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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED NOVEMBER 30, 1997
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER 1-6817
LEHMAN BROTHERS INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
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DELAWARE 13-2518466
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
3 WORLD FINANCIAL CENTER 10285
NEW YORK, NEW YORK (ZIP CODE)
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
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REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (212) 526-7000
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
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<CAPTION>
NAME OF EACH EXCHANGE
TITLE OF EACH CLASS ON WHICH REGISTERED
- ---------------------------------------- ----------------------------------------
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7 5/8% Senior Subordinated Notes Due New York Stock Exchange
2006
</TABLE>
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
NONE
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K (sec.229.405 of this chapter) is not contained herein, and
will not be contained, to the best of Registrant's knowledge, in definitive
proxy or information statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K. [X]
As the Registrant is a wholly-owned subsidiary of Lehman Brothers Holdings
Inc., none of the Registrant's outstanding common equity is held by
non-affiliates of the Registrant. As of February 10, 1998, 1,006 shares of the
Registrant's Common Stock, $0.10 per share, were issued and outstanding.
THE REGISTRANT MEETS THE CONDITIONS SET FORTH IN GENERAL INSTRUCTION
J(1)(a) AND (b) OF FORM 10-K AND THEREFORE IS FILING THIS FORM WITH A PORTION OF
THE REDUCED DISCLOSURE CONTEMPLATED THEREBY.
DOCUMENTS INCORPORATED BY REFERENCE:
NONE
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PART I
ITEM 1. BUSINESS
GENERAL DEVELOPMENT OF BUSINESS
As used herein, "LBI" or the "Registrant" means Lehman Brothers Inc., a
Delaware corporation, incorporated on January 21, 1965. LBI and its subsidiaries
are collectively referred to as the "Company" or "Lehman Brothers." LBI is a
wholly-owned subsidiary of Lehman Brothers Holdings Inc., a Delaware
corporation, which (together with its subsidiaries, as appropriate) is referred
to herein as "Holdings."
The Company is one of the leading global investment banks serving
institutional, corporate, government and high-net-worth individual clients and
customers. Its executive offices are located at 3 World Financial Center, New
York, New York 10285 and its telephone number is (212) 526-7000.
LEHMAN BROTHERS
The Company's worldwide headquarters in New York and regional headquarters
in London and Tokyo are complemented by offices in additional locations in North
America, Europe, the Middle East, Latin America and the Asia Pacific region.
Holdings provides investment banking and capital markets services in Europe and
Asia. The Company is engaged primarily in providing financial services. Other
businesses in which the Company is engaged represent less than 10 percent of
consolidated assets, revenues or pre-tax income.
The Company's business includes capital raising for clients through
securities underwriting and direct placements; corporate finance and strategic
advisory services; merchant banking; securities sales and trading; research; and
the trading of foreign exchange, derivative products and certain commodities.
The Company and its affiliates act as market-makers in all major equity and
fixed income products in both the domestic and international markets. Lehman
Brothers is a member of all principal securities and commodities exchanges in
the United States, as well as the National Association of Securities Dealers,
Inc. ("NASD"). Holdings holds memberships or associate memberships on several
principal international securities and commodities exchanges, including the
London, Tokyo, Hong Kong, Frankfurt, Paris, Stockholm and Milan stock exchanges.
Since 1990, Lehman Brothers has focused on a "client/customer-driven"
strategy. Under this strategy, Lehman Brothers concentrates on serving the needs
of major issuing and advisory clients and investing customers worldwide to build
an increasing flow of business that leverages the Company's research,
underwriting and distribution capabilities. Customer flow continues to be the
primary source of the Company's net revenues. Developing long-term relationships
with issuing clients and investing customers is a central premise of the
Company's client/customer-driven strategy. Based on management's belief that
each client and customer directs a majority of its financial transactions to a
limited number of investment banks, Lehman Brothers' investment banking and
institutional and private client sales professionals focus on a targeted group
of clients and customers worldwide to identify and develop lead relationships.
The Company believes that such relationships position Lehman Brothers to receive
a substantial portion of its clients' and customers' financial business and
lessen the volatility of net revenues generally associated with the financial
services industry.
LEHMAN BUSINESSES
Lehman Brothers is a leading underwriter of global fixed income and equity
securities in the public and private markets. The Company is also a prominent
advisor for corporations and governments around the world.
INVESTMENT BANKING
Lehman Brothers' Investment Banking professionals are responsible for
developing and maintaining relationships with issuing clients, gaining a
thorough understanding of their specific needs and bringing together the full
resources of Lehman Brothers and Holdings to accomplish their financial
objectives. Investment Banking is organized into industry, product and
geographic coverage groups, enabling individual bankers to develop specific
expertise in particular industries and markets. Global industry coverage groups
include Financial Services, Healthcare, Industrial, Media and
Telecommunications, Natural Resources,
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Power, Real Estate and Technology. Where appropriate, specialized product groups
are partnered with the industry and geographic groups to provide tailor-made
solutions for Lehman Brothers' clients. These groups include Equity Capital
Markets, which includes equity and equity-related securities and derivatives;
Debt Capital Markets, which incorporates expertise in syndicate, liability
management, derivatives and private placements; Mergers and Acquisitions; and
Leveraged Finance, which includes high yield debt and bank loan syndication.
Mergers and Acquisitions/Strategic Advisory. Lehman Brothers has a long
history of providing strategic advisory services to corporate, institutional and
government clients around the world on a wide range of financial matters,
including mergers and acquisitions, restructurings and spin-offs, targeted stock
transactions, share repurchase strategies, takeover defenses, corporate
governance issues and tax optimization strategies. Linkages between strategic
advisory services and the Firm's foreign exchange, derivatives and leveraged
financing products are widely utilized. The Company's Mergers and Acquisitions
group works closely with product, industry and geographic coverage bankers
around the world. Geographically, Lehman Brothers and Holdings maintain
investment banking offices in six cities within the U.S. and in 18 cities in
Europe, Canada, the Middle East, Asia and Latin America.
FIXED INCOME
Lehman Brothers actively participates in all key fixed income markets
worldwide and maintains a 24-hour trading presence in global fixed income
securities. The Company combines professionals from the distribution, research
and trading areas of Fixed Income, together with investment bankers, into teams
to serve the financial needs of the Company's clients and customers. The Company
is a leading underwriter of new issues, and is also a preeminent market-maker in
these and other fixed income securities. The Company's global presence
facilitates client and customer transactions and provides liquidity in
marketable fixed and floating rate debt securities.
Fixed Income businesses include the following:
Government and Agency Obligations. Lehman Brothers is one of the leading
primary dealers in U.S. government securities, as designated by the Federal
Reserve Bank of New York, participating in the underwriting and market-making of
U.S. Treasury bills, notes and bonds, and securities of federal agencies. The
Company is also a market-maker in the government securities of all G7 countries,
and participates in other major European and Asian government bond markets. The
Company is active in the Canadian market through its Toronto office, in France
as a reporting dealer and in Italy as a super-primary dealer.
Money Market Products. Lehman Brothers holds a dominant market position in
the origination and distribution of commercial paper. The Company is an
appointed dealer for over 600 active commercial paper programs on behalf of
companies and government agencies worldwide.
Corporate Debt Securities. Lehman Brothers engages in the underwriting and
market making of fixed and floating rate investment grade debt worldwide. Since
1995, the Company has received global medium-term note mandates for over 270
programs with a borrowing capacity of $657 billion. The Company is also a major
participant in the preferred stock market, managing numerous offerings of
long-term and perpetual preferreds and auction rate securities.
High Yield Securities and Bank Loans. The Company also underwrites and
makes markets in non-investment grade debt securities and bank loans. The
Company now provides a "one-stop" leveraged finance solution for corporate and
financial acquirers and high yield issuers.
Emerging Market Securities. The Company is active in the trading,
structuring and underwriting of Latin American, Eastern European, and Asian
dollar and local currency instruments. The Company maintains investment banking
offices in Mexico City, Sao Paulo, Buenos Aires and New Delhi, among other
locations.
Mortgage and Asset-Backed Securities. The Company is a leading underwriter
of and market-maker in residential and commercial mortgage- and asset-backed
securities and is active in all areas of secured lending, structured finance and
securitized products. Lehman Brothers underwrites and makes markets in the full
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range of U.S. agency-backed mortgage products, mortgage-backed securities,
asset-backed securities and whole loan products. The Company also is engaged in
principal real estate investments. Internationally, the Firm has expanded its
capabilities in mortgage- and asset-backed securities, leases, mortgages,
multi-family financing and commercial loans.
Municipal and Tax-Exempt Securities. Lehman Brothers is a major dealer in
municipal and tax-exempt securities, including general obligation and revenue
bonds, notes issued by states, counties, cities, and state and local
governmental agencies, municipal leases, tax-exempt commercial paper and put
bonds. Lehman Brothers is also a leader in the structuring, underwriting and
sale of tax-exempt and taxable securities and derivative products for city,
state, not-for-profit and other public sector clients.
Financing. The Company's Financing unit engages in three primary
functions: managing the Company's matched book activities, supplying secured
financing to customers, and providing funding for the Company's activities.
Matched book funding involves lending cash on a short-term basis to
institutional customers collateralized by marketable securities, typically
government or government agency securities. The Company enters into these
agreements in various currencies and seeks to generate profits from the
difference between interest earned and interest paid. The Financing unit works
with the Company's institutional sales force to identify customers that have
cash to invest and/or securities to pledge to meet the financing and investment
objectives of the Company and its customers. Financing also coordinates with the
Company's treasury area to provide collateralized financing for a large portion
of the Company's securities and other financial instruments owned. In addition
to its activities on behalf of its U.S. clients and customers, the Company and
its affiliates are major participants in the European and Asian repurchase
agreement markets, providing secured financing for the Firm's customers in those
regions.
Fixed Income Derivatives. The Company offers a broad range of derivative
product services in all major currencies on a 24-hour-per-day global basis.
Derivatives professionals are integrated into all of the Company's fixed income
areas in response to the continued convergence of the cash and derivative
markets worldwide.
Foreign Exchange. Lehman Brothers' global foreign exchange operation
provides its customers with 24-hour access and trade execution in all currencies
for spot, forward and over-the-counter option markets. In collaboration with the
Firm's emerging markets unit, the Firm's foreign exchange activities have
increasingly diversified into Latin America, Eastern Europe and Asian
currencies. Lehman Brothers also provides advisory services to central banks,
corporations and investors worldwide, structuring innovative products to fit
their specific needs. The Firm makes extensive use of its worldwide
macroeconomics research to advise clients on the appropriate strategies to
minimize interest rate and currency risk. In addition to the Company's
traditional client/customer-driven foreign exchange activities, Lehman Brothers
also trades foreign exchange for its own account.
EQUITIES
Lehman Brothers has integrated professionals from the Equities sales,
trading, investment banking and research areas to serve the financial needs of
the Company's equity clients and customers. The Company's equity expertise and
the integrated nature of the Company's global operations enable Lehman Brothers
and its affiliates to structure and execute global equity transactions for
clients worldwide. The Company is a leading underwriter of initial public and
secondary offerings of equity and equity-related securities. Lehman Brothers
also makes markets in these and other securities, and executes block trades on
behalf of clients and customers. The Company actively participates in assisting
governments around the world in raising equity capital as part of their
privatization programs.
The Equities group is responsible for the Company's equity operations and
all dollar and non-dollar equity and equity-related products worldwide. These
products include listed and over-the-counter ("OTC") securities, American
Depositary Receipts, convertibles, options, warrants and derivatives. The
Company and its affiliates participate in the global equity and equity-related
markets in all major currencies through its worldwide presence and membership in
major stock exchanges, including among others, those in New York, London, Tokyo,
Hong Kong, Frankfurt, Paris, Milan and Stockholm.
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Equity Derivatives. Lehman Brothers, in conjunction with affiliates,
offers equity derivative capabilities across a wide spectrum of products and
currencies, including domestic and international program trading, listed options
and futures and structured derivatives. In 1997, Lehman Brothers reorganized its
equity derivatives business into two major product areas -- a global volatility
business, encompassing options-related products, and a global portfolio trading
business that specializes in index arbitrage, agency/risk baskets and other
structured products.
Equity Finance. Lehman Brothers maintains an extensive Equity Financing
and Prime Broker business to provide liquidity to its clients and customers and
supply a source of secured financing for the Firm. Equity Finance provides
margin lending for the purchase of equities and other capital markets' products
as well as securities lending and short selling facilitation. The Prime Broker
business, which significantly increased its global business in 1997, engages in
full operations, clearing and processing services for that unit's customers.
MERCHANT BANKING
The Company and its affiliates' merchant banking activities include making
principal investments in corporations in partnership with clients of the Firm,
raising capital from institutional and high-net-worth investors and managing
these investments until they are realized. The Firm's Merchant Banking group has
more than 20 dedicated professionals based in New York, London and Hong Kong.
In September 1997, Holdings established a new $2 billion merchant banking
fund, for which the Company will act as general partner. The Company has
commitments to invest up to an additional $325 million in the partnerships,
which in turn will make direct merchant banking related investments.
The Company's current merchant banking activities include investments in
five active partnerships, for which the Company acts as general partner, as well
as direct investments. These merchant banking investments include both publicly
traded and privately held companies diversified on a geographic and industry
basis. At November 30, 1997, these investments totaled $47 million.
GLOBAL DISTRIBUTION
Lehman Brothers' institutional and private client sales organizations
encompass distinct global sales forces that have been integrated into the Fixed
Income and Equities businesses to provide investors with the full array of
products and research offered by the Firm.
Fixed Income Sales. The Firm's Fixed Income sales force is one of the
largest in the industry, with approximately 325 professionals in 14 locations
worldwide, serving the investing and liquidity needs of major institutional
investors. Employing a relationship management approach that provides superior
information flow and product opportunities for the Firm's customers, the Fixed
Income sales organization covers the major share of the buying power in the
global fixed income markets. Further, the Firm's expertise in foreign exchange
and derivatives provides customers with comprehensive solutions to their global
risk management needs.
Equity Sales. Lehman Brothers' institutional Equity sales group of over
315 professionals provides an extensive range of services to institutional
investors through locations in the U.S., Europe and Asia. The Equity sales
organization focuses on developing long-term relationships though a
comprehensive understanding of customers' investment objectives, while providing
proficient execution and consistent liquidity in a wide range of global equity
securities and derivatives.
Private Client Sales. The Company's Private Client Services group of 288
professionals serves the investment needs of private investors with substantial
assets as well as over 1,000 mid-sized institutional accounts worldwide. The
group has a global presence with investment representatives located in 12
offices worldwide. Among other services, investment professionals provide their
clients with direct access to fixed income, equity, foreign exchange and
derivative products, as well as the Firm's research and execution capabilities,
thereby serving as a valuable extension of the Firm's institutional sales force.
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RESEARCH
Fixed Income Research. Fixed Income research at Lehman Brothers
encompasses the full range of research disciplines: quantitative, economic,
strategic, credit, portfolio, relative value and market-specific analysis. Fixed
Income research is integrated with and supports the Company's investment
banking, sales and trading activities. An important objective of Fixed Income
research is to have in place high quality research analysts covering industry,
geographic and economic sectors that support the activities of the Company's
clients and customers. The department's 275 specialists provide expertise in
U.S., European and Asian government and agency securities, derivatives,
sovereign issues, corporate securities, high yield, asset- and mortgage-backed
securities, real estate, emerging market debt and municipal securities.
Equity Research. The Equity Research department, comprised of 260
professionals, is integrated with and supports the Company's investment banking,
sales and trading activities. To ensure in-depth expertise within various
markets, Equity Research has established regional teams on a worldwide basis
that are staffed with industry and strategy specialists.
OTHER BUSINESS ACTIVITIES
Lehman Brothers also participates in business opportunities such as
arbitrage and proprietary trading that leverage the Company's expertise,
infrastructure and resources. These businesses may generate substantial revenues
but generally entail a higher degree of risk as the Company trades for its own
account.
Arbitrage. Lehman Brothers engages in a variety of arbitrage activities.
In traditional or "riskless" arbitrage, the Company seeks to benefit from
temporary price discrepancies that occur when a security is traded in two or
more markets, or when a convertible or derivative security is trading at a price
disparate from its underlying security. The Company's "risk" arbitrage
activities involve the purchase of securities at discounts from the expected
values that would be realized if certain proposed or anticipated corporate
transactions (such as mergers, acquisitions, recapitalizations, exchange offers,
reorganizations, bankruptcies, liquidations or spin-offs) were to occur. To the
extent that these anticipated transactions do not materialize in a manner
consistent with the Company's expectations, the Company is subject to the risk
that the value of these investments will decline. Lehman Brothers' arbitrage
activities benefit from the Company's presence in the global capital markets,
access to advanced information technology, in-depth market research, proprietary
risk management tools and general experience in assessing rapidly changing
market conditions.
Asset Management. In 1997, the Firm launched a series of 12 onshore and
offshore funds managed by 25 third-party managers. The Firm also offers a number
of tailored products to its client base, including an array of single client
funds, managed accounts and advisory services.
Proprietary Trading. In addition to its customer-flow activities, Lehman
Brothers also takes proprietary positions in interest rates, foreign exchange,
various securities, derivatives and commodities for its own account. The
Company's proprietary trading activities bring together various research and
trading disciplines allowing it to take market positions, which at times may be
significant, consistent with the Company's expectations of future events (such
as movements in the level of interest rates, changes in the shape of yield
curves and changes in the value of currencies). The Company is subject to the
risk that actual market events will be different from the Company's
expectations, which may result in significant losses associated with such
proprietary positions. The Company's proprietary trading activities are
generally carried out in consultation with personnel from the relevant major
product areas (e.g., mortgages, derivatives and foreign exchange).
TRADING SERVICES AND CORPORATE
The Company's Trading Services and Corporate divisions provide support to
its businesses through the processing of certain securities and commodities
transactions; receipt, identification and delivery of funds and securities;
safeguarding of customers' securities; and compliance with regulatory and legal
requirements. In addition, this staff is responsible for technology
infrastructure and systems development, treasury operations, financial control
and analysis, tax planning and compliance, internal audit, expense management,
career development and recruiting and other support functions.
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In 1997, the Company invested in a strategic global foundation for
information technology upon which all future investments in technology will be
leveraged. The Company's response to the Year 2000 issue is described under the
caption "Management's Discussion and Analysis of Financial Condition and Results
of Operations -- Other -- Impact of the Year 2000" on page 50 hereof.
RISK MANAGEMENT
As a leading global investment banking company, risk is an inherent part of
the Company's businesses. Global markets, by their nature, are prone to
uncertainty and subject participants to a variety of risks. The Company has
developed policies and procedures to identify, measure and monitor each of the
risks involved in its trading, brokerage and investment banking activities on a
global basis. The principal risks of Lehman Brothers are market, credit,
liquidity, legal and operational risks. Risk Management is considered to be of
paramount importance. The Company devotes significant resources across all of
its worldwide trading operations to the measurement, management and analysis of
risk, including investments in personnel, information technology infrastructure
and systems.
A complete description of the Firm's Risk Management procedures is
contained in "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Risk Management" on pages 27-30 hereof.
NON-CORE ASSETS
Prior to 1990, the Company participated in a number of activities that were
not central to its current business as an institutional investment banking firm.
As a result of these activities, the Company carries on its balance sheet a
number of relatively illiquid assets (the "Non-Core Assets"), including a number
of individual real estate assets, limited partnership interests and a number of
smaller investments. Subsequent to their purchase, the values of certain of
these Non-Core Assets declined below the recorded values on the Company's
balance sheet, which necessitated the write-down of the carrying values of these
assets and corresponding charges to the Company's income statement. Certain of
these activities have resulted in various legal proceedings.
Since 1990, management has devoted substantial resources to reducing the
Company's Non-Core Assets. At November 30, 1997, the Company had $29 million of
net exposure to these real estate activities, including investments, commitments
and contingent liabilities under guarantees and credit enhancements. The value
of the Company's Non-Core Assets includes carrying value plus contingent
exposures net of reserves. Management's intention with regard to these Non-Core
Assets is the prudent liquidation of these investments as and when possible.
COMPETITION
All aspects of the Company's business are highly competitive. The Company
competes in domestic and international markets directly with numerous other
brokers and dealers in securities and commodities, investment banking firms,
investment advisors and certain commercial banks and, indirectly for investment
funds, with insurance companies and others.
The financial services industry has become considerably more concentrated
as numerous securities firms have either ceased operations or have been acquired
by or merged into other firms. In addition, several small and specialized
securities firms have been successful in raising significant amounts of capital
for their merger and acquisition activities and merchant banking investment
vehicles and for their own accounts. These developments have increased
competition from firms, a number of whom have significantly greater equity
capital than the Company.
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REGULATION
The securities industry in the United States is subject to extensive
regulation under both federal and state laws. LBI and certain other subsidiaries
of Holdings are registered as broker-dealers and investment advisors with the
Commission and as such are subject to regulation by the Securities and Exchange
Commission (the "SEC") and by self-regulatory organizations, principally the
NASD and national securities exchanges such as the New York Stock Exchange,
which has been designated by the SEC as LBI's primary regulator, and the
Municipal Securities Rulemaking Board. Securities firms are also subject to
regulation by state securities administrators in those states in which they
conduct business. LBI is a registered broker-dealer in all 50 states, the
District of Columbia and the Commonwealth of Puerto Rico. The SEC,
self-regulatory organizations and state securities commissions may conduct
administrative proceedings, which may result in censure, fine, the issuance of
cease-and-desist orders or suspension or expulsion of a broker-dealer or an
investment advisor, its officers or employees.
LBI is registered with the Commodity Futures Trading Commission (the
"CFTC") as a futures commission merchant and is subject to regulation as such by
the CFTC and various domestic boards of trade and other commodity exchanges. The
Company's U.S. commodity futures and options business is also regulated by the
National Futures Association, a not-for-profit membership corporation which has
been designated as a registered futures association by the CFTC.
Holdings and the Company do business in the international fixed income,
equity and commodity markets and undertake investment banking activities through
Holdings' London subsidiaries. The U.K. Financial Services Act of 1986 (the
"Financial Services Act") governs all aspects of the United Kingdom investment
banking business, including regulatory capital, sales and trading practices, use
and safekeeping of customer funds and securities, record keeping, margin
practices and procedures, registration standards for individuals, periodic
reporting and settlement procedures. Pursuant to the Financial Services Act,
Holdings and the Company are subject to regulations administered by The
Securities and Futures Authority Limited, a self regulatory organization of
financial services companies (which regulates the Company's equity, fixed
income, commodities and investment banking activities), and the Bank of England
(which regulates its wholesale money market, bullion and foreign exchange
businesses).
The Company believes that it is in material compliance with the regulations
described herein.
CAPITAL REQUIREMENTS
LBI is subject to various securities, commodities and banking regulations
and capital adequacy requirements promulgated by the regulatory and exchange
authorities of the countries in which it operates. Reference is made to
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Liquidity and Capital Resources -- Regulatory Capital" on page 23
hereof, and Note 5 of Notes to Consolidated Financial Statements on page F-15
hereof.
EMPLOYEES
As of November 30, 1997 LBI employed approximately 7,000 persons. The
Company considers its relationship with its employees to be good.
ITEM 2. PROPERTIES
The Company's headquarters occupy approximately 932,000 square feet of
space at 3 World Financial Center in New York, New York, which is owned by the
Company as tenants-in-common with American Express and various other American
Express subsidiaries, and approximately 77,000 square feet of which has been
subleased.
Holdings leases approximately 405,000 square feet for offices located at
101 Hudson Street in Jersey City, New Jersey (the "Operations Center"), of which
approximately 63,000 square feet has been subleased. The Operations Center is
used by systems, operations, and certain administrative personnel and contains
certain back-up trading systems. The lease expires in December 2010.
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Facilities owned or occupied by the Company and its subsidiaries are
believed to be adequate for the purposes for which they are currently used and
are well maintained.
ITEM 3. LEGAL PROCEEDINGS
The Company is involved in a number of judicial, regulatory and arbitration
proceedings concerning matters arising in connection with the conduct of its
business. Such proceedings include actions brought against the Company and
others with respect to transactions in which the Company acted as an underwriter
or financial advisor, actions arising out of the Company's activities as a
broker or dealer in securities and commodities and actions brought on behalf of
various classes of claimants against many securities and commodities firms,
including the Company.
Although there can be no assurance as to the ultimate outcome, the Company
has denied, or believes it has a meritorious defense and will deny, liability in
all significant cases pending against it including the matters described below,
and intends to defend vigorously each such case. Although there can be no
assurance as to the ultimate outcome, based on information currently available
and established reserves, the Company believes that the eventual outcome of the
actions against it, including the matters described below, will not, in the
aggregate, have a material adverse effect on the consolidated financial
condition of the Company.
Bamaodah v. E.F. Hutton & Company Inc.
In April 1986, Ahmed and Saleh Bamaodah commenced an action against E.F.
Hutton & Company Inc., ("EFH") to recover all losses the Bamaodahs had incurred
since May 1981 in the trading of commodity futures contracts in a
nondiscretionary EFH trading account. The Dubai Civil Court ruled that the
trading of commodity futures contracts constituted illegal gambling under
Islamic law and that therefore the brokerage contract was void. In January 1987,
a judgment was rendered against EFH in the amount of $48,656,000. On January 5,
1991, the Dubai Court of Appeals affirmed the judgment. On March 22, 1992, the
Court of Cassation, Dubai's highest court, revoked and quashed the decision of
the Court of Appeals and ordered that the case be remanded to the Court of
Appeals for a further review. On April 26, 1994, the Dubai Court of Appeals
again affirmed the judgment of the Dubai Civil Court. The Company appealed the
judgment to the Court of Cassation, which reversed the Court of Appeals on
November 27, 1994 and ordered that a new expert be appointed to review the case.
A new expert has been appointed, with instructions to report back to the Court
of Cassation.
Actions Relating To First Capital Holdings Inc.
Concurrent with the bankruptcy filing of First Capital Holdings ("FCH") in
May, 1991 and the conservatorship and receivership of its two life insurance
subsidiaries, First Capital Life Insurance Company ("First Capital Life") and
Fidelity Bankers Life Insurance Company ("Fidelity Bankers Life") (First Capital
Life and Fidelity Bankers Life collectively, the "Insurance Subsidiaries"), a
number of lawsuits were commenced, naming one or more of Holdings, Lehman
Brothers and American Express as defendants (individually or collectively, as
the case may be, the "American Express Defendants"). Most of these actions have
been subsequently settled and/or dismissed. The matter still pending is
described below.
The Virginia Commissioner of Insurance Action. On December 9, 1992, a
complaint was filed in the United States District Court for the Eastern District
of Virginia (the "Virginia Court") by Steven Foster, the Virginia Commissioner
of Insurance (the "Commissioner") as Deputy Receiver of Fidelity Bankers Life.
The Complaint names Holdings and Weingarten, Ginsberg and Leonard Gubar, a
former director of FCH and Fidelity Bankers Life, as defendants. The Complaint
alleges that Holdings acquiesced in and approved the continued mismanagement of
Fidelity Bankers Life and that it participated in directing the investment of
Fidelity Bankers Life assets. The complaint asserts claims under the federal
securities laws and asserts common law claims including fraud, negligence and
breach of fiduciary duty and alleges violations of the Virginia Securities laws
by Holdings. It allegedly seeks no less than $220 million in damages to Fidelity
Bankers Life and its present and former policyholders and creditors and punitive
damages. Holdings has
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answered the complaint, denying its material allegations. As a result of
Holdings' motion for summary judgment, the court limited the damages the
Commissioner may seek to less than approximately $30 million.
Easton & Co. v. Mutual Benefit Life Insurance Co., et al., Easton & Co. v.
Lehman Brothers Inc.
Lehman Brothers was named as a defendant in two consolidated class action
complaints pending in the United States District Court for the District of New
Jersey (the "N.J. District Court"). Easton & Co. v. Mutual Benefit Life
Insurance Co., et al. ("Easton I"), and Easton & Co. v. Lehman Brothers Inc.
("Easton II"). The plaintiff in both of these actions is Easton & Co., which is
a broker-dealer located in Fort Lee, New Jersey. Both of these actions allege
federal securities law claims and pendent common law claims in connection with
the sale of certain municipal bonds as to which Mutual Benefit Life Insurance
Company ("MBLI") has guaranteed the payment of principal and interest. MBLI is
an insurance company which was placed in rehabilitation proceedings under the
supervision of the New Jersey Insurance Department on or about July 16, 1991.
Easton I was commenced on or about September 17, 1991. The litigation was
purportedly brought on behalf of a class consisting of all persons and entities
who purchased DeKalb, Georgia Housing Authority MultiFamily Housing Revenue
Refunding Bonds (North Hill Ltd. Project), Series 1991, due November 30, 1994
(the "DeKalb Bonds") during the period from May 3, 1991 (when the DeKalb bonds
were issued) through July 16, 1991. Lehman Brothers acted as underwriter for
this bond issue, which was in the aggregate principal amount of $18.7 million.
The complaint alleged that Lehman Brothers violated Section 10(b) of the
Exchange Act and Rule 10b-5 promulgated thereunder, and sought damages in an
unspecified amount or rescission. The complaint also alleged a common law
negligent misrepresentation claim against Lehman Brothers and the other
defendants.
Easton II was commenced on or about May 18, 1992, and named Lehman Brothers
as the only defendant. Plaintiff purported to bring this second lawsuit on
behalf of a class composed of all persons who purchased "MBLI-backed Bonds" from
Lehman Brothers during the period April 19, 1991 through July 16, 1991. The
complaint alleged that Lehman Brothers violated Section 10(b) and Rule 10b-5,
and seeks monetary damages in an unspecified amount, or rescission pursuant to
Section 29(b) of the Exchange Act. The complaint also contained a common law
claim of alleged breach of duty and negligence. On or about February 9, 1993,
the N.J. District Court granted plaintiffs' motion for class certification in
Easton I. The parties agreed to certification of a class in Easton II for
purchases of certain fixed-rate MBLI-backed bonds during the class period. LBI,
together with the other defendants in Easton I and Easton II, has agreed to
settle both cases, subject to court approval.
Warren D. Chisum, et al. v. Lehman Brothers Inc. et al.
On February 28, 1994 a purported class action was filed in the United
States District Court for the Northern District of Texas. An amended complaint
was filed on December 15, 1994. The amended complaint names LBI and two former
EFH employees as defendants. The complaint alleges that defendants violated
Section 10(b) of the Exchange Act and RICO, breached their fiduciary duties and
the limited partners' contract and committed fraud in connection with the
origination, sale and operation of nine EFH net lease real estate limited
partnerships. Plaintiffs seek: (i) to certify a class of all persons who
purchased limited partnership interests in the nine partnerships at issue, (ii)
unspecified damages, plus interest or rescission, (iii) treble damages, (iv)
punitive damages and (v) accounting and attorneys' fees. On April 2, 1996 the
Court filed an opinion and order certifying the litigation as a class action,
consisting of all persons who purchased interests in the nine EFH net lease
limited partnerships. On July 11, 1996, the Court issued a memorandum and order
dismissing plaintiffs' RICO claim. Defendants answered the complaint and denied
its material allegations. The parties have entered into a settlement agreement
which was preliminarily approved by the Court on February 20, 1998 and is
subject to the Court's final approval.
9
<PAGE> 11
Actions Relating to the Sales and Marketing of Limited Partnerships
Subsequent to a January 26, 1996 article in the Wall Street Journal
entitled "SEC, Brokers Study Pact on Partnerships," various putative class
actions were filed in different state courts relating to the sales and marketing
of limited partnerships by E.F. Hutton & Co. and Shearson and their affiliates
during the 1980's. Thereafter all of these actions were consolidated into the
two actions described below, or were effectively stayed while these actions
proceed.
Under the terms of an agreement between American Express and Holdings,
American Express has agreed to indemnify Holdings for liabilities which it may
incur in connection with any action relating to any business conducted by The
Balcor Company, a former Lehman Brothers subsidiary ("Balcor"), in which
Holdings is named as a parent company or control person of Balcor. Holdings
believes that some of the allegations in certain of the actions described below
are covered by this indemnity.
In re Lehman Brothers Limited Partnership Litigation. On October 18, 1996,
a purported first consolidated and amended class action complaint was filed in
the Court of Chancery of the State of Delaware in and for New Castle County on
behalf of all persons who purchased units in various public, proprietary limited
partnerships organized by Shearson or E.F. Hutton & Co. or operated by
affiliates of those entities between 1981 and the present (with certain
exceptions). Defendants are LBI and 56 Lehman-affiliated general partners. The
complaint alleges that defendants breached their fiduciary duties or aided and
abetted such a breach by allegedly misrepresenting and or failing to disclose
the nature of the risks and the status and financial condition of the
partnerships; collecting excessive fees; failing to exercise due care in
selecting investments for the partnerships; and recommending and selling the
partnerships as suitable investments. The complaint seeks, among other things
(1) to certify the case as a class action; (2) to declare that defendants
breached their duties; (3) to enjoin defendants from operating the partnerships
for their own benefit; (4) to account for all profits and impose a constructive
trust on them; and (5) to award compensatory damages, costs and expenses and
attorneys' fees.
Klein, et al. v. Lehman Brothers, Inc., et al. On January 15, 1998, a
purported third amended class action complaint was filed in the Superior Court
of New Jersey, Law Division: Union County on behalf of investors in certain
specified limited partnerships sponsored by Balcor and sold by various entities,
including, among others, Shearson and certain of its affiliates. Named as
defendants are LBI, various affiliates of LBI, American Express Company, Smith
Barney Holdings, Inc., Balcor, a number of Balcor-originated limited
partnerships and various individuals and entities affiliated with Balcor. The
complaint alleges claims in connection with the marketing, sale and operation of
the limited partnerships for common law fraud and deceit, equitable fraud,
negligent misrepresentation, breach of fiduciary duty and contract and violation
of certain New Jersey statutes relating to the sale of securities. The complaint
seeks compensatory damages for lost principal and interest, general damages and
punitive damages, treble damages under the New Jersey statutes, and costs and
attorneys' fees.
Maxwell Related Litigation
There is one remaining lawsuit arising out of transactions entered into
with the late Robert Maxwell or entities controlled by Maxwell interests.
MCC Proceeds Inc. v. Lehman Brothers International (Europe) This action
was commenced by issuance of a writ in the High Court of Justice in London,
England on July 14, 1995. In this action, MCC Proceeds Inc., as successor to
Macmillan, Inc., seeks a declaration of the rightful ownership of approximately
10.6 million shares of Berlitz International Inc. common stock. The High Court
granted LBIE's application to dismiss the proceeding and assessed costs against
MCC Proceeds. On December 19, 1997, the Court of Appeal affirmed the dismissal
of this proceeding.
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<PAGE> 12
Lehman Brothers Commercial Corporation and Lehman Brothers Special Financing
Inc. v. Minmetals International Non-Ferrous Metals Trading Company
On November 15, 1994, two Lehman Brothers subsidiaries, Lehman Brothers
Commercial Corporation ("LBCC") and Lehman Brothers Special Financing Inc.
("LBSF"), commenced an action against Minmetals International Non-Ferrous Metals
Trading Company ("Minmetals") and China National Metals and Minerals Import and
Export Company ("CNM") in the United States District Court for the Southern
District of New York alleging breach of contract against Minmetals and breach of
guarantee against CNM. The litigation arose from the refusal by Minmetals and
CNM to honor their obligations with respect to certain foreign exchange and swap
transactions. LBCC and LBSF seek to recover approximately $52.5 million from
Minmetals and/or CNM. On June 26, 1995, the court granted CNM's motion to
dismiss the claims against it, but also granted LBCC and LBSF leave to replead.
Minmetals filed fourteen counterclaims against Lehman entities based on
violations of federal securities and commodities laws and rules, and theories of
fraud, breach of fiduciary duty and conversion. The court denied a motion by the
Lehman counterclaim defendants to dismiss the six fraud-based counterclaims. On
June 24, 1996, the court granted the motion of LBCC and LBSF to file an amended
complaint naming CNM as an additional defendant. Discovery is progressing.
Actions Relating to National Association of Securities Dealers Automated
Quotations System ("NASDAQ") Market Maker Antitrust and Securities Litigation.
Beginning in May, 1994, several class actions were filed in various state
and federal courts against various broker-dealers making markets in NASDAQ
securities. With respect to a number of those actions LBI was either
specifically named as a defendant or was not specifically named as a defendant
but could be deemed to be a member of the defendant class as defined in the
complaints. Plaintiffs in these cases have alleged violations of the antitrust
laws, securities laws and have pled a variety of other statutory and common law
claims. All of these actions are based on the theory that because odd-eighth
quotes occur less often than quarter quotes, NASDAQ market makers must be
colluding wrongfully to maintain a wider spread.
By Order filed October 14, 1994, the Judicial Panel on Multidistrict
Litigation consolidated these actions in the Southern District of New York and
ordered that all related actions be transferred and coordinated for all pretrial
purposes. The case is captioned In Re: NASDAQ Market-Makers Antitrust
Litigation, MDL No. 1023.
On December 16, 1994, plaintiffs served a consolidated Amended Complaint
naming 33 defendants including LBI. Plaintiffs claim violations of the federal
antitrust laws including Section I of the Sherman Antitrust Act. Plaintiffs seek
unspecified compensatory damages trebled in accordance with the antitrust laws,
costs including attorneys' fees as well as injunctive relief. The court
dismissed the action with leave to replead, stating that the complaint failed to
identify the securities involved with sufficient specificity. The plaintiffs
replied and the defendants answered the amended complaint on November 17, 1995.
On December 23, 1997, LBI settled the class action along with 29 other
broker-dealers. The settlement is subject to final approval by the court.
LBI entered into a Stipulation and Order resolving a civil complaint filed
by the U.S. Department of Justice alleging that LBI and 23 other NASDAQ market
makers violated Section 1 of the Sherman Act in connection with certain market
making practices. In entering into the Stipulation and Order the parties agreed
that the defendants would not engage in certain types of market making
activities and the defendants undertook specified steps to assure compliance
with their agreement. The Stipulation and Order were approved by the United
States District Court for the Southern District of New York, which decision is
on appeal to the Second Circuit Court of Appeals. If the approval is affirmed
throughout the appellate process, the complaint will be dismissed with
prejudice.
Sonnenfeld v. The City and County of Denver, Colorado, et al.
On August 4, 1995, a Consolidated Amended Class Action Complaint (the
"Complaint") was filed in the United States District Court for the District of
Colorado, consolidating and amending previously filed complaints and adding,
among other defendants, LBI. The Complaint was purportedly brought on behalf of
all
11
<PAGE> 13
persons, other than defendants, who purchased Denver Airport System Revenue
Bonds during the period February 27, 1992 through May 3, 1994 that were issued
by the City and County of Denver and who were damaged by their investments. The
parties entered into a settlement of the action which was approved by the Court
on December 8, 1997.
AIA Holding SA et al. v. Lehman Brothers Inc. and Bear Stearns & Co., Inc.
On July 9, 1997, LBI was served with a complaint in the U.S. District Court
for the Southern District of New York in which 277 named plaintiffs assert 24
causes of action against LBI and Bear Stearns & Co., Inc. The amount of damages
claimed is unspecified. The claims arise from the activities of an individual
named Ahmad Daouk, who was employed by an introducing broker which introduced
accounts to Shearson Lehman Hutton between 1988 and 1992. Daouk allegedly
perpetrated a fraud upon the claimants, who are mostly investors of Middle
Eastern origin, and the complaint alleges that Shearson breached various
contractual and common law duties owed to the investors. LBI and Bear Stearns &
Co., Inc. have filed a motion to dismiss the complaint and expect a ruling on
such motion within the next several months.
Actions Relating to Bre-X Minerals Ltd.
McNamara et al. v. Bre-X Minerals Ltd. et al. On July 25, 1997, an Amended
Class Action Complaint was filed in the United States District Court for the
Eastern District of Texas against 16 defendants, including LBI, which seeks
unspecified compensatory damages, interest, costs and attorney's fees on behalf
of purchasers of Bre-X common stock and/or Bresea common stock. The Complaint
raises claims under the federal securities laws and the common law of fraud and
negligent misrepresentation. The Complaint's stated basis for naming LBI is that
one of its securities analysts published research on Bre-X. On or about November
21, 1997, several defendants, including LBI, moved to dismiss the Complaint, or,
in the alternative, to transfer venue to the Southern District of New York.
Plaintiffs have also filed a motion for class certification, which is stayed
pending resolution of the motions to dismiss.
Klaasen v. Lehman Brothers Inc. et al. On October 2, 1997, William L.
Klaasen, "individually and for all those similarly situated within the State of
California," filed a Complaint against LBI in the Superior Court for the State
of California in and for the County of San Diego. The Complaint raises a claim
for common law negligence, and seeks, on behalf of California purchasers of
Bre-X and Bresea stock, class certification, rescission, interest, compensatory
and punitive damages, disgorgement and restitution of profits and compensation
received by LBI, and costs. The action is currently stayed by consent until the
earlier of April 1, 1998 or 30 days following the decision on the motion to
dismiss in the McNamara case.
Chow et al. v. Bre-X Minerals Ltd. et al. On October 10, 1997, 125
plaintiffs filed an action in the Court of Queen's Bench of Alberta, in Calgary,
Canada, against 35 named defendants, including LBI. Plaintiffs' claim against
LBI, which has not yet been served, is for common law negligence.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Pursuant to General Instruction I of Form 10-K, the information required by
Item 4 is omitted.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
All of the outstanding common stock of the Company is owned by Holdings.
ITEM 6. SELECTED FINANCIAL DATA
Pursuant to General Instruction I of Form 10-K, the information required by
Item 6 is omitted.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Set forth on the following pages is Management's Discussion and Analysis of
Financial Condition and Results of Operations for the twelve months ended
November 30, 1997, November 30, 1996 and November 30, 1995. Such information
should be read in conjunction with the Consolidated Financial Statements of the
Registrant and its Subsidiaries together with the Notes thereto contained on
pages F-3 to F-29 hereof.
12
<PAGE> 14
BUSINESS ENVIRONMENT
The principal business activities of Lehman Brothers Inc., a registered
broker dealer with the U.S. Securities and Exchange Commission ("LBI") and
subsidiaries (collectively, the "Company" or "Lehman Brothers") are investment
banking and securities trading and sales, which by their nature are subject to
volatility, primarily due to changes in interest and foreign exchange rates and
security valuations, global economic and political trends and industry
competition. As a result, revenues and earnings may vary significantly from
quarter to quarter and from year to year. LBI is a wholly owned subsidiary and
the principal operating subsidiary of Lehman Brothers Holdings Inc. (together
with its subsidiaries, where appropriate, "Holdings").
The favorable market and economic conditions that characterized fiscal 1996
continued throughout most of 1997, leading to increased industry-wide revenues
and to record levels of earnings and net revenues for the Company. Similar to
the 1996 market environment, improved valuations and strong investor demand in
worldwide equity markets led to a second consecutive year of record levels of
corporate finance advisory activities and near-record underwriting volumes.
During 1997, however, volatility became more persistent than in either 1996 or
1995. Investors focused more than ever on worldwide market conditions and
uncertainty about future valuation levels for their investments. The unraveling
of deep-seated structural and financing problems in Asia, which for years had
been masked by strong economic growth, sent stock markets and currencies
plummeting. The year 1997 ended with uncertainty surrounding the world markets.
Bond markets in the developed countries were strong, while the equity markets
were hesitant with investors still assessing the impact that events in Asia had
on the rest of the world.
Fixed Income. During 1997, global fixed income markets were robust, with
heavy trading volumes in both the U.S. and Europe. The year began with fears of
a rate hike in the U.S. which kept global bond markets in retreat until
mid-year. Ultimately, there was only one rate action by the U.S. Federal Reserve
Board ("Fed") during 1997 which occurred in March when the overnight lending
rate was raised by 0.25% to 5.50%. There were no long-term effects from this
event. For most of 1997, trading activity in the U.S. continued to reflect
investor optimism that the environment of sustained growth and low levels of
inflation would continue. During this period, U.S. trading activity was
bolstered by active purchases of U.S. securities by foreign investors due to the
favorable U.S. macroeconomic environment and the strong dollar. However, by the
end of 1997, the forced devaluation of Thailand's currency during July triggered
a chain reaction of currency depreciations across the Asian region. Heightened
uncertainty about the extent of the exchange rate volatility caused foreign and
domestic investors to sell their Asian holdings and move into U.S.
dollar-denominated assets which, in turn, led to further pressure on Asian
exchange rates. Consequently, the fixed income markets suffered as credit
spreads on corporate, Eurobond and emerging market issuers widened dramatically.
Issuers sat on the sidelines as spreads became unattractive. By the end of 1997,
investors' flight to quality caused the 30-year U.S. treasury bond to rally to
rates not seen since 1993.
While many of the peripheral European bond markets outperformed the U.S.
market in local currency terms in 1997, only the U.K. gilt market did so in U.S.
dollar terms. In the U.K., the yield curve flattened dramatically. This was in
response to the new Labour government granting independence to the Bank of
England which then implemented four interest rate increases. In Germany, an
interest rate hike in October 1997, combined with the Asian crisis, led to a
flattening of the German yield curve. For 1997, this amounted to just under one
percentage point between 10-year and two-year bonds. Also, several countries
seeking to enter the EMU on January 1, 1999 (e.g., Italy, Spain and Finland)
exhibited strength during 1997 as a result of reduced inflation and budget
deficits during the year.
During 1997, yields in Japan fell as a recovery in domestic demand
following an April tax hike proved elusive, Japanese banking problems
intensified, and the Asian crisis spread. By November 1997, yields on 10-year
bonds had fallen to below 2% -- a decline of 50 basis points for the year. Fixed
income markets in Southeast Asia were highly volatile in 1997 as the Asian
crisis depressed trading volumes and prices. By mid-December 1997, the
International Monetary Fund had negotiated medium-term funding agreements with
Thailand, Indonesia, and Korea to supply much-needed foreign exchange liquidity.
However, this failed to
13
<PAGE> 15
stabilize Asia's currency markets; and the major rating agencies lowered the
bond ratings of several Asian nations to below investment grade levels.
Equity. During 1997, all major U.S. equity indices established new
records, although they ended the year off from these highs. For fiscal 1997, the
S&P 500 return was 29%, making it the third consecutive year of double-digit
returns. Equity prices were helped by a benign inflation and interest rate
environment accompanied by good corporate earnings growth; inflation fell below
2% for the year; long-term interest rates declined to below 6%; and profit
growth was double-digit. However, the equity market was also more volatile in
1997, suffering through two corrections. The first one in March reflected the
interest rate hike by the Fed combined with investor concerns about earnings
performance in the technology sector. After the markets recovered strongly, the
Asian crisis occurred, and the market suffered a second correction, culminating
in a record drop of more than 550 points in the Dow Jones Industrial Average on
October 27. By the end of 1997, the markets had recovered once again, but
worries about the fallout from the Asian crisis persisted. Equity trading
volumes remained brisk as did inflows of capital into mutual funds.
The European equity markets performed extremely well during 1997, with
returns from the region as a whole much in line with those of the U.S. markets.
The Financial Times -- S&P European Index rose 20% in dollar terms, supported by
currency depreciation, which strengthened expectations of economic recovery and
boosted corporate earnings prospects, and by falling bond yields. Within Europe,
the smaller markets achieved the highest returns, reflecting narrowing bond
spreads over German yields and declines in short-term interest rates. Healthy
market conditions were reflected in strong trading volumes.
The situation in Asia, however, sharply contrasted with the performance of
the U.S. and European equity markets. In Japan, the Nikkei 225 Index fell by 17%
due to a deteriorating banking environment, major corporate bankruptcies, and an
economy on the verge of a recession. Similar to 1996, the Japanese market rose
over the first half of 1997 as investors looked for the economic recovery to
continue, but recorded losses in the second half as it became clear that the
fiscal tightening hurt economic growth and the banking crisis was intensifying.
Excluding Australia, the markets of southeast Asia were even more turbulent, as
one country after another became embroiled in the region's crisis. In local
currency terms, the worst-hit markets (e.g., Thailand, Malaysia, Indonesia,
Philippines and Korea) fell between 35% and 60% versus the prior year, with
returns in dollar terms recording even weaker results.
Latin American EMG markets, which realized a broad recovery in 1996, posted
very strong gains through much of 1997. These gains resulted from a continuation
of the process of economic reform and financial consolidation coupled with an
acceleration of economic growth in the region. As compared to the end of 1996,
Latin American equities rose over 50% in dollar terms to a peak during October
1997, as measured by the IFC Latin American Investable Index. However, the
escalating Asian crisis negatively impacted performance towards the end of 1997,
as global investors reined in their appetite for emerging markets. Despite the
year end weakening, these markets returned over 25% for the year.
Investment Banking. Combined worldwide underwriting volumes for fixed
income and equities continued on a torrid pace during 1997. Despite the
turbulence of the global stock markets in 1997, global equity underwritings
reached new highs. Significant merger and acquisition activity and continued
inflows into equity mutual funds led to a record $156 billion of common stock
underwritings. Worldwide fixed income underwriting surpassed 1996 levels led by
the issuance of corporate, asset-backed, and mortgage-backed bonds. Issuers came
to market to take advantage of the historically attractive yields as well as
favorable pricing in the spread sectors. However, as with many other businesses,
the Asian crisis caused credit spreads to widen, leading issuers to postpone
offerings in the latter part of the year.
Corporate Finance Advisory activities set another record in 1997, with the
level of announced merger and acquisition activity reaching historic levels
following strong performances in both 1996 and 1995. The increased activity
reflected the continuing trend of consolidation and globalization across
industry sectors and the overall strength in the global capital markets.
Reflecting the strength of advisory activities was the wide range of industry
sectors participating and the broad global and cross-border orientation of that
activity. Furthermore, the scale of advisory activity was unprecedented. Four of
the top ten domestic M&A deals of all
14
<PAGE> 16
time were announced in the past twelve months and three of the top seven
announced worldwide M&A transactions involved a foreign target.
Fiscal 1997 was characterized by strong financial markets, nevertheless,
the financial services industry is cyclical. As a result, the Company's
businesses are evaluated across market cycles for operating profitability and
their contribution to the Company's long-term strategic objectives. The Company
strives to minimize the effects of economic downturns through its diversified
product base, stringent cost controls, global presence and risk management
practices.
Note: Except for the historical information contained herein, this Management's
Discussion and Analysis of Financial Condition and Results of Operations
contains forward-looking statements that are based on current
expectations, estimates and projections about the industries in which the
Company operates. These statements are not guarantees of future
performance and involve certain risks, uncertainties and assumptions
which are difficult to predict. The Company undertakes no obligation to
update publicly any forward-looking statements, whether as a result of
new information, future events or otherwise.
RESULTS OF OPERATIONS
SUMMARY
The Company reported record net income of $391 million for 1997 which was
driven by continued strength in the Company's major businesses including
equities and investment banking. These results were achieved in worldwide
markets which were extremely favorable during the early portion of the year and
became volatile in the latter portion of the year. Despite market volatility,
many equity indices in the U.S. and Europe reached all-time highs during 1997.
The overall favorable market conditions led to a second straight year of
near-record industrywide underwriting volumes and a record year in worldwide
merger and acquisition activity.
The Company's continued focus on growing higher margin businesses
contributed to record revenues and a pretax margin of 22.8% for 1997 compared to
13.0% in 1996. Also contributing to these record results was the Company's
continued aggressive management of expenses as evidenced by the decrease in
non-interest expenses even though revenues increased.
The Company's 1996 net income was $189 million, including a $14 million
aftertax severance charge. The Company's 1996 results reflect strong
performances across all of the Company's core businesses. Fixed income sales and
trading and investment banking activities were responsible for the majority of
the increased net income and net revenues compared to 1995. The Company's
results were positively affected by favorable market conditions which led to
near record underwriting volumes, record highs in equity indices and a record
year in merger and acquisition activity.
The Company reported net income of $69 million for 1995, including a $26
million aftertax charge for occupancy-related real estate expenses and
severance. The Company's 1995 results reflect improved performance in corporate
finance advisory activity and in fixed income and equity origination as well as
higher levels of customer activity in a number of businesses. The Company
benefited from the continuing increase in merger and acquisition activity
throughout 1995 and from a stronger market climate beginning in the second
quarter of the year.
NET REVENUES
Net revenues were $2,599 million for 1997, $2,376 million for 1996 and
$2,078 million for 1995. Net revenues increased from 1996 levels led by
increased customer related trading activity, a strong global market for mergers
and acquisitions and increased levels of worldwide debt and equity underwriting.
During the second half of 1997, the Company recorded net revenues of $1,423
million, its highest level of net revenues for any six month period since the
spin-off of Holdings. The 1996 increase in net revenues from 1995 reflected a
general strengthening in customer-related trading activities in a number of
fixed income product areas, increased levels of debt and equity underwriting and
improved corporate finance advisory results. Revenues in
15
<PAGE> 17
1995 were positively affected by increased underwriting volumes and customer
flow activity due to strong rallies in the stock and bond markets during the
last three quarters of the year.
Since 1990, Lehman Brothers has focused on a "client/customer-driven"
strategy. Under this strategy, Lehman Brothers concentrates on serving the needs
of major issuing and advisory clients and investing customers worldwide to build
an increasing flow of business that leverages the Company's research,
underwriting and distribution capabilities. Customer flow continues to be the
primary source of the Company's net revenues. In addition to its customer flow
activities, the Company also takes proprietary positions based upon expected
movements in interest rate, foreign exchange, equity and commodity markets in
both the short-and long-term. The Company's success in this area is dependent
upon its ability to anticipate economic and market trends and to develop trading
strategies that capitalize on these anticipated changes.
As part of its market-making activities, the Company maintains inventory
positions of varying amounts across a broad range of financial instruments,
which are marked-to-market on a daily basis and, along with the Company's
proprietary trading positions, give rise to principal transactions revenues. The
Company utilizes various hedging strategies to minimize its exposure to
significant movements in interest and foreign exchange rates and the equity
markets.
Net revenues from the Company's market-making and trading activities in
fixed income and equity products are recognized as either principal transactions
or net interest revenues, depending upon the method of financing and/or hedging
related to specific inventory positions. The Company evaluates its trading
strategies on an overall profitability basis which includes both principal
transaction revenues and net interest. Therefore, changes in net interest should
not be viewed in isolation but should be viewed in conjunction with revenues
from principal transactions. Combined principal transactions and net interest
revenues decreased $60 million in 1997 as compared to 1996. Lower results in
certain fixed income derivative products were partially offset by increased
principal transaction and net interest revenues across many of the Company's
fixed income and equity product lines.
During 1996, combined principal transactions and net interest revenues
increased $251 million from 1995, as a result of greater contributions from a
number of fixed income products
The following table of net revenues by business unit and the accompanying
discussion have been prepared in order to present the Company's net revenues in
a format that reflects the manner in which the Company manages its businesses.
For internal management purposes, the Company has been segregated into four
major business units: Fixed Income, Equity, Corporate Finance Advisory and
Merchant Banking. Each business unit represents a grouping of financial
activities and products with similar characteristics. These business activities
result in revenues that are recognized in multiple revenue categories contained
in the Company's Consolidated Statement of Income. Net revenues by business unit
contain certain internal allocations, including funding costs, which are
centrally managed.
TWELVE MONTHS ENDED NOVEMBER 30, 1997
<TABLE>
<CAPTION>
PRINCIPAL
TRANSACTIONS AND INVESTMENT
NET INTEREST COMMISSIONS BANKING OTHER TOTAL
---------------- ----------- ---------- ----- ------
<S> <C> <C> <C> <C> <C>
Fixed Income........................ $1,030 $ 40 $337 $ 3 $1,410
Equity.............................. 186 304 281 2 773
Corporate Finance Advisory.......... 246 246
Merchant Banking.................... (3) 131 128
Other............................... 8 6 3 25 42
------ ---- ---- ---- ------
$1,221 $ 350 $998 $ 30 $2,599
====== ==== ==== ==== ======
</TABLE>
16
<PAGE> 18
TWELVE MONTHS ENDED NOVEMBER 30, 1996
<TABLE>
<CAPTION>
PRINCIPAL
TRANSACTIONS AND INVESTMENT
NET INTEREST COMMISSIONS BANKING OTHER TOTAL
---------------- ----------- ---------- ----- ------
<S> <C> <C> <C> <C> <C>
Fixed Income........................ $1,236 $ 51 $279 $1,566
Equity.............................. 51 230 245 $ 2 528
Corporate Finance Advisory.......... 200 200
Merchant Banking.................... (15) 47 32
Other............................... 9 17 8 16 50
------ ---- ---- ---- ------
$1,281 $ 298 $779 $ 18 $2,376
====== ==== ==== ==== ======
</TABLE>
TWELVE MONTHS ENDED NOVEMBER 30, 1995
<TABLE>
<CAPTION>
PRINCIPAL
TRANSACTIONS AND INVESTMENT
NET INTEREST COMMISSIONS BANKING OTHER TOTAL
---------------- ----------- ---------- ----- ------
<S> <C> <C> <C> <C> <C>
Fixed Income........................ $ 963 $ 84 $158 $ 9 $1,214
Equity.............................. 96 286 196 578
Corporate Finance Advisory.......... 186 186
Merchant Banking.................... (36) 77 9 50
Other............................... 7 25 4 14 50
------ ---- ---- ---- ------
$1,030 $ 395 $621 $ 32 $2,078
====== ==== ==== ==== ======
</TABLE>
The following discussion provides an analysis of the Company's net revenues
based upon the various business units which generated these revenues.
Fixed Income. The Company's fixed income revenues reflect customer flow
activities (both institutional and high-net-worth retail), secondary trading,
debt underwriting, syndicate and financing activities related to fixed income
products. Fixed income products include dollar and non-dollar government
securities, mortgage-and asset-backed securities, money market products, dollar
and non-dollar corporate debt securities, emerging market securities, municipal
securities, financing (global access to debt financing sources including
repurchase and reverse repurchase agreements), foreign exchange, and fixed
income derivative products. Lehman Brothers is one of the leading primary
dealers in U.S. government securities. The Company is also a dominant
market-maker for a broad range of fixed income products.
Fixed income revenues were $1,410 million for 1997, $1,566 million for 1996
and $1,214 million for 1995. During 1997, lower revenues from fixed income
derivatives and foreign exchange were partially offset by improved revenues from
high yield and preferreds. During 1997, the Company continued to focus its
resources and efforts towards growing its market share in higher margin
products. The Company's fixed income business benefited in 1997 from active
customer trading combined with increased levels of worldwide debt underwriting
which resulted from the favorable U.S. macroeconomic environment. High yield
benefitted from an increased volume of lead managed underwritings and syndicated
loans. Holdings and its subsidiaries lead-managed over $4.3 billion of offerings
in fiscal 1997 up from $2.3 billion in fiscal 1996. Reduced contributions from
fixed income derivatives and foreign exchange resulted from significant
volatility in the Asian markets.
Holdings and its subsidiaries lead-managed fixed income offerings in fiscal
1997 increased 29% with underwritings of $132 billion compared to underwritings
of $102 billion in fiscal 1996 based on information supplied by Securities Data
Company.
During 1996, fixed income revenues increased from 1995 primarily as a
result of stronger customer trading volumes reflecting a strengthening in the
U.S. economy, a reduced U.S. federal deficit and relatively low levels of
inflation. The improved market conditions in the U.S. led to a significant
increase in debt underwriting revenues and greater contributions from customer
flow and trading activities in a number of fixed income products including
mortgages, fixed income derivatives and high yield and high-grade corporate
bonds.
17
<PAGE> 19
Equity. Equity net revenues reflect customer flow activities (both
institutional and high-net-worth retail), secondary trading, equity
underwriting, equity finance and arbitrage activities.
Equity revenues were $773 million for 1997, $528 million for 1996 and $578
million for 1995. The results for the Company's equity business increased 46%
versus 1996 primarily due to the continued favorable equity markets which
existed for most of the year combined with the successful redirection of the
Company's resources into higher margin products. Equity underwriting volumes for
1997 were at an all-time high for the securities industry. Equity underwriting,
equity arbitrage and improved customer flow activities were the primary
contributors to the increase in revenues for 1997.
The improvement in equity underwriting revenues during fiscal 1997 resulted
from an improved product mix as Holdings and its subsidiaries increased its
common stock lead-managed underwriting volume by 27% with a 4.6% market share
which was improved from the 3.7% market share attained in fiscal 1996.
Equity revenues decreased in 1996 as compared to 1995, as improved
underwriting results were more than offset by reduced trading revenues
(principal transactions, net interest and commissions). The increase in
underwriting revenues reflected the favorable economic environment with improved
underwriting volumes, increased trading volumes on domestic exchanges and record
flows of capital into U.S. equity mutual funds. The decrease in trading revenues
reflected reduced profitability from certain products in 1996, including
financing and equity arbitrage. Holdings and its subsidiaries ranked third in
total NYSE listed trading volume throughout all of 1997, 1996 and 1995.
Corporate Finance Advisory. Corporate finance advisory net revenues,
classified in the Consolidated Statement of Income as a component of investment
banking revenues, result primarily from fees earned by the Company in its role
as strategic advisor to its clients. This role primarily consists of advising
clients on mergers and acquisitions, divestitures, leveraged buyouts, financial
restructurings, and a variety of cross-border transactions. The net revenues for
corporate finance advisory increased in 1997 to $246 million from $200 million
in 1996 and from $186 million in 1995. The increased revenues reflected the
closing of several large deals in 1997 and continued strength in the overall
merger and acquisition market environment. Holdings and its subsidiaries ended
fiscal 1997 with a strong transaction pipeline which stood at $81 billion in
terms of total dollar value based on information supplied by Securities Data
Company.
Merchant Banking. The Company is the general partner for five active
merchant banking partnerships. Current merchant banking investments held by the
partnerships include both publicly traded and privately held companies. Merchant
banking net revenues primarily represent the Company's proportionate share of
net realized and unrealized gains and losses from the sale and revaluation of
investments held by the partnerships. Such amounts are classified in the
Consolidated Statement of Income as a component of investment banking revenues.
Merchant banking net revenues also reflect the net interest expense relating to
the financing of the Company's investment in the partnerships. Merchant banking
net revenues were $128 million, $32 million and $50 million for 1997, 1996 and
1995, respectively. The increase in 1997 compared to 1996 was principally due to
realized gains on the sales of the partnerships' interests in certain
investments. The decrease in 1996 compared to 1995 was principally due to a
reduction in the net gains recognized on the publicly traded investments held by
the partnerships.
NON-INTEREST EXPENSES
During 1997, the Company's non-interest expenses totaled $2,006 million.
Non-interest expenses were $2,067 million for 1996, including a severance charge
of $23 million. Non-interest expenses were $2,000 million for 1995, including a
restructuring charge of $43 million. Excluding these special charges,
non-interest expenses were $2,044 million for 1996 and $1,957 million for 1995.
Professional services expenses increased to $82 million in 1997 from $69
million in 1996 as a result of increased system development costs which includes
costs associated with the Year 2000 initiative. Brokerage, commissions and
clearance fees declined to $191 million in 1997 from $205 million in 1996 as a
result of the renegotiation of certain contracts partially offset by increased
customer trading volumes.
18
<PAGE> 20
Management fees represent the allocation of various charges, such as
compensation and benefits, occupancy, administration and computer processing
between the Company, Holdings and other affiliates based upon certain allocation
methods. During fiscal 1997, the decrease in management fees was a result of
reduced affiliate activities on behalf of LBI as well as increased Company
activities on behalf of affiliates.
Cost Reduction Effort. At year-end 1994, Holdings announced a cost
reduction program aimed at reducing its expenses by a target of $300 million on
an annualized basis. The targets included personnel cost savings of $100
million, nonpersonnel cost savings of $150 million and interest and tax expense
savings of $50 million. By year-end 1995, Holdings surpassed its targets and
achieved $326 million of cost savings. During 1996, Holdings achieved an
additional $56 million of cost savings across numerous expense categories as a
result of the continuing systematic and comprehensive global review of all major
expense categories.
The Company's expense base was permanently lowered as a result of Holdings'
cost reduction efforts. However, the Company's cost structure differs from
Holdings in that the Company's management fees are subject to fluctuation due to
changes in the nature and levels of intercompany services provided.
The Company believes that while the absolute level of its expense base may
increase in response to related increases in revenue levels (due to the
variability of certain expenses), the cost savings achieved as a result of its
cost reduction efforts are permanent.
1996 Severance Charge. Holdings recorded an $84 million severance charge
($50 million aftertax) in the fourth quarter of 1996 related to certain
strategic actions taken to improve ongoing profitability. As a result, the
Company recorded a $23 million severance charge ($14 million aftertax) in the
fourth quarter of 1996 related to these actions. The 1996 severance charge
reflected the culmination of Holdings' worldwide business unit economic
performance review that was undertaken in the fourth quarter of 1996 to focus
Holdings on its core investment banking, equity and fixed income sales and
trading areas. This formalized review resulted in personnel reductions of
approximately 270 people across a number of underperforming fixed income and
equity businesses, including exiting the precious metals business in the U.S.,
Europe and Asia; exiting energy trading in the U.S. and Europe; consolidating
Asian fixed income risk management activities into one center in Tokyo;
refocusing foreign exchange trading activities, and combining the New York
Private Client Services offices. Additionally, the charge reflects various other
strategic personnel reductions aimed at delayering management.
The Holdings 1996 severance charge has led to personnel cost savings of
approximately $90 million annually. Holdings' charge also resulted in a
permanent decrease in nonpersonnel expenses of approximately $20 million
annually. Holdings intends to reinvest substantially all these savings into
certain businesses to expedite the Holdings' strategic initiatives; these
actions are expected to result in improved operating revenues.
Cash outlays relating to the charge were approximately $12 million in the
fourth quarter of 1996 and approximately $11 million during fiscal 1997.
1995 Restructuring Charge. The restructuring charge in 1995 included a $26
million occupancy-related real estate charge and a $17 million severance charge.
The real estate component of the charge resulted from a complete review of the
Company's real estate requirements at current headcount levels and the
elimination of excess real estate, primarily in New York, London and Tokyo. This
charge included costs to write-down the carrying value of leasehold
improvements, as well as projected shortfalls of sublease rentals versus
expected operating costs related to the Company's excess capacity. The excess
real estate capacity resulted from headcount reductions associated with the
Company's cost reduction efforts. The severance component of the charge related
to payments made to terminated personnel arising from a formalized fourth
quarter business unit productivity review.
INCOME TAXES
The Company had an income tax provision of $202 million, $120 million and
$9 million for 1997, 1996 and 1995, respectively. The 1997 income tax provision
reflects an overall higher level of earnings and an increase in tax benefits
attributable to income subject to preferential tax treatment as compared to 1996
and
19
<PAGE> 21
1995. The 1996 income tax provision includes a tax benefit of $10 million
related to the 1996 severance charge. The 1995 income tax provision includes a
tax benefit of $17 million related to the restructuring charge.
The Company's net deferred tax asset decreased by $40 million to $39
million at November 30, 1997 from $79 million at November 30, 1996. It is
anticipated that the Company's net deferred tax asset will be realized through
future earnings. The Company's net deferred tax asset increased by $40 million
to $79 million at November 30, 1996 from $39 million at November 30, 1995.
As of November 30, 1997, the Company had approximately $44 million of net
operating loss carryforwards available to offset future taxable income.
LIQUIDITY AND CAPITAL RESOURCES
Overview
As a leading global investment bank that actively participates in the
global capital markets, the Company has large and diverse capital requirements.
Many of the businesses in which the Company operates are capital intensive.
Capital is required to finance, among other things, the Company's securities
inventories, underwriting activities, principal investments, merchant banking
activities and investments in fixed assets.
The Company's balance sheet is liquid and consists primarily of cash and
cash equivalents, securities and other financial instruments owned, and
collateralized short-term financing agreements. The liquid nature of these
assets provides the Company with flexibility in financing and managing its
business. The Company's primary activities are based on the execution of
customer-related transactions. This flow of customer business supports the rapid
asset turnover rate of the Company's inventory.
The Company's total assets increased to $114.3 billion at November 30, 1997
from $107.7 billion at November 30, 1996 reflecting an increase in securities
purchased under agreements to resell as well as the strategic expansion of
certain business lines. The Company's continued focus on growing higher margin
businesses resulted in increased levels of mortgages, corporate bonds and
stocks, and derivative inventory positions at November 30, 1997 compared to
November 30, 1996.
Funding and Capital Policies
The Company's Finance Committee is responsible for establishing and
managing the funding and liquidity policies of the Company. These policies
include recommendations for capital and balance sheet size as well as the
allocation of capital and balance sheet to product areas. Under the authority of
the Finance Committee, members of the Company's treasury department work with
Regional Asset and Liability Committees to ensure coordination of global funding
efforts and implementation of the funding and liquidity policies. The Regional
Asset and Liability Committees are aligned with the Company's geographic funding
centers and are responsible for implementing funding strategies for their
respective regions.
The primary goal of the Company's funding policies is to provide sufficient
liquidity and availability of funding sources across a wide range of market
environments. There are five key elements of its funding strategy that the
Company attempts to achieve:
(1) Maintain an appropriate Total Capital structure to support the
business activities in which the Company is engaged.
The Company manages Total Capital, defined as long-term debt,
preferred stock and common stockholder's equity, on a business and product
level. The determination of the amount of Total Capital assigned to each
business and product is a function of asset quality, market risk, liquidity
and regulatory capital requirements. The Company reallocates its capital to
businesses based upon their ability to obtain targeted returns, perceived
opportunities in the marketplace and the Company's long-term strategy. The
Company strives to have sufficient Total Capital to meet its anticipated
long-term capital needs which are driven by cash capital (liquidity),
regulatory capital and market and credit risk requirements, and continually
monitors its Total Capital needs by employing models which measure its
market, credit and liquidity risks.
20
<PAGE> 22
(2) Minimize liquidity and refinancing risk by funding the Company's
assets on a global basis with secured and unsecured liabilities, which have
maturities equal to or exceeding the anticipated liquidation period of the
assets.
The Company continually reviews its mix of long- and short-term
borrowings as it relates to maturity matching and the availability of
secured and unsecured financing. In general, the Company finances its
equity investments in its subsidiaries with stockholder's equity and the
subordinated capital of subsidiaries is financed with a combination of
subordinated and senior long-term debt. Inventories and other short-term
assets are financed with a combination of short-term funding, floating rate
long-term debt and stockholder's equity. Fixed assets, property, plant and
equipment are generally financed with longer-dated fixed rate debt. Where
the Company deems it to be appropriate and to minimize currency risks,
foreign currency denominated assets are financed with corresponding foreign
currency denominated liabilities.
(3) Maintain sufficient financial resources to enable the Company to
meet its obligations in a period of financial stress through a combination
of collateralized short-term financings and Total Capital, as well as the
implementation of a contingency funding plan. Financial stress is defined
as any event which severely constrains the Company's access to unsecured
funding sources.
To achieve this objective, the Company strives to maximize its use of
global collateralized borrowing sources and reduce its reliance upon
short-term unsecured borrowings. In addition, the Company's liquidity
policies include maintaining sufficient excess unencumbered securities to
use as collateral, if necessary, to obtain secured financing to meet
maturities of short-term unsecured liabilities as well as current
maturities of long-term debt. Also, the Company strives to maintain a
sufficient amount of Total Capital to enable the Company to support all
assets not readily pledgeable to counterparties and to meet secured
borrowing advance rates as determined by reference to the Company's bank
lenders and other secured lending counterparties, should unsecured sources
of borrowings no longer be available. In this regard, the Company believes
that increasing Total Capital will provide additional liquidity to cover
periods of financial stress and further advance the Company's liquidity
management objectives. Lastly, the Company periodically tests its secured
and unsecured credit facilities to ensure availability and operational
readiness. These policies position the Company to meet its liquidity
requirements in all periods including those of financial stress. The
Company maintains a comprehensive one-year contingency funding plan. The
plan is reviewed and approved by the Company's Finance Committee annually.
(4) Obtain diversified funding through a global investor base which
maximizes liquidity and reduces concentration risk.
The Company obtains global funding from both the banking community and
short- and long-term investors. In addition to maintaining geographic
diversification, the Company also utilizes a broad range of debt
instruments, which it issues in varying maturities and currencies.
The Company issues both commercial paper and other short-term debt
instruments, including master notes, corporate and retail deposits, and
bank borrowings under uncommitted lines of credit and other uncommitted
arrangements. To reduce liquidity and concentration risk, the Company
carefully manages its maturities to avoid large refinancings on any one
given day, and limits its exposure to any single investor or type of
investor.
(5) Maintain funding availability in excess of actual utilization.
The Company maintains sizable uncommitted lines of credit from a broad
range of banks and financial institutions from which it draws funds in a
variety of currencies and which provide an additional source of liquidity.
Uncommitted lines consist of facilities that the Company has been advised
are available but for which no contractual lending obligations exists.
Short-Term Funding
The Company strives to maximize the portion of the Company's balance sheet
that is funded through collateralized borrowing sources, which in turn minimizes
the reliance placed upon unsecured short-term debt.
21
<PAGE> 23
Collateralized borrowing sources include cash market securities and other
financial instruments sold but not yet purchased, as well as collateralized
short-term financings, defined as securities sold under agreements to repurchase
("repos") and securities loaned. Because of their secured nature, OECD
government repos and certain other types of collateralized borrowing sources are
less credit-sensitive and have historically been a more stable financing source
under adverse market conditions.
The amount of the Company's collateralized borrowing activities will vary
reflecting changes in the mix and overall levels of securities and other
financial instruments owned and global market conditions. The majority of the
Company's assets are funded with collateralized borrowing sources. At November
30, 1997 and 1996, $77 billion and $75 billion, respectively, of the Company's
total balance sheet was financed using collateralized borrowing sources.
Total Capital
In accordance with the Company's liquidity plan, the Company increased its
Total Capital base in 1997 to $6.6 billion at November 30, 1997 from $5.9
billion at November 30, 1996. Total Capital increased primarily due to an
increase in long-term debt and the retention of earnings.
<TABLE>
<CAPTION>
NOVEMBER 30
----------------------------
1997 1996 1995
------ ------ ------
(IN MILLIONS)
<S> <C> <C> <C>
LONG-TERM DEBT
Senior Notes................................................... $ 229 $ 215 $ 420
Subordinated Indebtedness...................................... 4,313 3,950 3,077
------ ------ ------
4,542 4,165 3,497
STOCKHOLDER'S EQUITY............................................. 2,011 1,692 2,028
------ ------ ------
TOTAL CAPITAL.................................................... $6,553 $5,857 $5,525
====== ====== ======
</TABLE>
During 1997, the Company issued $1,108 million in long-term debt, which was
$357 million in excess of its maturing debt. Long-term debt increased to $4.5
billion at November 30, 1997 from $4.2 billion at November 30, 1996 with a
weighted average maturity of 4.5 years at November 30, 1997 and 1996.
[LONG-TERM DEBT GRAPH]
At November 30, 1997, the Company had approximately $1.1 billion available
for the issuance of debt securities under various shelf registrations.
The increase in Total Capital also reflects an increase in stockholder's
equity to $2.0 billion at November 30, 1997 from $1.7 billion at November 30,
1996. The net increase in stockholder's equity was
22
<PAGE> 24
primarily due to the retention of earnings partially offset by the payment of
$75 million to Holdings as a return of capital.
Credit Ratings
The Company, like other companies in the securities industry, relies on
external sources to finance a significant portion of its day-to-day operations.
The Company's access to and cost of funding is generally dependent upon its
short- and long-term debt ratings. In January 1998, S&P upgraded its ratings
outlook on the Company to "stable" and reaffirmed the Company's long-term debt
rating. As of November 30, 1997, the short- and long-term senior debt ratings of
Lehman Brothers Inc. ("LBI") were as follows:
<TABLE>
<CAPTION>
LBI
--------------------------
SHORT-TERM LONG-TERM**
---------- -----------
<S> <C> <C>
Duff & Phelps Credit Rating Co....................... D-1 A/A-
Fitch IBCA, Inc...................................... F-1 A/A-
Moody's.............................................. P2 A3*/Baa1
S&P.................................................. A-1 A+*/A
Thomson BankWatch.................................... TBW-1 A/A-
</TABLE>
-----------------------
* Provisional ratings on shelf registration
** Senior/subordinated
Regulatory Capital
LBI, as a registered broker-dealer, is subject to SEC Rule 15c3-1, the Net
Capital Rule, which requires LBI to maintain net capital of not less than the
greater of 2% of aggregate debit items arising from customer transactions, as
defined, or 4% of funds required to be segregated for customers' regulated
commodity accounts, as defined. At November 30, 1997, LBI's regulatory net
capital, as defined, of $1,484 million exceeded the minimum requirement by
$1,359 million.
The Company's "AAA" rated derivatives subsidiary, Lehman Brothers Financial
Products Inc. ("LBFP"), has established certain capital and operating
restrictions which are reviewed by various rating agencies. At November 30,
1997, LBFP had capital which exceeded the requirement of the most stringent
rating agency by approximately $100 million.
Repayment of subordinated indebtedness and certain advances and dividend
payments by LBI are restricted by the regulations of the SEC and other
regulatory agencies. In addition, certain instruments governing the indebtedness
of LBI contractually limit its ability to pay dividends. At November 30, 1997,
$1,603 million of net assets of the Company were restricted as to the payment of
dividends, principally as a result of regulations of the SEC and other
regulatory agencies.
Cash Flows
Cash and cash equivalents decreased $176 million in 1997 to $220 million,
as the net cash used in operating and investing activities exceeded the net cash
provided by financing activities. Net cash used in operating activities of
$5,108 million included income adjusted for non-cash items of $516 million for
1997. Net cash provided by financing activities was $4,951 million and net cash
used in investing activities was $19 million.
Cash and cash equivalents increased $109 million in 1996 to $396 million,
as the net cash provided by financing activities exceeded the net cash used in
operating and investing activities. Net cash used in operating activities of
$1,442 million included income from continuing operations adjusted for non-cash
items of $176 million for 1996. Net cash provided by financing activities was
$1,558 million and net cash used in investing activities was $7 million.
23
<PAGE> 25
Cash and cash equivalents decreased $74 million in 1995 to $287 million, as
the net cash used in financing and investing activities exceeded the net cash
provided by operating activities. Net cash provided by operating activities of
$2,037 million included income from continuing operations adjusted for non-cash
items of $219 million for 1995. Net cash used in financing and investing
activities was $2,090 million and $21 million, respectively.
High Yield Securities
The Company underwrites, trades, invests and makes markets in high yield
corporate debt securities. The Company also syndicates, trades and invests in
loans to below investment grade-rated companies. For purposes of this
discussion, high yield debt securities are defined as securities or loans to
companies rated BB+ or lower, or equivalent ratings by recognized credit rating
agencies, as well as non-rated securities or loans which, in the opinion of
management, are non-investment grade. Non-investment grade securities generally
involve greater risks than investment grade securities due to the issuer's
creditworthiness and the liquidity of the market for such securities. In
addition, these issuers have higher levels of indebtedness, resulting in an
increased sensitivity to adverse economic conditions. The Company recognizes
these risks and aims to reduce market and credit risk through the
diversification of its products and counterparties. High yield debt securities
are carried at market value and unrealized gains or losses for these securities
are reflected in the Company's Consolidated Statement of Income. The Company's
portfolio of such securities at November 30, 1997 and 1996 included long
positions with an aggregate market value of approximately $2.6 billion and $1.3
billion, respectively, and short positions with an aggregate market value of
approximately $151 million and $99 million, respectively. The portfolio may,
from time to time, contain concentrated holdings of selected issues. The
Company's largest high yield position was $438 million at November 30, 1997. The
Company, subsequent to year end, participated a significant portion of this
position.
Lending Activities
The Company, through its high yield sales and trading activities, makes
commitments to extend credit in loan syndication transactions principally to
below investment grade borrowers and participates a significant portion of these
commitments. These commitments, which totaled $1.4 billion at November 30, 1997,
are typically secured against the borrower's assets and have fixed maturity
dates. The draw down of these facilities is generally contingent upon certain
representations, warranties and contractual conditions of the borrower. The
total commitments may not be indicative of actual funding requirements as they
may expire without being drawn upon and the Company may participate additional
amounts in the normal course of its business.
Merchant Banking and Related Lending Activities
The Company's merchant banking activities include investments in five
partnerships, for which the Company acts as general partner, as well as direct
investments. At November 30, 1997, these investments totalled $47 million. The
Company's policy is to carry its investments, including its partnership
interests, at fair value based upon the Company's assessment of the underlying
investments.
In September 1997, Holdings established a $2.0 billion fund for which the
Company will act as general partner. The Company has commitments to invest up to
an additional $325 million in the partnerships, which in turn will make direct
merchant banking related investments. These commitments will be funded as
required through the end of the respective partnerships' investment periods,
principally expiring in 2004.
The Company is also a sponsor of a fund to provide interim acquisition
facilities. In connection therewith, the Company may provide up to $150 million
to be used by the fund to provide short-term acquisition financing. Any draw
downs under the facility are expected to be repaid within a short-term period.
In addition, at November 30, 1997, the Company had no short-term bridge
financings outstanding.
24
<PAGE> 26
Non-Core Activities and Investments
In March 1990, the Company discontinued the origination of partnerships
(the assets of which are primarily real estate) and investments in real estate.
Currently, Holdings and the Company act as general partner or co-general partner
for approximately $2.3 billion of partnership investment capital and manage the
remaining real estate investment portfolio. At November 30, 1997, the Company
had $29 million of net exposure to these real estate activities, including
investments, commitments and contingent liabilities under guarantees and credit
enhancements. The Company believes any exposure under these commitments and
contingent liabilities has been adequately reserved. In certain circumstances,
the Company has elected to provide financial and other support and assistance to
such investments to maintain investment values. There is no contractual
requirement that the Company continue to provide this support.
Management's intention with regard to non-core assets is the prudent
liquidation of these investments as and when possible.
OFF-BALANCE SHEET FINANCIAL INSTRUMENTS AND DERIVATIVES
Overview
Derivatives are financial instruments, which include swaps, options,
futures, forwards and warrants, whose value is based upon an underlying asset
(e.g., treasury bond), index (e.g., S&P 500) or reference rate (e.g., LIBOR). A
derivative contract may be traded on an exchange or negotiated in the
over-the-counter markets. Exchange-traded derivatives are standardized and
include futures, warrants and certain option contracts listed on an exchange.
Over-the-counter ("OTC") derivative contracts are individually negotiated
between contracting parties and include forwards, swaps and certain options,
including caps, collars and floors. The use of derivative financial instruments
has expanded significantly over the past decade. One reason for this expansion
is that derivatives provide a cost effective alternative for managing market
risk. In this regard, derivative contracts provide a reduced funding alternative
for managing market risk since derivatives are based upon notional values, which
are generally not exchanged, but rather are used merely as a basis for
exchanging cash flows during the duration of the contract. Derivatives are also
utilized extensively as highly effective tools that enable users to adjust risk
profiles, such as interest rate, currency, or other market risks, or to take
proprietary trading positions, since OTC derivative instruments can be tailored
to meet individual client needs. Additionally, derivatives provide users with
access to market risk management tools which are often unavailable in
traditional cash instruments.
Derivatives are subject to various risks similar to non-derivative
financial instruments including market, credit and operational risk. Market risk
is the potential for a financial loss due to changes in the value of derivative
financial instruments due to market changes, including changes in interest
rates, foreign exchange rates and equity and commodity prices. Credit risk
results from the possibility that a counterparty to a derivative transaction may
fail to perform according to the terms of the contract. Therefore, the Company's
exposure to credit risk is represented by its net receivable from derivative
counterparties, after consideration of collateral. Operational risk is the
possibility of financial loss resulting from a deficiency in the Company's
systems for executing derivative transactions. In addition to these risks,
counterparties to derivative financial instruments may also be exposed to legal
risks related to derivative activities, including the possibility that a
transaction may be unenforceable under applicable law. The risks of derivatives
should not be viewed in isolation but rather should be considered on an
aggregate basis along with the Company's other trading-related activities.
As derivative products have continued to expand in volume, so has market
participation and competition. As a result, additional liquidity has been added
into the markets for conventional derivative products, such as interest rate
swaps. Competition has also contributed to the development of more complex
products structured for specific clients. It is this rapid growth and complexity
of certain derivative products which has led to the perception, by some, that
derivative products are unduly risky to users and the financial markets. In
order to remove the public perception that derivatives may be unduly risky and
to ensure ongoing liquidity of derivatives in the marketplace, the Company
supports the efforts of the regulators in striving for enhanced risk management
disclosures which consider the effects of both derivative products and cash
instruments. In
25
<PAGE> 27
addition, the Company supports the activities of regulators which are designed
to ensure that users of derivatives are fully aware of the nature of risks
inherent within derivative transactions. As evidence of this support, the
Company is an active participant in the Derivative Policy Group and has been
actively involved with the various regulatory and accounting authorities in the
development of additional enhanced reporting requirements related to
derivatives. The Company strongly believes that derivatives provide significant
value to the financial markets and is committed to providing its clients with
innovative products to meet their financial needs.
Lehman Brothers' Use of Derivative Instruments
In the normal course of business, the Company enters into derivative
transactions both in a trading capacity and as an end user. As an end user, the
Company utilizes derivative products to adjust the interest rate nature of its
funding sources from fixed to floating interest rates and vice versa, and to
change the index upon which floating interest rates are based (e.g., Prime to
LIBOR) (collectively, "End User Derivative Activities"). For a further
discussion of the Company's End User Derivative Activities see Note 8 to the
Consolidated Financial Statements.
The Company utilizes derivative products in a trading capacity both as a
dealer to satisfy the financial needs of its clients and in each of its trading
businesses (collectively, "Trading-Related Derivative Activities"). The
Company's use of derivative products in its trading businesses is combined with
cash instruments to fully execute various trading strategies.
The Company conducts its derivative activities through a number of wholly
owned subsidiaries. The Company's fixed income derivative products business is
conducted through its special purpose subsidiary, Lehman Brothers Special
Financing Inc., and a separately capitalized "AAA" rated subsidiary, Lehman
Brothers Financial Products Inc. In addition, as a global investment bank, the
Company is also a market-maker in a number of foreign currencies and actively
trades in the global commodity markets. Counterparties to the Company's
derivative product transactions are primarily financial intermediaries (U.S. and
foreign banks), securities firms, corporations, governments and their agencies,
finance companies, insurance companies, investment companies and pension funds.
The Company manages the risks associated with derivatives on an aggregate
basis, along with the risks associated with its proprietary trading and
market-making activities in cash instruments, as part of its firmwide risk
management policies. For a further discussion of the Company's risk management
policies refer to Management's Discussion and Analysis pages 27-30.
The Company's Trading-Related Derivative Activities have increased during
the current year to a notional value of $1,524 billion at November 30, 1997 from
$1,406 billion at November 30, 1996, primarily as a result of growth in the
Company's activities as a dealer in fixed income derivative products. Notional
values are not recorded on the balance sheet and are not indicative of actual or
potential risk, but rather they provide a measure of the Company's involvement
with such instruments.
As a result of the Company's Trading-Related Derivative activities, the
Company is subject to credit risk. With respect to OTC derivative contracts, the
Company's credit exposure is directly with its counterparties and extends
through the duration of the derivative contracts. The Company views its net
credit exposure to be $4,473 million at November 30, 1997 (including $684
million from affiliates), representing the fair value of the Company's OTC
contracts in an unrealized gain position, after consideration of collateral and
master netting agreements. Collateral held related to OTC contracts generally
includes cash and U.S. government and federal agency securities. At November 30,
1997 approximately 88% of the Company's net credit risk exposure related to OTC
contracts was with counterparties rated "A-" or better.
Additionally, the Company is exposed to credit risk related to its
exchange-traded derivative contracts. Exchange-traded derivative contracts
include futures contracts, warrants and certain options. Futures contracts and
options on futures are transacted on the respective exchange. The exchange
clearing house is a counterparty to the futures contracts and options. As a
clearing member firm, the Company is required by the exchange clearing house to
deposit cash or other securities as collateral for its obligation upon the
origination
26
<PAGE> 28
of the contract and for any daily changes in the market value of open futures
contracts. Unlike OTC derivatives which involve numerous counterparties, the
number of counterparties from exchange-traded derivatives includes only those
exchange clearing houses of which the Company is a clearing member firm or other
member firms the Company utilizes as agents. Substantially all of the Company's
exchange-traded derivatives are transacted on exchanges of which the Company is
a clearing member firm. To protect against the potential for a default, all
exchange clearing houses impose net capital requirements for their membership.
Therefore, the potential for losses from exchange-traded products is limited. As
of November 30, 1997, the Company had approximately $523 million on deposit with
futures exchanges consisting of cash and securities (customer and proprietary),
and had posted approximately $157 million of letters of credit to domestic
exchanges. Included within these amounts was $458 million and $65 million of
cash and securities related to domestic and foreign futures exchanges,
respectively. In addition, the Company had approximately $361 million of cash
and securities (customer and proprietary) on deposit with affiliates, acting as
the Company's clearing broker related to futures contracts. These deposits
primarily relate to futures contracts on foreign exchanges.
See Note 8 to the Consolidated Financial Statements for a further
discussion of the Company's Trading-Related Derivative Activities.
Accounting and Valuation
The Company's accounting methodology for derivatives depends on both the
type and purpose of the derivative financial instrument. The Company records its
Trading-Related Derivative Activities on a mark-to-market or fair value basis.
Under mark-to-market or fair value accounting, realized and unrealized gains and
losses are recognized currently in Principal transactions, and resulting assets
and liabilities are recorded in the Consolidated Statement of Financial
Condition as Derivatives and other contractual agreements, as applicable.
Derivative assets and liabilities are netted by counterparty, when permitted
under a legally enforceable master netting agreement. Derivatives utilized in
conjunction with the Company's End User Derivative Activities are generally
recorded on an accrual basis. Interest is accrued into income or expense over
the life of the contract, resulting in the net interest impact of the derivative
and the underlying hedged item being recognized in income throughout the hedge
period.
Market or fair value for Trading-Related Derivative Activities is generally
determined by either quoted market prices or pricing models. Pricing models
utilize a series of market inputs to determine the present value of future cash
flows, with adjustments, as required, for credit risk, liquidity risk, and
ongoing costs. Further valuation adjustments may be recorded, as deemed
appropriate, for new or complex products or for significant positions. These
adjustments are integral components of the mark-to-market process.
RISK MANAGEMENT
As a leading global investment banking company, risk is an inherent part of
the Company's businesses. Global markets, by their nature, are prone to
uncertainty and subject participants to a variety of risks. The Company has
developed policies and procedures to identify, measure and monitor each of the
risks involved in its trading, brokerage and investment banking activities on a
global basis. The principal risks of Lehman Brothers are market, credit,
liquidity, legal and operational risks. Risk Management is considered to be of
paramount importance. The Company devotes significant resources across all of
its worldwide trading operations to the measurement, management and analysis of
risk, including investments in personnel, information technology infrastructure
and systems.
The Company seeks to reduce risk through the diversification of its
businesses, counterparties and activities in geographic regions. The Company
accomplishes this objective by allocating the usage of capital to each of its
businesses, establishing trading limits for individual products and traders and
setting credit limits for individual counterparties, including regional
concentrations. The Company seeks to achieve adequate returns from each of its
businesses commensurate with the risks that they assume. The Company
periodically reallocates capital to its businesses based on their ability to
obtain returns consistent with the established guidelines, opportunities in the
marketplace and the Company's long-term strategy.
27
<PAGE> 29
The Company's risk management strategy is headed by a Risk Management
Committee (the "Committee") comprised of the Chief Executive Officer, the Chief
Administrative Officer, Global Equity Division Head, Global Fixed Income
Division Head, European Senior Manager, Asian Senior Manager, Chief Financial
Officer, and Global Risk Manager. The Committee brings together senior
management with the sole intent of discussing risk related issues and provides
an effective forum for managing risk at the highest levels within the Company.
The Committee reviews risk exposures, ratifies division risk limits and
signs-off on risk management guidelines. The Committee meets on a monthly basis,
or more frequently if required, to discuss, among other matters, significant
market exposures, concentrations of positions (e.g., counterparty, market risk),
potential new transactions or positions and risk limit exceptions. Senior
management plays a critical role in the ongoing evaluation of risks and adjusts
risk management policies when necessary.
Overall risk management is based on a multi-tiered approach which includes
many independent groups (i.e., the Risk Management Committee, the Global Risk
Management Group, Operations, Audit, Finance, Legal and Treasury) that assist in
the identification, assessment and control of risk. Senior representatives from
these groups meet formally on a regular basis and on an ad hoc basis as
necessary.
Global Risk Management Group
The Global Risk Management Group (the "Group") is independent of the
trading areas and reports directly to the Chief Executive Officer. The Group
combines two disciplines, market risk management and credit risk management,
into one unit. This facilitates the analysis of market and counterparty credit
risk exposures and leverages personnel and information technology resources in a
cost-efficient manner. The Group also functions as the executive branch of the
Risk Management Committee. In addition to regular meetings at the senior
management level, the Group operates in each of the Company's regional trading
centers and has daily contact with trading staff at all levels within the
Company. These discussions include a review of trading positions and risk
exposures.
The Group utilizes qualitative as well as quantitative information in
managing trading risk, believing that a combination of the two approaches
results in a more robust and complete approach to the management of trading
risk. Quantitative information is developed from a variety of risk methodologies
based upon established statistical principles. These methodologies have been
financially engineered across a global technology platform, enabling the Company
to view risk from a number of perspectives, from the trade level to the desk
level and, ultimately, across the Company. To ensure high standards of
qualitative analysis, the Company has retained seasoned market and credit risk
managers with the requisite experience, academic and professional credentials.
The Company is committed to ensuring that individuals within the Group are
qualified with the skills necessary to assess the Company's risk exposures.
The Group is responsible for the preparation and dissemination of risk
reports, developing and implementing the firmwide Risk Management Guidelines and
evaluating adherence to these guidelines. The purpose of market risk management
guidelines is to address the review and approval of risk limits, the monitoring
and reporting of risks against such limits, the reporting of risk limit
exceptions, the review and approval of risk limit exceptions, as well as
identifying the requisite authorities governing these processes. These
guidelines provide a clear framework for risk management decision-making. To
that end, the Group identifies and quantifies risk exposures, develops limits,
and reports and monitors these risks with respect to the approved limits. The
identification of material market risks inherent in positions includes, but is
not limited to, interest rate, equity, and foreign exchange risk exposures. In
addition to these risks, the Group also evaluates liquidity risks, credit and
sovereign concentrations.
Credit risk management is an integral component of the Company's overall
risk management framework. The Credit Risk Management Department ("CRM
Department"), part of the Global Risk Management Group, has global
responsibility for establishing credit risk standards and defining the Company's
overall credit risk management framework. The Company recognizes that the credit
"risk appetite" is a finite resource and emphasizes the importance of allocating
this resource in such a way as to maximize the Company's profitability.
28
<PAGE> 30
The CRM Department is independent from the business units and reports
directly to the Global Risk Manager, who, in turn, reports to the Chief
Executive Officer. Corporate Credit is a global department centered in and
managed from New York, with credit officers operating in each of the Company's
regional trading centers.
The CRM Department manages the credit exposure related to its trading
activities by giving initial credit approval for counterparties, establishing
credit limits by counterparty, country and industry group and by requiring
collateral in appropriate circumstances. In addition, the CRM Department strives
to ensure that master netting agreements are obtained whenever possible. The CRM
Department also considers the duration of transactions in making its credit
decisions, along with the potential credit exposure for complex derivative
transactions. The CRM Department is responsible for the continuous monitoring
and review of counterparty credit exposure and counterparty creditworthiness.
Credit limits are reviewed periodically to ensure that they remain appropriate
in light of market events or the counterparty's financial condition.
Market Risk
Market risk represents the potential change in value of a portfolio of
financial instruments due to changes in market rates, prices, and volatilities.
Market risk is present in cash products, derivatives, and contingent claim
structures that exhibit linear as well as non-linear profit and loss
sensitivity. The Company's exposure to market risk varies in accordance with the
volume of client driven market-making transactions, the size of the Company's
proprietary and arbitrage positions, and the volatility of financial instruments
traded. The Company seeks to mitigate, whenever possible, excess market risk
exposures through the use of futures and option contracts and offsetting cash
market instruments.
The Company participates globally in interest rate, equity, and foreign
exchange markets. The Company's fixed income division has a broadly diversified
market presence in U.S. and foreign government bond trading, emerging market
securities, corporate debt (investment and non-investment grade), money market
instruments, mortgages and mortgage-backed securities, asset-backed securities,
municipal bonds, and interest rate derivatives. The Company's equity division
facilitates domestic and foreign trading in equity instruments, indices, and
related derivatives. The Company's foreign exchange businesses are involved in
trading currencies on a spot and forward basis as well as through derivative
products and contracts.
Interest Rate Risk. The Company incurs short-term interest rate risk when
facilitating the orderly flow of customer transactions through the management of
government and high-grade corporate bond inventories. Market-making in high
yield instruments exposes the Company to additional risk due to potential
variations in credit spreads. Trading in international markets exposes the
Company to spread risk between the term structure of interest rates in differing
countries. Mortgage related securities are subject to prepayment risk and
changes in the level of interest rates. Trading in derivatives and structured
products exposes the Company to changes in the level and volatility of interest
rates. The Company actively manages interest rate risk through the use of
interest rate futures, options, swaps, forwards, and offsetting cash market
instruments. Inventory holdings, concentrations, and agings are monitored
closely and used by management to selectively hedge or liquidate undesirable
exposures.
Equity Price Risk. The Company is a significant intermediary in the global
equity markets by making markets in U.S. and non-U.S. equity securities,
including common stock, convertible debt, exchange-traded and OTC equity
options, equity swaps and warrants. These activities expose the Company to
market risk as a result of price and volatility changes in its equity inventory.
Inventory holdings are also subject to market risk resulting from
concentrations, aging and liquidity that may adversely impact its market
valuation. Equity market risk is actively managed through the use of index
futures, exchange-traded and OTC options, swaps and cash instruments. Equity
risk exposures are aggregated and reported to management on a regular basis.
Foreign Exchange Risk. The Company enters into foreign exchange
transactions in order to facilitate the purchase and sale of non-dollar
instruments, including equity and interest rate securities. The Company is
exposed to foreign exchange risk on its holdings of non-dollar assets and
liabilities. The Company is active in many foreign exchange markets and has
exposure to the German mark, Japanese yen, British pound, Swiss
29
<PAGE> 31
franc, French franc, Canadian dollar and Italian lira. The Company hedges its
risk exposures primarily through the use of currency forwards, swaps, futures,
and options.
Value at Risk
For purposes of new Securities and Exchange Commission disclosure
requirements, the Company has elected to disclose an entity-wide value at risk
analysis of virtually all of the Company's trading activities. The value at risk
related to non-trading financial instruments has been excluded from this
analysis and not reported separately because the amounts were not material. The
value at risk calculation measures potential losses in expected revenues and is
based on a methodology which uses a one-day holding period and a 95% confidence
level. Value at risk was measured by analyzing the distribution of trading
revenues during the year and assumes a relatively consistent portfolio mix.
Value at risk is one measurement of potential losses in revenues that may
result from adverse market movements over a specified period of time with a
selected likelihood of occurrence. Value at risk has substantial limitations,
including its reliance on historical performance and data as valid predictors of
the future. Consequently, value at risk is only one of a number of tools the
Company utilizes in its daily risk management activities.
At November 30, 1997, the Company's value at risk for each component of
market risk and in total was as follows (in millions):
<TABLE>
<S> <C>
Interest rate risk................................... $ 9.8
Equity price risk.................................... 4.7
Foreign exchange risk................................ 1.3
Diversification benefit.............................. (4.8)
-----
Total Company........................................ $11.0
=====
</TABLE>
As discussed throughout Management's Discussion and Analysis, the Company
seeks to reduce risk through the diversification of its businesses and a focus
on customer flow activities. This diversification and focus, combined with the
Company's risk management controls and processes, helps mitigate the net revenue
volatility inherent in the Company's trading activities. Average weekly trading
revenue was $27.0 million in 1997. Although historical performance is not
necessarily indicative of future performance, the Company believes its focus on
business diversification and customer flow activities should continue to help
mitigate the volatility of future net trading revenues.
IMPACT OF THE YEAR 2000
The Year 2000 issue is the result of many computer programs being written
using two digits rather than four to define the applicable year. Any of the
Company's computer programs that have date-sensitive software may recognize a
date using "00" as the year 1900 rather than the year 2000. This could result in
a system failure or miscalculations causing disruptions of operations,
including, among other things, a temporary inability to process transactions or
engage in normal business activities.
The Company has determined that it will be required to modify or replace
portions of its software so that its computer systems will properly utilize
dates beyond December 31, 1999. The Company presently believes that with
modifications to existing software and conversions to new software, the Year
2000 issue will be mitigated. However, if such modifications and conversions are
not made, or are not completed on a timely basis, the Year 2000 issue could have
a material impact on the operations of the Company.
The Company has initiated formal communications with all of its suppliers
(hardware, software, market data, voice and data communications, facility
components and services) to determine the extent to which the Company is
vulnerable to those third parties' failure to remediate their respective Year
2000 issue. The Company has taken a lead in industry efforts to deal with the
Year 2000 issue by actively participating in the planning of industrywide
testing in 1998 and 1999. Industrywide testing is the forum in which firms
within the
30
<PAGE> 32
financial industry test the applications that transfer data between them.
However, there can be no guarantee that the systems of other companies on which
the Company's systems rely will be timely converted, or that a failure to
convert by another company, or a conversion that is incompatible with the
Company's systems, would not have a material adverse effect on the Company.
The Company will utilize both internal and external resources to reprogram,
or replace, and test software for Year 2000 modifications. The Company plans to
complete the Year 2000 project, including industrywide testing, no later than
August 1999.
The Company's total Year 2000 project cost includes the estimated costs and
time associated with the impact of a third party's Year 2000 issue, and are
based on presently available information. The total remaining cost of the Year
2000 project is estimated at approximately $9 million which will be funded
through operating cash flows and expensed as incurred over the next two and
one-half years. To date, the Company has incurred and expensed approximately $2
million related to the Year 2000 project.
The costs of the project and the date on which the Company plans to
complete the Year 2000 modifications are based on management's best estimates,
which were derived utilizing numerous assumptions of future events including the
continued availability of certain resources, third party modification plans and
other factors. However, there can be no guarantee that these estimates will be
achieved and actual results could differ materially from those plans. Specific
factors that might cause such material differences include, but are not limited
to, the availability and cost of personnel trained in this area, the ability to
locate and correct all relevant computer codes, and similar uncertainties.
NEW ACCOUNTING DEVELOPMENTS
In June 1996, the Financial Accounting Standards Board (the "FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 125, "Accounting for
Transfers and Servicing of Financial Assets and Extinguishments of Liabilities"
("SFAS No. 125"), which is effective for transactions occurring after December
31, 1996. In December 1996, the FASB issued SFAS No. 127, "Deferral of the
Effective Date of Certain Provisions of FASB Statement No. 125", which defers
the effective date until January 1, 1998 for certain provisions of SFAS No. 125.
SFAS No. 125 provides accounting and reporting standards for transfers and
servicing of financial assets and extinguishments of liabilities. Those
standards are based on consistent application of a financial components approach
that focuses on control. Under that approach, after a transfer of financial
assets, an entity recognizes the financial and servicing assets it controls and
the liabilities it has incurred, derecognizes the financial assets when control
has been surrendered, and derecognizes liabilities when extinguished. This
statement provides consistent standards for distinguishing transfers of
financial assets that are sales from transfers that are secured borrowings.
The Company expects that the full adoption of SFAS No. 125 will not result
in the material recognition of additional assets and liabilities on its
Consolidated Statement of Financial Condition, and will have no effect on the
equity or results of operations of the Company.
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive
Income" ("SFAS No. 130"). SFAS No. 130 establishes standards for the reporting
and display of comprehensive income and its components in the financial
statements. SFAS No. 130 is effective for fiscal years beginning after December
15, 1997. Reclassification of financial statements for earlier periods provided
for comparative purposes is required. The adoption of SFAS No. 130 will have no
impact on the Company's consolidated statement of income, financial condition or
cash flows.
In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of
an Enterprise and Related Information" ("SFAS No. 131"). SFAS No. 131
establishes standards for the way that public business enterprises report
information about operating segments in annual financial statements and requires
that those enterprises report selected information about operating segments in
interim financial reports issued to shareholders. It also establishes standards
for related disclosures about products and services, geographic areas, and major
customers. SFAS No. 131 is effective for financial statements for fiscal years
beginning after
31
<PAGE> 33
December 15, 1997. Financial statement disclosures for prior periods are
required to be restated. The adoption of SFAS No. 131 will have no impact on the
Company's consolidated statement of income, financial condition or cash flows.
In August 1997 the FASB released for comment portions of its proposed
standard entitled "Accounting for Derivative Instruments and for Hedging
Activities" (the "Draft Standard"). The Draft Standard provides comprehensive
accounting guidance for the recognition and measurement of derivatives and other
similar financial instruments used in hedging activities (collectively referred
to as "derivatives"). The Draft Standard would require all derivatives to be
recorded on the Consolidated Statement of Financial Condition as assets or
liabilities at fair value. The Draft Standard also would require recognition of
changes in the fair value of derivatives either in net income or in a separate
component of stockholders' equity, depending on the designation of the
derivative. The accounting basis for the hedged item would be adjusted,
depending on the designation of the derivative, by an amount offsetting the gain
or loss on the derivative instrument to the extent it is considered an effective
hedge. As currently proposed, the Company would be required to adopt this Draft
Standard in fiscal year 2000. The Company is monitoring the development of final
rules and their potential impact on the Company's accounting for its end user
activities.
In December 1996, the Accounting Standards Executive Committee of the
American Institute of Certified Public Accountants released for comment a
proposed statement of position "Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use" (the "Proposed SOP"). In December 1997,
the FASB gave approval for its final issuance, which is expected in the first
calendar quarter of 1998. The Proposed SOP would require the capitalization of
certain costs incurred in connection with developing or obtaining software for
internal use. The Proposed SOP would be effective for years ending after
December 15, 1998 with earlier application encouraged. When adopted, the rule
would be applied prospectively as of the beginning of an entity's fiscal year.
The Company is currently considering early adoption of these rules once they
become finalized.
RECENT DEVELOPMENTS
In December 1997, the Company, without admitting or denying any wrongdoing,
announced that it, along with 29 other broker-dealers settled a class action
alleging violations of the antitrust law with respect to certain practices on
the NASDAQ market, in the 1980's and early 1990's, primarily when the Firm
operated as Shearson Lehman Brothers. The Company's share of the settlement cost
was approximately $95 million and was charged against existing reserves. In
addition, this amount may be reduced by a recovery from a third party.
EFFECTS OF INFLATION
Because the Company's assets are, to a large extent, liquid in nature, they
are not significantly affected by inflation. However, the rate of inflation
affects the Company's expenses, such as employee compensation, office space
leasing costs and communications charges, which may not be readily recoverable
in the price of services offered by the Company. To the extent inflation results
in rising interest rates and has other adverse effects upon the securities
markets, it may adversely affect the Company's financial position and results of
operations in certain businesses.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information under the caption "Risk Management" on pages 27-30 hereof
is incorporated herein by reference.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements and supplementary financial information required
by this Item and included in this Report are listed in the Index to Financial
Statements and Schedules appearing on page F-l and are incorporated herein by
reference.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
32
<PAGE> 34
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Pursuant to General Instruction I of Form 10-K, the information required by
Item 10 is omitted.
ITEM 11. EXECUTIVE COMPENSATION
Pursuant to General Instruction I of Form 10-K, the information required by
Item 11 is omitted.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Pursuant to General Instruction I of Form 10-K, the information required by
Item 12 is omitted.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Pursuant to General Instruction I of Form 10-K, the information required by
Item 13 is omitted.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) 1. Financial Statements:
See Index to Financial Statements and Schedules appearing on page F-l.
2. Financial Statement Schedules:
Schedules are omitted since they are not required or are not
applicable.
3. Exhibits:
<TABLE>
<CAPTION>
EXHIBIT
NO.
- -------
<C> <S>
3.1 Restated Certificate of Incorporation of the Registrant dated May 27, 1994
(incorporated by reference to Exhibit 3.1 of the Registrant's Transition Report on
Form 10-K for the eleven months ended November 30, 1994).
3.2 By-Laws of the Registrant, amended as of March 26, 1997 (incorporated by reference to
Exhibit 10 of the Registrant's Quarterly Report on Form 10-Q for the quarter ended
February 28, 1997).
4.1 The instruments defining the rights of holders of the long-term debt securities of
the Registrant and its subsidiaries are omitted pursuant to section (b)(4)(iii)(A) of
Item 601 of Regulation S-K. The Registrant hereby agrees to furnish copies of these
instruments to the Securities and Exchange Commission upon request.
10.1 Agreement of Tenants-In-Common by and among American Express Company, American
Express Bank Ltd., American Express Travel Related Services Company, Inc., Shearson
Lehman Brothers Inc., Shearson Lehman Government Securities, Inc. and Shearson Lehman
Commercial Paper Incorporated (incorporated by reference to Exhibit 10.1 of Lehman
Brothers Holdings Inc.'s Transition Report on Form 10-K for the eleven months ended
November 30, 1994.)
12.1 Computation in support of ratio of earnings to fixed charges.*
21.1 Pursuant to General Instruction I of Form 10-K, the list of the Registrant's
Subsidiaries is omitted.
23.1 Consent of Ernst & Young LLP.*
24.1 Powers of Attorney.*
27.1 Financial Data Schedule.*
</TABLE>
(b) Reports on Form 8-K.
None.
- ---------------
* Filed herewith.
33
<PAGE> 35
SIGNATURES
Pursuant to the Requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form
10-K to be signed on its behalf by the undersigned, thereunto duly authorized.
LEHMAN BROTHERS INC.
Dated: February 27, 1998
By: /s/ KAREN M. MULLER
------------------------------------
Title: Managing Director
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
SIGNATURES TITLE DATE
- ------------------------------------------ -------------------------------- ------------------
<C> <C> <S>
* Chief Executive Officer and February 27, 1998
- ------------------------------------------ Chairman of the Board
Richard S. Fuld, Jr. of Directors
(principal executive officer)
* Chief Financial Officer and February 27, 1998
- ------------------------------------------ Director
Charles B. Hintz (principal financial and
accounting officer)
* Director February 27, 1998
- ------------------------------------------
Roger S. Berlind
* Director February 27, 1998
- ------------------------------------------
Howard L. Clark, Jr.
* Director February 27, 1998
- ------------------------------------------
Frederick Frank
* Director February 27, 1998
- ------------------------------------------
Harvey M. Krueger
* Director February 27, 1998
- ------------------------------------------
Bruce R. Lakefield
* Director February 27, 1998
- ------------------------------------------
Sherman R. Lewis
*By: /s/ KAREN M. MULLER
- ------------------------------------------
Attorney-in-Fact
February 27, 1998
</TABLE>
34
<PAGE> 36
LEHMAN BROTHERS INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
FINANCIAL STATEMENTS PAGE
- ------------------------------------------------------------------------------------ ----
<S> <C>
Report of Independent Auditors...................................................... F-2
Consolidated Statement of Income for the Twelve Months Ended November 30, 1997,
November 30, 1996 and November 30, 1995........................................... F-3
Consolidated Statement of Financial Condition at November 30, 1997 and November 30,
1996.............................................................................. F-4
Consolidated Statement of Changes in Stockholder's Equity for the Twelve Months
Ended November 30, 1997, November 30, 1996 and November 30, 1995.................. F-5
Consolidated Statement of Cash Flows for the Twelve Months Ended November 30, 1997,
November 30, 1996 and November 30, 1995........................................... F-6
Notes to Consolidated Financial Statements.......................................... F-7
</TABLE>
F-1
<PAGE> 37
REPORT OF INDEPENDENT AUDITORS
The Board of Directors and Stockholder of
Lehman Brothers Inc.
We have audited the accompanying consolidated statement of financial
condition of Lehman Brothers Inc. and Subsidiaries (the "Company") as of
November 30, 1997 and 1996, and the related consolidated statements of income,
changes in stockholder's equity, and cash flows for each of the three years in
the period ended November 30, 1997. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Lehman Brothers
Inc. and Subsidiaries at November 30, 1997 and 1996, and the consolidated
results of its operations and its cash flows for each of the three years ended
November 30, 1997 in conformity with generally accepted accounting principles.
ERNST & YOUNG LLP
New York, New York
January 7, 1998
F-2
<PAGE> 38
LEHMAN BROTHERS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF INCOME
<TABLE>
<CAPTION>
TWELVE MONTHS ENDED
NOVEMBER 30
------------------------------
1997 1996 1995
------ ------- -------
(IN MILLIONS)
<S> <C> <C> <C>
REVENUES
Principal transactions....................................... $ 848 $ 937 $ 695
Investment banking........................................... 998 779 621
Commissions.................................................. 350 298 395
Interest and dividends....................................... 12,589 10,465 10,289
Other........................................................ 30 18 32
------- ------- -------
Total revenues............................................ 14,815 12,497 12,032
Interest expense............................................. 12,216 10,121 9,954
------- ------- -------
Net revenues.............................................. 2,599 2,376 2,078
------- ------- -------
NON-INTEREST EXPENSES
Compensation and benefits.................................... 1,288 1,219 1,106
Brokerage, commissions and clearance fees.................... 191 205 192
Communications............................................... 89 94 120
Professional services........................................ 82 69 79
Business development......................................... 70 70 80
Occupancy and equipment...................................... 68 75 85
Depreciation and amortization................................ 52 53 63
Management fees.............................................. 88 211 188
Other........................................................ 78 48 44
Severance charge............................................. 23
Restructuring charge......................................... 43
------- ------- -------
Total non-interest expenses............................... 2,006 2,067 2,000
------- ------- -------
Income before taxes............................................ 593 309 78
Provision for income taxes................................... 202 120 9
------- ------- -------
Net income..................................................... $ 391 $ 189 $ 69
======= ======= =======
</TABLE>
See Notes to Consolidated Financial Statements.
F-3
<PAGE> 39
LEHMAN BROTHERS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF FINANCIAL CONDITION
<TABLE>
<CAPTION>
NOVEMBER 30
---------------------
1997 1996
-------- --------
(IN MILLIONS)
<S> <C> <C>
ASSETS
Cash and cash equivalents........................................................ $ 220 $ 396
Cash and securities segregated and on deposit for regulatory and other
purposes....................................................................... 1,128 663
Securities and other financial instruments owned:
Governments and agencies....................................................... 17,467 21,251
Corporate stocks............................................................... 5,439 3,164
Corporate debt and other....................................................... 5,544 4,739
Derivatives and other contractual agreements................................... 5,528 5,298
Mortgages and mortgage-backed.................................................. 2,751 2,055
Certificates of deposit and other money market instruments..................... 2,248 3,819
-------- --------
38,977 40,326
-------- --------
Collateralized short-term agreements:
Securities purchased under agreements to resell................................ 49,610 33,145
Securities borrowed............................................................ 13,661 19,035
Receivables:
Brokers, dealers and clearing organizations.................................... 3,148 4,909
Customers...................................................................... 3,874 3,956
Others......................................................................... 3,107 4,611
Property, equipment and leasehold improvements (net of accumulated depreciation
and amortization of $533 in 1997 and $502 in 1996)............................. 262 283
Other assets..................................................................... 146 214
Excess of cost over fair value of net assets acquired (net of accumulated
amortization of $102 in 1997 and $94 in 1996).................................. 158 166
-------- --------
Total assets................................................................. $114,291 $107,704
========= =========
LIABILITIES AND STOCKHOLDER'S EQUITY
Commercial paper and short-term debt............................................. $ 740 $ 2,299
Securities and other financial instruments sold but not yet purchased:
Governments and agencies....................................................... 8,556 9,326
Corporate stocks............................................................... 3,124 1,143
Corporate debt and other....................................................... 1,664 2,735
Derivatives and other contractual agreements................................... 3,685 4,662
-------- --------
17,029 17,866
-------- --------
Collateralized short-term financing:
Securities sold under agreements to repurchase................................. 56,017 52,200
Securities loaned.............................................................. 7,764 10,085
Advances from Holdings and other affiliates...................................... 14,777 8,552
Payables:
Brokers, dealers and clearing organizations.................................... 3,127 2,200
Customers...................................................................... 6,118 6,395
Accrued liabilities and other payables........................................... 2,166 2,250
Long-term debt:
Senior notes................................................................... 229 215
Subordinated indebtedness...................................................... 4,313 3,950
-------- --------
Total liabilities............................................................ 112,280 106,012
-------- --------
Commitments and contingencies
STOCKHOLDER'S EQUITY
Preferred stock, $0.10 par value; 10,000 shares authorized; none outstanding...
Common stock, $0.10 par value; 10,000 shares authorized; 1,006 shares issued
and outstanding..............................................................
Additional paid-in capital..................................................... 1,756 1,828
Foreign currency translation adjustment........................................ 3 3
Retained earnings (accumulated deficit)........................................ 252 (139)
-------- --------
Total stockholder's equity................................................... 2,011 1,692
-------- --------
Total liabilities and stockholder's equity................................... $114,291 $107,704
========= =========
</TABLE>
See Notes to Consolidated Financial Statements.
F-4
<PAGE> 40
LEHMAN BROTHERS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDER'S EQUITY
<TABLE>
<CAPTION>
TWELVE MONTHS ENDED
NOVEMBER 30
----------------------------
1997 1996 1995
------ ------ ------
(IN MILLIONS)
<S> <C> <C> <C>
Additional paid-in capital
Beginning balance.............................................. $1,828 $2,353 $2,905
Capital contributions.......................................... 3 13 7
Capital distributions.......................................... (75) (538) (559)
------ ------ ------
Ending balance................................................... 1,756 1,828 2,353
------ ------ ------
Foreign currency translation adjustment
Beginning and ending balance................................... 3 3 3
------ ------ ------
Retained earnings (accumulated deficit)
Beginning balance.............................................. (139) (328) (321)
Net income..................................................... 391 189 69
Dividends...................................................... (76)
------ ------ ------
Ending balance................................................... 252 (139) (328)
------ ------ ------
Total stockholder's equity....................................... $2,011 $1,692 $2,028
====== ====== ======
</TABLE>
See Notes to Consolidated Financial Statements.
F-5
<PAGE> 41
LEHMAN BROTHERS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
<TABLE>
<CAPTION>
TWELVE MONTHS ENDED NOVEMBER 30
--------------------------------
1997 1996 1995
-------- ------- -------
(IN MILLIONS)
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES
Net income........................................................ $ 391 $ 189 $ 69
Adjustments to reconcile net income to net cash provided by (used
in) operating activities:
Depreciation and amortization................................... 52 53 63
Severance charge................................................ 23
Restructuring charge............................................ 26
Provisions for losses and other reserves........................ 52 40 37
Deferred tax (benefit) provision................................ (149) 5
Other adjustments............................................... 21 20 19
Net change in:
Cash and securities segregated and on deposit................... (465) 122 478
Receivables from brokers, dealers and clearing organizations.... 1,761 (3,191) 2,150
Receivables from customers................................... 82 (1,780) (770)
Securities purchased under agreements to resell................. (16,465) (7,163) 3,410
Securities borrowed............................................. 5,374 (2,473) (7,352)
Securities and other financial instruments owned................ 1,349 (8,133) (3,064)
Payables to brokers, dealers and clearing organizations......... 927 (1,022) 492
Payables to customers........................................... (277) 739 3,487
Accrued liabilities and other payables.......................... (135) 360 (1,636)
Securities sold under agreements to repurchase.................. 3,817 10,300 (2,274)
Securities loaned............................................... (2,321) 7,436 2,334
Securities and other financial instruments sold but not yet
purchased.................................................... (837) 5,469 3,019
Other operating assets and liabilities, net.................. 1,566 (2,282) 1,544
-------- ------- -------
Net cash provided by (used in) operating activities............. $ (5,108) $(1,442) $ 2,037
-------- ------- -------
CASH FLOWS FROM FINANCING ACTIVITIES
Principal payments of senior notes................................ $ (1) $ (210) $ (98)
Proceeds from issuance of subordinated indebtedness............... 1,108 1,130 250
Principal payments of subordinated indebtedness................... (750) (261) (64)
Net proceeds from (payments for) commercial paper and short-term
debt............................................................ (1,559) 1,290 (1,161)
Increase (decrease) in advances from Holdings and other
affiliates...................................................... 6,225 134 (389)
Capital contributions............................................. 3 13 7
Dividends and capital distributions paid.......................... (75) (538) (635)
-------- ------- -------
Net cash provided by (used in) financing activities............. 4,951 1,558 (2,090)
-------- ------- -------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of property, equipment and leasehold improvements........ (19) (7) (21)
-------- ------- -------
Net cash used in investing activities........................... (19) (7) (21)
-------- ------- -------
Net change in cash and cash equivalents......................... (176) 109 (74)
-------- ------- -------
Cash and cash equivalents, beginning of period.................... 396 287 361
-------- ------- -------
Cash and cash equivalents, end of period........................ $ 220 $ 396 $ 287
-------- ------- -------
</TABLE>
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION (IN MILLIONS)
Interest paid totaled $12,225 in 1997, $10,104 in 1996 and $9,985 in 1995.
Income taxes paid totaled $151 in 1997, $45 in 1996 and $194 in 1995.
See Notes to Consolidated Financial Statements.
F-6
<PAGE> 42
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The consolidated financial statements include the accounts of Lehman
Brothers Inc. ("LBI") and subsidiaries (collectively, the "Company"). The
Company is a wholly-owned subsidiary of Lehman Brothers Holdings Inc.
("Holdings"). LBI is one of the leading global investment banks serving
institutional, corporate, government and high-net-worth individual clients and
customers. The Company's worldwide headquarters in New York are complemented by
offices in additional locations in North America, Europe, the Middle East, Latin
America and the Asia Pacific Region. The Company is engaged in providing
financial services. All material intercompany accounts and transactions have
been eliminated in consolidation.
The consolidated financial statements are prepared in conformity with
generally accepted accounting principles which require management to make
estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes. Management believes that the estimates
utilized in preparing its financial statements are reasonable and prudent.
Actual results could differ from these estimates.
The Company uses the trade date basis of accounting.
Certain prior period amounts reflect reclassifications to conform to the
current period's presentation.
Translation of Foreign Currencies
Assets and liabilities of foreign subsidiaries having non-U.S. dollar
functional currencies are translated at exchange rates at the statement of
financial condition date. Revenues and expenses are translated at average
exchange rates during the period. The gains or losses resulting from translating
foreign currency financial statements into U.S. dollars, net of hedging gains or
losses and related tax effects, are included in a separate component of
stockholder's equity, the Foreign currency translation adjustment. Gains or
losses resulting from foreign currency transactions are included in the
Consolidated Statement of Income.
Securities and Other Financial Instruments
Securities and other financial instruments owned and securities and other
financial instruments sold but not yet purchased are valued at market or fair
value, as appropriate, with unrealized gains and losses reflected in Principal
transactions in the Consolidated Statement of Income. Market value is generally
based on listed market prices. If listed market prices are not available, fair
value is determined based on other relevant factors, including broker or dealer
price quotations and valuation pricing models which take into account time value
and volatility factors underlying the financial instruments.
Derivative Financial Instruments
Derivatives, typically defined as instruments whose value is "derived" from
an underlying instrument, index or rate, include futures, forwards, swaps and
options and other similar instruments. A derivative contract generally
represents future commitments to exchange interest or other payment streams
based on the contract or notional amount or to purchase or sell financial
instruments at specified terms and future dates. In the normal course of
business, the Company enters into derivative transactions both in a trading
capacity and as an end user. Acting in a trading capacity, the Company enters
into derivative transactions to satisfy the needs of its clients and to manage
the Company's own exposure to market and credit risks resulting from its trading
activities in cash instruments (collectively, "Trading-Related Derivative
Activities"). The Company's accounting methodology for derivatives depends on
both the type and purpose of the derivative financial instrument.
F-7
<PAGE> 43
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Derivative transactions entered into for Trading-Related Derivative
Activities are recorded at market or fair value with realized and unrealized
gains and losses reflected currently in Principal transactions in the
Consolidated Statement of Income. Market or fair value for trading related
instruments is generally determined by either quoted market prices (for
exchange-traded futures and options) or pricing models (for over-the-counter
swaps, forwards and options). Pricing models utilize a series of market inputs
to determine the present value of future cash flows, with adjustments, as
required for credit risk, liquidity risk and ongoing costs. Further valuation
adjustments may be recorded, as deemed appropriate for new or complex products
or for significant positions. These adjustments are integral components of the
mark-to-market process.
The market or fair value associated with derivatives utilized for trading
purposes is recorded in the Consolidated Statement of Financial Condition on a
net by counterparty basis where a legal right of set-off exists and is netted
across products and against cash collateral when such provisions are stated in
the master netting agreement. The market or fair value of swap agreements, caps
and floors, and forward contracts in an unrealized gain position, as well as
options owned and warrants held, are reported in the Consolidated Statement of
Financial Condition as assets in Derivatives and other contractual agreements.
Similarly, swap agreements, caps and floors, and forward contracts in an
unrealized loss position, as well as options written and warrants issued, are
reported in the Consolidated Statement of Financial Condition as liabilities in
Derivatives and other contractual agreements. Margin on futures contracts is
included in receivables and payables, as applicable.
In addition to Trading-Related Derivative Activities, the Company enters
into various derivative financial instruments for non-trading purposes as an end
user to modify the interest rate exposure of certain assets and liabilities. In
this regard, the Company utilizes interest rate swaps, caps, collars and floors
to manage the interest rate exposure associated with its long-term debt
obligations and secured financing activities, including securities purchased
under agreements to resell, securities borrowed, securities sold under
agreements to repurchase and securities loaned.
In addition to modifying the interest rate exposure of existing assets and
liabilities, the Company utilizes derivative financial instruments as an end
user to modify the interest rate characteristics of certain anticipated
transactions related to its secured financing activities, where there is a high
degree of certainty that the Company will enter into such contracts. These
derivative financial instruments are designated against existing secured
financing transactions based upon their applicable maturity. The remaining term
of the derivative financial instruments is designated against anticipated
secured financing transactions which will replace the existing secured financing
transactions upon maturity. The Company monitors the level of secured financing
transactions to ensure that there is a high degree of certainty that it will
enter into the anticipated secured financing transactions at a level in excess
of the designated derivative product transactions.
Derivatives that have been designated as non-trading related positions and
are effective in modifying the interest rate characteristics of existing assets
and liabilities or anticipated transactions are accounted for on an accrual
basis. Under the accrual basis, interest is accrued into income or expense over
the life of the contract, resulting in the net interest impact of the derivative
and the underlying hedged item being recognized in income throughout the hedge
period.
The Company monitors the effectiveness of its end user hedging activities
by periodically comparing the change in the value of the hedge instrument to the
underlying item being hedged and reassessing the likelihood of the occurrence of
anticipated transactions. In the event that the Company determines that a hedge
is no longer effective, such as upon extinguishment of the underlying asset or
liability or a change in circumstances whereby there is not a high degree of
certainty that the anticipated transaction will occur, the derivative
transaction is no longer accounted for as a hedge. Instead, the Company
immediately recognizes the market or fair value of the derivative financial
instrument through earnings. Changes in the fair value of the derivative
contract would then be accounted for as a derivative used for trading purposes
as discussed above. In the event that a derivative designated as a hedge is
terminated early, any realized gain or loss on the
F-8
<PAGE> 44
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
termination would be deferred and amortized to interest income or interest
expense over the original period of the hedge.
Repurchase and Resale Agreements
Securities purchased under agreements to resell and securities sold under
agreements to repurchase, which are treated as financing transactions for
financial reporting purposes, are collateralized primarily by government and
government agency securities and are carried net by counterparty, when
permitted, at the amounts at which the securities will be subsequently resold or
repurchased plus accrued interest. It is the policy of the Company to take
possession of securities purchased under agreements to resell. The Company
monitors the market value of the underlying positions on a daily basis as
compared to the related receivable or payable balances, including accrued
interest. The Company requires counterparties to deposit additional collateral
or return collateral pledged as necessary, to ensure that the market value of
the underlying collateral remains sufficient. Securities and other financial
instruments owned that are sold under repurchase agreements are carried at
market value with changes in market value reflected in the Consolidated
Statement of Income.
Securities purchased under agreements to resell and securities sold under
agreements to repurchase for which the resale/repurchase date corresponds to the
maturity date of the underlying securities are accounted for as purchases and
sales, respectively. At November 30, 1997, such resale and repurchase agreements
that had not yet matured aggregated $3.0 billion and $279 million, respectively.
Securities Borrowed and Loaned
Securities borrowed and securities loaned are carried at the amount of cash
collateral advanced or received plus accrued interest. It is the Company's
policy to value the securities borrowed and loaned on a daily basis and to
obtain additional cash as necessary to ensure such transactions are adequately
collateralized.
Income Taxes
The Company accounts for income taxes under the provisions of Statement of
Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes."
The Company recognizes the current and deferred tax consequences of all
transactions that have been recognized in the financial statements using the
provisions of the enacted tax laws. In this regard, deferred tax assets are
recognized for temporary differences that will result in deductible amounts in
future years and for tax loss carryforwards, if in the opinion of management, it
is more likely than not that the deferred tax asset will be realized. SFAS 109
requires companies to set up a valuation allowance for that component of net
deferred tax assets which does not meet the "more likely than not" criterion for
realization.
Property, Equipment and Leasehold Improvements
Property, equipment and leasehold improvements are recorded at historical
cost, net of accumulated depreciation and amortization. Depreciation is
recognized on a straight-line basis over the estimated useful lives of the
related assets. Leasehold improvements are amortized over the lesser of their
economic useful lives or the terms of the underlying leases.
Goodwill
Excess of cost over fair value of net assets acquired (goodwill) is
amortized using the straight-line method over a period of 35 years and is
evaluated periodically for impairment. Goodwill is also reduced upon the
recognition of certain acquired net operating loss carryforward benefits.
F-9
<PAGE> 45
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Statement of Cash Flows
The Company defines cash equivalents as highly liquid investments with
original maturities of three months or less, other than those held for sale in
the ordinary course of business.
Stock Based Awards
The Company's employees participate in Holdings' stock-based incentive
plans. Holdings accounts for these awards in accordance with Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" and
its related interpretations. The Company records as compensation and benefits
its allocated share of Holdings' stock-based compensation cost.
NOTE 2. SHORT-TERM FINANCINGS
The Company obtains short-term financing on both a secured and unsecured
basis. The secured financing is obtained through the use of repurchase
agreements and securities loaned agreements, which are primarily collateralized
by government, agency and equity securities. The unsecured financing is
generally obtained through short-term debt and the issuance of commercial paper.
The Company's commercial paper and short-term debt financing is comprised of the
following:
<TABLE>
<CAPTION>
NOVEMBER 30
---------------
1997 1996
---- ------
(IN MILLIONS)
<S> <C> <C>
Short-term debt
Payables to banks......................................... $460 $ 441
Master notes.............................................. 260 1,326
Bank loans................................................ 20 532
---- ------
Total....................................................... $740 $2,299
==== ======
</TABLE>
The Company's weighted average interest rates were as follows:
<TABLE>
<CAPTION>
NOVEMBER 30
---------------
1997 1996
---- ------
<S> <C> <C>
Short-term debt(1).......................................... 1.7% 5.6%
Securities sold under agreements to repurchase.............. 5.2% 5.4%
</TABLE>
- ---------------
(1) Including weighted average interest rates of 0.8% as of November 30, 1997
and 5.4% as of November 30, 1996 related to non-U.S. dollar obligations.
F-10
<PAGE> 46
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
NOTE 3. LONG-TERM DEBT
<TABLE>
<CAPTION>
U.S. DOLLAR NOVEMBER 30
-------------------------- NON-U.S. DOLLAR ---------------
FIXED RATE FLOATING RATE FLOATING RATE 1997 1996
---------- ------------- --------------- ------ ------
(IN MILLIONS)
<S> <C> <C> <C> <C> <C>
SENIOR NOTES
Maturing in Fiscal 1997... $ 10
Maturing in Fiscal 1998... $ 70 $ 8 $ 78 1
Maturing in Fiscal 1999... 1 1 21
Maturing in Fiscal 2000... 1 1 23
Maturing in Fiscal 2001... 148 148 158
Maturing in Fiscal 2002... 2
December 1, 2002 and
thereafter.............. 1 1
------ ------ ------ ------
--
Senior Notes......... 221 229 215
8
------ ------ ------ ------
--
SUBORDINATED INDEBTEDNESS
Maturing in Fiscal 1997... 900
Maturing in Fiscal 1998... 350 $ 10 360 815
Maturing in Fiscal 1999... 334 358 692 334
Maturing in Fiscal 2000... 192 192 192
Maturing in Fiscal 2001... 200 200 200
Maturing in Fiscal 2002... 250 1,055 1,305 250
December 1, 2002 and
thereafter.............. 1,431 133 1,564 1,259
------ ------ ------ ------
--
Subordinated
Indebtedness....... 2,757 1,556 4,313 3,950
------ ------ ------ ------
--
LONG-TERM DEBT............ $2,978 $ 1,556 $4,542 $4,165
$ 8
====== ====== ====== ======
==
</TABLE>
The Company's interest in 3 World Financial Center is financed with U.S.
dollar fixed rate senior notes totaling $217 million as of November 30, 1997. Of
this amount, $70 million was redeemed prior to maturity in December 1997 and is
reflected in the above table as maturing in fiscal 1998. These notes are
unconditionally guaranteed by American Express with a portion of these notes
being collateralized by certain mortgage obligations.
As of November 30, 1997, the Company had $1.1 billion available for the
issuance of debt securities under various shelf registrations.
End User Derivative Activities
The Company utilizes interest rate swaps as an end user to modify the
interest rate characteristics of its long-term debt portfolio. The Company
actively manages the interest rate exposure on its long-term debt portfolio to
more closely match the terms of its debt portfolio to the assets being funded
and to minimize interest rate risk. In certain instances, two or more derivative
contracts may be utilized by the Company to manage the interest rate nature of
an individual long-term debt issuance. In these cases, the notional value of the
derivative contracts may exceed the carrying value of the related long-term debt
issuance.
At November 30, 1997 and 1996, the notional values of the Company's
interest rate swaps related to its long-term debt obligations were approximately
$2.8 billion and $3.7 billion, respectively. In terms of notional amounts
outstanding, these derivative products mature as follows:
F-11
<PAGE> 47
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
<TABLE>
<CAPTION>
NOVEMBER 30
-----------------
1997 1996
------ ------
(IN MILLIONS)
<S> <C> <C>
Maturing in Fiscal 1997.................................... $1,451
Maturing in Fiscal 1998.................................... $ 419 350
Maturing in Fiscal 1999.................................... 334 355
Maturing in Fiscal 2000.................................... 192 215
Maturing in Fiscal 2001.................................... 200 225
Maturing in Fiscal 2002.................................... 250 250
December 1, 2002 and thereafter............................ 1,360 869
------ ------
Total................................................. $2,755 $3,715
====== ======
Weighted average rate:
Receive rate............................................... 7.79% 7.16%
Pay rate................................................... 6.81% 6.32%
</TABLE>
On an overall basis, the Company's long-term debt related end user
derivative activities resulted in reduced interest expense of approximately $26
million, $20 million and $29 million in 1997, 1996 and 1995, respectively. In
addition, the Company's end user derivative activities resulted in the following
changes to the Company's mix of fixed and floating rate debt and effective
weighted average rates of interest:
<TABLE>
<CAPTION>
NOVEMBER 30, 1997
--------------------------------------------------------
LONG-TERM DEBT WEIGHTED AVERAGE(1)
--------------------- ------------------------------
BEFORE AFTER CONTRACTUAL EFFECTIVE RATE
END USER END USER INTEREST AFTER END USER
ACTIVITIES ACTIVITIES RATE ACTIVITIES
-------- -------- ----------- --------------
(IN MILLIONS)
<S> <C> <C> <C> <C>
USD Obligations
Fixed rate.......................... $2,978 $ 224 7.99% 11.03%
Floating rate....................... 1,556 4,310 6.99% 6.85%
Non-USD Obligations................... 8 8 0.57% 0.57%
------ ------ ---- -----
Total............................ $4,542 $4,542 7.63% 7.04%
====== ====== ==== =====
</TABLE>
<TABLE>
<CAPTION>
NOVEMBER 30, 1996
--------------------------------------------------------
LONG-TERM DEBT WEIGHTED AVERAGE(1)
--------------------- ------------------------------
BEFORE AFTER CONTRACTUAL EFFECTIVE RATE
END USER END USER INTEREST AFTER END USER
ACTIVITIES ACTIVITIES RATE ACTIVITIES
-------- -------- ----------- --------------
(IN MILLIONS)
<S> <C> <C> <C> <C>
USD Obligations
Fixed rate.......................... $3,214 $ 408 7.99% 8.88%
Floating rate....................... 942 3,748 6.55% 6.66%
Non-USD Obligations................... 9 9 0.88% 0.88%
------ ------ ---- ----
Total............................ $4,165 $4,165 7.65% 6.87%
====== ====== ==== ====
</TABLE>
- ---------------
(1) Weighted average interest rates were calculated using non-U.S. dollar
interest rates, where applicable.
F-12
<PAGE> 48
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
NOTE 4. INCENTIVE PLANS
Employee Stock Purchase Plan
Holdings' Employee Stock Purchase Plan (the "ESPP") allows its employees to
purchase Holdings' common stock ("Common Stock") at a 15% discount from market
value, with a maximum of $25,000 in annual aggregate purchases by any one
individual. The number of shares of Common Stock authorized for purchase by
eligible employees is 6 million. As of November 30, 1997 and 1996, 1.6 million
shares and 1.2 million shares, respectively, of Common Stock had been purchased
by eligible employees of Holdings through the ESPP. Holdings controls the
dilutive impact of the ESPP through open market purchases.
1994 Incentive Plans
Holdings' 1994 Management Replacement Plan (the "Replacement Plan")
provided awards similar to the American Express common shares granted to
Holdings' employees which were canceled as of the date of the spin-off from
American Express. Through November 30, 1997, a total of 2.0 million awards had
been granted under the Replacement Plan, including both stock options and
restricted stock; 0.6 million were outstanding at November 30, 1997. No future
awards will be granted under this plan.
Holdings' 1994 Management Ownership Plan (the "1994 Plan") provides for the
issuance of restricted stock units ("RSUs"), performance stock units ("PSUs"),
stock options and other equity awards for a period of up to ten years to
eligible employees. A total of 16.6 million shares of Common Stock may be
granted under the 1994 Plan. At November 30, 1997, RSU and stock option awards
by Holdings with respect to 15.6 million shares of Common Stock have been made
under the 1994 Plan of which 14.0 million are outstanding and 1.6 million have
been converted to freely transferable Common Stock. Holdings will utilize the
remaining authorization of 1.0 million shares to satisfy dividend reinvestment
requirements for outstanding awards and to fund the annual RSU awards for
Holdings' non-employee directors.
1996 Management Ownership Plan
During 1996, Holdings' stockholders approved the 1996 Management Ownership
Plan (the "1996 Plan") under which awards similar to those of the 1994 Plan may
be granted and under which up to 10 million shares of Common Stock may be
subject to awards. At November 30, 1997, RSU and stock option awards by Holdings
with respect to 4.4 million shares of Common Stock have been made under the 1996
Plan, of which 4.3 million are outstanding and 0.1 million have been converted
to freely transferable Common Stock.
Employee Incentive Plan
Holdings' Employee Incentive Plan ("EIP") has provisions similar to the
1994 Plan and the 1996 Plan and authorization up to 30 million shares of Common
Stock which may be subject to awards. Holdings controls the dilutive impact of
these awards through open market purchases. At November 30, 1997, awards with
respect to 19.1 million shares of Common Stock have been made under the EIP of
which 19.0 million are outstanding and 0.1 million have been converted to freely
transferable Common Stock. Approximately 16.0 million of the outstanding awards
consist of RSUs which have vesting and transfer restrictions extending through
the year 2004.
F-13
<PAGE> 49
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Restricted Stock Units
The following is a summary of RSUs outstanding under Holdings' stock-based
incentive plans:
<TABLE>
<CAPTION>
1994 1996
PLAN PLAN EIP TOTAL
---------- --------- ---------- ----------
<S> <C> <C> <C> <C>
Balance, November 30, 1994................. 4,605,105 4,605,105
---------- --------- ---------- ----------
Granted.................................. 8,021,784 2,039,220 10,061,004
Canceled................................. (586,092) (586,092)
---------- --------- ---------- ----------
Balance, November 30, 1995................. 12,040,797 2,039,220 14,080,017
---------- --------- ---------- ----------
Granted.................................. 419,614 7,130,720 7,550,334
Canceled................................. (801,614) (405,575) (1,207,189)
Exchanged for stock without
restrictions.......................... (474,222) (474,222)
---------- --------- ---------- ----------
Balance, November 30, 1996................. 11,184,575 8,764,365 19,948,940
---------- --------- ---------- ----------
Granted.................................. 1,814,685 1,332,250 8,810,609 11,957,544
Canceled................................. (846,191) (1,530,562) (2,376,753)
Exchanged for stock without
restrictions.......................... (254,894) (139,371) (55,825) (450,090)
---------- --------- ---------- ----------
Balance, November 30, 1997................. 11,898,175 1,192,879 15,988,587 29,079,641
---------- --------- ---------- ----------
</TABLE>
Eligible employees receive RSUs as a portion of their total compensation in
lieu of cash. There is no further cost to employees associated with the RSU
awards. Holdings records compensation expense for RSUs based on the market value
of its Common Stock and the applicable vesting provisions. RSU awards made to
employees have various vesting provisions and generally convert to unrestricted
freely transferable Common Stock five years from the grant date. Holdings pays a
dividend equivalent on each RSU outstanding based on dividends paid on its
Common Stock.
Of the RSUs outstanding at November 30, 1997, approximately 13.8 million
RSUs were vested, approximately 1.4 million RSUs will vest during fiscal 1998,
and the remaining RSUs will vest subsequent to November 30, 1998.
Total compensation cost recognized by Holdings during 1997 and 1996 for
Holdings' stock based awards was approximately $162 million and $136 million,
respectively.
In addition to the RSUs included in the above table, subsequent to November
30, 1997, Holdings awarded PSUs under the 1996 Plan and under the EIP to certain
senior officers. The number of PSUs which may be earned is dependent upon the
achievement of certain performance levels within predetermined performance
periods. At the end of a performance period, any PSUs earned will convert
one-for-one to RSUs which then vest in three, four or five years. As of December
31, 1997, approximately 1.7 million PSUs have been earned to date, subject to
vesting and transfer restrictions.
The compensation cost for the RSUs payable in satisfaction of PSUs is
accrued over the combined performance and vesting periods.
F-14
<PAGE> 50
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Stock Options
<TABLE>
<CAPTION>
WEIGHTED-
AVERAGE
1994 REPLACEMENT 1996 EXERCISE EXPIRATION
PLAN PLAN PLAN EIP TOTAL PRICE DATES
--------- ----------- --------- --------- ---------- --------- ---------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance, November 30, 1994... 1,960,720 1,789,769 3,750,489 $18.00 2/95-5/04
--------- --------- --------- --------- ---------- ------- ---------
Granted.................... 1,125,000 1,400,000 2,525,000 $20.875 10/00
Exercised.................. (68,996) (68,996) $18.00
Canceled................... (7,040) (291,588) (298,628) $18.00
--------- --------- --------- --------- ---------- ------- ---------
Balance, November 30, 1995... 3,078,680 1,429,185 1,400,000 5,907,865 $18.68 5/96-5/04
--------- --------- --------- --------- ---------- ------- ---------
Granted.................... 825,000 2,650,000 3,475,000 $24.16 3/01-5/01
Exercised.................. (93,333) (251,909) (345,242) $18.00
Canceled................... (116,667) (22,247) (850,000) (988,914) $22.83
--------- --------- --------- --------- ---------- ------- ---------
Balance, November 30, 1996... 2,868,680.. 1,155,029 825,000 3,200,000 8,048,709 $20.58 2/97-5/04
--------- --------- --------- --------- ---------- ------- ---------
Granted.................... 2,250,000 2,250,000 $30.52 1/02-3/02
Exercised.................. (743,040) (521,192) (1,264,232) $18.85
Canceled................... (4,943) (150,000) (154,943) $23.81
--------- --------- --------- --------- ---------- ------- ---------
Balance, November 30, 1997... 2,125,640 628,894 3,075,000 3,050,000 8,879,534 $23.64 1/98-5/04
--------- --------- --------- --------- ---------- ------- ---------
</TABLE>
At November 30, 1997 and 1996, approximately 8.9 million and 2.6 million
options, respectively, were exercisable at weighted-average prices of $23.64 and
$18.00, respectively. The weighted average remaining contractual life of the
stock options outstanding at November 30, 1997 is 3.3 years. The exercise price
for all stock options awarded has been equal to 100% of the market price of
Common Stock on the day of grant. As a result of Holdings' stock price exceeding
specific target prices, all stock options outstanding as of November 30, 1997
are exercisable.
NOTE 5. CAPITAL REQUIREMENTS
As a registered broker dealer, LBI is subject to the Securities and
Exchange Commission ("SEC") Rule 15c3-1, the Net Capital Rule, which requires
LBI to maintain net capital of not less than the greater of 2% of aggregate
debit items arising from customer transactions, as defined, or 4% of funds
required to be segregated for customers' regulated commodity accounts, as
defined. At November 30, 1997, LBI's regulatory net capital, as defined, of
$1,484 million exceeded the minimum requirement by $1,359 million.
In addition to amounts presented in the accompanying Consolidated Statement
of Financial Condition as cash and securities segregated and on deposit for
regulatory and other purposes, securities with a market value of approximately
$1,290 million and $345 million at November 30, 1997 and 1996, respectively,
primarily collateralizing securities purchased under agreements to resell, have
been segregated in a special reserve bank account for the exclusive benefit of
customers pursuant to the Reserve Formula requirements of SEC Rule 15c3-3.
The Company's "AAA" rated derivatives subsidiary, Lehman Brothers Financial
Products Inc. ("LBFP"), has established certain capital and operating
restrictions which are reviewed by various rating agencies. At November 30,
1997, LBFP had capital which exceeded the requirement of the most stringent
rating agency by approximately $100 million.
Repayment of subordinated indebtedness and certain advances and dividend
payments by LBI are restricted by the regulations of the SEC and other
regulatory agencies. In addition, certain instruments governing the indebtedness
of LBI contractually limit its ability to pay dividends. At November 30, 1997,
$1,603 million of net assets of the Company were restricted as to the payment of
dividends, principally as a result of regulations of the SEC and other
regulatory agencies.
F-15
<PAGE> 51
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
NOTE 6. EMPLOYEE BENEFIT PLANS
Holdings provides various pension plans for the majority of its employees
worldwide. In addition, Holdings provides certain other postretirement benefits,
primarily health care and life insurance to eligible employees. The Company
records as compensation and benefits its allocated share of the cost of these
plans. The following summarizes these plans:
Pension Plan
The Company is the principal participant in a noncontributory, domestic,
defined benefit pension plan, sponsored by Holdings, which covers substantially
all Company employees. The cost of pension benefits for eligible employees,
measured by length of service, compensation and other factors, is currently
being funded through a trust established under the plan. Funding of retirement
costs for the applicable plans complies with the minimum funding requirements
specified by the Employee Retirement Income Security Act of 1974, as amended,
and other statutory requirements.
Net (income) expense related to Holdings' domestic defined benefit plan for
1997, 1996 and 1995 consisted of the following components:
<TABLE>
<CAPTION>
TWELVE MONTHS ENDED
NOVEMBER 30
----------------------
1997 1996 1995
---- ---- ----
(IN MILLIONS)
<S> <C> <C> <C>
Service cost -- benefits earned during the period..... $ 8 $ 7 $ 5
Interest cost on projected benefit obligation......... 29 28 26
Actual return on plan assets.......................... (74) (93) (72)
Net amortization and deferral......................... 23 48 37
---- ---- ----
Net (income) expense.................................. $(14) $(10) $(4)
==== ==== ====
</TABLE>
Plan assets within the trust consist principally of equities and bonds. The
actual return on plan assets for 1997, 1996 and 1995 reflects the favorable
market environments in those years. In addition, Company contributions increased
assets under investment in 1995.
The following table sets forth the funded status of Holdings' domestic
defined benefit plan:
<TABLE>
<CAPTION>
NOVEMBER 30
---------------
1997 1996
----- -----
(IN MILLIONS)
<S> <C> <C>
Actuarial present value of benefit obligations
Vested benefit obligation................................. $(444) $(389)
Accumulated benefit obligation............................ $(447) $(391)
----- -----
Projected benefit obligation................................ $(456) $(399)
----- -----
Plan assets at fair value................................... 618 560
----- -----
Plan assets in excess of projected benefit obligation....... 162 161
Unrecognized net loss....................................... 47 34
----- -----
Prepaid pension asset recognized in Holdings' Consolidated
Statement of Financial Condition.......................... $ 209 $ 195
----- -----
</TABLE>
The weighted average assumed discount rate used in determining the
actuarial present value of the projected benefit obligation for the plans was
7.0% and 7.5% in 1997 and 1996, respectively. The weighted
F-16
<PAGE> 52
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
average rate of increase in future compensation levels used was 5.0% for 1997
and 1996. The weighted average expected long-term rate of return on assets was
9.25% in 1997, 9.5% in 1996 and 9.75% in 1995.
Postretirement Benefits
The Company participates in several defined benefit health care plans
sponsored by Holdings that provide health care, life insurance and other
postretirement benefits to substantially all eligible retired employees. The
health care plans include participant contributions, deductibles, co-insurance
provisions and service-related eligibility requirements. The Company funds the
cost of these benefits as they are incurred.
Net periodic postretirement benefits cost for 1997, 1996, and 1995
consisted of the following components:
<TABLE>
<CAPTION>
TWELVE MONTHS ENDED
NOVEMBER 30
----------------------
1997 1996 1995
---- ---- ----
(IN MILLIONS)
<S> <C> <C> <C>
Service cost............................................ $ 1 $ 1 $ 1
Interest cost........................................... 3 3 4
Amortization of unrecognized net reduction in prior
service cost and unrecognized gain.................... (2) (1) (1)
---- ---- ----
Net periodic postretirement benefits cost............... $ 2 $ 3 $ 4
==== ==== ====
</TABLE>
The following table sets forth the amount recognized in the Consolidated
Statement of Financial Condition for Holdings' postretirement benefit plans
(other than pension plans):
<TABLE>
<CAPTION>
NOVEMBER 30
-------------
1997 1996
---- ----
(IN MILLIONS)
<S> <C> <C>
Accumulated postretirement benefit obligation
Retirees..................................................... $ 36 $ 36
Fully eligible active plan participants...................... 3 3
Other active plan participants............................... 10 10
---- ----
49 49
---- ----
Unrecognized net gain.......................................... 22 21
Unrecognized net reduction in prior service cost............... 7 8
---- ----
Accrued postretirement liability recognized in the Consolidated
Statement of Financial Condition............................. $ 78 $ 78
---- ----
</TABLE>
The discount rate used in determining the accumulated postretirement
benefit obligation was 7.0% and 7.5% in 1997 and 1996, respectively.
The annual assumed health care cost trend rate is 8.5% for the year ended
November 30, 1998 and is assumed to decrease at the rate of 0.5% per year to
5.5% in the year ended November 30, 2004 and remain at that level thereafter. An
increase in the assumed health care cost trend rate by one percentage point in
each period would increase the accumulated postretirement benefit obligation as
of November 30, 1997 by approximately $5 million.
NOTE 7. INCOME TAXES
The Company's income is included in the consolidated U.S. federal income
tax return of Holdings and its subsidiaries. The income tax provision for the
Company is computed in accordance with the tax sharing
F-17
<PAGE> 53
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
agreement between Holdings and its subsidiaries. In accordance with this
agreement, the balances due to Holdings at November 30, 1997 and 1996 were $232
million and $169 million, respectively.
The provision for income taxes consists of the following:
<TABLE>
<CAPTION>
TWELVE MONTHS ENDED
NOVEMBER 30
-----------------------
1997 1996 1995
---- ----- ----
(IN MILLIONS)
<S> <C> <C> <C>
CURRENT
Federal............................................ $ 84 $ 177 $ 15
State.............................................. 66 86 (15)
Foreign............................................ 52 6 4
---- ----- ----
202 269 4
---- ----- ----
DEFERRED
Federal............................................ 1 (101) (11)
State.............................................. (1) (48) 16
---- ----- ----
$202 $ 120 $ 9
==== ===== ====
</TABLE>
Income before taxes included $86 million, $22 million and $24 million that
is subject to income taxes of foreign jurisdictions for 1997, 1996 and 1995,
respectively.
The income tax provision (benefit) differs from that computed by using the
statutory federal income tax rate for the reasons shown below:
<TABLE>
<CAPTION>
TWELVE MONTHS ENDED
NOVEMBER 30
----------------------
1997 1996 1995
---- ---- ----
(IN MILLIONS)
<S> <C> <C> <C>
Federal income taxes at statutory rate................ $208 $108 $ 27
State and local taxes................................. 42 24 1
Tax-exempt income..................................... (45) (24) (31)
Amortization of goodwill.............................. 3 3 2
Other, net............................................ (6) 9 10
---- ---- ---
$202 $120 $ 9
==== ==== ===
</TABLE>
Deferred income taxes are provided for the differences between the tax
bases of assets and liabilities and their reported amounts in the consolidated
financial statements. These temporary differences will result in future income
or deductions for income tax purposes and are measured using the enacted tax
rates that will be in effect when such items are expected to reverse. The
Company provides deferred income taxes on undistributed earnings of foreign
subsidiaries.
F-18
<PAGE> 54
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
At November 30, 1997 and 1996 the deferred tax assets and liabilities
consisted of the following:
<TABLE>
<CAPTION>
NOVEMBER 30
-------------
1997 1996
---- ----
(IN MILLIONS)
<S> <C> <C>
Deferred tax assets:
Reserves not currently deductible........................... $27 $ 32
Unrealized trading and investment activity.................. 38 78
Other....................................................... 3 3
--- ----
68 113
Less: Valuation allowance..................................... 27 32
--- ----
Total deferred tax assets net of valuation allowance..... 41 81
--- ----
Deferred tax liabilities...................................... (2) (2)
Net deferred tax asset........................................ $39 $ 79
=== ====
</TABLE>
The net deferred tax assets are included in Other assets in the
accompanying Consolidated Statement of Financial Condition. At November 30,
1997, the valuation allowance recorded against deferred tax assets was $27
million compared to $32 million at November 30, 1996. The decrease in the
valuation allowance has no impact in the Company's Consolidated Statement of
Income since it was primarily associated with a corresponding decrease in the
Company's net deferred tax asset.
For tax return purposes, the Company has approximately $44 million of NOL
carryforwards, substantially all of which are attributable to the 1988
acquisition of E.F. Hutton Group, Inc., (now known as LB I Group Inc.). For book
purposes, the net deferred tax assets associated with the NOL carryforward has
been transferred to Holdings in accordance with the tax sharing agreement.
Substantially all of the NOLs are scheduled to expire in the years 1999 through
2009.
In accordance with the tax sharing agreement with Holdings, the Company was
reimbursed for $36 million and $103 million of net deferred tax assets during
the fiscal years ended November 30, 1997 and November 30, 1996, respectively.
NOTE 8. DERIVATIVE FINANCIAL INSTRUMENTS
Derivatives are financial instruments whose value is based upon an
underlying asset (e.g., treasury bond), index (e.g., S&P 500) or reference rate
(e.g., LIBOR). Over-the-counter ("OTC") derivative products are privately
negotiated contractual agreements that can be tailored to meet individual client
needs and include forwards, swaps and certain options including caps, collars
and floors. Exchange-traded derivative products are standardized contracts
transacted through regulated exchanges and include futures and certain option
contracts listed on an exchange.
In the normal course of business, the Company enters into derivative
transactions both in a trading capacity and as an end user. Acting in a trading
capacity, the Company enters into derivative transactions to satisfy the needs
of its clients and to manage the Company's own exposure to market and credit
risk resulting from its trading activities in cash instruments (collectively,
"Trading-Related Derivative Activities"). As an end user, the Company primarily
enters into interest rate swap and option contracts to adjust the interest rate
nature of its funding sources from fixed to floating rates and vice versa, and
to change the index upon which floating interest rates are based (e.g., Prime to
LIBOR) (collectively, "End User Derivative Activities").
There is an extensive volume of derivative products available in the
marketplace which can vary from a simple forward foreign exchange contract to a
complex derivative instrument with multiple risk characteristics involving the
aggregation of the risk characteristics of a number of derivative product types
including swap
F-19
<PAGE> 55
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
products, options and forwards. Listed below are examples of various derivative
product types along with a brief discussion of the performance mechanics of
certain specific derivative instruments.
Swap Products
Interest rate swap products include interest rate and currency swaps,
leveraged swaps, swap options and other interest rate option products including
caps, collars and floors. An interest rate swap is a negotiated OTC contract in
which two parties agree to exchange periodic interest payments for a defined
period, calculated based upon a predetermined notional amount. Interest payments
are usually exchanged on a net basis throughout the duration of the swap
contract. A currency swap is an OTC agreement to exchange a fixed amount of one
currency for a specified amount of a second currency at the outset and
completion of the swap term. Leveraged swaps involve the multiplication of the
interest rate factor upon which the interest payment streams are based (i.e.,
Party A pays 3 times the six month LIBOR). Caps are contractual commitments that
require the writer to pay the purchaser the amount by which an interest
reference rate exceeds a defined contractual rate, if any, at specified times
during the contract. Conversely, a floor is a contractual commitment that
requires the writer to pay the amount by which a defined contractual rate
exceeds an interest reference rate at specified times over the life of the
contract, if any. Commodity swaps are contractual commitments to exchange the
fixed price of a commodity for a floating price (which is usually the prevailing
spot price) throughout the swap term.
Options
Option contracts provide the option purchaser (holder) with the right but
not the obligation to buy or sell a financial instrument, commodity or currency
at a predetermined exercise price (strike price) during a defined period
(American Option) or at a specified date (European Option). The option purchaser
pays a premium to the option seller (writer) for the right to exercise the
option. The option seller is obligated to buy (call) or sell (put) the item
underlying the contract at a set price, if the option purchaser chooses to
exercise. Option contracts also exist for various indices and are similar to
options on a security or other instrument except that, rather than settling
physical with delivery of the underlying instrument, they are cash settled. As a
purchaser of an option contract, the Company is subject to credit risk, since
the counterparty is obligated to make payments under the terms of the option
contract, if the Company exercises the option. As the writer of an option
contract, the Company is not subject to credit risk but is subject to market
risk, since the Company is obligated to make payments under the terms of the
option contract if exercised.
Option contracts may be exchange-traded or OTC. Exchange-traded options are
the obligations of the exchange and generally have standardized terms and
performance mechanics. In contrast, all of the terms of an OTC option including
the method of settlement, term, strike price, premium and security are
determined by negotiation of the parties.
Futures and Forwards
Futures contracts are exchange-traded contractual commitments to either
receive (purchase) or deliver (sell) a standard amount or value of a financial
instrument or commodity at a specified future date and price. Maintaining a
futures contract requires the Company to deposit with the exchange an amount of
cash or other specified asset as security for its obligation. Additionally,
futures exchanges generally require the daily cash settlement of unrealized
gains/losses on open contracts with the futures exchange. Therefore, futures
contracts provide a reduced funding alternative to purchasing the underlying
cash position in the marketplace. Futures contracts may be settled by physical
delivery of the underlying asset or cash settlement (for index futures) on the
settlement date or by entering into an offsetting futures contract with the
futures exchange prior to the settlement date.
F-20
<PAGE> 56
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Forwards are OTC contractual commitments to purchase or sell a specified
amount of a financial instrument, foreign currency or commodity at a future date
at a predetermined price. TBAs are forward contracts which give the
purchaser/seller an obligation to obtain/deliver mortgage securities in the
future. Therefore, TBAs subject the holder to both interest rate risk and
principal prepayment risk.
Trading-Related Derivative Activities
Derivatives are subject to various risks similar to other financial
instruments including market, credit and operational risk. In addition, the
Company may also be exposed to legal risks related to its derivative activities
including the possibility that a transaction may be unenforceable under
applicable law. The risks of derivatives should not be viewed in isolation, but
rather should be considered on an aggregate basis along with the Company's other
trading-related activities. The Company manages the risks associated with
derivatives on an aggregate basis along with the risks associated with its
proprietary trading and market-making activities in cash instruments as part of
its firmwide risk management policies.
Derivatives are generally based upon notional values. Notional values are
not recorded on-balance sheet, but rather are utilized solely as a basis for
determining future cash flows to be exchanged. Therefore, notional amounts
provide a measure of the Company's involvement with such instruments, but are
not indicative of actual or potential risk.
The following table reflects the notional/contract value of the Company's
Trading-Related Derivative Activities:
Trading-Related Derivative Financial Instruments
<TABLE>
<CAPTION>
NOTIONAL/CONTRACT VALUE 1997
----------------------------- WEIGHTED
NOVEMBER 30, NOVEMBER 30, AVERAGE
1997 1996 MATURITY
------------ ------------ -------------
(IN MILLIONS) (IN YEARS)
<S> <C> <C> <C>
Interest rate and currency swaps and options
(including caps, collars and floors)........ $ 990,893 $ 722,123 4.65
Foreign exchange forward and future contracts
and options................................. 197,093 331,366 .26
Other fixed income securities contracts
(including
futures contracts and options),
mortgage-backed
securities forward contracts and options.... 330,081 342,859 .92
Equity contracts (including equity futures,
warrants and options)....................... 5,710 4,060 .47
Commodity contracts (including swaps, futures,
forwards and options)....................... 565 6,043 .18
------------ ------------ -----
Total.................................... $1,524,342 $1,406,451 3.26
========== ========== =========
</TABLE>
Of the total notional value at November 30, 1997 and 1996, approximately
$1,324 billion and $1,118 billion are over-the-counter and $200 billion and $288
billion are exchange-traded, respectively. The total weighted average maturity
at November 30, 1997, for over-the-counter and exchange-traded contracts was
3.63 years and 0.77 years, respectively. Approximately $690 billion of the
notional/contract value of the Company's Trading-Related Derivative Activities
mature within the year ended November 30, 1998, of which approximately 35% have
maturities of less than one month.
The Company records its Trading-Related Derivative Activities on a
mark-to-market basis with realized and unrealized gains and losses recognized
currently in Principal transactions in the Consolidated Statement of Income.
Unrealized gains and losses on derivative contracts are recorded on a net basis
in the Consolidated
F-21
<PAGE> 57
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Statement of Financial Condition for those transactions with counterparties
executed under a legally enforceable master netting agreement and are netted
across products and against cash collateral when such provisions are stated in
the master netting agreement. While the Company may utilize derivative products
in all its businesses, the Company views its derivative product revenues as the
revenues earned from the Company's fixed income derivative products businesses
and foreign exchange and commodity derivatives. Principal transactions and net
interest revenues related to the Company's fixed income derivative products
business were $189 million for 1997, $319 million for 1996 and $185 million for
1995. Principal transactions and net interest revenues related to foreign
exchange and commodity derivatives were $91 thousand for 1997, $61 million for
1996 and $55 million for 1995.
Listed in the following table is the fair value of the Company's
Trading-Related Derivative Activities as of November 30, 1997 and 1996 as well
as the average fair value of these instruments. Average fair values of these
instruments were calculated based upon month-end statement of financial
condition values, which the Company believes does not vary significantly from
the average fair value calculated on a more frequent basis. Variances between
average fair values and period-end values are due to changes in the volume of
activities in these instruments and changes in the valuation of these
instruments due to variations in market and credit conditions.
Fair Value of Trading-Related Derivative Financial Instruments
<TABLE>
<CAPTION>
AVERAGE FAIR VALUE*
FAIR VALUE* TWELVE MONTHS ENDED
NOVEMBER 30, 1997 NOVEMBER 30, 1997
---------------------- ----------------------
ASSETS LIABILITIES ASSETS LIABILITIES
------ ----------- ------ -----------
(IN MILLIONS)
<S> <C> <C> <C> <C>
Interest rate and currency swaps and options
(including caps, collars and floors)....... $4,123 $ 2,344 $4,227 $ 2,295
Foreign exchange forward contracts and
options.................................... 1,066 1,072 847 1,120
Options on other fixed income securities,
mortgage-backed securities forward
contracts and options...................... 200 200 244 221
Equity contracts (including equity warrants
and options)............................... 87 63 102 50
Commodity contracts (including swaps,
forwards, and options)..................... 52 6 34 19
------ ----------- ------ -----------
Total................................... $5,528 $ 3,685 $5,454 $ 3,705
====== ======= ====== =======
</TABLE>
* Amounts represent carrying value (exclusive of collateral) and do not include
receivables or payables related to exchange-traded futures contracts.
F-22
<PAGE> 58
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
<TABLE>
<CAPTION>
AVERAGE FAIR VALUE*
FAIR VALUE* TWELVE MONTHS ENDED
NOVEMBER 30, 1996 NOVEMBER 30, 1996
---------------------- ----------------------
ASSETS LIABILITIES ASSETS LIABILITIES
------ ----------- ------ -----------
(IN MILLIONS)
<S> <C> <C> <C> <C>
Interest rate and currency swaps and options
(including caps, collars and floors)....... $3,943 $ 3,159 $3,336 $ 1,917
Foreign exchange forward contracts and
options.................................... 834 1,089 668 1,118
Options on other fixed income securities,
mortgage-backed securities forward
contracts and options...................... 221 248 236 237
Equity contracts (including equity warrants
and options)............................... 254 127 233 74
Commodity contracts (including swaps,
forwards, and options)..................... 46 39 51 50
------ ----------- ------ -----------
Total................................... $5,298 $ 4,662 $4,524 $ 3,396
====== ======= ====== =======
</TABLE>
- ---------------
* Amounts represent carrying value (exclusive of collateral) and do not include
receivables or payables related to exchange-traded futures contracts.
Assets included in the preceding table represent the Company's unrealized
gains, net of unrealized losses for situations in which the Company has a master
netting agreement. Similarly, liabilities represent net amounts owed to
counterparties. Therefore, the fair value of assets/liabilities related to
derivative contracts at November 30, 1997 represents the Company's net
receivable/payable for derivative financial instruments before consideration of
collateral. Included within the $5,528 million fair value of assets at November
30, 1997 was $5,444 million related to swaps and OTC contracts and $84 million
related to exchange-traded option and warrant contracts. Included within the
$5,298 million fair value of assets at November 30, 1996 was $5,044 million
related to swaps and OTC contracts and $254 million related to exchange-traded
option and warrant contracts.
The primary difference in risks related to OTC and exchange-traded
contracts is credit risk. OTC contracts contain credit risk for unrealized gains
from various counterparties for the duration of the contract, net of collateral.
With respect to OTC contracts, including swaps, the Company views its net
credit exposure to be $4,473 million at November 30, 1997 (including $684
million from affiliates), representing the fair value of the Company's OTC
contracts in an unrealized gain position, after consideration of collateral of
$971 million.
Counterparties to the Company's OTC derivative products are primarily
financial intermediaries (U.S. and foreign banks), securities firms,
corporations, governments and their agencies, finance companies, insurance
companies, investment companies and pension funds. Collateral held related to
OTC contracts generally includes cash and U.S. government and federal agency
securities. Presented below is an analysis of the Company's net credit exposure
at November 30, 1997 for OTC contracts based upon internal designations of
counterparty credit quality.
<TABLE>
<CAPTION>
COUNTERPARTY S&P/MOODY'S NET CREDIT
RISK RATING EQUIVALENT EXPOSURE
----------------------------------------- -------------------- ----------
<S> <C> <C>
1................................... AAA/Aaa 18%
2................................... AA-/Aa3 or higher 15%
3................................... A-/A3 or higher 55%
4................................... BBB-/Baa3 or higher 6%
5................................... BB-/Ba3 or higher 5%
6................................... B+/B1 or lower 1%
</TABLE>
F-23
<PAGE> 59
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
These designations are based on actual ratings made by external rating
agencies or by equivalent ratings established and utilized by the Company's
Corporate Credit Department.
The Company is also subject to credit risk related to its exchange-traded
derivative contracts. Exchange-traded contracts, including futures and certain
options, are transacted directly on the exchange. To protect against the
potential for a default, all exchange clearing houses impose net capital
requirements for their membership. Additionally, the exchange clearing house
requires counterparties to futures contracts to post margin upon the origination
of the contract and for any changes in the market value of the contract on a
daily basis (certain foreign exchanges provide for settlement within three
days). Therefore, the potential for losses from exchange-traded products is
limited.
End User Derivative Activities
The Company utilizes interest rate swap agreements as an end user to modify
the interest rate characteristics of its long-term debt portfolio. The Company
actively manages the interest rate exposure on its long-term debt portfolio to
more closely match the terms of its debt portfolio to the assets being funded
and to minimize interest rate risk. At November 30, 1997 and 1996, the notional
value of the Company's end user activities related to its long-term debt
obligations was approximately $2.8 billion and $3.7 billion, respectively. (For
a further discussion of the Company's long-term debt related end user derivative
activities see Note 4.)
The Company also utilizes derivative products as an end user to modify its
interest rate exposure associated with its secured financing activities,
including securities purchased under agreements to resell, securities borrowed,
securities sold under agreements to repurchase and securities loaned. At
November 30, 1997 and 1996, the Company had $127 billion and $114 billion,
respectively, of such secured financing activities. As with the Company's
long-term debt, its secured financing activities expose the Company to interest
rate risk. The Company, as an end user, manages the interest rate risk related
to these activities by utilizing derivative financial instruments, including
interest rate swaps and purchased options. The Company designates certain
specific derivative transactions against specific assets and liabilities with
matching maturities. In addition, the Company manages the interest rate risk of
anticipated secured financing transactions with derivative products. These
derivative products are designated against the existing secured financing
transactions for their applicable maturity. The remaining term of these
transactions is designated against the anticipated secured financing
transactions which will replace the existing secured financing transactions at
their maturity. The Company monitors the level of secured financing transactions
to ensure that there is a high degree of certainty that the Company will enter
into the anticipated secured financing transactions at a level in excess of the
designated derivative product transactions. At November 30, 1997 and 1996, the
Company, as an end user, utilized derivative financial instruments with an
aggregate notional amount of $38.7 billion and $47.6 billion, respectively, to
modify the interest rate characteristics of its secured financing activities.
The total notional value of these agreements had a weighted average maturity of
0.5 years as of November 30, 1997 and 1996.
The Company terminated certain swaps designated as hedges of the Company's
secured financing activities. At November 30, 1997, a loss of approximately $12
million from these terminated contracts was deferred and will be amortized to
interest expense over the original period of the hedge. On an overall basis, the
Company's secured financing end user derivative activities (decreased) increased
net interest income by approximately $(10) million, $16 million and $39 million
for 1997, 1996 and 1995, respectively.
NOTE 9. FAIR VALUE OF FINANCIAL INSTRUMENTS
SFAS No. 107 "Disclosures about Fair Value of Financial Instruments"
requires the Company to report the fair value of financial instruments, as
defined. Assets and liabilities that are carried at fair value include all of
the Company's trading assets and liabilities including derivative financial
instruments used for trading
F-24
<PAGE> 60
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
purposes as described in Note 1, which are recorded as securities and other
financial instruments owned and securities and other financial instruments sold
but not yet purchased.
Assets and liabilities, which are recorded at contractual amounts that
approximate market or fair value include cash and cash equivalents, cash and
securities segregated and on deposit for regulatory and other purposes,
receivables, certain other assets, commercial paper and short-term debt and
payables. The market value of such items are not materially sensitive to shifts
in market interest rates because of the limited term to maturity of these
instruments and their variable interest rates.
Financial instruments which are recorded at amounts that do not necessarily
approximate market or fair value include long-term debt, certain secured
financing activities and the related financial instruments utilized by the
Company as an end user to manage the interest rate risk of these exposures. The
Company's long-term debt is recorded at contractual or historical amounts. The
following table provides a summary of the fair value of the Company's long-term
debt and related end user derivative activities. The fair value of the Company's
long-term debt was estimated using either quoted market prices or discounted
cash flow analyses based on the Company's current borrowing rates for similar
types of borrowing arrangements. The unrecognized net gain (loss) related to the
Company's end user derivative activities reflects the estimated amounts the
Company would receive (pay) if the derivative financial instruments were
terminated based on market rates at November 30, 1997 and 1996, respectively.
<TABLE>
<CAPTION>
NOVEMBER 30
-----------------
1997 1996
------ ------
(IN MILLIONS)
<S> <C> <C>
Carrying value of long-term debt........................... $4,542 $4,165
Fair value of long-term debt............................... 4,673 4,352
------ ------
Unrecognized net gain (loss) on long-term debt............. $ (131) $ (187)
------ ------
Unrecognized net gain (loss) on long-term debt end user
activities............................................... $ 46 $ 60
====== ======
</TABLE>
The Company carries its secured financing activities, including securities
purchased under agreements to resell, securities borrowed, securities sold under
agreements to repurchase and securities loaned, at their original contract
amount plus accrued interest, which for the majority of such financing
activities is an approximation of fair value. At November 30, 1997 and 1996, the
Company had $127 billion and $114 billion, respectively, of such secured
financing activities. As with the Company's long-term debt, its secured
financing activities expose the Company to interest rate risk.
At November 30, 1997 and 1996, the Company, as an end user, utilized
derivative financial instruments with an aggregate notional amount of $38.7
billion and $47.6 billion, respectively, to modify the interest rate
characteristics of its secured financing activities. The unrecognized net losses
related to these derivative financial instruments were $6 million and $10
million at November 30, 1997 and 1996, respectively.
NOTE 10. OTHER COMMITMENTS AND CONTINGENCIES
As of November 30, 1997 and 1996, the Company was contingently liable for
$3.2 billion and $2.0 billion, respectively, of letters of credit, primarily
used to provide collateral for securities and commodities borrowed and to
satisfy margin deposits at option and commodity exchanges and other guarantees.
As of November 30, 1997 and 1996, in connection with its financing
activities, the Company had outstanding commitments under certain lending
arrangements of approximately $1.9 billion and $1.6 billion, respectively. These
commitments require borrowers to provide acceptable collateral, as defined in
the agreements, when amounts are drawn under the lending facilities. Advances
made under the above lending arrangements are typically at variable interest
rates and generally provide for over-collateralization based upon the borrowers'
creditworthiness.
F-25
<PAGE> 61
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
As of November 30, 1997 and 1996, the Company had pledged or otherwise
transferred securities, primarily fixed income, having a market value of
approximately $44.1 billion and $28.2 billion, respectively, as collateral for
securities borrowed or otherwise received having a market value of approximately
$43.6 billion and $27.6 billion, respectively.
Securities and other financial instruments sold but not yet purchased
represent obligations of the Company to purchase the securities at prevailing
market prices. Therefore, the future satisfaction of such obligations may be for
an amount greater or less than the amount recorded. The ultimate gain or loss is
dependent upon the price at which the underlying financial instrument is
purchased to settle its obligation under the sale commitment.
In the normal course of business, the Company is exposed to off-balance
sheet credit and market risk as a result of executing, financing and settling
various customer security and commodity transactions. Off-balance sheet risk
arises from the potential that customers or counterparties fail to satisfy their
obligations and that the collateral obtained is insufficient. In such instances,
the Company may be required to purchase or sell financial instruments at
unfavorable market prices. The Company seeks to control these risks by obtaining
margin balances and other collateral in accordance with regulatory and internal
guidelines.
The Company, through its high yield sales and training activities, makes
commitments to extend credit in loan syndication transactions principally to
below investment grade borrowers and participates a significant portion of these
commitments. These commitments, which totaled $1.4 billion at November 30, 1997,
are typically secured against the borrower's assets and have fixed maturity
dates. The draw down of these facilities is generally contingent upon certain
representations, warranties and contractual conditions of the borrower. The
total commitments may not be indicative of actual funding requirements as they
may expire without being drawn upon and the Company may participate additional
amounts in the normal course of its business.
The Company has commitments to invest up to $325 million in partnerships,
which in turn will make direct merchant banking related investments. These
commitments will be funded as required through the end of the respective
partnerships' investment periods, principally expiring in July 2004.
The Company is also a sponsor of a fund to provide interim acquisition
facilities. In connection therewith, the Company may provide up to $150 million
to be used by the fund to provide short-term acquisition financing. Any draw
downs under the facility are expected to be repaid within a short-term period.
Subsidiaries of the Company, as general partner, are contingently liable
for the obligations of certain public and private limited partnerships organized
as pooled investment funds or engaged primarily in real estate activities. In
the opinion of the Company, contingent liabilities, if any, for the obligations
of such partnerships will not in the aggregate have a material adverse effect on
the Company's consolidated financial position or results of operations.
In the normal course of its business, the Company has been named a
defendant in a number of lawsuits and other legal proceedings. After considering
all relevant facts, available insurance coverage and the advice of outside
counsel, in the opinion of the Company such litigation will not, in the
aggregate, have a material adverse effect on the Company's consolidated
financial position or results of operations.
Concentrations of Credit Risk
As a major international securities firm, the Company is actively involved
in securities underwriting, brokerage, distribution and trading. These and other
related services are provided on a worldwide basis to a large and diversified
group of clients and customers, including multinational corporations,
governments, emerging growth companies, financial institutions and individual
investors.
F-26
<PAGE> 62
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
A substantial portion of the Company's securities and commodities
transactions is collateralized and is executed with, and on behalf of,
commercial banks and other institutional investors, including other brokers and
dealers. The Company's exposure to credit risk associated with the
non-performance of these customers and counterparties in fulfilling their
contractual obligations pursuant to securities transactions can be directly
impacted by volatile or illiquid trading markets, which may impair the ability
of customers and counterparties to satisfy their obligations to the Company.
Securities and other financial instruments owned by the Company include
U.S. government and agency securities, and securities issued by non-U.S.
governments which, in the aggregate, represented 15% of the Company's total
assets at November 30, 1997. In addition, primarily all of the collateral held
by the Company for resale agreements or securities borrowed, which together
represented 55% of total assets at November 30, 1997, consisted of securities
issued by the U.S. government, federal agencies or non-U.S. governments. In
addition to these specific exposures, the Company's most significant
concentration is financial institutions, which include other brokers and
dealers, commercial banks and institutional clients. This concentration arises
in the normal course of the Company's business.
Lease Commitments
The Company leases office space and equipment throughout the world and is a
party to a ground lease with the Battery Park City Authority covering its
headquarters at 3 World Financial Center which extends through 2069. Total rent
expense for 1997, 1996 and 1995 was $15 million, $21 million and $31 million,
respectively. Certain leases on office space contain escalation clauses
providing for additional rentals based upon maintenance, utility and tax
increases.
Minimum future rental commitments under noncancellable operating leases
(net of subleases of $138 million) are as follows:
<TABLE>
<CAPTION>
AMOUNT
-------------
(IN MILLIONS)
<S> <C>
Fiscal 1998...................................... $ 18
Fiscal 1999...................................... 14
Fiscal 2000...................................... 11
Fiscal 2001...................................... 9
Fiscal 2002...................................... 9
December 1, 2002 and thereafter.................. 165
-----
$ 226
=====
</TABLE>
NOTE 11. RELATED PARTY TRANSACTIONS
In the normal course of business, the Company engages in various securities
trading, investment banking and financing activities with Holdings and many of
its subsidiaries (the "Related Parties"). Various charges, such as compensation
and benefits, occupancy, administration and computer processing are allocated
between the Related Parties, based upon specific identification and allocation
methods.
Holdings has allocated to the Company the cost of certain employees and
space in the World Financial Center and 101 Hudson Street, Jersey City, New
Jersey. In addition, the Company charges other affiliates of Holdings for their
share of costs incurred by the Company. These charges are classified in the
Consolidated Statement of Income as Management fees or Compensation and benefits
as appropriate.
In addition, Holdings and subsidiaries of Holdings raise money through
short- and long-term funding in the capital markets, which is used to fund the
operations of certain of the Company's wholly owned
F-27
<PAGE> 63
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
subsidiaries. Advances from Holdings and other affiliates were $14,777 million
and $8,552 million at November 30, 1997 and 1996, respectively.
In connection therewith, advances from Holdings aggregating approximately
$12.3 billion and $6.6 billion at November 30, 1997 and 1996, respectively, are
generally payable on demand. The average interest rate charged on these advances
is primarily based on Holdings' average daily cost of funds, which was 5.8% for
the twelve months ended November 30, 1997 and 1996. In addition, the Company had
borrowings from subsidiaries of Holdings comprised of approximately $1,414
million and $806 million in subordinated indebtedness at November 30, 1997 and
1996, respectively. Total net interest charges incurred during the twelve months
ended November 30, 1997, 1996 and 1995 from Holdings amounted to $565 million,
$492 million, $483 million, respectively. In addition, the Company has advances
from other subsidiaries of Holdings aggregating approximately $2.5 billion and
$2.0 billion, at November 30, 1997 and 1996, respectively, with various
repayment terms. The Company had notes and other receivables due from Holdings
and subsidiaries of Holdings aggregating approximately $3.0 billion and $4.5
billion at November 30, 1997 and 1996, respectively, with various interest rates
and repayment terms.
The Company believes that amounts arising through related party
transactions, including those allocated expenses referred to above, are
reasonable and approximate the amounts that would have been recorded if the
Company operated as an unaffiliated entity.
During 1997 and 1996, the Company paid $75 million and $538 million,
respectively, to Holdings as a return of capital.
NOTE 12. OTHER CHARGES
1996 Severance Charge
In the fourth quarter of 1996, Holdings recorded an $84 million severance
charge ($50 million aftertax) related to certain strategic actions taken to
improve ongoing profitability. The severance charge reflected the culmination of
a worldwide business unit economic performance review that was undertaken in the
fourth quarter of 1996 to focus Holdings on its core investment banking, equity
and fixed income sales and trading areas. This formalized review resulted in
personnel reductions of approximately 270 people across a number of
underperforming fixed income and equity businesses, including exiting the
precious metals business in the U.S., Europe and Asia; exiting energy trading in
the U.S. and Europe; consolidating Asian fixed income risk management activities
into one center in Tokyo; refocusing foreign exchange trading activities, and
combining the New York Private Client Services offices. Additionally, the charge
reflects various other strategic personnel reductions aimed at delayering
management. The Holdings' severance charge has led to personnel cost savings of
approximately $90 million annually. Holdings' charge also resulted in a
permanent decrease in nonpersonnel expenses of approximately $20 million
annually. Holdings intends to reinvest substantially all these savings into
certain businesses to expedite Holdings' strategic initiatives; these actions
are expected to result in improved operating revenues.
The Company recorded a $23 million severance charge ($14 million aftertax)
in the fourth quarter of 1996 related to these actions. The Company's cash
outlays relating to the charge were approximately $12 million in the fourth
quarter of 1996 and approximately $11 million during fiscal 1997.
1995 Restructuring Charge
During the fourth quarter of 1995, the Company recorded a charge of $43
million pretax ($26 million aftertax) for occupancy-related real estate and
severance expenses. The occupancy-related real estate component of the charge,
$26 million pretax ($16 million aftertax), resulted from a complete global
review of the Company's real estate requirements at current headcount levels and
the elimination of excess real estate, primarily in its New York, London and
Tokyo locations. The charge included the cost to write-down the
F-28
<PAGE> 64
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
carrying value of leasehold improvements as well as the difference between
expected operating costs and projected sublease recoveries. In addition, the
restructuring charge included a $17 million pretax ($10 million aftertax)
component related to severance payments made during the fourth quarter. The
severance component of the charge related to payments made to terminated
personnel arising from a fourth quarter formalized business unit productivity
review.
NOTE 13. QUARTERLY INFORMATION (UNAUDITED)
The following information represents the Company's unaudited quarterly
results of operations for 1997 and 1996. Certain amounts reflect
reclassifications to conform to the current period's presentation. These
quarterly results reflect all normal recurring adjustments which are, in the
opinion of management, necessary for a fair presentation of the results.
Revenues and earnings of the Company can vary significantly from quarter to
quarter due to the nature of the Company's business activities.
<TABLE>
<CAPTION>
1997 1996
------------------------------------ ------------------------------------
NOV. 30 AUG. 31 MAY 31 FEB. 29 NOV. 30 AUG. 31 MAY 31 FEB. 28
------- ------- ------ ------- ------- ------- ------ -------
(IN MILLIONS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Total revenues.................. $ 4,043 $ 3,927 $3,405 $ 3,440 $ 3,265 $ 3,057 $3,107 $ 3,068
Interest expense................ 3,319 3,228 2,850 2,819 2,554 2,614 2,492 2,461
------ ------ ------ ------ ------ ------ ------ ------
Net revenues.................... 724 699 555 621 711 443 615 607
Non-interest expenses
Compensation and benefits..... 278 391 259 360 335 267 303 314
Other expenses................ 119 197 210 192 207 186 217 215
Restructuring charge.......... 23
------ ------ ------ ------ ------ ------ ------ ------
Total non-interest
expenses................. 397 588 469 552 565 453 520 529
------ ------ ------ ------ ------ ------ ------ ------
Income (loss) before taxes...... 327 111 86 69 146 (10) 95 78
Provision for (benefit from)
income taxes.................. 126 27 27 22 57 (10) 40 33
------ ------ ------ ------ ------ ------ ------ ------
Net income (loss)............... $ 201 $ 84 $ 59 $ 47 $ 89 $ 0 $ 55 $ 45
====== ====== ====== ====== ====== ====== ====== ======
</TABLE>
F-29
<PAGE> 65
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT
NO. DESCRIPTION
- ------- -------------------------------------------------------------------------------------
<C> <S>
3.1 Restated Certificate of Incorporation of the Registrant dated May 27, 1994
(incorporated by reference to Exhibit 3.1 of the Registrant's Transition Report on
Form 10-K for the eleven months ended November 30, 1994).
3.2 By-Laws of the Registrant, amended as of March 26, 1997 (incorporated by reference to
Exhibit 10 of the Registrant's Quarterly Report on Form 10-Q for the quarter ended
February 28, 1997).
4.1 The instruments defining the rights of holders of the long-term debt securities of
the Registrant and its subsidiaries are omitted pursuant to section (b)(4)(iii)(A) of
Item 601 of Regulation S-K. The Registrant hereby agrees to furnish copies of these
instruments to the Securities and Exchange Commission upon request.
10.1 Agreement of Tenants-In-Common by and among American Express Company, American
Express Bank Ltd., American Express Travel Related Services Company, Inc., Shearson
Lehman Brothers Inc., Shearson Lehman Government Securities, Inc. and Shearson Lehman
Commercial Paper Incorporated (incorporated by reference to Exhibit 10.1 of Lehman
Brothers Holdings Inc.'s Transition Report on Form 10-K for the eleven months ended
November 30, 1994.)
12.1 Computation in support of ratio of earnings to fixed charges.*
21.1 Pursuant to General Instruction I of Form 10-K, the list of the Registrant's
Subsidiaries is omitted.
23.1 Consent of Ernst & Young LLP.*
24.1 Powers of Attorney.*
27.1 Financial Data Schedule.*
</TABLE>
- ---------------
* Filed herewith.
<PAGE> 1
EXHIBIT 12.1
LEHMAN BROTHERS INC. AND SUBSIDIARIES
COMPUTATION IN SUPPORT OF RATIO OF EARNINGS TO FIXED CHARGES
<TABLE>
<CAPTION>
FOR THE FOR THE
FOR THE ELEVEN TWELVE MONTHS
YEAR MONTHS ENDED
ENDED ENDED NOVEMBER 30
DECEMBER 31 NOVEMBER 30 ---------------------------
1993 1994 1995 1996 1997
----------- ----------- ------- ------- -------
(DOLLARS IN MILLIONS)
<S> <C> <C> <C> <C> <C>
Fixed charges:
Interest expense:
Subordinated indebtedness.............. $ 192 $ 184 $ 204 $ 221 $ 236
Bank loans and other borrowings*....... 4,393 5,661 9,750 9,900 11,980
Interest component of rentals of office
and equipment........................ 62 27 25 18 16
Other adjustments**....................... 101 53 2 7 3
------ ------ ------ ------- -------
Total(A).......................... $ 4,748 $ 5,925 $ 9,981 $10,146 $12,235
====== ====== ====== ======= =======
Earnings:
Pre-tax income (loss) from continuing
operations............................. $ (146) $ 1 $ 78 $ 309 $ 593
Fixed charges............................. 4,748 5,925 9,981 10,146 12,235
Other adjustments***...................... (68) (52) (1) (6) (2)
------ ------ ------ ------- -------
Total(B).......................... $ 4,534 $ 5,874 $10,058 $10,449 $12,826
====== ====== ====== ======= =======
(B / A)..................................... **** **** 1.01 1.03 1.05
</TABLE>
- ---------------
* Includes amortization of long-term debt discount.
** Other adjustments include capitalized interest and debt issuance costs,
amortization of capitalized interest and preferred stock dividends of a
wholly owned subsidiary.
*** Other adjustments include adding the net loss of affiliates accounted for
at equity whose debt is not guaranteed by the Company and subtracting
capitalized interest costs and undistributed net income of affiliates
accounted for at equity and preferred stock dividends of a wholly owned
subsidiary.
**** Earnings were inadequate to cover fixed charges and would have had to
increase approximately $214 million in 1993 and $51 million in 1994 in
order to cover the deficiencies.
<PAGE> 1
EXHIBIT 23.1
CONSENT OF INDEPENDENT AUDITORS
We consent to the incorporation by reference in the Registration Statements
and Post Effective Amendments on Form S-3 File Nos. 333-08319 and 33-63613 of
Lehman Brothers Inc. and in the related Prospectuses, of our report dated
January 7, 1998, with respect to the consolidated financial statements of Lehman
Brothers Inc. included in this 1997 Annual Report on Form 10-K for the year
ended November 30, 1997.
ERNST & YOUNG LLP
New York, New York
February 27, 1998
<PAGE> 1
EXHIBIT 24.1
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Thomas A. Russo, Marc A. Silverman and Karen M.
Muller and each of them, his true and lawful attorneys-in-fact and agents, with
full power of substitution and resubstitution, for him and in his name, place
and stead, in any and all capacities, to sign the Annual Report on Form 10-K of
Lehman Brothers Inc., for the fiscal year ended November 30, 1997 and any and
all amendments thereto, and to file the same, with all exhibits thereto, and
other documents in connection therewith, with the Securities and Exchange
Commission, granting unto said attorneys-in-fact and agents, and each of them,
full power and authority to do and perform each and every act and thing
requisite and necessary to de done, as fully to all intents and purposes as he
might or could do in person, hereby ratifying and confirming all that said
attorneys-in-fact and agents, or any of them, or their substitute or
substitutes, may lawfully do or cause to be done by virtue hereof.
Dated: As of February 27, 1998
<TABLE>
<CAPTION>
SIGNATURES TITLE
- ------------------------------------- ---------------------------------------------
<S> <C>
/s/ RICHARD S. FULD, JR. Chief Executive Officer and,
- ------------------------------------- Chairman of the Board of
Richard S. Fuld, Jr. Directors
(principal executive officer)
/s/ CHARLES B. HINTZ Chief Financial Officer
- ------------------------------------- and Director
Charles B. Hintz (principal financial and accounting officer)
/s/ ROGER S. BERLIND Director
- -------------------------------------
Roger S. Berlind
/s/ HOWARD L. CLARK, JR. Director
- -------------------------------------
Howard L. Clark, Jr.
/s/ FREDERICK FRANK Director
- -------------------------------------
Frederick Frank
/s/ HARVEY M. KRUEGER Director
- -------------------------------------
Harvey M. Krueger
/s/ BRUCE R. LAKEFIELD Director
- -------------------------------------
Bruce R. Lakefield
/s/ SHERMAN R. LEWIS, JR. Director
- -------------------------------------
Sherman R. Lewis, Jr.
</TABLE>
<TABLE> <S> <C>
<ARTICLE> BD
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONSOLIDATED STATEMENT OF FINANCIAL CONDITION AT NOVEMBER 30, 1997 AND THE
CONSOLIDATED STATEMENT OF INCOME FOR THE TWELVE MONTHS ENDED NOVEMBER 30, 1997
AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000,000
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> NOV-30-1997
<PERIOD-START> DEC-01-1996
<PERIOD-END> NOV-30-1997
<CASH> 1,348
<RECEIVABLES> 10,129
<SECURITIES-RESALE> 49,610
<SECURITIES-BORROWED> 13,661
<INSTRUMENTS-OWNED> 38,977
<PP&E> 262
<TOTAL-ASSETS> 114,291
<SHORT-TERM> 740
<PAYABLES> 9,245
<REPOS-SOLD> 56,017
<SECURITIES-LOANED> 7,764
<INSTRUMENTS-SOLD> 17,029
<LONG-TERM> 4,542
0
0
<COMMON> 0
<OTHER-SE> 2,011
<TOTAL-LIABILITY-AND-EQUITY> 114,291
<TRADING-REVENUE> 848
<INTEREST-DIVIDENDS> 12,589
<COMMISSIONS> 350
<INVESTMENT-BANKING-REVENUES> 998
<FEE-REVENUE> 0
<INTEREST-EXPENSE> 12,216
<COMPENSATION> 1,288
<INCOME-PRETAX> 593
<INCOME-PRE-EXTRAORDINARY> 391
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 391
<EPS-PRIMARY> 0
<EPS-DILUTED> 0
</TABLE>
