Profile of the Company
Lehman Brothers Holdings Inc. is a global financial services company in the United States. The company has a long history; it was founded in 1850 and closed in 2008 due to bankruptcy (Karim, 2021). Asset management, trading, banking services, and investment management were the key activities of the holding.
Throughout its development history, the organization has experienced rapid growth in its reputation and the trust of its people. In its last year, the company reported net income of US$1.3 billion and total revenues of US$5.5 billion, which were all-time highs (Langton, 2007). These data indicate that the organization showed solid financial parameters, and its bankruptcy could not have been predicted.
The company managed to achieve significant financial success using some original strategies. To a large extent, the organization has been dependent on mortgages to work with different securities, combine them, and provide much leverage (Kumar, 2021). This approach allowed Lehman Brothers to accumulate significant capital by collecting profits from the interest rate. It also created a need for the company to save securities, which was one of its activities.
However, despite the company’s financial success since its inception, the financial crisis of 2008 had a substantial impact on it. Since Lehman Brothers had a significant investment in the subprime mortgage market, this affected the company’s fortunes due to a sharp drop in market value. The number of securities associated with housing assets was significant in the company, so they could not keep the share price at the same level, and financial insurance began to disappear. This state of affairs led to a sharp drop in prices, causing the inability to continue functioning, and Lehman Brothers was forced to declare bankruptcy.
Analysis of Violations
To prevent financial collapse, the company resorted to some strategies that were not legal under United States law. The organization used schemes based on the Repurchase agreement (repo) to meet the requirements for receiving funds (Apollon, 2021). However, Lehman Brothers did not use this strategy as intended, as other firms operated with it.
The company temporarily removed assets from the balance sheet to hide the disastrous financial situation and the amount of borrowed funds, thereby misleading investors. The company made great efforts to maintain its reputation and reduce leverage, thus creating a Repo 105 scheme (Ramirez, 2019). The stages of the firm’s transactions were significantly different in that they attracted third-party affiliates and carried out the purchase of securities and bonds in an illegal way.
The central aspect of the company’s strategy was transferring funds through several branches in Europe to hide the source of income. In this way, the company could obtain a large amount of finance to pay off its obligations and create an image of sustainability in front of state control bodies and private parties. The temporary stripping of assets helped Lehman Brothers evade the presentation of accurate financial statements for an extended period, violating the provisions of the Generally Accepted Accounting Principles (GAAP) (Apollon, 2021).
This principle of action allowed the company to submit documents with ideal financial statements to banking institutions in order to obtain loans. The money was then used to buy back the securities sold by the subsidiary in Europe (Apollon, 2021). Although such a mechanism of action allowed the company to effectively withstand the crisis, after the redemption of securities, financial indicators again deteriorated significantly.
The company violated accounting standards because the firm that was responsible for the company’s accounts failed to detect financial fraud. Thus, the Generally Accepted Auditing Standards (GAAS) were not met because Ernst & Young (the audit firm) was an accomplice in financial fraud involving securities that were carried out through the Repo 105 scheme described above (Burke, 2019). The auditors’ skepticism was not shown because Lehman Brothers had a strong reputation that had not been violated then, which created a trusting relationship with audit companies. GAAS requires auditors to exercise the necessary care and foresight in preparing financial statements, so it may be concluded that this provision has been violated. Thus, Lehman Brothers legalized fraudulent transactions through a third-party company.
The violations of the company in question also affected the Sarbanes-Oxley Act, which should oblige firms to establish adequate internal controls. This concept also includes transparent financial reporting, which was violated by using Repo 105 (Mieszala, 2019). At the same time, during the reporting to regulatory authorities, Lehman Brothers management knew about the fraud that was done to create the appearance of stability of indicators (Lioudis, 2019). This makes them responsible because the company failed to meet all the standards put forward by the Sarbanes-Oxley Act. Later, such a violation significantly affected the company’s perception, having an effect opposite to what the firm’s representatives had hoped for.
The legal and financial consequences for the company were severe, and the company was forced to close. The deepening financial crisis in 2008 made it impossible for Lehman Brothers to continue to engage in securities fraud and receive large amounts of financial assistance (Bishop, 2019). The firm’s bankruptcy was the largest in the history of the United States. The company’s trading volumes were large enough that the bankruptcy and cessation of its activities provoked a multiple increase in the financial crisis, leading to a recession. In addition, legal consequences for the company and its parties included numerous lawsuits from affected parties (Luo, 2021).
Government regulators have also launched investigations into this fraud case. This resulted in criminal charges against all the firm’s senior management members who were involved in organizing financial fraud. The accounting firm Ernst & Young, which was responsible for preparing the financial statements, was also accused of failing to recognize Lehman Brothers’ wrongdoing.
Numerous lawsuits regarding the bankrupt company led to several significant consequences. Major violations, such as collusion, false statements, and fraud, were identified to establish guilt. For the company’s top management, legal orders meant imprisonment with compensation and a ban on holding positions in the financial sector. Thus, the fraud done with securities lowered the company’s shares to a critically low level, resulting in Lehman Brothers being unable to pay its obligations.
Prevention of the Problem
The practice that led to the financial collapse of Lehman Brothers could have been prevented by increased regulatory control. Compliance with the rules and regulations of legal requirements for financial transactions could contribute to the normalization of the company’s financial performance (Wiggins & Metrick, 2019). In addition, the desire of managers to maintain a high image of the company without disclosing the problematic financial situation led to further deterioration of the company’s position. Accounting and securities use rules could be followed using a Repurchase agreement so that profits are not falsified.
Another method that could have a positive effect on maintaining the financial stability of the organization would be an extended risk assessment. The company needed to conduct a better analysis of hazardous situations that could potentially harm the business of Lehman Brothers. Potential systemic risks and excessive leverage could be identified early enough to allow time for action to secure assets. Pulling them out of the mortgage sector could have prevented a stock decline and a lack of financial reserves (Ramirez, 2019). Therefore, Lehman Brothers would not have had to take the emergency action that led to the securities fraud.
Off-balance sheet transactions are also prohibited, requiring the firm to check the financial statements for fraud. It is the responsibility of the regulators who were negligent and did not respond to the strange indicators of Lehman Brothers. Because state investigations of the organization’s activities did not lead to the effect of Repo 105, it was not recognized as illegal (Mieszala, 2019).
Accordingly, strengthening control over the procedures and executive procedures of the company could address offenses in a preventive manner. Control also had to be brought in by the auditing firm Ernst & Young, which failed to recognize the fraudulent activities. A strengthened package of measures against securities crimes could change the situation by making it impossible to implement Repo 105.
References
Apollon, G. (2021). Chief loophole officer or chief legal officer: Inside Lehman Brothers-a film case study about corporate and legal ethics. St. Mary’s Journal on Legal Malpractice & Ethics, 12(1), 2-56. Web.
Bishop, V. (2019). The failure of Lehman Brothers: What went wrong? [Honors Thesis, East Carolina University]. East Carolina University. Web.
Burke, J. J. (2019). Deconstructing the use of REPO 105 and Repo 108 Transactions Under SFAS 140: the Case of Lehman Brothers Holding Inc. and the Liability of Ernst & Young. International Scientific Journal, 19, 165-187. Web.
Karim, M. M. A. (2021). Failure of Lehman Brothers. Journal of Finance & Investment Analysis, 10(4), 1-14. Web.
Kumar, P. B. (2021). Ethics erosion in capital market: Lehman Brothers’ case study of Repo 105. AIMS-18, 4, 21-30. Web.
Langton, J. (2007). Lehman reports record income and revenue. Investment Executive. Web.
Lioudis, N. (2019). The collapse of Lehman Brothers: A case study. Journal of Investment Banking, 11(1), 34-36. Web.
Luo, S. (Ed.). (2021). Proceedings of the 2021 international conference on education innovation, economics management and social sciences. Huaer Zizhu International College, 296-304. Web.
Mieszala, R. (2019). Impact of the collapse of the Lehman Brothers bank and the 2008 financial crisis on global economic security. Scientific Journal of the Military University of Land Forces, 51(1), 146-154. Web.
Ramirez, S. A. (2019). Lehman 10 years later: Lessons learned? Loyola University Chicago Law Journal, 50(3), 512-522. Web.
Wiggins, R. Z., & Metrick, A. (2019). The Lehman Brothers bankruptcy e: The effects on Lehman’s US broker-dealer. Journal of Financial Crises, 1(1), 124-137. Web.