Category Archives: Financial Reporting

Lehman, D&O Liability and Mark-to-Market Reporting

The Devil’s Casino, Vicky Ward’s first book, is the latest account of the fall of Lehman Brothers.  Released in April, this Lehman tome applies  a gossipy approach to storytelling.  Although we learn much about the shopping habits of some Lehman wives, repo transactions are nowhere to be found.   The book, however, becomes noteworthy when Ward details a September 9, 2008 meeting between JPMorgan’s Jamie Dimon and the Fed’s head Ben Bernake (on page 200) that purportedly directly led to JPMorgan’s request that Lehman provide $5 billion more in collateral. Less than a week later, Lehman filed its bankruptcy petition (the largest in US history) ostensibly given its lack of liquidity brought on by the collateral call of its clearing bank, JPMorgan. 

In a Report by Lehman’s bankruptcy examiner, dated March 11, 2010, the issue of JPMorgan’s collateral demand was analyzed and determined to be barely actionable.  The Report states: 

the Examiner concludes that the evidence may support the existence of a colorable claim – but not a strong claim – that JPMorgan breached the implied covenant of good faith and fair dealing by making excessive collateral requests to Lehman in September 2008.  A trier of fact would have to consider evidence that the collateral requests were reasonable and that Lehman waived any claims by complying with the requests.  

(Report of Anton R. Valukas, Examiner at page 1073)

On the heels of this Report and the Ward book, on May 27, 2010, the Lehman estate sued JPMorgan.  The suit takes a different position regarding the relationship between JPMorgan and Lehman by alleging that JPMorgan’s breach of duty was actionable. 

Unlike JPMorgan, Lehman’s board and officers were essentially given a free pass by Lehman’s bankruptcy estate as well as all regulators.  The Lehman Examiner’s Report actually spends much ink analyzing Delaware fiduciary law yet concludes numerous potential fiduciary lapses were not colorable claims.   On the other hand, a bank that potentially obtains crucial information from a third party (a governmental third party with a near real-time raw account of Lehman’s financial status) and merely seeks to protect its own interests, is forced to defend itself in a costly legal battle.   To many, it makes little sense that Lehman’s directors and officers were exonerated by regulators and Lehman’s bankruptcy Examiner.  Although the existing shareholder suits and claims made by those who sustained direct harm may eventually hit their mark, it is just not the same as potential jail time or a large personal SEC fine.  Not even close.  It is easy to argue that some Lehman folks should have paid with more than the inconvenience of a deposition.

If FASB had acted a bit more aggressively two years ago, maybe none of this would have even happened.  It would have been interesting to have seen FASB actually go through with its Exposure Draft of two years ago regarding FASB Statement 5 (loss contingency accounting) and FASB Statement 133 (hedging strategy accounting).  The vast opposition to the drafts caused FASB to abandon its plans.   Much of the opposition was typified in the McDermott Will & Emery letter that opined if the suggested changes to FASB Statement 5 were made, the opposing side to a filing entity would be able to learn litigation strategy.  If the proposed changes had matured (FASB Statement 5 has not changed since 1975) some of the decisions made by Lehman may have been altered or some of the actions may have been more cleanly delineated as wrongful.  Either way, there would have been more clarity regarding the propriety of their actions. 

As it stands, the Lehman saga provides some guidance to directors and officers looking to see how insulated they are from their financial accounting decisions.  They are pretty insulated given current standards. 

FASB may now be ready to change that dynamic.  It will revive the FASB Statement 5 Exposure Draft in the second quarter of 2010 – now with only a 30-day comment period.  And, FASB issued on May 26, 2010 an Exposure Draft that provides guidance regarding the financial reporting of derivative instruments and hedging strategies.  The overall approach taken moves towards a “mark-to-market” approach for derivative instruments that will have a “seismic effect” on how banks value loan portfolios beginning in 2013 (for large banks) and 2017 (for regional and community banks).  It remains to be seen what FASB will ultimately do given the negative comments it is certain to receive prior to the September 30, 2010 comment deadline.   The takeaway is that FASB  is finally taking a serious look at how companies report on loss contingencies and asset valuations.

All reporting companies – not just financial institutions – should obviously monitor how this and other related financial reporting initiatives evolve.   To a large degree, these accounting standards dictate the extent to which firms such as Lehman can push the envelope.  Although a widening of the reporting net may bring with it a separate set of problems, the change will certainly cause executives to think twice before being coy about a lack of liquidity.  As seasoned investors themselves, reporting officers should probably apply a “Would I want to know this information?” test the next time they are on the fence about the materiality of an item.  True mark-to-market reporting (not Lehman’s “mark-to-make believe” strategy) may bring on headaches for companies with many assets  having big value swings.  Nevertheless, it certainly seems to be part of the reporting standard of the future so you might as well get used to it.