The Bankruptcy of Lehman Brothers - Case Study Example

Executive Summary The world has been continuously witnessing failures of organization as they don’t look into the corporate governance norms seriously. One such example the crisis is shown by Lehman Brothers. The report looks into the issues which resulted in Lehman Brothers filing for bankruptcy. The report presents the fact that over relying on the rating agencies and investing a lot in the real estate business resulted in Lehman brother looking for help from government bodies. Along with it the lack of transparency and concealing material information by manipulating it resulted in the failure of Lehman brothers. The report also presents the manner in which different theories like the stakeholder theory, agency theory, and stewardship theory can help organizations. The report finally provides implications for other organizations and adhering to the different theories will help to reduce financial crisis in the future. Table of Content 1.0 Introduction 3 1.1 Corporate financial and legal responsibility 3 2.0 Lehman brother CSR 3 2.1 Financial CSR issues of Lehman Brother 3 2.2 The drivers for Lehman brothers to break CSR 5 2.3 Legal CSR issues of Lehman brother 5 2.4 Rating agencies issue in Lehman brother case 6 3.0 Implications and lessons for other organizations 7 3.1 Recommendation for developing Financial & legal CSR 7 4.0 Conclusion 9 5.0 References 11 1. Introduction 1.1 Corporate Financial & Legal Responsibility Corporate governance is an aspect which organization pays importance to. Organization based on their needs and requirements have developed different models which ensure proper corporate governance within the organization. Despite different theories and models which ensure corporate governance the world continuously witnesses failure of corporate governance. One such example is the crisis shown by Lehman Brothers which resulted in the company looking towards bankruptcy. Lehman brothers were one of the largest global finance banks which failed during the sub-prime crisis due to excess investment in the capital market. The financial institution had over relied on the rating agencies and invested heavily in asset backed securities. The bubble burst made the financial institution face heavy loss in tune of $85 billion. The financial institutions could have survived the shock if different theoroies like agency theory, stakeholder theory would have been used. These theories would have ensured that the interest of the stakeholder’s was of prime importance and separating the duties of the management would have helped to protect the interest of the shareholders. 2. Lehman Brother Corporate Social Responsibility 2.1 Financial CSR issues of Lehman Brother The failure of Lehman brothers brought forward several financial issues that the organizations are facing. The main reason for the failure of Lehman brother was the over exposure in the real estate market. The company had invested heavily in the real estate business and with the bubble burst the real estate market failed resulting in Lehman brothers looking towards bankruptcy (Rapoport & McGinty, 2010). This can be seen from the fact that the company had invested “$146 billion in 2006 a 10% jump over previous year” (Case Study, 2009). This made Lehman Brothers look towards unethical ways by not disclosing financial information which were true and fair (Manmohan & Aitken, 2009). The company on this front has shown profits of “$4.2 billion on a revenue of $19.3 billion” (Case Study, 2009) where as the actual scenario was different. The company completely ignored the perspective of the shareholder by not following the requirements of the stakeholders. Lehman brothers didn’t disclose their transaction and manipulated the information which was a sign of poor corporate governance (Mitton, 2001). The company focussed on few instrument instead of diversifying their investment which made the investment very risky. The company had invested heavily in the asset backed security market which resulted in writing off $85 billion of the financial statement (Case Study, 2009). Staying away from the policy of corporate governance and devising ways which benefitted them resulted in a crisis (Austin, 2008). Not using IAS 16 correctly which relates to “treatment of assets, especially plant and equipment and property” (Deloitte, 2010) made Lehman Brothers misuse the accounting system prevalent in the country The company to reduce the loss of $85 billion manipulated the financial statement and had written off debts four times their shares resulting in widespread panic and fall in the stock prices (Case Study, 2009). The management didn’t look into this matter resulting in lack of policies for the organization. 2.2 The drivers for Lehman brothers to break CSR There were various reasons which made Lehman Brothers look towards breaking corporate social responsibility. The company was of the view that the investment in the mortgage backed assets would not have any effect on the financial markets and the excess investment in the real estate market would have been handled in the mean time (Valukas, 2010). The company was also of the view that concealing information would ensure little or no effect on the stock prices. The other driver for Lehman Brothers was that they have a lower liquidity risk (Kose, Saunders & Senbet, 2002) and manipulating the assets and liabilities would not have affected the liquidity risk. This misconception of the company backfired as the leverage rose and the company was unable to ensure proper transparency (Ward, 2010). 2.3 Legal CSR issues of Lehman brother Lehman brother ignored the legal issues seriously. The company after loosing money in the real estate business was looking towards making amends by taking all steps which led towards giving up on the legal issues. On the legal front the major issue surrounding Lehman brother was the contribution provided by the auditors Ernst & Young by manipulating the financial statement (William, 2010) Another legal issue was the support that management received from different departments especially the CEO resulted in misuse of laws. This resulted in the organization providing wrong information and concealing information which were true and could have change the attitude of the investors towards the company. The fact that the crisis hit the economy so badly can be seen from the graph below (Econbrowser, 2009) The above chart shows that adhering and falling in the trap made Lehman Brothers file for bankruptcy at the same time crashed the stock market. 2.4 Rating agencies issue in Lehman brother case The rating agencies aggravated the problems for Lehman brothers. On the first hand the auditors of the company didn’t prevent the management from using unethical ways by not adhering to the law (McDonald, 2009). This provided the required freedom that Lehman brothers banked on and invested heavily in the real estate industry. The ratings provided by the rating agencies with regard to investment in the real estate business were overestimated. The rating agencies had given most of the investment a rating on AAA or AAA-. The manner in which the rating agencies rated the real estate business houses was one of the major reasons which led towards the downfall of Lehman Brothers. 3.0 Implications and lessons for other organizations The failure of Lehman Brothers highlighted and presented several important issues which other organizations need to adhere to. Doing so will enable them to ensure that the accounting principles and corporate social responsibility are followed by the organizations. Some of the implications and learning for other To ensure that while investing the organization don’t rely only on the rating agencies and gather valuable information regarding the company so that the decision to invest in the company is correct. To ensure that companies follow a corporate governance norm and look towards proper monitoring and mechanism to check the validity of the information provided To ensure transparency by disclosing all information which is true and correct and ensuring that no information is concealed which could have an effect on the return for stakeholders 3.1 Recommendation for developing Financial & legal CSR Organizations need to follow strict corporate governance norms to ensure that such mistakes are not committed in the future. Some of the ways which can ensure proper financial and legal corporate governance in an organization are as follows To follow the accounting principles laid by the governing body. The International Accounting Standard Board (IASB) and Financial Accounting Standard Board work in tandem to develop and bring changes in the accounting principles and policies so that the presentation of financial statements becomes more consistent and recognized internationally. The growing importance of fair value accounting and using it for business purpose arises due to several reasons. Since, fair value involves a “logical pattern which reflects globalisation and international economic integration” (Barlev & Haddad, 2003) the results and decision taken on the basis of this are better and correct. Even investors prefer fair value as the results reflect the actual scenario prevalent in the organisation. This will ensure that the financial statements reflect the correct value and the chances of loss of consumer confidence and failure reduces. This is true in case of Lehman Brothers as disclosing the actual condition of asset backed securities would have helped to receive consumer support and the fall in the financial market would not have been so strong which would have helped economy. To use the perspective developed by Agency theory where organizations use agents who work on behalf of the shareholders to ensure that the right of the shareholders are protected (Nicholson, 1998). The benefit of this method can be identified when the role of the board of directors and management is differentiated. This will benefit organizations as past study have shown that using agents enable them to handle problems in a different way as they have a different attitude and looks towards the wellbeing of the stakeholders (Eisenhardt, 1989). Having an agent who is external to the organizations will ensure that there is no asymmetry of information and clarity on the part of the manager and the management as to the work for the interest of the stakeholder (Fama, Eugene & Jensen, 1983). Using an agent would have helped the investors as they could have provided correct information to the public regarding the various decisions. This would have helped the investor to understand the actual position in hand and would have reduced the impact of failures on other organizations. Organizations can look forward towards integrating stewardship theory where the role of the shareholders and management are shared to ensure that the rights of the shareholders are protected (Donaldson & Davis, 1991). This will bring clarity on the work to be carried out and provide direction to the manager. The only problem associated with it is that using this perspective will make the company rely on the manager to a large extent which might result in misuse of power. If this was adopted in Lehman brothers then the different role would have enabled the organization to reduce their investments in asset backed certificate and would have reduced the chances of failure. Organization can look towards using the stakeholders’ theory which puts the stakeholders above all and looks towards maximizing the return for them (Hill & Jones, 1992). This theory will ensure that all the managers and management work towards a common purpose and look towards protecting the interest of the stakeholders. Past study supports this theory as it looks into the benefit of individuals and the company on the whole (Corfield, 1998) thereby ensuring that the shareholders get proper return on their investment. Using this prospective would have helped to ensure that the investors interest were protected in case of Lehman brothers and the investment in asset backed securities were diversified and limited to the leverage of the company. This could have helped to protect the interest of the investor and would have helped the organization to overcome the situation. 4.0 Conclusion Organizations need to ensure that they take steps which ensure corporate governance and devise a strategy and policy which makes it easy for the organization to improve corporate governance. Thus, corporate governance has become a vital tool for business. This is making organizations and businesses look into this aspect and devise mechanism which ensures strong corporate governance. The different theories and models can be used by organization to ensure corporate governance in the organization which will help to reduce scandals and improve transparency in operations. The growth in the failure of organizations has made it important that organizations need to look towards corporate governance in the organizations so that transparency improves and the organization is able to grow. 5.0 References Austin, R. (2008). The credit crunch and the law. Corporation and Taxation law monograph series, Sydney Barlev, Y. & Haddad, T. (2003). Fair value accounting and the management of firm. Critical perspective on accounting, Australia Taxation Board, Australia Corfield A, (1998), “The Stakeholder Theory and its Future in Australian Corporate Governance”, Bond Law Review, Volume 10, Issue 2, page 213 Case Study. (2009). Case Study: The collapse of Lehman Brothers. Retrieved on July 15, 2011 from http://www.investopedia.com/articles/economics/09/lehman-brothers-collapse.asp#axzz1SFB13rTL Deloitte. (2010). IAS 16 Property, Plant & Equipment. IAS Plus, Deloitte Touche Tohmatsu Donaldson, L. & Davis, J. (1991). “Stewardship Theory or Agency Theory: CEO Governance & Shareholder Return”. Australian Journal of Management, Volume 16, Number 1, page 49-64 Eisenhardt, M. (1989). “Agency Theory: An Assessment & Review”. Academy of Management Review, Volume 14, Issue 1, page 57 Econbrowser. (2009). Consequences of Lehman Brothers. Retrieved on July 15, 2011 from http://www.econbrowser.com/archives/2009/11/consequences_of_1.html Fama, Eugene, & Jensen, M. (1983). “Agency Problems & Residual Claims”. Journal of Law & Economics, Volume 26, page 327-349 Hill, C. & Jones, T. (1992). “Stakeholder Agency Theory”. Journal of Management Studies, Volume 24, Issue 2, page 191-205 Kose, J., Saunders, A. & Senbet, L.W. (2002). A Theory of Bank Regulation and Management Compensation. The Review of Financial Studies, Vol. 13, No. 1, 95-125. Mitton, T. (2001). A cross firm analysis of corporate governance on the East Asian Financial Crisis. Journal of Financial Economics, Elsevier Science Manmohan, S. & Aitken, J. (2009). Deleveraging After Lehman-Evidence from Reduced Rehypothecation, IMF Working Paper No.09/42, at 7 McDonald G. L (2009). A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers. Crown Business Nicholson, M. (1998). “Applying Agency Theory and the concept of corporate governance”. retrieved on June 14, 2011 from http://www.lotsofessays.com/viewpaper/1706098.html Rapoport, M and McGinty, T. (2010). "Banks trim debt, obscuring risks", The Wall Street Journal, Vol.122 No.May ppA1-A2 Valukas, A. (2010). Lehman brothers holdings, inc. Debtors. Volume 4, “government,” part iii Ward, V. (2010). The Devil's Casino: Friendship, Betrayal, and the High Stakes Games Played Inside Lehman Brothers. Wiley; 1 edition William, M. (2010). Uncontrolled Risk: The Lessons of Lehman Brothers and How Systemic Risk Can Still Bring Down the World Financial System. McGraw-Hill; 1 edition Read More