Cioffi and Tannin's Indictment: Good News for Investors

Ralph Cioffi and Mathew Tannin, the former managers of the Bear Stearns' hedge funds that collapsed last year, were indicted today. The SEC also filed civil charges today as well. I appeared on CNBC this afternoon to discuss whether the evidence will be enough to show "intent" and whether criminal charges were warranted. The answer is a resounding yes to both questions, especially given Tannin's "smoking gun" email from his personal account to Cioffi's wife's email account where he frets over the funds future performance just days before making upbeat comments to investors. Cioffi's withdrawal of $2 million from the funds before the collapse appears to provide evidence of his "intent".

The criminal and SEC developments could bode well for investors seeking recovery of losses through the arbitration process. Tannin and Cioffi will be called to testify in arbitration hearings before their criminal trials take place and likely will exercise their Fifth Amendment rights against self incrimination. Attorneys can ask the arbitration panel to take what's called an "adverse inference", which means panelists can assume that if the defendants answered the questions, rather than pleading the Fifth, the answers would have adversely affected their interest.

It should be noted that JP Morgan has put aside billions of dollars for litigation costs when it acquired Bear Stearns.

Keeping Callan and Gregory in the Lehman Tent

It’s standard practice for Wall Street firms to retain executives tied to extensive financial losses and persistent questions about accounting practices, particularly if there is the likelihood of lawsuits. So I note with great interest that that Erin Callan and Joseph Gregory, who today “resigned” respectfully as CFO and COO of Lehman Brothers, will remain at the embattled firm, at least for now. Ms. Callan will rejoin the firm's investment banking division in an unspecified “senior capacity,” and Mr. Gregory will stay with the company in an “undefined capacity.” Suffice it to say, Callan and Gregory aren’t getting promotions.

It’s doubtful that Lehman is retaining the tarnished executives out of sheer loyalty. More probably, it’s out of concern for the litigation that will no doubt ensue. Company lawyers prefer to have all the major participants responsible for activities leading to litigation in the corporate tent, thereby having some measure of control over the proceedings. Throwing Callan and Gregory to the wolves could put their legal interests at odds with Lehman’s.

The irony of Ms. Callan returning to investment banking must also be noted. During her previous tenure there, Lehman took public both Fortress Capital and Och-Ziff and IPOs that certainly didn’t serve investors well. Since their respective public offerings, Fortress lost 56 percent of its value and Och-Ziff some 25 percent of its value. As I noted earlier, Lehman was also responsible for orchestrating Wachovia’s highly questionable takeover of Golden West.

Perhaps Ms. Callan had no involvement with the aforementioned deals. But given her track record as CFO, Ms. Callan’s return to Lehman’s investment banking group somehow doesn’t inspire further confidence in Lehman’s deal making prowess.

Lessons From Lehman

I’m still trying to make sense of Lehman’s disclosure yesterday that it will post a whopping $2.8 billion loss in the second quarter and raise $6 billion in equity by selling shares at a 20% discount to book value, but one lesson is already readily apparent: the best and brightest analysts aren’t working at the major Wall Street brokerage firms.

Lehman’s projected loss amounts to $5.14 a share, a mind-boggling deficit given that Wall Street analysts were expecting a loss of no more than $1.28 a share. Lehman’s planned fund raising will dilute the holdings of existing common shareholders by 30 percent.

As best I can tell, the loss gives some credence to warnings by hedge fund manager David Einhorn, who repeatedly has charged that Lehman hasn’t adequately marked down some of its assets. While it isn’t entirely clear to me that Lehman plans to write down some of the assets whose value Mr. Einhorn has questioned, the hedge fund manager was indeed correct in predicting a massive earnings train wreck. As Mr. Einhorn so elegantly puts it: “(Lehman) just raised $6 billion of capital that they said they didn’t need to replace losses they said they didn’t have.”

Individual Lehman shareholders should be concerned how Mr. Einhorn – who has a short position on Lehman’s stock – knew with such certainty that the company’s asset values would have to be aggressively written down. Admittedly, it’s quite possible that Mr. Einhorn is just way smarter than the Wall Street analysts who cover Lehman’s stock and is better versed on how to read a balance sheet. But Mr. Einhorn’s public statements indicate that he based his analysis on Lehman’s valuation methods, which possibly suggests we are dealing with basic accounting issues.

Lehman previously maintained that Mr. Einhorn’s criticisms had “no basis in fact.” The merits of that defense are increasingly hard to believe.

Don Quixote and ARS Investors

Recent articles in The Boston Globe and Bloomberg underscore how Wall Street firms woefully favor their own interests at the expense of individual investors.

According to a report in today's Globe, UBS Financial Services warned some of its big investment banking clients of looming problems in the auction rate securities (ARS) market three months before the market for these securities collapsed. Nevertheless, the firm continued marketing the securities as cash equivalents to unsuspecting individual investors.

Adding insult to injury, the Globe and Bloomberg report that UBS, Bank of America, and Wachovia along with others are preventing their clients from unloading auction rate securities at a loss saying – are you ready for this? – it isn't in their clients' best interests!

In an ideal world, it would be nice to believe that Wall Street firms are actually trying to do right by unsuspecting investors whose brokers assured them that auction rate securities were cash equivalents. But Bryan Lantagne, the securities division director for Massachusetts, offers Bloomberg a more compelling explanation:

"By allowing customers to sell at a discount, the banks allow customers to establish damages."

Richard Stahl, a retired New Hampshire car dealer, is one of the auction rate securities victims caught in limbo. The 73-year-old UBS client wants to sell some $650,000 worth of auction rate securities, but UBS won't let him.

"I feel like Don Quixote fighting windmills," Mr. Stahl told the Globe.

Sadly, Mr. Stahl, compared to taking on Wall Street, Don Quixote had it easy.

Lehman’s Investment Banking Prowess

The ways of Wall Street never cease to amaze me.

You might think that a company responsible for orchestrating one of the biggest M&A banking debacles in recent memory, the reputational damage would be quite severe. Think again. In justifying his upgrade of Lehman’s stock, Merrill Lynch analyst Guy Moszkowski cites Lehman’s “very strong global franchises” in various areas, including investment banking.

Investment banking?

Lehman has “bragging” rights for Wachovia’s failed 2006 acquisition of Golden West Financial, a major California thrift and mortgage lender. Analysts estimate that Wachovia could rack up more than $10 billion in losses on Golden West’s $122 billion mortgage portfolio. The botched acquisition is said to have cost Wachovia CEO Ken Thompson his job earlier this week.

Fortunately for Lehman, the brilliant investment banking minds behind M&A deals that go south aren't called to task. So kudos to Dealbreaker for taking note of Lehman’s additional contribution to Wachovia’s financial woes.

When Companies Doth Complain Too Much

I was taken somewhat aback when I read how Lehman Brothers responded to an inquiry about allegations made by short seller David Einhorn. “We will not continue to refute Mr. Einhorn’s allegations and accusations,” an unnamed spokeswoman told The Wall Street Journal. "Mr. Einhorn cherry-picks certain specific items from our quarterly filing and takes them out of context and distorts them to relay a false impression of the firm’s financial condition which suits him because of his short position in our stock. He also makes allegations that have no basis in fact with the same hope of achieving personal gain."

It’s understandable that Lehman would vehemently deny Mr. Einhorn’s allegations questioning the firm’s accounting. However, the statement seems a tad personal, particularly since Mr. Einhorn has made no secret of his short position. Lehman’s essential public defense appears to be that Mr. Einhorn’s allegations are wrong simply because he benefits handsomely if they are right.

I’m not going to take sides on this one, as I’m not privy to all the facts. Still, Lehman’s seemingly personal attacks on Mr. Einhorn hardly inspire confidence if history is any indication.

Back in 2001 a young reporter at Fortune named Bethany McLean began questioning the accounting of a then highly revered Houston-based company called Enron. Jeffrey Skilling, the company’s then chief executive, called her unethical for failing to do more research. And Kenneth Lay, Enron’s former chairman, complained to Fortune’s editor that McLean was relying on information provided by a short seller who wanted to drive down the price of the company’s stock. Turns out, that short seller had good reason to be short on the stock.

Then there were the attacks by L. Dennis Kozlowski when he was the CEO of Tyco International. In response to a report by David Tice questioning Tyco’s accounting, Mr. Kozlowski said he was outraged by the “false and baseless” report. ''There is no risk that investors will wake up one day and find out'' that ''there's something wrong with the way we've been recording revenue or the way we've been recording margins.'' Mr. Tice, too, was also a short seller.

Finally, there was the press release Calpine International issued on August 27, 2004 attacking a report by an independent research firm called Rate Financials questioning Calpine’s accounting. The release said the report was riddled with “flagrant, misleading and inaccurate allegations.” Sixteen months later Calpine filed for bankruptcy.

For the sake of the public markets, I truly hope that Lehman ultimately defies a disturbing trend that suggests a possible inverse relationship between reality and the vehemence of a company’s denials.

Making Sense of David Einhorn vs. Lehman Brothers

One of the sad lessons that most individual investors fail to learn is just how badly the stock market is stacked against them. Yes, there are rules that supposedly ensure a level playing field, but those rules become meaningless when some of the players are decidedly smarter and know how to play the system to their financial advantage. The market uncertainty about Lehman Brothers Holdings affords a textbook example.

Lehman’s stock plummeted earlier this week in the wake of a Wall Street Journal story saying the firm is “considering” a common stock offering that would be dilutive to shareholders. The precipitous decline was no doubt welcomed by David Einhorn, a hedge fund manager who is short Lehman’s stock and has been quite vocal in his attacks questioning the transparency of the brokerage firm’s financials. Mr. Einhorn’s repeated public slamming of Lehman Brothers reportedly has contributed to the decline in Lehman’s stock price.

Mr. Einhorn has made some extremely damning allegations about Lehman’s accounting practices. He questions some large, unrealized gains Lehman booked in the first quarter that helped goose up the firm’s earnings. The gains were on illiquid securities for which there are no public markets, which means Lehman’s management can assign values at its own discretion. As if that alone isn’t enough of a red flag, Mr. Einhorn also charges that Lehman has given him conflicting explanations of its valuation process. To boot, Mr. Einhorn says Lehman has not properly disclosed or written down various complex debt securities, including $6.5 billion of CDOs. Lehman vehemently denies Mr. Einhorn’s allegations, saying they have “no basis in fact.”

I’m in no position to evaluate Lehman’s earnings statements, and I have no reason to question them. But I also am not quick to accept that Mr. Einhorn’s allegations have no basis in fact. The short seller’s claim that Lehman has placed an artificially high valuation on illiquid securities is eerily familiar. There were similar allegations that Bear Stearns priced artificially high the illiquid assets in its subprime hedge funds before those investment vehicles collapsed. A recent comment by Sy Jacobs, a hedge-fund manager who correctly predicted the subprime mortgage crisis, also cannot be ignored. “Just because we got saved from what would have happened that Monday if Bear went down doesn’t mean we are saved from all the forces that conspired to get Bear Stearns to the brink in the first place,” Mr. Jacobs told Barrons.

I also note a comment by star banking analyst Meredith Whitney about Lehman CFO Erin Callan in the May 17th issue of the Journal: “(Callan) is going out on a limb to provide more transparency in Lehman’s earnings, business and strategy.” On Monday, Ms. Whitney predicted Lehman would report a second quarter loss after earlier predicting a profit. The sudden about face possibly suggests that Lehman’s transparency wasn’t quite as clear as Ms. Whitney originally believed.

The reality is there is so much market turmoil and uncertainty today that it is no longer possible to accurately value many of the assets the major brokerage firms have on their books. As Standard & Poor’s analyst Diane Hinton has noted, “We’re in a market environment where sometimes perception becomes reality.” At the moment, it appears that a short seller on Lehman’s stock appears to have the upper hand in shaping the company’s market perception.

And that, folks, is the sad state of the public markets in this Country.