Lehman Brothers one of the big financial services company was founded during the year 1850 filed its bankruptcy protection during September 2008. Numerous reasons caused this financial investment firm to cripple through the financial turmoil. The court ordered an external examiner to conduct an investigation by giving out ten requirements to guide him through his investigation about the issues of litigation and any breaches of law that might have occurred.
Mr Anton R. Valukas the chairman of Jenner & Block has taken up the task of investigation and conducted 100’s of interviews and searched through the company’s files and documents about a year costing $38 million. Mr. Valukas generated 2200 pages of document about his findings of investigation. This article discusses about the learning’s in regards to corporate governance from the failure of Lehman Brothers and the scenario of Australia in comparison with America considering the regulations by regulatory authorities and relevant legislation controlling the financial services sector.
Corporate governance learning’s: The document by examiner raises the flaws in the corporate governance those have to be reviewed to avoid such collapses in future.
The major findings of investigation as per the examiner which are relevant to problems addressing the corporate governance are Risk Management and relevant disclosures by management to the board and issues of relevant internal controls. Deficiencies in stress testing scenarios.
The need for disclosures to board of directors. Remuneration of top executives tied to short-term performance. Those listed out findings are further discussed in brief about surrounding issues by comparing what happened and the suggestions to avoid the occurrence of these problems in future. Risk Management and relevant disclosures by management to the board and issues of relevant internal controls: The risk models used by LBHI had number of assumptions resulting to inaccurate results, but still the major reason being the usage of information within the organisation had flaws.
The board and the management of Lehman Brothers started to adopt the high risk taking business strategies.
The understanding of the risks involved in financial instruments like collateralised debts, sub-prime lending, and derivatives was insufficient and lack of appropriate control procedures to lessen those risks. The board had not asked a question to management about the risk handling strategies and the models used to calculate the risk even thought one of the primary principles being overseeing the risk management system for investment firms. The board’s supervision of issues relating to risk has to be strengthened. The usage of risk model which is dynamic with respect to market changes addresses the current scenario better than using a old static model with limitations. The board should have a combination of directors with different skills which are needed for that particular firm.
One of the director’s with technical knowledge of risk related issues would have helped to identify the ‘red flags’ much earlier allowing them to take appropriate actions to overcome the problem.
The lack of systematic procedures to communicate potentially significant business risks through effective channels weighs down to the issue of corporate governance. The board of directors should clearly establish the accountability and responsibilities right through the organisation. The lack of internal controls which can raise red flags to management while dealing transactions which lead to exceeding the risk limits of organisation helps in avoiding those transactions. The management and officers have taken very risky decisions based on their intent and pas experience about how it might result rather than analysing the situation based on the quantitative facts.
Therefore the practice of every significant transaction with supporting documents which includes fact based analysis has be prepared and approved by relevant authority.
Lack of timely action: The management and board along with the government thought the effect of crisis is short term and therefore LBHI went on to acquire risky investments increasing their risk appetite without actually calculating their capacity based on the relevant facts. Later they realised effects and took actions to bring down the leverage ratio, but due to lack of liquid assets and anticipation of losses in getting rid of illiquid assets further troubled. Deficiencies in stress testing scenarios: LBHI always used the testing scenarios in deciding whether to practise a particular transaction was value the risk it carries. They also used its risk management system to promote the firms capabilities to credit rating agencies, potential investors and regulating government bodies.
The scenarios used had lot of assumptions which biased the actual calculations from the reality. They excluded including the effects of financial instruments like commercial real estate investments, leveraged loans, and private equity instruments leaving a big gap in analysing the risks posed by these securities.
Therefore they ended up acquiring very risky options which created significant problems. Later when they included all those instruments the risk well exceeded the risk appetite of LBHI forcing them to reduce the leverage but that was too late to construct the damages caused.
Gathering more information about the wide range of risk measures, different perspectives of similar risks helps in more effective measurement and effective communication across the organisation from board to manager’s leaves in better situation. Lehman Brothers had good rules and self governing rules in place but when it came to following those rules in business decisions the management failed to do so. For example, the management exceeded the single transaction limit policy to favour the handling of large deals. Instead of just keeping the rules and policies to books and constitution of a firm, having internal controls which do not allow overriding these rules avoids the problem.
The need for disclosures to board of directors: The disclosure by the management of the impacts of transactions and strategies both in terms of positive as well as negative consequences to the board helps them to take the better decisions due to the available information.
The lack of information about the negative effects and the way the risk model is calculated disabled the directors from good business decisions. If the management would have provided the board with all the relevant disclosures have raised red flags about the situation forcing to act quicker to recover the situation by reducing the overall risk taken by firm.
Therefore the board of directors should have access to the timely, relevant and accurate information. Proper foresight and forecasts by senior management should be practised. It can also be done by including CRO to occupy the position on the board and reviewing the risks management issues during meetings gives a good guidance. The combination of competence of board of directors has to be addressed since the right combination helps discussing about different views in analysing the different situations.
Remuneration of top executives tied to short-term performance: Many firms practice the method of calculating the remuneration of top executives based on their performance which is obtained from their financial statements, therefore tying down to short-term performance rather than long-term goals.
This method of practicing is discouraging those who act favouring long-term sustainability of firm and provides incentive to accept those strategies which boosts the revenues in short-term but they might cause serious risks later. Therefore the calculation should also consider the risk factor and should encourage the long-term perspective. The CRO’s pay usually is not tied with their performance, the provision of tying CRO’s remuneration in relation to their performance also provides an incentive to act in favour of building a robust risk methods.
Comparison of American situation to Australia: The major distinction of Australian situation was the financial markets were in good shape with good governance of ASIC and APRA the two regulating authorities of Australia. The Australian economy had a robust growth, very stable financial system, lesser unemployment rate and a little inflation rate.
There is no issue of ‘too big to fail’ and Australia doesn’t have financial institutions as big as LBHI. The sub-prime market in Australia accounted for less than 1% of financial instruments unlike the England, U.S mortgage industry and many other countries. The rate of arrears for loans was lesser in Australian case on comparison with American which is mainly due to the features of the loans offered. The Australian market did not offered risky loan structures like offering lower introductory interest rates for a period of time. The intense competition in banking sector in U.S caused offering high-risk loans and lower price.
Major Australian financial services sector maintained potential strength in balance sheets and stayed away from smaller amount viable financial disinterested parties.
The Australian legislative system allows the lender to acquire the loan repayments not only through proceeding of sale of collateral but also other personal if the given collateral alone was not sufficient, therefore providing a stronger inducement to repay the loan. The lower unemployment rate also facilitated the Australian economy unlike the huge layoffs of American scenario.
The laws in Australia in relation to insolvency trading, liquidation are very stringent. As per the corporations law if the director trades during insolvency is considered as breach of directors duties, if any directors found guilty in breach of directors duties are held responsible for the losses therefore it prompts to appoint administrator. The administrator takes charge of the entire firm where he analyses and negotiates with creditors about the possibilities and director is not entitled to any role unlike American case where director still runs the company.
The failure in corporate governance and risk management, weakness in regulatory frameworks caused the collapse of Lehman Brothers. ASIC (Australian Securities and Investment Commission): The objective of ASIC is to endeavour to preserve, facilitate and improve the performance of the financial system and the entities operating within that system.
ASIC also promotes the confidence in investors and consumers by information transparency in securities offered. All the financial service providers must possess a licence from ASIC therefore enabling ASIC to monitor the activities. The working standards and employing competent staff for responsible roles forms a usual guide lines under ASIC. ASIC works based on corporation’s law and ASIC act for corporate governance and the conduct of the companies with respect to the share holders and beneficiaries. There is no off balance sheet vehicles or short-term loans provided in the Australian regulatory framework.
Therefore any changes or deviation from AASB has to state properly by giving out the reasons for non-compliance and the method used with adequate disclosures.
Director’s breach of fiduciary duties and as long as they are not protected by business judgement rule the directors are subjected to forgo the losses incurred. The business judgement rule protection in Delaware courts was very broadly protecting directors with the need for stronger evidence. In Australian case it doesn’t protect as well as it was with Delaware courts law. Regulations need to be considered by ASIC in light of the collapse of the financial institution Lehman Brothers.
The usage of ‘Repo 105’ transaction and any other off balance sheet vehicles are to be disclosed with clear description of the methods used. Any such accounting gimmicks are to be prohibited in first place. The flaws in the accounting framework regarding ahs to be addressed to resolve the way of calculating and the relevant disclosures has to be clearly stated. As the corporation’s law has described the role of directors similarly the description of role of senior management officers and their responsibilities puts some pressure on their duty to deliver.
The requirement to communicate all the facts to the board must be held as one of the duties. Need to formulate rules concerning the corporate governance issues in respect to both management and directors duties have to be reviewed.
APRA (Australian Prudential Regulations Authority): The role of APRA is to protect depositors, superannuation fund members and insurance policy holders but not the share holders. The role of APRA is to promote robust risk management and prudent behaviour.
The Australia had thought about Basel committee during 2004 on banking regulation is working to set up shock absorbers into capital frameworks. When the board doesn’t understand the high risk products and how to mitigate the effects it is advised to not to invest on those products. The good governance is important for any organisation.
The calculation of risk appetite was flawed in the LBHI’s case leaving gap for institutions to develop their own. But in APRA’s case the regulations has generally avoided certain short comings but development of quantitative methods.
The local regulating bodies like APRA worked towards improving the market condition. A few initiative’s are to reduce the complexity of products, transparency of securities offered, enhancing the role of credit rating agencies. Certain issues to be addressed by regulators included based on the Lehman Brother’s collapse are: The capital requirements for investment firms has to be reviewed, there should be a regulations towards controlling the leverage ratios. The whole banking system is based on mitigating the risk and gaining the profits appropriate to risk, since risk is the critical issue for investment firms that should be managed by distributing the risk. Regulators should impose restrictions on high-risk business strategies by imposing a cap on total allowed risk at any time.
The financial firms have to get the approval from regulators about the risk model usage and adaptive stress testing scenarios.
The prudential regulator APRA making proposals on remuneration emphasising on financial stability and long-term growth. All the entity’s personnel involved in decision making which affects the share holders are included in remuneration plan. Legislative provisions: So for the global financial crisis has not provided much changes to the Australian legislation. The Australian corporate governance and other regulatory bodies have well handled the global financial crisis with less impact on the economy.
The ‘Too Big To Fail’ financial services firm Lehman Brothers collapse has focussed the flaws in corporate governance, risk management strategies, and effects of age old off balance vehicles i.e., the accounting standards are learning’s for the future.
Many regulations and law reforms are developed from the problems the world faced as they form like Sarbanes-Oxley act which caused the formulation of internal controls as a standard. Therefore this collapse also comes out with well regulated rules and robust methods to handle the stress and limitations on risk taking are necessary. The part of law which governs the issues discussed in this article is corporations act 2001. Other regulatory frameworks which require review are prudential regulation, Accounting standards, corporate governance issues.
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