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Introduction
 

Lehman Brothers was established in Montgomery, Alabama, United States, in 1844 by German immigrants: Henry Lehman, and his two brothers, Emanuel Lehman and Mayer Lehman. It was first set up to be a small general store selling groceries, dry goods and utensils to local farmers. Until 1920s the company was run as a strictly family business, i.e. only family members were allowed to be partners.
 

Shortly after its establishment, the nature of business that Lehman Brothers conducted changed and the company started to act as a broker that bought and sold cotton for the planters living in and around Montgomery, Alabama. Lehman Brothers became known as a “King Cotton”. Successful operations in the cotton business, allowed the brothers to open a New York office in 1858 which provided the firm with a stronger presence in the commodities trading business as well as a foothold in the financial community (HBS, n.d.). Lehman Brothers’ commodities sales and trading business grew to include other goods and the company was among the first to set up commodities futures trading ventures in the United States.
 

Changes in the economic environment from agrarian to industrial era led to changes in the operations of the firm. Rapid infrastructure developments including construction of the railroad networks called for financing and this is how Lehman Brothers first started to act as the financial advisors and underwriters firm. The company continued to heavily finance various industries and with the developments in the external environment they always seemed to be among the first to show interest in particular industries. Company’s openness to innovation, diverse portfolio of investments and overall culture was reflected in its mission statement: “Where vision gets built”.
 

In the year of 2000, Lehman celebrated its 150th anniversary. The team was really proud by the achievements; after all, the organization survived the Great Depression of the 1930s, Railroad Crash, World Wars and many other obstacles that didn’t seem to damage the company’s strong position in the financial sector as one of the largest investment banks in US. In fact, those challenges served as a catalyst for the firm to develop itself further. For example, in 1929 Lehman Brothers was one of the pioneers promoting new ways of financing that helped many companies to survive the crisis.
 

In 2007 the firm reported net income of a record $4.2 billion on revenue of $19.3 billion. The stock reached a record $86.18 which put the company to a market capitalization of close to $60 billion (Investopedia, n.d.). This was also the year when Lehman underwrote more mortgage-backed securities than any other firm – four times its shareholders’ equity, increasing its leverage of total assets to shareholders’ equity to 30 to 1 (Investopedia, n.d.). With increasing number of home delinquencies, Lehman’s Chief Financial Officer made a public announcement stating that those risks didn’t have any impact on firm’s earnings and that he didn’t foresee problems in the subprime market. However, the year of 2008 proved him wrong. As the housing market crashed, Lehman Brothers stock fell in value by 77% in the first week of September 2008 (Investopedia, n.d.). Continuous declines in value led to Lehman declaring bankruptcy on Monday, September 15th, 2008.
 

Lehman Brothers’ bankruptcy was the biggest downfall in the US history. The company was “Too Big to Fail” and no one ever believed it until it really happened. Its bankruptcy is said to wipe out more than $46 billion of market value which is a significant loss to one country’s economy (Investopedia, n.d.). But it also raises the question as to what went wrong with the company’s governance structure that made it possible for this giant to fall so fast. It is therefore the goal of this report to further investigate the external as well as the internal environments of Lehman Brothers and then develop a comprehensive case as to the sources and causes of organizational crisis that led to corporate governance failure; crisis that resulted in a significant financial loss to the economies of the countries where it operated as well as served as a catalyst for comprehensive financial system reform in the United States. The report will also identify the controls that, if in place, could have prevented the crisis as well as lessons that could be drawn by other organizations as means to avoiding a similar situation.
 

 
External Environment
 

The sources and causes of any organizational crisis are often hidden in the external environment in which the firm operates. There are certain factors that are bound to make it possible for the governance at the firm to be done the way it’s done. Failure of Lehman Brothers, one of the largest US investment banks, is no exception. Thus, PEST analysis will be used to examine external macro-environment in which the firm operated with the goal to identify any factors that could have contributed to the organizational crisis that took place at Lehman in September of 2008 (refer to Appendix 1 – PEST Analysis Summary).
 

Political
 

Political factors of PEST framework include investigation of government regulations that impacted financial sector prior to the financial crisis of 2008. Prior to the financial crisis, there was an overall belief that capitalistic markets, in order to function efficiently, should be free from political interference. Governments should not restrict them by regulations and should instead trust them to discipline themselves by means of interaction of various economic forces (Acharya, et al., 2009). These beliefs were among contributing political factors that led to lack of regulation in the financial sector and instead put trust in the executives of the firms to do what is best not only for their companies but also for the overall economy.
 

Among one of the most significant deregulations that took place is the Gramm-Leach-Biley Act, 1999, which is known as bank deregulation bill that eliminated the restrictions put in place by the Glass-Steagall Act of 1993 (Neal & White, 2012). The Glass-Steagall Act separated banks that did risky investing from those that did lending; these were the two factors that led to a number of bank failures during the Great Depression (Leonhardt, 2008). As a result of this deregulation, the economy saw growth of bank behemoths like Citigroup, Bank of America, J.P. Morgan Chase which were good when the economy was booming but that posed significant risks if they were to fail. Thus, the new act of 1999 encouraged a more relaxed approach to supervision (Robertson et al, 2013). Financial firms were allowed to chop bad mortgages into thousands of little parts and stated that the sum of the parts was less risky than the whole (Leonhardt, 2008). Later, those parts were resold to other banks among which Lehman Brothers was known as the one who invested the most capital.
 

Another significant factor that contributed to the development of the crisis is Securities and Exchange Commission (SEC) regulation in regards to the leverage that banks could have. In 2004, SEC changed the leverage rules for five largest banks. 1977 net capitalization rule allowed leverage of 12 to 1 but the new regulation or lack of thereof is what allowed the five largest US banks to increase its leverage to 20-, 30-, even 40 to 1 (Denning, 2011). For example, Lehman Brothers had a leverage ratio of 30 to 1 in the year of its collapse.
 

Economic
 

Central bankers and other regulators are not the only parties that should bear the blame for laying the foundation for the financial crisis of 2007-2009. Some of the macroeconomic factors created environment with low inflation and stable growth which “fostered complacency and risk-taking” (Crash Course, 2013). These were the economic factors that led to significant increases in borrowing in US as well as various European countries. The banks were giving mortgages to people willing to buy houses in the low interest rate environment. High demand for housing created a rise in the prices for houses leading to overstatement of the real value of the asset that was supposed to back the mortgage. Loans were given to everyone, even the borrowers with poor credit histories. Later, those risky mortgages were passed on to financial engineers at the big banks that broke them into smaller parts and put them into pools claiming that this way risk was significantly lower (Crash Course, 2013).
 

Agencies such as Moody’s and Standard & Poor assigned high ratings to these debt securities since they didn’t see the risk from debt that was backed by an asset – house. However, rise of interest rates in 2006 and inability of people to meet their mortgage obligations started to lead to defaults and banks were not able to recover the mortgaged value since the prices for the houses drastically decreased (due to excess supply of houses put for sale by the owners who were not able to pay the mortgage) and it became impossible for the banks to recover the investment that was considered to be “safe”. Banks faced liquidity problems that eventually led to the failure of the financial sector that was witnessed in 2008 (Kwaku&Mawutor, 2014).
 

Social
 

Social factors also contributed to the failure of Lehman Brothers. American lifestyle is such that its people always want to try to “keep up with the Jonses”. It is a part of the culture known as American dream: having a car for every member in the family, a big house, well paid job and other perks that access to credit makes easy to have. Following the dot-com bust in 2000, the Federal Reserve dropped rates to 1% and kept them there for an extended period of time (Denning, 2011). Lower interest rates boosted consumer spending and made people less risk averse to financing it with borrowing. At the same time with the Gramm-Leach-Biley Act, it became possible for the banks to respond to this need and lend money to highly risky customers. Further, financial engineering made it possible to grade these risky investments as relatively safe.
 

Executive compensation schemes that were dominant before and still are is among other social factors that played a significant role in the failure of Lehman Brothers. Wall Street CEO compensation system is mostly based on short-term performance (Denning, 2011) as opposed to long term targets. This creates desire among executives to take excessive risks with high payoffs in the short term that will guarantee large bonuses during the term of a given CEO but that don’t regard the long term sustainability of the firm.
 

Technological
 

The years prior to the financial crisis are known for the rapid developments in technology that led to growth of financial engineering known for the creation of various derivative financial assets that were combinations of multiple financial instruments traditionally available in the market. Growth in the derivative market and at the same time inability of the systems to keep track as well as properly assess the risks associated with those assets are yet additional factors that prevented the stakeholders in the financial sector to correctly assess the magnitude of the forthcoming crisis.
  

Internal Environment

 

To gain better insight into the organizational crisis that took place in one of the largest investment banks in US, it is vital to analyze Lehman Brothers’ internal environment through corporate governance lens. This means conducting the analysis of the internal structure of the firm, rules of the board of directors, presence of independent audit committees, rules for disclosure of information to the stakeholders as well as control of the management. In this section three components that make up the system of corporate governance will be discussed: Lehman Brothers’ structures, systems and composition.
 

Structures
 

This component of the governance system includes analysis of the company’s board, roles, committees and ethical codes. Lehman Brothers corporate structure followed one tier board structure that is similar to other companies in US. It included the shareholders who then selected the board of 10 directors to preside over the management of the company. However, what was different is that Lehman’s CEO Richard Fuld had dual responsibility: one of a CEO and the other as the Chairman of the Board.
 

The firm had 5 committees which included: Audit Committee, Compensation and Benefits Committee, Nominating and Governance Committee, Finance and Risk Committee, and Executive Committee. The table below presents the number of times each Committee met during the year prior to bankruptcy.

  

Systems
 

Systems analysis includes review of company’s rules of order, investment policies and procedures including independence requirements. In accordance with Lehman Brothers standards all the Board members had to be independent and were considered to be so if they were not employed as executives in the company. In terms of its operations the company followed financial industry standards and codes in terms of the decisions, disclosure of the information and investment advice given to its clients. The accounting, preparation of financial statements as well as decisions made in regards to corporate assets had to follow US GAAP rules and regulations. Since the company was listed on various stock exchanges it also had to abide by the regulatory requirements that are applicable to the publicly traded firms, e.g. SEC for US.
 

Composition
 

The final component of the corporate governance systems is the composition, this component requires analysis of demographic and experiential characteristics of the board as well as executive team. As previously mentioned, the board of Lehman Brothers consisted of 10 directors, eight of whom met the independence standards of the New York Stock Exchange (Stanford, 2010). The average age of the members was about 68 years old which was higher than 61 observed at various large corporations. The directors had diverse professional background that they obtained while being employed as CEOs and executives in various sectors of the economy. The one attribute that stands out is the “quality” of the professional background and engagement in board responsibilities (Stanford, 2010). There were no CEOs of major public corporations on the board, there were only 2 members who had related experience in the financial sector which indicated lack of financial expertise among the members (e.g. two of the board members worked as theatrical producer and the other was an actress) and most of the members were well into retirement (12 years on average) (Stanford, 2010). Some of the board members were actually from non-profit corporations which was a strange choice for a company like Lehman Brothers.
 

Given the lack of public information, it is difficult to assess the engagement of the board members with the matters of the firm. But it is known from various interviews that the company’s CEO was rather aggressive and preferred military style of management. He liked to craft the company’s strategy in isolation and is widely known as a man in an ivory tower (McDonald & Robinson, 2009). There is also evidence that the board was not structured to provide oversight of management or strategic advice (company’s CEO was the Chairman of the Board!); in fact, the responsibilities of independent directors appeared to be perfunctory (Stanford, 2010). This evidence is drawn from the fact that for example, compensation committee met more times than the audit committee, while the finance and risk committee met only two times in the year when it was rather crucial to pay attention to company’s risk management strategy. The executive committee appears to also be more active than the board or the independent committees which suggests that management had significant influence over boardroom matters (Stanford, 2010).
 

 
Organizational Crisis
 

On September 15, 2008 Lehman Brothers filed for Chapter 11 bankruptcy protection. This rocked the financial industry to the core (Montgomery,2012) as this was considered to be the fourth largest investment bank in the United States of America; it was “too big to fail”. This part of the report will rely on the external and internal analyses conducted in the previous sections and will provide further insight as to the reasons why the company that was in existence for over 158 years had gone bankrupt as well as describe the role that the aforementioned factors have played in the collapse of Lehman Brothers (refer to Appendix 2 – Lehman Brothers Governance Structure and its Deficiencies).
 

Profile of the crisis
 

Appelbaum, Keller, Alvarez and Bedard (2012) state that an organization’s survival depends on its ability to undergo changes. Some changes are initiative from within and other changes occur in response to an external stimulus (Appelbaum, et al., 2012). In case of Lehman Brothers the crisis that took place was a result of factors that came from both external and internal environments. Originally, the company’s investment strategy seemed to be quite viable but eventually it resulted in a $613 billion loss when the housing bubble collapsed. The governance-leadership-management failed to predict, recognize and react to the building crisis and this left the company in bankruptcy (Appelbaum, et al., 2012). Given that there were instances of companies that were in a similar position to Lehman Brothers but that managed to survive the financial downfall of 2008-2009, it is therefore evident that the corporate governance system, structure and composition of the firm were the contributing factors to the inability of the company to reposition itself and turn the situation into a positive outcome.
 

The origins of the crisis can, first of all, be traced to the external environment in which the company functioned. Loose regulatory requirements combined with low interest rate economic environment and significant technological advances in the fields of financial engineering is what lay the initial foundation. As mentioned earlier, the Gramm-Leach-Biley Act, 1999 allowed investment banks to undertake risky investments and SEC further decreased its requirement allowing the five largest banks on Wall Street (including Lehman Brothers) to increase its leverage ratio from 12 to 1 to a much higher proportion. This is what allowed Lehman Brothers to purchase debt securities, that became widely available as a result of the prolonged period of low interest rates and smart financial engineering efforts that also established that those assets had lower risk compared to the sum of its total.
 

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Role of the governance in the organizational crisis
 

One would say that Lehman Brothers was not the only large investment bank in US that was heavily leveraged, it was not the only bank that held debt securities and yet they were the ones to go bankrupt. Given that external factors were same for many companies (including the ones that survived) in the financial sector, it means that the primary reason for Lehman’s failure was its corporate governance and the role it played in the organizational crisis.
Evaluation of the corporate governance involves its assessment based on the following three parameters: structures (Boards, roles, committees and ethical codes); systems (policies, procedures and independent requirements); and composition (demographics and experiential characteristics). As shown in the previous section, Lehman Brothers Board included ten independent members, half aged over 70 (with two members being in their 80s), and only two Board members who had relevant financial sector experience (Tricker, 2015). The executive committee consisted of CEO Fuld, COO Joseph Gregory and CFO Erin Callan. The Board also chaired 5 committees which also included the Finance and Risk Committee that only met two times in the year of a financial crisis.
 

Sonnenfeld (2002) suggests that Board member age and expertise is not everything. However, in case of Lehman Brothers it is possible to state that age and expertise did play its role. The fact that majority of the Board is composed of people who are well past their retirement ages as well as evident lack of expertise makes it possible to question as to whether this Board was truly functional or only existed to meet the requirements for the corporation to have the Board of Directors? Attendance is not performance further states Sonnenfeld (2002) in his article “What Makes Great Boards Great?” and this is an important statement since at Lehman attendance probably did count as performance. There was a system of multiple Committees at the company, however the meetings for the Committees that were crucial in making a decision and steering the company towards survival in the context of a crisis didn’t take place. The Finance and Risk Committee only met twice in the year of the financial crisis!
 

Further evidence that there was a faulty structure of the governance system at Lehman Brothers is the fact that the CEO of the company was also the Chairman of the Board. This shows conflict of interest since the Board was not able to fully deliver on its responsibilities of selecting, overseeing and compensating the executives, ability to evaluate the results of an independent audit. One of the interested parties was directly involved in its decision making processes which means that the Board was under the influence of the CEO of the company. This led to competing stakeholder interests further explained by the Agency Problem whereby the agent (CEO) does not act in the interests of the principle (the shareholders as represented by the Board of Directors).
 

Corporate governance missing links identified above show that the structure and composition of the governance team made it possible to influence the decision making processes that contributed to the organizational crisis. First of all, ability of the CEO to serve as the Chairman of the Board made it possible for him to determine his own compensation that was tied to short term outcomes rather than long term deliverables. Fuld received bonuses that totalled over billion dollars for the time that he was employed at Lehman Brothers.
 

Secondly, it also became possible to break established rules and principles, i.e. prepare misleading financial statements and making public claims that the burst of the housing market bubble will have no impact on the financial assets of the firm. Deficiencies in the governance system were evident prior to the financial crisis of 2008-2009. For example, in 2003, the US SEC settled charges against Lehman Brothers that arose because Lehman’s research analysts gave supposedly independent investment advice on companies in which Lehman had an interest (Tricker, 2015). Further, in 2010, an examiner appointed by the Bankruptcy Court reported questionable activities of the firm in 2007-2008 whereby Lehman executive team made a decision to remove certain securities from the balance sheet, showing them as sales in order to improve its financial standing (Tricker, 2015).
 
It can be concluded that involvement of the executives in the decisions of the Board as well as their direct influence made it possible to impact the company’s past choices about assets, investments as well as internal controls (preventive and detective controls) or lack of thereof.
 

Governance-leadership-management response to the crisis
 

McDonald and Robinson (2009) call Lehman Brothers’ CEO Richard Fuld a man in the ivory tower. They justify the choice of this nickname by the fact that he never listened, he was too remote from “people who formed the heart and soul of Lehman Brothers” and only dreamt of “accelerating growth, nursing ambitions far removed from reality” (McDonald & Robinson, 2009). These ambitions were the contributing factors to the failure of the company and Fuld stayed true to them even on the brink of collapse. Lerbinger(2012) states that in a conference call for investors on September 10, 2008 (5 days prior to filing for bankruptcy protection) CEO Richard Fuld continued to state that the decisions made in regards to the financial assets of the firm “will create a very clean, liquid balance sheet”. The CEO ensured the shareholders that the company was on the right track to recover from the financial losses recorded in the last two quarters. Even on the brink of bankruptcy the company’s deteriorated governance system was prevalent.

 

Appelbaum, Keller, Alvarez and Bedard (2012) believe that the survival of the firm during the organizational crisis is highly dependent on the ability of the management to adequately address the problem: “an organization must plan its crisis management as if it were a chess game. A good chess player always thinks several moves ahead”. However, the governance-leadership-management team at Lehman Brothers never considered this advice. The Chairman and CEO Richard Fuld continued to build crisis management strategy within the failed governance system that was already established. This approach to crisis management identifies yet another governance problem within the company: lack of proper signaling systems that could have helped Lehman identify the crisis in its preliminary stages and allow to minimize the damage to the organization.
 

Organizational consequences of the crisis
 

Lehman Brothers was a global company and this meant that its bankruptcy had significant impact on multiple financial market participants not only in US but all over the world. It is said that Lehman’s insolvency has resulted in more than 75 separate and distinct bankruptcy proceedings (refer to Appendix 3 – Lehman Brothers’ Global Footprint) (PWC, 2009) and wiped out more than $46 billion of market value (Investopedia, n.d.). But these are just the external consequences of the crisis. As for the internal, the organizational crisis led to the complete destruction of the shareholder value that was so carefully accumulated over 150 years. Lehman Brothers thus serves as a perfect example to show the severe consequences of the corporate governance failure that leads not only to erred business judgement but also creates room for manipulation of the financial statements and ultimately results in enormous economic and social losses.

 

 
Things required
 

1. Executive Summary
2. What could have been done to get the organization out of the crisis?
3. What should others learn from to avoid creating a similar situation
4. Conclusion
 
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