Lehman’s Accounting Deception

The blistering report by the bankruptcy-court examiner investigating the collapse of Lehman Brothers should make investors blood boil.  The report outlines in painstaking detail how Lehman managed risk by essentially cooking its books with off-balance-sheet accounting shenanigans reminiscent of Enron. That Lehman’s deception took place years after the collapse of Enron makes the dishonesty especially outrageous. Former CEO Dick Fuld reportedly claims that he didn’t know about the deception but ignorance isn’t a defense.  He and the three CFOs named in the report should be held accountable civilly and possibly criminally. Lehman’s auditor Ernst & Young could also be held accountable.

What is especially galling given Lehman’s blatant deception is the public statement the company issued in June 2008 in response to short-seller David Einhorn publicly questioning Lehman’s earnings:

“We will not continue to refute Mr. Einhorn’s allegations and accusations. Mr. Einhorn cherry-picks certain specific items from our quarterly filing and takes them out of context and distorts them to relay a false impression of the firm’s financial condition which suits him because of his short position in our stock. He also makes allegations that have no basis in fact with the same hope of achieving personal gain.”

No basis in fact? Einhorn based his conclusions after meeting with former CFO Erin Callan and determined that she didn’t have a good handle on the company’s numbers.  As best I can tell, Lehman’s deception was far greater than even Einhorn figured out.  Regulators should investigate the chain of command involved with the issuance of this statement and charge all of them. There has to be serious consequences for issuing such a patently false statement.

The examiner’s findings will have a ripple effect and could potentially help bolster securities arbitration cases of retail investors who were sold Lehman “100 Percent Principal Protected Notes.”  As noted earlier, in December I won a significant arbitration award on behalf of a client in South Carolina relating to these securities.

What concerns me is how Lehman’s rivals would fare if Lehman’s bankruptcy court examiner spent a year combing the books of the other major Wall Street firms, particularly those that received TARP money.  It’s painfully obvious that investors can’t rely on the Big Four accounting firms to provide effective oversight.

Lessons From Lehman

I’m still trying to make sense of Lehman’s disclosure yesterday that it will post a whopping $2.8 billion loss in the second quarter and raise $6 billion in equity by selling shares at a 20% discount to book value, but one lesson is already readily apparent: the best and brightest analysts aren’t working at the major Wall Street brokerage firms.

Lehman’s projected loss amounts to $5.14 a share, a mind-boggling deficit given that Wall Street analysts were expecting a loss of no more than $1.28 a share. Lehman’s planned fund raising will dilute the holdings of existing common shareholders by 30 percent.

As best I can tell, the loss gives some credence to warnings by hedge fund manager David Einhorn, who repeatedly has charged that Lehman hasn’t adequately marked down some of its assets. While it isn’t entirely clear to me that Lehman plans to write down some of the assets whose value Mr. Einhorn has questioned, the hedge fund manager was indeed correct in predicting a massive earnings train wreck. As Mr. Einhorn so elegantly puts it: “(Lehman) just raised $6 billion of capital that they said they didn’t need to replace losses they said they didn’t have.”

Individual Lehman shareholders should be concerned how Mr. Einhorn – who has a short position on Lehman’s stock – knew with such certainty that the company’s asset values would have to be aggressively written down. Admittedly, it’s quite possible that Mr. Einhorn is just way smarter than the Wall Street analysts who cover Lehman’s stock and is better versed on how to read a balance sheet. But Mr. Einhorn’s public statements indicate that he based his analysis on Lehman’s valuation methods, which possibly suggests we are dealing with basic accounting issues.

Lehman previously maintained that Mr. Einhorn’s criticisms had “no basis in fact.” The merits of that defense are increasingly hard to believe.

When Companies Doth Complain Too Much

I was taken somewhat aback when I read how Lehman Brothers responded to an inquiry about allegations made by short seller David Einhorn. “We will not continue to refute Mr. Einhorn’s allegations and accusations,” an unnamed spokeswoman told The Wall Street Journal. “Mr. Einhorn cherry-picks certain specific items from our quarterly filing and takes them out of context and distorts them to relay a false impression of the firm’s financial condition which suits him because of his short position in our stock. He also makes allegations that have no basis in fact with the same hope of achieving personal gain.”

It’s understandable that Lehman would vehemently deny Mr. Einhorn’s allegations questioning the firm’s accounting. However, the statement seems a tad personal, particularly since Mr. Einhorn has made no secret of his short position. Lehman’s essential public defense appears to be that Mr. Einhorn’s allegations are wrong simply because he benefits handsomely if they are right.

I’m not going to take sides on this one, as I’m not privy to all the facts. Still, Lehman’s seemingly personal attacks on Mr. Einhorn hardly inspire confidence if history is any indication.

Back in 2001 a young reporter at Fortune named Bethany McLean began questioning the accounting of a then highly revered Houston-based company called Enron. Jeffrey Skilling, the company’s then chief executive, called her unethical for failing to do more research. And Kenneth Lay, Enron’s former chairman, complained to Fortune’s editor that McLean was relying on information provided by a short seller who wanted to drive down the price of the company’s stock. Turns out, that short seller had good reason to be short on the stock.

Then there were the attacks by L. Dennis Kozlowski when he was the CEO of Tyco International. In response to a report by David Tice questioning Tyco’s accounting, Mr. Kozlowski said he was outraged by the “false and baseless” report. ”There is no risk that investors will wake up one day and find out” that ”there’s something wrong with the way we’ve been recording revenue or the way we’ve been recording margins.” Mr. Tice, too, was also a short seller.

Finally, there was the press release Calpine International issued on August 27, 2004 attacking a report by an independent research firm called Rate Financials questioning Calpine’s accounting. The release said the report was riddled with “flagrant, misleading and inaccurate allegations.” Sixteen months later Calpine filed for bankruptcy.

For the sake of the public markets, I truly hope that Lehman ultimately defies a disturbing trend that suggests a possible inverse relationship between reality and the vehemence of a company’s denials.

Making Sense of David Einhorn vs. Lehman Brothers

One of the sad lessons that most individual investors fail to learn is just how badly the stock market is stacked against them. Yes, there are rules that supposedly ensure a level playing field, but those rules become meaningless when some of the players are decidedly smarter and know how to play the system to their financial advantage. The market uncertainty about Lehman Brothers Holdings affords a textbook example.

Lehman’s stock plummeted earlier this week in the wake of aWall Street Journal story saying the firm is “considering” a common stock offering that would be dilutive to shareholders. The precipitous decline was no doubt welcomed by David Einhorn, a hedge fund manager who is short Lehman’s stock and has been quite vocal in his attacks questioning the transparency of the brokerage firm’s financials. Mr. Einhorn’s repeated public slamming of Lehman Brothers reportedly has contributed to the decline in Lehman’s stock price.

Mr. Einhorn has made some extremely damning allegations about Lehman’s accounting practices. He questions some large, unrealized gains Lehman booked in the first quarter that helped goose up the firm’s earnings. The gains were on illiquid securities for which there are no public markets, which means Lehman’s management can assign values at its own discretion. As if that alone isn’t enough of a red flag, Mr. Einhorn also charges that Lehman has given him conflicting explanations of its valuation process. To boot, Mr. Einhorn says Lehman has not properly disclosed or written down various complex debt securities, including $6.5 billion of CDOs. Lehman vehemently denies Mr. Einhorn’s allegations, saying they have “no basis in fact.”

I’m in no position to evaluate Lehman’s earnings statements, and I have no reason to question them. But I also am not quick to accept that Mr. Einhorn’s allegations have no basis in fact. The short seller’s claim that Lehman has placed an artificially high valuation on illiquid securities is eerily familiar. There were similar allegations that Bear Stearns priced artificially high the illiquid assets in its subprime hedge funds before those investment vehicles collapsed. A recent comment by Sy Jacobs, a hedge-fund manager who correctly predicted the subprime mortgage crisis, also cannot be ignored. “Just because we got saved from what would have happened that Monday if Bear went down doesn’t mean we are saved from all the forces that conspired to get Bear Stearns to the brink in the first place,” Mr. Jacobs told Barrons.

I also note a comment by star banking analyst Meredith Whitney about Lehman CFO Erin Callan in the May 17th issue of the Journal: “(Callan) is going out on a limb to provide more transparency in Lehman’s earnings, business and strategy.” On Monday, Ms. Whitney predicted Lehman would report a second quarter loss after earlier predicting a profit. The sudden about face possibly suggests that Lehman’s transparency wasn’t quite as clear as Ms. Whitney originally believed.

The reality is there is so much market turmoil and uncertainty today that it is no longer possible to accurately value many of the assets the major brokerage firms have on their books. As Standard & Poor’s analyst Diane Hinton has noted, “We’re in a market environment where sometimes perception becomes reality.” At the moment, it appears that a short seller on Lehman’s stock appears to have the upper hand in shaping the company’s market perception.

And that, folks, is the sad state of the public markets in this Country.