection of the business judgment rule. Under the

traditionalbusinessjudgmentruleasitappliestodirectors,thereisapresumptionthat

inmakingabusinessdecisionthedirectorsofacorporationactedonaninformedbasis,

ingoodfaithandinthehonest beliefthattheactiontakenwasinthebestinterestsof

thecompany.636Thus,acourtwillnotsubstituteitsjudgmentforthatoftheboardif

thelattersdecisioncanbeattributedtoanyrationalbusinesspurpose.637

Thebusinessjudgmentrulehasrarelybeenappliedtoofficers.However,based

upon a recent decision by the Delaware Supreme Court638 holding that the fiduciary

duties of directors and officers are identical, the Examiner concludes that Delaware

courts will likely hold, at a minimum, that officers are protected by the business

judgment rule whenever they act under an express delegation of authority from the

Board;theDelawarecourtsarealsolikelytoholdthatofficersareprotectedbytherule

636Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 954 (Del. 1985) (quoting Aronson v. Lewis, 473 A.2d

805,812(Del.1984))(internalquotationmarksomitted).
637Id. (quoting Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971)); see the discussion of Delaware

corporatefiduciarylawinAppendix1,LegalIssues.
638Gantlerv.Stephens,965A.2d695,709(Del.2009).

164

whenevertheyactwithinthescopeoftheirdiscretionevenifnotpursuanttoexpress

delegationbytheBoard.639

The Examiner concludes that the Delaware courts are likely to hold that an

officer can be stripped of the protection of the business judgment rule only in fairly

narrowcircumstancesnotpresentedhere.640

If the evidence overcomes the presumption of the business judgment rule, the

plaintiffmustthenproveaviolationofthedutyofcare.641Thestandardofprooffora

dutyofcareclaimforcorporatemisconductisgenerallydefinedasgrossnegligence.642

Gross negligence means reckless indifference to or a deliberate disregard of the

corporationsinterests,oractionswhicharewithouttheboundsofreason.643

Overcoming the business judgment rule and establishing gross negligence are

particularly difficult when a plaintiff is challenging the risktaking of a financial

institution.AsacourtapplyingDelawarelawhasrecentlynoted,takingrisksisatthe

heart of a financial institutions business, and decisions about what risks to take are

639Cf.id.(holdingthatthefiduciarydutiesofofficersanddirectorsareidentical).

640See,e.g.,McMullinv.Beran,765A.2d910,922(Del.2000);seealsoSmithv.VanGorkom,488A.2d858,872

(Del.1985),overruledonothergroundsbyGantler,965A.2dat713n.54;Aronson,473A.2dat812,overruled
onothergroundsbyBrehmv.Eisner,746A.2d244,254(Del.2000).Ryanv.Gifford,918A.2d341,354(Del.
Ch.2007);Massarov.VernitronCorp,559F.Supp.1068,1080(D.Mass.1983);OmnibankofManteev.United
S.Bank,607So.2d76,8485(Miss.1992)Cf.MillsAcquisitionCo.v.MacMillan,Inc.,559A.2d1261,1279
(Del. 1989) ([J]udicial reluctance to assess the merits of a business decision ends in the face of illicit
manipulationofaboardsdeliberativeprocessbyselfinterestedcorporatefiduciaries.).
641Unlikethedirectors,LehmansofficersarenotimmunizedbyLehmansarticlesofincorporationfrom

personal liability for breaching the duty of care. See Lehman Brothers Holdings Inc., Certificate of
Incorporation,at10.1,LimitationofLiabilityofDirectors.
642VanGorkom,488A.2dat873.

643Tomczakv.MortonThiokol,Inc.,No.7861,1990WL42607,at*12(Del.Ch.Apr.5,1990).

165

inherently protected by the business judgment rule from hindsight challenge.644

Therefore, a plaintiff asserting a breach of the duty of care by Lehmans senior

managerswouldfacesignificantburdens.

(b) Background

The Examiner finds insufficient evidence to support a claim that any Lehman

officer breached the fiduciary duty of care in connection with managing the risks

associatedwiththemoreaggressivebusinessstrategyLehmanadoptedin2006.

Asmentionedabove,Lehmansbusinessstrategyin2006and2007waspremised

onusingmoreofitsbalancesheettoincreaseitsprincipalinvestments.Inadditionto

the risks in the proprietary investments themselves, many of the firms proprietary

investments entailed a commitment by Lehman to a much larger amount of debt or

equity than Lehman ultimately expected to retain for itself. Although these bridge

equity and bridge debt transactions were risky, Lehmans management decided to

engage in these transactions because they were profitable in their own right, because

they helped Lehman participate in more and larger deals, and because they helped

Lehmantodeveloplongtermclientrelationships.

644In re Citigroup Inc. Sholder Derivative Litig., 964 A.2d 106, 126 (Del. Ch. 2009) (The essence of the

business judgment of managers and directors is deciding how the company will evaluate the tradeoff
betweenriskandreturn.Businessesandparticularlyfinancialinstitutionsmakereturnsbytakingon
risk;acompanyorinvestorthatiswillingtotakeonmoreriskcanearnahigherreturn.).

166

Lehmans officers were entitled under Delaware law to pursue this aggressive

highriskstrategy,andtheExaminerdoesnotquestiontheirbusinessdecisiontodoso;

decisionsofthistypeareatthecoreofthebusinessjudgmentrule.

Although its management was entitled to pursue a business strategy of

increasingitsprincipalinvestmentsandengaginginsubstantialbridgedebtandequity

transactions,Lehmansownpoliciesrequiredmanagementtoconsiderandanalyzethe

risks of that strategy in a systematic manner. The Examiner has found evidence that

raises questions whether Lehmans senior management disregarded Lehmans risk

managementframework,includingitsriskappetitelimits,itssingletransactionlimits,

itsstresstesting,itsbalancesheetlimits,andtheadviceoftheriskmanagers.Asone

former risk manager put it, whatever risk governance process we had in place was

ultimately not effective in protecting the Firm. . . . The function lacked sufficient

authority within the Firm. Decisionmaking was dominated by the business.645

Indeed, there is substantial evidence that after Lehman adopted a more aggressive

business strategy in 2006, its risk management policies and limits were not a major

factorinthefirmsinvestmentdecisions,eventhoughmanagementcontinuedtotellthe

645EmailfromVincentDiMassimo,Lehman,toChristopherM.OMeara,Lehman(Sept.1,2008)[LBEX

DOCID203219].

167

Board, the rating agencies, and regulators that Lehman was prudently managing risk

throughitsriskmanagementsystem.646

The evidence that Lehman disregarded its risk controls is particularly strong

withrespecttobridgeequityandbridgedebt.Inseveralimportantcontexts,Lehman

excluded bridge equity and bridge debt commitments entirely from its risk metrics.

Theseexclusionswereapparentlybasedonmanagementsassumptionthatitwouldbe

abletodistributetheequityanddebtsuccessfullytootherparties.Whenthesubprime

crisiseruptedintothecreditmarketsgenerally,thisexpectationprovedtobeerroneous.

However, the Examiner does not find that the decisions by Lehmans officers

werenotentitledtotheprotectionofthebusinessjudgmentrule.AlthoughLehmans

seniorofficerschosetodisregardindicationsfromLehmansriskmanagementsystems

that the firm was undertaking excessive risk, the Examiner did not find evidence that

Lehmans management entered into financial transactions without informing

themselvesofthebasicfactsofthetransactions,aswouldbenecessarytostripthemof

thebusinessjudgmentrulesprotectionandprovegrossnegligence.Lehmansofficers

wereentitledtosetanddecidetoexceedrisklimits,whichweremerelytoolstoassist

646 E.g., SEC, Lehman Monthly Risk Review Meeting Notes (July 19, 2007), at p. 5 [LBEXSEC 007363]

(Jeff [Goodman] told us that . . . VaR is just one measure that Lehman uses, and is more of a speed
bump/warningsignthanatrue,hardlimitthatrolefallstoRA[(i.e.riskappetite)].[.]Hesaidthat
Madelyn[Antoncic],Dave[Goldfarb],andtheexecutivecommitteetendtolookmoreatRA.Asanaside,
MadelyncameinafterJeffsexplanationandgavevirtuallythesamespeech.).

168

themin theirinvestmentdecisions,notlegalrestraintsontheirauthority. Theymade

consideredbusinessdecisionstodosobecauseofprofitmakingopportunities.

Nor does the Examiner find that Lehmans officers exceeded the scope of their

authority by pursuing an aggressive countercyclical growth strategy. Lehmans

management was entitled to calculate that the subprime crisis offered Lehman the

opportunity to become a dominant residential mortgage originator, to expand its

alreadypowerfulcommercialrealestatefranchise,andtouselargeleveragedloansasa

meanstowardsdeveloping its investmentbankingbusiness. Although managements

disclosurestotheBoardontherisksofthisstrategywerenotasdetailedorasobjective

as they might have been, the Examiner does not find that managements disclosures

were so lacking as to deprive the officers of the protection of the business judgment

rule.

Even if the business judgment rule did not apply to the officers pursuit of a

countercyclical growth strategy, the Examiner would not find gross negligence

sufficienttoestablishabreachofthedutyofcare.Grossnegligencerequiresproofthat

the officer made decisions that were irrational or reckless. Lehmans senior officers

decidedtomakebusinessdecisionsprimarilybasedontheirintuitiveunderstandingof

the markets and their evaluation of the risks and rewards of entering into certain

transactions.Their decision to use theirpracticalbusinessexperienceratherthan rely

169

oncertainquantitativerisklimitsandothermetricscannotbeconsideredirrationalor

reckless.

ThedecisionsbyLehmansmanagementmustalsobeconsideredincontext.In

manyrespects,Lehmanstransactionswerenodifferentfromthoseconductedbyother

market participants, and were, in some respects, less aggressive than those of their

competitors.Forexample,severalfinancialinstitutionssufferedcatastrophiclosseson

investmentsinCDOsandcreditdefaultswaps;Lehmanprudentlylimiteditsexposure

intheseareas.Lehmansofficerswouldarguethatananalysisoftheirmanagementof

Lehmans risks should consider the risks that Lehman prudently avoided along with

therisksthatLehmanunsuccessfullytook.

Moreover,abreachofthedutyofcareclaimwouldrelyheavilyonthetestimony

and email communications of Lehmans risk managers and financial controllers. But

riskmanagersandcontrollersarebydefinitionmoreriskaversethanrisktakersthe

business people who actually make the decisions on behalf of the enterprise. Indeed,

risk managers and controllers are naturally inclined to see limits and controls as

harder and less susceptible to judgment than businesspersons. Lehmans officers

would have a compelling argument that the risk managers opposition to various

strategiesandtransactionsmustbeconsideredinthiscontext.

170

(i) CountercyclicalGrowthStrategywithRespectto
ResidentialMortgageOrigination

TheExaminerdoesnotfindthatLehmanscountercyclicalgrowthstrategywith

respect to its residential mortgage origination gives rise to a colorable duty of care

claim. Lehmans management took significant steps to curtail and control its

origination of subprime mortgages, including discontinuing certain mortgage

programs,installingimprovedriskmanagementsystems,andreplacingmanagementof

itssubprimeoriginator.Lehmansmanagementalsosuccessfullyhedgeditssubprime

mortgage risk, at least until early 2008, and avoided some of the catastrophic

investmentsthatotherfinancialinstitutionsmadeinthemortgagemarket,forexample

inCDOs.

Lehmans management can be secondguessed, perhaps, for its decision to

continue originating AltA mortgages through its Aurora subsidiary even as it was

curtailing the origination of subprime mortgages through its BNC subsidiary, and for

failingtocurtailitssubprimemortgageoriginationsmorequickly.Asdescribedabove,

however, these business decisions were part of Lehmans strategy to benefit from a

consolidation in the mortgage origination industry. In 2007, Lehman curtailed

originationofriskiersegmentsofitsAltAproductionafteritbecameevidentthatthese

riskiersegmentswereperformingaspoorlyassubprimeloans.

Thebusinessjudgmentruleshieldsfromjudicialreviewtheforegoingdecisions

by Lehman concerning its AltA and subprime originations. The Examiner does not

171

find that Lehmans management should be deprived of that protection, or that these

businessdecisionswereirrationalorreckless.

(ii) LehmansConcentrationofRiskinItsCommercial
RealEstateBusiness

As described above, Lehman entered into large commercial real estate

transactions during the course of 2007, including transactions that left Lehman with a

substantialinvestmentinbridgeequity.Themostsignificantofthesetransactionswas

Archstone.

Lehmanenteredintothesecommercialrealestatebridgeequitytransactionsata

precarious time in the financial markets. After the onset of the subprime mortgage

crisisinDecember2006orJanuary2007,therewasariskofcontagiontothecommercial

real estate market. Lehmans officers recognized this risk but concluded that it was

manageable.647Althoughinhindsightthisconclusionwaswrong,theExaminercannot

concludethatatthetimeitwasrecklessorirrational.

Lehmans officers exercised judgment to pursue commercial real estate

opportunities,andtooverrideindicatorsfromthefirmsrisksystems.BeforeLehman

enteredintotheArchstonetransaction,LehmansRealEstategroupwasalreadynearits

risk limits. And the risk in the Archstone commitment and several contemporaneous

real estate bridge equity deals was enormous perhaps as large as or larger than

647ExaminersInterviewofRichardS.Fuld,Jr.,Sept.30,2009,atpp.1415;ExaminersInterviewofJoseph

Gregory,Nov.13,2009,atpp.78;ExaminersInterviewofMarkA.Walsh,Oct.21,2009,atpp.79.

172

Lehmansentirepreexistingrealestatebookputtogether.648Thus,itwasobviousthat

entering into Archstone and these other transactions would put Lehman well over its

real estate risk appetite limit. Several witnesses, including Jeffrey Goodman, the risk

managerprimarilyresponsibleforGREG,saidintheirinterviewsthatthecommercial

realestategroupwasnotsubjecttoitsriskappetitelimits.649Similarly,MarkWalsh,the

headofGREG,saidhewasinformedthatGREGwasallocatedexcessriskappetitefrom

otherbusinessdivisions.650

Theriskappetitelimitapplicabletoanindividualbusinesslinemaybeviewedas

atypeofconcentrationlimit.Concentrationlimitsareimportanttoensurethatafirm

does not take too much risk in a single, undiversified business or area. By exceeding

the concentrationlimits applicabletoLehmansrealestatebusiness,Lehmansofficers

tooktheriskthatthefirmwouldoverconcentrateitscapitalincommercialrealestate

investments.

648 See Mark Weber, Lehman, Chart Showing Risk Appetite Adjustment for Archstone (July 24, 2008)

[LBEXDOCID425705],attachedtoemailfromMarkWeber,Lehman,toPortfolioRiskSupport,Lehman,
et al. (July 24, 2008) [LBEXDOCID 265567] (showing that as a result of the inclusion of the Archstone
positions into the firmsrisk measurements, GREGs riskappetite usageincreasedfrom$689millionto
$1.233billion);emailfromMadelynAntoncic,Lehman,toRogerNagioff,Lehman,etal.(June29,2007)
[LBEXDOCID1478403];emailfromJeffreyGoodman,Lehman,toMarkA.Walsh,Lehman,etal.(June
29,2007)[LBEXDOCID2538925](same).
649Examiners Interview of Jeffrey Goodman, Aug. 28, 2009; Examiners Interview of David S. Lazarus,

Nov. 18, 2009, at p. 4; Examiners Interview of Paul A. Hughson, Oct. 28, 2009, at p. 4; Examiners
InterviewofKennethCohen,Oct.20,2009,atp.6;ExaminersInterviewofMarkWeber,Aug.11,2009,at
p.3.
650ExaminersInterviewofMarkWalsh,Oct.21,2009,atp.5.

173

The risk attributable to Archstone and at least one other bridge equity

transaction was excluded from Lehmans risk appetite usage calculation for almost

three months after the May 2007 commitment date for Archstone.651 These two

transactions were not included in the firms risk appetite calculation until August 13,

2007.652 After the exclusion was acknowledged in August 2007, Lehman retroactively

corrected its risk appetite figures to include the previously omitted risks.653 The

retroactive calculation shows that if these transactions had been included in the risk

appetite usage, Lehman would have been over its firmwide and real estate risk

appetitelimitsalmostcontinuouslyfromthedateoftheArchstonecommitment.

Although Lehmans decision to concentrate heavily in real estate bridge equity

wasunwiseinretrospect,andexcludingmajortransactionsfromLehmansriskusage

calculationwasabreachofriskmanagementprotocol,thefactremainsthatLehmans

management seriously considered the risks in the Archstone transaction in a series of

651MarkWeber,Lehman,ChartShowingRiskAppetiteAdjustmentforArchstone(July24,2008)[LBEX

DOCID425705],attachedtoemailfromMarkWeber,Lehman,toPortfolioRiskSupport,Lehman,etal.
(July24,2008)[LBEXDOCID265567];accordExaminersInterviewofJeffreyGoodman,Aug.28,2009;e
mailfromMarkWeber,Lehman,toLauraVecchio,Lehman,etal.(July31,2008)[LBEXDOCID264849];
Lehman, Market Risk Control Committee Meeting Agenda (Nov. 12, 2007), at p. 17 [LBEXDOCID
271334], attached to email from Mark Weber, Lehman, to Paul Shotton, Lehman, et al. (Nov. 12, 2007)
[LBEXDOCID265289].
652MarkWeber,Lehman,ChartShowingRiskAppetiteAdjustmentforArchstone(July24,2008)[LBEX

DOCID425705],attachedtoemailfromMarkWeber,Lehman,toPortfolioRiskSupport,Lehman,etal.
(July 24, 2008) [LBEXDOCID 265567]; see also email from Mark Weber, Lehman, to Laura Vecchio,
Lehman,etal.(July31,2008)[LBEXDOCID264849];Lehman,MarketRiskControlCommitteeMeeting
Agenda(Nov.12,2007),atp.17[LBEXDOCID271334],attachedtoemailfromMarkWeber,Lehman,to
PaulShotton,Lehman,etal.(Nov.12,2007)[LBEXDOCID265289].
653MarkWeber,Lehman,ChartShowingRiskAppetiteAdjustmentforArchstone(July24,2008)[LBEX

DOCID425705],attachedtoemailfromMarkWeber,Lehman,toPortfolioRiskSupport,Lehman,etal.
(July24,2008)[LBEXDOCID265567].

174

Executive Committee and Commitment Committee meetings over a period of weeks,

modified the transaction in several important ways to try to manage the risk, and

ultimately decided that the rewards from the transaction outweighed the risk.

Moreover, Lehmans management plainly was aware of the risk associated with the

Archstonetransactionduringthisperiod.Infact,Lehmansmanagementwasfocused

on trying to distribute the Archstone debt and equity and reduce the firms risk in

advanceoftheclosingofthattransaction.

The Examiner thus concludes that there is no colorable claim of breach of

fiduciary duty on the part of Lehmans officers. Lehman managements decision to

exceed its limit for this business and invest heavily in commercial real estate is

protected by the business judgment rule. That rule does not operate retroactively to

judge a business decision based on its ultimate failure, but instead focuses on the

reasonsformakingthatdecisionasofthetimeandinthecontextinwhichitwasmade.

The officers decision not to follow the guidance of its internal and voluntary risk

managementsystemdoesnotgiverisetoabreachofthedutyofcare.

(iii) ConcentratedInvestmentsinLeveragedLoans

As described above, Lehmans principal investment strategy also included

participating in leveraged loan transactions. This business grewspectacularly in 2006

and the first half of 2007. Many of these loans were made to private equity firms, or

sponsors, who were purchasing companies as part of leveraged buyouts. These

175

transactions were risky for Lehman because they consumed tremendous amounts of

capital, were made on terms that strongly favored the borrowers, and often involved

bridge equity or bridge debt that Lehman hoped to distribute to other financial

institutions(butwascommittedtokeepforitselfifitwasunabletodoso).

The evidence is that during the first eight months of Lehmans fiscal 2007,

Lehmans leveraged loan business, like its commercial real estate business, was not

subject to any limits. Between August 2006 and July 2007, Lehman entered into

approximately 30 leveraged loans that exceeded the single transaction limit that had

previously been adopted for these transactions, often by significant margins.654 The

chartbelowdemonstratesthemagnitudeoftheseoverages:

654JoeLi,Lehman,STLBacktestingExcelSpreadsheet(July25,2007)[LBEXDOCID2506462],attachedto

emailfromJoeLi,Lehman,toFredS.Orlan,Lehman,etal.(July25,2007)[LBEXDOCID2563167].

176


LeveragedFinanceDealswithSingleTransactionLoss(STL)inExcessofLimit1
(July2007Analysis,DealsbetweenAugust2006andJuly2007)($inMillions)
DealName Original OldFrameworkSTL NewFramework
Commitment fordealswithSTL STLfordealswith
Date2 over$250MM3 STLover$400MM3
Intelsat 2,090 1,045
Weatherford 4/30/2007 2,030 1,015
HoughtonMifflinRiverdeepGroup 7/16/2007 1,389 694
TXUCorp 2/26/2007 1,368 684
FirstDataCorporation 4/2/2007 1,203 601
AlcoaInc. 5/24/2007 1,200 600
HomeDepotSupply 6/19/2007 971 486
CDWCorporation 5/29/2007 909 455
DollarGeneral 3/1/2007 882 441
HarmanInternationalIndustries 4/25/2007 692 346
USFoodService 651 326
CVS 1/16/2007 600 300
BCE 6/29/2007 553 277
BAWAGPSK 3/1/2007 550 275
TognumAG 515 258
ProSiebenSat.1MediaAG 1/31/2007 500 250
CBSCorporation 476 238
WestCorp 465 232
IBMInternationalGroupBV 440 220
SequaCorp 6/18/2007 431 216
Tesoro 4/10/2007 431 215
AllianceData 5/31/2007 424 212
ApplebeesInternational,Inc. 7/16/2007 403 202
AllisonTransmission 5/21/2007 390 195
Dockwise 388 194
UnivisionCommunications 7/14/2006 387 193
PHHCorporation 3/15/2007 386 193
FormulaOneGroup 378 189
UnitedRentals,Inc. 7/22/2007 372 186
ThermoElectronCorp. 5/7/2006 360 180
NationalBeefPackingCo. 5/11/2007 335 168
BulgarianTelecommunications 3/28/2007 327 164
EndemolHoldings 5/11/2007 322 161
LindeMaterialHandlingGroup 293 146
PinnacleFoods 2/10/2007 277 138
TheKlocknerPentaplastGroup 276 138
GuitarCenter,Inc. 6/20/2007 263 132

Note:HighlightedcellsindicatetransactionswithSTLinexcessofthelimitconditionsdescribedbelow:
1 Table includes all deals from August 2006 to July 2007 that are in excess of $900M and also have a calculated STL of > $250M under the loss

calculationmethodologyinplaceJuly2007(SeeOldFrameworkSTLcolumn).HighlighteddealshaveanSTLinexcessoftheappliedlimitstatedin
columntitle.TransactionsinexcessoftheLimitswouldhaverequiredExecutiveCommitteeapproval(LBEXDOCID2170674).
2OriginalcommitmentindicatesearliestknowndateonwhichadealwascommittedtobyLehman,aspresentedintheLPGWeeklyReviews.

3 All deal data is from an Excel spreadsheet (LBEXDOCID 2506463) attached to a July 25, 2007 Joe Li email (LBEXDOCID 2563148) stating:

Previouslywehaveusedalosslimitof250mmto350mm.Wewouldliketoproposea400mmastheFirmsrevenuehasincreased.Inadditionto
changingthelimit,itwasproposedthatriskfactorsbeadjustedtoexcludedefaultrisk,leavingonlysystematicriskastheSingleTransactionLoss.
ThisproposedchangehadtheeffectofhalvingtheSTL(calculatedriskoftheposition),andsimultaneouslyincreasingthelimit.Itemshighlightedin
theOldFrameworkcolumnareSTLnumberscalculatedunderthemethodologyinplaceinJuly2007thatexceedthe$250Mlosslimitinplace
at the time. Highlighted items in the New Framework column represent STL numbers calculated under the proposed methodology (which
halved the STL amount) that exceed the proposed $400M Limit. Please note that a September 2007 presentation on STL (LBEXDOCID 194075)
stated that the current limit was $250 and proposed that the limit be increased to $300M. A leveraged finance risk presentation to the Executive
Committeeonemonthlaterrecommendedthatthelimitbeincreasedto$400M(LBEXDOCID569902).

177

Lehmans decision to exceed the single transaction limit proved to be unwise.

JustasLehmanwasenteringintoaparticularlylargevolumeofcommitments,Lehman

won a huge volume of deals, and the credit markets froze, causing Lehman to be left

with tremendous risk on its books. Before long, Lehmans high yield book showed a

risk appetite usage almost double the limit for those exposures an enormous

concentrationofriskinasingle,illiquidassetclass.

Asaresultofthishighvolumeofcommitments,someinLehmansmanagement

becameconcerned,asearlyasJuly2007,thatthefirmwouldnotbeabletofundallofits

commitments.AsIanLowitt,thentheCAO,wroteinanemaildatedJuly20,2007:In

caseweeverforget;thisiswhyonehasconcentrationlimitsandoverallportfoliolimits.

Marketsdoseizeup.655

Although Lehmans decision to enter into huge illiquid transactions during a

recognized credit bubble656 was unwise, the large leveraged loan transactions were

considered and approved by Lehmans Executive Committee, which was entitled to

increase or override the single transaction limit, just as it was entitled to increase or

override the risk appetite limits. Such decisions are subject to the business judgment

rule.

655EmailfromIanT.Lowitt,Lehman,toChristopherM.OMeara,Lehman(July20,2007)[LBEXDOCID

194066].
656Email from Christopher M. OMeara, Lehman, to Paulo R. Tonucci, Lehman (Apr. 6, 2007) [LBEX

DOCID1349076].

178

(iv) FirmWideRiskAppetiteExcesses

The Examiner also considered whether Lehmans handling of its overall risk

limits was a breach of the duty of care. As described above, Lehmans management

decidedtotreatthefirmsriskappetitelimitasasoftlimitratherthanasameaningful

constraintonmanagementsassumptionofrisk.

Lehmandecidedtoexceedthefirmwideriskappetitelimitatseveraljunctures.

First, though Lehman dramatically increased the limit for fiscal 2007, Lehman

nevertheless approachedthe newlimit by May2007. Lehman enteredinto Archstone

andseveralotherbridgeequitytransactionsnotwithstandingtheobviousfactthatthose

transactionswouldimmediatelyputLehmanoveritsfirmwideriskappetitelimits.657

Several months later, with Lehmans firmwide risk usage actually in excess of

the limit, Lehman decided to increase the limit again, even as one of its senior risk

managers admitted to the SEC that Lehman did not in fact have increased risktaking

capacity.658

Then,inearlyOctober2007,whenLehmansriskappetiteexcesseswereattheir

peak, at least some members of Lehmans senior management discussed the limit

breaches and decided to grant a temporary reprieve from the limits based on the

difficult conditions in the real estate and leveraged loan markets. For the most part,

657ExaminersInterviewofJeffreyGoodman,Aug.28,2009.

658SEC,NotesfromLehmansMonthlyRiskReviewmeeting(Oct.11,2007),atp.6[LBEXSEC007438].

179

Lehman did not pursue aggressive risk reduction strategies until sometime in 2008,

particularlywithrespecttocommercialrealestate.

Rather than reduce its risk usage, Lehman cured its risk appetite overages by

increasingthefirmwideriskappetitelimityetagain.659Thereisevidencewhichraises

the question whether Lehmans risktaking capacity had in fact increased. The

increased limit amount was calculated by substantially changing the assumptions

previously used in calculating the risk appetite limit, and by using a very aggressive

2008 budgeted revenue figure. If Lehman had used the same assumptions as it had

previously used for calculating the risk appetite limit, and a more realistic revenue

figure,itwouldlikelyhaveconcludedthatitwasnecessarytoreduceitsriskappetite

limit to take account of its diminished profitability relative to its equity base. Such a

conclusion might have impelled management more urgently to sell assets, reduce the

firmsriskprofile,andreducethefirmsleverage.

AlthoughLehmansriskappetitelimitsultimatelyprovidedlittleornolimiting

functionatall,theExaminerdoesnotfindthatthedecisiontoexceedordisregardthese

limitsgivesrisetoacolorableclaimofbreachoffiduciaryduty.Theseinternallimits

wereintendedonlyforthe guidanceofLehmansownmanagement;theydidnotput

659Examiners Interview of Christopher M. OMeara, Aug. 14, 2009, at p. 10; Lehmans Material for
Market Risk Control Committee Meeting (Jan. 14, 2008), at p. 33 [LBEXDOCID 271352], attached to e
mail from Mark Weber, Lehman, to Paul Shotton, Lehman, et al. (Jan. 14, 2008) [LBEXDOCID 223263];
EstimatedThirdQuarter2007FinancialInformationPresentationtoLehmanBoardofDirectors(Sept.11,
2007),atp.6[LBHI_SEC07940_026288].

180

anylegalconstraintsonthescopeofmanagementsauthority.Andbecausebusinessin

general and investment banking in particular is an inherently risky enterprise,

Lehmansmanagementwasentitledtopursueacountercyclicalgrowthstrategybased

on its evaluation of the markets and of Lehmans business, even if that strategy

necessarily posed a risk to the firm. Moreover, Lehmans risk appetite limit overages

werereportedtotheSEC.TheExaminerdoesnotfindthatmanagementsdecisionto

increaseandthenexceedLehmansriskappetitelevelsgivesrisetoacolorableclaimfor

breachoffiduciaryduties.

(v) FirmWideBalanceSheetLimits

Lehmanalsofailedtoapplyitsbalancesheetlimitsinlate2007.Applicationof

these limits would also have restricted Lehmans risktaking. Instead, Lehman

dramaticallyincreasedthesizeofitsbalancesheet,andusedincreasinglylargevolumes

of Repo 105 transactions to create the appearance that the firms net leverage ratio

remainedwithinareasonablerangeofsuchratiosestablishedbytheratingagencies.660

(vi) StressTesting

As described above, Lehmans stress tests suffered from a significant flaw.

AlthoughLehmanmadeastrategicdecisionin2006totakemoreprincipalrisk,Lehman

did not modify its stress tests to include the risks arising from many of its principal

investments including its real estate investments other than commercial mortgage

660ForfurtherdetailregardingtheRepo105transactions,seeSectionIII.A.4ofthisReport.

181

backed securities (CMBS), its private equity investments, and, during a crucial

period, its leveraged loan commitments.661 Thus, Lehmans management pursued its

countercyclicalgrowthstrategy,includinganincreasingconcentrationofriskinilliquid

assets, without availing itself of a common risk management technique for evaluating

thepotentialrisktothefirmfromthatstrategy.

But stress tests, like risk limits, are an instrument available for use of

managementasitdeemsappropriate;Lehmansmanagementwasnotlegallyrequired

tomakebusinessdecisionsbasedontheresultsofstresstesting.662Moreover,theSEC

was aware that Lehmans stress tests excluded untraded investments and did not

question the exclusion, because historically it had been the norm to limit stress tests

only to traded positions.663 Based on these facts, the Examiner does not find that

Lehmanmanagementsuseofthestresstestsgivesrisetoacolorableclaimforabreach

ofthedutyofcare.

(vii) Summary:OfficersDutyofCare

TheExaminerreviewedextensiveevidenceconcerningLehmansseniorofficers

decisiontodisregardtheguidanceprovidedbyLehmansriskmanagementsystemas

they implemented the firms aggressive business strategy in 2006 and 2007. That

661Email from Melda Elagoz, Lehman, to Stephen Lax, Lehman, et al. (June 21, 2007) [LBEXDOCID

2546617];ExaminersInterviewofPaulShotton,Oct.16,2009,atpp.45.
662LehmanwasrequiredtoconductcertainstresstestingaspartofitsparticipationintheCSEprogram.

See17C.F.R.240.15c31(2007).
663Examiners Interview of Matthew Eichner, Nov. 23, 2009, at p. 12; Examiners Interview of Paul

Shotton,Oct.16,2009,atpp.45;ExaminersInterviewofJeffreyGoodman,Aug.28,2009.

182

evidence goes to the heart of Lehmans ultimate financial failure because the illiquid

investmentsacquiredduringthatperiodcouldnotbesoldoffsufficientlyquickly,and

Lehmans liquidity and confidence suffered as a result. When the run on Lehman

began in September 2008, Lehman lacked the liquidity to survive. Thus, Lehmans

collapse can be traced in part to Lehman managements adoption of a countercyclical

growth strategy in 2006 and 2007. Although management turned out to be wrong in

their business judgments, the evidence does not establish that managements actions

and decisions were so reckless and irrational as to give rise to a colorable claim of

breachoffiduciaryduty.

[B]usiness failure is an everpresent risk. The business judgment rule


existspreciselytoensurethatdirectorsandmanagersactingingoodfaith
maypursueriskystrategiesthatseemtopromisegreatprofit.Ifthemere
fact that a strategy turned out poorly is in itself sufficient to create an
inference that the directors who approved it breached their fiduciary
duties,thebusinessjudgmentrulewillhavebeendenudedofmuchofits
utility.664

(2) TheExaminerDoesNotFindColorableClaimsThatLehmans
SeniorOfficersBreachedTheirFiduciaryDutytoInformthe
BoardofDirectorsConcerningtheLevelofRiskLehmanHad
Assumed

The Examineralsodoes notfinda colorable claim that,during theperiod from

May2007throughJanuary2008,Lehmansseniorofficersbreachedtheirdutyofcandor

with respect to their disclosures to the Board of Directors concerning Lehmans risk

664Trenwick Am. Litig. Trust v. Ernst & Young, L.L.P., 906 A.2d 168, 193 (Del. Ch. 2006), affd sub nom.

TrenwickAm.Litig.Trustv.Billett,931A.2d438(Del.2007).

183

management system. Lehmans management gave the Board regular reports

concerning the state of the firms business, including reports containing quantitative

risk,balancesheet,revenue,andothermetrics.Lehmansmanagementalsodiscussed

marketconditionsandtheirpotentialimpactonthefirmwiththeBoard.TheExaminer

didnotfindevidencethatmanagersknowinglymadefalsestatementstotheBoard.

In light of the Boards limited role in supervising the risk management of the

enterprise,andtheabsenceofauthoritymandatinggreaterdisclosuretotheBoard,the

ExaminerdoesnotbelievethattheofficershadalegaldutytoprovidetheBoardwith

additional negative information. The Examiner does not find that the evidence gives

risetoacolorableclaimforabreachofthedutyofcandor.

LehmansmanagementrepeatedlydisclosedtotheBoardthatLehmanintended

to grow its business dramatically, increase its risk profile, and embrace risk even in

declining markets. The Board undoubtedly understood and approved of Lehmans

growthstrategy.

During 2007, there were a number of instances in which management did not

provide information to the Board. For example, management did not disclose its

decision to exceed or disregard the various concentration limits applicable to the

leveraged loan business and to the commercial real estate businesses, including

184

especially the single transaction limit, contrary to representations to the Board that

managementtookstepstoavoid[]overconcentrationinanyonearea.665

In hindsight, various Board members stated that it would have been helpful to

have had more information. For example, some directors said that if the risk limit

breachesweresufficientlylargeandlonglasting; 666ifmanagementsliquidityconcerns

weremorethanasingleincursion;667oriftheexclusionsfromthestresstestingwere

sufficientlysignificant;668theywouldhavewantedtoknowaboutthesefacts.669

Ontheotherhand,theBoarddidnotexplicitlydirectmanagementtoprovideit

with this information, and there is no evidence that the Board asked questions that

managementdidnotanswer,oransweredinaccurately.Moreover,asdiscussedabove,

management was not required by any regulatory authority or by Delaware common

lawtoprovidesuchdetailedinformationtotheBoardofDirectors.

Although Lehmans management did not provide the Board with all available

informationconcerningtherisksfacedbythefirmduring2007andearly2008,thatfact

is not surprising given the Boards limited role in overseeing the firms risk

management, and the extraordinarily detailed information available to management.

665DavidGoldfarb,etal,ManagingtheFirmPresentationtoLehmanBoardofDirectors(May15,2007),at

p.20[LBHI_SEC07940_026136]
666ExaminersInterviewofRogerBerlind,May8,2009,atp.4;ExaminersInterviewofMarshaJohnson

Evans, May 22, 2009, at p. 6; Examiners Interview of Roland A. Hernandez, Oct. 2, 2009, at p. 10;
ExaminersInterviewofJohnD.Macomber,Sept.25,2009,atp.17.ExaminersInterviewofDr.Henry
Kaufman,May19,2009,atp.17.
667ExaminersInterviewofDr.HenryKaufman,Dec.22,2009.

668ExaminersInterviewofJohnD.Macomber,Sept.25,2009,atpp.6,17.

669SeeIII.A.1.bofthisReport.

185

After reviewing this evidence, the Examiner finds insufficient evidence to support a

colorable claim that Lehmans management was either grossly negligent or

intentionally deceptive in providing information to the Board concerning risk

management.

First,theExaminerhasfoundnocolorableclaimthatLehmansseniormanagers

violated their fiduciary duty of care through their handling of risk issues.

ManagementsdisclosureoftheriskappetiteexcessestotheSECsupportstheviewthat

managementdidnotbelieveitwasactingimprudently,muchlessviolatingthelaw,by

taking on a higher level of risk than was consistent with the firms preexisting risk

policiesandlimits.Underthesecircumstancesitwouldtakeverysubstantialevidence

ofmanagementsintenttomisleadtheBoardinordertolayasufficientfoundationfora

claimthatLehmansseniorofficersbreachedtheirdutyofcandor.

Establishingaviolationofthedutyofcandorwithrespecttoriskmanagementis

particularlydifficult.AstheDelawareChanceryCourtrecentlyexplainedinconnection

withdirectorsmonitoringofriskdecisionsbymanagement:Itisalmostimpossiblefor

a court, in hindsight, to determine whether the directors of a company properly

evaluatedriskandthusmadetherightbusinessdecision....Businessdecisionmakers

must operate in the real world, with imperfect information, limited resources, and an

uncertainfuture.670

670InreCitigroupInc.SholderDerivativeLitig.,964A.2d106,126(Del.Ch.2009).

186

Managementsdutyofcandorconcerningriskmanagementaddsanotherlevelof

complexity beyond the issues raised by the duty of care. Risk limits, policies, and

metricsweredesignedforusebymanagement,nottheboard.Absentexpressdirection

fromtheboardastowhatinformationconcerningriskmanagementitshouldbegiven

(and there was no such direction here), management must make the determination of

whatlevelofdetailtheboardneedstofulfillitsobligationtomonitorriskdecisions.

Applyingthestandardofproofrequiringatleastgrossnegligenceandperhaps

intentional deception to establish a breach of the duty of candor means that senior

managersmaymakeagoodfaithmistakebynotprovidingmaterialinformationtothe

board without violating their fiduciary duties. Although it can be fairly debated

whetherLehmansmanagementshouldhaveprovideditsBoardwithmoreinformation

and more timely information concerning the firms risk usage, stress test results, and

liquidity, the Examiner does not find that any mistake by management in this regard

constitutedgrossnegligenceorintentionaldeception.

187

(3) TheExaminerDoesNotFindColorableClaimsThatLehmans
DirectorsBreachedTheirFiduciaryDutybyFailingtoMonitor
LehmansRiskTakingActivities

(a) LehmansDirectorsareProtectedFromDutyofCare
LiabilitybytheExculpatoryClauseandtheBusiness
JudgmentRule

Corporate directors duty of care is a duty of informed decision making.671 It

involves the process by which directors make business decisions, not the content of

those decisions.672 However, directors are generally afforded additional protection by

thebusinessjudgmentrule,ajudicialpresumptionthatacourtshouldnotsubstitute

its judgment for that of the board if the latters decision can be attributed to any

rationalbusinesspurpose.673

Lehman,likemanyDelawarecorporations,immunizeditsdirectorsfromclaims

ofbreachingthedutyofcare.Lehmanscertificateofincorporationprovides:

A director shall not be personally liable to the Corporation or its


stockholders for monetary damages for breach of fiduciary duty as a
director; provided that this sentence shall not eliminate or limit the
liability of a director (i) for any breach of his duty of loyalty to the
Corporationoritsstockholders,(ii)foractsoromissionsnotingoodfaith
or which involve intentional misconduct or a knowing violation of law,
(iii)underSection174of[theDelawareGeneralCorporationLaw],or(iv)

671Smithv.VanGorkom,488A.2d858,872(Del.1985),overruledonothergrounds,Gantlerv.Stephens,965

A.2d695,713n.54(Del.2009).
672InreCaremarkIntl.Inc.DerivativeLitig.,698A.2d959,967(Del.Ch.1996).

673UnocalCorp.v.MesaPetroleumCo.,493A.2d946,954(Del.1985)(quotingSinclairOilCorp.v.Levien,280

A.2d717,720(Del.1971)).ForamoredetaileddiscussionofDelawarelawgoverningcorporatedirectors
fiduciaryduties,seeAppendix1,LegalIssues.

188

foranytransactionfromwhichthedirectorderivesanimproperpersonal
benefit.674

The wording of this clause is nearly identical to that in Section 102(b)(7) of the

Delaware General Corporate Law, which authorizes a corporation to exculpate its

directors from personal liability for breaches of fiduciary duties, except in the four

exceptionsstatedinthestatute:conductviolatingthedirectorsdutyofloyalty;actsor

omissionsnotingoodfaith;intentionalmisconduct;andknowingviolationsoflaw.675Courts

uphold such a clause to protect directors from liability provided that the conduct in

question does not violate their duty of loyalty.676 In addition, Delaware protects

directors from personal liability to the extent their decisions are based on information

providedtothembymanagement.677

Therefore, Delaware has chosen to impose personal liability only on those

directorswhohavehandledtheirresponsibilityinarecklessorirrationalmanner:

Directorsdecisionsmustbereasonable,notperfect.Inthetransactional
context,[an]extremesetoffacts[is]requiredtosustainadisloyaltyclaim
premised on the notion that disinterested directors were intentionally
disregarding their duties. . . . Only if they knowingly and completely

674LehmanBrothersHoldingsInc.,CertificateofIncorporation,at10.1,LimitationofLiabilityofDirectors.

675SeeDEL.CODEANN.tit.8,102(b)(7)(2009).

676SeeStoneexrel.AmSouthBancorporationv.Ritter,911A.2d362,367(Del.2006)(Suchaprovisioncan

exculpatedirectorsfrommonetaryliabilityforabreachofthedutyofcare,butnotforconductthatisnot
ingoodfaithorabreachofthedutyofloyalty.).
677SeeDEL. CODE ANN.tit.8,141(e)(2009);seealsoBrehmv.Eisner,746A.2d244,261(Del.2000);Inre

CitigroupInc.SholderDerivativeLitig.,964A.2d106,132&n.86(Del.Ch.2009).

189

failedtoundertake their responsibilities would theybreach theirdutyof


loyalty.678

(b) LehmansDirectorsDidNotViolateTheirDutyofLoyalty

A directors duty of loyalty [e]ssentially...mandates that the best interest of

the corporationand itsshareholderstakeprecedenceoveranyinterestpossessed bya

director, officer or controlling shareholder and not shared by the stockholders

generally.679 The duty of loyalty chiefly involves situations in which directors utilize

their positions to confer special benefits onto themselves or majority stockholders.680

Thesesituationsarefrequentlyreferredtoasselfdealingorinterestedsituations.681

A director is considered interested when he will receive a personal financial benefit

fromatransactionthatisnotequallysharedbythestockholders.682Directorsarealso

consideredinterestedwheretheirmotivationsinexecutingabusinessdecisionappear

tobesubservienttotheinterestsofamajoritystockholder.683

TheExaminerhasfoundnoevidenceofselfdealingbyLehmansdirectors,and

Lehmandidnothaveamajoritystockholdinginterest.

678LyondellChem.Co.v.Ryan,970A.2d235,24344(Del.2009)(quotingInreLearCorp.SholderLitig.,967

A.2d640,65455(Del.Ch.2008)).
679Cede&Co.v.Technicolor,Inc.,634A.2d345,361(Del.1993),modifiedonothergrounds,636A.2d956(Del.

1994).
680Aronsonv.Lewis,473A.2d805,812(Del.1984),overruledonothergrounds,Brehmv.Eisner,746A.2d244,

254(Del.2000).
681Seeid.

682GlobisPartners,L.P.v.PlumtreeSoftware,Inc.,No.1577VCP,2007WL4292024,at*5(Del.Ch.Nov.30,

2007).
683See,e.g.,EmeraldPartnersv.Berlin,787A.2d85(Del.2001);Tooleyv.AXAFin.,Inc.,No.18414,2005WL

1252378,at*5(Del.Ch.May13,2005).

190

(c) LehmansDirectorsDidNotViolateTheirDutytoMonitor

UnderDelawarelaw,directorshaveafiduciarydutytomonitormanagements

compliance with corporate reporting and control systems. The Delaware Supreme

Courthasadopted theCaremarkstandardforassessingdirector oversight liability.684

Under Caremark, the fiduciary duty to monitor management is breached if (a) the

directorsutterlyfailedtoimplementanyreportingorinformationsystemorcontrols;or

(b) having implemented such a system or controls, consciously failed to monitor or

oversee its operations thus disabling themselves from being informed of risks or

problemsrequiringtheirattention.685TheDelawareSupremeCourtstressed,however,

that a director can be held liable only for a conscious failure to fulfill the oversight

function:

[I]mposition of liability requires a showing that the directors knew that


theywerenotdischargingtheirfiduciaryobligations.Wheredirectorsfail
to act in the face of a known duty to act, thereby demonstrating a
conscious disregard for their responsibilities, they breach their duty of
loyaltybyfailingtodischargethatfiduciaryobligationingoodfaith.686

(i) ApplicationofCaremarktoRiskOversight:Inre
CitigroupInc.

In the Citigroup case, the Delaware Chancery Court rejected a claim that

Citigroups current and former directors and officers had breached their fiduciary

duties by failing to properly monitor and manage the risks the Company faced from

684Stone,911A.2dat36465.

685InreCitigroupInc.SholderDerivativeLitig.,964A.2d106,123(Del.Ch.2009)(quotingStone,911A.2dat

370).
686Stone,911A.2dat370(internalcitationsomitted).

191

problems in the subprime lending market and for failing to properly disclose

Citigroupsexposuretosubprimeassets.687Thecomplaintallegedvarioustheoriesof

liabilityincludingabreachofthedutytomonitorunderCaremark.Plaintiffsbasedtheir

claimonseveralredflagsthatallegedlyshouldhavegivendefendantsnoticeofthe

problems that were brewing in the real estate and credit markets.688 Noting that the

supposed red flags amount[ed] to little more than portions of public documents that

reflected the worsening conditions in the subprime mortgage market and in the

economygenerally, theCourt foundtheallegationslegally insufficienttoshowthat

the directors were or should have been aware of any wrongdoing at the Company or

were consciously disregarding a duty somehow to prevent Citigroup from suffering

losses.689

The Court also held that a Caremark claim involving risk management must be

consistentwiththebusinessjudgmentrule:

Itisalmostimpossibleforacourt,inhindsight,todeterminewhetherthe
directorsofacompanyproperlyevaluatedriskandthusmadetheright
businessdecision.

...

To impose liability on directors for making a wrong business decision


wouldcrippletheirabilitytoearnreturnsforinvestorsbytakingbusiness
risks.690

687Citigroup,964A.2dat111.

688Id.

689Id.atp.128.

690Id.atp.126.

192

TheCourtheldthatplaintiffshadfailedtotietheCaremarkclaimtoafailureof

thecorporateriskmanagementsystem:

[P]laintiffs allegations do not even specify how the boards oversight


mechanisms were inadequate or how the director defendants knew of
theseinadequaciesandconsciouslyignoredthem.Rather,plaintiffsseem
to hope the Court will accept the conclusion that since the Company
suffered large losses, and since a properly functioning risk management
systemwouldhaveavoidedsuchlosses,thedirectorsmusthavebreached
theirfiduciarydutiesinallowingsuchlosses.691

TheCourtemphasizedthatredflagssufficienttostateaCaremarkclaimmust

gobeyondsignsinthemarketthatreflectedworseningconditionsandsuggestedthat

conditionsmaydeteriorateevenfurther....692TheCourtwasprotectiveofdirectors

facing personal liability because the risk assumed by their corporation resulted in

losses:

Oversight duties under Delaware law are not designed to subject


directors,evenexpertdirectors,topersonalliabilityforfailuretopredictthe
futureandtoproperlyevaluatebusinessrisk.693

(ii) ApplicationofCaremarkandCitigrouptoLehmans
Directors

The Examiner does not find that Lehmans directors breached their Caremark

dutytomonitormanagementscompliancewiththelaw.

First,theExaminerdoesnotfindthatthedirectorsutterlyfailedtoimplement

any reporting or information system or controls.694 As explained above, the Board

691Id.at128.

692Id.at130.

693Citigroup,964A.2dat131.

193

received regular information at every Board meeting concerning the firms risk,

liquidity, and balance sheet situation. The Board also created a Finance and Risk

Committee to receive considerably more detailed information about these topics.

Moreover,theBoardreceivedregularreportsaboutthefirmsriskmanagementsystems

and controls. The directors plainly implemented a sufficient reporting system and

controls.

Second, the Examiner does not find that the directors consciously failed to

monitor or oversee its operations thus disabling themselves from being informed of

risks or problems requiring their attention.695 As explained above, the Examiner has

notfoundcolorableclaimsthatLehmansseniorofficersbreachedtheirfiduciaryduties

through the manner in which they managed risk. To the contrary, managements

conduct is protected from liability by the business judgment rule. There is also

insufficient evidence that Lehmans management violated any legal requirements or

obligations relating to risk management. The risk limits, policies, metrics, and stress

teststhatLehmandevelopedwereintendedtobeusedinternallyanddidnotconstitute

legal obligations.Because Lehmanmanagementshandling ofrisk didnotviolate the

law,thedirectorscannotbeliableforabreachoftheirdutytomonitormanagementto

preventsuchviolations.

694Id.atp.123.

695Id.

194

Moreover, there is no evidence, as Delaware law requires, that Lehmans

directors consciously disregarded violations by Lehmans senior officers of their

fiduciary or other legal duties through their decisions concerning the amount of risk

that Lehman assumed and their management of that risk. The directors were not

presented with red flags of such misconduct. And in monitoring risk issues, the

Board justifiably relied entirely on information provided by management. Under

Delawarelaw,thedirectorsaretherebyimmunizedfrompersonalliability.696

696SeeDEL.CODEANN.tit.8,141(e)(2009).

195

UNITEDSTATESBANKRUPTCYCOURT
SOUTHERNDISTRICTOFNEWYORK

x
:
Inre : Chapter11CaseNo.
:
LEHMANBROTHERSHOLDINGSINC., : 0813555(JMP)
etal., :
: (JointlyAdministered)
Debtors. :
x

REPORTOF
ANTONR.VALUKAS,EXAMINER


Jenner&BlockLLP
353N.ClarkStreet
Chicago,IL606543456
3122229350

919ThirdAvenue
37thFloor
NewYork,NY100223908
2128911600

March11,2010 CounseltotheExaminer

VOLUME2OF9

Section III.A.2: Valuation

Section III.A.3: Survival

EXAMINERSREPORT

TABLEOFCONTENTS

(SHORTFORM)

VOLUME1

Introduction,SectionsI&II:ExecutiveSummary&ProceduralBackground

Introduction...................................................................................................................................2

I. ExecutiveSummaryoftheExaminersConclusions ......................................................15

A. WhyDidLehmanFail?AreThereColorableCausesofActionThat
AriseFromItsFinancialConditionandFailure?.....................................................15

B. AreThereAdministrativeClaimsorColorableClaimsForPreferencesor
VoidableTransfers?......................................................................................................24

C. DoColorableClaimsAriseFromTransfersofLBHIAffiliateAssetsTo
Barclays,orFromtheLehmanALITransaction? ....................................................26

II. ProceduralBackgroundandNatureoftheExamination ..............................................28

A. TheExaminersAuthority ...........................................................................................28

B. DocumentCollectionandReview..............................................................................30

C. SystemsAccess..............................................................................................................33

D. WitnessInterviewProcess...........................................................................................35

E. CooperationandCoordinationWiththeGovernmentandParties ......................37

SectionIII.A.1:Risk

III. ExaminersConclusions......................................................................................................43

A. WhyDidLehmanFail?AreThereColorableCausesofActionThat
AriseFromItsFinancialConditionandFailure?.....................................................43

1. BusinessandRiskManagement..........................................................................43

a) ExecutiveSummary .......................................................................................43

b) Facts..................................................................................................................58

c) Analysis .........................................................................................................163

VOLUME2

SectionIII.A.2:Valuation

2. Valuation ..............................................................................................................203

a) ExecutiveSummary .....................................................................................203

b) OverviewofValuationofLehmansCommercialRealEstate
Portfolio .........................................................................................................215

c) SeniorManagementsInvolvementinValuation....................................241

d) ExaminersAnalysisoftheValuationofLehmansCommercial
Book................................................................................................................266

e) ExaminersAnalysisoftheValuationofLehmansPrincipal
TransactionsGroup......................................................................................285

f) ExaminersAnalysisoftheValuationofLehmansArchstone
Positions.........................................................................................................356

g) ExaminersAnalysisoftheValuationofLehmansResidential
WholeLoansPortfolio .................................................................................494

h) ExaminersAnalysisoftheValuationofLehmansRMBS
Portfolio .........................................................................................................527

i) ExaminersAnalysisoftheValuationofLehmansCDOs ....................538

j) ExaminersAnalysisoftheValuationofLehmansDerivatives
Positions.........................................................................................................568

k) ExaminersAnalysisoftheValuationofLehmansCorporate
DebtPositions ...............................................................................................583

l) ExaminersAnalysisoftheValuationofLehmansCorporate
EquitiesPositions .........................................................................................594

ii

SectionIII.A.3:Survival

3. LehmansSurvivalStrategiesandEfforts........................................................609

a) IntroductiontoLehmansSurvivalStrategiesandEfforts.....................609

b) LehmansActionsin2008PriortotheNearCollapseofBear
Stearns............................................................................................................622

c) ActionsandEffortsFollowingtheNearCollapseofBearStearns .......631

VOLUME3

SectionIII.A.4:Repo105

4. Repo105................................................................................................................732

a) Repo105ExecutiveSummary.................................................................732

b) Introduction ..................................................................................................750

c) WhytheExaminerInvestigatedLehmansUseofRepo105
Transactions ..................................................................................................764

d) ATypicalRepo105Transaction ................................................................765

e) ManagingBalanceSheetandLeverage ....................................................800

f) ThePurposeofLehmansRepo105ProgramWastoReverse
EngineerPubliclyReportedFinancialResults.........................................853

g) TheMaterialityofLehmansRepo105Practice ......................................884

h) KnowledgeofLehmansRepo105ProgramattheHighestLevels
oftheFirm .....................................................................................................914

i) Ernst&YoungsKnowledgeofLehmansRepo105Program..............948

j) TheExaminersConclusions ......................................................................962

iii

VOLUME4

SectionIII.A.5:SecuredLenders

5. PotentialClaimsAgainstLehmansSecuredLenders .................................1066

a) IntroductionandExecutiveSummary ....................................................1066

b) LehmansDealingsWithJPMorgan ........................................................1084

c) LehmansDealingsWithCitigroup.........................................................1224

d) LehmansDealingsWithHSBC ...............................................................1303

e) LehmansDealingsWithBankofAmerica ............................................1375

f) LehmansDealingsWithBankofNewYorkMellon............................1376

g) LehmansDealingsWithStandardBank................................................1382

h) LehmansDealingsWiththeFederalReserveBankofNewYork .....1385

i) LehmansLiquidityPool...........................................................................1401

SectionIII.A.6:Government

6. TheInteractionBetweenLehmanandtheGovernment..............................1482

a) Introduction ................................................................................................1482

b) TheSECsOversightofLehman ..............................................................1484

c) TheFRBNYsOversightofLehman ........................................................1494

d) TheFederalReservesOversightofLehman .........................................1502

e) TheTreasuryDepartmentsOversightofLehman ...............................1505

f) TheRelationshipoftheSECandFRBNYinMonitoring
LehmansLiquidity....................................................................................1507

g) TheGovernmentsPreparationfortheLehmanWeekend
MeetingsattheFRBNY .............................................................................1516

iv

h) OntheEveningofFriday,September12,2008,theGovernment
ConvenedaMeetingoftheMajorWallStreetFirmsinan
AttempttoFacilitatetheRescueofLehman ..........................................1523

i) LehmansBankruptcyFiling ....................................................................1535

VOLUME5

SectionIII.B:AvoidanceActions

B. AreThereAdministrativeClaimsorColorableClaimsforPreferencesor
VoidableTransfers....................................................................................................1544

1. ExecutiveSummary ..........................................................................................1544

2. ExaminersInvestigationofPossibleAdministrativeClaimsAgainst
LBHI(FirstBullet) .............................................................................................1546

3. ExaminersInvestigationofPossibleAvoidanceActions(Third,
FourthandEighthBullets)...............................................................................1570

4. ExaminersInvestigationofPossibleBreachesofFiduciaryDutyby
LBHIAffiliateDirectorsandOfficers(FifthBullet) .....................................1894

5. ExaminersAnalysisofLehmansForeignExchangeTransactions
(SecondBullet) ...................................................................................................1912

6. ExaminersReviewofIntercompanyTransactionsWithinThirty
DaysofLBHIsBankruptcyFiling(SeventhBullet).....................................1938

7. ExaminersAnalysisofLehmansDebttoFreddieMac..............................1951

SectionIII.C:BarclaysTransaction

C. DoColorableClaimsAriseFromTransfersofLBHIAffiliateAssetsto
Barclays,orFromtheLehmanALITransaction? ................................................1961

1. ExecutiveSummary ..........................................................................................1961

2. Facts .....................................................................................................................1965

3. WhetherAssetsofLBHIAffiliatesWereTransferredtoBarclays .............1997

4. LehmanALITransaction..................................................................................2055

5. Conclusions ........................................................................................................2063

6. BarclaysTransaction .........................................................................................2103

vi

UNITEDSTATESBANKRUPTCYCOURT
SOUTHERNDISTRICTOFNEWYORK

x
:
Inre : Chapter11CaseNo.
:
LEHMANBROTHERSHOLDINGSINC., : 0813555(JMP)
etal., :
: (JointlyAdministered)
Debtors. :
x

REPORTOF
EXAMINERANTONR.VALUKAS

Section III.A.2: Valuation

TABLEOFCONTENTS

2. Valuation ..............................................................................................................203
a) ExecutiveSummary .....................................................................................203
(1) ScopeofExamination ...........................................................................210
(2) SummaryofApplicableLegalStandards..........................................212
(3) SummaryofFindingsandConclusions.............................................214
b) OverviewofValuationofLehmansCommercialRealEstate
Portfolio .........................................................................................................215
(1) OverviewofLehmansCREPortfolio................................................217
(a) SummaryofPortfolio................................................................... 217
(b) OverviewofValuationofCREPortfolio................................... 220
(i) GREGLeaders ..................................................................... 220
(ii) ParticipantsintheValuationProcess............................... 220
(c) ChangesintheCREPortfoliofrom2006through2008 .......... 223
(d) PerfectStormImpactonCREValuationin2008.................. 227
(2) OutsideReviewofLehmansCREValuationProcess.....................232
(a) SEC .................................................................................................. 233
(b) Ernst&Young ............................................................................... 237
c) SeniorManagementsInvolvementinValuation....................................241
(1) SeniorManagementsGeneralRoleWithRespecttoCRE
Valuation ................................................................................................243
(2) SeniorManagementsInvolvementinValuationinthe
SecondQuarterof2008 ........................................................................245
(3) SeniorManagementsInvolvementinValuationintheThird
Quarterof2008 ......................................................................................247
(a) SeniorManagementsAccount ................................................... 248
(b) PaulHughsonsAccount ............................................................. 253
(c) OtherAccounts ............................................................................. 254
(4) ExaminersFindingsandConclusionsWithRespectto
SeniorManagementsInvolvementinCREValuation....................265
d) ExaminersAnalysisoftheValuationofLehmansCommercial
Book................................................................................................................266
(1) ExecutiveSummary..............................................................................266
(2) LehmansValuationProcessforitsCommercialBook ...................270

196

(3) ExaminersFindingsandConclusionsastothe
ReasonablenessofLehmansValuationofitsCommercial
Book ........................................................................................................274
(a) AsoftheSecondQuarterof2008 ............................................... 274
(b) AsoftheThirdQuarterof2008 .................................................. 282
e) ExaminersAnalysisoftheValuationofLehmansPrincipal
TransactionsGroup......................................................................................285
(1) ExecutiveSummary..............................................................................285
(2) OverviewofLehmansPTGPortfolio................................................292
(3) EvolutionofLehmansPTGPortfolioFrom2005Through
2008..........................................................................................................296
(4) LehmansValuationProcessforItsPTGPortfolio...........................303
(a) TheRoleofTriMontintheValuationProcessfor
LehmansPTGPortfolio............................................................... 306
(i) LehmansIssueswithTriMontsData ............................. 311
(ii) LehmanChangedItsValuationMethodologyfor
ItsPTGPortfolioinLate2007............................................ 312
(b) TheRoleofLehmansPTGBusinessDeskinthe
ValuationProcessforLehmansPTGPortfolio........................ 319
(c) TheRoleofLehmansProductControlGroupinPrice
TestingtheValuationofLehmansPTGPortfolio ................... 321
(d) TheInfluenceofLehmansPTGBusinessDeskuponthe
PriceTestingFunctionofLehmansProductControl
Group.............................................................................................. 326
(5) TheExaminersFindingsandConclusionsastothe
ReasonablenessofLehmansValuationofPTGPortfolio...............329
(a) LehmanDidNotMarkPTGAssetstoMarketBased
Yield ................................................................................................ 331
(b) TheEffectofNotMarkingtoMarketBasedYield .................. 337
(i) EffectofCap*105NotMarkingtoMarketBased
Yield ...................................................................................... 337
(ii) EffectofIRRModelsNotMarkingtoMarketBased
Yield ...................................................................................... 342
(iii) EffectofProductControlPriceTestingNot
MarkingtoMarketBasedYield ........................................ 349

197

(iv) EffectofModifyingTriMontsDataintheThird
Quarterof2008 .................................................................... 351
(c) ExaminersFindingsandConclusionsastotheEffectof
NotMarkingLehmansPTGPortfoliotoMarketBased
Yield ................................................................................................ 353
f) ExaminersAnalysisoftheValuationofLehmansArchstone
Positions.........................................................................................................356
(1) ExecutiveSummary..............................................................................356
(2) LehmansAcquisitionofArchstone...................................................364
(a) BackgroundonArchstone ........................................................... 364
(b) AcquisitionofArchstone ............................................................. 365
(i) AnalystReaction.................................................................. 367
(ii) LehmansSyndicationEfforts ........................................... 370
(iii) BridgeandPermanentEquityatClosing ........................ 374
(iv) CapitalStructureatClosing............................................... 375
(v) PriceFlex .............................................................................. 377
(vi) Standard&PoorsCreditRating ...................................... 380
(3) LehmansValuationofArchstone ......................................................382
(a) ValuationBetweenCommitmentandClosing......................... 386
(b) ValuationasoftheClosingDate ................................................ 388
(c) ValuationasoftheFourthQuarterof2007............................... 390
(d) ValuationIssuesDuringtheFirstQuarterof2008 .................. 391
(i) BarronsArticle.................................................................... 391
a. ArchstonesResponsetotheBarronsArticle.......... 392
b. LehmansResponsetotheBarronsArticle ............. 394
(ii) January2008ArchstoneUpdate ....................................... 396
(iii) ValuationasofFebruary29,2008..................................... 399
(iv) FirstQuarter2008EarningsCallandLenders
DiscussionRegardingModifyingtheArchstone
Strategy ................................................................................. 401
(e) ValuationIssuesDuringtheSecondQuarterof2008.............. 402
(i) March2008ArchstoneUpdate.......................................... 402
(ii) March2008Valuation......................................................... 404
(iii) April2008DowngradebyS&P ......................................... 407

198

(iv) EinhornSpeechinApril2008 ............................................ 407


(v) May2008Valuation ............................................................ 408
(vi) SecondQuarter2008EarningsConferenceCall ............. 411
a. PreparationandLehmansMethodsof
AnalyzingReasonablenessofValuationsPrior
totheCall ...................................................................... 411
b. DiscussionDuringtheSecondQuarter2008
EarningsCall................................................................. 412
(vii) LehmansRevisedPlantoSellArchstonePositions ...... 414
(f) ValuationIssuesDuringtheThirdQuarterof2008 ................ 416
(i) DiscussionAmongLendersinJuly2008 ......................... 417
(ii) August2008Valuation ....................................................... 417
(g) ProductControlsReviewofArchstoneValuations................ 418
(4) ExaminersAnalysisofLehmansValuationProcessforits
ArchstonePositions ..............................................................................419
(a) DiscountedCashFlowValuationMethod................................ 421
(i) RentGrowth......................................................................... 422
a. NetOperatingIncome................................................. 426
b. SensitivityAnalysis...................................................... 429
(ii) ExitCapitalizationRate...................................................... 431
(iii) ExitPlatformValue............................................................. 433
(iv) DiscountRate....................................................................... 436
(b) SumofthePartsMethod ............................................................. 438
(c) ComparableCompanyMethod .................................................. 440
(i) PotentialOvervaluationBasedonPrimary
ComparableCompanies..................................................... 445
(5) ExaminersAnalysisoftheReasonablenessofLehmans
ValuationofitsArchstonePositionsonaQuarterlyBasis .............446
(a) ReasonablenessasoftheFourthQuarterof2007 .................... 446
(b) ReasonablenessasoftheFirstQuarterof2008 ........................ 449
(i) BarronsArticle.................................................................... 450
(ii) DiscussionsAmongArchstone,Tishmanand
Lenders ................................................................................. 458
(iii) LehmansValuationDuringtheFirstQuarterof
2008........................................................................................ 459

199

(iv) SumoftheParts................................................................... 460


(v) DCFMethod......................................................................... 464
(vi) ExaminersFindingsandConclusionsastothe
ReasonablenessofLehmansArchstoneValuation
asoftheEndoftheFirstQuarterof2008 ........................ 466
(c) ReasonablenessasoftheSecondQuarterof2008.................... 468
(i) SecondQuarterEarningsCall ........................................... 469
(ii) SumoftheParts................................................................... 476
(iii) DCFModel ........................................................................... 477
(iv) RentGrowth......................................................................... 478
(v) ExitCapitalizationRate...................................................... 479
(vi) QuantificationofChangesinAssumptions .................... 480
(vii) ExaminersFindingsandConclusionsastothe
ReasonablenessofLehmansArchstoneValuation
asoftheEndoftheSecondQuarterof2008 ................... 481
(d) ReasonablenessasoftheThirdQuarterof2008 ...................... 484
(i) SumoftheParts................................................................... 487
(ii) DCFMethod......................................................................... 488
(iii) RentGrowth......................................................................... 489
(iv) ExitCapitalizationRate...................................................... 490
(v) QuantificationofChangesinAssumptions .................... 491
(vi) ExaminersFindingsandConclusionsastothe
ReasonablenessofLehmansArchstoneValuation
asoftheEndoftheThirdQuarterof2008 ...................... 492
g) ExaminersAnalysisoftheValuationofLehmansResidential
WholeLoansPortfolio .................................................................................494
(1) ResidentialWholeLoansOverview ...................................................494
(2) LehmansU.S.ResidentialWholeLoansin2008 .............................497
(3) LehmansValuationProcessforitsResidentialWholeLoans .......501
(a) LehmansMay2008PriceTesting .............................................. 504
(b) LehmansAugust2008PriceTesting......................................... 515
(4) ExaminersIndependentValuationofLehmansResidential
WholeLoansPortfolio..........................................................................520

200

(5) ExaminersFindingsandConclusionsWithRespecttothe
ReasonablenessofLehmansValuationofItsResidential
WholeLoansPortfolio..........................................................................525
h) ExaminersAnalysisoftheValuationofLehmansRMBS
Portfolio .........................................................................................................527
i) ExaminersAnalysisoftheValuationofLehmansCDOs ....................538
(1) LehmansPriceTestingProcessforCDOs ........................................543
(2) PriceTestingResultsfortheSecondandThirdQuarters2008 ......551
(a) LehmansPriceTestingofitsCeagoCDOs .............................. 553
(3) ExaminersReviewofLehmansLargestU.S.ABS/CRECDO
Positions .................................................................................................562
(4) ExaminersFindingsandConclusionsWithRespecttothe
ReasonablenessofLehmansValuationofitsCDOs .......................567
j) ExaminersAnalysisoftheValuationofLehmansDerivatives
Positions.........................................................................................................568
(1) OverviewofLehmansDerivativesPositions...................................568
(2) LehmansUseofCreditSupportAnnexestoMitigate
DerivativesRisk ....................................................................................574
(3) LehmansPriceTestingofitsDerivativesPositions ........................578
k) ExaminersAnalysisoftheValuationofLehmansCorporate
DebtPositions ...............................................................................................583
(1) OverviewofLehmansCorporateDebtPositions ...........................583
(2) LehmansPriceTestingofitsCorporateDebtPositions.................585
(3) ExaminersFindingsandConclusionsWithRespecttothe
ValuationofLehmansCorporateDebtPositions............................589
(a) RelianceonNonTrades............................................................... 590
(b) QualityControlErrorsMismatchedCompanies .................. 591
(c) NoTestingofInternalCreditRating ......................................... 592
l) ExaminersAnalysisoftheValuationofLehmansCorporate
EquitiesPositions .........................................................................................594
(1) OverviewofLehmansCorporateEquitiesPositions......................594
(2) LehmansValuationProcessforitsCorporateEquities
Positions .................................................................................................596
(3) ExaminersFindingsandConclusionsWithRespecttothe
ValuationofLehmansCorporateEquitiesPositions......................599

201

(a) ImpairedDebtwithNoEquityMarkDown ............................ 601


(b) StaticMarks ................................................................................... 603

202

2. Valuation

a) ExecutiveSummary

UnderGAAP,Lehmanwasrequiredtoreportthevalueofitsfinancialinventory

at fair value.697 Beginning in the first quarter of 2007,698 Lehman adopted SFAS 157,

which established the fair value of an asset as the price that would be received in an

orderlyhypotheticalsaleoftheasset.699

Toincreaseconsistencyandcomparabilityinfairvaluemeasurements,SFAS157

createdabroad,threelevel,fairvaluehierarchythatprioritizestheinputstovaluation

techniques used to measure fair value.700 Generally, this hierarchy gives the highest

priority to quoted prices in active markets for identical assets or liabilities (Level 1),

followedbyobservableinputsotherthanquotedprices(Level2)andthelowestpriority

to unobservable inputs (Level 3).701 To the extent that the value of an asset cannot be

determinedbyreferencetoobservabledatabasedontransactionsbetweenpartiesinthe

market,otherthandatafromdistressedsales,SFAS157requiresthereportingentityto

697Fin.AccountingStandardsBd.,SFASNo.107,1011.Inaddition,Lehmanownedpositionswithin

itsfinancialinventorythatwereclassifiedasheldforsale,whichwerereportedatthelowerofcarrying
amountorfairvalue.
698SFAS 157 became mandatory for financial statements issued for fiscal years beginning after

November15,2007,andFASBencouragedearlyadoption.Fin.AccountingStandardsBd.,SFASNo.157,
36.
699Lehman Brothers Holdings Inc., Quarterly Report as of Feb. 28, 2007 (Form 10Q)(filed on Apr. 9,

2007),atp.14(LBHI10Q(filedApr.9,2007))(WeelectedtoearlyadoptSFAS157beginninginour
2007fiscalyear....).SFAS157andfairvaluemeasurementsarediscussedfurtherinAppendix1,Legal
Issues,SectionVII.A.
700SFASNo.157,22.

701Id.at2230.

203

use its judgment to determine fair value, taking into account its view as to the

assumptionsthatmarketparticipantswoulduseinpricingtheasset.702

As the level of market activity declined in late 2007 and 2008 resulting in

valuation inputs becoming less observable and certain of Lehmans assets became

increasinglylessliquid,Lehmanprogressivelyreliedonitsjudgmenttodeterminethe

fairvalueofsuchassets.703Inlightofthedislocationofthemarketsanditsimpacton

theinformationavailabletodeterminethemarketpriceofanasset,investors,analysts

andthemediafocusedonLehmansmarktomarketvaluations.704Lehmandevoteda

702Id.at22,30.

703Examiners Interview of Abebual A. Kebede, Oct. 6, 2009, at pp. 4, 68. See Lehman, Valuation &
Control Report Fixed Income Division (Feb. 2008), at p. 27 [LBEXWGM 002260] (noting that to
compensate for the lack of sales data, [p]roduct control is having continuous discussions with Front
Office going through deals in more detail and trying to obtain market color using recent syndications,
bids,offersandanyothermarketinformation.)LehmanreportedanincreasingamountofLevel2and
Level3assetsinitsfinancialstatementsfromtheendofthefourthquarterforits2007fiscalyeartothe
endofthefirstquarterof2008.SeeLehmanBrothersHoldingsInc.,AnnualReportasofNov.30,2007
(Form10K),atp.41(filedonJan.29,2008)(LBHI200710K)(Duringthe2007fiscalyear,ourLevel3
assetsincreased,endingtheyearat13%ofFinancialInstrumentsandotherinventorypositionsowned.);
LehmanBrothersHoldingsInc.,QuarterlyReportasofFeb.29,2008(Form10Q),atp.23(filedonApr.9,
2008)[LBEXDOCID1024435](LBHI10Q(filedApr.9,2008))(showinganincreaseintheamountof
Level2andLevel3assetsonaquarteroverquarterbasisfromtheendofthe2007fiscalyear).Although
by the end of the second quarter of 2008 the aggregate amount of Lehmans financial inventory
considered Level 2 or Level 3 decreased on a quarteroverquarter basis, the majority of this decrease
occurred in the Level 2 asset category, and due to an even more substantial decrease in the amount of
Level 1 assets over the same time period, the proportion of Lehmans financial inventory that was
categorized as Level 2 and Level 3 increased on a quarteroverquarter basis. See Lehman Brothers
Holdings Inc., Quarterly Report as of May 31, 2008 (Form 10Q), at pp. 2930 (filed on July 10, 2008)
(LBHI10Q(filedJuly10,2008)).
704See Andrew Bary, ApartmentHouse Blues, Barrons, Jan. 21, 2008, available at http://online.barrons.

com/article/SB120070919702802265.html#articleTabs_panel_article%3D1 (noting that based on current


REIT prices, the value of the Archstone equity could be zero.); see also David Einhorn, Greenlight
Capital, Presentation to the Value Investing Congress, A Few Thoughts About Risk (Nov. 29, 2007)
[LBEXDOCID 2490444]; Transcript of Speech by David Einhorn, Presentation to Grants Spring
InvestmentConference,PrivateProfitsandSocializedRisk(Apr.8,2008),atp.9,availableat

204

considerablepartofitsearningscallsforthefirstandsecondquartersof2008toexplain

thevaluesithaddeterminedforawiderangeofitsassetsandthemethodologiesithad

employed in doing so.705 Notwithstanding such disclosures, it is apparent that

Lehmans valuations, or its marks, for its illiquid assets, were being questioned by

marketparticipants.706

For example, David Einhorn of Greenlight Capital, who at the time held short

positionsinLehman,statedinanApril8,2008speech:

There is good reason to question Lehmans fair value calculations. . . .


Lehmancouldhavetakenmanybillionsmoreinwritedownsthanitdid.
Lehman had large exposure to commercial real estate. . . . Lehman does
notprovideenoughtransparencyforustoevenhazardaguessastohow
they have accounted for these items. . . . I suspect that greater
transparencyonthesevaluationswouldnotinspiremarketconfidence.707

http://www.foolingsomepeople.com/main/mroom/Grants%20Conference%2004082008.pdf (last
visited Feb. 2, 2010); Transcript of Speech by David Einhorn, Presentation to Ira W. Sohn Investment
Research Conference, Accounting Ingenuity (May 21, 2008), at pp. 34, available at
http://www.foolingsomepeople.com/main/TCF%202008%20Speech.pdf.
705Transcript of Lehman Brothers Holdings Inc. Second Quarter 2008 Earnings Call (June 16, 2008);

TranscriptofLehmanBrothersHoldingsInc.FirstQuarter2008EarningsCall(March18,2008).
706JonathanWeil,LehmansGreatestValueLiesInLessonsLearned,Bloomberg.com(June11,2008),available

at http://www.bloomberg.com/apps/news?pid=20601039&refer=columnist_weil&sid=aLvc47iu_Re0
(Lehmansmarket capitalization,at $19.2 billion,is nowalmost $7 billionless than the companys$26
billionbookvalue,orassetsminusliabilities.ThatsuggeststhatthemarketbelievesLehmanhasntfully
cleaned up its balance sheet and that the worst is still to come, managements assurances
notwithstanding.).
707TranscriptofSpeechbyDavidEinhorn,PresentationtoGrantsSpringInvestmentConference,Private

Profits and Socialized Risk (Apr. 8, 2008), at p. 9, available at http://www.foolingsomepeople.


com/main/mroom/Grants%20Conference%2004082008.pdf. See also Transcript of Speech by David
Einhorn, Presentation to Ira W. Sohn Investment Research Conference, Accounting Ingenuity (May 21,
2008), at pp. 34, available at http://www.foolingsome people.com/main/ TCF%202008%20Speech.pdf
(Theissueoftheproperuseoffairvalueaccountingisntaboutstrictversuspermissiveaccounting....
The cycle has exposed the investments to be more volatile and in many cases less valuable than they
thought.Thedeclineinmarketvalueshasforcedtheseinstitutionstomakeatoughdecision.Dothey
followtherules,takethewritedownsandsuffertheconsequenceswhatevertheymaybe?Orworse,do

205

Einhorns skepticism was also reflected in the financial press. On March 20, 2008,

Portfolio.compublishedanarticletitledTheDebtShuffle,whichasked:Whatactually

happenedtoLehmansbalance sheet in thefirstquarter?Assets rose. Leveragerose.

Writedowns were suspiciously miniscule. And the company fiddled with the way it

definesakeymeasureofthefirmsnetworth.708LehmansHeadofU.S.GlobalCredit

Products, Eric Felder, forwarded this article to Ian Lowitt, Lehmans CoChief

AdministrativeOfficer,withthenote,bunchofpeoplelookingatthisarticle,towhich

Lowittreplied,[d]oesnthelp.709FirmssuchasLehmanrequiredtheconfidenceofthe

markettoassureitssourcesofshorttermfinancingthattheywouldberepaid;andthe

marketsconfidenceinLehmanwaspubliclyquestioned.710

According to the SEC, one of the reasons that the market lost confidence in

LehmanwasthatthemarkethadlittleconfidenceintheassetvaluesthatLehmanwas

reporting.711ThislackofconfidencewasevidentintheperformanceofLehmansstock

price,whichdroppedtonearhistoriclowsfollowingLehmansJune9,2008preliminary

theytaketheviewthattheycantreallyvaluetheinvestmentsinordertoavoidwritingthemdown?Or,
evenworse,dotheyclaimtofollowtheaccountingrules,butsimplylieaboutthevalues?)
708Jesse Eisinger, The Debt Shuffle: Wall Street cheered Lehmans earnings, but there are questions about its

balance sheet, Portfolio.com (Mar. 20, 2008), available at http://www.portfolio.com/newsmarkets/top


5/2008/03/20/LehmansDebtShuffle.
709See email from Eric Felder, Lehman, to Ian T. Lowitt, Lehman (Mar. 23, 2008)

[LBHI_SEC07940_625905]; email from Ian T. Lowitt, Lehman, to Eric Felder, Lehman (Mar. 23, 2008)
[LBHI_SEC07940_625905]. There is substantial evidence that the market lost a significant degree of
confidenceinLehmaninthesummerof2008.InJune2008,S&P,FitchandMoodyseachissuedratings
downgradesforLehman,andLehmansstockpriceplummetedfollowingitsearningsannouncementfor
thesecondquarterof2008.SeeSectionIII.B.3.d.2.eofthisReport.
710ExaminersInterviewofSECstaff,Aug.24,2009,atp.14.

711Id.

206

earnings announcement.712 The decline in Lehmans stock price resulted in Lehman

having a market capitalization of $19.2 billion, which was nearly $7 billion below

Lehmans book value. According to Bloomberg.coms Jonathan Weil, the decline in

stock price suggest[ed] that the market believes Lehman hasnt fully cleaned up its

balance sheet and the worst is still to come, managements assurances

notwithstanding.713

ThelackofconfidenceinLehmansvaluationswasalsoevidentinthedemands

for collateral made by Lehmans clearing banks throughout 2008 to secure risks they

assumed in connection with clearing and settling Lehmans triparty and currency

trades,andotherextensionsofcredit.714Tocontinuetheprovisionofclearingservices

and intraday credit that Lehman relied upon for daytoday operations, Lehmans

712SeeSection III.B.3.d.2.e of this Report for further discussion of the markets lack of confidence in
Lehmaninsummerof2008.Fromthebeginningof2008throughtheendofthesecondquarterof2008,
Lehmanscommonstocktradedinrangebetweenahighof$66pershareonFebruary1,2008toalowof
$31.75 on March 17, 2008, immediately after the near collapse of Bear Stearns. Starting in June 2008,
Lehmanssharepricewasapproachingits52weeklow,wouldsoonfallbelow$30pershareandwould
notagainreturntothatlevel.ThelasttimeLehmansstockhadtradedbelow$30/sharewasinSeptember
andOctober1998intheaftermathofthecollapseofLongTermCapitalManagementandtheRussian
Sovereign Debt Crisis. On June 12, 2008, Lehmans stock opened at $21.35/share, and closed at
$21.17/sharelowsthatLehmanhadnotreachedsince1996andthevolumeontradingofLehmans
sharesreachedanalltimehighofover173millionaleveloftradingthatwouldonlybeeclipsedin
Lehmans final week prior to the bankruptcy filing. All historical pricing information is publicly
availablefromsitessuchasYahoo!Finance.
713JonathanWeil,LehmansGreatestValueLiesInLessonsLearned,Bloomberg.com(June11,2008),available

at http://www.bloomberg.com/apps/news?pid=20601039&refer=columnist_weil&sid=aLvc47iu_Re0.
Notably, Robert Azerad, Lehmans Global Head of Asset and Liability Management, forwarded this
articletoPaoloTonucci,LehmansGlobalTreasurer,anddescribedthisarticleas[r]epresentativeofthe
tone of the market. Email from Robert Azerad, Lehman, to Paolo Tonucci, Lehman (June 11, 2008)
[LBHI_SEC07940_517806809]
714SeeSectionIII.A.5.ofthisReportforadiscussionofthecollateraldemandsmadebyLehmansclearing

banks.

207

clearing banks began demanding collateral.715 In response, Lehman pledged, or

attemptedtopledge,Lehmanstructuredinstruments,suchascertaincollateralizedloan

obligations, to Citigroup and JPMorgan two of its principal settlement banks.716

Citigroup rejected the assets proposed by Lehman, due to their illiquid characteristics

andtheinabilitytoestablishreliablemarksforsuchassets.717WhileJPMorganaccepted

Lehmans structured instruments, that bank demanded additional cash collateral after

conducting analyses showing that the collateral was likely not worth the par values

assignedbyLehman.718JPMorganscollateralcallwasoneofthecontributingfactorsto

theliquidityproblemsthathastenedLehmansbankruptcy.719

Further, the lack of confidence in Lehmans valuation of its CRE assets was a

principal reason why Lehman sought to shed its illiquid CRE assets in a spinoff

715See Section III.A.5. of this Report, which discusses the importance of Lehmans secured lenders in

general, and Sections III.A.5.b.d., which discuss Lehmans dealings with JPMorgan, Citigroup and
HSBC, which were three of Lehmans most important clearing and settlement banks. Each bank
requestedcollateralfromLehmaninthesummerof2008.
716See Section III.A.5.c.1.c.ii of this Report, which discusses Lehmans proposed pledge of securities to

Citi;andseealsoSectionsIII.A.5.b.1.eandIII.A.5.b.1.kofthisReportwhichdiscussesJPMorgansconcerns
withsecuritiespledgedbyLehmanascollateral.
717See Section III.A.5.c.1.c.ii of this Report, which discusses Lehmans proposed pledge of securities to

Citi.
718See Sections III.A.5.b.1.e and III.A.5.b.1.l, of this Report, which discuss JPMorgans concerns over

Lehman collateral, and certain of JPMorgans valuation analyses of Lehmans collateral. See Section
III.A.5.b.1.k of this Report, which notes that JPMorgans concerns over the value of Lehmans pledged
assets,atleastinpart,ledthebanktoaskforapledgeofcashcollateral.
719See Section III.A.6 of this Report which discusses the effect of clearing bank collateral demands on

Lehmansliquidity.

208

companythatwouldnotberequiredtoreportthefairvalueofsuchassetspursuantto

SFAS157.720

TheuncertainlyastothefairvalueofLehmansassetsalsoplayedaroleinthe

negotiationsbetweenBofAandLehmanregardingapotentialacquisitionofLehmanby

BofA.LewistoldtheExaminerthatforBofA,thequestionofwhetherornotitwasa

gooddealwasbasedentirelyonthenumbers.721BofAputtogetheradiligenceteam

atsomepointaroundSeptember10or11,2008,anditbecamequicklyapparenttothem

that, without substantial government assistance, the deal would not be beneficial to

BofA.722ThestickingpointforBofAwaswhatLewisdescribedasa$66billionholein

Lehmansvaluationofitsassets.723AlthoughLewisstatedthathedidnotthinkthatthe

assetswerecompletelyworthless,BofAdidnotwantthose$66billioninassetsatany

price,andwantedthemoffthebooks.724LewisstatedthathethoughtLehmansmarks

were out of line with BofAs.725 Once it became apparent to Lewisthat government

assistancewasnotforthcoming,BofAeffectivelyendeditsnegotiationswithLehman.726

720Examiners Interview of SEC staff, Aug. 24, 2009, at p. 14. For a discussion of SpinCo, see Section

III.A.5.c.4ofthisReport.
721ExaminersInterviewofKennethD.Lewis,Oct.9,2009,atp.4.

722Id.

723Id.atp.5.

724Id.

725Id.

726Id.atp.6.

209

(1) ScopeofExamination

To address the tasks in the Examiners Order, the Examiner evaluated the

reasonableness of Lehmans marktomarket valuations in two distinct but related

differentcontexts.TheExaminerconsideredthereasonablenessofLehmansmarkto

marketvaluationsfortworeasons.First,inconnectionwiththeExaminersanalysisas

to whether LBHI or any LBHI Affiliates were insolvent, the Examiner considered

whether there was sufficient evidence that Lehmans valuations for a particular asset

class were unreasonable such that the court could adjust, or even disregard, such

valuations in determining the solvency of these debtors. Second, where there was

sufficient evidence to demonstrate that valuations were unreasonable, the Examiner

considered whether such valuations were the product of actions of a Lehman officer

thatwouldsupportacolorableclaimofbreachoffiduciaryduty.

The Examiners inquiry into the reasonableness of Lehmans valuation focused

onLehmansU.S.assets.TheExaminerdeterminedthat,inlightofthecompositionof

the LBHI Affiliates assets, the relative inaccessibility of information regarding the

valuation and price testing of Lehmans nonU.S. assets and the time and expense

necessarytoobtainandanalyzesuchinformation,anassessmentofLehmansnonU.S.

assets was not a prudent use of resources. Accordingly, unless otherwise noted, any

referencetoanassetclassoraparticularLehmanbusinessunitinthisSectionistoU.S.

assetsoraLehmanU.S.businessunit.

210

The Examiner analyzed Lehmans valuation of the following asset categories:

commercial real estate (CRE), residential whole loans (RWLs), residential

mortgagebacked securities (RMBS), collateralized debt obligations (CDOs),

derivatives, corporate debt and corporate equity. The Examiner selected these asset

categoriesduetotherelativesizeofeachassetclassandtheriskofavaluationerrorin

light of deteriorating market conditions. Given that the primary purpose of the

valuation was to support the solvency analysis, the Examiner focused the valuation

analysis on the second and third fiscal quarters of 2008,727 except with respect to

Lehmans valuations of its Archstone positions, which are addressed beginning with

theArchstoneacquisitioninOctober2007.

Acrossallassetclasses,theassetvaluesLehmanreportedwerethosedetermined

by its business desk,subject to revision pursuant to a price testing process performed

by its Product Control Group.728 Even within a single asset class, the valuation

methodologies employed by the business desk differed, and the Product Control

727LBHIsmarketcapitalizationwasapproximately$28.1billionasoftheendofitsfirstfiscalquarteron

February29,2008.SeeLBHIForm10Q(filedApril9,2008),atp.6.TheExaminerfocusedonthedates
May 31, 2008, and August 31, 2008, because these were the last days of Lehmans second and third
quarters, respectively. While Lehman did not file a quarterly report for the third quarter of 2008, the
businessdesksdidvaluetheirpositionsandtheProductControlGroupperformedpricetestingforthis
period. In light of the primary purpose of the valuation analysis, the Examiner determinedthat it was
not a prudent use of resources to examine the reasonableness of Lehmans valuations (other than
Archstone)priortothesecondquarterof2008.WithrespecttoArchstone,giventhesubstantialanalyst
andmediafocusonthistransactionandthenatureofLehmansparticipation,theExaminerdeterminedit
wouldbeprudenttobeginthevaluationanalysiswiththeArchstoneacquisitioninthefourthquarterof
2007 toprovideappropriate context in which to consider the reasonableness of Lehmans valuations
duringlaterperiods.
728Lehman, Price Verification Policy: Global Capital Markets 2008 [Draft], at p. 4
[LBHI_SEC07940_2965994].

211

Groupspricetestingservedasastandardizedcheckonthevaluationprocess.Forthis

reason,theinvestigationfocusedontheroleplayedbytheProductControlGroupand

themethodsemployedinthepricetestingprocess.

(2) SummaryofApplicableLegalStandards

ThestandardfordeterminingthefairvalueofanassetpursuanttoSFAS157is

closely aligned with the standard courts have applied in determining the value of a

debtors assets for purposes of a solvency determination.729 The Bankruptcy Code

definesinsolventinrelevantpartasthefinancialconditionsuchthatthesumofthe

entitysdebtsisgreaterthanallofsuchentitysproperty,atafairvaluation[.]730When

assessingthefairvalueofadebtorsassets,courtsconsiderthefairmarketpriceofthe

debtorsassetsthatcouldbeobtainedifsoldinaprudentmannerwithinareasonable

periodoftimetopaythedebtorsdebts.731Inthismanner,boththeSFAS157standard

for marktomarket valuation and the courts solvency analysis are predicated on the

price that could be obtained for the asset in the marketplace as of the applicable

measurementdate.

Given that valuation is, to a great extent, a subjective exercise,732 courts have

assessedthereasonablenessofadebtorsvaluationorprojectionoffuturecashflowsin

729See Appendix 1, Legal Issues, Section VII.A, for a discussion of the applicable valuation standards

underSFAS157andforasolvencydeterminationundertheBankruptcyCode.
73011U.S.C.101(32)(A)(definitionapplicabletoentitiesotherthanapartnershipormunicipality).

731InreRoblinIndustries,Inc.,78F.3d30,35(2dCir.1996).

732InreIridiumOperatingLLC,373B.R.283,348(Bankr.S.D.N.Y.2007).

212

light ofinformationavailableatthetimethevaluationwasundertaken.AstheThird

Circuit has explained with respect to the analysis of a debtors cash flow projections,

far from hindsight or posthoc analysis, a court looks at the circumstances as they

appearedtothedebtoranddetermineswhetherthedebtorsbeliefthatafutureevent

wouldoccurwasreasonable.Thelessreasonableadebtorsbelief,themoreacourtis

justifiedinreducingtheassets(orraisingliabilities)toreflectthedebtorstruefinancial

condition at the time of the alleged transfers.733 Accordingly, the Examiner has

considered the reasonableness of Lehmans asset values in light of contemporaneous

informationavailabletoLehmanandwiththeunderstandingthatvaluationofilliquid

assetsrequirestheapplicationofconsiderablejudgment.

With respect to the fiduciary duty analysis, a corporate fiduciary would have

breached such duty if the fiduciary caused Lehman to improperly value an asset

intentionally or with conscious recklessness i.e., a state of mind approximating

actualintent,andnotmerelyaheightenedformofnegligence.734Inorderforthereto

beacolorableclaim,thefactsneedtosupportafindingthatthecorporatefiduciaryhad

thenecessaryscienter.

733Mellon Bank, N.A. v. Official Committee of Unsecured Creditors of R.M.L., Inc., 92 F.3d 139, 157 (3d Cir.

1996).
734See,e.g.,Desimonev.Barrows,924A.2d908,93435&n.89(Del.Ch.2007).SeeAppendix1,LegalIssues,

Section II, for a discussion regarding the legal standards for breach of fiduciary duty. See also South
CherryStreet,LLCv.HennesseeGroupLLC,573F.3d98,109(2dCir.2009).

213

(3) SummaryofFindingsandConclusions

The Examiner finds insufficient evidence to support a finding that Lehmans

valuations of its RWL, RMBS, CDO or derivative positions were unreasonable during

thesecondandthirdquartersof2008.AlthoughtheExamineridentifies,anddiscusses

below,certainproblematicissuesrelatedtothepricetestingoftheseassetclasses,these

problems either did not impact the ultimate asset values determined or the resulting

valuationerrorswereimmaterial.

Because an assessment of the reasonableness of Lehmans asset values for

corporate debt and corporate equity would require an expensive and time consuming

assetbyasset analysis, the Examiner determined that such an assessment was not a

prudentuseofresources.TheExaminerconsideredLehmansvaluationsofthelargest

corporate debt and corporate equity positions and identified issues that may warrant

furtherreviewbypartiesininterest.

Withrespecttocommercialrealestate,theExaminerfindsinsufficientevidence

toconcludethatLehmansvaluationsofitsCommercialportfoliowereunreasonableas

of the second and third quarters of 2008. The Examiner determines that there is

sufficientevidencetoconcludethatcertainofthePrincipalTransactionsGroup(PTG)

realestateassetswerenotreasonably valued during thesequarters. Furthermore,the

ExaminerfindssufficientevidencetosupportafindingthatLehmansvaluationsofits

214

Archstonebridgeequityinvestmentwereunreasonableasofthefirst,secondandthird

quartersof2008.735

The Examiner did not find sufficient evidence to support a colorable claim for

breachoffiduciarydutyinconnectionwithanyofLehmansvaluations.Inparticular,

inthethirdquarterof2008thereisevidencethatcertainexecutivesfeltpressuretonot

take all of the writedowns on real estate positions that they determined were

appropriate;thereissomeevidencethatthepressureactuallyresultedinunreasonable

marks. But, as the evidence is in conflict, the Examiner determines that there is

insufficient evidence to support a colorable claim that Lehmans senior management

imposedarbitrarylimitsonwritedownsofrealestatepositionsduringthatquarter.

b) OverviewofValuationofLehmansCommercialRealEstate
Portfolio

This Section addresses Lehmans valuation of its CRE portfolio, principally

duringthesecondandthirdquartersof2008,736andprovidesanoverviewofLehmans

CREportfolioandLehmansvaluationprocessacrosstheCREportfolio.Inordertoput

Lehmans valuation process and decisions in context, this overview summarizes the

735Thisanalysisalsopertainstothepermanentequity(i.e.,generalpartnerinterest)whichwasvaluedat

$246 millionat closing. See Lehman, Archstone Monthly Exposure as of July 2008 revised.xls [LBEX
BARFID0013113].
736As is the case with each of the other asset classes that were the focus of the investigation as to

Lehmansvaluationofassets,theExaminerdeterminedthatitwouldnotbeaprudentuseofresourcesto
conductaninvestigationofLehmansvaluationofitsnonU.S.CREassets.WiththeexceptionofLCPI,
which owned certain European debt and Coeur Defense positions (located in Paris, France), the LBHI
AffiliatesdidnotdirectlyownmaterialCREpositionsinrespectofrealestatelocatedoutsideoftheU.S.
See Section III.B.3.c.3.a of this Report, which discusses the Examiners finding that LCPI was either
insolventorborderlinesolventduringtheperiodbeginningSeptember2007.

215

changes in Lehmans CRE portfolio beginning in 2006 and Lehmans response to the

changing market conditions throughout 2007 and 2008, including the writedowns

Lehman took in 2008. This Section concludes by addressing the SECs review of

Lehmans price verification processes for its CRE portfolio and the quarterly review

performedbyE&YofLehmansCREvaluationsin2008.

Following the overview, the Examiner discusses the role played by Lehman

senior management in the valuation process and, in particular, addresses whether

senior managers set predetermined limits on the amount of CRE writedowns for the

second and third quarters of 2008. This Report continues with an analysis of the

valuation of the CRE assets within each of Global Real Estate Groups (GREGs)

business units Commercial, Principal Transactions Group (PTG) and Bridge

Equity.737 The Report, in separate subsections, describes the assets in the PTG and

Commercial portfolios, Lehmans Archstone investments,738 the methodologies

employedbyLehmantovaluesuchassetsandtheproceduresusedtopricetestthose

values. Each subsection includes the Examiners analysis as to whether there is

737Lehman, GREG Update (Aug. 7, 2008), at p. 2 [LBHI_SEC_07940_ICP_003590]. According to this


presentation,thethreebusinessunitsofGREGwereCommercialWholeLoansandCMBS(whichwere
referred to as Commercial), PTG and Real Estate Advisory. Id. Real Estate Advisory provide[d]
comprehensive advisory and capital raising services but did not utilize [Lehmans] balance sheet,
whichmeansthatpositionsoriginatedfromthisbusinessunitwerenotownedbyLBHIorthedebtors.
Id.;seealsoLehman,RealEstateUpdatePresentationtoS&P(Oct.2007),atp.3[LBHI_SEC07940_126498].
738The Examiners analysis of the Bridge Equity units valuation focuses on Lehmans valuation of its

Archstone bridge equity position because this single position represented over 50% of the value of
Lehmansbridgeequityportfolio.

216

sufficientevidenceto support afindingthatLehmansvaluations of these assets were

unreasonable.739

(1) OverviewofLehmansCREPortfolio

(a) SummaryofPortfolio

The Commercial portfolio (Commercial Book) was comprised of debt

instruments, such as commercial mortgage loans and Commercial MortgageBacked

Securities (CMBS).740 These assets were backed by real estate properties that were

generating cash flow and Lehmans intention was to syndicate, securitize and/or sell

theseassetstoinvestorswithinafewmonthsaftertheiroriginationoracquisition.741

PTG assets were typically highly leveraged debt or equity investments in real

estate assets that Lehman intended to hold for its own account while a developer

improvedordevelopedtheunderlyingasset.742Asageneralmatter,Lehmansstrategy

739WhileLehmandidnotfileaquarterlyreportforthethirdquarterof2008,itdidvalueitsCREassets

and perform price testing for this period. Lehman publicly disclosed its preliminary third quarter
results. Lehman, Press Release: Lehman Brothers Announces Preliminary Third Quarter Results and
StrategicRestructuring[LBHI_SEC07940_028677].
740WyattdeSilva,E&Y,MemorandumtoFiles:LehmanCommercialRealEstateFAS157Adoption(Jan.

28,2008),atpp.24[EYLELBHIKEYPERS2025661];Lehman,GlobalRealEstateProductControlReal
EstateAmericasPriceVerificationPresentation[Draft](Feb.2008),atp.4[LBEXWGM916015];Lehman,
GREGUniversity:STARTAnalysts&AssociatesDeepDiveTrainingPresentation(Sept.2007),atp.50
[LBHI_SEC_07940_ICP_007982].Inaddition,Lehmanwouldsellwholeloanstoinstitutionalinvestors.
741Lehman, GREG Update (Aug. 7, 2008), at p. 2 [LBHI_SEC_07940_ICP_003590]; see also E&Y

Workpaper, Lehman Brothers Holdings Inc. 6 Month Period Ending May 31, 2008, Mortgage Capital
Team:PrincipalTransactionsP&LReview,atp.3[EYSECLBHIMCGAMX08138373](Commercials
are primarily composed of conduit and large loans with a principal exit strategy, historically of sale,
namelysecuritization.)
742Lehman, Global Real Estate Product Control Real Estate Americas Price Verification Presentation

[Draft] (Feb. 2008), at p. 4 [LBEXWGM 916018] (describing PTG assets as High Leveraged debt and
equityinvestmentsincommercialrealestateproperties).

217

was to monetize a PTG investment in connection with a sale of the underlying real

estateassetaftersuchdevelopmentorimprovementwascompleted.743

Lehman would provide bridge equity, together with debt financing, to a real

estate company in connection with its acquisition of particular properties, or to the

acquirerofarealestatecompanythroughaleveragedbuyout. 744Lehmanintendedto

sell bridge equity positions it originated over the shortterm to mediumterm to

institutionalinvestors.

As of May 31, 2008, GREG valued its global CRE portfolio at $49.3 billion,745

which consisted of $28.0 billion in the U.S., $12.5 billion in Europe and $8.9 billion in

Asia.746Asofthatdate,GREGvalueditsU.S.CREpositionsasfollows:Commercial

743WyattdeSilva,E&Y,MemorandumtoFiles:LehmanCommercialRealEstateFAS157Adoption(Jan.

28, 2008), at p. 5 [EYLELBHIKEYPERS 2025665] (Lehmans exit strategy for PTG Investments is
throughsaleoftheunderlyingassetorrefinanceofthedebt/equitypositions.);ExaminersInterviewof
AristidesKoutouvides,Nov.20,2009,atpp.78.
744Lehman, GREG University: START Analysts & Associates Deep Dive Training Presentation (Sept.

2007),atp.85[LBHI_SEC_07940_ICP_007982];Lehman,GREGApprovalPoliciesandProceduresManual
(May 2008 ed.), at 1 [LBEXOTS 000245]. See Section I.B.2.c, which discusses Lehmans strategy with
respecttobridgeequityinvestments.
745These amounts refer to Lehmans balance sheet at risk and do not include the value of certain real

estate assets held by entities (such as votinginterest entities and variableinterest entities) in which
Lehmanmadedebtandequityinvestments.LBHI10Q(filedJuly10,2008)atp.26([Lehman]considers
itself to have economic exposure only to its direct investments to these entities; the Company does not
haveeconomicexposuretothetotalunderlyingassetsintheseentities.)TheExaminerdidnotperform
aforensicreviewofLehmansaccountingrecords.LehmanreporteditsvaluationsaccordingtoGAAP
asset class (e.g., Real Estate Held for Sale) but managed its business according to business unit. The
ExamineruseddatacreatedbyLehmanintheordinarycourseinconnectionwiththisvaluationanalysis.
746Lehman, Global Real Estate Inventory Spreadsheet as of May 31, 2008 (Aug. 8, 2008) [LBEXDOCID

2077095]. The Examiners financial advisor has determined that the amounts in this spreadsheet for
Commercial Mortgages ($29.4 billion) and Real Estate Held for Sale ($10.4 billion) GAAP asset classes
reconcilewithLehmansfinancialdisclosuresinitsSECfilingforthesecondquarterof2008.LBHI10Q
(filedJuly10, 2008)at p.71. Although the Examiner haslimitedthe investigation into Lehmans CRE

218

$15.1 billion; PTG $8.5 billion; and Bridge Equity $3.1 billion.747 For assets that

weresubjecttoSFAS157,748substantiallyalloftheCommercialpositionswereclassified

asLevel2,whilethePTGandBridgeEquitypositionsweregenerallyclassifiedasLevel

3.749

As of August 31, 2008, GREG valued its global CRE portfolio at $41.3 billion,

which consisted of $23.4 billion in the United States, $10.1 billion in Europe and $7.8

billion in Asia.750 As of that date, GREG valued its U.S. CRE positions as follows:

Commercial $11.9 billion; PTG $7.8 billion; and Bridge Equity $2.8 billion.751

ForassetsthatweresubjecttoSFAS157,substantiallyalloftheCommercialpositions

portfoliototheU.S.positions,someportionsoftheReportwill,attimes,refertoGREGsglobalholdings
inordertoprovidecontext.
747Lehman, Global Real Estate Inventory Spreadsheet as of May 31, 2008 (Aug. 8, 2008) [LBEXDOCID

2077095]. GREGs assets in the U.S. also included $0.8 billion that was classified as Other. For
purposesofanalysisandpresentation,thisReportalsoreclassifies$0.4billionofSunCalpositionsfrom
PTGintotheOthercategory.
748Real Estate Held for Sale was reported at the lower of its cost basis and fair value, so therefore the

valuationanalysisisthesamefortheseassetsandFAS157forthepurposesofthisReport.
749Id.GREGreportedthefollowingamountsasofMay31,2008:Level1$57million;Level2$26.1

billion;Level3$12.8billion;RealEstateHeldforSale$10.4billion.
750Lehman,GlobalRealEstateInventorySpreadsheetasofAug.31,2008[LBEXDOCID1025119].Thee

Examiners financial advisor has determined that the combined amount in this spreadsheet for the
Commercial Mortgages and Real Estate Held for Sale asset classes ($32.6 billion) reconciles with
LehmansfinancialdisclosuresforthethirdquarterinitsSeptember10,2008pressrelease.Lehman,Press
Release: Lehman Brothers Announces Preliminary Third Quarter Results and Strategic Restructuring
(Sept.10,2008)[LBHI_SEC07940_028677].SimilartotheMay31,2008amounts,theseamountsreferto
Lehmansbalancesheetatriskanddonotincludethevalueoftheunderlyingassetsheldbyentitiesin
which Lehman had an investment interest because Lehman did not have direct economic exposure to
suchunderlyingassets.
751Id.GREGreportedthefollowingamounts:Level1$15million;Level2$20.1billion;Level3$12.5

billion;andRealEstateHeldforSale$8.7billion.GREGsassetsintheU.S.included$0.6billionthat
wasclassifiedasOther.TheExamineralsoreclassified$0.4billionofSunCalpositionsfromPTGinto
theOthercategory.

219

were classified as Level 2, while the PTG and Bridge Equity positions were generally

classifiedasLevel3.752

(b) OverviewofValuationofCREPortfolio

(i) GREGLeaders

Mark A. Walsh served as the Head of GREG and reported to the head of

LehmansFixedIncomeDivision(FID).753ServingunderWalshwereKennethCohen,

HeadofU.S.Originations,andPaulA.Hughson,HeadofCreditDistribution.754Walsh,

CohenandHughsonservedonGREGsGlobalCreditCommitteeandwereresponsible

forapprovingoriginationofCREdealsinthefirstinstance.755

(ii) ParticipantsintheValuationProcess

Aswithotherbusinessunits,theapplicableGREGbusinessunitwasresponsible

for valuing, or marking, its assets.756 The values assigned to assets are commonly

referred to as marks, and determining the value of the assets as marking the

752Id.

753ExaminersInterviewofMarkA.Walsh,Oct.21,2009,atp.4.MichaelGelbandservedasLehmans

HeadofFIDuntilMay2007,whenhewasreplacedbyRogerNagioff.Lehman,PressReleaseNaming
RogerB.NagioffGlobalHeadofFixedIncome(May2,2007)[LBEXDOCID1470086],attachedtoemail
from Monique Wise, Lehman, to Jasjit Bhattal, Lehman, et al. (May 1, 2007) [LBEXDOCID 1605828].
NagioffhimselfdepartedLehmaninJanuary2008.
754ExaminersInterviewofMarkA.Walsh,Oct.21,2009,atp.4.

755Lehman,GREGApprovalPoliciesandProceduresManual(June2006),atp.12[LBEXDOCID624251].

SeeSectionIII.A.1.b.2.b.viiiforinformationontheapprovalprocessfordealorigination.
756Theprocessformarkingbythebusinessdeskisdiscussedingreaterdetailinthesubsectionsdealing

withvaluationsofeachportfolioandtheArchstonepositions.

220

book.757ForthePTGpositions,assetmanagersvaluedthesepositionsbasedontheir

knowledge of the development of the underlying real estate asset.758 Anthony J.

Barsanti, Senior Vice President in PTG, and Aristides Koutouvides, Vice President in

PTG,werethetwoemployeesprimarilyresponsiblefordeterminingthemarksforthe

PTG assets during the period that is the subject of the Examiners review. Their

valuations were subject to review by Kenneth Cohen, Walsh and other members of

Lehmansseniormanagement.759

Commercialpositionswerevaluedbypersonnelwhomarkedthebookbasedon

their understanding of how debt was trading in the applicable market.760 Their

valuationsweresubjecttoreviewbyHughson,whoalsosupervisedthemarkingofthe

BridgeEquityassets.761

Agroupofproductcontrollerswasassignedtoconductpriceverificationforthe

CRE assets. This price verification, or price testing, process for each GREG business

unit is discussed in more detail in the applicable subsection addressing Lehmans

valuationofsuchassets.JonathanCohen,SeniorVicePresident,directlyoversawthis

757ExaminersInterviewofAbebualA.Kebede,Sept.29,2009,atp.5;ExaminersInterviewofKenneth

Cohen, Oct. 20, 2009, at p. 11; Examiners Interview of Kenneth Cohen, Jan. 21, 2010, at pp. 2, 4;
ExaminersInterviewofJonathanCohen,Jan.11,2010,atp.6.
758ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.11.

759Id.atpp.1011.

760ExaminersInterviewofPaulA.Hughson,Oct.28,2009,atp.10.

761Id.atp.10.

221

process.762 Abebual Kebede, Vice President, served under Jonathan Cohen, and was

responsible for price testing the Bridge Equity positions and supervised the three

product controllers who price tested the Commercial Book and the PTG positions.763

JenniferParkpricetestedCommercialBook,EliRabinpricetestedPTGequitypositions

andRebeccaPlattpricetestedthePTGdebtpositions.764

Asageneralmatter,theproductcontrollersperformedpricetestingonpositions

by inputting positionspecific information into spreadsheet models that produced an

outputvaluebasedoncalculationsandformulasselectedbyLehmanaspricetesting

tools.765Theproductcontrollersthencomparedthemodeloutputvaluetothebusiness

desk value to determine whether the difference between the two, referred to as the

variance, exceeded a certain threshold.766 The product controllers discussed variances

withtheappropriatebusinessdeskpersonwhoselectedthemarkinordertodetermine

762Lehman, Global Real Estate Product Control, Real Estate Americas Price Verification Presentation
[Draft](Feb.2008),atp.3[LBEXWGM916015].
763Id.;ExaminersInterviewofAbebualA.Kebede,Sept.29,2009,atp.5(KebedetoldtheExaminerthat

hisjobwastomakesurethemarksmadesense.)
764Lehman, Global Real Estate Product Control, Real Estate Americas Price Verification Presentation

[Draft](Feb.2008),atp.3[LBEXWGM916015].
765Id.atpp.610;ExaminersInterviewofAbebualA.Kebede,Sept.29,2009,atp.5.

766Lehman, Global Real Estate Product Control, Real Estate Americas Price Verification Presentation

[Draft](Feb.2008),atpp.610[LBEXWGM916015];ExaminersInterviewofAbebualA.Kebede,Sept.
29,2009,atp.6.

222

whether the business desk or valuation control value should be accepted for each

position.767

When disagreement persisted as to the variance, Product Control elevated the

issuetoKebede,andifKebedewasnotsatisfiedwiththebusinessdesksbasisforthe

marks, he would bring the dispute to Jonathan Cohens attention.768 Cohen could

further elevate the dispute up through the Product Control chain of command, to

ClementBernard,theCFOforFID,769toGerardReilly,theGlobalProductController770

andultimatelytoLehmansCFO.771TheinteractionbetweentheGREGbusinessdesks

andProductControlisdiscussedinthefollowingsubsection.

(c) ChangesintheCREPortfoliofrom2006through2008

In order to understand the difficulties Lehman encountered in valuing its CRE

positionsinthesecondandthirdquartersof2008,itisnecessarytofirstbrieflyreview

the material changes in the GREG portfolio and the real estate markets beginning in

767Lehman, Global Real Estate Product Control, Real Estate Americas Price Verification Presentation
[Draft](Feb.2008),atp.21[LBEXWGM916015];ExaminersInterviewofAbebualA.Kebede,Sept.29,
2009,atp.3.
768Examiners Interview of Abebual A. Kebede, Sept. 29, 2009, at pp. 68 (noting that prior to 2008, the

valuation control team, along with senior GREG employees, including Barsanti and Jonathan Cohen,
determinedthefinalmarksforCREassets).
769Lehman,CapitalMarketsandIBDFinanceOffsitePresentationonValuationandControlGroup(Jan.

16,2008),atp.12[LBEXWGM756817].
770ExaminersInterviewofKennethCohen,Oct.20,2009,atp.10.GerardReillypassedawayinaskiing

accidentonDecember29,2008;ChristopherM.OMeara,LehmansformerCFO,describedReillyasthe
person ultimately responsible for valuations of Level 2 and Level 3 assets. Examiners Interview of
ChristopherM.OMeara,Aug.14,2009,atp.26.
771Examiners Interview of Christopher M. OMeara, Aug. 14, 2009, at p. 26 (stating that the product

controllerswhotookresponsibilityforvaluationwereunderhisdirectionasCFO);ExaminersInterview
ofAbebualA.Kebede,Sept.29,2009atp.6.

223

2006. In 2006, Lehman decided to commit more of its balance sheet to historically

profitable businesses and to put more of Lehmans capital at risk in order to remain

competitive with other investment banks.772 That strategy included substantially

increasingitsCREinvestments.773Lehmanexecuteduponthisstrategy,reportingthat

theaggregatevalue ofits globalCREassetswas$55.2billionasofthe endof its 2007

fiscalyear,increasingfrom$28.9billionasoftheendofits2006fiscalyear.774

Over July and August 2007 Lehman personnel recognized that the market for

placinginvestmentsbackedbycommercialrealestatewasvirtuallyclosed775andthe

leveragedloansmarkethadshutdown.776Inlightoftheseevents,Lehmandecidedto

stoporiginatingnewloansintheleveragedloanandcommercialrealestatebusinesses

untiltheendofthethirdquarterof2007.777However,Lehmanhadalreadycommitted

to finance several large CRE deals that closed in October and November of 2007,

includingArchstone.

772ExaminersInterviewofKennethCohen,Oct.20,2009,atp.7.

773Id.;emailfromPaulA.Hughson,Lehman,toKentaroUmezaki,Lehman,etal.(May9,2006)[LBEX

DOCID1776281](requestingameetingwithUmezakitodiscussGlobalRealEstateRiskAppetiteand
howthenewlimitscoincidewithourplantoexpandourbusinessinAsia,Europeandourbridgeequity
globally).
774Lehman, Presentation to Moodys Investors Service, Commercial Real Estate (Feb. 13, 2008), at p. 5

[LBHI_SEC_07940_ICP_008206].
775Email from William J. Hughes, Lehman, to Alex Kirk, Lehman, et al. (July 27, 2007) [LBEXDOCID

174304].
776Email from Alex Kirk, Lehman, to Roger Nagioff, Lehman (Aug. 6, 2007) [LBEXDOCID 173492];

ExaminersInterviewofRogerNagioff,Sept.30,2009,atp.9.
777ExaminersInterviewofRogerNagioff,Sept.30,2009,atp.9.

224

As 2007 progressed, Lehman increased its focus on the size of its balance sheet

and its leverage.778 On November 3, 2007, Walsh emailed Roger Nagioff, Lehmans

Global Head of Fixed Income, regarding his plans to reduce the balance sheet at a

steady rate, with a target of a $45 billion GREG balance sheet on a global basis.779

GREGsNovember6,2007presentationtotheExecutiveCommitteestatedthatunder

any circumstance an estimated $15 billion reduction in global balance sheet is

warranted,andrecommendedreducingtheglobalGREGbalancesheetto$43.7billion

byMarch31,2008.780

Despitethisemphasisondeleveragingand thestatedplantoreducetheGREG

balance sheet by $15 billion, GREGs balance sheet of $55.0 billion at the end of

February 2008 was only $200 million less than the GREG balance sheet at the end of

November 2007.781 In the first quarter of 2008, Lehmans plan to reduce its balance

778See Section III.A.4.f on Repo 105/108. With respect to reducing the size of the GREG balance sheet,

Hughson told the Examiner that he and Walsh recognized the need for such reduction in May 2007.
ExaminersInterviewofPaulA.Hughson,Oct.28,2009,atpp.45;seealsoemailfromPaulA.Hughson,
Lehman,toThomasPearson,Lehman,etal.(May23,2006)[LBEXDOCID1776282].Walshpointedtothe
fallof2007aswhenheknewbalancesheetreductionwasanecessarystep.ExaminersInterviewofMark
A.Walsh,Oct.21,2009,atp.10.InSeptember2007,KentaroUmezaki,HeadofFixedIncomeStrategy,
told Hughson that a flat growth policy was being considered for GREG. See email from Kentaro
Umezaki,Lehman,toPaulA.Hughson,Lehman,etal.(Sept.24,2007)[LBEXDOCID1809381].
779Walsh broke down the target GREG balance sheet as follows: $25 billion in the United States, $10

billioninEuropeand$10billioninAsia.EmailfromMarkA.Walsh,Lehman,toRogerNagioff,Lehman
(Nov.3,2007)[LBEXDOCID175741].
780Lehman,GREGGlobalRealEstateUpdatePresentation(Nov.6,2007),atp.1[LBEXDOCID2072935];

emailfromAbebualA.Kebede,Lehman,toJonathanCohen,Lehman,etal.(Nov.4,2007)[LBEXDOCID
523669].
781Lehman,GREGUpdate(June5,2008),atp.1[LBEXDOCID1417258].

225

sheetresultedinthesaleoflessthan$400millionofCREassets.782Accordingtoformer

Lehman CFO Erin Callan, Lehman did not set balance sheet reduction targets for

businessesuntilafterBearStearnssnearcollapseinMarch2008.783

During the second quarter of 2008, Lehman publicly disclosed that it sold

approximately$8billionofCREpositions.784Despitethesecondquartersales,manyof

the largest CRE positions originated in 2007 were not sold or securitized, such that

many of these transactions remained among the 10 largest exposures on GREGs

balancesheetasofMay31,2008.785LehmanreportedthatitsglobalCREpositionsasof

782Lehman,GREGSecondQuarter2008SalesSpreadsheet(May29,2008)[LBEXDOCID4352112].The

spreadsheet shows the GREG positions that were sold since November 30, 2007. According to the
spreadsheet, during the first quarter of 2008, 13 positions were sold in the United States for $350.5
million,nopositionsweresoldinEuropeandonepositionwassoldinAsiafor$33.1million.
783ExaminersInterviewofErinM.Callan,Oct.23,2009,atpp.1112.

784TranscriptofLehmanBrothersHoldingsInc.SecondQuarter2008EarningsCall(June16,2008),atp.

12.LehmanalsoreportedtoitsAuditCommitteethatitsoldapproximately$8billionofCREpositions
duringthesecondquarterof2008.Lehman,PresentationtotheAuditCommittee:ValuationReview
2nd Quarter 2008 (July 2008), at pp. 2123 [LBHI_SEC07940_2969525]. However, for purposes of
benchmarkingitssalesduringthequartertothevaluationofitsremainingCREpositions,Lehmantold
E&Ythatitsold$5.2billionofCREassetsduringthesecondquarterof2008.E&YWorkpaper,Global
Real Estate Q208 Sales Activity, Q2.J1 GREG Sales 2nd Qtr 08 Lead.xls, at p. 30 [EYSECLBHIMC
GAMX08138412]. The Examiners financial advisor has observed that the difference in these numbers
reflectsadifferentmethodologyforcalculatingsalesforthepurposesofbenchmarkingtheremaining
positions,andthelowernumberreflectstheexclusionofapproximately$1billionofsalesinEuropethat
were sellerfinanced without recourse, over $600 million of loan payments that were characterized as
sales to the Audit Committee and over $250 million from the sale of two U.S. PTG positions that were
deemed outside the scope of the benchmarking analysis due to the unique nature of the investments.
Therewere$3.8billionofCommercialsalesintheUnitedStatesduringthesecondquarterof2008that
Lehmandeemedtoberelevantforpurposesofbenchmarkingtothevaluationofitsremainingpositions;
there were no suchsales for PTG or BridgeEquitypositions. See Lehman, GREG SecondQuarter 2008
Sales Spreadsheet (May 29, 2008) [LBEXDOCID 1139324]; Lehman, GREG Second Quarter and Third
Quarter2008SalesSpreadsheet(Aug.19,2008)[LBEXDOCID4323975].
785Ronald S. Marcus, Office of Thrift Supervision, Report of Examination (July 7, 2008), at p. 6 [LBEX

OTS000004].

226

that date had a value of approximately $50 billion.786 After accounting for total net

writedowns, the Commercial Book was valued at $15.1 billion, the PTG positions at

$8.5billionandtheBridgeEquitypositionsat$3.1billion.787

(d) PerfectStormImpactonCREValuationin2008

Theeconomiccrisisinthe2007and2008wasreferredtoasaperfectstormin

severalLehmanpresentations.788Asthedecliningmarketpersistedinthefourthquarter

of2007,LehmanconsideredtakingwritedownsonitsCREpositions.OnOctober28,

2007,WalshemailedNagiofftolethimknowthatthelastfewdaysinthemarkethave

beenuglyandcmbsisdownbig.789Asaresult,WalshreportedGREGwillbepassing

thru a significant write down on monday, and anticipated more writedowns to

come.790

786LBHI10Q(filedJuly10,2008),atp.70.TheamountofCREoftendependsonthedefinitionusedby

Lehman. Lehmans 10Q for the second quarter of 2008 listed its CRE holdings at $40 billion, but that
amountexcludedcertainrealestaterelatedcorporatedebtorcorporateequitypositions.The$50billion
totalincludesthosepositions,whichweredeterminedbytheExaminersfinancialadvisorpursuanttoa
review of Lehmans product control share drive. Unless noted otherwise, these figures represent
Lehmansnumbersasbalancesheetatrisk.Balancesheetatriskistheportionofanasset,adjustedto
marketvalue(whichtakesintoaccountthewritedowns),thatLehmanconsideredasrepresentativeofits
economicexposure.Thebalancesheetatriskisthebestindicatorforthesepurposesbecauseitlooksat
Lehmanstrueexposuretoanassetasitdoesnotincludeanythirdpartyportionthatisconsolidatedfor
accountingpurposes.
787Lehman, Global Real Estate Inventory Spreadsheet as of May 31, 2008 (Aug. 8, 2008) [LBEXDOCID

2077095]. GREGs assets in the U.S. also included $0.8 billion that was classified as Other. The
Examineralsoreclassified$0.4billionofSunCalpositionsfromPTGintotheOthercategory.
788See Lehman, GREG 2009 Strategy Executive Update Draft Presentation (June 20, 2008), at p. 1

[LBHI_SEC07940_124425]; Lehman, Global Commercial Real Estate Presentation (Aug. 6, 2008), at p. 4


[LBHI_SEC07940_302586].
789EmailfromMarkA.Walsh,Lehman,toRogerNagioff,Lehman,etal.(Oct.27,2008)[LBEXDOCID

175724].
790Id.Also,onNovember6,2007,GREGproducedforinternalcirculationaGlobalRealEstateUpdate

statingthatLehmansglobalCREassetsweremaintainingstrongprofitabilitybasedonitsconservative

227

Overthecourseof2008,LehmanwrotedownitsCREpositionsbymorethan$3

billion:

NetWritedownsbyBusinessUnit791

Q1 Q2 Q3 Total

PTG 271 302 504 1,077

BridgeEquity 72 349 265 686

Commercial 293 195 306 794

SunCal792 156 178 212 546

Total 792 1,025 1,286 3,103

The January 2008 GREG Product Control report on Global Real Estate

Markdownsprovidesausefulsummaryofthemarketconditionsatthetimeandtheir

policies and the cushion of imbedded profitability. Lehman, GREG Global Real Estate Update
Presentation (Nov.6, 2007), at p. 1 [LBEXDOCID 2072935]. The update continued: Notwithstanding
strong real estate fundamentals, transactions have slowed to a trickle due to uncertainty around
financing, valuation (stalemate), and weakening of economic forecasts. Id. The update stated that
LehmanwouldmakenetwritedownsofitsU.S.CREassetsintheamountof$825millionforfiscalyear
2007.Id.
791Lehman,GlobalRealEstate2008NetMarkDowns(Sept.5,2008)[LBEXAM346991].

792SunCal consisted of approximately 25 positions inCalifornia real estate that straddled both the PTG

andCommercialportfolios.TheExaminersfinancialadvisorhasobservedthatthefilescontainingthe
writedowns reported one number for SunCal and did not allocate it between PTG and Commercial.
Therefore,theExaminerhaspresentedSunCalseparatelyanddidnotattempttoallocatethetotalSunCal
writedownintoitsPTGandCommercialcomponents.Further,giventhatSunCalwascomprisedofas
manyas25properties(dependingonthedate),theExaminerdeterminedthatitwasnotaprudentuseof
resourcestoinvestigatethevaluationofeachSunCalposition.

228

impactonthevalueoftheCREportfolio.793Thisreportsexecutivesummarystatedin

fullasfollows:

The capital markets meltdown continued into the first quarter.


CMBS spreads have widened to alltime highs and investors have
beenstayingonthesidelines.

CMBS delinquencies are still at historic lows, but real estate is


usuallyalaggingindicator.

Many of our bank loans and PTG positions are directly related to
theresidentialhousingsector,whichisextremelytroubled.

In general, the collateral performance of our whole loan positions


has not been an issue, but the spread widening at all the debt
trancheshaveledtolowervalues.

Theinabilitytohedgeourfloatingratebookandthemezzclasses
ofourfixedrateloanshascontinuedtoresultinlosses.

The mark downs effected in January are the best estimates by the
businessandproductcontrolatthistime.

Aspartofitsongoingmethodology,theGlobalRealEstateGroup
(GREG)performedavaluationreviewoftheirentireportfolio.The
review took into consideration the continuing widening of credit
spreads,continuedsluggishnessintheresidentialmarket,andlack
ofliquidityinthemarketplace.

The Real Estate Product Control group has reviewed the mark
adjustmentsandagreeswiththeseadjustments.

The review resulted in a total markdown of $665 mn (approx.


$505mnintheUS,and$160mninEurope.

ForCMBSpositionsandloansoriginatedwiththeintentionthattheywouldbe

transformed into CMBS, the January 2008 report further stated that [w]ritedowns

793Lehman,GlobalRealEstateProductControl,GlobalRealEstateMarkdownsPresentation(Jan.2008),

atpp.12[LBEXWGM771226].

229

weretriggeredbyspreadwideningandlackofliquidity.794Forbothfloatingrateand

fixedrate loans, the [o]riginal exit plan was through syndication to institutional

investorsandthe[s]yndicationmarketissufferingfromlackofliquidityinpartdue

to marketwide inability to create liquidity through securitization of loans for sale as

CMBS positions.795 The value of PTG investments, which were primarily related to

land or condominium development/conversion, were affected by the softness of the

residential market thereby extending the absorption period and reducing sales

prices.796 With respect to Bridge Equity, the report explains that the [w]idening of

creditspreadseatsintotheequityyield,makingsyndicationatpardifficult.797

In February 2008, the Product Control Group observed that the [f]loating rate

securitization market is inactive; no deal in the market since Dec07.798 As a result,

794Id.atp.4.ThespreaddatareferencedinthisJanuary2008reportisCMBSspreaddatacontainedin

publicationssuchasCommercialMortgageAlert.Aswithspreadsproducedforothertypesofassets,the
CMBSspreadstypicallyshowthedifferencebetweentheCMBSyield(orreturnonaCMBSinvestment
divided by each month of ownership) and the yield of some benchmark asset (which is typically U.S.
treasuries)assumingthesamematuritydateforeach.Spreadsareanindicatorofanassetsrisk,asthey
showthepremium(ordiscount)aninvestorrequiresaboveandbeyondtheriskfreebenchmarkasset.
To form CMBS bonds, commercial loans are pooled and carved up into different risk baskets, or
tranches.TheCMBSspreadtrackstheyielddifferenceforinvestmentsineachtranche.Thelowerend
of the CMBS spread range features tranches containing the pooled loans with the highest risk (i.e.,
subprime loans) and the higher end of the spread range features tranches with the best credit risk or
lowestrisk(i.e.,conventionalloanstoborrowerswithgoodcredit).Awidercreditspreadindicatesthat
thelowerratedportionsofthepooledloanswillresultinloweryields,andasaresult,themarketplace
imposesahigherdiscounttothelowerratedtrancheinanyattemptedsale.Inotherwords,awidecredit
spreadindicatesthatinvestorswilleitherdemandahigherrateofreturnorareductioninpurchaseprice.
795Id.atpp.68.

796Id.atp.9.

797Id.atp.5.

798Lehman, Valuation & Control Report Fixed Income Division (Feb. 2008), at p. 27 [LBEXWGM

002238];ExaminersInterviewofAbebualA.Kebede,Oct.6,2009;FrankS.Aldridge,E&YWalkthrough

230

Lehmans ability to verify the prices for floating rate loans had become extremely

challenging.799 As the market for new issuances of CMBS deteriorated and then

eventually shut down (a trend documented in contemporaneous industry

publications),800 Lehman lost the ability to execute its traditional exit strategy for a

substantialpartofitsCommercialBook.Furthermore,Lehmanrecognizedthatthelack

ofsecuritizationsmadepricetestingparticularlydifficult.801

TemplateforConduit,LargeLoan,andCMBXPriceVerificationProcess(Nov.30,2008),atp.9[EYLE
LBHIMCGAMX08063735] (citing to E&Y Workpaper B32.4); E&Y Workpaper, B32.4 First Quarter
Management Valuation & Control Report No. 137 (Nov. 30, 2008) [EYLELBHIMCGAMX08063053]
(containing Lehmans Feb. 2008 Pricing Report with E&Ys note that it deems management review of
pricingreasonable).
799Lehman, Valuation & Control Report Fixed Income Division (Feb. 2008), at p. 27 [LBEXWGM

002260].
800Prudential Real Estate Investors, U.S. Quarterly, Oct. 2007, at p. 1, available at
http://www.irei.com/web/do/pub/research/view(Thecreditmarkettroublesthatbeganwiththecollapse
ofthesubprimemortgagemarketinFebruarycaughtupwithcommercialrealestateinthethirdquarter,
upsettingthedebtmarketsandslowingtransactionactivity.)ThequarterlyissuanceofU.S.CMBSfell
from approximate aggregate amounts of $75.83 billion in secondquarter2007, to $59.94 billion in third
quarter 2007, $33.27 billion in fourth quarter 2007, $5.90 billion in first quarter 2008, $6.24 billion in
secondquarter2008,andfinallytozerothroughouttheremainderofthe2008fiscalyear.SeeCommercial
Mortgage Alert, Summary of CMBS Issuance, Sept. 30, 2009, available at http://www.
cmalert.com/ranks.php;CommercialMortgageAlert,SummaryofCMBSIssuance,June30,2009,available
at http://www.cmalert.com/ranks.php; Commercial Mortgage Alert, Summary of CMBS Issuance, Mar.
31,2009,availableathttp://www.cmalert.com/ranks.php;CommercialMortgageAlert,SummaryofCMBS
andRealEstateCDOIssuance,Dec.31,2008,availableathttp://www.cmalert.com/ranks.php.
801TheFebruary2008Valuation&ControlReportalsostates,withrespecttotheCommercialBook,that

[s]preadspublishedinthirdpartypublicationsarestale.Lehman,Valuation&ControlReportFixed
IncomeDivision(Feb.2008),atp.27[LBEXWGM002260].Thismeantthatthereportedspreadsdidnot
reflecttherapiddeteriorationinthemarketandwereofquestionablevalueforcalculatingthediscount
rateusedtovalueCommercialpositions.CMBSyieldsobtaineddirectlyfromBloomberg.comshowthat
CMBSAAAJunioryieldsincreasedfrom6.8%onNovember30,2007to9.6%onFebruary29,2008.Over
thesameperiod,CMBSAAAMezzyieldsincreasedfrom6.3%to8.0%,CMBSAAyieldsincreasedfrom
7.2%to10.6%,CMBSAyieldsincreasedfrom8.3%to12.6%andCMBSBBByieldsincreasedfrom11.1%
to17.1%.Themovementinyieldsduringthefourthquarter2007andfirstquarter2008causedLehman
tobeconcernedthatthelagtimeforreportingmarketdatainthirdpartypublicationswouldundermine
Lehmansabilitytopricetestthemarks.ExaminersInterviewofAbebualA.Kebede,Oct.6,2009,atpp.
23,78.ThelackofsalesdatainthemarketplacealsomadeitdifficultforLehmantodeterminethefair
marketvalueofitsCREassets.Id.Tocompensateforthelackofsuchdata,theFebruary2008Valuation

231

Lehman noted the effects of the perfect storm on its CRE business in a

presentationtotheBoardofDirectorsonAugust6,2008(appearinginearlieriterations

throughout the summer),802 which detailed an [u]nprecedented [credit] spread

wideningacrossthecapitalstructure[that][d]ramaticallyreducedCMBSvolumessince

securitizationmarketsareshut,causinga[d]ichotomybetweenEquitybuyersfocused

on fundamentals and Credit buyers impacted by spread contagion.803 The spread

widening caused Lehman to hold [CRE] positions originally originated for

securitization/syndication, meaning that assets that had been liquid were now

illiquid.804

(2) OutsideReviewofLehmansCREValuationProcess

InreviewingthereasonablenessofLehmansvaluationofitsCREportfolio,the

Examiner has taken into consideration the separate reviews of Lehmans valuation

processthatwereundertakenbytheSECandErnst&Youngin2008.

&ControlReportstatedthat[p]roductcontrolishavingcontinuousdiscussionswithFrontOfficegoing
throughdealsinmoredetailandtryingtoobtainmarketcolorusingrecentsyndications,bids,offersand
any other market information. Lehman, Valuation & Control Report Fixed Income Division (Feb.
2008),atp.27[LBEXWGM002260].
802Lehman, GREG 2009 Strategy Executive Update Draft Presentation [Draft] (June 20, 2008), at p. 1

[LBHI_SEC07940_124424]
803Lehman,GlobalCommercialRealEstatePresentation(Aug.6,2008),atp.4[LBHI_SEC07940_302580]

(emphasis in original). CMBS AAA Junior spreads widened from 4.15% on May 30, 2008, to 6.95% on
August29,2008.Overthesameperiod,CMBSAAAMezzspreadswidenedfrom2.95%to4.60%,CMBS
AAspreadswidenedfrom5.65%to9.20%,CMBSAspreadswidenedfrom7.15%to13.70%andCMBS
BBBspreadswidenedfrom14.65%to21.70%.TheExaminersfinancialadvisorcompiledthisdatafrom
Bloomberg.
804Lehman,GlobalCommercialRealEstatePresentation(Aug.6,2008),atp.4[LBHI_SEC07940_302580].

232

(a) SEC

InFebruary2008theSECcommencedaspecialprojecttoreviewtheCSEsprice

verificationprocessesfortheirCREportfolios.805Lehmancooperatedwiththisprocess,

as did the four other CSE firms.806 The SEC did not produce a formal report for this

project and declined to provide the Examiner any formal conclusions produced in

connection with this project.807 However, the SEC provided the Examiner with its

informalanalysisandcommentsduringaninterview.808

TheSECsinspectionincludedareviewofthematerialsLehmanusedinitsprice

verificationprocess,andwasinitiallyfocusedonthemarksreportedasofJanuary31,

2008, and then as of February 29, 2008.809 The SEC began meeting with Lehman in

805MemorandumfromRaymondDoherty,SEC,etal.,toErikSirri,SEC,etal.,re:ScopeMemorandumfor

the Consolidated Supervised Entity (CSE) Commercial Real Estate (CRE) Price Verification
Inspections (Feb. 27, 2008), at p. 1 [LBEXWGM 001752]. An email widely circulated within Lehman
statedthat[t]heintentoftheinspectionsprogram...isfortheSECtoconductmeaningfulandfocused
inspections of the five CSE firms. Email from Laura Vecchio, Lehman, to Christopher M. OMeara,
Lehman,etal.(Jan.22,2008)[LBHI_SEC07940_068584].TheSECslettertoLehmandescribingthescope
ofthereviewstatedthatitwould:
[F]ocuson(1)gainingageneralunderstandingoftheCREproductsheldininventoryby[Lehman],
including the related hedging strategies, (2) reviewing the price verification policies and procedures to
determine if appropriate valuation controls have been designed, and (3) testing the price verification
process to ensure that the controls are operating as intended. Ultimately, the staff will compare and
contrastthevariousCRErelatedpriceverificationpoliciesandproceduresacrossthefiveCSEs.
MemorandumfromRaymondDoherty,SEC,etal.,toErikSirri,SEC,etal.,re:ScopeMemorandum
for the Consolidated Supervised Entity (CSE) Commercial Real Estate (CRE) Price Verification
Inspections(Feb.27,2008),atp.1[LBEXWGM001752]
806ExaminersInterviewofSECstaff,Aug.24,2009,atpp.34,1314.

807Id.atp.14(notingthattheSECneverreleaseditsfindingsformally).TheSECexpresseditsconcerns

informallythroughoutitsinspectionbutnoformalpresentationwasmade.
808Id.atpassim.

809Id.;LetterfromRaymondDoherty,SEC,toLauraVecchio,Lehman,re:CommercialRealEstatePrice

Verification Inspection Initial Document Request (Feb. 27, 2008), at p. 1 [LBEXWGM 001754]; email
from Thomas ODougherty, SEC, to Abebual A. Kebede, Lehman, et al. (Apr. 11, 2008)

233

February 2008 and continued these meetings throughout the spring and summer.810

Duringthefirstmeetings,theSECconductedageneralreviewoftheCREbusiness,and

the related audit and product control functions.811 Lehman addressed various topics,

including an overview of the CMBS business,812 an overview of the real estate risk

review process,813 real estate product control process,814 and the fixed income product

control process. As the inspection continued, the SEC focused on Lehmans price

verification procedures,815 price verification models816 and the valuation of particular

positions.817

[LBHI_SEC07940_2229003].TheSECheldaseriesofmeetingstoreviewinformationandaskquestions,
and the SEC typically requested materials in advance of and subsequent to a meeting. Letter from
Raymond Doherty, SEC, to Laura Vecchio, Lehman, re: Commercial Real Estate Price Verification
InspectionInitialDocumentRequest(Feb.27,2008),atpp.12[LBEXWGM001754](indicatingSECs
intenttoschedulemeetingsforaninternalauditworkpaperreview,towalkthroughthepriceverification
packageandtowalkthroughtheQuestGFSreconciliation);emailfromLauraM.Vecchio,Lehman,to
AbebualA.Kebede,Lehman,etal.(Feb.29,2008)[LBHI_SEC07940_5494331].
810In2008,theSECmetwithLehmanonFebruary78,March5,March31,May2122,June20,July3and

July16.
811Lehman, Feb. 8,2008Meeting AgendaforSECCSEInspections of Commercial Mortgage Valuations

(Jan. 29, 2008) [LBHI_SEC07940_113571], attached to email from Laura Vecchio, Lehman, to Kenneth
Cohen,Lehman,etal.(Jan.29,2008)[LBHI_SEC07940_113570].
812Lehman,AnOverviewoftheCMBSBusinessPresentationtotheSEC(Feb.8,2008),atpp.122[LBEX

WGM00057495].
813Lehman, Holistic Trading Book Migration Presentation to the SEC (Feb. 7, 2008), at pp. 132 [LBEX

DOCID3176398](addressingriskallowanceandmodelassumptions),attachedtoemailfromLauraM.
Vecchio,Lehman,toErinCallan,Lehman,etal.(Feb.8,2008)[LBEXDOCID3186259].
814Lehman, Global Real Estate Product Control, Real Estate Americas Price Verification Presentation

[Draft](Feb.2008),atpp.123[LBEXWGM91601537].
815Letter from Raymond Doherty, SEC, to Laura Vecchio, Lehman, re: Commercial Real Estate Price

Verification Inspection Initial Document Request (Feb. 27, 2008), at p. 1 [LBEXWGM 001754]; email
from Laura M. Vecchio, Lehman, to Jonathan S. Cohen, Lehman, et al. (Feb. 13, 2008)
[LBHI_SEC07940_972136] (noting that SEC has made its first followup request, asking for GREG price
verificationpoliciesandprocedures).
816EmailfromP.C.Venkatesh,SEC,toMicheleBourdeau,Lehman,etal.(Mar.19,2008)[LBEXDOCID

271655]; Letter from Raymond Doherty, SEC, to Laura Vecchio, Lehman, re: Commercial Real Estate

234

The SEC asked Lehman to provide detailed information regarding the price

verification process,includingdatarelatingtoLehmansuse ofathirdparty,TriMont

RealEstateAdvisors(TriMont),thethirdpartyservicerforPTGpositions.818TheSEC

soughtthisinformationinordertosampleCREpositionsfromallportionsofLehmans

CRE book.819 In particular, during May and June 2008 the SEC sought supporting

documentation confirming the status of $5 billion in sales of CRE positions.820 In late

Price Verification Inspection Initial Document Request (Feb. 27, 2008), at p. 1 [LBEXWGM 001754].
BaseduponthemodelinventoryLehmanprovidedit,theSECselectedasampleofmodelsdesignedto
get a broad crosssectioncore models/frameworks likely to be heavily used; models likely to have
somecomplexity,potentialsensitivitytomodelingassumptions,andsoon.
817Email from Laura M. Vecchio, Lehman, to Raymond Doherty, SEC, et al. (Feb. 21, 2008)

[LBHI_SEC07940_977936] (forwarding detailed inventory listing as of January 31, 2008 for CMBS, PTG,
andrelatedderivatives).
818Email from Thomas ODougherty, SEC, to Abebual A. Kebede, Lehman, et al. (Mar. 31, 2008)

[LBHI_SEC07940_2872557].TheSECrequestedalistofsecondquartersalesandcirclesfromwhichit
wouldselectasampleforwhichLehmanwouldbeaskedtosupplysupportingdocumentation.Email
from Thomas ODougherty, SEC, to Abebual A. Kebede, Lehman, et al. (May 27, 2008)
[LBHI_SEC07940_2906636] (requesting additional documentation based on a spreadsheet of post first
quarter sales and circles that Laura [Vecchio] provided to the SEC in the middle of April); email from
Thomas ODougherty, SEC, to Abebual A. Kebede, Lehman, et al. (June 18, 2008)
[LBHI_SEC07940_294973435] (same). Lehman provided the SEC with a document summarizing its
secondquarter2008totalselldownsasproofthatLehmanhadminimallossesonsalesandsupporting
the fact that Lehman sold assets at prices that equaled Lehmans marks. Lehman, Total Selldown
SummaryforQ208(June18,2008)[LBHI_SEC07940_1141406],attachedtoemailfromJeffreyGoodman,
Lehman,toPaulA.Hughson,Lehman,etal.(June18,2008)[LBHI_SEC07940_1141405].InaJune18,2008
emailforwarding the selldown summary to the SEC, Jeffrey Goodman, Senior Risk Manager of Fixed
IncomeRiskManagement,statedthat[w]ewouldsaythateverythingwesoldwasatthemarkshence
nogain/loss.EmailfromJeffreyGoodman,Lehman,toPaulA.Hughson,Lehman,etal.(June18,2008)
[LBHI_SEC07940_1141405]. The SEC apparently discussed the supporting documentation, which
includedsecuritiestradeconfirmations,commitmentdocumentation,andbidsforselectsecondquarter
sales, at a June 20, 2008 meeting with Kebede. Email from Thomas ODougherty, SEC, to Abebual A.
Kebede, Lehman, et al. (June 16, 2008) [LBHI_SEC07940_2946054]; email from Thomas ODougherty,
SEC,toAbebualA.Kebede,Lehman,etal.(May27,2008)[LBHI_SEC07940_2946054].
819Email from Thomas ODougherty, SEC, to Abebual A. Kebede, Lehman, et al. (May 14, 2008)

[LBHI_SEC07940_2889284].
820Id.

235

June,theSECrequestedtheArchstonepriceflexagreement,materialsrelatedtocertain

February2008marks,andfurthersupportforsecondquartersales.821

The SECs requests for material in July included questions about Lehmans

InternalRateofReturn(IRR)modelsandinformationoncreditspreads.822Followup

emailscontinueduntilearlyAugust.823TheSECwasunabletocompleteitsinspection

ofLehmanspricevaluationcontrolsbeforeLBHIsbankruptcyfiling.TheSECdidnot

provide Lehman with any formal feedback from the project or issue any formal

conclusionsrelatedtoLehman.824

The SEC did, however, identify strengths and weaknesses in Lehmans price

verificationproceduresfromtimetotimeduringtheinspection.TheSECbelievedthat

Lehmans price verification weaknesses were more pronounced than the other CSEs

because of the size of Lehmans balance sheet and the nature of its CRE business.825

Specifically,theSECrecognizedthatLehmansproductcontrolstaffwastoosmalltobe

821Email from Abebual A. Kebede, Lehman, to Thomas ODougherty, SEC, et al. (June 20, 2008)
[LBHI_SEC07940_7545309].
822Email from Thomas ODougherty, SEC, to Abebual A. Kebede, Lehman, et al. (July 7, 2008) [LBEX

DOCID697796](IreceivedtheIRRcalculationsandtheSunCalMay31stmarksfromLaura[Vecchio]on
Thursday[July3,2008].);emailfromLauraM.Vecchio,Lehman,toThomasODougherty,SEC,etal.
(July 21, 2008) [LBEXWGM 011921] (providing a response to SECs question regarding LehmanLive
spreads).
823Email from Laura M. Vecchio, Lehman, to Thomas ODougherty, SEC, et al. (Aug. 1, 2008) [LBEX

WGM011934].
824ExaminersInterviewofSECstaff,Aug.24,2009,atp.14(notingthattheSECwasunabletocomplete

CSE inspection of Lehmans price valuation controls or give Lehman formal feedback before Lehman
collapsed).
825Id.atpp.1314.

236

an effective independent check on the business desks valuations given the size and

numberofassetsintheCREportfolio.826

(b) Ernst&Young

Although E&Y audited Lehmans valuation of the CRE portfolio as part of the

2007audit,827E&Ysannual2008auditofLehmansvaluationoftheCREportfoliowas

only in its beginning stages when LBHI filed for bankruptcy.828 While E&Y had

performed quarterly reviews throughout 2008, these reviews consisted of inquiry,

observation, and analytical review and did not include substantive testing as to the

accuracy or reasonableness of Lehmans marks.829 When LBHI filed for bankruptcy,

826Id.

827E&Ys 2007 yearend audit included a comprehensive memo on CRE price testing, a memorandum

specificallyaboutPTGpositions,aspreadsheetanalyzingparticularvariancesbetweenthemarksbythe
businessdeskandvaluationcontrol,andareviewof25ofTriMontscollateralvaluations.SeeWyattde
Silva, E&Y, Memorandum to Files: Commercial Real Estate Testing Approach (Jan. 25, 2008) [EYLE
LBHIMCGAMX07 067631] (comprehensive memo); Memorandum from Nicholas McClay, E&Y, to
Files, re: U.S. PTG Analytics (Feb. 7, 2008) [EYLELBHIMCGAMX07 070778] (memorandum about
PTGpositions);E&Y,PTGYearEndSubstantiveAnalysis:ProductControlPriceVerificationVariances
(Nov.11,2007)[EYLELBHIMCGAMX0707451774)(spreadsheetanalyzingvariances);Memorandum
from Robert Martinek, E&Y, to E&Y Audit Team for Lehman Brothers, et al., re: Lehman Brothers
CommercialRealEstatePortfolio(Dec.17,2006)[EYLELBHIKEYPERS0675302](reviewof25TriMont
valuations).
828ExaminersInterviewofErnst&Young,Nov.11,2009,atpp.4,1314.Theauditprocesswas:(1)a

staff person or senior manager conducts detailed audit work; (2) the results from the audit work are
reviewed by an audit team, which formulates an initial opinion and (3) the audit work is reviewed an
additionaltwotofourtimes(theexactnumberofreviewsdependsontheriskoftheareabeingtested).
Generally,foraudittestingoftheCREportfolio,E&Ywoulddesigntesting,picktwomonthsofproduct
controlworkpaperstoreviewandconfirmthatproductcontrolwasperformingtheworkasdescribedin
thewalkthrough.E&Ywouldalsodesignatetwomonthstoretestselectpositions.Id.
829Id.atpp.34.E&Ys2008quarterlyreviewsofproductcontrolandthevaluationofLehmansCRE

portfoliofocusedonwhethertheprocess,asawhole,wasfunctioning.Id.atp.4.E&Yreviewedprice
testing files, examined variances between business desk prices and product controls prices, and
confirmed that variances deemed to be significant were resolved in accordance with Lehmans internal
procedures.Id.E&Ydidnotresolvethesevariances,butmerelyassureditselfthatdiscussionsregarding

237

some underlying testing of the CRE portfolio had begun, but no review of that work

had been performed and no initial opinions had been reached.830 Regarding CRE

specifically,E&Yhadnotyetselectedallofthepositionsitplannedtotest.831

E&Y performed walkthrough analyses as part of the annual audit process to

understand how Lehmans Product Control Group performed its independent price

verification functions.832 The purpose of the walkthroughs was to document the

significant classes of transactions, and [v]erify that [E&Y had] identified the

appropriate what could go wrongs (WCGWs) that have the potential to materially

affectrelevantfinancialstatementassertions.833Inaddition,E&Yidentifiedthedesign

and implementation of controls that Lehman had in place to internally regulate its

priceverificationprocess.834

AnE&YsWalkthroughTemplatememorandumreviewingthepriceverification

processforlargeloansandCMBSstatedthatallcomponentsoftheU.S.CREportfolio

metE&YscriteriabasedonpriceverificationdataselectedfromthemonthofFebruary

significantvarianceswereoccurringandthatproductcontrolwasultimatelycomfortablewiththefinal
mark.Id.
830ExaminersInterviewofErnst&Young,Nov.11,2009,atpp.1314.

831Id.

832Id.atp.3.

833E&Y,WalkthroughTemplate(Nov.30,2008),atpp.2,13[EYLELBHIMCGAMX08063735].The

Walkthrough Template memoranda contain three sections: the walkthrough description of the
valuation control process, an assessment of whether valuation control is segregated from other
incompatibleduties,suchasmanagement,andaconclusion.
834Id.

238

2008.835OtherdocumentsproducedbyE&Ypersonneloverthecourseof2008indicate

that E&Y did not find any material flaws with Lehmans price verification process.836

E&YpersonneltoldtheExaminerthattheconclusionsstatedinthesedocumentswere

preliminaryinnatureandtheproductofworkperformedbylowerlevelauditors,and

thereforewerenotreflectiveoftheopinionofE&Y.837

Given the prominence of Archstone and SunCal positions in 2008, E&Y had

already determined that it would be substantively testing both positions as part of its

2008 yearendaudit. E&Y separatelydocumentedits walkthroughs of thesepositions

aspartofitspreliminaryplanningforthe2008yearendaudittesting.838

An E&Y memorandum dated July 9, 2008 explained E&Ys quarterly review

valuation procedures for Archstone in the second quarter 2008.839 E&Y held multiple

835Id.atp.5.

836E&Y, Lehman Brothers Holdings Inc. Summary Review Memorandum, Consolidated Financial
StatementsQuarterendedMay31,2008(Aug.8,2008),atp.17[EYSECLBHIWP2Q08000117](Based
onourreviewofCompanysunauditedinterimconsolidatedfinancialstatementsasofandforthethree
andsixmonthperiodsendedMay31,2008,nothingcametoourattentionthatindicatesthatamaterial
modification should be made to the unaudited interim financial statements in order for them to be in
conformity with U.S. generally accepted accounting principles. Furthermore, we are not aware of any
materialmodificationthatinourjudgmentshouldbemadetothedisclosuresaboutchangesininternal
controloverfinancialreportinginorderformanagementcertificationtobeaccurateandtocomplywith
the requirements of Section 302 of the SarbanesOxley Act of 2002.); E&Y Workpaper, GREG Price
VerificationSummary,Q2J1J2J3PTGComlPricingSummary.xls,atp.1[EYSECLBHIMCGAMX
08138328](Basedontheresultsofourreview,wenotedthatsignificantpositionsappeartobevalued
withinProductControlsthresholdorwerereasonablycontemplatedandexplained.);E&YWorkpaper,
GlobalRealEstate Q208Sales Activity, Q2.J1 GREG Sales 2nd Qtr 08 Lead.xls,at p. 1 [EYSECLBHI
MCGAMX08138412](AppearsReasonable.)
837ExaminersInterviewofErnst&Young,Nov.11,2009,atp.6.

838Id.

839Memorandum from Nicholas McClay, E&Y, to Files, re: Quarterly Review Valuation Procedures for

Archstone&SunCalRealEstateInvestments(July9,2008),atp.12[EYSECLBHIDFMFIN000048].

239

meetingswithJonathanCohenandKebedetounderstandtheportfoliosofpositions,

the underlying variables and value drivers of each position, and the summary of the

methodology used to price each position in the portfolio.840 The memorandum

explains that E&Y obtained and reviewed the Archstone valuation model for

reasonableness and noted detailed data inputs and assumptions, specific calculation

scenarios,andpricesensitivitystresstestsofIRR,growthrates,caprates,development

value and timing, loan terms, and other assumptions designed to provide reasonable

ranges for position values.841 The memorandum states that, based on E&Ys

understanding of the Archstone position, Lehmans valuation assumptions and the

resultsofdiscussionswithLehmanmanagement,theprocessbywhichtheArchstone

positionsarevaluedaswellastherelatedinputs,assumptions,andcalculatedvalues

appear reasonable for the purpose of assessing reasonableness for our quarterly

review.842

Jerry Gruner, a senior manager on the E&Y Lehman audit team, told the

ExaminerthatE&YhadreceivedLehmansArchstonemodelbuthadnotreviewedthe

modeloritsinputsaspartofitsquarterlyreview.843Grunerexplainedthatheandother

E&YauditorshadscannedthroughtheArchstonemodeltoconfirmthatitlookedon

itssurfacetobeacomplexmodel....Therewerealotoftabsthatweflippedthrough

840Id.atp.1.

841Id.atp.2.

842Id.

843ExaminersInterviewofErnst&Young,Nov.11,2009,atp.9.

240

as part of a high level review.844 According to Gruner, E&Y intended to review the

modelandmarksingreaterdetailduringthe2008audit,whichneveroccurred.845

William Schlich, E&Ys lead audit partner, told the Examiner that E&Y was

aware that Lehman had not sold any Archstone bridge equity and that Lehman was

generally having difficulties selling Archstone bridge equity.846 Both Schlich and

Gruner stated that they never heard any concerns from product controllers that the

unsoldbridgeequitywasimproperlymarked.847

c) SeniorManagementsInvolvementinValuation

During the second and third quarters of 2008, Lehmans senior management

intensifieditsfocusonvaluationoftheGREGportfolio.848Therehadbeenhighprofile

publiccriticismthatLehmanhadnotproperlymarkeddownitsassetvaluesthatyear.849

844Id.

845Id.

846Id.atp.4.

847Id.atp.15.

848ExaminersInterviewofClementBernard,Oct.23,2009,atp.13;ExaminersInterviewofAbebualA.

Kebede,Sept.29,2009,atp.8;ExaminersInterviewofEliRabin,Oct.21,2009,atpp.1112;Examiners
InterviewofRebeccaPlatt,Nov.2,2009,atp.10.
849See Andrew Bary, ApartmentHouse Blues, Barrons, Jan. 21, 2008, available at http://online.

barrons.com/article/SB120070919702802265.html#articleTabs_panel_article%3D1 (noting that based on


currentREITprices,thevalueoftheArchstoneequitycouldbezero.);seealsoDavidEinhorn,Greenlight
Capital, Presentation to the Value Investing Congress, A Few Thoughts About Risk (Nov. 29, 2007)
[LBEX_DOCID 2490444]; Transcript of Speech by David Einhorn, Presentation to Grants Spring
Investment Conference, Private Profits and Socialized Risk (Apr. 8, 2008), at p. 9, available at
http://www.foolingsomepeople.com/main/mroom/Grants%20Conference%2004082008.pdf.

241

Ontheotherhand,certainseniorLehmanmanagerswereconcernedthatGREGmight

havebeenoverlyaggressiveintakingwritedowns.850

Beginning in 2008, Mark A. Walsh, Head of GREG, was required to submit

proposedmarkdownstoAndrewJ.Morton,GlobalHeadofCapitalMarketsFIDor

Alex Kirk, CoCOO for FID and later, Head of Global Principal Businesses, for

approval.851ItwasWalshsunderstandingthatMortonandKirkshowedtheproposed

marks to another person, who he assumed to be Joseph M. Gregory, Lehmans

President,priortoapprovingthem.852

Whilethefirmsseniormanagementhadlegitimatereasonstobeconcernedwith

the valuation process, the potential for undue management involvement in valuation

raisestwoseriousissues.First,thatinvolvementmighthaveresultedinunreasonable

valuationsthatmustbetakenintoaccountwhendeterminingthesolvencyofLBHIand

the LBHI Affiliates in the months prior to their bankruptcy cases. Second, if senior

management intentionally caused Lehman to report materially inaccurate valuations,

850Examiners Interview of Alex Kirk, Jan. 12, 2010, at p. 14. It might seem counterintuitive that a
businessunitwhoseperformancewasatleastpartiallytiedtothevaluationofitsinvestmentswouldbe
incented to mark down those assets more than necessary. But Kenneth Cohen told the Examiner that
GREGs senior managershad alreadybeen told that they would receive no bonusesin 2008 because of
significant GREG losses already incurred; they had no incentive, therefore, to artificially prop up the
valuesofGREGassetsin2008.ExaminersInterviewofKennethCohen,Oct.20,2009,atp.11.Kirkand
otherswereconcernedthatGREGmightbeincentedtomarkdownassetsmorethanindicatedin2008to
setthestagetoshowgreaterprofitsin2009whenbonusespresumablywouldbereinstated.Id.,atp.14.
851ExaminersInterviewofMarkA.Walsh,Oct.21,2009,atp.14.

852Id.Walshhadnounderstandingastowhetherthereviewwasactuallyforapprovalofthemarksor

simplytogivemanagementnotice.Id.Therewasnooccasionwhenhisproposedmarkswerechanged
byMorton,Kirk,Gregoryoranyoneelse.Id.

242

such an action might constitute a breach of the fiduciary duty of care owed by those

officers.853

TheExaminerfindsevidencethatcertainLehmanexecutivesperceivedpressure

fromaboveinthesecondquarterof2008toartificiallylimitwritedowns,butthereisno

evidence that any caps were in fact imposed or that improper marks were knowingly

taken.Inthethirdquarterof2008,thereissimilarevidencethatcertainexecutivesfelt

pressure, and there is also some evidence that the pressure actually resulted in

improper marks. But the evidence is in conflict, and because it relates to the third

quarter it is not possible to conclude that improper marks were actually taken

Lehman,ofcourse,hadceasedoperationsbeforefinalthirdquarterfinancialstatements

were prepared. The Examiner therefore finds insufficient evidence to support the

existence of a colorable claim that Lehmans senior management imposed arbitrary

limitsonwritedownsofassetsduringthatquarter.

(1) SeniorManagementsGeneralRoleWithRespecttoCRE
Valuation

Aswithotherassetclasses,marksforLehmansCREportfolioweredetermined

by its business desks, subject to price testing performed by the Product Control

853See
Appendix 1, Legal Issues, Section II, for a discussion of corporate officers fiduciary duties.
Lehman did not file a quarterly report for the third quarter of 2008 before the commencement of the
bankruptcycases.However,duringitsthirdquarterearningscall,Lehmandidreporttoitsinvestorsand
themarketthat[o]nanetbasis,commercialwritedownsforthequartertotaled$1.6billion.Transcript
ofLehmanBrothersHoldingsInc.ThirdQuarter2008EarningsCall(Sept.10,2008),atp.9.

243

Group.854 Historically,GREGhadfullcontrolof itsmarksandwould simply givethe

headoftheFIDnoticeofthemarks.855However,during2008,theprocesschangedand

requiredWalshtosubmitGREGsproposedmarkstoMortonforapproval.856Atsome

laterpoint,approvalresponsibilityshiftedtoAlexKirk.857

WalshunderstoodthatMortonandKirkshowedGREGmarkstosomeoneelse

before they approved them; Walsh assumed it was Joseph Gregory.858 Walsh was not

clearwhethertheseniorofficersreviewedthemarkstoactuallyapprovethemorsimply

tobeinformedbeforewritedownsweretaken.859Walshstatedthat,inanyevent,there

was no occasion on which a writedown GREG proposed to take was overruled or

modified.860Likewise,WalshtoldtheExaminerthattherewasneveratimewhensenior

854Examiners Interview ofKenneth Cohen, Oct. 20, 2009,at pp. 910; Examiners Interview of Mark A.

Walsh,Oct.21,2009,atp.13.
855ExaminersInterviewofMarkA.Walsh,Oct.21,2009,atp.14.

856Id.Walshwasunabletospecifytheexactdateonwhichthischangeoccurred;however,Mortonwas

appointedheadofFIDinFebruary2008,soitmusthavebeenafterthisdate.KennethCohen,headof
U.S.OriginationsforGREG,confirmedtheprocessbywhichvaluationswereapproved,notingthatafter
GREG came up with marks, Walsh would provide them to the head of FID and that GREG would be
givenpermissiontotakewritedownsorwriteups.ExaminersInterviewofKennethCohen,Oct.20,
2009,atpp.910.
857ExaminersInterviewofMarkA.Walsh,Oct.21,2009,atp.14.

858Id.

859Id.

860Id. at p. 14. While Walsh was clear that senior management never changed marks he deemed to be

appropriate,hedidnotethatmanagementplayedanactiveroleinresolvingdisputesbetweenLehmans
tradingdesksandtheProductControlGroupastopropervaluations.WalshtoldtheExaminerthatin
late2007and2008itbecamedifficultforhimtoresolvedisagreementsastoapositionsvalue,andWalsh
wasmoreinclinedtokickitupstairsforresolutionbyMcDade,KirkorLowitt.Id.

244

management predetermined the amount of writedowns that would be taken for a

quarterorlimitedtheamountofwritedownsGREGwaspermittedtotake.861

(2) SeniorManagementsInvolvementinValuationintheSecond
Quarterof2008

Duringthesecondquarterof2008,therewasgreaterscrutinyofLehmansU.S.

CRE marks after an Executive Committee meeting in early 2008 regarding CRE

valuationsduetocommunicationproblemsbetweenWalshandMorton.862Gregory

stated that Morton thought that the CRE marks were being written down without

anyoneinforminghim,andGregorysetupthismeetingtodiscusstheneedforclearer

andmoreconsistentcommunication.863

JonathanCohen,aSeniorVicePresidentandHeadoftheGREGProductControl

Group,recalledanincidentinthesecondquarterof2008thatmadehimuncomfortable

with the degree to which senior management was involved in the valuation process.

JonathanCohenproposedtoKennethCohen,HeadofU.S.OriginationsforGREG,that

certainpositionsforwhichKennethCohenwasresponsiblebewrittendown.864These

included one PTG position and two or three Commercial positions. Jonathan Cohen

861Id. Other members of Lehmans senior management confirmed that Lehman did not place limits on

writedownsorpredeterminemarksforGREGassets.ExaminersInterviewofChristopherM.OMeara,
Aug.14,2009,atp.26;ExaminersInterviewofErinM.Callan,Oct.23,2009,atpp.2122.
862Examiners Interview of Abebual A. Kebede, Sept. 29, 2009, at p. 8; Examiners Interview of Joseph

Gregory,Nov.13,2009,atp.9;ExaminersInterviewofJonathanCohen,Jan.11,2010,atp.6.
863ExaminersInterviewofJosephGregory,Nov.13,2009,atp.9.

864ExaminersInterviewofJonathanCohen,Jan.11,2010,atp.7.

245

recalledthatKennethCohenrepliedthatIcanttakeitrightnow.865ItwasJonathan

Cohens impression that Kenneth Cohen did not have the authority to take the write

down.866

Jonathan Cohen explained that he was surprised by Kenneth Cohens reaction

andthatheraisedtheissuewiththeCFOforFID,ClementBernard,whointurnwent

toMorton.867JonathanCohenwasuncomfortablethathewasforcedtogohighupthe

chain to get approval to take the writedown, but approval was eventually given.868

JonathanCohentoldtheExaminerthatintheend,allIcandoispricetestthefront

officeownsthemarkandallIcandoisstarttheconversation.869

A similar incident was related by Anthony Barsanti, the PTG Senior Vice

PresidentresponsibleformarkingthePTGpositions.870Barsantirecountedthatduring

the second quarter valuation process, he met with Kenneth Cohen to inform him of a

listofPTGassetshewantedtowritedown.871Barsantiwantedtotakewritedownson

three positions, but Kenneth Cohen told him that hewas only allowed to write down

positions to a certain dollar value, which would not allow Barsanti to take the three

865Id.

866Id.

867Id.

868Id.

869Id.

870ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atpp.3,11.

871Id., at p. 15. As noted above, PTG refers only to U.S. PTG, and PTG assets refers only to assets

heldormanagedbyU.S.PTG.

246

writedownsidentified.872Thenextday,KennethCohencalledBarsantiandstatedthat

hecouldtakethewritedownsonthethreepositions.873

Kenneth Cohen did not recall the events described by Jonathan Cohen or

BarsantiinhisinterviewwiththeExaminer.874

WhiletheincidentsdescribedbyJonathanCohenandBarsantiestablishthatthey

perceivedpressuretocapwritedowns,thereisnoevidencethatanycapswereactually

imposed; rather, the writedowns Jonathan Cohen and Barsanti determined should

have been taken were actually taken. The Examiner finds insufficient evidence to

support theexistenceofa colorableclaimthatseniormanagement involvementled to

unreasonablevaluationsinthesecondquarterof2008.

(3) SeniorManagementsInvolvementinValuationintheThird
Quarterof2008

Similarly,theExaminerfindsinsufficientevidencetosupporttheexistenceofa

colorableclaimthatLehmanpredeterminedanetlossforGREGinthethirdquarterof

2008.875

TheExaminerwasgiventhreesomewhatdifferentbutnotentirelyconflicting

accountsoftherolethatseniormanagementplayedinthevaluationprocessforthe

872Id.

873Id.

874Examiners Interview of Kenneth Cohen, Oct. 20, 2009, at p. 11; Examiners Interview of Kenneth
Cohen,Jan.21,2010,atpp.45.
875Because of Lehmans bankruptcy, Lehmans third quarter financial statements were never formally

finalized.ThetentativeGREGgrosswritedownforthequarterwas$1.732billionandthegrosswriteup
was$0.147billion,foranetwritedownof$1.585billion.SeeLehman,GlobalRealEstate2008NetMark
Downs(Sept.5,2008)[LBEXAM346991].

247

quarter: (1) Senior managers told the Examiner, without reservation or qualification,

that there was never a predetermined limit on writedowns for any business unit;876

(2)PaulHughson,HeadofCreditDistribution,toldtheExaminerthatseniormanagers

initially attempted to impose a limit on writedowns, but GREG eventually prevailed

and was allowed to take the marks it had determined were appropriate877 and (3)

BarsantiandJonathanCohentoldtheExaminerthatanarbitrarylimitpreventedGREG

fromtakingwritedownstheydeterminedwereappropriate.878

(a) SeniorManagementsAccount

During the pressurefilled third quarter of 2008, senior management became

concernedwithlatebreakingnewsaboutproposedCREwritedowns.879

Christopher M. OMeara, Global Head of Risk Management, was asked by

Herbert H. Bart McDade, III, President and COO, and Ian Lowitt, CFO, during the

weekendofAugust23,2008,tohelpwiththethirdquarterP&Lclose.880Thingswere

chaotic and Lowitt was being pulled away for due diligence on a potential Korea

Development Bank transaction; there was a likelihood of an accelerated close and

876This position is consistent with findings by the SEC, which informed the Examiner that it did not

uncoveranyevidenceduringtheSECs2008reviewofLehmansCREpricetestingprocessthatLehman
priceditspositionstohitpredeterminedbalancesheetorearningstargets.However,itshouldbenoted
that the SEC did not examine Lehmans price testing process for the third quarter of 2008. Examiners
InterviewofSECstaff,Aug.24,2009,atp.14.
877ExaminersInterviewofPaulA.Hughson,Oct.28,2009,atp.8.

878ExaminersInterviewofJonathanCohen,Jan.11,2010,atpp.78.

879ExaminersInterviewofMarkA.Walsh,Oct.21,2009,atp.14.

880ExaminersInterviewofChristopherM.OMeara,Jan.21,2010,atp.2.

248

preliminary earnings call to address the markets concerns.881 As a former CFO,

OMeara had the stature to move the process along and get information to the

appropriatefinancegroupmorequickly.882

OMearatoldtheExaminerthathehadnodirectconversationswithMcDadeor

Lowittaboutwritedownsorhownumberswerecalculated.883Hewassimplytoldby

GerardReilly,LehmansGlobalProductController,thattherewasalreadyanestimate

oftheGREGquarterlywritedown.Herecalledthatthewritedownwasestimatedto

be $1.5 billion, but he was not sure whether this included hedges or not. Reilly told

OMearathatthe$1.5billionfigurewaspresentedtoseniormanagementandhadbeen

discussed between the Walsh team and senior management, including McDade and

others.884

However, on Monday, August 25th, OMeara heard that the third quarter real

estatewritedownmightbelarger.885Subsequenttohearingabouttheadditionalwrite

downs,OMearareceivedafax,theQ3WritedownSummary,preparedbyKenneth

Cohen and forwarded to him by Reilly, showing positionlevel estimated PTG write

downs and including two pages of handwritten notes and calculations providing an

881Id.

882Id.OMearaalsostatedthathewasnotdoinganythinginregardtofinancialreportingandwasnot

involvedinplanningfortheearningscall.Id.
883Id.

884Id.

885Id.atp.3.

249

estimatedtotalwritedownof$1.561billion.886OMearatoldtheExaminerthatheasked

Jonathan Cohen whether the numbers had changed since the presentation to senior

management, but Jonathan Cohen was not able to provide him specific information.

OMearastatedthatJonathanCohentoldhimthatheshouldcontactWalshsteamfor

moreinformationandOMearaexplainedthathewasdisappointedthatCohendidnot

knowmoreaboutthevaluationprocessatthispoint.887

In addition to this conversation with Jonathan Cohen, OMeara stated that he

hadconversationswithKennethCohen,andpossiblyWalsh,abouttheQ3Writedown

Summary.Hewastoldthatnothingsubstantivehadchanged,andthatKennethCohen

had advised that the $1.5 billion figure previously provided was the result of

rounding.888 OMeara noted that there was definitely some confusion there, and

askedthemtogobackandtakeaharderlookattheprojectedwritedown.889OMeara

emphasizedthathedidnthaveaviewonanyparticularnumber.890OMearathought

itwasfairtocharacterizethisaspushbackonthehigherwritedownsGREGwanted

to take, but that he did not have a view on what was the appropriate number.891 He

stated that he just wanted to understand why the number was higher than what had

886See email from Gerard Reilly, Lehman, to Christopher M. OMeara, Lehman, et al. (Aug. 25, 2008)

[LBHI_SEC07940_2278241];Lehman,Q3WritedownSummary[LBHI_SEC07940_2278242].
887ExaminersInterviewofChristopherOMeara,Jan.21,2010,atp.3.

888Id.

889Id.

890Id.

891Id.

250

previouslybeenpresentedtoseniormanagement.Henotedthathisresponsetohigher

writedowns could be characterized as resistance and that he thought the higher

writedownswereoverlyconservativebasedonthefactthatalowerfigurehadalready

beenprovidedbyGREGtoseniormanagement.892

OMeara stated that he thought it was possible that someone may have

interpreted something he said as imposing an inflexible limit on writedowns. He

noted that when presented with the higher writedown number he told Jonathan

Cohen, Kenneth Cohen and possibly others that this has to be 1.5, meaning that if

nothinghadchangedthenumbershouldbesameaswhathadalreadybeenpresented

toseniormanagement.893OMearaemphasizedthathethoughtGREGmanagerswere

being excessively conservative and he was simply pushing back.894 OMeara told the

ExaminerthatGREGmayhavefeltpressuredtochangethenumberasaresultofthis

questioningbutinsistedthathewasmerelytryingtounderstandthereasoningforthe

additional writedown.895 The final writedown number, according to OMeara, was

exactlywhatthebusinessunitsproposed.896

OMearas account is consistent with the recollection of Kirk. Kirk stated that

Lowitt was frustrated in late August 2008 because writedowns, particularly on

892Id.atp.4.

893Id.

894Id.

895ExaminersInterviewofChristopherM.OMeara,Aug.14,2009,atp.27.

896Id.

251

Archstone, were a moving target.897 Kirk noted that Kenneth Cohen told the Finance

group late in August that GREG writedowns were going to be $1.5 billion and then

told them the next day that they were actually $1.6 billion.898 Kirk also stated that

Lowitt was concerned that GREG wanted lower valuations to set itself up for better

bonusesin2009.899Ultimately,LowittsentReillytodiscusshisconcernswithmanagers

inGREG.900

The specific position at issue was Archstone, where Hughson thought an

additional $90 to $100 million in writedowns were appropriate.901 Kirk did not think

thatthisamountwasmaterialinthecontextofa$50billionportfolio,butHughsonwas

concerned about the mark given Archstones visibility.902 Kirk instructed Kenneth

CohentodiscusstheissuewithStevenBerkenfeld,HeadoftheLegalComplianceand

Audit Division, Thomas A.Russo,ChiefLegalOfficer,andBart McDadeand believes

that theissuewas finally resolvedtoeveryonessatisfaction.903 Kirkwasclearthat he

neverheardofacapbeingsetontheamountofwritedownstaken.904

897ExaminersInterviewofAlexKirk,Jan.12,2010,atp.14.

898Id.InhisinterviewwiththeExaminer,KirkstatedthattheArchstonewritedownforthethirdquarter

was originally $1.5 billion and then changed to $1.6 billion. It is the Examiners view that this was an
accidentalmisstatementandthatKirkwasactuallyspeakingofthetotalGREGnetlossforthequarter.
The Archstone valuation writedown for the quarter was much smaller, $125 million. See Lehman, Q3
WritedownSummary,atp.36[LBHI_SEC07940_2258765].
899ExaminersInterviewofAlexKirk,Jan.12,2010,atp.14.

900Id.

901Id.

902Id.

903Id.

904Id.

252

LowitttoldtheExaminerthathehadnoroleinapprovingwritedownsandthat

senior managementhadneverimposedarbitrarylimits onthe levelof writedowns.905

Lowitt explained that Lehman had a process of forecasting likely writedowns within

assetclassesbutfrequentlythefinalwritedownsdifferedfromtheforecasts.906Hewas

clear that the forecasts were not static but would change when new information was

obtained.907

(b) PaulHughsonsAccount

HughsontoldtheExaminerthatKirkcommunicatedtoWalsh,whothenrelayed

to Hughson that you got 1.5 of marks, meaning that GREG could not take write

downsbeyond$1.5billioninthethirdquarter.908Hughsonstatedthatsomemembers

ofLehmansseniormanagement,suchasLowitt,hadchallengedGREGtoexplainwhy

thewritedownsshouldbegreaterthan$1.0billion.909Hughsonstatedthathebelieved

905ExaminersInterviewofIanT.Lowitt,Oct.28,2009,atp.39.

906Id.

907Id.

908Examiners Interview of Paul A. Hughson, Oct. 28, 2009, at p. 8. Hughsons description of having

conversations with senior management regarding the contentious third quarter marks is partially
corroboratedbyAbebualA.KebedeintheProductControlGroup.KebedestatedthatHughsontoldhim
thathewasunabletowritedowncertaincommercialrealestateassetsasmuchashewouldlikeduring
thethirdquarterof2008.ExaminersInterviewofAbebualA.Kebede,Sept.29,2009,atp.89.Kebede
couldnotrecallwhichassetswerediscussed,butthatHughsonreferredtoabunchofassets.Id.atp.9.
Kebede stated that Hughsons statement gave him suspicion that there had been an order regarding
acceptablelevelsofwritedownsforthequarter.Id.
909ExaminersInterviewofPaulA.Hughson,Oct.28,2009,atp.8.

253

that the appropriate writedowns were approximately $1.7 billion and that he argued

forwritedownsheandhisteamdeterminedwereappropriate.910

DavidOReilly,aSeniorVicePresidentinRealEstateInvestmentBanking,told

theExaminer that he overheard Hughson tellWalsh:you can tell Alex[]Kirk that if

thatsthewayhewantstomarkit,hecantalktotheSEC.911

Hughsontookprideinthefactthathehadpushedforhigherwritedownsand

thought that the $1.7 billion figure was the appropriate writedown in light of then

current market conditions. Hughson, who was directly involved in discussions with

senior management as to the third quarter writedown, took the fact that the gross

writedown ultimately taken was $1.7 billion as evidence that there was no limit on

writedownsinthethirdquarter.912

(c) OtherAccounts

WhileHughson,whowasresponsiblefordistributionofbridgeequityanddebt

positionsheldinLehmansCommercialBookandwasultimatelycontentwiththelevel

of writedowns taken in the third quarter of 2008, those responsible for marking and

pricetestingLehmansPTGbookwerenot.

910Id.

911ExaminersInterviewofDavidOReilly,Oct.26,2009,atp.2(expletivedeleted).Hughsonconfirmed

thatthisexchangeoccurred.ExaminersInterviewofPaulA.Hughson,Oct.28,2009,atp.8.
912ExaminersInterviewofPaulA.Hughson,Oct.28,2009,atp.8.

254

Historically,LehmanhadusedamethoditreferredtoasCap*105tovaluethe

collateralunderlyingPTGdebtandequitypositions.913Thismethodsimplymultiplied

the capitalization of the development by 105% to determine the collateral value.914

Whilethismethodwasdeemedaconservativeapproachwhenrealestatevalueswere

increasing,Lehmanrecognizedthatinthedownmarketoflate2007and2008itcould

produce overstated collateral values.915 Accordingly, Lehman had worked with its

primary asset manager, TriMont, to implement a new valuation model, known as an

internal rate of return (IRR) model, to value PTG collateral.916 The process was

managed by Anthony Barsanti and Aristides Koutouvides, Asset Managers in

LehmansPTGgroup.917TheIRRmodelwasintroducedonarollingbasisandbythe

thirdquarterof2008asubstantialpartofLehmansPTGbookwasvaluedusinganIRR

model.918TheswitchtotheIRRmodelresultedinlowerestimatesofcollateralvalues

than the old Cap * 105 method, and, as a consequence, indicated that material write

downswereappropriateforasignificantnumberofPTGassets.

913Examiners Interview of Anthony J. Barsanti, Oct. 15, 2009, at pp. 1213; Examiners Interview of
JonathanCohen,Jan.11,2010,atp.4.
914ExaminersInterviewofJonathanCohen,Jan.11,2010,atp.4.

915Id.;Lehman,Valuation&ControlReportFixedIncomeDivision(Feb.2008),atp.27[LBEXBARFID

0000058] (Current valuation methodology for land and development projects is based on cap * 105%,
whichwasaconservativeorprudentapproachisanupmarket.Givencurrentmarketconditions,this
approachmaynotbeappropriate.).
916ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.13.

917Id.

918Id.

255

AccordingtoBarsanti,duringthethirdquarterof2008,hewantedtotake$700

million in writedowns on PTG positions.919 However, Barsanti stated that Kenneth

Cohen directed that no more than $500 million of writedowns could be taken on the

PTG portfolio during that quarter.920 Kenneth Cohen, during his interview with the

Examiner,didnotrecallanysuchexchange.921

Thesame$500millionlimitonPTGwritedownswasalsorecalledbyJonathan

Cohen,whoremembereditasonepartofa$1.585billionlimitonGREGwritedowns

generally. Jonathan Cohen stated that during a meeting with Kenneth Cohen in

KennethCohensofficeafewdaysbeforetheendofthethirdquarter,KennethCohen

told him that there was a limit of $1.585 billion for GREGs third quarter

loss.922JonathanCohenstatedthatKennethCohenexplainedthatthiswouldresultina

limit of $500 million in writedowns on PTG assets.923 During the meeting, Jonathan

CohenpointedouttoKennethCohenthatcertainwritedownshadnotbeenconsidered

in Kenneth Cohens analysis. These additional writedowns included $28 millionin

Asia, run rate GREG P&L of $20 million, and Coeur Defense and IMD Archstone

919Id.

920Id.

921ExaminersInterviewofKennethCohen,Oct.20,2009,atp.11.TheincidentdescribedbyBarsantiis

somewhat corroborated by Walsh. Barsantis proposed writedown was one part of the late breaking
newsduringthethirdquarterthatWalshdescribed.WalshstatedthatwhenBarsantiinformedhimthat
GREGs initial estimate of $1 billion in writedowns should have been increased by $700 million, this
causedMcDadeandLowitttobecomeupsetaboutgettinginformationsolateinthequarter.Examiners
InterviewofMarkA.Walsh,Oct.21,2009,atp.14.
922ExaminersInterviewofJonathanCohen,Jan.11,2010,atp.7.

923Id.

256

writedownsof$19million.924JonathanCohenalsostatedthatduringthismeeting,Jim

Blakemore, a Managing Director in the London office, called and wanted to take an

additional$10to$15millionofwritedownsoncertainassetsandwastoldbyKenneth

Cohenthathecouldnotdoso.925

Additionally, Jonathan Cohen told the Examiner that at one point during this

meeting OMeara joined by phone.According to Jonathan Cohen, the three discussed

additional writedowns and Jonathan Cohen was told that the number is the

number.926

Jonathan Cohen stated that during this meeting he and Kenneth Cohen

performedcalculationsandhetooknotesontheQ3WritedownSummary.927Inthetop

righthand corner of the Q3 Writedown Summary (as sent by Kenneth Cohen), the

document shows a column of figures summed to 1,585, the same number Jonathan

CohenstatedwasthelimitimposedonGREGsthird quarterwritedowns.928Thenet

924Id.

925Id.

926Id.atp.8.

927See Lehman, Q3 Writedown Summary [LBHI_SEC07940_2258765]. During their meeting, Jonathan

Cohen added additional handwritten notations to this document. Examiners Interview of Jonathan
Cohen,Jan.11,2010,atp.7.
928Examiners Interview of Jonathan Cohen, Jan. 11, 2010, at p. 7. The document also shows that the

additionoftwowriteupstothe1,585figure,oneof15relatedtoEuropeandanotherof9attributed
to Santa Monica, brought the total net writedown on the document to $1.561 billion. Lehman, Q3
WritedownSummary,atp.23[LBHI_SEC07940_2258765].

257

lossactuallydeterminedbyGREGforthequarterwas$1.585billion.929Inaddition,the

bottom of the first page of the document also shows 500 as the number assigned to

PTG for third quarter writedowns, consistent with the $500 million limit on write

downsthatbothJonathanCohenandBarsantidescribedonPTGassets.Thenetwrite

downtakenonPTGassetsforthethirdquarterwas$504million.930

The Examiner has found no evidence suggesting that the Q3 Writedown

Summary,whichwascirculatedonAugust25,2008,wasdraftedinbadfaith.Kenneth

Cohen,whodraftedthisdocument,waslikelyunawareatthetimeofthesignificantly

larger than expected writedown of PTG assets suggested by the recent switch to IRR

models.931JonathanCohentoldtheExaminerthathedidnotdiscusstheadditional$200

million PTG writedown he thought was appropriate with anyone more senior than

929Lehman, Global Real Estate 2008 Net Mark Downs, at p. 1 [LBEXAM 346991]. However, as noted

above, Lehman did not finalize its financial statements for the third quarter of 2008 and did not file a
Form10Qpriortothebankruptcy.
930Thecalculationofthisnetwritedownincludesnetwritedownsof$8milliononacategoryLehman

labeledCALand&CondosTroxler,$145milliononCALand&CondosOther,and$350million
onLandandCondos(USexcludingCA).Lehman,GlobalRealEstate2008MarkDowns,atp.1[LBEX
AM346991].ThePTGgrosswritedownforthequarterwas$555million,withawriteupof$51million,
foranetwritedownof$504million.Id.atpp.24.TheExaminersfinancialadvisorhasobservedthata
summary of writedowns in E&Ys workpapers suggests $503 million for PTG positions, but attributes
thisdifferencetorounding.SeeLehman,3QRealEstateGrossandNetMTMCashBondsSpreadsheet
(Aug.29,2008)[EYSECLBHIMCGAMX08045830].
931It should be noted that Kenneth Cohen stated that he heard sometime early in August that some

withinGREGthoughtthat$700millioninPTGwritedownswereappropriate,butthatbytheendofthe
quarter,whentheconversationwithJonathanCohenandOMearaoccurred,hethoughtthatonly$500
millioninwritedownswerebeingsuggested.ExaminersInterviewofKennethCohen,January21,2010,
atp.4.

258

himselfotherthanReilly.932Accordingly,itistheExaminersviewthatthisdocument

representedagoodfaithefforttoestimatewritedownsasofAugust25,2008.

JonathanCohenstated that hehadneverbeforeheardof a predetermined limit

onwritedowns.933However,eventhoughheknewthatsuchalimitwouldmeanthat

there were appropriate writedowns that would not be taken, Jonathan Cohen stated

thathedidnotquestionitwithKennethCohenorOMeara.934Hethoughtthathelikely

just said OK inreturn.935 When asked why he did not raise the issue during this

discussion with Kenneth Cohen and OMeara, Jonathan Cohen explained that when

someone like Chris is telling me that is the number, Im not going to bring up

somethingelse.936

When asked whether he was surprised at the limit he understood to be set,

JonathanCohenstatedthathewasnotbecauseofananalysishehaddoneforReillyin

lateJuly.937HeexplainedthatReillytoldhimthathewastryingtogetasenseofwhat

positionstheyhadtotakeawritedownonandwheretheystillhadoptions.Jonathan

Cohen stated that Reilly asked him to determine how GREG writedowns would be

allocatedunderdifferentscenariosforglobalGREGwritedowns.938Cohensaidthatat

932ExaminersInterviewofJonathanCohen,Jan.22,2010,atp.3.

933ExaminersInterviewofJonathanCohen,Jan.11,2010,atp.7.

934Id.

935Id.

936ExaminersInterviewofJonathanCohen,Jan.22,2010,atp.3.

937ExaminersInterviewofJonathanCohen,Jan.11,2010,atp.8.

938Id.

259

thattimeheunderstoodthathewasbeingaskedifwecouldonlytake$Xamountin

writedowns, what would it be?939Jonathan Cohen stated thatthistask prepared him

fortheideaofpredeterminedlevelsofwritedowns.Cohenalsostatedthatduringthe

conversation in which Reilly asked him to do this, he voiced his opinion that they

shouldtakemorewritedowns,butdidnotaskwhythelimitwasbeingsetorwhereit

was coming from.940 Cohen explained that his impression was that the directive was

comingfromaboveReilly.941

The document that Cohen prepared is titled GREG Potential Markdowns

Q308 and sets forthfour different scenarios for total GREG writedownsin the third

quarterof2008and the applicableassetlevelwritedowns under each scenario.942 The

total GREG writedowns under each scenario are $2.194 billion, $1.531 billion, $1.0

billion,and$750million.JonathanCohentoldtheExaminerthatthatthetargetwrite

downnumbersforthelasttwoscenarioswereprovidedbyReilly.943

Jonathan Cohen also stated that the writedown numbers for specific assets on

thisdocumentweremadeupnumbers,ashedidthisanalysisveryquicklyandhadto

939Id.

940Id.

941Id.

942Lehman,GREGPotentialMarkdownsasofJuly23,2008(July2008)[LBEXJC000001].Theadditional

handwritten notes on the document were made by Jonathan Cohen. Examiners Interview of Jonathan
Cohen,Jan.11,2010,atp.8.
943ExaminersInterviewofJonathanCohen,Jan.11,2010,atp.8.

260

meet thescenarios targets.944 For instance, he stated that the writedown number for

Archstone on this document was a completely made upnumber.945 Jonathan Cohen

explainedthattherewasalotofjugglingtogetthenumberstofitthetotalwritedown

scenariosandthatitwashardtogetdowntothesenumbersinthelasttwoscenarios.946

Jonathan Cohen told the Examiner thatit was his opinion at the time that the proper

writedownsinthethirdquarterwouldhavebeensomewherebetween$1.5billionand

$2.2 billion, which are the writedowns reflected by the first two scenarios in this

document.947 He also noted that he personally delivered the document to Reilly and

thatitwasagoodquestionwhetherReillyaskedhimnottoemailit.948

AfterhisdiscussionwithKennethCohenandOMeara,JonathanCohenworked

todeterminehowto meet the$500millionwritedowntargetforPTGassets. Heand

Kebede divided the writedowns into three tiers.949 The first tier was composed

ofwritedowns that Lehmanwould be unable tojustify not taking.950 The second and

thirdtiers were composed of potential writedowns that Jonathan Cohen determined

wereappropriate,butforwhichLehmanwouldbeabletooffersupportforadecision

944Id.

945Id.

946Id.JonathanCohenstatedthatKebedehelpedhimputthedocumenttogetherandtheyhadonlyan

hourortwoinwhichtoproducethedocument.Id.
947Id.;Lehman,GREGPotentialMarkdownsasofJuly23,2008[LBEXJC000001].

948ExaminersInterviewofJonathanCohen,Jan.11,2010,atp.8.

949Id.atp.9.

950Id.

261

not to implement.951 The third tier was composed of potential writedowns that

Jonathan Cohen determined they had the strongest case for not taking.952 However,

Jonathan Cohen stated that he felt that all of the writedowns in each of the tiers

shouldhavebeentaken.953ThetotalamountofthePTGwritedownsCohencalculated

foralltierswas$714 million, or $214millionoverthe limithe understood was set for

PTG.954

Ultimately, Jonathan Cohen could not identify any person he believed to be

responsibleforimposingalimitforGREGthirdquarterwritedowns.955Hestatedthat

he did notthink that Kenneth Cohen had the authority to impose such a limit on his

ownandthatitalsocouldnothavebeenWalsh.956HespeculatedthatLowitt,OMeara,

Michael Gelband, Global Head of Capital Markets, or Kirk may have had such

authority.957

Jonathan Cohen and Barsanti were the only witnesses who had direct contact

withLehmanseniormanagementonthesubjectofpossiblewritedowncaps.Butother

witnessesprovidedtheExaminerwithrelevantevidence.Kebedestatedthathefound

itdifficulttoexplainwhywritedownswerenottakenonmanyassetsduringthethird

951Id.

952Id.

953Id.

954See Lehman, untitled spreadsheet, at pp. 25 [LBHI_SEC07940_2258765]; Examiners Interview of


JonathanCohen,Jan.11,2010,atp.8.
955ExaminersInterviewofJonathanCohen,Jan.11,2010,atp.9.

956Id.

957Id.

262

quarterof2008.958Healsonotedthat,contrarytowhathadpreviouslybeencustomary,

he was not involved in the final decision on writedowns in the second and third

quartersof2008.959

RebeccaPlatt,aproductcontrollerresponsibleforPTGdebtpositions,alsotold

theExaminerthatsheheardofacapontotalwritedownsforthequarter,althoughshe

did not hear of this directly from senior managers and could not recall a specific

number.960 She also stated that, in her view, product controllers Jonathan Cohen and

Kebede did not have sufficient authority to control valuations and that in many

instancestheywereoverruledbythebusinessdeskorseniormanagement.961Plattalso

explainedthatpartofherjobwasexplainingtheoutcomeofthepricetestingprocess

that is, why writedowns suggested by Product Controls models were not, in some

cases, taken. She stated that as 2008 progressed, she had increasing difficulty coming

up with justifications for not taking writedowns and that requests for writedowns

were met with increasing resistance from the business desk and/or senior

management.962 When Platt could not create a rationale for why the writedown was

nottaken,shewouldconsultwithKebede.963FortheAugust2008pricingreport,which

set forth the results of the price verification process for the last month in the third

958ExaminersInterviewofAbebualA.Kebede,Oct.6,2009,atp.5.

959Id.

960ExaminersInterviewofRebeccaPlatt,Nov.2,2009,atp.10.

961Id.

962Id.

963Id..

263

quarter,neitherKebedenorPlattcouldcreatecogentrationalestoexplainwhycertain

positionswerenotwrittendown.964KebedesuggestedthatPlattwritePCG[Product

ControlGroup]isindiscussionwithdeskregardingthisvariancewithrespecttothese

positions.965 Platt stated that, although she thought the PTG debt positions were not

reasonably marked, there was only so much [we] could do.966 Referring to the

ProductControlGroup,shestatedthattheywere,kindofsadly,thelittlepeople.967

EliRabin,theproductcontroller responsibleforPTGequitypositions,alsotold

theExaminerthatheheardrumorsthattherewasalimitontheamountofwritedowns

thatcouldbetakenonPTGpositionsinthethirdquarterof2008.968Hedidnotknow

whetherthelimitwasimposedonjustGREGorallofLehmananddidnotspecifywho

setthelimit.969

Aristides Koutouvides, who worked on the PTG business desk, stated that the

roleplayedbyseniormanagementchangedinthethirdquarterof2008.970Specifically,

he remembered that there was more pushback from senior management as to write

downs.971Koutouvidesstatedthatthelimitheunderstoodtobeinplacewasallocated

964Id.atp.11;ExaminersInterviewofAbebualA.Kebede,Oct.6,2009,atp.6.

965Lehman, Pricing Report (Aug. 2008), at pp. 1924 [LBEXBARFID 0000248]; Examiners Interview of

RebeccaPlatt,Nov.2,2009,atpp.1011;ExaminersInterviewofAbebualA.Kebede,Oct.6,2009,atpp.
56.
966ExaminersInterviewofRebeccaPlatt,Nov.2,2009,atp.11.

967Id.

968ExaminersInterviewofEliRabin,Oct.21,2009,atp.12.

969Id.

970ExaminersInterviewofAristedesKoutouvides,Nov.20,2009,atp.16.

971Id.

264

across allpositions,suchthateveryposition that he felt should bewritten downwas,

justnottotheextenthedeemedappropriate.Herecalledoneexampleinwhichheand

Barsantiwanted$500millioninwritedowns,butwereonlyallowed$450million.972He

was also unable to specify where the supposed limit on writedowns originated.

Koutouvides characterized the dialogue between the heads of the business units and

seniormanagersasexpectationsmanagementwhenitcametovaluations.973

(4) ExaminersFindingsandConclusionsWithRespecttoSenior
ManagementsInvolvementinCREValuation

The evidence is in great conflict as to whether senior management actually

attemptedtoimposeartificiallimitsonwritedownsorwhethermorejuniormanagers

misperceived management pushback as management interference. The evidence is

murky and based upon speculation as to exactly who among the senior managers

wouldhaveengagedinsuchinterferenceifinfactitoccurred.Theamountofthewrite

downsnottakenbecauseofthepossibleinterferenceapproximately$200millionina

quarter in which Lehman would report $3.9 billion of losses is of questionable

materiality. Furthermore, the actual writedowns right or wrong were never

formally reported. For all of these reasons, the Examiner concludes that the evidence

does not support the existence of colorable claims arising out of writedowns in the

thirdquarterof2008.

972Id.

973Id.

265

d) ExaminersAnalysisoftheValuationofLehmansCommercial
Book

(1) ExecutiveSummary

ThissectionoftheReportaddressesLehmansvaluationofthecommercialreal

estate assets commonly referred to as the Commercial Book. Lehmans Commercial

Book was comprised of debt instruments, such as commercial mortgage loans and

CMBS.974 Within the Commercial Book, Lehman recognized, among others, the

following asset categories: Large Loans (Fixed and Floating) and Conduit Loans, B

Notes / Mezzanine Notes, CMBS, and REIT Line of Credit (LOC). 975 These assets

werebackedbyrealestatepropertiesthatweretypicallyalreadyconstructed,operating

and generating cash flow. Lehmans expectation at the time it originated or acquired

thesepositionswasthatitwouldbeabletosyndicate,securitizeand/orsellthemwithin

a few months. This expectation caused individuals within Lehman to refer to the

CommercialBookasbeinginthemovingbusiness.976

974WyattdeSilva,E&Y,MemorandumtoFiles:LehmanCommercialRealEstateSFAS157Adoption(Jan.

28, 2008), at pp. 34 [EYLELBHIKEYPERS 2025663]. A significant portion of positions held in the
CommercialBookrelatedtoLehmansinvestmentsinArchstoneandSunCal.However,Lehmandidnot
pricetestthesepositionsaspartoftheCommercialBookpricetestingprocess.ExaminersInterviewof
JonathanCohen,Jan.11,2010,atp.10.Accordingly,thevaluationofthesepositionsisnotaddressedin
thisSection,althoughArchstoneisaddressedinSectionIII.A.2.foftheReport.
975Lehman, Real Estate Monthly Price Verification Policy and Procedures (July 16, 2008), at p. 1

[LBHI_SEC07940_1184459].
976ExaminersInterviewofJonathanCohen,Jan.11,2010,atpp.3,6.ExaminersInterviewofAnthonyJ.

Barsanti,Oct.15,2009,atp.6.ExaminersInterviewofLisaBeeson,Oct.23,2009,atp.9.Conversely,
LehmansPTGinvestments,whichwereintendedtobeheldwhiletheunderlyingrealestatewasbeing
developed,wasreferredtoasthestoragebusiness.ExaminersInterviewofAnthonyJ.Barsanti,Oct.
15,2009,atp.6.

266

As of May 31, 2008, Lehman determined that the value of its worldwide

CommercialBookwasapproximately$29.5billion,with$15.1billionintheU.S.,$10.3

billioninEurope,and$4.2billioninAsia.977AsofAugust31,2008,Lehmandetermined

the value of its worldwide Commercial Book to be approximately $24.4 billion, with

$11.9billionintheU.S.,$8.9billioninEurope,and$3.6billioninAsia.978Aswithother

asset classes, the analysis in this section focuses on Lehmans U.S. assets, as the

Examinerdeemedthetimeandexpensenecessarytoobtaininformationregardingnon

U.S.assetstobeanimprudentuseofEstateresources.979

Historically, Lehman was able to sell certain positions within the Commercial

Book shortly after origination.980 However, beginning in the latter half of 2007 and

continuing through the third quarter of 2008, the loss of liquidity due to the

deterioration of the securitization and syndication markets forced Lehman to retain

moreofitsCommercialBookassetsonitsbalancesheetatatimewhenproblemsinthe

977Lehman,GlobalRealEstateInventorySpreadsheetasofMay31,2008(August8,2008)[LBEXDOCID

2077095]. The Examiner notes that there is an immaterial difference between the value of the U.S.
CommercialBookbasedonthissource($15.1billion)ascomparedtothevalueoftheU.S.Commercial
BookpositionsreviewedbyE&Y($14.9billion)asdiscussedbelow.Inaddition,pricetestingmodelsand
internal and external Lehman presentations that have been located by the Examiner indicate slightly
differentvaluesfortheU.S.CommercialBook.TheExaminersfinancialadvisorhasconcludedthatthe
differencesamongthesesourcesmaybeduetocategorizationormarktomarketadjustments.
978Lehman,GlobalRealEstateInventorySpreadsheetasofAugust31,2008[LBEXDOCID1025119].

979As used in this Section, unless otherwise noted, the term Commercial Book refers only Lehmans

U.S.assets.
980See E&Y, Memorandum re: Conduit, Large Loan, and CMBX Price Verification Process, at p. 5 [EY

SECLBHIMCGAMx08063735].FixedRateConduitLoans&LargeLoanswerehistoricallysyndicated
everytwotothreemonths.Id.atp.5.FixedRateLoansweretypicallyheldbyLehmanfor180days.Id.
atp.6.However,theaverageholdingperiodforBNotes/MezzanineNoteswasover180days.Id.atp.
8.

267

realestatemarketwereputtingdownwardpressureonvaluations.981Asevidencedby

contemporaneous emails written by senior Lehman personnel, the markets for

investmentsbackedbycommercialrealestatewerevirtuallyclosedatthetime.982The

reductioninCMBSsecuritizationsafterthethirdquarterof2007isdemonstratedinthe

tablebelow:

LehmansCommercialSecuritizationActivitiesfromtheSecondQuarterof2006to
theSecondQuarterof2008983

In$Millions 2Q06 3Q06 4Q06 1Q07 2Q07 3Q07 4Q07 1Q08 2Q08
Commercial
mortgages 3,412 6,700 7,149 2,829 5,083 10,480 1,507 1,500
securitized
Quarterover
100.7% 96.4% 6.7% 60.4% 79.7% 106.2% 85.6% n/a n/a
quarterchange

Asthesecuritizationmarketdriedup,andLehmansexitstrategyfortheseassets

becameuntenable,thevalueofLehmanspositionsfell.Inthesecondquarterof2008,

Lehman took approximately $195 million in writedowns on assets within its

981Examiners Interview of Jonathan Cohen, Jan. 11, 2010, at p. 3; Diane Hinton, S&P, Liquidity
ManagementInTimesOfStress:HowTheMajorU.S.BrokerDealersFare,Nov.2007,S&PRatingsDirect,
(Nov.8,2007),atpp.23[LBHI_SEC07940_439424](Recentdisruptionsinthesubprimemarketandits
contagion effects into the leveraged finance, assetbacked commercial paper (ABCP), and CDO spaces
have substantially curtailed market liquidity.); FRBNY President Timothy Geithner, Transcript of
Remarks to The Economic Club, New York City, New York, Reducing Systemic Risk In A Dynamic
Financial System (June 9, 2008), available at http://www.newyorkfed.org/newsevents/speeches/
2008/tfg080609.html (The funding and balance sheet pressures on banks were intensified by the rapid
breakdown of securitization and structured finance markets. Banks lost the capacity to move riskier
assets off their balance sheets, at the same time they had to fund, or to prepare to fund, a range of
contingentcommitmentsoveranuncertaintimehorizon.).
982Email from William J. Hughes, Lehman, to Alex Kirk, Lehman, et al. (Jul. 27, 2007) [LBEXDOCID

174304].
983SeeLehmanBrothersHoldingsInc.,QuarterlyReportasofMay31,2007(Form10Q)(filedonJuly10,

2007),atp.27(LBHI10Q(filedJuly10,2007));LehmanBrothersHoldingsInc.,QuarterlyReportasof
August31,2007(Form10Q)(filedonOct.10,2007),atp.22(LBHI10Q(filedOct.10,2007));LBHI2007
10Katp.111(LBHI200710K);LBHI10Q(filedJuly10,2008)atp.35.

268

CommercialBook.Similarly,inthethirdquarterof2008,Lehmantookapproximately

$306 million in writedowns on its Commercial Book. Lehmans valuations of its

Commercial Book resulted in cumulative net writedowns of $958 million during the

periodbeginninginthefourthquarterof2007andendinginthethirdquarterof2008,

assetforthinthetablebelow.984

CommercialBookNetWritedownsFirstQuarter2007toThirdQuarter2008

$inmillions
1Qthru3Q07 4Q07 1Q08 2Q08 3Q08 4Q07thru3Q08

NetWriteDowns
(38) (164) (293) (195) (306) (958)

ThissectionoftheReportexamineswhetherthevalueofLehmansCommercial

Book assets, as determined by Lehman in May and August of 2008, was reasonable.

TheExaminersinvestigationhasrevealedthatthesalesdatausedbyLehmantoverify

the marks for many of its Commercial assets in the second and third quarters of 2008

may not have been sufficiently broad to be applicable to the entirety of the portfolio.

However,whilethereissomeuncertaintyastowhetherthesalesdataLehmanhadfor

thesecondandthirdquartersof2008wasrepresentativeoftheassetsremaininginits

Commercial portfolio, the data shows that Lehmans valuations at this time assumed

higheryields,andasaresultlowervalues,thanisreflectedbyactualsalesduringthe

quarter. Thus, Lehmans valuations appear reasonable in light of the available sales

984E&Y, Lehman Brothers Holdings Inc. CRE Sign P&L Q4 and YTD (November 11, 2007), at p. 2 [EY

SECLBHIMCGAMx07 071061]; E&Y, Lehman Brothers Holdings Inc. 3Q.RE.8 Gross and Net MTM
Cash Bonds 082908.xls [EYSECLBHIMCGAMX08045833]. Lehman, Global Real Estate 2008 Net
MarkDowns(Sept.5,2008)[LBEXAM346991].ThewritedownsexcludeSunCalrelatedpositions.

269

data. Furthermore, this sales data was the primarysource of information available to

Lehman,otherthantheoreticalmodelsthatrelied,inpart,upondatafromthirdparties,

to conduct price verification of these assets at the time.985 Most importantly, the asset

values ultimately determined did not fall outside of a range of reasonableness.

Accordingly, the Examiner does not find sufficient evidence to support a finding that

Lehmans valuation of its U.S. Commercial Book in the second and third quarters of

2008wasunreasonable.

(2) LehmansValuationProcessforitsCommercialBook

Aswithotherassetclasses,themarksLehmanreportedforitsCommercialBook

assetswerethosedeterminedbyitsbusinessdesk,subjecttoapriceverificationprocess

performed by its corresponding Product Control Group.986 Product Control used a

numberofmethodologies,dependingontheassetcategoryandavailableinformation,

toverifythepricinginformationprovidedbyLehmansbusinessdesk.987Forconduits

985The Examiner notes that Lehman internally recognized that its theoretical models suffered from the

useofstaledata.SeeLehman,Valuation&ControlReportFixedIncomeDivision(February2008),atp.
27[LBEXBARFID0000058].ThisreportlistedthefollowingissuefortheFloatingRateLargeLoans&
Junior Notes: Floating rate securitization market is inactive; No deal in the market since Dec07.
Spreads published in third party publications are stale; Pricing becoming extremely challenging. Id.
The proposed solution was for Product Control to work with Front Office to obtain market color on
deals that are currently in the market for syndication/sale. Id. This document also stated Product
controlishavingcontinuousdiscussionswithFrontOfficegoingthroughdealsinmoredetailandtrying
toobtainmarketcolorusingrecentsyndications,bids,offersandanyothermarketinformation.Id.
986Lehman, Price Verification Policy and Procedure 2008 [Draft] [LBHI_SEC07940_2965994]; Brian

Sciacca, et al., Lehman, HG, HY, & EMG Cash Price Testing Policy & Procedure (Jan. 24, 2007) [LBEX
BARVAL0000001].
987Lehman, Price Verification Policy and Procedure 2008 [Draft] [LBHI_SEC07940_2965994]; Brian

Sciacca, et al., Lehman, HG, HY, & EMG Cash Price Testing Policy & Procedure (Jan. 24, 2007) [LBEX
BARVAL0000001].TestingfilesfornonU.S.positionswerenotavailableandtheExaminerexpressesno

270

and large fixed rate loans, prices were historically tested in aggregate using a mock

securitizationmodel,basedonthemostrecentcomparableLehmansecuritizationdeal.

Key model inputsincludedwaterfall paymentof thebonds,termtomaturity, coupon

rateandtheLoantoValue(LTV)ratio,whichwasgenerallyderivedfromthevalue

ofthecollateralatthetimetheloanwasoriginated.988Thepresentvalueofthesubject

loan was discounted based on a weighted average yield that was estimated from a

mock securitization and/or yield spreads as published in the Commercial Mortgage

Alert (CMA).989 However, the use of this methodology became ineffective as the

securitizationmarketsclosed,causingProductControltodeemphasizetheiruseinthe

firstquarterof2008.990

Forfloatingratelargeloansandmezzanineloans,Lehmansmarksweretested

using a net present value (NPV) methodology which considered the subject loans

riskinessanditscollateralpropertyvalue.991Keymodelinputsincludedtheindividual

loansLTVratio,maturitydate,spread,couponrate,remainingpayments,anddiscount

viewofthereasonablenessofthevaluationmethodologyorultimatemarksreportedforLehmansnon
U.Scommercialrealestateassets.
988E&Y, Walkthrough Template re Conduits, Large Loan, and CMBX Price Verification Process, at p. 5

[EYSECLBHIMCGAMX08063735].
989Id.atp.8;Lehman,GlobalRealEstateProductControl,RealEstateAmericasPriceVerification(Feb.

2008),atp.10[LBEXWGM000762].
990ExaminersInterviewofJonathanCohen,Jan.11,2010,atp.4.

991E&Y,WalkthroughTemplatereConduits,LargeLoan,andCMBXPriceVerificationProcess,atpp.78

[EYSECLBHIMCGAMX08063735].

271

rate.992Forthediscountrate,ProductControlbasedtheircalculationonthekeymodel

inputsmentionedaboveandyieldspreaddatapublishedbyCMA.993

ForCMBS,pricesweretestedusingthirdpartypricingdatafromIDC,andother

marketsourceswhenavailable.994Productcontrollersthencomparedtheaverageofall

thirdpartypricingdataforapositiontothemarkdeterminedbythebusinessdesk.995

Finally, REIT LOC and term loans were typically price tested on an individual

basis,usingtheNPVapproachbasedonindividualloancharacteristics.996

Duringthefourthquarterof2007andthefirstquarterof2008,thelackofsalesof

Lehmans Commercial Book assets, due to the slowing pace of securitizations and

syndicationsnotedabove,meantthattherewaslimitedrelevantmarketinformationto

relyupon inperforming price testingoftheseassets.Thislackofinformationcaused

Lehman to be heavily reliant upon its theoretical pricing models for purposes of

confirmingassetvaluations.However,inthesecondandthirdquartersof2008,greater

sales activity allowed Lehmans product controllers to use sales data in addition to

models to perform price verification of the Commercial Book.997 During the second

992Id.atpp.79.

993E&Y,BNote,DiscountRateRecalculation.xls[EYSECLBHIMCGAMX08063388].

994Lehman, Global Real Estate Product Control, Real Estate Americas Price Verification (Feb. 2008), at

p.16[LBEXWGM000762].
995E&Y,WalkthroughTemplatereLiquidProductsPriceVerificationProcess,atp.7[EYSECLBHIMC

GAMX08067466].
996Lehman,GlobalRealEstateProductControl,RealEstateAmericasPriceVerification(Feb.2008),atp.

18[LBEXWGM000762].
997The increased sales activity would have also benefited the business desk as they determined the

correctmarkfortheirpositions.

272

quarterof2008,LehmanwasabletosellarangeofCommercialBookpositionsforan

aggregate price of $3.8 billion.998 Similarly, during the third quarter of 2008, Lehman

soldvariousCommercialBookpositionsforanaggregatepriceof$2.5billion.999

Thevolumeofactualsalestransactionsinthesecondandthirdquartersof2008

gave Lehmans management a higher level of confidence in the valuation process

comparedtopriorperiodswhenthelackofanymeaningfulsalesdataforcedthemto

relymostlyontheoreticalpricingmodels.1000

After the product controllers determined their test marks for a position,

variances, defined as the difference between the business desks mark and the mark

calculated by the product controller, were calculated. Lehman determined certain

variance thresholds for each asset category.1001 As with other asset classes, variances

exceeding these thresholds were resolved through discussions between business desk

and product controllers and unresolved variances were escalated to senior

management.1002

998Lehman,Q2Q3GregSalesScatterv2[LBHI_SEC07940_1234185].

999Id.

1000ExaminersInterviewofJonathanCohen,Jan.11,2010,atpp.56.

1001E&Y,Memorandumre:Conduit,LargeLoan,andCMBXPriceVerificationProcess,atp.9[EYSEC

LBHIMCGAMX08063735];E&Y,LehmanBrothersHoldingsInc.,REITPriceVerificationProcess,atp.
7 [EYSECLBHIMCGAMX080641780]; E&Y, Lehman Brothers Holdings Inc., Liquid Products Price
Verification, at p. 8 [EYSECLBHIMCGAMX08067466]; Lehman, Price Verification Policy and
Procedure2008[Draft],atp.4[LBHI_SEC07940_2965994].
1002E&Y, Lehman Brothers Holdings Inc. Price Verification P&P, Securitized Products and Valuation

Controls (March 3, 2008), at p. 23 [EYSECLBHIMCGMAX08067482]; E&Y, Lehman Brothers


HoldingsInc.PriceVerificationPolicyandProcedure2008[Draft],atp.4[LBHI_SEC07940_2965994].

273

(3) ExaminersFindingsandConclusionsastotheReasonableness
ofLehmansValuationofitsCommercialBook

In assessing the reasonableness of Lehmans marks in the second and third

quartersof2008,theExaminerreviewedvaluationanalysesprovidedbyLehmantoits

auditors, models that Lehmans product controllers used to price test the business

desksassetvaluations,anddatafromcompletedsalestransactions.

(a) AsoftheSecondQuarterof2008

In a real estate price verification presentation, the Product Control Group

summarized its price testing analysis for the second quarter of 2008.1003 The

presentationprovidedPricingCommentarythatexplainedhowtheProductControl

Group arrived at its test prices and showed the aggregate variance calculated for the

quarter. In the presentation, the Product Control Group identified a $70 million net

negative variance, equal to approximately 0.5% of Lehmans $14.5 billion Commercial

portfolio.1004AnegativevariancemeansthatLehmansmarksfortheassetstestedwere

higherthanthetestprices,suggestinganovervaluation.

Inadditiontoprovidinginformationregardingthetestpricesdeterminedforthe

Commercial Book, the Product Control presentation also contained observations on

factors impacting the pricing of each asset type.1005 The presentation noted that some

1003Lehman,RealEstatePriceVerification[Draft](July17,2008),atpp.2,3,5[LBHI_SEC07940_1169231].

1004Id. at p. 2. The Examiner notes that this presentation identified the value of the US Commercial

portfoliotobeapproximately$17.5billion,whichincluded$3.0billionofbridgeequitypositions.Forthe
purposeofCommercialBookanalysis,bridgeequitypositionswereexcludedfromtheanalysis.
1005Id.atpp.2,3,and5.

274

asset classes, specifically Archstone, benefited from price flex.1006 Price flex shifted

marktomarketlossesfromdebtpositionstoequitypositions.Apartiallyreproduced

summary of the Product Control Groups price testing analysis is shown in the table

below.

1006Id.atpp.2,5.TheArchstonedebtpositionswereincludedintheCommercialBookandthevaluation

ofthesepositionsisaddressedinSectionIII.A.4.eoftheReport,whichaddressesLehmansvaluationof
itsArchstoneBbridgeequityinvestment.

275

ProductControlsDraftPriceTestingSummaryforQ22008
U.S.Commercial1007

Legal Market Pricing


Balance Mark Value Variance PricingCommentary
FixedRate:
Significantexpsureis61%LTV,$319mnseniorloan
FirstLien 419 90.60 379 onGMbuildingmarkedat95.7,orayieldof6.7%.
Soldallof$500mnplacedintoaQ208securitization.

Apporxiamtely31%ofportfoliohaspriceflex;
remainderofbookedmarkedbasedoncomparable
BNotes/Mezz 1,021 88.50 904 (26)
spreadlevelsfromrecentsynidcation/salesactivity.
Sold$947mnduringQ208.

FloatingRate:
FullPriceflexondebt,i.e.,anylosswillbeabsorbed
Archstone 526 99.00 521 bybridgeequity.450DMassumedonmezzin
pricingbridgeequityyield.

Markedbasedonspreadsderivedorimpliedfrom
recentsyndication/salesactivityonseniorloansas
FirstLien 3,434 94.90 3,260 (12)
wellasbnotes/mezznotes.Sold$545mnduring
Q208.

Priceverifiedbasedoncomparablespreadlevelson
BNotes/Mezz(excl.Archstone) 3,516 91.90 3,230 (32) recentsyndications/salesactivity.Sold$742mn
duringQ208.

TermLoans/LOCs:
Fullpriceflex.Pricingassumptionsincorporatedin
Archstone 2,395 98.50 2,359 bridgeequity(i.e.,termloanAtoberepaidfromasset
salesandtermloanBtobesyndicated@90).

Pricedtotargetinvestoryieldof15%(exceptfor
MarbleheadandPacificPoint,whichareat12%to
accountfortheirsuperiorlocation&demographics
comparedtotherestoftheportfolio).Cashflowand
SunCal 1,944 75.60 1,470
otherprojections(lotabsorption,constructioncosts,
andsaleprice)obtainedeitherfromthirdparty
vendorshiredbyLBorthirdpartyindustry
publications.

Others(excl.ArchstoneandSunCal) 876 96.00 841 Basedonbankdebttradingmarketofsimilarcredits.

SellerfinancedtradesoriginatedinMay08atmarket
CorporateDebt 626 100.00 626
spreads.

Total(excludingSecurities) 14,757 13,590 (70)

Priceverifiedusingthirdpartysourcesandrecent
tradingactivity.Sold$1bnofalltranchesofsecurities
Securities 29,966 908 duringQ208.FloatingrateIOsmarkedatzerodue
tothelackofprepaymentprotectionandshort
duration.

Total(includingSecurities) 44,723 14,498 (70)

1007SeeLehman,RealEstatePriceVerification[Draft](July17,2008),atpp.23[LBHI_SEC07940_1169231].

Thistableexcludesbridgeequitypositionsandcollapsesthedifferenttypesofsecuritiesintoasingleline
item. The Examiner notes that the total value for U.S. Commercial assets in this draft price testing
document ($14.5 billion) is different than the final values reviewed by E&Y ($14.9 billion) and other
summaries of the Commercial Book located by the Examiner. The Examiners financial advisor has
concludedthatthesedifferencesmaybeduetocategorizationormarktomarketadjustments.

276

Forthesecondquarterof2008,LehmanprovidedE&Yananalysisthatcompared

datafromsalesduringtheperiodtothecarryingvaluesoftheassetsthatremainedon

Lehmansbalancesheet.1008Theanalysiscomparedthesellingyieldsthatwereimplied

bythe prices atwhich assets weresoldduringthe quarter tothe carrying yields used

forvaluingtheportfolioasofquarterend.1009Theanalysisconcludedthattheaverage

selling yield was lower than the average carrying yield of the remaining assets; and

therefore, the prices that Lehman was achieving on actual sales were, on average,

higher than the prices at which Lehman was carrying assets in these categories on its

balance sheet.1010 However, the Examiner notes that there is great variation among

positions even within a single asset category and the applicability of a sale price to

positions still held by Lehman can only be determined by a positionspecific analysis.

Assumingthattheassetssoldwerecomparabletotheremainingassets,theCommercial

Book as of May 31, 2008, was undervalued in light of the second quarter sales data

available. Lehman relied on the sales data to support the valuation of Commercial

assetsatquarterend.1011

1008SeeE&Y,GlobalRealEstateQ208SalesActivity[EYSECLBHIMCGAMX08138412].

1009Id.

1010Id.

1011Lehman, Real Estate Price Verification [Draft] (July 17, 2008), at p. 1 [LBHI_SEC07940_1169231].
Kebede affirmed the emphasis of sales data during his interview with the Examiner. Examiners
InterviewofAbebualA.KebedeonOct.6,2009,atp.8.E&Ysworkpapersstated:Forpurposesofthe
Q2 review, the comparisons between inventory values and yields and sold values and yields appears
reasonabletosupportProductControlsassertionsofreasonable,observable,applicablesalesactivityto
supportitsfairvaluemarksasof5/30/08inadditiontoitsotherpriceverificationprocedures.Appears
Reasonable. E&Y, Global Real Estate Q208 Sales Activity, at p. 1 [EYSECLBHIMCGAMX08

277

ToevaluatetheapplicabilityofthesalesdatatothevalueofLehmansremaining

assets,theExaminerreviewedthedistributionofsalesacrosstheassetcategorieswithin

theCommercialportfolio.1012Thisanalysisissummarizedinthetablebelow.

138412].WilliamSchlichtoldtheExaminerthatE&Ysquarterlyreviewsarenotthesameastheannual
auditandthatE&Ywasstillintheplanningstagesforits2008auditwhenLehmanfiledforbankruptcy.
ExaminersInterviewofErnst&Young,Nov.11,2009,atpp.1314.
1012See E&Y, Global Real Estate Q208 Sales Activity [EYSECLBHIMCGAMX08138412]; Lehman, Q2

Q3GregSalesScatter.xls,[LBHI_SEC07940_1234185].

278

U.S.CommercialAssetClasseswithSalesDataQ22008

Carrying
Yield
SalesDuring Remaining
SellingYield on
Quarter Exposure
Remaining
Portfolio

MezzanineFloatingRate 606 2,799 8.8% 9.3%

MezzanineFixedRate 947 479 8.7% 9.4%

LargeLoansSeniorFloatingRate 545 3,575 5.9% 6.6%

BNotesFloatingRate 136 152 6.6% 9.7%

Subtotal#1 2,234 7,005 N/A N/A


SmallFixedRateMezzanine 499 379 7.5% N/A

Securities 1,018 589 N/A N/A

InterestOnly 25 319 0.0% N/A

Subtotal#2 1,542 1,287 N/A N/A

LoanstoREITs(e.g.,Archstoneand
SunCal) 4,869 N/A N/A

FloatingRateMezzanineArchstone 485 N/A N/A

BNotesFixedRate 363 N/A N/A

DerivativesMarktoMarket 893 N/A N/A

Subtotal#3 6,610 N/A N/A


Total 3,776 14,902 N/A N/A

As this table shows, Lehman was able to sell a substantial portion of assets

withincertainassetclasses,andwasunabletosellanyportionofassetsforotherasset

279

classes. The four categories for which the Examiner obtained both selling yield and

carrying yield information together account for approximately 47% of Lehmans

Commercial Book, as measured by value.1013 Within these categories, the average

carrying yield for the remaining portfolio was consistently higher than the average

selling yield.1014 The majority of asset classes without any sales data are related to

Archstonedebtpositions,whichbenefitedfrompriceflex,andSunCal.1015

While the sales data provides a degree of price transparency, many of the

transactions that were executed during the second quarter closed during the last few

daysofthequarter.1016Further,manyofthetransactionsthatclosedonthelastdayof

the quarter were seller financed (with recourse).1017 Kebede believed the terms of the

seller financing wereconsistent with market rates atthe time.1018 The Examiner is not

awareofanycontemporaneousevidencethatcontradictsKebedesbelief.

The Product Control Group used data from the sale of positions during the

quarter tovaluethe remainingpositionsbycomparing positions: (1) within thesame

deal; (2) within the same sector (i.e., office); (3) within the same geography; (4) with

1013SeeLehman,Q2Q3GregSalesScatter.xls[LBHI_SEC07940_12341851234225].

1014See E&Y, Global Real Estate Q208 Sales Activity [EYSECLBHIMCGAMX08138412]; Lehman, Q2

Q3GregSalesScatter.xls[LBHI_SEC07940_12341851234225].
1015Id. As noted, the impact of price flex on the valuation of Archstone bridge equity is discussed in

SectionIII.A.4.e.
1016E&Y,GlobalRealEstateQ208SalesActivity,atpp.110of31[EYSECLBHIMCGAMX08138412].

1017Id.Lehman,SellerFinancedPositions,atp.2[LBEXWGM763628].Becausethesellerfinancingwas

provided with recourse, in the event of a default Lehman would be permitted to seek the full
outstandingamountoftheloanfromtheborrower,notjustthecollateral.
1018ExaminersInterviewofAbebualA.Kebede,Oct.6,2009,atp.9

280

similar loantovalue ratio; and (5) with similar term to maturity.1019 For example,

Lehmansoldatrancheofthe301HowardmezzanineloanportfoliowithalowerLTV

ratiothantheremainingtranches,whichisconsistentwiththefactthattheremaining

positionsweremarkedtohigheryieldsthanthepositionssold.Thisisalsoconsistent

with the relative riskiness of each tranche the higher the LTV ratio, the riskier the

tranche.

As an additional check of the price testing process, the Examiner investigated

how Lehmans valuation models performed when compared to spreads reflected in

actualsalesdata.Areviewofavailablepricingmodelsshowedthat,whensalesdata

providing spreads was available, these spreads were manually entered by product

controllers in place of the spreads calculated by the models.1020 Among the 25

Commercial Bookpositions thattheExaminerreviewed,thispracticewasdonefor22

positions.1021 To assess the models ability to predict reasonable carrying spreads, the

Examiner replaced the spreads reflected by the sales data with Lehmans own model

calculations. A comparison of the selling spreads to the predicted spreads of the

positions examined indicates that Lehmans pricing models, on average, predicted a

1019Id.

1020TheExaminers financial advisor reviewed the majority of sold large loans and mezzanine loans
withintheLargeLoanandJuniorNotepricetestingmodels.However,sinceLehmanreportedlimited
information regarding the selling spreads for several of these sold positions, the Examiners financial
advisoronlyreviewed63.7%ofthepositionsasmeasuredbymarketvalue.
1021Lehman, Large Loans Pricing Summary (Apr. 30, 2008) [LBEXBARFID 0022055]; Lehman, Junior

Loans Pricing Summary (Apr. 30, 2008) [LBEXBARFID 0020702]; Lehman, Large Loans (PTG Model)
PricingSummary(Apr.30,2008)[LBEXBARFID0022055].

281

higher spread than the average selling spread.1022 This suggests that the price testing

processwasgenerallyconservative,producinglowermarksthanthosereflectedinthe

salesdata.

Based on the aforementioned facts and analyses, Lehmans Product Control

GrouphadsufficientsalesdataandotherinformationtoeffectivelypricetestLehmans

CommercialBookduringthesecondquarterof2008.Furthermore,theavailablesales

data suggests that Lehmans marks for these assets were conservative during the

quarter.Accordingly,theExaminerfindsthatthereisinsufficientevidencetosupporta

findingthatLehmansvaluationsofitsCommercialBookassetsinthesecondquarterof

2008wereunreasonable.

(b) AsoftheThirdQuarterof2008

TheExaminerobtainedlessinformationaboutLehmanspricetestingprocessfor

thethirdquarterof2008thanforthesecondquarter.ThisappearstobeduetoLBHIs

bankruptcy filing, which occurred just 15 days after the third quarter ended. As a

result, the Examiners financial advisor could not identify a document summarizing

Lehmans price testing process similar to the one obtained for the second quarter.

However, the process that Lehman used was generally similar to that for the second

quarterrelianceonsalesdatawhereavailableandmodelsintheabsenceofsuchdata.

1022Thepredictedspreadswereonaverage262basispointshigherthanthesellingspreads.

282

Therefore,theExaminersanalysisforthethirdquarterfollowedasimilarapproachas

wasusedforthesecondquarter.

Lehman sold approximately $2.5 billion of Commercial positions during the

thirdquarterof2008.1023Thesesalesoccurredacrossavarietyofassetclasses,asshown

inthetablebelow.Similartothesecondquarter,therewerenosalesofArchstone or

SunCalpositions.1024

ThirdQuarterU.S.CommercialBookAssetSales(ExcludingREO/Equity)

Value
AssetType
(inMillions)
LargeLoansFloatingRate 725
LargeLoansFixedRate 305
MezzanineFloatingRate 846
MezzanineFixedRate 195
BNote 144
Securities 253
Total 2,468

The majority of U.S. Commercial positions that were reviewed by the product

controllersduringthisquarterwerepricetestedintwopricingmodels:theLargeLoan

price testing model and the Junior Note price testing model.1025 Therefore, the

Examinersanalysisfocusedonthesetwopricetestingmodels.

1023Lehman, Q2 Q3 Greg Sales Scatter.xls [LBHI_SEC07940_1234185]. The $2.5 billion figure excludes

REO/Equitysales.
1024Id.

1025See
Lehman, US Real Estate Inventory vs. Pricing Reconciliation (Aug. 2008), at p. 1
[LBHI_SEC07940_3103034].Fixedrateandfloatingratelargeloansofanaggregatevalueof$6.3billion
werepricetestedintheAugustLargeLoanpricingmodel.SeeLehman,LargeLoansPricingSummary
(Aug.29,2008),atp.7[LBEXBARFID0021979].BNotes,Fixedrateandfloatingratemezzanineloansof
an aggregate value of $2.5 billion were price tested in the August Junior Loan pricing model. See

283

A review of the Large Loan Floating Rate model shows that Product Controls

review of the desks valuations for the third quarter suggested a $45 million positive

variance,or a0.7% potentialundervaluation of $6.3billion worthofpositions.1026 The

largestgroupofpositions(excludingArchstoneandSunCal)pricetestedinthismodel

was a group of $412 million of senior Hilton positions, which were benchmarked

againsttheyieldsreceivedfromthesaleofrelativelyjuniorHiltonpositionssoldduring

thequarter.

A review of the Junior Note price testing model shows that Product Controls

reviewofthedesksvaluationsforthethirdquartershowedan$87millionnetnegative

variance,orapotential3.5%overvaluationof$2.5billionworthofpositions.1027

Similartothesecondquarterreview,theExaminerfollowedthesameprocedure

to examine how Lehmans valuation models performed in the third quarter when

compared to the actual selling price/spread. The examination shows that Lehmans

pricing models,1028 on average, predicted a higher spread than the average selling

Lehman, Junior Loans Pricing Summary (Aug. 29, 2008), at p. 14 [LBEXBARFID 0021642]. These two
modelsincluded$8.8billionofthe$10.4billioninCommercialBookpositionsthatwerepricetestedasin
thethirdquarterof2008.Lehman,RealEstateAmericasPriceTestingSummary(Aug.29,2008)[LBEX
DOCID1971828].
1026SeeLehman,LargeLoansPricingSummary(Aug.29,2008)[LBEXBARFID0021979].

1027SeeLehman,JuniorLoansPricingSummary(Aug.29,2008)[LBEXBARFID0021642].

1028TheExaminerreviewedthemajorityofsoldlargeloansandmezzanineloanswithintheLargeLoan

and Junior Note price testing models. However, since Lehman reported limited information regarding
thesellingspreadsforseveralofthesesoldpositions,theExamineronlyreviewed30.6%ofthepositions
soldasmeasuredbyvalue.

284

spread,implyingthatpositionsweremarkedatlowerpricesthansimilarpositionssold

duringthethirdquarter.1029

Aswiththesecondquarter,basedontheaforementionedfactsandanalyses,the

Examiner concludes that there is insufficient evidence to support a finding that the

CommercialBookvaluationsasofthethirdquarterof2008wereunreasonable.

e) ExaminersAnalysisoftheValuationofLehmansPrincipal
TransactionsGroup

(1) ExecutiveSummary

Lehmans Principal Transactions Group (PTG) made debt and equity

investmentsinrealestateprojectsthatwereintendedtobeheldfortheperiodduring

which the underlying real estate was developed or improved.1030 Unlike Lehmans

Commercial Book positions, which were backed by alreadydeveloped, income

1029Thepredictedspreadswereaveraged117bpshigherthanthesellingspreads.

1030ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.4;ExaminersInterviewofMarkA.

Walsh,Oct.21,2009,atp.4.SeeLehman,GlobalRealEstateProductControl,RealEstateAmericasPrice
Verification Presentation [Draft] (Feb. 1, 2008), at p. 4 [LBEXWGM 916015]; Wyatt de Silva, E&Y,
Memorandum to Files: Commercial Real Estate FAS 157Adoption (Jan.28, 2008), at p.5 [EYLELBHI
KEYPERS 2025661]. As noted above, this Report addresses the valuation of Lehmans U.S. assets.
Accordingly,exceptasnoted,thetermPTGonlyreferstotheGREGPrincipalTransactionsGroupin
the U.S. and the investments that this group originated and managed. Additionally, the term PTG, as
used herein, excludes the SunCal development, which was technically a part of the PTG portfolio. See
Cushman&Wakefield,AppraisalofPacificaSanJuanMasterPlan(289Lots)(Oct.1,2007)[TR00031835].
LehmansinvestmentinSunCalamountedto,asofMay2008,approximately4.4%ofthebalancesheetat
riskforthePTGportfolio.Lehman,GlobalRealEstateInventorySpreadsheetasofMay31,2008(Aug.8,
2008) [LBEXDOCID 2077095]. However, Barsanti stated that PTG had limited involvement in valuing
SunCal,asthatpositionmigratedovertoHughsonsgroup.ExaminersInterviewofAnthonyJ.Barsanti,
Oct.15,2009,atp.17.JonathanCohenalsostatedthatProductControlhadnoinvolvementinvaluing
SunCal. Examiners Interview of Jonathan Cohen, Jan. 11, 2010, at p. 5. Because PTG and Product
ControlgenerallyexcludedSunCalfromthevaluationprocess,theExaminerhaslikewiseexcludedthat
assetfromconsiderationofthereasonablenessofthePTGmarks,exceptasabasisofcomparisoninone
instancebelow.

285

producingrealestateandwereintendedtobesoldtoinvestorsshortlyafterorigination,

PTG positions were not intended for nearterm sale. Instead, PTG investments were

premisedonexecutionofabusinessplan,typicallyoftwotofiveyearduration,which

oftenincludedsaleoftheunderlyingpropertyafterdevelopment.1031

Giventhisbusinessstrategy,LehmangenerallydidnotmarketPTGpositionsfor

sale, as it did Commercial Book assets. As a result, PTG positions were relatively

illiquid, even when commercial real estate values were increasing and capital was

readily available. Anthony J. Barsanti, the PTG Senior Vice President responsible for

marking the PTG positions, told the Examiner that Lehman valued these investments

through a combination of financial projections and gut feeling, due to the unique

nature of each asset and the lack of sales data regarding comparable debt and equity

positions.1032 Lehman employed valuation models incorporating assetspecific

informationandprojectingexpectedperformanceovertime.However,whilePTGasset

managersonthebusinessdeskusedthemodelsasaguide,theydidnotregardthemas

gospel.1033BarsantiandAristidesKoutouvides,thePTGVicePresidentwhoreported

to Barsanti and also valued PTG positions, made judgment calls as to whether to

modify or give weight to the model values.1034 Barsanti and Koutouvides based these

judgment calls on their experience, the collaterals performance with respect to the

1031ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.4.

1032Id.atp.11.

1033Id.

1034Id.atpp.9,1112;ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atpp.1112.

286

developments business plan, and other market data related to the collaterals

geographic region or property type that was not always accounted for in their

models.1035

Lehmanengagedathirdparty,TriMont,toproducetheassetspecificdataused

by the business desk.1036 This TriMont data was also used by the product controllers

whoseparatelypricetestedtheassetvaluesdeterminedbythebusinessdesk.

Pursuant to GAAP, and specifically SFAS 157, the PTG portfolios value was

supposedtorepresentLehmansjudgmentastothepriceatwhicheachpositioncould

besoldtoathirdpartyasofaparticularmeasurementdate,assumingthatLehmanhad

sufficientopportunitytomarketsuchinvestmentpriortothatdate.1037However,there

was disagreement between Lehman personnel about whether the PTG portfolio

reflectedthisprice.KoutouvidesandJonathanCohen,SeniorVicePresident,Headof

ProductControlGroupinGREG,toldtheExaminerthatPTGassetswerenotvaluedat

the price they could be sold to a thirdparty investor in 2008.1038 With respect to the

valuesdeterminedbyLehmanforPTGassetsduring2008,Koutouvidesstated,noone

1035Examiners Interview of Anthony J. Barsanti, Oct. 15, 2009, at. pp. 9, 1112; Examiners Interview of

AristidesKoutouvides,Nov.20,2009,atpp.1112.
1036Lehman&TriMont,AmendedandRestatedLoanServicingandAssetManagementAgreement(Sept.

1,2004),pp.1112[TR00044479].
1037ForamoredetaileddiscussionofthelegalstandardsgoverningthisReportsvaluationanalysis,see

Appendix1,LegalIssues,SectionVII.
1038Examiners Interview of Aristides Koutouvides, Nov. 20, 2009, at p. 12; Examiners Interview of

JonathanCohen,Jan.11,2010,atp.5.

287

wouldpayyouthat.1039Infact,KoutouvidesandJonathanCohenstatedthatLehman

was not required to mark the PTG assets at the price at which an investor would

purchase such assets as of the particular measurement date.1040 In contrast, another

witness,KennethCohen,aManagingDirectorinGREGandHeadofU.S.Originations,

toldtheExaminerthatthePTGassetsweremarkedatthepricethataninvestorwould

pay to purchase the asset.1041 Barsanti, who Kenneth Cohen identified as the person

principally responsible for determining PTG marks, stated that he did not know

whetherPTGassetscouldbesoldforthepriceatwhichtheyweremarkedandstated

hehadnotthoughtaboutit.1042

The Examiners analysis of the data provided by TriMont, as well as Lehmans

useofthisinformationtoproducevaluations,supportsafindingthatLehmansprocess

forvaluingitsPTGportfoliowassystemicallyflawedbecauseLehmanprimarilyvalued

these assets based on whether the development was proceeding according to the

projects business plan and not the price a buyer would pay for the asset. This

methodologydidresult,inthefirstthreequartersof2008,inapproximately$1.1billion

in aggregate writedowns of the PTG portfolio, which was valued at approximately

1039ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atp.12.

1040Id.atpp.1112;ExaminersInterviewofJonathanCohen,Jan.11,2010,atpp.45.

1041ExaminersInterviewofKennethCohen,Jan.21,2010,atp.4.

1042ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.11.

288

$9.6 billion at the end of fiscal year 2007.1043 However, there are sufficient facts to

demonstrate that Lehman did not generally value PTG assets in light of the rates of

return(oryields)thatinvestorswouldrequiretopurchasethem.Inotherwords,the

facts support a finding that Lehman generally did not value PTG assets during these

quartersatthepricesatwhichtheycouldbesoldtoathirdpartyinvestor.

This failure to appropriately consider an investors required rate of return was

initially due to thefactthatTriMont calculatedthe valueof the underlying real estate

simplybyreferencetotheprojectscapitalization.1044ThiscalculationwascalledCap*

105,becausethecollateralvaluethemostimportantinputinthevaluationexercise1045

was calculated by multiplying the developments capitalization (i.e., outstanding

debtplusequityraised)by105%.1046

As the real estate markets deteriorated in 2007, Lehman recognized that Cap *

105 was flawed, and instructed TriMont to produce internal rate of return (IRR)

modelsforeachdevelopment.1047TheIRRmodelsweretypicallydesignedtodetermine

1043See Lehman, Global RealEstate 2008Net Mark Downs (Sept.5, 2008) [LBEXAM346991]. Lehman,

GREG(PTG)BalanceSheetPositionasofNov.30,2007(Dec.6,2007)[LBEXDOCID1374315](Nov.2007
data).
1044ExaminersInterviewofJonathanCohen,Jan.11,2010,atp.4.

1045Examiners Interview of Jennifer Park, Sept. 10, 2009, at p. 8, Examiners Interview of Abebual A.

Kebede,Oct.13,2009,atp.6;ExaminersInterviewofEliRabin,Oct.21,2009,atpp.67.
1046ExaminersInterviewofJonathanCohen,Jan.11,2010,atp.4.

1047The Examiner notes that the IRRmodels referenced here are not the same IRRmodels referenced

elsewhereinthisReportinthevaluationanalysisofArchstone.SeeSectionIII.A.2.fofthisReport.The
IRRmodelsusedinArchstoneassumedavalue,andthemodelderivedadiscountrate.WhileTriMonts
models could perform the same calculation, Lehman relied on TriMonts models for PTG positions to
produceavaluebasedonanassumeddiscountrateforthecollateral.

289

the value of the real estate by discounting the projected cash flows of the completed

projecttoapresentvalue.Thiswasacumbersomeandtimeconsumingprocess,butby

July2008TriMontwasabletoprovideearlyversionsoftheIRRmodelsforsubstantially

all of the PTG assets.1048 Lehman recognized that the IRR models required continued

development, and this process was projected to take many more months.1049 The

Examiner has analyzed a subset of the IRR models and determined that the models

generallyattributedadiscountratefortheequityportionofthecapitalstructurebased

onLehmansexpectedrateofreturn(i.e.,20%forlanddevelopments)and,forthedebt

portion,adiscountratebasedontheinterestrateassociatedwiththeunderlyingloans

atorigination.1050TheIRRmodelstookaweightedaveragebetweenthesetworatesto

arriveattheweightedaveragediscountratefortheproperty.1051Inthismanner,theIRR

models used a yield that did not necessarily correspond to investors required rate of

return(i.e.marketbasedinterestrates)asoftheparticularmeasurementdate.

Barsanti and Jonathan Cohen, in part by using the TriMont IRR models,

determined that it would be appropriate to write down the PTG assets by

approximately$714millionforthethirdquarterof2008.1052JonathanCohenunderstood

1048ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atp.15.

1049Id.

1050TriMont, TriMont Valuation Methodologies Lehman PTG and LLG CMBS Hold Assets (Apr. 28,

2008)[LBEXDOCID2089942].
1051Theweightedaveragewasbasedontheequityinvestedtodateandoutstandingdebt.

1052ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.15;ExaminersInterviewofJonathan

Cohen,Jan.11,2010,atp.9.

290

thattherewasa$500millionlimitonsuchwritedownsforthethirdquarter,1053buthe

did not inform Kenneth Cohen, Christopher M. OMeara, Global Head of Risk

Management, or anyone senior to him (other than Gerard Reilly, Global Product

Controller) that he and Barsanti had calculated proposed writedowns beyond the

perceived$500millionlimit.1054Inthismanner,approximately$214millionofthewrite

downswerenottaken.

TheExaminerfindsthereissufficientevidencetosupportafinding,forpurposes

ofasolvencyanalysis,thatcertainofLehmansPTGvaluationsasofMay31,2008and

August 31, 2008 were unreasonable. Given that there were approximately 700 PTG

positionsasofLBHIsbankruptcyfiling,1055theExaminerdeterminedthatitwasnota

prudentuseofresourcestodeterminetherangeofovervaluationforeachinvestment.

For purposes of illustration, the Examiner did analyze select positions, and describes

belowhowLehmansfailuretoproperlyconsidertheinvestorsrequiredrateofreturn

affected the valuation. Due to time constraints and lack of information that fully

capturesthenuancesofPTGpositions(orLehmansinternalprocessforvaluingmany

ofthem),theExaminersanalysisoftheseassetsdoesnotpresentanopinionastothe

1053TheExaminerconcludesthatthereisinsufficientevidencetosupportafindingthatLehmanssenior

managersintendedtoimposesuchalimit,butJonathanCohenwasunambiguousinassertingthatitwas
hisunderstandingthatsuchalimitwasinplace.ExaminersInterviewofJonathanCohen,Jan.22,2010,
atpp.23.SeeSectionIII.A.2.cofthisReport,whichdiscussesseniormanagementsprocessfordeciding
writedownsforCREassets,whichincludedPTGassets,inthesecondandthirdquartersof2008.
1054ExaminersInterviewofJonathanCohen,Jan.22,2010,atpp.23.

1055Lehman,GREGInventorySpreadsheetasofAug.31,2008(Sept.13,2008)[LBEXDOCID1025119].

291

fair value of these assets as of May or August 2008, but simply investigates the

assumptionsandpracticesLehmanusedinvaluingtheselectedPTGassetsandreaches

aconclusionastothereasonablenessofthoseassumptionsandpractices.

Inaddition,theevidencedoesnotsupporttheexistenceofacolorableclaimfora

breach of fiduciary duty related to Lehmans valuation errors, as there is insufficient

evidence to establish that any Lehman officer acted with the necessary scienter to

supportsuchaclaim.

(2) OverviewofLehmansPTGPortfolio

Lehmans PTG positions took the form of investments in both the debt and

equity of the development or improvement projects. PTG invested in real estate that

required development or improvement in order to produce the desired return on

capital.1056 Prior to the development or improvement, the underlying PTG real estate

hadeithernocashflow(i.e.,landtobedeveloped),ormateriallylesscashflowthanwas

projected to be generated upon development (i.e., conversion of rental apartment

buildings to condominiums).1057 Lehman generally planned to exit its PTG positions

when the underlying real estate project was completed, at which point the real estate

wouldbestabilizedandcouldproduceacashflowthroughleasingorsales.1058While

Lehman actively marketed Commercial Book assets for sale soon after origination,

1056ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atpp.78.

1057Id.atp.4.

1058Id.

292

Lehman usually did not market PTG assets. Development projects were typically

completedtwotofiveyearsafterLehmanprovidedthefunding(withtheaveragebeing

threeyears),atwhichtimetheunderlyingpropertywastypicallysold.1059

PTG invested in [p]roperties in markets with lack of competition for the

propertytypeorhavingsignificantbarrierstoentryduetocomplexityofthesituation

ormarketissues.1060PTGtypicallyinvestedintheconstructionofofficesorhotels,the

leasingofrentalunitsinexistingapartmentsorofficebuildings,theconversionofrental

unitsintocondominiumunits,andtheacquisitionanddevelopmentoflandforcreation

ofresidential,commercial,orresortproperties.1061

Lehman partnered with developers on PTGinvestments. Each Lehman banker

withinPTGwhooriginatedinvestmentshadrelationshipswithcertaindeveloperswith

a proven track record in a particular real estate market.1062 It was not uncommon for

Lehman to do multiple deals with a developer who had demonstrated the ability to

1059Id. See Memorandum from Sunny Galynsky, Lehman, to Kenneth Cohen, Lehman, re: Corporate

Audit Report for Real Estate: Principal Transactions Americas (Dec. 19, 2007), at p. 2 [LBEXDOCID
3570967](ThePrincipalTransactionGroupprovidesequityanddebtfundsforrealestateinvestmentin
nonstabilized assets which were scheduled to be repaid over a three to five year period. The group
engagesinoriginatingandrestructuringshorttermmezzanineloans(averagedurationof2.5years)...
.);MarkA.Walsh&KennethCohen,Lehman,AnOverviewoftheGlobalRealEstateBusiness(June6,
2005),atp.18[LBEXDOCID271653].
1060MarkA.Walsh&KennethCohen,Lehman,AnOverviewoftheGlobalRealEstateBusiness(June6,

2005),atp.18[LBEXDOCID271653].
1061Lehman,GREGUniversity:STARTTrainingAnalysts&AssociatesDeepDiveTrainingPresentation

(Sept.2007),atp.79[LBHI_SEC_07940_ICP_007982].
1062ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.7;ExaminersInterviewofAristides

Koutouvides,Nov.20,2009,atp.8.

293

successfullycompleteaproject.1063WhilecertainPTGpositionsincludedsaleortransfer

restrictions, Lehman recognized that a thirdparty investor evaluating a PTG

investmentpriortothecompletionofadevelopmentwouldneedtoconductsignificant

due diligence on the developer responsible for the project, as the profitability of the

investmentlargelydependedonthedevelopersabilitytocompletetheprojectontime

and on budget.1064 Koutouvides explained that Lehman relied on the developer to

successfully complete the project, and that the relationship between Lehman and a

developercouldbedescribedasamarriage.1065

LehmanrecognizedthatPTGinvestmentswerehigherrisk,higherreturnthan

Commercial Book investments,1066 due to the lack of stabilized cash flows and the risk

thatdevelopmentorimprovementoftheassetmightnotbeaccomplishedaccordingto

the business plan.1067 For example, a project could be delayed or derailed due to the

developers failure to timely obtain necessary zoning variances or to successfully

1063ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.7.

1064Id.atpp.4,5,17.

1065ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atp.8.

1066E.g.,ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.4.

1067E.g.,
Lehman, GREG Global Real Estate Update (Nov. 6, 2007), at p. 12 [LBEXWGM 771145]
(identifying key risks to include refinancing risk, residential sales, execution, and credit risk);
Lehman, GREG University: START Training Analysts & Associates Deep Dive Training Presentation
(Sept. 2007), at p. 96 [LBHI_SEC_07940_ICP_007982] (identifying CRE risks generally); Examiners
InterviewofAristidesKoutouvides,Nov.20,2009,atp.8.

294

manageaproject.1068Thedevelopersfailuretoperforminaccordancewiththebusiness

plancouldhaveamaterialeffectonthevalueofthePTGinvestment.1069

Given that the entity owning the underlying real estate was often highly

leveraged, and a PTG asset generated insufficient cash flow until the completion of

development, Lehmans expectation was that the entity would have substantial

difficulty repaying the debt at maturity unless the development was successfully

completed.1070 Similarly, execution of the business plan was crucial to obtaining

Lehmanstargetedannualrateofreturn(oryield),forexample,20%foraPTGequity

1068Email from Aristides Koutouvides, Lehman, to Anthony J. Barsanti, Lehman (May 16, 2008)
[LBHI_SEC07940_2229897]; Zev Klasewitz, Lehman, Single Asset Debt Model May 2008 Spreadsheet
(June 14, 2008), at tab Pricing, cell BK98 [LBEXLL 1985749]; Dennis Grzeskowiak, TriMont,
KnickerbockerHotelIRRModel(July1,2008),atcellF2[TR00021056];Lehman,SingleAssetDebtModel
Aug. 2008 Spreadsheet (Aug. 31, 2008), at cell BK95 [LBEXBARFID 0023236]; Lehman, Valuation &
ControlReportFixedIncomeDivision(Dec.1,2007),atp.22[LBEXWGM755798](Projectisstillin
the entitlement process; [o]verall financing package is being restructured); Examiners Interview of
AristidesKoutouvides,Nov.20,2009,atp.8.
1069Lehman,GREGGlobalRealEstateUpdate(Nov.6,2007),atp.12[LBEXWGM771145](identifying

key risks to include refinancing risk, residential sales, execution, and credit risk); Examiners
InterviewofAristidesKoutouvides,Nov.20,2009,atp.8.
1070Examiners Interview of Anthony J. Barsanti, Oct. 15, 2009, at pp. 5, 12. Additionally, if the

development failed, Lehman could foreclose on the real estate and attempt to salvage value from the
assetbyrevisingthebusinessplan,whichcouldincludepartneringwithanewdeveloperorsellingthe
property. When Lehman foreclosed and took ownership, the asset became Real Estate Owned or
REO. Lehman, Corporate Audit Dept. Entity Control Evaluation for Commercial Real Estate
Mezzanine & Equity (Jan. 4, 2006), at p. 2 [LBHI_SEC_07940_ICP_010891]; Memorandum from Robert
Martinek,E&Y,toE&YAuditTeamforLehmanBrothers,re:LehmanBrothersCommercialRealEstate
Portfolio (Dec. 17, 2006), at p. 5 [EYLELBHIKEYPERS 0675302] (noting that Lehman foreclosed on a
borrowerandcategorizedthenoteasanREO).

295

investment in land developments.1071 Either way, as Barsanti told the Examiner, [i]f

youcouldnotexecuteyourplanyouredead.1072

(3) EvolutionofLehmansPTGPortfolioFrom2005Through2008

AsLehmanexecuteditsgrowthstrategyduring2006and2007,thePTGportfolio

grew larger in size and the average position became riskier. Beginning in November

2006,thePTGbookbalancesheetincreasedsubstantially,asillustratedbythefollowing

graph.1073

U.S. PTG Balance Sheet Value at Risk over Time


$10,000
$9,000
$8,000
$7,000
USD Millions

$6,000
$5,000
$4,000
$3,000
$2,000
$1,000
$-
FY 2002 FY 2003 FY 2004 FY 2005 FY 2006 FY 2007

1071Examiners Interview ofAnthony J. Barsanti, Oct.15,2009,at pp. 5, 12. According to Koutouvides,

this 20% rate for equity approximated Lehmans expected rate of return for underwriting a deal.
ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atp.7.
1072ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.5.

1073See Lehman, Balance Sheet Trend and Profit & Loss Spreadsheet (Sept. 14, 2007) [LBEXDOCID

2504119](20022006data);Lehman,GREG(PTG)BalanceSheetPositionasofNov.30,2007(Dec.6,2007)
[LBEXDOCID 1374315] (Nov. 2007 data); Lehman, Global Real Estate Group (PTG) Balance Sheet
Position as of Aug. 31, 2007 (Sept. 7, 2007) [LBEXDOCID 1639856] (Aug. 2007 data); Lehman, GREG
(PTG) Balance Sheet Position as of Feb. 29, 2008 (Mar. 5, 2008) [LBEXDOCID 1374362] (Feb. 2008);
Lehman,GREG(PTG)BalanceSheetPositionasofMay31,2008(June4,2008)[LBEXDOCID1639939]
(May 2008 data); GREG (PTG) Balance Sheet Position as of Aug. 31, 2008 (Sept. 4, 2008) [LBEXDOCID
4418520](Aug.2008data).

296

Afterremainingrelativelyconstantfrom2002to2005,thePTGbalancesheetgrew57%

betweenfiscalyear2005andfiscalyear2007,orfrom$6.1billioninfiscalyear2005,to

$6.9billioninfiscalyear2006,andto$9.6billioninfiscalyear2007.

During this period, the composition of the PTG portfolio also changed in ways

that made the portfolio more risky.1074 The increasing level of risk associated with

Lehmans PTG investments was largely the result of three factors: (1) an increased

focusonlanddevelopmentprojects;(2)afocusonCaliforniaandotherboommarkets;

and (3) a greater proportion of equity investments. Each of these factors is discussed

below.

Inregardtothefirstfactor,landdevelopments,Lehmandeterminedthatcertain

types of PTG investments, such as office building upgrades, no longer provided the

returnsthebusinessrequiredduetocompetitionfromotherinvestorswhowerewilling

to accept lower returns.1075 In order to obtain the targeted return on investment, PTG

redirecteditsfocustodevelopingland,particularlyforresidentialdevelopment.1076

1074ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.5;ExaminersInterviewofAristides

Koutouvides,Nov.20,2009,atp.8.
1075ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.5;ExaminersInterviewofAristides

Koutouvides,Nov.20,2009,atp.8.
1076Lehman, GREG, Americas Portfolio as of June 30, 2008 (July 19, 2008), at p. 4
[LBHI_SEC07940_241063] (stating that PTGs largest exposure is in land); Examiners Interview of
AnthonyJ.Barsanti,Oct.15,2009,atp.5;ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,
atp.8.Asnoted,LehmansSunCalpositionsarenotincludedinthisanalysisandwouldinflatethetotal
valueofthePTGportfolioifincluded.However,theExaminernotesthatSunCalisanotherexampleof
thistrend.See,e.g.,Cushman&Wakefield,AppraisalofPacificaSanJuanMasterPlan(289Lots)(Oct.1,
2007)[TR00031835].

297

For example, Lehmans investment in Heritage Fields, PTGs largest position,

representing approximately 6% of the PTG portfolio as of May 2008, involved the

creationofanewresidentialcommunityonthesiteofadecommissionedMarineCorps

basenearIrvine,California.1077TheHeritageFieldsdeveloperproposedthepreparation

of parcels to be subdivided between builders of a planned community that included

4,895residentialunits,alongwithparks,agolfcourse,educationalfacilities,amedical

office, and commercial space.1078 Lehman provided $500 million in first lien financing

for Heritage Fields in December 2005 and provided an additional $275 million of

financinginJune2007.1079

The PTG portfolios increasing concentration of land developments, such as

Heritage Fields, increased the overall risk profile of the portfolio. Land carries more

risk than all other property types and is the most volatile in terms of value.1080 As a

1077See TriMont, Heritage Fields El Toro LLC IRR Model (May 1, 2008) [LBEXBARFID 0026891]; Zev

Klasewitz,Lehman,SingleAssetDebtModelMay2008Spreadsheet(June14,2008)[LBEXLL1985749].
LehmandidnotinvestdirectlyinthehomebuildingforHeritageFields.Instead,Lehmaninvestedinthe
sponsor,LNRPropertyCorp.,thatwastopreparetheinfrastructureandprovideenvironmentalcleanup
in order to deliver the land parcels that would be subdivided between builders. Memorandum from
BrentBossung,etal.,Lehman,toLBHIInvestmentCommittee,re:LoanProposalforHeritageFields,LLC
(July1,2005),atpp.3,69[LBEXAM193357].
1078Cushman & Wakefield, Heritage Fields MasterPlan SelfContained Appraisal Report Vol. I (July 1,

2007),atp.8[LBEXDOCID2501688];Lehman,RealEstateDealSummaries:Top50AssetReviews(Sept.
13,2008),attab8[CSSEC00003929].
1079Lehman, Real Estate Deal Summaries: Top 50 Asset Reviews (Sept. 13, 2008), at tab 8 [CSSEC

00003929];TriMont,HeritageFieldsElToroLLCIRRModel(May1,2008)[LBEXBARFID0026891].
1080See Stuart M. Saft, 7 Comm. Real Estate Forms 3d 22.2 (Nov. 2009) (The biggest risk of an

investmentinundevelopedanddevelopinglandisthevirtualimpossibilityofpredictingthedirectionof
growthandtheeverincreasingcostofholdingthelandforfuturedevelopment....Anotherproblemis
determining the sales price of raw land due to the fact that, unlike securities, there is no established
market, which makes determining comparable sales impossible.); John D. Hastie, Real Estate

298

generalmatter,landisonlyprojectedtoappreciateifitisentitled,meaningthatthe

developer has obtained the various zoning and environmental approvals to construct

thedevelopment.1081 Theriskassociatedwithinvestmentsin landisthat approvals to

construct the development might not be obtained, or might be obtained only after

significantdelay.1082Furthermore,giventhetimerequiredtoobtainsuchapprovalsand

tothenbuildthephysicalstructures,thereisthepossibilityofsignificantchangesinthe

real estate market during the development period. For example, when Lehman first

provided financing to Heritage Fields in December 2005, the expectation was that the

landentitlementswouldbeobtainedinDecember2006,constructionofimprovements

would follow over the course of several years, and sales would continue through

2013.1083

In addition, the PTG portfolio was particularly concentrated in California land

development.TherisingvalueofalltypesofCaliforniapropertythroughoutthe2000s

(particularlyin2005and2006),1084combinedwithlowinterestrates,perceivedconsumer

Acquisition,DevelopmentandDispositionfromtheDevelopersPerspective,SR001ALIABA1,3(2009)
(That cost [of land acquisition] customarily includes raw land cost, the cost of providing utility and
othergovernmentalservicestotheland,thecostsofobtainingzoning,useandenvironmentalapprovals,
thecostofcreatingaccesstoandwithinthedevelopment,thecostofcuringtitledefectsandtheinterest
expenseorreturnoninvestmentchargedtothecarryingperiodpriortodevelopment.).
1081ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atp.8.

1082Id.

1083MemorandumfromBrentBossung,Lehman,etal.,toLBHIInvestmentCommittee,re:LoanProposal

forHeritageFields,LLC(July1,2005)atpp.3,69[LBEXAM193357].
1084SeeMoodys/REALCommercialPropertyPriceIndex,http://mit.edu/cre/research/credl/rca.html;Fed.

Housing Fin. Agency, House Price Index for California (CASTHPI), http://research.stlouisfed.org/fred2
/series/CASTHPI(showingapeakinhousepricesin2005and2006).

299

demand for housing, available liquidity, and Lehmans recent track record of success,

made raw California land an attractive PTG investment to Lehman during this

period.1085 As of the end of the second quarter of 2007, California land development

represented17.6%ofthebalancesheetatriskinthePTGportfolio.1086

Finally, Lehmans risk exposure also increased as it took equity stakes in

developments.1087Forfiscalyear2004,PTGequitymadeupapproximately26%ofthe

PTGportfolio,increasingto34%in2005and2006.1088During2007,Lehmantooknoteof

thesofteningmarketandrealizedthatthePTGportfoliowastooconcentratedinland

development and in equity positions.1089 Koutouvides noted that the market was

dropping like a stone.1090 Kenneth Cohen stopped approving, and originators

stopped submitting, deals where Lehman was not sufficiently senior in the capital

structure(i.e.,firstliendebtinsteadofequity),therebyreducingtheriskprofile.1091

1085ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.5.ApresentationgivenbyPaulA.

HughsonoutlinesseveraladvantageousaspectsoftheCaliforniamarket.PaulA.Hughson,Lehman,The
Search for Yield Alternative Real Estate Investment Opportunities (June 20, 2006) [LBEXDOCID
1745526].
1086Lehman, Portfolio Characteristics Americas (Principal Investments and CMBS Retained Positions)

Spreadsheet as of May 31, 2007 (Oct. 23, 2007) [LBEXDOCID 2501412]. SunCal is not included in this
percentage.
1087ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atpp.5,8.

1088Ketaki Chakrabarti, Lehman, Real Estate Balance Sheet Trends Spreadsheet (Apr. 18, 2007) [LBEX

DOCID 1419729]; Melissa Sullivan, Lehman, Bridge Equity Spreadsheet (July 5, 2007) [LBEXDOCID
3604474].
1089ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.6;ExaminersInterviewofAristides

Koutouvides,Nov.20,2009,atp.9.SeeEmailfromJeffreyGoodman,Lehman,toAnthonyJ.Barsanti,
Lehman (Jan. 3, 2007) [LBEXDOCID 249993] (discussing deteriorating homebuilding market in
CaliforniaandforwardingarticlewithaprettynegativeviewofCAland).
1090ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atp.9.

1091ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.6.

300

At the end of fiscal year 2007, despite further growth in the PTG portfolio, the

proportionofequityinvestmentshaddecreasedslightlyto30%ofthePTGportfolio.1092

Lehman originated fewer PTG positions during the last quarter of 2007, a trend that

continuedinto2008.1093Inaddition,LehmanwrotedownthevalueofPTGinvestments

by$137millioninthefourthquarterof2007andby$271millioninthefirstquarterof

2008.1094 Lehman wrote down PTG assets by $302 million in the second quarter of

2008.1095

As of the end of the second quarter of 2008, Lehman held 741 positions in the

PTGportfolio.Lehmanvaluedthesepositionsat$8.5billionwithanaverageposition

1092Lehman, GREG (PTG) Balance Sheet Position as of Nov. 30, 2007 (Dec. 6, 2007) [LBEXDOCID
1374315].
1093Laura M. Vecchio, Lehman, FAS 144 Face_Basis Spreadsheet (July 14, 2008) [LBEXDOCID 587401].

Lehmanoriginated52positionsinthefourthquarterof2007,40inthefirstquarterof2008,and19inthe
secondquarterof2008.Id.
1094Lehman,GlobalRealEstate2008NetMarkDowns(Sept.5,2008)[LBEXAM346991].Thenetfigures

subtractLehmanswriteupsonPTGassetsfromthewritedowns.Althoughnetwritedownstypically
include the offset from hedging, the Examiners financial advisor has observed that Lehman did not
effectivelyhedgePTGpositionsduringthisperiod.ExaminersInterviewofAristidesKoutouvides,Nov.
20,2009,atp.9.Thegrosswritedownfiguresare$137millioninfourthquarter2007and$318millionin
firstquarter2008.LehmandidnotwriteupPTGassetsinfourthquarter2007,butdidwriteupcertain
PTGassetsby$47millioninfirstquarter2008(principally,TroxlerSpringMountainRanch).Lehman,
GlobalRealEstate2008NetMarkDowns(Sept.5,2008)[LBEXAM346991].
1095Lehmans gross writedown for second quarter 2008 was $316 million, with a $13 million writeup.

Lehman,GlobalRealEstate2008NetMarkDowns(Sept.5,2008)[LBEXAM346991].

301

sizeof$11million.1096Atthattime,thePTGportfoliofeaturedthefollowingproperty

types:1097

Balance Sheet Value at Risk by


Property Type
# of
Property Type
Other
Retail
Positions
3.3%
Office 1.5%
10.5% Condo 146
Condo Hotel 46
21.7%
Industrial 27
Multi
family Land 210
12.1% Hotel Multifamily 103
17.0%
Office 128
Land
32.9% Industrial
Other 64
1.1% Retail 17
Total 741

Approximately33%oftheoverallportfolio,or210positions,waslandfordevelopment,

with condominium developments and conversions comprising the second largest

category.

The size of the PTG portfolio decreased slightly between the second and third

quartersof2008,from741positionsvaluedat$8.5billionto690positionsvaluedat$7.8

1096Lehman, Real Estate Price Verification Presentation [Draft] (July 17, 2008), at p. 3
[LBHI_SEC07940_1169231]. The U.S. PTG portfolio accounted for 60.3% of the total PTG portfolio in
termsofbalancesheetatrisk.TheremainingPTGpositionswereheldintheAsiaandEuropeportfolios.
Id.
1097Lehman,GlobalRealEstateInventorySpreadsheetasofMay31,2008(Aug.8,2008)[LBEXDOCID

2077095].ThecategoryLandwaslabeledLand/SingleFamilybyLehmanininternalpresentations.
Basedonalimitedreviewofunderlyingpositions,theExaminersfinancialadvisorhasobservedthatthis
categoryonlycontainslanddevelopmentassets.

302

billion.1098Thisdecreasewasprimarilydrivenbya$504millionnetwritedowninthe

thirdquarter.1099

By 2008, Lehman had slowed the pace of new originations, but still held many

relatively risky positions originated during the upmarket of 20042007. These

positions, especially equity positions in land development projects, proved difficult to

accuratelyvaluethroughout2008,asisdiscussedbelow.

(4) LehmansValuationProcessforItsPTGPortfolio

Determining the fair value of any asset, especially illiquid assets such as PTG

debt and equity positions, requires the party performing the valuation to exercise

judgmentastoavarietyofcriteriathatapotentialpurchaserwouldconsider.1100These

criteriainclude,amongothers,theamountoffutureexpectedcashflowsexpectedfrom

theassetandaninvestorswillingnesstoaccepttheriskthattheassetwillnotproduce

thesecashflows.1101Thesecriteriaarereflectedinthetwocomponentsofthemarkto

marketvaluationprocess:markingtocreditandmarkingtoyield.1102

1098Id.;
Lehman, GREG Inventory Spreadsheet as of Aug. 31, 2008 (Sept. 13, 2008) [LBEXDOCID
1025119]. The SunCal positions are excluded from this calculation. The Examiners financial advisor
observedthatthedatainLehmansPTGfilesdonotincludethebasisforapositionbeingremovedfrom
thePTGportfolio(otherthansalestothirdparties).
1099Lehman,GlobalRealEstate2008NetMarkDowns(Sept.5,2008)[LBEXAM346991].TheExaminer

notesthatasummaryofwritedownsinE&Ysworkpaperssuggests$503millionforPTGpositions.The
differenceisduetorounding.SeeLehman,3QRealEstateGrossandNetMTMCashBondsSpreadsheet
(Aug.29,2008)[EYSECLBHIMCGAMX08045830].
1100SeeAppendix1,LegalIssues,SectionVII.A,foramoredetaileddiscussionofthelegalstandardfor

determiningfairvaluepursuanttoSFAS157.
1101Futureexpectedcashflowsrefertotheweightedaverageofprojectedcashflowprojectionsadjusted

for the probability that the cash flow will materialize. For example, if there were two cash flow
projections,(1)a50%chancethatcashflowwillbe$10and(2)a50%chancethatcashflowwillbe$20in

303

InthecontextofLehmansPTGportfolio,markingtocreditreferstorecognition

of changes in the amount and/or timing of the future expected cash flows from the

properties underlying the PTG positions (the collateral).1103 In terms of marking a

PTGasset,markingtocreditincludestherecognitionofachangedcollateralvaluedue

toanychangeinthebusinessplanthatchangedtheamountofcashflowsthecollateral

was expected to generate and/or the time period in which the expected cash flows

would be received.1104 Thus, marking to credit takes into account the changed

circumstancesoftheparticularassetinquestion.

In contrast, marking to yield takes into account changes in broader market

conditions affecting the value of an asset even if the circumstances of the asset itself

havenotchanged.Yieldsometimesreferredtoasarateofreturnordiscountrate

is the discount rate used to determine the present value of the future expected cash

flows, accounting for the risk that the asset will not perform as expected. As an

Year1,theexpectedcashflowforYear1is$15,whichiscomputedasfollows:(50%*$10)+(50%*$20)=
$15.
1102ThetermsmarkingtocreditandmarkingtoyieldwereusedbyvariousLehmanpersonnelwho

wereresponsibleforthevaluationofPTGassets.E.g.,ExaminersInterviewofAbebualA.Kebede,Sept.
29,2009,atp.6;ExaminersInterviewofEliRabin,Oct.21,2009,atp.7;ExaminersInterviewofAristides
Koutouvides,Nov.20,2009,atp.18.Forexample,inreviewingtheproposedPTGwritedownsforthe
thirdquarterof2008,KennethCohenmadenotesonadocumentstatingwhetherthereasonforthewrite
down was Credit or Yield. Kenneth Cohen, Lehman, Q3 Writedown Fax (Aug. 25, 2008)
[LBHI_SEC07940_2278242].
1103ExaminersInterviewofEliRabin,Oct.21,2009,atp.7.

1104Markingtocreditwouldresultinanincreaseinvalueifthechangeinthebusinessplanresultedinan

increase in expected cash flows and/or accelerated the time period in which the expected cash flows
wouldbereceived.

304

investors willingness to accept the risk associated with an asset decreases, the yield

demandedtopurchasetheassetincreasesandthepurchasepricegoesdown.

ForthevaluationofequitypositionsinthePTGportfolio,yieldisrelevantforthe

determination of the value of the underlying collateral. For the loans and debt

instruments in the PTG portfolio, yield is relevant for the same purpose, but also for

determiningthediscountraterequiredforvaluingthedebtinvestmentsthatarebacked

by the collateral.1105 Both discount rates adjust value to account for the risk that the

expected cash flows will not materialize, but one is in relation to the cash flows

producedbytheunderlyingcollateralandtheothertothecashflowsproducedbythe

debtinstrument.

Inshort,markingto marketisintegraltotheconceptoffairvalue.Markingto

credit involves adjusting the value for deterioration (or appreciation) of future cash

flows expected from the investment. Marking to marketbased yield involves

discounting the cash flows expected based on a rate of return that is required by

investorsasofthevaluationdate.

1105Foranexampleofadiscountrateusedinvaluingtheunderlyingrealestatecollateral,seeTriMont,

AssetStatusReportforHeritageFieldsElToroLLC(July1,2008),attabNPV[LBEXBARFID0027112].
Foranexampleofadiscountrateusedinvaluingthedebtinvestmentsthatwerebackedbythecollateral,
see Zev Klasewitz, Lehman, Single Asset Debt Model May 2008 Spreadsheet (June 14, 2008), at tab
matrix(new)[LBEXLL1985749].

305

(a) TheRoleofTriMontintheValuationProcessfor
LehmansPTGPortfolio

LehmansvaluationprocessforitsPTGPortfoliobeganwithTriMontproviding

assetspecific information to the PTG business desk and Product Control. On the

businessdesk,BarsantiandKoutouvidesusedthatinformation,supplementedbytheir

knowledge of the status of the development and local market conditions, to value the

PTG positions.1106 ProductControl entered theTriMontdata and otherdata into their

modelstopricetestthevaluationsdeterminedbythebusinessdesk.1107

PTG outsourced a substantial part of the loan servicing and asset management

functions to TriMont, its primary asset servicer.1108 Given the substantial number and

geographicdiversityofPTGpositions,itwasmorecosteffectiveforTriMonttoprovide

theseservicesthantouseLehmanpersonnel.1109AsofMay2008,TriMontservicedover

90%ofLehmansPTGassets.1110

1106Examiners Interview of Anthony J. Barsanti, Oct. 15, 2009, at pp. 9, 1112; Examiners Interview of

AristidesKoutouvides,Nov.20,2009,atpp.1112.
1107Lehman,GlobalRealEstateProductControl,RealEstateAmericasPriceVerificationPresentationto

theSEC(Feb.1,2008),atp.5[LBEXWGM916015];ExaminersInterviewofEliRabin,Oct.21,2009,atp.
8;ExaminersInterviewofRebeccaPlatt,Nov.2,2009,atp.5.
1108Lehman&TriMont,AmendedandRestatedLoanServicingandAssetManagementAgreement(Sept.

1,2004),atpp.1112[TR00044479].
1109ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.9;ExaminersInterviewofAristides

Koutouvides,Nov.20,2009,atpp.8,910.
1110SeeZevKlasewitz,Lehman,SingleAssetDebtModelMay2008Spreadsheet(June14,2008)[LBEXLL

1985749]; Zev Klasewitz, Lehman, Single Family Debt Model May 2008 Spreadsheet (June 14, 2008)
[LBEXLL1985605];Lehman,SingleFamilyEquityModelMay2008Spreadsheet(May31,2008)[LBEX
LL 1985924]; Lehman, Strategic Equity Model May 2008 Spreadsheet (May 31, 2008) [LBEXBARSOX
0000594]; Zev Klasewitz, Lehman, Single Family REO Model May 2008 Spreadsheet (June 13, 2008)
[LBEXLL 1985887]; Lehman, Strategic REO Model May 2008 Spreadsheet (May 31, 2008) [LBEXLL
1985926].

306

TriMontservicedloans,handledinsuranceissuesfortheunderlyingrealestate,

dealtwiththeadministrativeaspectsoffundingborrowingsforconstruction,anddealt

withthelocaldeveloperonaregularbasisregardingoperationalissues.1111Withrespect

tothevaluationprocess,TriMontprovidedLehmanwithpropertyleveldata,aswellas

data regarding overall value of the development and the status of the project.1112

Barsanti and Koutouvides relied on this information to value the PTG positions.1113

Koutouvides had daytoday responsibility for working with TriMont.1114 Lehmans

policy was to not disclose its marks to TriMont, thus ensuring that TriMont provided

datafreefromtheinfluenceofLehmansvaluationofitsinvestments.1115

1111Lehman&TriMont,AmendedandRestatedLoanServicingandAssetManagementAgreement(Sept.

1, 2004), at pp. 1112 [TR00044479]; Examiners Interview of Anthony J. Barsanti, Oct. 15, 2009, at p. 9.
PCCP,LLC,servicedasmallernumberofassetsthatareirrelevanttothisanalysis.Lehman,GlobalReal
EstateProductControl,RealEstateAmericasPriceVerificationPresentationtotheSEC(Feb.1,2008),at
p.5[LBEXWGM916015];ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.10.
1112ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atpp.10,14.Aspartofthe2007audit,

E&Yinternallycirculatedareviewof25positions.MemorandumfromRobertMartinek,E&Y,toE&Y
AuditTeamforLehmanBrothers,etal.,re:LehmanBrothersCommercialRealEstatePortfolio(Jan.24,
2007),atp.1[EYLELBHIWPHC000397].TriMontprovidedvaluationdataforallofthesepositions,
andthereviewconcludesforallofthemthatTriMontprovidedavaluationestimatewithintheexpected
rangeofprobablevaluessupportedbythemarket.Id.atpp.3,5,79,11,13,15,1718,20,22,2425,27,
29,30,32,3435,37.
1113ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.9;ExaminersInterviewofAristides

Koutouvides,Nov.20,2009,atpp.10,14.
1114ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.9;ExaminersInterviewofAristides

Koutouvides,Nov.20,2009,atpp.10,14;Lehman,GREG,IntroductiontoAssetManagement(Sept.11,
2007),atp.3[LBEXLL2746736](describingTriMontas[i]dentify[ing]deals,propertytypes,sponsors
and/ormarketstofocusassetmanagereffortsand[d]evelop[ing]anddeliver[ing]efficientreportingto
[Lehman] at the deal and portfolio level (projected deal P&L, IRR returns, annual valuations, expected
payoffs,etc.).
1115ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.9;ExaminersInterviewofAristides

Koutouvides,Nov.20,2009,atp.12.

307

The value of the underlying real estate the collateral value was the most

important piece of information for purposes of valuation.1116 For each asset, TriMont

provided a collateral value eight months after Lehman made its investment, and

annuallythereafter.1117LehmantypicallydidnotchangeaPTGvaluationfrompar(i.e.,

100% of the investment or the funded amount) unless there was a triggering event,

suchasafailureofthebusinessplanthatreducedthecollateralvalueprovidedtoPTG

byTriMont1118

ThedatafilesproducedbyTriMontforthesecondquarterof2008categorizethe

collateralvaluation methodsin avariety ofways,butasthedata wasincomplete, the

Examinersfinancialadvisoridentifiedthemethodusedtovaluecollateralfor473ofthe

741positions(or64%ofthePTGportfolio).1119Amongthese473positions,thevaluation

1116Examiners Interview of Jennifer Park, Sept. 10, 2009, at p. 8, Examiners Interview of Abebual A.

Kebede,Oct.13,2009,atp.6;ExaminersInterviewofEliRabin,Oct.21,2009,atpp.67.
1117Lehman&TriMont,AmendedandRestatedLoanServicingandAssetManagementAgreement(Sept.

1,2004),atp.23.[TR00044479].InJuly2008,TriMontagreedtoreducethistothreemonthsafterclosing.
TriMont, TriMont Valuation Methodologies for Lehman Brothers PTG and LLG Assets: General
Guidelines(July1,2008)[LBHI_SEC07940_1201683].TriMontlistedboththecurrentvalue,whichwas
the present value of the asset, and the stabilized value, which was the anticipated value of the asset
afterthedevelopmentprojectwascompletedandtheassetwasgeneratingsufficientoperatingrevenue.
ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atpp.10,12.
1118ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.10.KoutouvidesconfirmedBarsantis

statement,sayingtherehadtobeacatalystforthevaluetochange.ExaminersInterviewofAristides
Koutouvides,Nov.20,2009,atpp.1011.
1119TriMont, TriMont Valuation Methodologies for Lehman Brothers PTG and LLG Assets: General

Guidelines(July1,2008)[LBHI_SEC07940_1201683].ForexamplesoftheTriMontexportspreadsheets,
seetheMay2008TriMontexportspreadsheetfordebtpositions,TriMont,DebtExportasofMay5,2008
(June 2, 2008) [LBEXAM 262026], and the May 2008 TriMont export spreadsheet for equity positions.
TriMont,EquityExportasofMay5,2008(June2,2008)[LBEXAM262362].

308

method usedbyTriMontcan beseparatedintotwo general categories: historical cost

basedvaluationmethodsandmarketbasedmethods.

Thehistoricalcostbasedvaluationmethodswereusedforatleast228positions,

or about 30% of the positions in the PTG portfolio in the second quarter of 2008.1120

Thesemethodsreliedprimarilyoncapitalizationofthedevelopment,alongwithsome

multiplier,tocalculatecollateralvalues.1121Cap*105wasthemethodusedforthevast

majorityofthesepositions,althoughvariationsofthecapitalizationmethodwerealso

used.1122

The marketbased methods were used for at least 245 positions, or 33% of the

positions in the PTG portfolio in the second quarter of 2008.1123 These categories

includedIRRmodels(80positions),aswellasothermethodsthatincorporatedmarket

basedassumptions.1124However,theTriMontspreadsheetscontainlittleexplanationfor

severalofthesemethods.Forsomecategories,suchaspurchaseoffer(17positions),

themethodappearstobeselfexplanatory,buttheTriMontfilesrefertofactsthatwere

1120Cap*105wasusedfor225ofthesepositionsandCap*100for3positions.

1121Duetolimitationsinthedata,theExaminerhasnotdeterminedwhyanyofthevariantsofCap*105

were used instead of Cap * 105, but all of them appear to be equivalent in using historical costbased
approachesinvaluingcollateralandnotincludinganymarketdata.
1122TriMont,DebtExportasofMay5,2008(June2,2008)[LBEXAM262026];TriMont,EquityExportas

ofMay5,2008(June2,2008)[LBEXAM262362].
1123TriMont,DebtExportasofMay5,2008(June2,2008)[LBEXAM262026];TriMont,EquityExportas

ofMay5,2008(June2,2008)[LBEXAM262362].
1124The full list of categories includes: purchase offer, IRR, expected sale price, market prices, sellout

calculation,paidoff,propertysold,andcaprate.ForexamplesoftheTriMontexportspreadsheets,see
the May 2008 TriMont export spreadsheet for debt positions, TriMont, Debt Export as of May 5, 2008
(June 2, 2008) [LBEXAM 262026], and the May 2008 TriMont export spreadsheet for equity positions.
TriMont,EquityExportasofMay5,2008(June2,2008)[LBEXAM262362].

309

not documented in the files.1125 For other categories, such as one for sellout

developments (95 positions),1126 the TriMont files simply note a sellout calculation

was performed, but provide very little additional information.1127 The Examiners

financial advisor has observed that most of these methods appear to rely on market

based assumptions, but there is insufficient information for the Examiner to evaluate

theinputsTriMontusedorthebasisforthecollateralvaluecalculated.

However, one particular marketbased method for calculating collateral value

wasthefocusofPTGandTriMontduringthistimethediscountedcashflowmethod

that served as the basis for IRR models. As described below, Lehman and TriMont

wereintheprocessofincorporatingIRRmodelsthroughout2007and2008.Becauseof

the increased use of IRR models, and the effect that this switch had on Lehmans

valuation of PTG assets, the Examiner has focused on this method in evaluating the

reasonableness of Lehmans PTG valuations during the second and third quarters of

2008.

1125For example, for purchase offer, the Examiners financial advisor has observed no evidence
showingthetermsofanyofferfromaninvestororhowthatwasusedtovaluethecollateral.
1126A sellout development is a real estate development in which the business plan is to sell off

individualunitsofthepropertyratherthanthepropertyasawhole.
1127TriMont,DebtExportasofMay5,2008(June2,2008)[LBEXAM262026];TriMont,EquityExportas

ofMay5,2008(June2,2008)[LBEXAM262362].

310

(i) LehmansIssueswithTriMontsData

AccordingtoseveralLehmanwitnesses,itwascommonplaceforTriMontsdata

toincludeerrors.1128KoutouvidestoldtheExaminerthatTriMonthadweakcontrols

forvaluinglanddevelopmentassets.1129Whenthedataindicatedthatapositionmight

need to be remarked, it was sometimes caused by an error.1130 The errors were

substantial and extensive enough that Koutouvides spent much of his time fixing

TriMontserrors.1131Koutouvidesnotedthat,despiteinstructingTriMonttofixdataas

to an asset in one month, the same problem would often reappear the next month.1132

During the period in which TriMont was providing IRR models, Koutouvides

1128ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atpp.1314;ExaminersInterviewofEli

Rabin, Oct. 21, 2009, at p. 8; Examiners Interview of Rebecca Platt, Nov. 2, 2009, at p. 5; Examiners
Interview of Aristides Koutouvides, Nov. 20, 2009, at p. 13. See Lehman, Business Requirements
Document(Full)forGREGTriMontExportFile[Draft](Oct.29,2007),atp.7[LBEXDOCID3501542]
(In the current system, Trimont has not modeled the exit date as a function to factor the changes in
marketcondition.Thechangesinmarketconditionmayresultinrepaymentdelaysandhencetheexit
date may change.); email from Anthony J. Barsanti, Lehman, to Britt Payne, TriMont (July 25, 2007)
[LBEXDOCID 2291650] (Barsanti responding I thought so to Paynes message that the value for
AnnapolisJunctionat100%ofcapitalizationisoverstatedanditsawriteoff);emailfromEliRabin,
Lehman, to Aristides Koutouvides, Lehman (Dec. 12, 2007) [LBEXDOCID 1639358] (According to the
[TriMont]export,thispropertyhasalreadybeensold.IknowthisisstillanactivepositionontheBS,soI
know something is incorrect.). Because of the errors, Koutouvides considered the stabilized value
reportedbyTriMonttobeuseless.ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atp.
15.
1129ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atp.13.

1130Examiners Interview of Aristides Koutouvides, Nov. 20, 2009, at p. 13; Examiners Interview of

Rebecca Platt, Nov. 2, 2009, at p. 5. Platt stated that, on occasion, a position would have a value that
madeabsolutelynosense.Forexample,thepositionshouldhavebeenmakingmoneybutwasnot.Platt
statedthatshewouldassumethatTriMontsdatawasflawed,suchasthattherewasawrongmaturity
datethatthrewoffthecashflows,ratherthanconcludethatthepositionneededtoberemarked.Id.
1131ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atp.13.

1132Id. According to Koutouvides, PTG hired him in late 2006 in part to improve TriMonts data

reporting.Koutouvidesstatedthat,eventhoughhehadnopriorrealestateexperience,PTGhiredhim
from Lehmans corporate division because of his experience overhauling Lehmans IT system and
infrastructure.Id.atp.6.

311

characterized several meetings with TriMont as screaming matches, where he and

BarsantiexpressedfrustrationatTriMontsinabilitytoprovideaccuratedata.1133

In Koutouvides view, TriMont asset managers varied widely in ability, and

some had become too close to the developers, such that the asset managers were not

reporting on deteriorating local market conditions, preferring instead to rely on the

developers assurances that the project would be a success.1134 Koutouvides recalled

that, on at least one occasion, his concern that the TriMont asset managers were not

obtaining credible data as to the status of the project and local market conditions

resulted in his telling TriMonts asset managers to stop feeding me bullshit. I dont

believeyou.1135

Barsanti disagreed with Koutouvides opinion that TriMont provided high

valuations,butheconfirmedthatthereweremanyinstanceswherePTGhadtoinstruct

TriMonttocorrectthedata.1136

(ii) LehmanChangedItsValuationMethodologyforIts
PTGPortfolioinLate2007

As noted, until 2007 Lehmans primary method for valuing the collateral

underlying its PTG positions was the Cap * 105 method. Cap * 105 calculated the

1133Id.atp.14.

1134Id.

1135Id.

1136Examiners Interview of Anthony J. Barsanti, Oct. 15, 2009, at pp. 1314. Barsanti stated that, in his

view, TriMont had a conservative view towards valuation. Id. Barsanti also stressed throughout his
interviewwiththeExaminerthedifficultyofvaluingPTGassetswithoutsalesdatatogiveanindication
ofvalue.Id.atp.11.

312

current capitalization of the underlying property (i.e., outstanding debt plus equity

investedtodate),andthenmultipliedthisnumberby105%toestimatethevalueofthe

collateral as of the specific valuation date.1137 The additional 5% represented the

presumedappreciationofthecollateral.

By late 2007, Lehman had determined that Cap * 105 was not an appropriate

methodologyfordeterminingcollateralvalue.1138Inanupwardtrendingmarket,Cap*

105tendstoundervaluecollateralwhenappreciationoccursataratehigherthan5%.1139

Kebede,VicePresidentinProductControl,statedthatCap*105wasawaytorestrain

value inflation when the markets were going crazy.1140 Despite pressure from

auditorsandotherbusinessunits,PTGspolicywastonotwriteuppositionsuntilthe

businessplanwassubstantiallyexecutedandrealizationofgainswasimminent.1141

Whenrealestatevaluesbegantodeclinein2007,Cap*105startedtoovervalue

PTGcollateral.1142BecauseCap*105simplycalculatedcurrentcapitalizationandadded

1137Adealstotalcapitalizationincludesalloutstandingdebtsuchasloanprincipalandequityasof

thevaluationdate,includingborrowersequityand/orinvestedcapital.
1138Examiners Interview of Anthony J. Barsanti, Oct. 15, 2009, at pp. 1213; Examiners Interview of
AristidesKoutouvides,Nov.20,2009,atp.15.SeeemailfromEdDziadul,RealComFinancialPartners
LLC, to Dennis Grzeskowiak, TriMont, et al. (Mar. 23, 2008) [LBEXDOCID 2293586] (noting that
TriMontscollateralvaluationmethodologymadecurrentvalueworthless).
1139See,e.g.,Lehman,Valuation&ControlReportFixedIncomeDivision(Dec.1,2008),atp.27[LBEX

WGM755798](Currentvaluationmethodologyforlanddevelopmentprojectsisbasedoncap*105%,
whichwasaconservativeorprudentapproach[in]anupmarket.).
1140ExaminersInterviewofAbebualA.Kebede,Oct.6,2009,atp.4;ExaminersInterviewofAnthonyJ.

Barsanti,Oct.15,2009,atp.10.
1141ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.10;ExaminersInterviewofAristides

Koutouvides,Nov.20,2009,atp.11.BarsantistatedthatthispolicycamedirectlyfromKennethCohen
andMarkA.Walsh.ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.10.
1142ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atpp.1213.

313

a 5% premium, it could never capture deterioration of collateral value that could

happen through, for example, marketwide declines in property values. Product

Controldeterminedbytheendof2007thatalthoughCap*105wasaconservativeor

prudent approach [in] an upmarket . . . [g]iven current market conditions, this

approachmaynotbeappropriate.1143

Inearly2007,PTGbegantoenactaplantochangeTriMontsprovisionofasset

leveldata.1144ThisoverhaulinthereportingsystemwasintendedtorequireTriMontto

providesupportforassumptionsaboutassetsandtobemoreresponsivetomarketplace

changes.1145Aspartofthatoverhaul,PTGdecidedthatCap*105wasnotgoingtocut

it, and planned to have TriMonts calculation of collateral value move to a more

marketbasedmethodology.1146PTGandTriMontreferredtothenewmodelsbasedon

thismethodologyasIRRmodels.

BarsantiandKoutouvidespreferredIRRmodelstoCap*105becausethemodels

hadtheabilitytovaluecollateralunderadiscountedcashflowmethod,whichBarsanti

and Koutouvides considered to be the best method for valuing collateral for PTG

1143See,e.g.,Lehman,Valuation&ControlReportFixedIncomeDivision(Dec.1,2007),atp.27[LBEX

WGM755798].
1144Examiners Interview of Anthony J. Barsanti, Oct. 15, 2009, at pp. 1213; Examiners Interview of

AristidesKoutouvides,Nov.20,2009,atp.15.
1145ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atpp.4,15.

1146ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.13.

314

positions.1147 Under the discounted cash flow method, an IRR model calculated the

currentvalueofcollateralbydeterminingtheNetPresentValue(NPV)ofallmonthly

discounted Net Cash Flows (NCF).1148 As a first step, the IRR model calculated the

NCF produced by the asset by taking monthly expected revenue and subtracting

monthlyexpectedexpenses.1149Tothisresult,theIRRmodelappliedadiscountrateto

produce the NPV of the NCF. In order to reflect fair value, the discount rate should

reflect, for both equity and debt investments, the yield an investor would require to

purchase theproperty. However,Lehmangenerally attributeda discount rate for the

equity portion of the capital structure based on Lehmans expected rate of return (i.e.

20% for land developments) and, for debt, a discount rate based on the interest rate

associatedwiththeunderlyingloansatorigination.1150TheIRRmodelstookaweighted

1147Id.;
Examiners Interview of Aristides Koutouvides, Nov. 20, 2009, at pp. 4, 15. The Examiners
financial advisor has observed that IRR models are a flexible tool for valuing collateral and do not
necessarilyusethediscountedcashflowmethodforeveryvaluation.However,theprimaryreasonPTG
requiredTriMonttouseIRRmodelswasthattheyperformedadiscountedcashflowanalysis.Id.
1148TriMont, TriMont Valuation Methodologies Lehman PTG and LLG CMBS Hold Assets (Apr. 28,

2008)[LBEXDOCID2089942].Thecashflowsinthiscalculationincludedthecashflowsexpectedtobe
generatedbythepropertythatwouldbeavailablefordistributiontoallinvestors.
1149ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.14.Revenuesconsistedofallofthe

income that the investors in the property expected to generate from the time of investment through
executionoftheexitstrategy.Asof2007,therevenuesforPTGassetstypicallywerethesalesrevenue
once the project was completed (i.e., sale of a hotel), but sometimes the asset generated revenue in the
formofrent,portionsofadevelopmentsold,orotherpaymentsbeforeitssale.Expensescouldinclude
anythingtheinvestorsexpectedtopayindevelopmentcosts(i.e.,entitlingland,construction),financing
costs(i.e.,loanfees,interests),orotherindirectcosts(i.e.,administrativefees,marketing).
1150TriMont, TriMont Valuation Methodologies Lehman PTG and LLG CMBS Hold Assets (Apr. 28,

2008)[LBEXDOCID2089942].

315

averagebetweenthesetworatestoarriveattheweightedaveragediscountrateforthe

property.1151

Instead of referring just to what Lehman and the other investors paid for the

positiontoreflectcurrentvalue,IRRmodelshadtheadvantageofincorporatingfuture

events(projectedrevenuesandexpenses)intothepresentvalue,andthendiscounting

thatvalueinrecognitionoftheriskthattheinvestmentmightnotbesuccessful.Cap*

105 incorporated no discount for risk, and therefore, generally produced higher

collateralvaluesthanIRRmodelsinadownwardtrendingmarket.1152

The IRR models were implemented on a rolling basis and the models were

calibrated after they were put into use.1153 TriMont started implementing the IRR

models in California in 2007, as valuation of California land developments was a

primarysourceofconcernforPTG.1154KoutouvidesandBarsantiworkedcloselywith

TriMontinimplementingtheIRRmodels,andKoutouvidesstatedthatinMarch2007

hewasonaplaneallthetimetovisitTriMont.1155

1151Theweightedaveragewasbasedontheoutstandingdebtandtheequityinvestedtodate.

1152Examiners Interview of Aristides Koutouvides, Nov. 20, 2009, at p. 15; Examiners Interview of
JonathanCohen,Jan.22,2010,atp.4.
1153Examiners Interview of Aristides Koutouvides, Nov. 20, 2009, at p. 15. Koutouvides managed the

process of acquiring the models, reviewing them with Barsanti, and following up with TriMont to fix
errorsinthedata.Id.atp.10.
1154ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.13;ExaminersInterviewofAristides

Koutouvides,Nov.20,2009,atp.15.
1155ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atp.14.SeeemailfromLoriGiesler,

TriMont, to Chris W. Warren, Lehman (Jan. 21, 2007) [LBEXDOCID 3606437]. Barsanti occasionally
joinedKoutouvidesonthesetrips.SeeemailfromDennisGrzeskowiak,TriMont,toJimHill,TriMont,et
al.(Mar.7,2008)[LBEXDOCID2293369].

316

TherolloutofIRRmodelsexperiencedmanydelays,andTriMontmissedseveral

deadlinesin2007and2008,causingmorefrustrationforPTG.1156Forexample,afterone

misseddeadline,BarsantistatedinaMarch2007emailthat[a]sthemarketcontinues

tosoften,IcanttellyouhowmuchwedependontheseIRRstomarkourposition.1157

Over a year later, on March 23, 2008, an email sent to TriMont by a PTG consultant

indicatedthattheCap*105method,whichwasstillwidelyinuse,wasworthless.1158

In Product Controls Valuation & Control Reports, the same comment appears

unchanged over a series of months, stating that TriMont was developing IRR models

and walking away from cap * 105% methodology.1159 Because of the delays,

1156SeeemailfromDennisGrzeskowiak,TriMont,toJimHill,TriMont,etal.(Mar.7,2008)[LBEXDOCID

2293367](TheyarerefusingtofundtheMonteSerenodrawrequestuntiltheIRRmodelisupdatedto
reflect the current scenario.); email from Aristides Koutouvides, Lehman, to Anthony J. Barsanti,
Lehman(Mar.7,2008)[LBEXDOCID2293369]([T]hey[TriMont]needtoupdatethemodelaccurately
beforethefinalnumbercanbedetermined.);emailfromDennisGrzeskowiak,TriMont,toEdDziadul,
RealComFinancialPartnersLLC(Mar.23,2008)[LBEXDOCID2293586](containinganemailexchange
revealing Dziaduls concern as to why Current Value . . . determined by discounting the Remaining
ValuetotheExitDatewasnotbeingapplieduniversallyandGrzeskowiaksresponsethat[t]hattiesto
TriMonts current valuation methodology . . . were working on revising that policy). Barsanti stated
that many times he was laying the hammer down on TriMont because of its delays, which made
updatingthecollateralvalueslumpy.ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.
13.
1157Email from Anthony J. Barsanti, Lehman, to Lori Giesler, TriMont, et al. (Mar. 13, 2007) [LBEX

DOCID2290789].
1158Email from Ed Dziadul, RealCom Financial Partners LLC, to Dennis Grzeskowiak, TriMont, et al.

(Mar.23,2008)[LBEXDOCID2293586].DziadulwasaformerPTGemployeelocatedinCaliforniawho,
afterleavingLehman,assistedwithTriMontsimplementationofIRRmodels.ExaminersInterviewof
AnthonyJ.Barsanti,Oct.15,2009,atp.13.
1159Lehman, Valuation & Control Report Fixed Income Division (June 2008), at p. 29 [LBEXWGM

370046]; Lehman, Valuation & Control Report Fixed Income Division (July 1, 2008), at p. 29 [LBEX
WGM790236];Lehman,Valuation&ControlReportFixedIncomeDivision(Aug.2008),atp.29[LBEX
BARFID0000260].SeealsoemailfromBrianBarry,Lehman,toJeffreyGoodman,Lehman,etal.(June19,
2008) [LBHI_SEC07940_2234984] (Within the last 6+/ months, a change to the methodology (for
valuations)wasimplementedbyTrimont(attherequestofProdControl&thebusiness).Trimonthas

317

KoutouvidesstatedthatheoftenstillreliedoncollateralvaluesbasedonCap*105in

markingpositions,asitwastheonlyavailableinformation.1160

As noted, TriMonts data provided to Lehman did not contain the information

necessarytoidentifythemethodsusedtovaluethecollateralforeachPTGposition.1161

However, in May 2008, at least 228 PTG positions still relied on some variant of the

capitalizationmethod(suchasCap*100andCap*105)tovaluetheircollateral.1162This

representedroughlyathirdofthePTGportfolio.TheExaminersfinancialadvisorhas

identified IRR models for 80 PTG positions in the second quarter of 2008.1163 By July

2008,thattotalforIRRmodelsfoundincreasedto292.Duetolimitationsinthedata,

the Examiners financial advisor has identified only 105 positions that switched from

Cap*105toIRRmodelsbetweenMayandJulyof2008.1164BarsantiandKoutouvides

madetremendousprogressinimplementingthesechanges,itisjustaquestionofhowmuchhasactually
madeittotheexportwereceive.Withthatsaid,Trimontisactivelyupdatingcurrentvalues.);TriMont,
TriMont Valuation Methodologies Lehman PTG and LLG CMBS Hold Assets (Apr. 28, 2008) [LBEX
DOCID2089942](replacing105%ofcapmethodologywith[l]esserof100%ofTotalCaportheNPVof
allmonthlyNCFs).
1160ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atp.15.

1161The Examiner determined that it would not be a prudent use of resources to interview numerous

TriMontassetmanagerstodetermineiftheycouldrecallinformationthatwasnotsetforthinthereports
providedtoLehman.
1162TriMont,DebtExportasofMay5,2008(June2,2008)[LBEXAM262026];TriMont,EquityExportas

ofMay5,2008(June2,2008)[LBEXAM262362].
1163TriMont,DebtExportasofMay5,2008(June2,2008)[LBEXAM262026];TriMont,EquityExportas

ofMay5,2008(June2,2008)[LBEXAM262362].
1164TriMont,DebtExportasofMay5,2008(June2,2008)[LBEXAM262026];TriMont,EquityExportas

ofMay5,2008(June2,2008)[LBEXAM262362];TriMont,DebtExportasofJuly5,2008(Aug.1,2008)
[LBEXAM 267134]; TriMont, Equity Export as of July 5, 2008 (Aug. 4, 2008) [LBEXAM 267510]. The
Examinersfinancialadvisorhasidentified153positionsthattransitionedfromCap*105(oritsvariants)
toadifferentvaluationmethod,buthasnotidentifiedwhatthatnewmethodwasfor75positions.There

318

assertedthat,byJuly2008,TriMonthadimplementeduseofIRRmodelsforallofthe

land deals managed by its California office (which had approximately 100 positions)

and80%ofthosemanagedbyitslargerAtlantaoffice.1165

(b) TheRoleofLehmansPTGBusinessDeskintheValuation
ProcessforLehmansPTGPortfolio

Since PTG assets were risky, illiquid, mediumtolong term investments, the

business desk had a difficult time valuing them, particularly during a market

downturn.1166 Under the classification scheme established by SFAS 157, which

categorizes assets based on the degree of certainty the valuation process can provide,

almost all PTG assets were classified as Level 3, whose values are the most subjective

becausetheydependonunobservableinputs.1167

Consistentwiththeunobservablenatureofthevaluationinputs,theExaminers

financialadvisorhasobservedthatLehmansrecordsdonotindicatethedirectrelation

between the collateral values provided by TriMont and the business desks mark.

is a high likelihood that there were more than 105 positions that transitioned from Cap * 105 to IRR
modelsinJuly2008.
1165ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.13;ExaminersInterviewofAristides

Koutouvides,Nov.20,2009,atp.15.
1166Examiners Interview of Anthony J. Barsanti, Oct. 15, 2009, at pp. 1114; Examiners Interview of

AristidesKoutouvides,Nov.20,2009,atpp.89,13.
1167Fin.AccountingStandardsBd.,FairValueMeasurements,SFASNo.157,2122,24(2006);Lehman,

GlobalRealEstateInventorySpreadsheetasofMay31,2008(Aug.8,2008)[LBEXDOCID2077095].As
ofMay31,2008,PTGheldnoLevel1assets,6Level2assets,and380Level3assets.Lehman,GlobalReal
EstateInventorySpreadsheetasofMay31,2008(Aug.8,2008)[LBEXDOCID2077095].Theremainder
ofPTGassetswereConsolidatedassetsandnotsubjecttoSFAS157.SeeLehmanBrothersHoldings
Inc.,PressRelease:LehmanBrothersReportsFirstQuarterResults(Mar.18,2008),atp.14[CITILBHI
EXAM00078274];ConsolidationofVariableInterestEntities,InterpretationofFin.AccountingStandards
No.46(Fin.AccountingStandardsBd.2003).

319

Lehmans asset managers, Barsanti and Koutouvides, routinely had to look beyond

TriMonts data and refer to the business plans and submarket data for a particular

propertytype,andthenexerciseindependentjudgmentastohowmuchthecollaterals

current value, as determined by the information provided by TriMont, should inform

themark.1168AlthoughPTGsrecordssetforththestatusofeachproject,includingany

problems that the development was experiencing, they do not describe how Lehman

employed its judgment to translate such problems into a writedown of a particular

amountforthecorrespondingPTGasset.1169

KoutouvidesdescribedhisvaluationprocessascastinganetwithTriMontsdata

to identify outliers and closely observing those positions to determine which ones

neededtoberemarked.1170AccordingtoKoutouvides,Lehmanspolicyforrevaluinga

positionwasthattherehadtobeacatalystforthevaluetochange,suchasafailureof

thebusinessplan.1171Koutouvidesfocusedonhardertovaluelandandcondominium

positions.1172 Notably, 99% of writedowns taken on the PTG portfolio during 2008

relatedtopositionswithlandorcondominiumsascollateral.1173Whenthereliabilityof

1168ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atpp.9,11,1314.

1169Forexample,theExaminersfinancialadvisorhasobservedthatTriMontsIRRmodelsandLehmans

price testing files do not indicate how exactly the business desk used this information to mark the
portfolio or write down assets. See, e.g., TriMont, Asset Status Report for Heritage Fields El Toro LLC
(July 1, 2008) [LBEXBARFID 0027112]; Lehman, Valuation & Control Report Fixed Income Division
(May2008),atp.22[LBHI_SEC07940_2554301].
1170ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atp.13.

1171Id.atpp.1011.

1172Id.atp.12.

1173Lehman,GlobalRealEstate2008NetMarkDowns(Sept.5,2008)[LBEXAM346991].

320

TriMonts method for calculating collateral values improved through the shift to IRR

models,BarsantiandKoutouvidesreliedonthosevaluesmorefrequently,butnothing

TriMontprovidedwastakenasgospelbythebusinessdesk.1174

(c) TheRoleofLehmansProductControlGroupinPrice
TestingtheValuationofLehmansPTGPortfolio

Separate from the marking process of the PTG business desk, the Product

Control Group performed an independent price verification of the PTG marks.

JonathanCohenoversawProductControlsvaluationandpricetesting,andAbebualA.

Kebede worked under him and had daytoday oversight of the Product Control

staff.1175DirectedbyKebede,twojuniorproductcontrollersranmodelstogeneratetest

pricesforPTGpositions.1176EliRabinperformedpricetestingonallPTGpositionsuntil

early2008,whenLehmanhiredRebeccaPlatttopricetestthePTGdebtpositions.1177

Product Control performed the price testing process for a given month at the

beginning of the following month and performed its most thorough price testing at

quarterend.1178Topricetest,productcontrollersfedcollateralvaluesandotherinputs

1174ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.14.

1175ExaminersInterviewofJonathanCohen,Jan.11,2010,atpp.67.

1176Lehman,GlobalRealEstateProductControl,RealEstateAmericasPriceVerificationPresentationto

theSEC(Feb.1,2008),atp.3[LBEXWGM916015].
1177Id.; Examiners Interview of Eli Rabin, Oct. 21, 2009, at p. 4; Examiners Interview of Rebecca Platt,

Nov.2,2009,atp.4.IncludedinthepricetestingforPTGequitywerethepositionsonwhichLehman
foreclosed and recategorized as real estate owned. Lehman, Real Estate Monthly Price Verification
PolicyandProcedures(July16,2008),atp.12[LBEXDOCID1454682].
1178Lehman, Real Estate Price Verification Presentation [Draft] (July 17, 2008), at p. 1

[LBHI_SEC07940_1169231] (Price Verification is performed on a monthly basis); Lehman, Real Estate


MonthlyPriceVerificationPolicyandProcedures(July16,2008),atp.11[LBEXDOCID1454682](The

321

intotheir modelstoproduceamodelpriceforthedebtorequityposition,whichwas

comparedwiththebusinessdesksvalue.Thedifferencebetweenthetwowastermeda

variance.1179

Rabin and Platt used the same assetspecific data that TriMont provided to the

business desk.1180 They generally applied the collateral values provided by TriMont,

whether they were based on Cap * 105 or IRR models.1181 However, Rabin told the

Examiner that both of his superiors in the Product Control Group and business desk

personnel sometimes instructed him to disregard the current value provided by the

models.1182 Product Control knew that Cap * 105 caused inaccurate valuations of

collateral, but those collateral values were still used in the absence of IRR models.1183

PlatttoldtheExaminerthatsheobservedasuddendropincollateralvaluesacrossthe

PTGdebtbookwhenmoreIRRmodelswereincorporatedinJuly2008.1184Inaddition,

quarterly analysis is a much more detailed analysis of pricing variances resulting from the routine
monthlyprocess.);ExaminersInterviewofEliRabin,Oct.21,2009,atp.5.
1179ExaminersInterviewofAbebualA.Kebede,Sept.29,2009,atp.5.

1180Lehman,GlobalRealEstateProductControl,RealEstateAmericasPriceVerificationPresentationto

theSEC(Feb.1,2008),atp.5[LBEXWGM916015];ExaminersInterviewofEliRabin,Oct.21,2009,atp.
8;ExaminersInterviewofRebeccaPlatt,Nov.2,2009,atp.5.RabinandPlattcouldcontactTriMonton
theirowntodiscussthedata.See,e.g.,emailfromHardingBrannon,TriMont,toRebeccaPlatt,Lehman
(Mar.13,2008)[LBEXDOCID1802324].
1181ExaminersInterviewofEliRabin,Oct.21,2009,atp.8;ExaminersInterviewofRebeccaPlatt,Nov.2,

2009,atp.5.
1182ExaminersInterviewofEliRabin,Oct.21,2009,atp.8.

1183ExaminersInterviewofAbebualA.Kebede,Oct.6,2009,atp.7;ExaminersInterviewofEliRabin,

Oct. 21, 2009, at p. 7. Rabin stated that the Cap * 105 pricing methodology often caused his price
verificationmodelstosuggestthatthevaluesofaPTGpositionshouldbewrittenup,evenwhenRabin
hadspecificknowledgethattheunderlyingdealwasnotperformingwell.ExaminersInterviewofEli
Rabin,Oct.21,2009,atp.7.
1184ExaminersInterviewofRebeccaPlatt,Nov.2,2009,atp.7.

322

the price testing results at this time showed that the marks overvalued the PTG debt

book.1185

ThepricetestingmodelsforPTGdebtusedmarketdatatoapplyadiscountrate

(or yield) to account for the marketbased risk of an investment in the debt of that

property type. The risk level was in part determined by the LoantoValue ratio

(LTV),whichistheratioofthevalueoftheoutstandingdebtdividedbythevalueof

thecollateral.AfterdeterminingtheLTVofadebtposition,PlattreferredtotheReal

EstateFinance&Investmentsnewsletter,whichprovideddiscountratesbasedonLTV

andpropertytype.1186Plattthenappliedtheappropriatediscountratetodeterminethe

presentvalueofthedebtposition.1187

Topricetestequitypositions,1188Rabinsmodelsperformedawaterfallanalysis

tocheckthemarks,whichisaprocessthatexaminesthedistributionofproceedsfroma

hypothetical sale of the collateral.1189 In the waterfall analysis any outstanding debt is

1185Id.atpp.7,1011.

1186Email from Rebecca Platt, Lehman, to Abebual A. Kebede, Lehman (June 16, 2008)
[LBHI_SEC07940_2945503]; Examiners Interview of Rebecca Platt, Nov. 2, 2009, at p. 8. The property
typeswereresidential,apartments,retail,malls,stripandpowercenters,industrial,multitenant,office,
CBD,suburban,andhotel.SeeInstitutionalInvestors,Inc.,RealEstateFin.&Inv.Newsl.,May26,2008,
at p. 7 [LBHI_SEC07940_2945508]; Lehman, Global Real Estate Product Control, Real Estate Americas
PriceVerificationPresentationtotheSEC(Feb.1,2008),atp.6[LBEXWGM916015].
1187Examiners Interview of Rebecca Platt, Nov. 2, 2009, at p. 8. There were additional, more technical

stepsinthisprocess,wherethepresentvaluecalculatedbythemodelwascomparedtootherbenchmark
values,suchasthevalueofproceedsfromthecollateralinaliquidationscenario,andthelowestnumber
after these comparisons became the model output. Lehman, Global Real Estate Product Control, Real
EstateAmericasPriceVerificationPresentationtotheSEC(Feb.1,2008),atp.6[LBEXWGM916015].
1188PTGREOpositionsweretestedwith asimilarprocessasthatforPTGequity.Lehman,RealEstate

MonthlyPriceVerificationPolicyandProcedures(July16,2008),atp.12[LBEXDOCID1454682].
1189ExaminersInterviewofEliRabin,Oct.21,2009,atp.6.

323

assumed to be paid out first, with equity holders entitled to the remaining proceeds

subjecttothetermsofanyshareholderagreements.1190

As noted, after Product Control calculated the model price for a debt or equity

position, this price was compared to the business desks mark to determine the

variance.Lehmanspolicywasthat[v]ariancesoutsidethresholdsarediscussedwith

the business for potential mark adjustments.1191 In the PTG debt and equity models,

the threshold for an overvaluation variance was $2 million and the threshold for an

undervaluation variance was $5 million.1192 If Rabin and Platt were unable to resolve

the variance with the business desk, the issue was escalated to Kebede and Jonathan

Cohen, who could then, if necessary, direct these valuation issues to Lehmans senior

managers.1193

1190Id. at p. 6. The models assumed distribution of cash flows in the following order: (1) pay off full

amountofdebt;(2)distributiontoownersforaccumulatedpreferredreturns;(3)distributiontoowners
for return of capital; and (4) distribution to owners for split of any remaining profit according to their
profit and loss sharing ratios. Lehman, Real Estate Monthly Price Verification Policy and Procedures
(July16,2008),atp.12[LBEXDOCID1454682];Lehman,GlobalRealEstateProductControl,RealEstate
AmericasPriceVerificationPresentationtotheSEC(Feb.1,2008),atp.8[LBEXWGM916015].
1191Lehman,GlobalRealEstateProductControl,RealEstateAmericasPriceVerificationPresentationto

theSEC(Feb.1,2008),atpp.6,8[LBEXWGM916015].
1192ForanexampleofsuchthresholdsinthePTGdebtpricetestingmodels,seeformulaincellBF4onthe

PricingtabofLehmansSingleAssetDebtModelfromMay2008.ZevKlasewitz,Lehman,SingleAsset
DebtModelMay2008Spreadsheet(June14,2008),attabPricing,cellBF4[LBEXLL1985749].Foran
exampleofsuchthresholdsinthePTGequitypricetestingmodels,seeExcelsfilterfunctionappliedto
column BA on the Valuation tab of Single Family Equity Pricing Model from June 2008. Lehman,
Single Family Equity Model June 2008 Spreadsheet (June 30, 2008), at tab Valuation [LBEXBARFID
0023444].
1193See, e.g., email from Rebecca Platt, Lehman, to Abebual A. Kebede, Lehman (June 18, 2008)

[LBHI_SEC07940_2949726] (stating that she wanted to discuss the comment [for positions that had
pricing variances] with[Kebede] because they[were] foreclosures); Examiners Interview of Eli Rabin,
Oct.21,2009,atp.4;ExaminersInterviewofRebeccaPlatt,Nov.2,2009,atpp.5,1011.

324

As a result of this escalation and resolution process, the positions for which

variances exceeded the given threshold were either remarked or resolved.1194 If

remarked,thebusinessdeskloweredorraiseditsmarkinlightoftheProductControl

testprice.1195Ifresolved,thebusinessdesksmarkwouldremainthesameandProduct

Controlprovidedanexplanationforwhythepositionwasnotremarked.1196Thegoalof

theexplanation,notedinProductControlsmonthly Valuation&ControlReport,was

toprovideinformationnotcapturedbythemodelsthatjustifieddisregardingthemodel

priceandmaintainingthedeskmark.1197

PlattandKebedetoldtheExaminerthattheyoftenhaddifficultyexplainingwhy

positionswerenotremarkedandthatinthesesituationstheycameupwithformulaic

explanations.1198Asaresult,Plattstatedthatmanyoftheexplanationssheprovidedfor

not changing the marks in the PTG debt pricing models were not meaningful and

contained many form responses, such as Based on discussions with the business,

1194Lehman,GlobalRealEstateProductControl,RealEstateAmericas,PriceVerificationPresentationto

theSEC(Feb.1,2008),atp.21[LBEXWGM916015];Lehman,RealEstatePriceVerificationPresentation
[Draft](July17,2008),atp.1[LBHI_SEC07940_1169231].
1195Lehman, Real Estate Price Verification Presentation [Draft] (July 17, 2008), at p. 1

[LBHI_SEC07940_1169231].
1196Id.

1197Id.;Lehman,GlobalRealEstateProductControl,RealEstateAmericasPriceVerificationPresentation

totheSEC(Feb.1,2008),atp.21[LBEXWGM916015];ExaminersInterviewofAbebualA.Kebede,Oct.
6,2009,atp.5;ExaminersInterviewofRebeccaPlatt,Nov.2,2009,atpp.1011.
1198Examiners Interview of Abebual A. Kebede, Oct. 6, 2009, at pp. 1011 (noting that he wrote

explanationsformarksandthatheagreedwithsomeofthem);ExaminersInterviewofRebeccaPlatt,
Nov.2,2009,atp.4.

325

position is marked appropriately and continue to monitor.1199 Kebede confirmed

that no writedown was taken for many of the positions for which a significant price

testing variance was determined in the third quarter of 2008.1200 Kebede stated that,

althoughtherewasavalidexplanationfornotwritingdownsomeofthesepositions,he

wroteoroversawthewritingofseveralformresponseshedidnotactuallyagreewith

thatwereonlywrittentocomeupwithsomething.1201

(d) TheInfluenceofLehmansPTGBusinessDeskuponthe
PriceTestingFunctionofLehmansProductControlGroup

SeveralwitnessesgaveconflictingstatementsastowhetherProductControlhad

the ability to effectively provide an independent check on the business desk marks.

Walsh told the Examiner that Product Control existed on an independent track and

couldnotbefrozenoutofthevaluationprocess.1202KennethCohenalsostatedthat

ProductControlranonaparalleltrack,andcameupwithitsownnumbersrunning

its own models.1203 Kenneth Cohen stated that the business desk had no control over

ProductControlandthat,ifthebusinessdeskcouldnotconvinceProductControlthat

1199See e.g., Lehman, Valuation & Control Report Fixed Income Division (May 2008), at p. 22
[LBHI_SEC07940_2554301](noting,withrespecttoCalwestandtheNashvillePortfolio,that[b]asedon
discussionwith[the]desk....Nomarkdownsuggested);Lehman,Valuation&ControlReportFixed
IncomeDivision(July2008),atpp.2223[LBEXWGM790236](stating,withrespecttoseveralpositions
for which no writedown was taken, including Whitworth Estates Senior, [i]n discussion with the
business); Lehman, Valuation & Control Report Fixed Income Division (Aug. 2008), at pp. 2223
[LBEXBARFID 0000260] (stating, with respect to Whitworth Estates Senior Whole, [b]ased on
discussionswiththebusiness,positionismarkedappropriately);ExaminersInterviewofRebeccaPlatt,
Nov.2,2009,atpp.1011.
1200ExaminersInterviewofAbebualA.Kebede,Oct.6,2009,atp.5.

1201Id.;ExaminersInterviewofRebeccaPlatt,Nov.2,2009,atpp.1011.

1202ExaminersInterviewofMarkA.Walsh,Oct.21,2009,atp.13.

1203ExaminersInterviewofKennethCohen,Oct.20,2009,atp.10.

326

anumberwascorrect,ProductControlcouldelevatetheissue,allthewayuptoReilly

ifnecessary.1204

Koutouvides considered the Product Control process to be credible, but stated

thatiftherewasadifferenceofopinionbetweenProductControlandthebusinessdesk

regarding valuation ofaPTGasset(which Koutouvides estimated ashappening three

times a month), the mark did not change.1205 Koutouvides confirmed that he did not

take a suggested writedown from Product Control unless he was convinced that the

price testing model was correct.1206 With the market fluctuation in 2008, Koutouvides

statedhewasreluctanttoremarkapositiononlybasedonpricetestinguntilhecould

see where the asset was trending after another quarter.1207 The process resulted in

staggered writedowns, where a lag existed between identification of a trend and the

resultingwritedown.1208

Jonathan Cohen described Product Control as compromised by a lack of

information, and stated that Product Control often took the business desks word on

1204Id.

1205ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atpp.1617.

1206Id.

1207Lehman, Valuation & Control Report Fixed Income Division (Aug. 2008), at pp. 2123 [LBEX
BARFID0000260];ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atpp.1617.
1208Examiners Interview of Aristides Koutouvides, Nov. 20, 2009, at pp. 1617. As an illustrative

example,ifthemodelsuggesteda$20millionwritedownandifLehmanbelievedthattherewasa60%
chancethatawritedownwasappropriate,Lehmanwouldtakea$12millionwritedown($20million*
60%=$12million).Insomeinstances,Lehmanwouldwaitaquartertoseewhathappenedbeforetaking
the$12millionwritedown.

327

valuation issues.1209 For example, Jonathan Cohen pointed out that Product Control

used the same discount rate for collateral that the business desk used (e.g., 20% for

equityinvestmentsinlanddevelopments).1210

Kebedestatedthattheformcommentsheusedtoexplainwhyapositionwas

notremarked,suchasbasedondiscussionswiththebusiness,indicatedthathecould

not think of anything else to explain as the reason for keeping the current mark and

that,insomecases,hemaynothaveactuallyagreedwiththecomment.1211Certaine

mailsconfirmthatKebedesworkwastosomeextentinfluencedbythePTGbusiness

desk. On August 30, 2008, Koutouvides emailed Kebede stating that Anthony

[Barsanti]andIhavegivenyouguidanceontheseniordealsthatwefeelwereincorrect.

Pleasemakethechangesandletusknowhowthischangedthetotal.1212

Rabin also stated that, in most matters, he deferred to the judgment of

Koutouvides on the business desk, given Koutouvides familiarity with the valuation

modelsandtheunderlyingbusinessfundamentalsofeachposition.1213

Plattstatedthatdespitethefactthathermodelsproducedlargeovervaluations

inthethirdquarterof2008(whichshestatedwasaftertheintegrationofasignificant

1209ExaminersInterviewofJonathanCohen,Jan.11,2010,atp.5.

1210ExaminersInterviewofJonathanCohen,Jan.22,2010,atp.4.

1211ExaminersInterviewofAbebualA.Kebede,Oct.6,2009,atp.5.

1212Emailfrom Aristides Koutouvides, Lehman, to Abebual A. Kebede, Lehman (Aug. 30, 2008)
[LBHI_SEC07940_212040]. See also email from Abebual A. Kebede, Lehman, to Anthony J. Barsanti,
Lehman,etal.(Aug.27,2008)[LBEXDOCID4449124](KebedeaskingBarsantinotalargenumber[$1.4
million],shouldwelooktoawriteoff?).
1213ExaminersInterviewofEliRabin,Oct.21,2009,atp.8.

328

number of IRR models), writedowns were not taken for many PTG assets.1214 Platt

stated that Lehman didnotpay much attentiontoherthirdquarter2008pricetesting

results, characterizing the Product Control Group as, kind of sadly, the little

people.1215

(5) TheExaminersFindingsandConclusionsastothe
ReasonablenessofLehmansValuationofPTGPortfolio

TheExaminerfindssufficientevidencetosupportadeterminationthatLehman

did not appropriately consider marketbased yield when valuing PTG assets in the

secondandthirdquartersof2008.WhiletheExaminerrecognizesthatthevaluationof

illiquidassetsrequiresjudgmentandthatthereisawiderangeofreasonablevaluations

foranyparticularasset,Lehmanssystemicfailuretoincorporateamarketbasedyield

generallyresultedinanovervaluationofPTGassets.Accordingly,theExaminerfinds

that there is sufficient evidence to support a finding, for purposes of a solvency

analysis, that the values Lehman determined for certain of these assets were

unreasonable.

The evidence supports a finding that, as real estate markets deteriorated and

investorsincreasedtheirrequiredratesofreturn,Lehmanwasunabletoquicklyreplace

Cap * 105 with a valuation methodology that employed marketbased yields.

Furthermore,evenwhenLehmandidimplementavaluationmethodologythatapplied

1214ExaminersInterviewofRebeccaPlatt,Nov.2,2009,atpp.7,1011.

1215Id.atp.11.

329

a yield IRR models the yields reflected the weighted average of the contractual

interestratefordebtatoriginationandLehmansexpectedrateofreturnforequity(i.e.

20%forlanddevelopments),ratherthanmarketbasedrates.

TheExaminerdoesnotfindsufficientevidencethatLehmansfailuretoemploy

appropriateyieldsforPTGassetsduringthesecondandthirdquarterof2008supports

afindingthatanyLehmanofficersbreachedtheirfiduciaryduties.1216Althoughthereis

sufficient evidence to demonstrate that the valuation methodology for PTG assets did

notrelyonmarketbasedassumptions,thereisinsufficientevidencetodemonstratethat

any Lehmanofficeracted withanintentto produceincorrectvaluesorconductedthe

valuation process in a reckless manner. While Lehmans staffing was inadequate to

comprehensivelyvalueortestthesignificantnumberofpositionsinthePTGportfolio,

and there was also questionable judgment in the selection of yields, the valuation

determinedbyLehmandidnotresultfromactions(oromissions)thatwouldsupporta

claimofabreachoffiduciaryduty.

TheExaminerhasdeterminedthatitwouldnotbeaprudentuseofresourcesto

perform an independent valuation of every PTG asset by selecting the marketbased

yield that would have been applicable in the second and third quarters of 2008. The

uniquenessandilliquidityofPTGassets,combinedwiththevolatile2008market,create

1216SeeAppendix1,LegalIssues,SectionII,foramoredetaileddiscussionofthelegalstandardgoverning

aclaimofbreachoffiduciaryduty.

330

ahighriskoferrorforanyportfoliowideestimateofmarketbasedyield.1217Insteadof

attempting to cast a wide net, the Examiner has made observations about PTGs

applicationofyieldgenerallyandhasinvestigatedselectpositionsingreaterdetail,as

discussedbelow.1218

(a) LehmanDidNotMarkPTGAssetstoMarketBasedYield

Former Lehman personnel provided conflicting statements as to whether PTG

assets were valued at the price at which the asset could be sold, and in particular,

whetherthevaluationtookintoaccountthemarketbasedyieldthatwouldberequired

byaninvestorinlightofthencurrentmarketconditions.However,thestatementsof

those most deeply involved in the process of valuing PTG assets, as well as the

documentary evidence, provide sufficient evidence to support a finding that Lehman

didnotmarkitsPTGassetstomarketbasedyieldinthesecondandthird quartersof

2008.

Mark Walsh, head of GREG, did not indicate to the Examiner whether PTG

assets were marked at a price at which they could be sold, but stated that Lehman

1217This is especially true in that the Examiners financial advisor has had limited time to review
LehmansfilesonPTGassetsandhashadlimiteddatamadeavailableduringthediscoveryprocess.The
Examiners financial advisor did not find sufficiently detailed information to value many PTG assets.
Severalwitnesseswerealsounabletorememberanythingrelatedtothevaluationofspecificassets.See,
e.g.,ExaminersInterviewofAbebualA.Kebede,Oct.6,2009,atp.5;ExaminersInterviewofEliRabin,
Oct. 21, 2009, at pp. 9, 1112; Examiners Interview of Rebecca Platt, Nov. 2, 2009, at pp. 7, 9, 1011;
Examiners Interview of Aristides Koutouvides, Nov. 20, 2009, at p. 18 (providing very few details on
HeritageFields).
1218The chief criteria for selecting the assets (or groups of assets) analyzed below is whether the

Examiners financial advisor received sufficient information to issue a conclusion as to the valuation
processfortheseassetsinthesecondandthirdquartersof2008.

331

always marked CRE assets to both credit and yield, although he conceded that it

became difficult to mark to marketbased yield as market conditions deteriorated

during2008.1219Walshalsostatedthathewasnotnormallyinvolvedinvaluationissues

and that Barsanti and Kenneth Cohen were more knowledgeable about PTG

valuation.1220

Kenneth Cohen told the Examiner that PTG assets were marked to the price at

whichtheassetscouldbesoldtoaninvestor.1221Hestatedthatmarkingtobothcredit

and marketbased yield were components of PTGs valuation process.1222 Kenneth

Cohen described the PTG approach as markingtomodel but was clear that the

model price was intended to incorporate Lehmans best judgment as to the market

basedyieldandreflectthepriceatwhichtheassetcouldbesold.1223Healsostatedthat

awritedownbasedoncreditshouldalsoencapsulatetheeffectofchangestomarket

basedyieldaswell.1224However,KennethCohenalsostatedthatdeterminingthePTG

markswasprimarilyBarsantisjob.1225

1219ExaminersInterviewofMarkA.Walsh,Oct.21,2009,atp.13.

1220Id.

1221ExaminersInterviewofKennethCohen,Jan.21,2010,atp.4.

1222Id.

1223Id.HemaintainedthispositionevenashedescribedPTGsvaluationprocessasbasedonmarkto

model,whichimpliesthatLehmanvaluedpositionsbyselectingitsownassumptionsandinputsforthe
model.Id.
1224Id. Jonathan Cohen also said that where a notation in a Lehman document indicated that a write

down was made due to credit, yield was also taken into account. Examiners Interview of Jonathan
Cohen,Jan.22,2010,atp.4.
1225Examiners Interview of Kenneth Cohen, Jan. 21, 2010, at p. 2. Kenneth Cohen could not recall the

specifics of any particular discussion regarding PTG marks and, in particular, did not remember the

332

Barsanti told the Examiner that Lehman was probably not marking to yield,

andinsteadwouldmarkPTGassetsbasedmoreonagutfeelingaboutthepositionin

relation to the market.1226 Barsanti, who both Walsh and Kenneth Cohen identified as

the person principally responsible for determining PTG marks, stated that he did not

knowwhetherPTGassetscouldbesoldforthepriceatwhichtheyweremarkedand

stated he had not thought about it.1227 As discussed below, Barsantis statement is

consistentwiththeExaminersfindingthatPTGassetsweregenerallymarkedinlight

of whether the development was proceeding according to plan, and not according to

thereturnthataninvestorwouldrequiretopurchasetheposition.

Koutouvides, who reported to Barsanti, spent substantially all of his time

workingonvaluingPTGassets.1228KoutouvidesstatedthatthePTGbusinessdeskdid

notmarktomarketbasedyieldinthesecondandthirdquartersof2008,explainingthat

thedesksassetvaluationsdidnotreflectwhatabuyerwouldpayfortheassetsonthe

openmarketatthattime.1229KoutouvidesstatedthatLehmansvaluesforassetsdidnot

equal the prices at which they could be sold on the market and noted, regarding

valuationmethodologiesusedbyPTG.Id.Asdiscussedherein,theuseofIRRmodelsinplaceofCap*
105todeterminecollateralvalueswasaprincipaldriverbehindtheapproximately$214millioninwrite
downsthatwereproposedbutnottakeninthethirdquarterof2008.ExaminersInterviewofJonathan
Cohen,Jan.11,2010,atp.9.
1226ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.11.

1227Id.

1228ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atp.13.

1229Id.atpp.1112.Hestatedthatonlyassetsmarkedforcreditimpairmentweretaken.Id.

333

Lehmans marks, no one would pay you that.1230 He stated that any sale of illiquid

PTGassetswouldbesteeplydiscounted,duetothemanyuniquefactorsrelatedtothe

development of the underlying real estate.1231 These factors included the uncertainty

surrounding the process of entitling the property and the relationship with the

developerwhowasresponsibleforthedaytodaymanagementoftheproject.

KoutouvidesalsostatedthatLehmandidnotoriginatepositionsatthecarrying

yieldsusedin2008,meaningLehmanwouldnotenterintoinvestmentsattheyieldsit

usedtovalueitspositions.1232Ineffect,by2008Lehmanrequiredahigherrateofreturn

when making a new investment than it would use when marking an equivalent

positionthatwasalreadyincludedinthePTGportfolio.

However,Koutouvidesstatedthatdespitenotmarkingtoyield,theassetswere

markedatfairmarketvalue.1233AccordingtoKoutouvides,theselectionofyieldwas

largelyimmaterialbecauseitwouldnotmakemuchdifferenceovertheshortduration

oftheloansassociatedwithPTGdebtpositions.1234Koutouvidesalsopointedtothetwo

tofiveyearsthatLehmantypicallyheldPTGassets,arguingthatitwasinappropriateto

focusonthevalueoftheinvestmentinthecurrentmarketenvironmentwhenLehman

1230Id.atp.12.

1231Id.

1232Id.atp.3.

1233Id.
at pp. 1112; Lehman, Q3 Firmwide Q&A Summary [Draft] (Sept. 2008), at p. 43
[LBHI_SEC07940_743659](notinggenerallythattheassetsintheCREportfolioweresubjecttofairvalue
(marktomarket)accounting).
1234ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atp.3.

334

hadnointentiontosellthepositioninthenearfuture.1235Koutouvidesexplainedthat,

although a sudden decline in values could have a huge effect on the value of the

property, the value of a PTG asset did not strictly correlate with market trends.1236

KoutouvidesdismissedtheargumentthatPTGassetsshouldhavebeenmarkedbased

onlyonmacroeconomictrendsobservedinthe2008market.1237

JonathanCohentoldtheExaminerthatitwasfairtosaythat,inthesecondand

thirdquartersof2008,thePTGportfoliowasgenerallynotmarkedatpricesatwhich

the assets could be sold.1238 Jonathan Cohen stated that, due to the large pricing

variances between sellers and buyers in the market at that time, many buyers were

offering what he thought of as fire sale prices.1239 He expressed the view that PTG

wasnotrequiredtomarkitsassetsatthesefiresaleprices.Specifically,hepointedto

asignificantnumberofpositionsthatwerecarriedat90%ofparvalueandstatedthat

awillingbuyerwasnotgoingtopaythat.1240

With respect to the valuation of PTG assets in the second quarter of 2008,

JonathanCohennotedthattheCap*105methodprovidednowaytomarktocreditor

1235Id. at p. 11. See Lehman, Q3 Firmwide Q&A Summary [Draft] (Sept. 2008), at p. 43
[LBHI_SEC07940_743659](noting generally for assets in the CREportfolio that a separate entity REI
GlobalwouldbeabletomanageassetswithalongertimehorizonthanLehmanwouldhaveinthe
currentmarketenvironment).
1236ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atp.11.

1237Id.

1238ExaminersInterviewofJonathanCohen,Jan.11,2010,atp.5.

1239Id.

1240Id.

335

yield.1241Hestatedthatduringthistime,PTGassetsweregenerallymarkedtotheyield

thatwasincorporatedintoLehmansplanfortheinvestment,andthatassetswereonly

written down when PTG had specific information that a project was experiencing

difficulties.1242

WhenTriMontprovidedmoreIRRmodelsinthethirdquarterof2008,Jonathan

Cohen stated thatPTG was thenableto marktomarketbased yield.1243Cohenstated

thatheneverconsideredmarkingtomarketbasedyieldaconcernuntilthistime,when

the IRR models were producing materially lower collateral valuations, and in turn

indicating materially lower values for PTG assets.1244 Cohen identified approximately

$714millionofPTGwritedownsforthequarter,andonlyapproximately$504million

ofsuchwritedownsweretaken.1245

The documentary evidence also supports Cohens assertion that Lehman

generallymarkedforcreditandnotyield.AdocumentlistingLehmansthirdquarter

2008 writedowns shows that 93% of those writedowns were based on credit

impairment, with only the remaining 7% related to yield.1246 Although both Jonathan

1241Id.atpp.45.

1242ExaminersInterviewofJonathanCohen,Jan.22,2010,atp.4.

1243Id.;ExaminersInterviewofJonathanCohen,Jan,11,2010,atpp.45.

1244Examiners Interview of Jonathan Cohen, Jan. 11, 2010, at p. 5; Examiners Interview of Jonathan
Cohen,Jan.22,2010,atp.4.
1245ExaminersInterviewofJonathanCohen,Jan.11,2010,atp.9;Lehman,GlobalRealEstate12008,Net

MarkDowns(Sept.5,2008)[LBEXAM34699].
1246JonathanCohen,Lehman,Q3WritedownsSpreadsheet(Aug.2008)[LBHI_SEC07940_2258789].The

Examiner has not found any comparable analyses that allocated writedowns to credit or yield for the
PTGwritedownsinthesecondquarterof2008.

336

CohenandKennethCohenstatedthatamarkforcreditimpairmentwouldnecessarily

take into account yield impairment, Jonathan Cohen stated that the rationale given in

thedocumentwastheprimaryreasonforthewritedown.1247

(b) TheEffectofNotMarkingtoMarketBasedYield

(i) EffectofCap*105NotMarkingtoMarketBasedYield

The Examiner has investigated the impact of the switch from the Cap * 105

method to IRR models between the second and third quarters of 2008 and concludes

that the large drop in collateral values between those quarters provides sufficient

evidence to support a finding that collateral values, and thus PTG asset values, were

overvaluedinthesecondquarterof2008.

JonathanCohenacknowledgedthatCap*105couldnotbeusedformarkingto

marketbased yield.1248 As described, Cap * 105 had no marketbased inputs and was

incapable of marking collateral to either credit or yield; it simply computed collateral

value by multiplying the developments current capital structure (reflecting all

outstandingdebtplusequityinvestedtodate)by105%.Cap*105appliednodiscount

anddidnotcalculatecashflows.TheExaminersfinancialadvisorhasobservedthat,as

ofMay2008,historicalcostbasedapproaches(suchasCap*100andCap*105)were

stillusedforcollateralvaluationforatleast228positions,whichwasathirdofthePTG

1247ExaminersInterviewofJonathanCohen,Jan.22,2010,atp.4.

1248Examiners Interview of Jonathan Cohen, Jan. 11,2010, at pp.45;Examiners Interview of Jonathan

Cohen,Jan.22,2010,atp.4.

337

portfolio in the second quarter of 2008.1249 The Examiners financial advisor has

identifiedonly54positionsvaluedbythehistoricalcostbasedapproachasofJuly2008,

orlessthan10%ofthePTGportfolio.1250ThisdoesnotmeanthatLehmancarriedthese

positions at the amount of its investment. Lehman did write down assets for credit

based on assetspecific conclusions that, regardless of the Cap * 105 calculation, there

wasdeteriorationofthecollateralvalue.However,thehighproportionofPTGassets

withcollateralvaluesdeterminedbytheCap*105methodinthesecondquarterof2008

isanindicationthatLehmandidnotrelyonreasonablecollateralvaluesinmarkingthe

PTGportfolio.

The large effect of Cap * 105 on collateral values can be observed in Platts

descriptionofherpricetestingpracticesduring2008.Asnotedabove,Plattstatedthat

whenmoreIRRmodelswereaddedtoLehmanssysteminJuly2008,thecurrentvalues

forcollateralinhermodelsdroppedsignificantlyandhermodelsproducedanoutput

suggesting the PTG debt portfolio was significantly overvalued.1251 The Examiner

1249TriMont,DebtExportasofMay5,2008(June2,2008)[LBEXAM262026];TriMont,EquityExportas

ofMay5,2008(June2,2008)[LBEXAM262362].
1250TriMont,DebtExportasofMay5,2008(June2,2008)[LBEXAM262026];TriMont,EquityExportas

ofMay5,2008(June2,2008)[LBEXAM262362];TriMont,DebtExportasofJuly5,2008(Aug.1,2008)
[LBEXAM267134];TriMont,EquityExportasofJuly5,2008(Aug.4,2008)[LBEXAM267510].
1251ExaminersInterviewofRebeccaPlatt,Nov.2,2009,atp.7.

338

investigatedandconfirmedthatLehmanscollateralvaluesdroppedsubstantiallywhen

PTGmovedawayfromCap*105.1252

The Examiners financial advisor identified 153 PTG positions that used a

historicalcostbasedvaluationmethod(Cap*105orCap*100)inthesecondquarterof

2008,andthentransitionedtoadifferentvaluationmethodinJuly2008.1253These153

positions represented a $3.1 billion value in the second quarter of 2008, or

approximately 36% of the PTG portfolio by value. After a significant number of IRR

models were incorporated into the price testing process in July 2008, the collateral

values for these 153 positions dropped by 20% when compared to the second quarter

values.1254

Due to limitations in the data, the Examiners financial advisor has confirmed

that105ofthesepositionstransitionedfromCap*105toIRRmodelsbetweenMayand

July2008,althoughitispossiblethatothersdidsoaswell.TheMay2008pricetesting

models suggested that the marks for these 105 positions were undervalued by $192

1252TriMont,DebtExportasofMay5,2008(June2,2008)[LBEXAM262026];TriMont,EquityExportas

ofMay5,2008(June2,2008)[LBEXAM262362];TriMont,DebtExportasofJuly5,2008(Aug.1,2008)
[LBEXAM267134];TriMont,EquityExportasofJuly5,2008(Aug.4,2008)[LBEXAM267510].
1253TriMont,DebtExportasofMay5,2008(June2,2008)[LBEXAM262026];TriMont,EquityExportas

ofMay5,2008(June2,2008)[LBEXAM262362];TriMont,DebtExportasofJuly5,2008(Aug.1,2008)
[LBEXAM267134];TriMont,EquityExportasofJuly5,2008(Aug.4,2008)[LBEXAM267510].
1254TriMont,DebtExportasofMay5,2008(June2,2008)[LBEXAM262026];TriMont,EquityExportas

ofMay5,2008(June2,2008)[LBEXAM262362];TriMont,DebtExportasofJuly5,2008(Aug.1,2008)
[LBEXAM 267134]; TriMont, Equity Export as of July 5, 2008 (Aug. 4, 2008) [LBEXAM 267510]. The
Examinersfinancialadvisorfoundthat228positionswerevaluedusingCap*105,butduetolimitations
inthedata,wasnotabletoconfirmhowcollateralfortheother75positionswerevaluedinthirdquarter
2008.

339

million.1255Aftertheswitchtocalculatingcollateralvaluesforthese105positionswith

IRR models,the price testingresultsuggestedthatthe marksforthese same positions

were overvalued by $298 million as of July 31, 2008, and $90 million as of August 31,

2008.1256

Both the PTG business desk and Product Control knew that Cap * 105 led to

unreasonable valuations in a downward trending market if strictly applied.1257

Although the Examiner has not found any direct evidence to explain exactly how the

business desk used the collateral values based on Cap * 105 in marking the PTG

Portfolio,BarsantiandKoutouvideseachstatedthattheyusedindependentjudgment,

including a judgment that positions with collateral values calculated by Cap * 105

1255For the full set of 153 positions with collateral values based on a historical cost valuation
methodology, the Examiners financial advisor observed that price testing model suggested a $271
million undervaluation of the marks as of May 2008. TriMont, Debt Export as of May 5, 2008 (June 2,
2008) [LBEXAM 262026]; TriMont, Equity Export as of May 5, 2008 (June 2, 2008) [LBEXAM 262362];
Zev Klasewitz, Lehman, Single Asset Debt Model May 2008 Spreadsheet (June 14, 2008) [LBEXLL
1985749]; Zev Klasewitz, Lehman, Single Family Debt Model May 2008 Spreadsheet (June 14, 2008)
[LBEXLL 1985605]; Single Family Equity Model May 2008 Spreadsheet (May 31, 2008) [LBEXLL
1985924]; Lehman, Strategic Equity Model May 2008 Spreadsheet (May 31, 2008) [LBEXBARSOX
0000594]; Zev Klasewitz, Lehman, Single Family REO Model May 2008 Spreadsheet (June 13, 2008)
[LBEXLL 1985887]; Lehman, Strategic REO Model May 2008 Spreadsheet (May 31, 2008) [LBEXLL
1985926].
1256TriMont,DebtExportasofJuly5,2008(Aug.1,2008)[LBEXAM267134];TriMont,EquityExportas

ofJuly5,2008(Aug.4,2008)[LBEXAM267510];TriMont,DebtExportasofAug.5,2008(Sept.2,2008)
[LBEXAM 273310]; TriMont, Equity Export as of Aug. 5, 2008 (Sept. 2, 2008) [LBEXAM 273058]. The
Examiners financial advisor observed that the lower overvaluation figure in August 2008 is primarily
duetoProductControlsmodificationsofthecurrentvaluesbasedonIRRmodels,discussedbelow,that
occurredwhentheprincipalcollateralvaluationmethodologyswitchedtoIRRmodels.
1257E.g., Examiners Interview of Abebual A. Kebede, Oct. 6, 2009, at p. 7; Examiners Interview of

AnthonyJ.Barsanti,Oct.15,2009,atp.13;ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,
atp.15;emailfromEdDziadul,RealComFinancialPartnersLLC,toDennisGrzeskowiak,TriMont,etal.
(Mar.23,2008)[LBEXDOCID2293586](describingCap*105asworthless).

340

neededtobewrittendown.1258However,collateralvaluewasthemostimportantdata

point for valuing PTG positions, and there is no indication that Barsanti and

Koutouvides used some other method for calculating collateral values when they did

notuseTriMontsvaluebasedonCap*105.1259

Theevidenceissufficienttosupportafindingthatcollateralvaluescalculatedby

Cap * 105 were inflated, and this method calculated collateral values for at least one

third of the PTG portfolio.1260 The large drop in collateral values that occurred when

PTGmovedawayfromCap*105providessufficientevidencetosupportafinding,for

purposes of a solvency analysis, that certain marks in the PTG portfolio were not

reasonableassessmentsoffairvalueasofthesecondquarterof2008.

1258Examiners Interview of Anthony J. Barsanti, Oct. 15, 2009, at pp. 1112; Examiners Interview of
AristidesKoutouvides,Nov.20,2009,atp.12.
1259ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.13;ExaminersInterviewofAristides

Koutouvides,Nov.20,2009,atp.15.
1260The Examiners financial advisor analyzed data from TriMont export files from May 2008 and July

2008.TriMont,DebtExportasofMay5,2008(June2,2008)[LBEXAM262026];TriMont,EquityExport
asofMay5,2008(June2,2008)[LBEXAM262362];TriMont,DebtExportasofJuly5,2008(Aug.1,2008)
[LBEXAM 267134]; TriMont, Equity Export as of July 5, 2008 (Aug. 4, 2008) [LBEXAM 267510]. The
Examiners financial advisor also analyzed data from pricing files from May 2008 and July 2008. Zev
Klasewitz,Lehman,SingleAssetDebtModelMay2008Spreadsheet(June14,2008)[LBEXLL1985749];
Zev Klasewitz, Lehman, Single Family Debt Model May 2008 Spreadsheet (June 14, 2008) [LBEXLL
1985605];Lehman,SingleFamilyEquityModelMay2008Spreadsheet(May31,2008)[LBEXLL1985924];
Lehman, Strategic Equity Model May 2008 Spreadsheet (May 31, 2008) [LBEXBARSOX 0000594]; Zev
Klasewitz,Lehman,SingleFamilyREOModelMay2008Spreadsheet(June13,2008)[LBEXLL1985887];
Lehman,StrategicREOModelMay2008Spreadsheet(May31,2008)[LBEXLL1985926];Lehman,Single
Family Debt Model July 2008 Spreadsheet (July 31, 2008) [LBEXBARFID 0022574]; Lehman, Strategic
REO Model July 2008 Spreadsheet (July 31, 2008) [LBEXBARFID 0024563]; Lehman, Strategic Equity
ModelJuly2008Spreadsheet(July31,2008)[LBEXBARFID0012795];Lehman,SingleFamilyREOModel
July 2008 Spreadsheet (July 31, 2008) [LBEXBARFID 0024208]; Lehman, Single Asset Debt Model July
2008Spreadsheet(July31,2008)[LBEXBARFID0023120];Lehman,SingleFamilyEquityModelJuly2008
Spreadsheet(July31,2008)[LBEXBARFID0023610].

341

(ii) EffectofIRRModelsNotMarkingtoMarketBased
Yield

IRR models, in discounting projected cash flows, offered a more reasonable

method of valuing collateral than Cap * 105. However, even when Lehman did

implementIRR modelsthatapplied ayield, thesemodels didnot basetheir yields on

marketbased interest rates.1261 Both Koutouvides and Jonathan Cohen stated that the

yields selected were based on Lehmans expected rate of return at origination, rather

thantherateofreturnthatatypicalmarketinvestorwouldrequire.1262

The Examiner has investigated select positions to determine whether TriMonts

IRRmodelsusedayieldcomparabletothatappliedtootherpositionsorprovidedby

other marketdata sources, such as an appraisal. This analysis has focused on the

property type identified by witnesses as being of greatest concern to PTG asset

managerslanddevelopments.

ThediscountratethatTriMontusedintheIRRmodelstodeterminethecurrent

collateralvalueofanassetwastheweightedaverageofthediscountratesoftheequity

anddebtpositionsatorigination,asdiscussedabove.1263

1261Examiners Interview of Jonathan Cohen, Jan. 11,2010, at pp.45;Examiners Interview of Jonathan

Cohen, Jan. 22, 2010, at pp. 34. Although Jonathan Cohen also stated that he discussed the issue of
markingtomarketbasedyieldwithReilly,theExaminerhasfoundnoevidencethatanysuchdiscussion
endedupaffectingthemarks.ExaminersInterviewofJonathanCohen,Jan.11,2010,atp.5.
1262ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atpp.7,1112.ExaminersInterview

ofJonathanCohen,Jan.11,2010,atp.5.
1263See, e.g., TriMont, Asset Status Report for Heritage Fields El Toro LLC (July 1, 2008), at tab NPV

[LBEXBARFID0027112].Inthismannerthediscountwasaweightedaveragecostofcapital,weighted

342

Since the cost of debt and cost of equity were based on rates as of deal

origination, they remained static regardless of how the market participants risk

assessment changed throughout the investments lifetime.1264 Therefore, the discount

ratesusedinIRRmodelswerenotmarketbased,asthediscountratedidnotmaterially

change if the markets changing assessment of risk resulted in demand for a higher

yield.

HeritageFieldsprovidesanexampleofapositionthatLehmanvaluedusingIRR

modelsthatcontainedadiscountrateforcollateralthatwasmateriallylowerthanthat

producedbyathirdparty,Cushman&Wakefield(C&W).InaJuly2007appraisalof

HeritageFieldsthatwasprovidedtoLehman,C&Wnoted18%asthediscountratefor

the collateral,1265 and in an April 2008 appraisal, that discount rate was 21%.1266

Meanwhile,TriMontusedan8.23%discountrateinitsMay2008IRRmodeland11.98%

rate in its July 2008 IRR model.1267 In the face of this discrepancy, TriMont did not

increase the discount rate to be more in line with the April 2008 C&W appraisal, but

in this case by the current outstanding debt and all paidin equity (which may be different than the
capitalstructureatorigination).
1264Again,Cap*105didnotapplyadiscountratetocollateralvalues.TheExamineralsonotesthatthe

capital structure could change over time due to amortization of debt or equity raises, which would
impacttheweightedaveragediscountrate.
1265Cushman & Wakefield, Heritage Fields MasterPlan SelfContained Appraisal Report Vol. I (July 1,

2007), at pp. 34041 [LBEXDOCID 2501688]. This discount rate was characterized by C&W as an
unleveragedcost of equity, and the Examinersfinancial advisor observed that this is consistent with a
weightedaveragecostofcapitalratewithonlyequityinthecapitalstructure.Id.
1266Cushman&Wakefield,HeritageFieldsMasterPlanSummaryAppraisalReport(Apr.1,2008),atp.

61[LBEXDOCID2096020].ThediscountrateselectedbyC&Wassumedanunleveragedposition.
1267TriMont, Heritage Fields El Toro LLC IRR Model (May 1, 2008), at tab NPV [LBEXBARFID

0026891]; TriMont, Asset Status Report for Heritage Fields El Toro LLC (July 1, 2008), at tab NPV
[LBEXBARFID0027112].

343

rather, in its July 2008 model, TriMont lowered the projected cash flows of the

development.1268 Through this change, the collateral value TriMont produced in July

2008 for Heritage Fields, $797 million, was close to C&Ws collateral value for April

2008,$790million.1269EventhoughTriMontadjustedthecashflowandcameupwitha

similar collateral value, the large gap between the discount rates indicates that

TriMontsIRRmodelsincludeddiscountratesthatweretoolow.

InordertoinvestigatewhetherthediscountratesusedintheIRRmodelswere

consistentlylowerthanthoseobtainedfromothersources,theExaminercomparedthe

discount rate that C&W used for Heritage Fields as a benchmark to measure the

discount rates used for other similar properties. Heritage Fields was a land

development with a sellout component, meaning it was a real estate development

wherethebusinessplanwastoselloffindividualunitsofthepropertyratherthanthe

property as a whole.1270 Sellouts were typically the most risky form of land

1268SeeTriMont,AssetStatusReportforHeritageFieldsElToroLLC(July1,2008),attabNPV[LBEX

BARFID 0027112]. For example, absorption the amount of time it takes to sellout all lots was
assumedbyTriMonttobecompleteby2013intheMaydataandthatwasextendedto2015intheJuly
data.TriMont,HeritageFieldsElToroLLCIRRModel(May1,2008),attabCFDeal,cellBO4[LBEX
BARFID 0026891]; TriMont, Asset Status Report for Heritage Fields El Toro LLC (July 1, 2008) [LBEX
BARFID0027112].
1269TriMont,AssetStatusReportforHeritageFieldsElToroLLC(July1,2008)[LBEXBARFID0027112].

1270Id.Forexample,inalanddevelopment,thedeveloperwillfirstpurchaseaplotofland,thensecure

entitlement (approvals to build), put in infrastructure (such as grading, roads, utilities, etc.), and
subdivide the plot into individual lots. The developer will then sell the individual lots to merchant
builderswhowillconstructhomesonthelots.Whenallthelotshavebeensold,theprojectissoldout.
ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.4.

344

development, because they involved overseeing a development to completion and

holdingontotheassetwhileitwassoldpiecebypiece.1271

Forthepurposeofthiscomparison,theExaminerincludedonlythosepositions

for which IRR models were used to estimate the collateral values. The Examiners

financial advisor identified three applicable land development sellout properties

meetingthesecriteria.1272Belowisacomparisonofthecollateralvaluescalculatedusing

TriMontsdiscountratesforthesepropertieswiththecollateralvaluescalculatedbythe

Examiners financial advisor using the C&W April 2008 discount rate for Heritage

Fields.

Collateral Value
C&W Heritage % Difference in
TriMont TriMont Using C&W
Property Name Fields Discount Collateral
Discount Rate Collateral Value Heritage Fields
Rate Values
Discount Rate
(A) (B) (B)/(A)-1
1 West Bay Club Development 10.9% 81,185,918 21.0% 74,636,592 -8.1%
2 PlazaCorp 1.Berkley 7.3% 72,699,971 21.0% 50,205,769 -30.9%
3 Laurel Cove 12.2% 53,917,607 21.0% 40,298,467 -25.3%
Average 10.1% 69,267,832 21.0% 55,046,943 -20.5%

1271SeeTonySevelka,SubdivisionDevelopment:Risk,Profit,andDeveloperSurveys,AppraisalJ.242,24252

(Summer 2004), available at http://www.entrepreneur.com/tradejournals/article/120353039_2.html (noting


generally that [l]and in a raw state . . . carries the highest level of overall development risk and that
landmayberipeforresidentialdevelopment...butthequestionremainsastowhetherthedeveloper
willbeabletoselltheproposedfinishedlots).
1272These were West Bay Club Development, PlazaCorp1.Berkley, and Laurel Cove. TriMont, Asset

Status Report for West Bay Club Development (July 1, 2008), at tab NPV [LBEXBARFID 0030164];
TriMont, Asset Status Report for PlazaCorp1.Berkley (Aug. 1, 2008), at tab NPV [LBEXBARFID
0029074]; TriMont, Asset Status Report for Laurel Cove (July 1, 2008), at tab NPV [LBEXBARFID
0028845].

345

Thethreepropertiesfeaturediscountratesthatweremateriallylowerthanthediscount

rateusedbyC&WinitsApril2008appraisalofHeritageFields.1273Ifthediscountrate

intheApril2008C&WappraisalofHeritageFieldswereappliedtothesepositions,the

collateralvaluesofthesepropertieswoulddropbyanaverageof20%.

An additional benchmark by which the Examiners financial advisor measured

the discount rates Lehman used to value the collateral of these three properties is the

discount rates used to value its SunCal collateral. SunCal consisted of investments in

California land development projects.1274 Lehman used a 15% weighted average

discount rate for the majority of the SunCal properties.1275 As shown above, the

discountratesforallthreePTGlanddevelopmentpropertieswerelowerthan15%.

The C&W appraisals for Heritage Fields also illustrate how Lehmans discount

rates did not respond to market changes. C&Ws two appraisals for Heritage Fields

were performed in two different years when, according to Koutouvides, the market

1273The discount rates used by TriMont were different due to differences in the cost of debt and the

weightsofdebtversusequityinthecapitalstack.TriMontusedthesamecostofequityforeachposition,
though it would likely have been more appropriate to use a cost of equity commensurate with the
leverage.
1274See,e.g.,Cushman&Wakefield,AppraisalofPacificaSanJuanMasterPlan(289Lots)(Oct.1,2007)

[TR00031835].
1275ExaminersInterviewofPaulA.Hughson,Oct.28,2009,atp.9.TheSunCalpositionswerevalued

based on projections that were influenced by third parties and a discount rate determined by Lehman.
Hughson stated that he was the person who determined the 15% unleveraged discount rate for the
majorityofthepositions.Id.The15%unleverageddiscountwasbasedontheassumptionofa2/3debt,
1/3 equity capital structure post restructuring with a cost of debt of 10% and cost of equity of 25%.
Hughsonstatedthatthisdiscountrateassumptionwassupportedbyassetsalesintheregion.Id.

346

was dropping like a stone.1276 Therefore, the increase in the discount rates between

C&Ws two appraisals 3% is likely to have been the result of marketbased

activity.1277ThisassumptionisconsistentwithLehmansownpracticesinvaluingnon

PTG positions. In valuing Lehmans bridge equity position in Archstone, Lehman

increaseditsdiscountratefromapproximately12%inMay2007to15%bythesecond

quarter of 2008.1278 This approximately 3% increase in the Archstone discount rate

reflects Lehmans recognition that marketbased yields were increasing as the market

conditionsdeterioratedforstabilizedassets.Inaccordancewiththehigherrisk,higher

returnnatureofthePTGinvestments,1279theExaminersfinancialadvisorhasobserved

thatitisreasonabletoexpectthatthemarketyieldforhigherrisk,nonstabilizedassets

wouldincreaseatasimilarorhigherratethanforstabilizedassets(e.g.Archstone)ina

1276ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atp.9.

1277TheExaminernotesthatitisalsopossiblethatthedifferenceindiscountratesmaysuggestspecific

problemswiththeHeritageFieldssunderlyingcollateral.
1278Memorandum from Mark A. Walsh, Lehman, et al., to LBHI Bridge Loan Committee & Investment

Committee, re: Debt and Equity Financing Commitment Proposal for the Potential Acquisition of
ArchstoneSmith(May16,2007),atp.9[LBEXDOCID1674960].Lehman,$23.4billiondebtandequity
financing commitment in connection with the potential acquisition of ArchstoneSmith by Lehman
Brothers and Tishman Speyer Properties, May 16, 2007 [LBEXDOCID 1674960]. The commitment
documentsidentifyanIRRforArchstonebridgeequityof12.1%.Thisrateincludedthecostofcapitalas
well as Lehmans expected return from the investment. Therefore, the Examiners financial advisor
observesthat,strictlyspeaking,thecostofcapitalalonewouldbelessthan12.1%.EmailfromWebster
Neighbor, Lehman, to Paul A. Hughson, Lehman, et al. (June 14, 2008) [LBEXDOCID 1865693]; email
from Paul A. Hughson, Lehman, to Webster Neighbor, Lehman, et al. (June 15, 2008) [LBEXDOCID
1865693]; emailfrom Webster Neighbor, Lehman, to Paul A. Hughson, Lehman (Sept.12,2008) [LBEX
DOCID2903130].
1279E.g.,ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.4.

347

downward trending market.1280 Instead, the IRR models for PTG assets incorporated

debt and equity discount rates that were incapable of responding to market changes.

Theserateswereequaltotheapplicabledevelopmentsratesfordebtandequityasof

theoriginationoftheinvestment.

Koutouvides told the Examiner that the choice of discount rate for both the

collateral and debtpositions did notmatter asmuchfor PTGpositionsbecauseof the

shorttermmaturitydateofmanyoftheloans.1281Koutouvidesstatementwasbasedon

theobservationthatthedifferenceinyieldbetweenwhatLehmanusedinitsvaluation

and what a market participant would require in a sale did not have much time to

compoundforashorttermdebtposition.

Koutouvides argument that the particular yield used is insignificant must be

evaluated on a positionbyposition basis. If the position has less leverage (and

consequently a lower LTV ratio) and a shorter term maturity for the debt, then it is

possiblethatthechangescausedbythediscountratemightnothaveamaterialeffect

onvalue.However,alongertermdebtposition,suchastheHeritageFieldsposition,

wouldhaveamuchlongertimeforthedifferenceinyieldtocompound,resultingina

1280Foroneofthethreelanddevelopments,WestBayClubDevelopment,Lehmandidtakeawritedown

of$24millioninAugust2008,afterthepositionwasvaluedat$76.5millioninJuly.Lehman,GlobalReal
Estate 2008 Net Mark Downs (Sept. 5, 2008), at tab Position & Monthly Detail, cell M148 [LBEXAM
346991] However, Lehman did not write down the other two positions, and the use of a possibly
incorrectdiscountrateforallthreepropertiesissufficientevidencetosupportafindingthatTriMonts
IRR models produced discount rates used in the valuation process that were lower than the market
supported.
1281Id.atp.3.

348

bigger difference in values. If the development has significant leverage and the debt

hasalongermaturitydateforthedebt,thenthechangestothediscountratecanhavea

significanteffectonvalue.

The PTG portfolio featured many positions that were highly leveraged debt

positionsorequitypositionsthatwouldbeaffectedbyachangeincollateralvalues.1282

BarsantiandKoutouvideswouldtogethermarkthePTGportfolio,positionbyposition,

usingTriMontsdataasmodifiedbytheirjudgment.1283Thedecreaseof20%or15%in

collateral value, as in the examples above, is sufficient evidence to support a finding

thatthePTGbusinessdeskwas,atleastinpart,basingvaluationsondatathatincluded

highercollateralvaluesthanthemarketthensupported,evenafterthetransitiontoIRR

models.

(iii) EffectofProductControlPriceTestingNotMarkingto
MarketBasedYield

AccordingtoBarsantiandKoutouvides,thePTGbusinessdesklackednecessary

resources.1284 Barsanti and Koutouvides were primarily responsible for valuing 700

positions in the book, and Koutouvides spent much of his time addressing TriMonts

errors.1285 Although, in theory, Lehman intended Product Control to serve as an

1282Lehman Brothers, Global Real Estate Product Control Real Estate Americas Price Verification
Presentation[Draft](Feb.2008),atp.4[LBEXWGM916018](describingPTGassetsasHighLeveraged
debtandequityinvestmentsincommercialrealestateproperties).
1283ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atpp.11,1314.

1284Id.;ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atpp.10,13.ExaminersInterview

ofSECstaff,Aug.24,2009,atpp.1415.
1285ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atpp.10,13.

349

independent check on the business desk marks, it suffered from a similar lack of

resources.1286 According to Jonathan Cohen, product controllers were not given

sufficientinformationtoproperlytestvalues.1287WithoutaneffectiveProductControl

process,theriskofmisstatingthevalueofPTGassetsrisessignificantly.

Above all, Product Control had no effective method for using marketbased

yieldstotestthemarksforPTGassets.ThiswaslargelyduetothefactthattheProduct

Controlpricetestingprocessreliedheavilyoninputfromthebusinessdeskand,inthis

manner,wasnottrulyindependent.ProductControlusedthesamecollateralvaluesas

thoseprovidedbyTriMonttothebusinessdesk.1288Cap*105inarguablyfailedtotake

marketbased yields into account and thus caused overvaluation of collateral in the

secondquarterof2008.Asnotedabove,theIRRmodelsthatbecamemoreprevalentin

the third quarter of 2008 also did not use a marketbased yield for determining

collateral value.1289 Additionally, Product Control would defer to the business desks

1286ExaminersInterviewofJonathanCohen,Jan.11,2010,atp.5;ExaminersInterviewofRebeccaPlatt,

Nov. 2,2009, at pp. 4, 7. The SEC also reached aninformal conclusion that Lehmans Product Control
staffwastoosmalltobeaneffectiveindependentcheckonthebusinessdesksvaluationsgiventhesize
andnumberofassetsintheCREportfolio.ExaminersInterviewofSECstaff,Aug.24,2009,atpp.34,
1314
1287ExaminersInterviewofJonathanCohen,Jan.11,2010,atp.5.Additionally,JonathanCohennoted

that, without certain necessary information, Product Control could not effectively employ the models
availabletoit.Id.
1288ExaminersInterviewofAnthonyJ.Barsanti,Oct.15,2009,atp.9.

1289In testing certain PTG debt positions, Product Control applied a discount rate based on the rates

published in the Real Estate Investment & Finance newsletter. Examiners Interview of Abebual A.
Kebede, Sept. 29, 2009, at p. 8; Examiners Interview of Abebual A. Kebede, Oct. 6, 2009, at p. 8;
Examiners Interview of Abebual A. Kebede, Oct. 13, 2009, at p. 7. The Examiners financial advisor
conducted a review of the spreads used by Product Control to calculate the debt discount rate and
determinedthatthespreadsusedinthesecondquarterof2008didnotreflectcurrentmarketdata.

350

judgment as to when to replace or modify the collateral values provided by TriMont

andusethebusinessdeskscollateralvaluesinstead.1290

(iv) EffectofModifyingTriMontsDataintheThird
Quarterof2008

According to Jonathan Cohen, the switch to IRR models in the third quarter of

2008 enabled PTG to mark positions to marketbased yield.1291 This suggests that

TriMontsIRRmodelsmateriallyimprovedLehmansvaluationstoaccountformarket

basedyields.However,inmanyinstancesinthethirdquarterof2008,PTGmodified

the collateral values provided by TriMont, elected to not give weight to other

information suggesting that a position should be remarked, or was not persuaded by

price testing results showing a large overvaluation after lower collateral values were

incorporated into the price testing models. These facts provide further evidence that

Lehmandidnotmakeaconcertedefforttomarktomarketbasedyieldandthatitwas

notmerelythelackofIRRmodelsinthesecondquarterof2008thatpreventedLehman

frommarkingPTGassetstomarketbasedyield.

ThereissufficientevidencetosupportafindingthatthePTGbusinessdeskused

its judgment to conclude that it should not use many of the values produced by

TriMont when it was replacing Cap * 105 with IRR models. Among the positions for

1290E.g., email from Aristides Koutouvides, Lehman, to Abebual A. Kebede, Lehman (Aug. 30, 2008)

[LBHI_SEC07940_212040];ExaminersInterviewofEliRabin,Oct.21,2009,atp.8;ExaminersInterview
ofPaulA.Hughson,Oct.28,2009,atp.7;ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,
atpp.1617;ExaminersInterviewofJonathanCohen,Jan.11,2010,atp.5.
1291ExaminersInterviewofJonathanCohen,Jan.22,2010,atpp.34.

351

which the Examiners financial advisor has observed that TriMonts collateral values

weremodified,Lehmansubstitutedahighercollateralvaluefor14ofthe18positions

(or 78%) in May 2008,1292 and 38 of the 40 positions (or 95%) in August 2008.1293 The

magnitude of the departure from TriMonts collateral values also materially increased

from May to August. In May 2008, the collateral values used by Lehman for these

positions were, in aggregate, $636 million higher than TriMonts collateral values.1294

However, in August 2008, Lehmans collateral values were $1.7 billion higher than

TriMonts collateral values.1295 The Examiners financial advisor calculated that, had

1292SeeZevKlasewitz,Lehman,SingleAssetDebtModelMay2008Spreadsheet(June14,2008)[LBEXLL

1985749]; Zev Klasewitz, Lehman, Single Family Debt Model May 2008 Spreadsheet (June 14, 2008)
[LBEXLL 1985605]; Single Family Equity Model May 2008 Spreadsheet (May 31, 2008) [LBEXLL
1985924]; Lehman, Strategic Equity Model May 2008 Spreadsheet (May 31, 2008) [LBEXBARSOX
0000594]; Zev Klasewitz, Lehman, Single Family REO Model May 2008 Spreadsheet (June 13, 2008)
[LBEXLL 1985887]; Lehman, Strategic REO Model May 2008 Spreadsheet (May 31, 2008) [LBEXLL
1985926].
1293See Lehman, Single Asset Debt Model Aug. 2008 Spreadsheet (Aug. 31, 2008) [LBEXBARFID

0023236]; Lehman, Single Family Debt Model Aug. 2008 Spreadsheet (Aug. 31, 2008) [LBEXBARFID
0022749]; Lehman, Single Family Equity Model Aug. 2008 Spreadsheet (Aug. 31, 2008) [LBEXBARFID
0023801]; Lehman, Strategic Equity Model Aug. 2008 Spreadsheet (Aug. 31, 2008) [LBEXBARFID
0012946]; Lehman, Single Family REO Model Aug. 2008 Spreadsheet (Aug. 31, 2008) [LBEXBARFID
0024249];Lehman,StrategicREOModelAug.2008Spreadsheet(Aug.31,2008)[LBEXBARFID0024594].
The specificvaluation methodology for many of these positionsis unknown,although the data reflects
thatonlyoneofthesepositionswasvaluedinAugust2008usingacapitalizationmethod.
1294SeeZevKlasewitz,Lehman,SingleAssetDebtModelMay2008Spreadsheet(June14,2008)[LBEXLL

1985749]; Zev Klasewitz, Lehman, Single Family Debt Model May 2008 Spreadsheet (June 14, 2008)
[LBEXLL 1985605]; Single Family Equity Model May 2008 Spreadsheet (May 31, 2008) [LBEXLL
1985924]; Lehman, Strategic Equity Model May 2008 Spreadsheet (May 31, 2008) [LBEXBARSOX
0000594]; Zev Klasewitz, Lehman, Single Family REO Model May 2008 Spreadsheet (June 13, 2008)
[LBEXLL 1985887]; Lehman, Strategic REO Model May 2008 Spreadsheet (May 31, 2008) [LBEXLL
1985926].
1295See Lehman, Single Asset Debt Model Aug. 2008 Spreadsheet (Aug. 31, 2008) [LBEXBARFID

0023236]; Lehman, Single Family Debt Model Aug. 2008 Spreadsheet (Aug. 31, 2008) [LBEXBARFID
0022749]; Lehman, Single Family Equity Model Aug. 2008 Spreadsheet (Aug. 31, 2008) [LBEXBARFID
0023801]; Lehman, Strategic Equity Model Aug. 2008 Spreadsheet (Aug. 31, 2008) [LBEXBARFID

352

LehmanemployedTriMontscollateralvalues,thepricetestinginAugust2008would

have indicated a $671 million overvaluation for these positions.1296 Instead, after

Lehman used its own collateral values, the price testing indicated only a $56 million

overvaluation.1297

(c) ExaminersFindingsandConclusionsastotheEffectof
NotMarkingLehmansPTGPortfoliotoMarketBased
Yield

AsasubstantialpartofthePTGportfoliowasnotvaluedbasedonmarketbased

yield,theExaminerconcludesthatthereissufficientevidencetosupportafindingthat

certain PTG assets were unreasonably valued, for purposes of a solvency analysis,

duringthesecondandthirdquartersof2008.

Koutouvides and Jonathan Cohen told the Examiner that the PTG marks

representedfairvalue.1298Accordingtothesewitnesses,PTGwasnotrequiredtomark

these illiquid assets, backed by nonstabilized real estate, at prices they could sell for

0012946]; Lehman, Single Family REO Model Aug. 2008 Spreadsheet (Aug. 31, 2008) [LBEXBARFID
0024249];Lehman,StrategicREOModelAug.2008Spreadsheet(Aug.31,2008)[LBEXBARFID0024594].
1296See Lehman, Single Asset Debt Model Aug. 2008 Spreadsheet (Aug. 31, 2008) [LBEXBARFID

0023236]; Lehman, Single Family Debt Model Aug. 2008 Spreadsheet (Aug. 31, 2008) [LBEXBARFID
0022749]; Lehman, Single Family Equity Model Aug. 2008 Spreadsheet (Aug. 31, 2008) [LBEXBARFID
0023801]; Lehman, Strategic Equity Model Aug. 2008 Spreadsheet (Aug. 31, 2008) [LBEXBARFID
0012946]; Lehman, Single Family REO Model Aug. 2008 Spreadsheet (Aug. 31, 2008) [LBEXBARFID
0024249];Lehman,StrategicREOModelAug.2008Spreadsheet(Aug.31,2008)[LBEXBARFID0024594].
1297See Lehman, Single Asset Debt Model Aug. 2008 Spreadsheet (Aug. 31, 2008) [LBEXBARFID

0023236]; Lehman, Single Family Debt Model Aug. 2008 Spreadsheet (Aug. 31, 2008) [LBEXBARFID
0022749]; Lehman, Single Family Equity Model Aug. 2008 Spreadsheet (Aug. 31, 2008) [LBEXBARFID
0023801]; Lehman, Strategic Equity Model Aug. 2008 Spreadsheet (Aug. 31, 2008) [LBEXBARFID
0012946]; Lehman, Single Family REO Model Aug. 2008 Spreadsheet (Aug. 31, 2008) [LBEXBARFID
0024249];Lehman,StrategicREOModelAug.2008Spreadsheet(Aug.31,2008)[LBEXBARFID0024594].
1298ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atpp.1112;ExaminersInterviewof

JonathanCohen,Jan.11,2010,atp.5;ExaminersInterviewofJonathanCohen,Jan.22,2010,atp.4.

353

duringasharpmarketdownturn.Koutouvides,whowasclosesttothetechnicaldetails

ofthebusinessdesksvaluationofPTGassets,toldtheExaminerthatLehmanmadeno

attempttomarkPTGassetstomarketbasedyieldduringthesecondandthirdquarters

of2008.1299KoutouvidesandJonathanCohenassertedthatLehmansintentiontohold

theseassetsaslongterminvestmentsmeantthattheassetvaluesshouldnotbesubject

to shortterm fluctuations in the market. Lehmans logic (as represented in these

witnessstatements)wasthatsellingPTGassetswasverydifficult,andLehmandidnot

wanttosellPTGassetsatsteeplydiscountedprices.JonathanCohenassertedthatany

sale of PTG assets at this time was a fire sale, and Lehman had a policy against

valuingassetsbasedondistressedsales.1300

Lehman did not originate PTG positions with the intention of selling half

developedproperties,andtheuniquefeaturesofeachproject,aswellasthemarriage

betweenLehmanandthedeveloper,madeitdifficultforathirdpartytoassesstherisks

inherentinanunfinishedproject.However,markingassetsatfairvalue(whetherfor

purposes of solvency or SFAS 157) is not overridden by the fact that Lehman did not

markettheunderlyingpropertyuntiltheprojectwasnearlycomplete.1301

1299ExaminersInterviewofAristidesKoutouvides,Nov.20,2009,atp.11.

1300Examiners Interview of Jonathan Cohen, Jan. 11, 2010, at p. 5; Examiners Interview of Jonathan
Cohen,Jan.22,2010,atp.4.
1301Fin.AccountingStandardsBd.,DeterminingFairValueWhentheVolumeandLevelofActivityfor

theAssetorLiabilityHaveSignificantlyDecreasedandIdentifyingTransactionsThatAreNotOrderly,
StaffPositionNo.1574,2(2009)(Fairvalueisthepricethatwouldbereceivedtosellanassetorpaid
totransferaliabilityinanorderlytransaction(thatis,notaforcedliquidationordistressedsale)between

354

The definition of fair value under SFAS 157 relies on a transaction with typical

marketingperiods.1302Thisisanobjectivedefinition,allowingforthemarketingperiod

toextendforanappropriateperiodoftime.

TheExaminersconclusionsthatthereissufficientevidencetosupportafinding

that certain PTG positions were unreasonably valued during the second and third

quarters of 2008 does not extend to all of Lehmans PTG positions. As described, the

process of valuing PTG positions requires assetspecific information and an

investigationofthecircumstancesandcurrentstateofadevelopmentproject.Forthe

purposeofperformingasolvencyanalysis,acourtcoulddiscountthePTGassetvalues

reportedbyLehmanonacasebycasebasisafteraconsiderationofthespecificassetsin

question.

Asnoted,althoughthereissufficientevidencetodemonstratethatthevaluation

methodology for PTG assets did not rely on marketbased assumptions, there is

insufficientevidencetosupportacolorableclaimthatanyLehmanofficeractedwithan

intent to produce incorrect values or conducted the valuation process in a reckless

manner.Theerrorsinvaluationdidnotresultfromactions(oromissions)thatwould

supportaclaimofabreachoffiduciaryduty.1303

market participants at the measurement date under current market conditions). For a more detailed
discussionofthelegalstandardforfairvaluemeasurements,seeAppendix1,LegalIssues,SectionVII.
1302SeeAppendix1,LegalIssues,SectionVII.A.

1303For a more detailed discussion of the standard governing a claim of breach of fiduciary duty, see

Appendix1,LegalIssues,SectionII.

355

f) ExaminersAnalysisoftheValuationofLehmansArchstone
Positions

(1) ExecutiveSummary

This section of the Report addresses Lehmans valuations of its Archstone

positions.

Lehman,togetherwithTishmanSpeyer,agreedtoacquireArchstone,apublicly

traded Real Estate Investment Trust (REIT), on May 29, 2007 (the Commitment

Date). The transaction closed on October 5, 2007 (the Closing Date). Lehman

fundedapproximately$5.4billionofthe$23.6billionpurchaseprice,makingArchstone

Lehmanslargestcommercialrealestateinvestment.

Aftertheacquisitionwasannounced,analystsopinedthatLehmanandTishman

Speyer had negotiated a favorable price. However, as the stock prices of Archstones

publicly traded peers began to decline over the summer and early fall of 2007, a

Citigroup analyst suggested that Archstones enterprise value had declined to a level

wheretheArchstoneacquirerswouldbebetteroffpayingthe$1.5billionbreakupfee

insteadofcompletingthetransaction.1304

Lehman initially projected that its Archstone investments would generate in

excess of $1.3 billion in profits over 10 years. This projection was based on the

following assumptions: (1) Archstone would sell certain properties for $8.9 billion

1304Citigroup,ArchstoneSmithTrust:CouldtheBuyerCutTheirLossesandWalkAway?(July26,2007),

atp.1[LBEXDOCID1192001].

356

contemporaneouslywiththeclosing,therebyreducingLehmansexposureandrisk;(2)

Archstonesprojecteddebttoenterpriseratioofover80%atclosingwouldbereduced

shortlythereaftertoapproximately70%pursuanttoa$1.9billionequityoffering;(3)the

promotefeatureembeddedinLehmansgeneralpartnerinterest(whichitreferredtoas

permanent equity) would result in that equity interest receiving enhanced returns;

and (4) Lehman would syndicate onehalf of its Archstone debt and limited partner

interests(whichitreferredtoasbridgeequity)withintwoweeksofclosingandthe

remainderduringthefollowingsixmonths.

TheassumptionssupportingLehmansinitialprofitprojectionwerenotrealized:

(1)Archstone sold only $1.4 billion of properties contemporaneously with the closing;

(2)Archstonedidnotexecuteapostclosingequityoffering;(3)byMarch2008,Lehman

determined that the promote feature would not provide enhanced returns; and

(4)Lehmandidnotsyndicateamaterialpartofeitherits$2.3billionArchstoneentity

leveldebtoritsbridgeequitybeforeLBHIfiledforbankruptcy.AlsoasoftheClosing

Date, the lenders, including Lehman, only syndicated $71 million of bridge equity,

which represented 1.5% of the aggregate $4.6 billion bridge equity commitment.1305

1305The
lending group received expressions of interests from D.E. Shaw and Abu Dhabi Investment
Authority, but these investors ultimately chose not to participate in the Archstone transaction. Email
fromMikeMazzei,Barclays,toMarkWalsh,Lehman(Nov.19,2007)[LBEXDOCID1787730].TheAbu
Dhabi Investment Authority expressed an interest in acquiring $250 to $550 million of bridge equity.
Memorandum from Coburn Packard, Lehman, and Arash Dilmanian, Lehman, to Brett Bossung,
Lehman, and Mark Newman, Lehman, Archstone Acquisition Update (Sept. 17, 2007), at p. 4 [LBEX
DOCID2073832].Lehmansold$50milliontotheIrvineCompany,$20milliontoConsolidatedInvestor
Group, and $1 million to Larry Cohen, a high net worth individual associated with Tishman Speyer.

357

However, Lehman and its financing partners were able to reduce their aggregate

exposure by over $8 billion through the placement of Archstone mortgage debt with

Fannie Mae and Freddie Mac at the closing. After the closing, Lehman, BofA and

Barclays did not syndicate any bridge equity and only syndicated $43 million of term

loans.1306

Archstonewasahighlyleveragedcompanywith76%loantoenterprisevalueas

of the Closing Date.1307 Lehmans approximately $2.2 billion of entitylevel debt was

structurally subordinate to over $12.0 billion of Archstone assetlevel debt, and its

approximately $2.4 billion of equity was subordinate to approximately $17 billion of

debt. Given Archstones leverage, a small decline in Archstones enterprise value

would result in a materially larger decrease in the fair value of Lehmans equity

interest.Conversely,asmallincreaseinArchstonesenterprisevaluewouldresultina

materiallylargerincreaseinthefairvalueofthatinvestment.1308

Lehman, Archstone Smith Multifamily JV Debt and Equity Redemption Schedule (Jan. 3, 2008), at
Redemptions tab [LBEXDOCID 2502413], attached to email from Keith Cyrus, Lehman, to Paul A.
Hughson,Lehman,etal.(Jan.3,2008)[LBEXDOCID2646616].
1306Lehman, Pro Forma Capitalization Company Balance Sheet (May 30, 2008), at p. 2 [LBEXDOCID

4329013]attachedtoemailfromRachelHamilton,Lehman,toPaulA.Hughson,Lehman,et.al.(May31,
2008)[LBEXDOCID4329012].
1307The76%ratioassumesthepurchasepricewasrepresentativeoffairvalueasoftheClosingDate.

1308The Examiners financial advisor calculated that Lehmans $2.4 billion Archstone equity investment

wouldbereducedby$1billioninvalueifArchstonesenterprisevaluedeclinedbyapproximately10%.

358

AsoftheClosingDate,LehmanwrotedownthevalueofitsArchstonepositions

by$2