Hoisted from Comments: The Lehman Whistleblower Letter

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?

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  1. Cynthia

    If you plan on being a top bankster while Obama is in power, make sure that you become one of Obama’s favorite golfing buddies, because in exchange for playing a good game of golf with him, he’s likely to strong-arm his prosecutors into getting you off scot-free for your criminal activities.


    But if you plan on being a whistleblower while Obama is in power, think again, because his prosecutors are likely to make you into a scapegoat and have you hauled off to jail.


    So my advise to Micheal Lee: Watch your back, because Obama Justice may indeed make you into a scapegoat.

    1. Doug Terpstra

      Sadly, evidence is mounting that Obama’s detractors were spot on: Obama is Chicago machine Democrat through and through. The coroporate wealthcare suasage, mandatory profit-protection racket, is even now being extruded through Congress, thanks to arm-twisting by recently energized president. How disheartening.

  2. Independent Accountant

    The press is all wet here. I have some posts coming on the Lehman disaster. It would be EASY to win a criminal case against Lehman (LEH) senior executives. Wire fraud, mail fraud, securities fraud, FCPA books and records violations, SOX violations, RICO, you name it. It’s all here. The problem: Suppose LEH executives decide to “rat out” the rest of the STREET? Do you think only LEH was cooking its books? LEH can crash the STREET and the Justice Department and SEC known it. Therefore they will do everything possible to protect LEH.

    1. Carrick

      Isn’t there a finance lawyers’ blog/board out there that could just write up the imaginary proceedings of a criminal case against Lehman.

      Granted they don’t have all the info, but in advance of a trail (or during it), there have to be lawyers who’d love to play out both sides of this in a virtual court. If not for the sick pleasure of living their work, then for all the business it would unleash if it galvanized momentum towards prosecutions against the other ‘book cookers’ on Wall St.

      You know they sit around reading Grisham lawyer-adventure books in their free time.. they must be yammering away on some legal blogs as well.

    2. MichaelC

      All those cases will probably be easy to prosecute. But all of those, with the exception of SOX, have precedents and will be tied up in court for years. Besides, who really gives a damn about LEH at this point. What’s important are the other time bombs waiting to go off. Better for all of us to get a glimpse of those issues before Geithner/Dodd/Summers et al lock up the ‘reform’ package.

      The opportunity available now with SOX, is that it can have immediate effect on the rest of the existing financial institutions. Charges against Lehman execs would be the catalyst for immediate full compliance with the anti-fraud rules.

      Consider: If the SEC announces tomorrow it is going to charge LEH executives with SOX fraud charges, every person who has to sign off on the 1Q10 results next month (and there are a lot of people in that chain) is going to seriously consider becoming a whistleblower, or at least reconsider the risk they are assuming by signing.

      Perhaps the SEC considers that too big a risk to take. I can’t imagine a scenario where that position would be defensible, since they’re responsible for enforcing the rule that requires honest disclosure.

    3. Jimbo

      Can you imagine the political uproar if President Obama goes after Erin Callan of Lehman, a woman? Every woman will ask herself, what about Geithner, Paulson, and so many others. Why a woman?? And they’d be right. Hard to believe that Bush prosecuted his buddy at Enron, and Obama has failed to prosecute anyone of any importance. Erin’s not the place to start.

    4. Skippy

      Funny you say wire and mail fraud, because I’ve been helping pro bono quite a few people with debt collectors re-examining old delinquency’s (6 years or more) or closed accounts sold as active to 2nd and 3rd world agencies or off shore facilities.

      I personally have gone several orders up the food chain till I get some one that hablas the meaning of your screen image is not a legal document, send me paper or do you have the letter of credit and can prove it.

      Skippy…don’t be such a stranger.

    5. jdmckay

      The problem: Suppose LEH executives decide to “rat out” the rest of the STREET? Do you think only LEH was cooking its books?

      Ah yes… kind’a like a sub-contextual-2-big-2-fail contagion. Don’t even have to go across borders, just cross the street. (brings to mind “why did the chicken not cross the street” jokes.)

      Following this trail could lead to an in-the-park homerun.

  3. mario

    “…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?”

    In my opinion the problem is in the scale of this issue. Financial statements of large financial institutions are not transparent. Period.

  4. nowhereman

    All the Kings horses and all the Kings men, couldn’t put Humpty together again.
    That is unless you contributed big time to the Kings purse.

  5. ab initio

    There will be intentional neglect regarding any prosecution and even arguments that “technically” no law was broken. Too many folks in power or close to those in power have too many skeletons that need to remain buried.

    Don’t expect that there will be any official attempt to shine the light on all the chicanery on Wall Street and DC. The can is being kicked down the road until it can’t – then ???

    1. anon

      Agreed. In the current political climate, even if there are prosecutions (grudgingly undertaken only because of perceived political necessity), they will be halfhearted and botched in a way that gives a pass to both the prosecutors and the accused. I really hope I’m wrong.

      1. bob

        Cuomo is already proving this. He’s riding the appearance of prosecution to the NYS governors office.

  6. Carrick

    This might be a dumb question, but can’t shareholders use this same letter in a civil case.

    Is it already happening? if Lehman got pounded in civil court, wouldn’t that attract public curiosity, and the question, “when is the criminal trial?” If it is happening, is it not on the evening news b/c the media has other fixations or because its too complex/”boring.” Lehman must have directly bankrupted camera-worthy working poor people as well..

  7. sam hamster

    Unless someone broke a window at Lehman, no crime was committed. That’s what I get from this letter.

  8. Doc Holiday

    Re: “SEC has not had much success in prosecuting complex criminal cases”

    > Has the SEC ever been involved in anything complex, other than aiding and abetting fraud…. or is it willful misrepresentation, conspiracy, collusion, treason and other Shi$ like that, which no one gives a Shit$ about….

    1. Skippy

      Hi ya Doc, the priests are fiddling kids you say, well we better call the pope.

      Skippy…all fixed right.

  9. Francois T

    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?

    The execs from the networks wine and dine in the same locales than their own megastars AND the banksters. Their kids go to the same schools, they subscribe to the same exclusive clubs.

    Between “friends” you know…

    1. NS

      and this is their Achilles heel. Concentrated contempt and arrogance of all but their own.

      Actions speak louder than words. If 105repos were an industry wide practice, then Houston, we have a problem. It would mean shareholders were favored over taxpayers. Paulson as exCEO of Goldman cannot claim ignorance. This would mean some top dogs are more than bystanders, they were enablers. It means the trillions used to support the wealthiest was done with full knowledge of their criminal acts. In supporting them, they risked the actual and real solvency of the nation; with nothing in return to taxpayers who backstopped them.

      Those are some big IFs but certainly not unimaginable.

      Its instructive that the DOJ has been utterly and completely SILENT during the last 3 years.

  10. Anonymous

    You really think it will make a difference? So the SEC investigates. The investigation will be a long drawn out affair. Years will pass. The public will lose interest. Eventually there will be a resolution. The results will be a slap on the hand. Don’t believe this?

    Recall Global Crossing and the telecom accounting frauds from the early 2000’s? Remember the outrage? It was about overstating revenues utilizing phony baloney “round trip” revenue transactions. GX ( Not Enron, Not WorldCom but probably the third largest accounting fraud in the history of the country before the current crisis- tens of billions of dollars in losses) went ka-pooey a short time after the fraudulent transactions were publicized.

    What did the SEC do? Read SEC Release 51517 from 2005 http://www.sec.gov/litigation/admin/34-51517.pdf
    Cease and desist order. $100,000 fine. No criminal charges…Just a slap on the hand to the CEO, CFO and accounting top dog. Why? Oooooohh…They cooperated.

    After reading the document I was amazed that the SEC didn’t even bother to explain the relationship between the bogus round trip transactions (referred to as “reciprocal transactions” in the SEC release), inflated revenues and the impact of those on the company’s stock valuation. (Industry analysts at the time were telling everyone the way to value the telecoms was based upon gross revenues).

    The SEC Investigations are a joke. Lehman people will get off because they too “will cooperate”. New investigations will branch out from that – but then- eventually wither over time. In the end no one will pay.

    1. rita

      I think you’ re right. These scandals have their own script: Initial public outrage, Congressional hearings where our elected representatives use their day in front of the camera for echoing public outrage and posturing for the camera, perhaps window-dressing legislation that started out well because it was crafted by “punk staffers” (the ones who might actually know something) but then was gutted by lobbyists, years later the regulatory agencies publish their findings which usually merit a paragraph in business sections of newspapers and sometimes there are minimal jail sentences for the worst but mostly slaps on the wrist.

      On the other hand, Enron did cause Arthur Anderson a serious ostracism from the bad publicity. Perhaps E & Y will face the same music. The Lee letter delivered to the outside auditor should have caused a major internal investigation under Lehman’s own procedures. And civil lawsuits will probably result in a lot of pain for insurors.

      Part of the difficulty here for the regulators like the SEC maybe that accounting shenanigans were (and may still be) widespread. Lehman’s shenanigans were brought to light because it filed Chapter 11. Singling out Lehman might just seem a tad bit unfair.

  11. Justicia

    It’s about time the DOJ and the regulators stopped dodging the mandates of Sarbanes-Oxley and started enforcing the law.

    There were multiple violations of the statute:
    — fraudulent certifications by the CEO and CFO of internal controls;
    — fraudulent certifications of financials and other SEC filings;
    — retaliation against whistle blower Lee (and perhaps others).

    As I wrote on the Daily Beast in response to Gasbagerino’s boot-licking post saying Fuld would (implying should) go free, any good prosecutor could craft an indictment of both Lehman and E&Y under the statute: 

    18 U.S.C. § 1519 :
” Whoever knowingly alters, destroys, mutilates, conceals, covers up, falsifies, or makes a false entry in any record, document, or tangible object with the intent to impede, obstruct, or influence the investigation or proper administration of any matter within the jurisdiction of any department or agency of the United States or any case filed under title 11, or in relation to or contemplation of any such matter or case, shall be fined under this title, imprisoned not more than 20 years, or both.

    1. MichaelC

      This may be of interest to you. I’m not a lawyer so I don’t know if your reference is the relevant one.

      This is from the Examiner’s report (discussion of SOX Issues)
      (link to full text below) The Examiners report includes a discussion of legal issues in Volume 6
      Section III covers Securities Law issues
      Section III F covers the Sarbanes Oxley Act (beginning on p 81)

      Section 302 of the act requires:

      a “fair presentation of an issuer’s financial condition, results of operations and cash flows encompasses the selection of appropriate accounting policies, proper application of
      appropriate accounting policies, disclosure of financial information that is informative
      and reasonably reflects the underlying transactions and events

      and the inclusion of any additional disclosure necessary to provide investors with a materially accurate and complete picture of an issuer’s financial condition, results of operations and cash flows.”

      (Emphasis Valukas)

      Thus, if the certifying officer, “‘at the time of the certification . . . knew or consciously avoided any meaningful exposure to the information that was rendering their [Sarbanes‐Oxley] certification erroneous,’ a false or misleading certification may form the basis of a § 10(b) and Rule 10b‐5 claim.”

      Criminal penalties may attach when the certifying officer knowingly or willfully certifies a quarterly or annual statement that does not comport with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act.
      See 18
      83 U.S.C. § 1350(c) (2006)
      (officer who knowingly certifies deficient statement may be fined
      no more than $1 million or imprisoned not more than ten years or both, and that officer who willfully certifies deficient statement may be fined not more than $5 million or imprisoned not more than twenty years or both).


  12. MichaelC

    So the consensus of the commenters is that nothing can be done, the system is corrupt beyond repair, we’re settling in for a long siege, grow up, we live in a land ruled by men, not laws.

    I get it.

    We’re all so conditioned to think we’re helpless, and maybe ultimately we are, but what’s the harm in asking the simple question.

    SEC\DOJ will you enforce this one rule for us, please? and if not why not?

    Sometimes we get to a point where the abuses are so outlandish as to be farcical. It’s like the scene in Raider’s of the Lost Ark where Harrison Ford rolls his eyes and just shoots the guy putting on the sword show.

    If the SEC/DOJ simply say they’re going after Callin alone on the specific crimminal fraud charges in SOX, it will have an immediate effect. The lawsuits can come later.

    The external accountants are under siege as a result of the examiner’s report. No charges have been brought yet but their behavior has changed. In the event the SEC/DOJ signal they will enforce the anti-fraud provisions in SOX, the behavior of everyone involved in that process at every public company will change immediately.

    Then we just sit back and watch and listen. How many people working for these firms outside the Csuite today have a vested interest in hiding anything anymore? IBG/YBG isn’t such a smart strategy anymore, since there are fewer and fewer places to be gone to.

    1. Anonymous

      “So the consensus of the commenters is that nothing can be done, the system is corrupt beyond repair, we’re settling in for a long siege, grow up, we live in a land ruled by men, not laws…”

      I wrote the comment about Global Crossing…and I was too negative.

      Maybe there should be a public discussion on a specific group of past SEC Investigations and the results. Are we happy that the three GX leaders faced no criminal charges, especially when one considers the scope and scale of the losses that arose from that fraud? How about the repercussions of what Quattrone, Meeker, Blodget, et al did during the previous crisis, were they punished in an appropriate fashion? What about the hundreds or thousands of well paid minions that knowingly participated in those frauds. Should they have been let off the hook? If not, why not? Let’s discuss where the SEC dropped the ball on those investigations. If the SEC screwed up on those investigations make them admit that publicly.

      The results of this will be more than just therapeutic. It would shine a spotlight on the SEC. Maybe unwanted attention will set the stage for the SEC to act more in the public interest and really hammer the bad guys this time.

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