Jonathan Weil: Lehman Needs to Come Clean About R3

Readers may remember that this blog broke the story, thanks to information provided by a former senior Lehman employee, that some of the asset sales in Lehman’s touted second quarter deleveraging were in fact to a newly formed hedge fund, R3 Capital, staffed by former Lehman MDs and employees, that not only has Lehman as an investor, but reportedly also has Lehman retaining an economic interest in the assets sold. Moreover, the former employee charged, based on information provided by several people at Lehman, that the R3 employees’ restricted stock was still vesting on its original schedule, as if they were still on the firms’ payroll. If true, this is both highly unusual and costly.

Jonathan Weil at Bloomberg has taken an interest in the R3 question and is not letting the investment bank off the hook. As this story makes abundantly clear, he thinks Lehman has been far less forthcoming than it needs to be. That suggests the firm may be trying to hide the fact that R3 is a related party, which in turn would mean the supposed asset sales might be viewed by investors as anything but. Note that the Bloomberg story also confirms the former staffer’s intelligence about the restricted stock.

Reader Marielle, who e-mailed us about this story, drily noted, “Makes you wonder why Merrill sold to Lodestar when they could have just created an S3.”

From Bloomberg:

The more you learn about Lehman Brothers Holdings Inc.’s relationship with R3 Capital Partners, the more it looks as if Lehman may not be telling investors all they need to know.

When Lehman filed its second-quarter financial statements three weeks ago, it was the first time the securities firm disclosed its $1.1 billion investment in R3, the hedge fund that Rick Rieder and other former Lehman executives started in May. Lehman’s report gave few details, though it did say Lehman sold R3 lots of assets last quarter. The big question is whether Lehman, which also is R3’s landlord, disclosed enough.

To help answer that, consider some of the disclosures R3 made in a private-placement memorandum this month for prospective investors, a copy of which I reviewed. They go to a critical issue: Are R3 and Lehman related parties?

Under the rules known as Financial Accounting Standard No. 57, the answer would be yes, if Lehman has the ability to “significantly influence the management or operating policies” of R3. Based on the statements in R3’s memo, it looks to me as though Lehman does. Lehman and R3 demur.

The 110-page memo includes six pages describing “actual and potential conflicts of interest” arising from R3’s relationship with Lehman. For instance, it says that “LB (Lehman Brothers) interests may comprise as much as 48 percent of the net asset value of the master fund.” As a result, “a withdrawal of all or a substantial portion of the LB interests could have an adverse effect on the fund as a whole and its ability to pursue its strategy.”

R3 also said its executives may continue to own Lehman restricted stock that they received during their previous jobs, which “may influence the principals’ dealings with LB as well as their investment decisions.” In other words, R3 might be prevented from fully pursuing its own separate interests.

Ed Ketz, an accounting professor at Pennsylvania State University, said Lehman’s potential 48 percent stake in R3’s master fund by itself would be “significant influence in anybody’s book,” even without voting rights.

I am quite certain that Felix Rohatyn, now a senior advisor to Lehman, has said publicly (apropos investments by sovereign wealth funds) that a passive investment would still give the owner influence. I cannot recall whether the level Rohatyn discusses was 10% or 20%, but it was way below the 48% in question.

Here’s why details like those matter. Under FAS 57, if R3 is a related party, then Lehman should have disclosed enough information about its R3 transactions so that an outside reader could gain “an understanding of the effects of the transactions on the financial statements.” Lehman didn’t do this….

Here’s what Lehman did disclose about R3: During the second quarter, it acquired “non-voting, minority ownership stakes” in R3’s master fund, general partner, special limited partner and management company. As of May 31, its investment was $1.1 billion. Lehman said it “sold assets and transferred derivative risk of approximately $4.5 billion at fair value to R3” last quarter. The assets primarily were corporate bonds and loans….

Ultimately, the question of “significant influence” is a judgment call. Even if an investor’s stake is small, that doesn’t necessarily preclude the investor from having a lot of sway. Likewise, the test for identifying related parties isn’t whether one party is influencing the other’s management or policies now. The test is whether it can.

In its memo, R3 says it will hire Lehman to perform “marketing, financing, derivatives intermediation and trading, prime brokerage, placement agent, price verification, risk control and information technology services.” Its six principals all came from Lehman, as did the 10 other key professionals it listed.

R3 also said that Lehman “may come into possession of material, non-public information” that “could limit the ability of the fund to buy and sell investments.” Consequently, “the investment flexibility of the fund may be constrained as a result of the advisor’s relationship with LB.” It’s hard to understand why any insider knowledge Lehman has would be imputed to R3 if they weren’t related.

Lehman also “will have greater access to information” than other R3 investors about the fund, which Lehman can use in deciding whether to withdraw its investment, and in recommending to clients whether they should, too.

Significant influence or not, it sure looks like Lehman has a lot of pull. Meantime, investors can only wonder what information Lehman isn’t disclosing about its dealings with R3.

They shouldn’t have to.

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  1. Bob_in_MA

    Between this nonsense and he Merrill manipulation of their faux sale of CDOs, it’s clear we’re turning Japanese. Financials will finally be safe to invest in around 2020.

  2. doc holiday

    I'm curious as to how EPS is being manipulated with dividends and share buy backs and of course option grants; thus the CDOs, SIVs and synthetic trash that falls into QSPEs and Level 3 are still very mystifying! Any clues out there as to how to value stocks?

    >> …stock repurchases have a direct, mechanical impact on reported
    EPS that is determined by three factors: the timing of the repurchase, the proportion of share bought back,
    and the financial return forfeited on the funds used to buy back shares. The first two factors are responsible
    for a reduction in the EPS numerator, but the third factor (forfeited return) decreases the EPS numerator.
    The net result is that some stock repurchase increase reported EPS while other repurchases decrease EPS.

    From: Stock Repurchases as an Earnings Management Device

    Paul Hribara, Nicole Thorne Jenkinsb, W. Bruce Johnson

  3. doc holiday

    Maybe this will make sense?

    Re: Jan 29, 2008

    Lehman Brothers Holdings Inc the Wall Street investment bank, on Tuesday raised its common stock dividend 13 percent and said its board of directors authorized the buyback of up to 100 million shares.

    The quarterly dividend will rise to 17 cents per share from 15 cents. Lehman said the higher dividend is payable on Feb 22 to shareholders of record as of Feb 15.

    New York-based Lehman said the buyback program covers nearly 19 percent of its 530.6 million shares outstanding at year end, and supersedes a prior authorization.

    The shares covered by the new program are worth about $6.25 billion, based on Lehman’s Tuesday closing price. Lehman shares rose $1.90, or 3.1 percent, on Tuesday to close at $62.53 on the New York Stock Exchange.

  4. doc holiday

    FYI (as a contrast): Re: December 18, 2007

    Goldman bought back 41.2 million shares at $217.29 apiece in the 12 months ended last month. In the fourth quarter alone, it bought back 11.6 million shares at an average of $230.65 each.

    With Goldman’s shares closing at $208.63 yesterday, the firm lost about $350 million on the investment.

    And Goldman is undaunted. Its board just Monday authorized the repurchase of another 60 million shares. Given that betting against the firm’s brain trust has rarely been profitable in the past, Goldman’s paper losses on its own stock may be shortlived.

  5. Anonymous

    Maybe I got it all wrong,but with both Lehman and Goldman able to borrow Fed funds on faux collateral.
    Does this mean that the Fed (us!) are lending money to them to buyback their own stock?
    Is this OK with the FED?

  6. Caleb Mardini

    This is really good stuff on Weil’s and Naked Capitolism’s part.

    But why is no one mentioning Enron and Chewco. I did a little comparison at the end of my post on the subject.

  7. Fledermaus

    Aw Caleb got there first. But I was going to say that this looks a lot like the enron SPE deals to get a bunch of dogs off their books for a quarter or two. IIRC Enron then bought them back ask paid off the insiders for their troubles.

  8. doc holiday

    OK, good, I like progressive thinking!

    Enron is a fine model to use for share buybacks and look for peas under different shells!

    Re: (: October 27, 2001) The Enron Corporation, trying to reassure investors that it has ample liquidity, began to repurchase all its outstanding commercial paper yesterday, using $3.3 billion it borrowed from banks by depleting its lines of credit.

    An Enron spokesman said that when the commercial paper repurchases are completed the company will retain more than $1 billion in cash.

    The moves did not appear to reassure investors, as Enron’s share price fell to another six-year low. Shares traded as low as $15.04 yesterday, before ending the day at $15.40, down 95 cents.

    This is all bout capital structure, so any help with this puzzle is appreciated; make Yves proud and use her blog to break the pirates!

  9. Anonymous


    From December 1997through December 2000, Kopper received $2 million in “management” and other feesrelating to Chewco. Our review failed to identify how these payments were determined,or what, if anything, Kopper did to justify the payments. More importantly, inMarch 2001 Enron repurchased Chewco’s interest in JEDI on terms Kopper apparentlynegotiated with Fastow (during a time period in which Kopper had undisclosed interestswith Fastow in both LJM1 and LJM2). Kopper had invested $125,000 in Chewco in1997. The repurchase resulted in Kopper’s (and a friend to whom he had transferred partof his interest) receiving more than $10 million from Enron.

    Re: To the Members of the Board of DirectorsEnron Corporation

  10. Anonymous

    Defense Goes After Fastow’s ‘Greed’ With a Vengeance

    Daniel Petrocelli, the lead attorney for Skilling, launched his cross-examination of former Enron CFO Andrew Fastow by mocking the witness for saying he was a “hero” who helped Enron meet its earnings targets every quarter. Instead, he told the jury of eight women and four men, Fastow stole millions and allowed his wife to file false tax returns, which ultimately resulted in her spending a year in jail.

    “We are talking about greed, greed, greed,” he said. “Greed for money. That’s what drove you. Your greed was so great that you allowed your wife to go to prison.”

    For nearly four hours, Petrocelli hammered away at Fastow, asking for details about secret side deals between Enron and two private partnerships he controlled, side deals that netted him and a confederate, Michael Kopper, tens of millions of dollars. At one point, he showed Fastow a computer printout showing that the sum of their illicit gains, unknown to Enron management, exceeded $120 million.

    Petrocelli finished his cross-examination with the so-called Raptor arrangement, which was a vehicle used to take pieces of a business that were doing poorly and essentially hide them from investors and the public.

    Fastow acknowledged that for awhile he explored marketing the idea to other businesses. Major companies, including Aeon of Chicago and GE Corp., had expressed interest in how the Raptors worked.

  11. Anonymous

    This seems on track:

    “When you artificially inflate earnings, improperly book losses so you can sell stock or make earnings targets so you can make high salaries and bonuses, that is stealing,” Fastow said. “I stole in other ways and that way. All that I’m saying is that we stole.”

  12. Anonymous

    The most important question is, Who cares…?

    Unless we can pin the disappearance of some pregnant mother or a teen drug addict on LEH, no one is going to give a crap.

    I think that we all know that LEH and brethren are going to get away with it. These guys are smart. It’s the stock holders that are morons and they’re going to get just what they deserve.

    Best regards,


  13. S

    Fuld – this is like the scene in A Few Good Men, with Jack playing the role of Fuld. For a guy whio is known as the Guerrilla and an intimidating control freak, is it remotely possible that he was not engineering this drive to expand the book? Can you picture him on the stand — did you order the move into subprime? DID YOU ORDER THE MOVE INTO SUBPRIME? the temptation is too great and the arrgoance to entrenched, he screams Fuld screams back – you’re god damn right I did….

  14. Anonymous

    Your damn right I did…LOL, ROTFLMAO!

    Re: “It’s the stock holders that are morons”

    Yes, and that includes mutual fund managers that hold stocks that have massive dilution. Let’s be real, if your mutual fund is holding the next Enron, you either better wake up, which is way to late at this stage or get ready to be screwed, while your asleep! The fact that EPS has vaporized and the fact that option grants are increasing obviously points to both dilution of common shares and a cut in dividends. That cash burn impact is not going to be any easier during a recession when deflationary pressures will blow apart anything connected to crap like LEH, et al.

    Where is the cash flow or value going to come from, when they have to keep selling their shares for less and less to raise cash for compensation and dividends?????

  15. Anonymous

    seems like LEH needs an R3 AND a Lone Star subsidiary(speaking of which… was that subsidiary a new one set up to handle MER’s purchase or has it been established in the past, with a business track record?)


    “In a move similar to what Merrill Lynch has done, Lehman Brothers’ CEO Dick Fuld is trying to shop tens of billions of dollars in mortgage securities on its balance sheet in order to reduce leverage at the embattled investment bank, The Post has learned.”


    “At the same time, speculation has emerged that Lazard has been hired to advise Lehman. Exactly what the boutique advisory firm has been hired to do could not be learned.”

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