naked capitalism

I had not pointed to the letter written by Matthew Lee, the so-called Lehman whistle blower, because it seemed to add little to the main story: insider alerts senior management to a Big Problem (or in Lehman’s case, that its chicanery/incompetence was so pervasive as to be impossible for anyone within hailing distance of it to miss). The fact that there was someone who knew things did not smell right, alerted the top brass, and was ignored with prejudice (as in fired, demoted, or marginalized) is typical and disheartening.

But reader Michael C, who was involved in Sarbanes-Oxley compliance for a major bank, argues that the letter is significant, despite its failure to mention Repo 105 by name.

This was the meat of Michael Lee’s May 2008 letter:

1. Senior Firm management manages its balance sheet assets on a daily basis. On the last day of each month, the books and records of the Firm contain approximately five (5) billion dollars of net assets in excess of what is managed on the last day of the month. I believe this pattern indicates that the Firm’s senior management is not in sufficient control of its assets to be able to establish that its financial statements are presented to the public and governmental agencies in a “full, fair accurate and timely manner”. In my opinion, respectfully submitted, I believe the result is that at the end of each month, there could be approximately five (5) billion dollars of assets subject to a potential write-off. I believe it will take a significant investment of personnel and better control systems to adequately identify and quantify these discrepancies but, at the minimum, I believe the manner in which the Firm is reporting these assets is potentially misleading to the public and various governmental agencies. If so, I believe the Firm may be in violation of the Code.

2. The Firm has an established practice of substantiating each balance sheet account for each of its worldwide legal entities on a quarterly basis. While substantiation is somewhat subjective, it appears to me that the Code as well as Generally Accepted Accounting Principles require the Firm to support the net dollar amount in an account balance in a meaningful way supporting the Firm’s stated policy of “full, fair, accurate and timely manner” valuation. The Firm has tens of billions of dollars of unsubstantiated balances, which may or may not be “bad” or non-performing assets or real liabilities. In any event, the Firm’s senior management may not be in a position to know whether all of these accounts are, in fact, described in a “full, fair, accurate and timely” manner, as required by the Code. I believe the Firm needs to make an additional investment in personnel and systems to adequately address this fundamental flaw.

3. The Firm has tens of billions of dollar of inventory that it probably cannot buy or sell in any recognized market, at the currently recorded current market values, particularly when dealing in assets of this nature in the volume and size as the positions the Firm holds. I do not believe the manner in which the Firm values that inventory is fully realistic or reasonable, and ignores the concentration in these assets and their volume size given the current state of the market’s overall liquidity.

4. I do not believe the Firm has invested sufficiently in the required and reasonably necessary financial systems and personnel to cope with this increased balance sheet, specifically in light of the increased number of accounts, dollar equivalent balances and global entities, which have been created by or absorbed within the Firm as a result of the Firm’s rapid growth since the Firm became a publicly traded company in 1994.

5. Based upon my experience and the years I have worked for the Firm, I do not believe there is sufficient knowledgeable management in place in the Mumbai, India Finance functions and department. There is a very real possibility of a potential misstatement of material facts being efficiently distributed by that office.

6. Finally, based upon my personal observations over the past years, certain senior level internal audit personnel do not have the professional expertise to properly exercise the audit functions they are entrusted to manage, all of which have become increasingly complex as the Firm has undergone rapid growth in the international marketplace.

Yves here. It is important to note that Sarbanes Oxley requires the CEO and CFO to certify the published financial statements (which must adhere to SEC standards) and the adequacy of financial controls. So the issues that Lee raises point to multiple Sarbox violations.

As Michael C noted:

In his role he would be one of the key signers of the internal control assesments. His letter serves to both blow the whistle on some specific charges (i.e $5b in excess assets (?) and to formally inform mgt and the auditors that a fundamental key control (substantiation of the accounts)is compromised. This is a big deal, since the auditors, both internal and external rely on the substantiations to sign off on the overall internal control assessment. One would expect a letter like this to trigger a significant response from E+Y.

Every major GL [general ledger] account is assigned an individual ‘owner’ at the firm. That individual is responsible for certifying that the account balance is reported correctly and the balance can be substantiated.

It’s not surprising then that he didn’t mention the 105 specifically. He didn’t need to, since he’s implying that the 105 isn’t the only material issue, the entire control structure was at least ‘significantly deficient’ a term that normally sets off alarms, especially with the external auditors, and demands prompt corrective action.

Yves here. One thing that continues to puzzle me is the press continuing to harp on the idea that it would be hard to succeed in a criminal case against Lehman. Huh? This letter arrived before the end of 2Q, so Lehman issued what turned out to be its final quarterly reports with this information in hand. Fuld was not one of the recipients but Callan was. The barrier that is arguably hard to surmount in a criminal case is intent, that is, that the perps knowingly did something wrong, as opposed to were merely stupid or sloppy. The Lee letter strikes me as a smoking gun for a criminal case.

And the noise in the media re the supposed difficulty of successful criminal prosecution raises a second set of issues: whose interest is served by promoting that point of view?

As Frank Partnoy has pointed out, it is true the SEC has not had much success in prosecuting complex criminal cases, but this case (cooking the books) is not as difficult as ones involving, say, derivatives. Is the failure due to the difficulty of mounting these cases, or that the SEC lacks its own ability to pursue these cases (no joke, it has to go to the DoJ) and the SEC-DoJ combination is dysfunctional?