UNITED STATES BANKRUPTCY COURT SOUTHERN DISTRICT OF …

[Pages:239]UNITED STATES BANKRUPTCY COURT SOUTHERN DISTRICT OF NEW YORK

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In re

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LEHMAN BROTHERS HOLDINGS INC., :

et al.,

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Debtors.

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Chapter 11 Case No. 08-13555 (JMP) (Jointly Administered)

REPORT OF ANTON R. VALUKAS, EXAMINER

March 11, 2010

Jenner & Block LLP 353 N. Clark Street Chicago, IL 60654-3456 312-222-9350

919 Third Avenue 37th Floor New York, NY 10022-3908 212-891-1600

Counsel to the Examiner

VOLUME 1 OF 9 Sections I & II: Introduction, Executive Summary & Procedural Background

Section III.A.1: Risk

EXAMINER'S REPORT

TABLE OF CONTENTS

VOLUME 1 Introduction, Sections I & II: Executive Summary & Procedural Background

Introduction ...................................................................................................................................2 I. Executive Summary of The Examiner's Conclusions ......................................................15

A. Why Did Lehman Fail? Are There Colorable Causes of Action That Arise From Its Financial Condition and Failure?..................................................................15

B. Are There Administrative Claims or Colorable Claims For Preferences or Voidable Transfers? ........................................................................................................24

C. Do Colorable Claims Arise From Transfers of LBHI Affiliate Assets to Barclays, or From the Lehman ALI Transaction?.......................................................26

II. Procedural Background and Nature of the Examination................................................28 A. The Examiner's Authority .............................................................................................28 B. Document Collection and Review ................................................................................30 C. Systems Access ................................................................................................................33 D. Witness Interview Process .............................................................................................35 E. Cooperation and Coordination With the Government and Parties ........................37

Section III.A.1: Risk

III. Examiner's Conclusions .......................................................................................................43 A. Why Did Lehman Fail? Are There Colorable Causes of Action That Arise From Its Financial Condition and Failure?..................................................................43 1. Business and Risk Management .............................................................................43 a) Executive Summary............................................................................................43 (1) The Examiner Does Not Find Colorable Claims That Lehman's Senior Officers Breached Their Fiduciary Duty of Care by Failing to Observe Lehman's Risk Management Policies and Procedures......................................................................................................47

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(2) The Examiner Does Not Find Colorable Claims That Lehman's Senior Officers Breached Their Fiduciary Duty to Inform the Board of Directors Concerning The Level of Risk Lehman Had Assumed.........................................................................................................52

(3) The Examiner Does Not Find Colorable Claims That Lehman's Directors Breached Their Fiduciary Duty by Failing to Monitor Lehman's Risk-Taking Activities................................................................54

b) Facts.......................................................................................................................58 (1) From Moving to Storage: Lehman Expands Its Principal Investments ....................................................................................................58 (a) Lehman's Changed Business Strategy .................................................59 (b) The Increased Risk From Lehman's Changed Business Strategy .....................................................................................................62 (c) Application of Risk Controls to Changed Business Strategy ...........65 (i) Stress Testing Exclusions ................................................................66 (ii) Risk Appetite Limit Increase For Fiscal 2007...............................70 (iii) Decision Not To Enforce Single Transaction Limit.....................73 (d) The Board's Approval of Lehman's Growth Strategy .......................76 (2) Lehman Doubles Down: Lehman Continues Its Growth Strategy Despite the Onset of the Subprime Crisis..................................................78 (a) Lehman's Residential Mortgage Business...........................................82 (i) Lehman Decides to Curtail Subprime Originations but Continues to Pursue "Alt-A" Originations ..................................82 (ii) The March 20, 2007 Board Meeting...............................................90 (b) The Explosion in Lehman's Leveraged Loan Business .....................95 (i) Relaxation of Risk Controls to Accommodate Growth of Lehman's Leveraged Loans Business ...........................................97 (c) Internal Opposition to Growth of Leveraged Loans Business .......100 (d) Growth of Lehman's Commercial Real Estate Business at the Start of the Subprime Crisis.................................................................103 (i) Relaxation of Risk Controls to Accommodate Growth of Lehman's Commercial Real Estate Business..............................105 (ii) Internal Opposition to Growth of Commercial Real Estate Business ...............................................................................107 (iii) Archstone ........................................................................................108

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a. Lehman's Commitment............................................................108 b. Risk Management of Lehman's Archstone

Commitment ..............................................................................112 (e) Nagioff's Replacement of Gelband as Head of FID .........................114 (f) The Board of Directors' Awareness of Lehman's Increasing

Risk Profile .............................................................................................116 (3) Early Warnings: Risk Limit Overages, Funding Concerns, and

the Deepening Subprime Crisis ................................................................117 (a) Nagioff and Kirk Try to Limit Lehman's High Yield Business......119 (b) July-August 2007 Concerns Regarding Lehman's Ability to

Fund Its Commitments ........................................................................123 (c) Lehman Delays the Archstone Closing .............................................128 (d) Lehman Increases the Risk Appetite Limit to Accommodate

the Additional Risk Attributable to the Archstone Transaction.............................................................................................131 (e) Cash Capital Concerns .........................................................................134 (f) Lehman's Termination of Its Residential Mortgage Originations ...........................................................................................138 (g) September, October, and November 2007 Meetings of Board of Directors.............................................................................................139 (i) Risk Appetite Disclosures.............................................................139 (ii) Leveraged Loan Disclosures ........................................................144 (iii) Leverage Ratios and Balance Sheet Disclosures........................147 (iv) Liquidity and Capital Disclosures...............................................148 (4) Late Reactions: Lehman Slowly Exits Its Illiquid Real Estate Investments ..................................................................................................150 (a) Fiscal 2008 Risk Appetite Limit Increase ...........................................152 (b) January 2008 Meeting of Board of Directors .....................................154 (c) Executive Turnover...............................................................................156 (d) Commercial Real Estate Sell-Off: Too Little, Too Late ...................157 (e) Lehman's Compensation Practices.....................................................161

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c) Analysis ..............................................................................................................163 (1) The Examiner Does Not Find Colorable Claims That Lehman's Senior Officers Breached Their Fiduciary Duty of Care by Failing to Observe Lehman's Risk Management Policies and Procedures....................................................................................................164 (a) Legal Standard.......................................................................................164 (b) Background............................................................................................166 (i) Countercyclical Growth Strategy with Respect to Residential Mortgage Origination...............................................171 (ii) Lehman's Concentration of Risk in Its Commercial Real Estate Business ...............................................................................172 (iii) Concentrated Investments in Leveraged Loans ........................175 (iv) Firm-Wide Risk Appetite Excesses..............................................179 (v) Firm-Wide Balance Sheet Limits .................................................181 (vi) Stress Testing ..................................................................................181 (vii) Summary: Officers' Duty of Care ..............................................182 (2) The Examiner Does Not Find Colorable Claims That Lehman's Senior Officers Breached Their Fiduciary Duty to Inform the Board of Directors Concerning the Level of Risk Lehman Had Assumed.......................................................................................................183 (3) The Examiner Does Not Find Colorable Claims That Lehman's Directors Breached Their Fiduciary Duty by Failing to Monitor Lehman's Risk-Taking Activities..............................................................188 (a) Lehman's Directors are Protected From Duty of Care Liability by the Exculpatory Clause and the Business Judgment Rule.......................................................................................188 (b) Lehman's Directors Did Not Violate Their Duty of Loyalty ..........190 (c) Lehman's Directors Did Not Violate Their Duty to Monitor .........191 (i) Application of Caremark to Risk Oversight: In re Citigroup Inc. ....................................................................................................191 (ii) Application of Caremark and Citigroup to Lehman's Directors ..........................................................................................193

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VOLUME 2

Section III.A.2: Valuation

2. Valuation ..................................................................................................................203 a) Executive Summary..........................................................................................203 (1) Scope of Examination .................................................................................210 (2) Summary of Applicable Legal Standards................................................212 (3) Summary of Findings and Conclusions...................................................214 b) Overview of Valuation of Lehman's Commercial Real Estate Portfolio ..............................................................................................................215 (1) Overview of Lehman's CRE Portfolio......................................................217 (a) Summary of Portfolio ...........................................................................217 (b) Overview of Valuation of CRE Portfolio ...........................................220 (i) GREG Leaders ................................................................................220 (ii) Participants in the Valuation Process .........................................220 (c) Changes in the CRE Portfolio from 2006 through 2008...................223 (d) "Perfect Storm" Impact on CRE Valuation in 2008..........................227 (2) Outside Review of Lehman's CRE Valuation Process...........................232 (a) SEC ..........................................................................................................233 (b) Ernst & Young .......................................................................................237 c) Senior Management's Involvement in Valuation.........................................241 (1) Senior Management's General Role With Respect to CRE Valuation ......................................................................................................243 (2) Senior Management's Involvement in Valuation in the Second Quarter of 2008 ............................................................................................245 (3) Senior Management's Involvement in Valuation in the Third Quarter of 2008 ............................................................................................247 (a) Senior Management's Account ...........................................................248 (b) Paul Hughson's Account .....................................................................253 (c) Other Accounts......................................................................................254 (4) Examiner's Findings and Conclusions With Respect to Senior Management's Involvement in CRE Valuation ......................................265 d) Examiner's Analysis of the Valuation of Lehman's Commercial Book ....................................................................................................................266 (1) Executive Summary....................................................................................266

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(2) Lehman's Valuation Process for its Commercial Book .........................270 (3) Examiner's Findings and Conclusions as to the Reasonableness

of Lehman's Valuation of Its Commercial Book.....................................274 (a) As of the Second Quarter of 2008 .......................................................274 (b) As of the Third Quarter of 2008 ..........................................................282 e) Examiner's Analysis of the Valuation of Lehman's Principal Transactions Group ..........................................................................................285 (1) Executive Summary....................................................................................285 (2) Overview of Lehman's PTG Portfolio......................................................292 (3) Evolution of Lehman's PTG Portfolio From 2005 Through 2008.........296 (4) Lehman's Valuation Process for Its PTG Portfolio.................................303 (a) The Role of TriMont in the Valuation Process for Lehman's

PTG Portfolio .........................................................................................306 (i) Lehman's Issues with TriMont's Data ........................................311 (ii) Lehman Changed Its Valuation Methodology for Its PTG

Portfolio in Late 2007.....................................................................312 (b) The Role of Lehman's PTG Business Desk in the Valuation

Process for Lehman's PTG Portfolio ..................................................319 (c) The Role of Lehman's Product Control Group in Price

Testing the Valuation of Lehman's PTG Portfolio ...........................321 (d) The Influence of Lehman's PTG Business Desk upon the

Price Testing Function of Lehman's Product Control Group.........326 (5) The Examiner's Findings and Conclusions as to the

Reasonableness of Lehman's Valuation of PTG Portfolio.....................329 (a) Lehman Did Not Mark PTG Assets to Market-Based Yield ...........331 (b) The Effect of Not Marking to Market-Based Yield...........................337

(i) Effect of Cap * 105 Not Marking to Market-Based Yield .........337 (ii) Effect of IRR Models Not Marking to Market-Based

Yield .................................................................................................342 (iii) Effect of Product Control Price Testing Not Marking to

Market-Based Yield .......................................................................349 (iv) Effect of Modifying TriMont's Data in the Third Quarter

of 2008..............................................................................................351 (c) Examiner's Findings and Conclusions as to the Effect of Not

Marking Lehman's PTG Portfolio to Market-Based Yield ..............353

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