From Enron To Lehman Bros.: What Can We Learn From These Corporate Governance Failures? (PART II)
04/21/2013 | by Lipman, Frederick D.
Sox Hotlines are IneffectiveIn reaction to the Enron, WorldCom and other shareholder disasters during the 2000 to 2002 period, Congress enacted the Sarbanes- Oxley Act of 2002 which mandated that companies whose stock is traded on national securities exchanges require audit committees to establish procedures for “the confidential, anonymous submission by employees of the issuer of concerns regarding questionable accounting or auditing matters.” This resulted in employee hotlines being established by most public companies. However, these hotlines have not been effective in most cases to induce management personnel to go over the heads of the CEO or CFO and make disclosures to the audit committee.
For example, prior to the collapse of AIG, there were executives who recognized the major risks being undertaken through its derivatives business in credit default swaps, but had no incentive to reveal these risks to the directors. According to a Michael Lewis article, in mid-2005, an AIG executive named Eugene Park was fiddling around at work with his online trading account after reading about this wonderful new stock called New Century Financial with a terrific dividend yield.
So Park looked at New Century’s financial statements and noticed something “frightening”.The average homeowner counted on to feed the interest on the “A+” tranche of New Century mortgage-backed collateralized debt obligations (“CDOs”) had a credit score of only 598, with a 4.28% likelihood of being 60 days or more late on payment. Park subsequently discovered that the AIG Financial Products Division was insuring a substantial portion of the New Century mortgages. He allegedly revealed this information to Joseph Cassano’s No. 2 person in the AIG Financial Products Division and was ultimately blown off by Cassano.  Had a robust whistleblower system existed at AIG at that time, Park might have used it to advise the AIG audit committee. Instead, the AIG Financial Products Division did not reduce or hedge their existing super-senior tranches of subprime CDOs, although they stopped writing credit default swaps in late 2005/2006.
Why did Eugene Park not use the AIG anonymous employee hotline to report to the AIG audit committee the excess risk being taken by AIG in issuing credit default swaps? One can only speculate that there was no reward for Park to do so and it is likely he would have had an abbreviated career at AIG had Joseph Cassano discovered that Park had gone over his head to the AIG audit committee.
According to the Lehman Bros. Bankruptcy Examiner Report, Matthew Lee, a Senior Vice President of Lehman Bros. finance division, was aware of accounting improprieties at Lehman Bros. In May 2008, he sent a letter to his superior, Martin Kelly, the Lehman Bros. controller, about the Repo 105 transactions which were used by Lehman Bros. to move assets off the balance sheet at quarter-end. There was no response to the letter.
Why did Matthew Lee not use the employee hotline to report this directly to the audit committee? We can only speculate. Perhaps Lee decided that sending a letter to a superior was risky enough without further jeopardizing his career by going to the Lehman Bros. audit committee. There is no evidence that Lehman Bros. created any reward for providing legitimate information on the employee hotline. In any event, Lee was laid-off less than a month after sending the letter.
According to the McLean and Nocera book “All the Devils Are Here: The Hidden History of the Financial Crisis”, Jeff Kronthal, a senior executive at Merrill Lynch, warned the then CEO, Stan O’Neal, about the excessive subprime risk being assumed by Merrill Lynch. This warning was ignored and disbelieved by the CEO.
Why didn’t Jeff Kronthal use the anonymous employee hotline to warn the audit committee of this excessive risk? Going over the head of the CEO, even on an anonymous basis, is considered an act of disloyalty to the management team and typically results in some form of retaliation, including being considered a pariah within the company and the industry as a whole.
The Financial Crisis Inquiry Report notes that Matthew Tannin, a Bear Stearns executive, stated in a diary in his personal e-mail account in 2006, long before the collapse of Bear Stearns, that “a wave of fear set over [him]” when he realized that the Enhanced Fund “was going to subject investors to ‘blow up risk’” and “we could not run the leverage as high as I had thought we could.” Why didn’t Matthew Tannin use the anonymous employee hotline to report his concern to the Bear Stearns audit committee? Likely for the same reasons stated above, i.e. lack of reward and likelihood of retaliation.
Each of these cases are examples of significant information which was known within the management group but was unknown by the audit committee or other independent directors. One may speculate that had this vital information been reported to the audit committee, the tremendous losses subsequently incurred by shareholders may have been wholly or partially avoided.
 Bethany McLean and Joel Nocera, “All The Devils Are Here: The Hidden History of the Financial Crisis”, Portfolio/Penguin (2010) p. 190.
 “The Great Hangover: 21 Tales of the New Recession from the Pages of Vanity Fair”, Harper Perennial (2010); See also The Financial Crisis Inquiry Report, Pgs. 200-201 (January 2011).
 Moe Tkacik’s Page, “That AIG Story, For Readers Who Are Sick of AIG Already” (7/6/2009)
 “The Great Hangover: 21 Tales of the New Recession from the Pages of Vanity Fair”, Harper Perennial (2010).
 “Report of Anton R. Valukas, Examiner,” March 11, 2010, p. 21. http://lehmanreport.jenner.com.
 “The Financial Crisis Inquiry Report”, The Financial Crisis Report Commission, Pursuant to Public Law 111-21, January 2011CATEGORY: Internal Whistleblowing