Lessons from Lehman: Don't Let CEOs Write Their Own Report Cards

I remember well the bankruptcy of Lehman Brothers because a few days before it happened, I went on CNBC's Power Lunch to argue that Goldman Sachs Group (GS) should rescue Lehman. But on Sept. 15, 2008, Lehman became history's largest bankruptcy at $639 billion in assets. A big reason why it went bust is the same one that caused Enron, WorldCom and Bernie Madoff to hit the skids -- America's woefully weak system for protecting common shareholders.

Before getting into that weakness, let's explore what caused Lehman to collapse. The 2,200 page report authored by Anton R. Valukas, fingered an accounting practice that Lehman called Repo 105 -- a way to get loads of debt off its balance sheet just in time for its quarterly reports to shareholders. This accounting trick fooled stockholders, market analysts and credit rating agencies into thinking Lehman was in much sounder financial shape than it really was.

As the subprime mortgage market began collapsing, Lehman, which was heavily dependent on mortgage-backed securities, began using Repo 105 to mask more debt each quarter until it collapsed. Lehman used Repo 105 to temporarily rid itself of $39 billion in the fourth quarter of 2007, $49 billion in the first quarter of 2008 and $50 billion in the second quarter of 2008, its last full quarter prior to filing for bankruptcy, according to the Valukas report.

The real lesson of the Lehman bankruptcy isn't the technical details of how its Repo 105 worked. It's our severely compromised system of "protecting" shareholders. That system makes common shareholders the greatest of fools and lets CEOs write their own report cards.

At the Bottom of the Hierarchy

Why are common shareholders the greatest fools? As bond maven Bill Gross told me in a February 2009 interview, common shareholders are at the bottom of a public company's liquidation hierarchy. That is, when a company goes into bankruptcy, its lenders get first dibs on the proceeds from selling the bankrupt company's assets. Common shareholders get whatever scraps are left over after the bondholders and preferred shareholders get theirs.

And the biggest problem is that CEOs write their own report cards. As happened at Enron, WorldCom and Madoff Securities, the executives in charge of the companies manipulated their financial reporting to make it appear that their companies were doing better than they really were. According to the Valukas report, the same thing happened at Lehman.

With Enron -- and at Lehman, says the report -- the idea was to mask excessive borrowing by getting debt off the balance sheet reported to the public each quarter. At WorldCom, the accounting fraud was about making the company look like it had higher sales than it really did. And Bernie Madoff simply made up fake account statements so his investors would think they had money that he had really stolen from them.

Sailing Too Close to the Wind?

Auditors and lawyers are supposed to adhere to higher standards to protect shareholders from this kind of management manipulation of financial reporting. But CEOs pay the lawyers and auditors so partners in those firms face a choice of watching millions of fees go to their competitors or sailing too close to the wind when it comes to their professional ethics.

The Valukas report makes it appear that Lehman's auditor, Ernest & Young, may have chosen fees over ethics. Ernst & Young certified Lehman's financial statements despite "receiving warnings from a whistle-blower who said there were accounting improprieties," according to The New York Times.

If America ever wants to get serious about protecting shareholders, it needs to take away the power of CEOs to write their own report cards. As I have written before, this would mean creating an independent group of accountants not paid by public companies who would produce their financial reports. If independent grading is good enough for our schools, why can't we do it for our financial markets?

An Independent Group of Accountants

In the competition to create value for customers, financial reporting isn't a core competence for any business. And if manipulating its accounting is what a company is good at, it has no right to be in business. My proposed independent group of accountants would, if done right, make it much harder for companies to trick others into lending them money or buying their stock.

Unless we take that power away from CEOs, we are giving those so tempted the chance to destroy whatever confidence remains in our system of shareholder capitalism.