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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, 1998
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER 1-6817
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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
NEW YORK, NEW YORK 10285
(Address of principal executive offices) (Zip Code)
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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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NAME OF EACH EXCHANGE
TITLE OF EACH CLASS ON WHICH REGISTERED
7 5/8% Senior Subordinated Notes Due 2006 New York Stock Exchange
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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 (Section229.405 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 19, 1999, 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 I(1)(a)
AND (b) OF FORM 10-K AND THEREFORE IS FILING THIS FORM WITH 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," the "Firm" 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 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 and market-maker 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.
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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 Banking Brothers and Holdings to accomplish their financial
objectives. Investment 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 Institutions, Health Care, Industrial/Consumer,
Media/Telecommunications, Natural Resources, Power, Real Estate, Retailing 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 product 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; Leveraged Finance,
which includes high yield debt and bank loan syndication; Private Placements;
and Financial Sponsors, which structures and executes leveraged acquisitions.
Geographically, Lehman Brothers maintains investment banking offices in five
cities in the U.S. and in twenty cities in Europe, the Middle East, Asia and
Latin America.
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, and tax
optimization strategies. Linkages between strategic advisory services and the
Firm's foreign exchange, derivatives and leveraged financing products are widely
utilized.
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 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. 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.
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HIGH YIELD SECURITIES AND BANK LOANS. The Company also underwrites and
makes markets in non-investment grade debt securities and bank loans. The
Company provides "one-stop" leveraged finance solutions for corporate and
financial acquirers and high yield issuers, including multi-step, multi product
acquisition financing.
EMERGING MARKET SECURITIES. The Company engages in the trading, structuring
and underwriting of Latin American, Eastern European, and Asian dollar and local
currency instruments.
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 range
of U.S. agency-backed mortgage products, mortgage-backed securities,
asset-backed securities and whole loan products. 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 worldwide convergence of the cash and
derivative markets.
FOREIGN EXCHANGE. Lehman Brothers' global foreign exchange operation
provides market access and liquidity in all currencies for spot, forward and
over-the-counter option markets on a 24 hour per-day basis. Lehman Brothers
offers its customers superior execution, market intelligence, analysis and
hedging capabilities, utilizing foreign exchange options and derivatives. In
collaboration with the Firm's emerging markets unit, the Firm's foreign exchange
activities have 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 currencies for its own account.
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EQUITIES
Lehman Brothers combines professionals from the sales, trading, investment
banking and research areas of its Equities Division 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 and Milan.
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. Lehman Brothers' equity derivatives
business is organized 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 integrated Equity Financing
and Prime Broker business to provide liquidity to its clients and customers and
supply a source of secured financing for the Firm.
MERCHANT BANKING AND PRIVATE EQUITY
The Company and its affiliates' merchant banking activities include making
principal investments 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 Merchant Banking group has more than 20 dedicated
professionals based in New York and London. Through its merchant banking funds,
the Company's affiliates invest in established companies worldwide. In 1998, the
Company also formalized its venture capital activities, investing a total of $37
million in 10 companies across a broad range of industries. In addition, Lehman
Brothers affiliates engage in select equity and equity-related investments in
commercial and residential properties. Further information is contained in
"Management's Discussion and Analysis of Financial Condition and Results of
Operations--Merchant Banking and Related Lending Activities" on pages 23-24
hereof.
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 most
productive in the industry, with approximately 278 professionals in 12 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.
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EQUITY SALES. Lehman Brothers' institutional Equity sales group of over 345
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 293
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 11
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.
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 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 291 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 120 analysts,
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.
ASSET MANAGEMENT. The Firm has several asset management related businesses.
These include Investment Consulting Services, a wrap-fee series of third party
managed products and management of multiple manager funds onshore and offshore.
The Firm also has dealer agreements with a large number of mutual fund families.
In addition, the Company packages internally managed product with emphasis on
the various sectors of the private equity markets.
ARBITRAGE. Lehman Brothers also engages in a variety of arbitrage
activities including "riskless" arbitrage, where the Company seeks to benefit
from temporary price discrepancies that occur when a security is traded in two
or more markets, and "risk" arbitrage activities, which 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.
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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.
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.
TECHNOLOGY AND YEAR 2000 READINESS
During 1998, considerable technology resources were devoted to ensuring the
Company's successful conversion to the Euro and addressing the Year 2000 issue.
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--Year 2000 Readiness Disclosure" on pages 29-32 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. 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
26-29 hereof.
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 other firms, a number of whom have significantly greater equity
capital than the Company. Pending legislative and regulatory changes in the
United States may allow commercial banks to enter businesses previously limited
to investment banks, further increasing competition.
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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 22
hereof, and Note 6 of Notes to Consolidated Financial Statements on page F-15
hereof.
EMPLOYEES
As of November 30, 1998 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 78,000 square feet of which has been subleased.
Holdings leases approximately 400,000 square feet for offices located at 101
Hudson Street in Jersey City, New Jersey (the "Operations Center"), of which
approximately 67,000 square feet has been
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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.
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 was appointed, who returned a report favorable to EFH. The Court
ordered a review of additional documents and has set an April 1999 hearing date.
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 and Fidelity Bankers Life
Insurance Company ("Fidelity Bankers Life"), a number of lawsuits were
commenced, naming one or more of Holdings, Lehman Brothers and American Express
as defendants. Most of these actions have been subsequently settled and/or
dismissed. The only material 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
alleged that Holdings acquiesced in and approved the continued mismanagement of
Fidelity Bankers Life and that it participated in directing the
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investment of Fidelity Bankers Life assets. The complaint asserted claims under
the federal securities laws and asserts common law claims including fraud,
negligence and breach of fiduciary duty and alleged violations of the Virginia
Securities laws by Holdings. It sought no less than $220 million in damages to
Fidelity Bankers Life and its present and former policyholders and creditors and
punitive damages. On May 21, 1998, after trial, the Court entered a Judgment
Order in accord with the jury verdict, ordering that the plaintiffs recover
nothing and dismissing the complaint. On July 7, 1998, the Commissioner filed a
Notice of Appeal to the United States Court of Appeals for the Fourth Circuit
from such Judgment Order.
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.
ACTIONS RELATING TO THE SALES AND MARKETING OF LIMITED PARTNERSHIPS
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
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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. On September 24, 1998, the Court filed an opinion dismissing
the complaint, and plaintiffs have appealed that dismissal.
BRUSS, ET AL. V. LEHMAN BROTHERS INC., ET AL. On January 25, 1999, a
purported class action complaint was filed in the Superior Court of New Jersey,
Law Division: Essex 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. The complaint mirrors the claims
raised, the relief sought and the defendants named in KLEIN, ET AL. V. LEHMAN
BROTHERS, INC., ET AL.
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 complete, and
summary judgment motions are pending before the court.
COUNTY OF ORANGE ET AL. V. BEAR STEARNS & CO. ET AL.
On December 6, 1996, the County of Orange, California (the "County") filed a
complaint in the United States Bankruptcy Court for the Central District of
California (the "Complaint"), naming 15 broker-dealers, along with various
subsidiaries, including LBI, Lehman Brothers International (Europe), Lehman
Capital Corp. and Lehman Commercial Paper, Inc. (the "Lehman defendants"), as
defendants.
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The Complaint alleges that defendants sold the County unsuitable securities and
entered into unsuitable reverse repurchase transactions with the County that
were ultra vires. The County seeks a declaration that the reverse repurchase
agreements are void and unenforceable and violated the California Constitution
and Government Code, and it claims that the defendants violated the California
Constitution and Government Code and committed negligence. No damages are
specified, and restitution is sought. Immediately after filing the Complaint,
the parties entered into a stay of the action.
On July 1, 1998, the case was transferred to the United States District
Court for the Central District of California, and on August 21, 1998 the stay
was lifted. On November 10, 1998 the Lehman defendants answered the Complaint,
denying its material allegations. On December 21, 1998, the County moved to
amend the Complaint to add breach of fiduciary duty and aiding and abetting
breach of fiduciary duty claims, and the Court has ruled that plaintiff may file
the amended complaint (the "Amended Complaint"). On January 5, 1999, the Court
entered an order granting summary judgment for defendants on the ultra vires
claims.
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, including LBI. Plaintiffs in these cases alleged violations of the
antitrust laws, securities laws and have pled a variety of other statutory and
common law claims. All of these actions were 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 claimed violations of the federal
antitrust laws including Section I of the Sherman Act. Plaintiffs sought
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. The plaintiffs repled 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 Court
entered a Final Judgment and Order of Dismissal on November 9, 1998.
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. On March 27, 1998, the
District Court dismissed without prejudice 18 of the 24 counts pleaded in the
complaint. On July 3, 1998 the plaintiffs served their First Amended Complaint
containing 18 causes of action against LBI and/or Bear Stearns.
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,
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<PAGE>
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. On
January 6, 1999, the court issued an order dismissing the claims of Canadian
plaintiffs who bought their shares on Canadian exchanges. The remaining motions
to dismiss are still pending.
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.
IN RE MOBILEMEDIA SECURITIES LITIGATION
LBI was named as a defendant in several purported class actions filed in
December, 1996 in the United States District Court for the District of New
Jersey in connection with (I) a November 7, 1995 offering of common stock of
MobileMedia Corporation; and (ii) a November 7, 1995 offering of 9 3/8% senior
subordinated notes of MobileMedia Communications Inc. due in 2007. On November
3, 1997, a consolidated amended class action complaint was filed naming certain
of MobileMedia Corporation's officers and directors and the four co-lead
underwriters of these offerings, including LBI. MobileMedia filed for Chapter 11
bankruptcy protection on January 30, 1997, and therefore is not named as a
defendant. The complaint alleges that the underwriters violated Sections 11 and
12 of the Securities Act. Plaintiffs seek rescission and unspecified
compensatory damages.
HAROLD GILLET, ET AL. V. GOLDMAN SACHS & CO., ET AL., YAKOV PRAGER, ET AL. V.
GOLDMAN, SACHS & CO., ET AL., DAVID HOLZMAN, ET AL. V. GOLDMAN, SACHS & CO., ET
AL.
Beginning in November, 1998, three class actions were filed in the United
States District Court for the Southern District of New York against in excess of
25 underwriters of IPO securities including LBI. Plaintiffs in these cases seek
compensatory and injunctive relief for alleged violations of the antitrust laws
based on the theory that the defendant underwriters fixed and maintained fees
for underwriting certain IPO securities at supracompetitive levels. Plaintiffs
plan to file a Consolidated Amended Complaint.
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.
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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, 1998, 1997 and 1996. 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.
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 generally favorable market and economic conditions that characterized
fiscal 1997 continued throughout most of 1998, leading to increased industrywide
revenues and to record levels of earnings and net revenues for the Company. The
first eight months of fiscal 1998 were characterized by favorable fixed income
spreads, strong investor demand, high valuations, low interest rates and
significant merger and acquisition activity. However, by mid-August, instability
in various emerging markets surfaced and dramatically changed the market
landscape over the course of the next three months as spreads widened in core
U.S. fixed income markets and major equity market indices experienced sharp
declines. As a result of these factors, the IPO market was virtually halted in
September, as investors sought safe havens.
In response to fears that the global capital markets turmoil would impact
the U.S. economy, the Federal Reserve (the "Fed") reduced interest rates three
times. A number of European central banks also engaged in a coordinated series
of interest rate cuts. The equity markets responded positively to the Fed
easings, with the Dow Jones returning 21%, the S&P 22%, and the NASDAQ 30% from
August 31 to November 30. The equity new issue market was revived in late
October, initially by large, liquid issues and later by Internet-related IPOs.
Despite the record levels of equity and equity-related issuance during the first
eight months of fiscal 1998, total equity underwriting volume was significantly
affected by the August-October slowdown. The total completed volume of
equity-related offerings was 6.4% lower in fiscal 1998 than in fiscal 1997.
FIXED INCOME Following relative stability for the first half of the year,
turmoil erupted in many emerging markets in mid-August. Markets were buffeted by
concerns about the lingering Asian economic troubles, which spread to Russia and
still threaten Latin America, as well as political uncertainty in Washington.
The trigger concerns were exacerbated by a Russian technical default on certain
types of ruble-denominated debt and an effective devaluation of the ruble. As
investors sought safe havens, U.S. Treasury and European government bond yields
moved sharply lower, while spreads on core fixed income products widened
dramatically.
The widening of bond spreads prompted further concerns about a credit crunch
that could threaten the continued expansion of the U.S. economy. The Fed, taking
note of the increasing risks, stepped in to aggressively ease the Federal Funds
rate by 75 basis points within two months to alleviate concern about the growth
and stability of the U.S. and global economies.
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<PAGE>
These factors influenced U.S. and European government bond markets. Ten-year
U.S. Treasury yields touched a new historic low of 4.2% in early October--a fall
of 155 basis points from the beginning of the fiscal year before ending the year
at just over 4.71%. The Fed's rate cuts coincided with a wave of international
cuts that helped stabilize the higher yielding markets. Yields on ten-year
German Bunds fell even more than comparable Treasuries--by just under 170 basis
points, to a new low of 3.77%, before ending the fiscal year slightly off their
global lows of 4%.
EQUITIES In 1998, the U.S. equity markets experienced the most volatile
year since the crash of 1987. Still, the major stock market indices established
new records in 1998 despite suffering a 20% peak-to-trough decline that almost
equaled the recession-related decline in 1990. For the year ended November 30,
1998, the S&P 500 index returned 22%. Equity prices continued to be helped by a
benign inflation and interest rate environment. Inflation remained below 2% for
the year ended November 1998, while long-term interest rates declined. Given
that there was no appreciable earnings growth, price/ earnings multiple
expansion was the primary driver of market performance.
European equity markets performed strongly over the 12 months to November
1998, with the FT/S&P European Index achieving a handsome return of 27% in
dollar terms. The domestic environment was highly supportive, with regional bond
yields declining over 150 basis points in aggregate. However, the crisis across
emerging markets and, in particular, events in Russia, resulted in extremely
turbulent market conditions in the last four months of the year. From their peak
in mid-July, European equities lost 26% of their value before recouping over
half these losses, as a series of policy initiatives rebuilt market confidence.
Despite the turmoil, European trading volumes remained healthy, with average
turnover levels up on the previous year.
Outside Europe, equity returns were negative for the year as a whole. In the
Far East, equities lost 4% of their value in dollar terms (as measured by the
FT/S&P Pacific Basin Index), although the equity markets outside of Japan
experienced a dramatic turnaround in the last quarter. Sharp decreases in local
interest and inflation rates, alongside some tentative signs of cyclical
improvement and progress on fundamental reform allowed the region's equity
markets to rise 46% from their trough at the start of September. The Japanese
market failed to enjoy such a rebound, as economic output continued to contract
and much of the corporate sector remained mired in excessive balance sheet
leverage and low profitability. Latin American equities fared the worst over the
year, declining 23% in dollar terms (as measured by the IFC Latin America
Investable Index) as the Russian crises prompted investors to turn their
attention to the fundamental imbalances in the region, especially Brazil's large
fiscal deficit.
CORPORATE FINANCE ADVISORY Corporate Finance Advisory activities continued
at record levels throughout fiscal 1998, despite the global market turmoil
caused by economic uncertainties throughout the world. Coming off a strong pace
in 1997, the volume of announced transactions surged in 1998 to over $2.5
trillion, while the volume of completed transactions totaled a record $2.1
trillion. This record volume of merger and acquisition activity continued to
reflect the trend of consolidation, deregulation and globalization across
industry sectors and across borders.
The financial services industry is cyclical. Fiscal 1998 results reflected
this as the Company alternated between eight strong months followed by three
weak months only to end the year on a high note. 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
revenue 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.
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RESULTS OF OPERATIONS
SUMMARY
The Company reported record net income of $575 million for 1998. This result
was built on the strong foundation for growth and profitability established in
earlier years and demonstrates the impact of the Company's strategy to grow its
high margin businesses within investment banking, equities, certain fixed income
products, merchant banking and the high-net-worth retail business. The Company's
shift in revenue mix in favor of these high margin businesses resulted in a more
diversified revenue base and helped increase the Company's operating margin to
29.5% in 1998 from 22.8% in 1997. Also contributing to these record results was
the Company's continued aggressive management of expenses.
For 1997, the Company reported net income of $391 million which was driven
by continued strength in the Company's major businesses including equities and
investment banking. The Company began to realize the benefits associated with
its strategy to grow certain high margin businesses. 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. 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.
For 1996, the Company reported net income of $189 million, including a $14
million after-tax severance charge. The Company's 1996 results reflected strong
performances across all of the Company's core major businesses. Fixed income
sales and trading and investment banking activities were responsible for the
majority of the increased net revenues and net income 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.
NET REVENUES
Net revenues were $2,871 million for 1998, $2,601 million for 1997 and
$2,376 million for 1996. During 1998, the Company continued to build its global
franchise. The increase in net revenues from 1997 levels reflects the Company's
long-term strategy of growing high margin businesses, such as investment
banking, high yield and private client services. These businesses enjoyed strong
results and helped to offset a difficult fixed income and equity environment.
In 1997, net revenues increased in all of the major business units led by
increased customer flow activity, a strong global market for mergers and
acquisitions and increased levels of worldwide debt and equity underwriting. The
increase in net revenues in 1996 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 merger and acquisition
results.
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.
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<PAGE>
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 combines both principal
transactions 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. During 1998, combined principal
transactions and net interest revenues decreased $56 million from 1997.
Principal transactions revenues declined due to decreased customer flow in fixed
income driven by the severe spread widening in core U.S. fixed income markets in
the later portion of the year. This was offset by improved performance in
foreign exchange and high yield debt. Net interest revenues increased as a
result of an increase in interest bearing assets and a shift in the composition
of the Company's fixed income portfolio towards higher yielding products.
Combined principal transactions and net interest revenues decreased $58
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.
In the following table, 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 from both institutional and high-net worth retail clients and customers
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, 1998
<TABLE>
<CAPTION>
PRINCIPAL
TRANSACTIONS AND INVESTMENT
NET INTEREST COMMISSIONS BANKING OTHER TOTAL
----------------- --------------- ----------- ----------- ---------
<S> <C> <C> <C> <C> <C>
Fixed Income....................................... $ 1,057 $ 28 $ 511 $ 4 $ 1,600
Equity............................................. 106 363 259 3 731
Corporate Finance Advisory......................... (16) 426 410
Merchant Banking................................... (9) 60 51
Other.............................................. 29 15 35 79
------ ----- ----------- --- ---------
$ 1,167 $ 406 $ 1,256 $ 42 $ 2,871
------ ----- ----------- --- ---------
------ ----- ----------- --- ---------
</TABLE>
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....................................... $ 1,032 $ 40 $ 337 $ 3 $ 1,412
Equity............................................. 186 304 281 2 773
Corporate Finance Advisory......................... 246 246
Merchant Banking................................... (3) 131 128
Other.............................................. 8 6 3 25 42
------ ----- ----- --- ---------
$ 1,223 $ 350 $ 998 $ 30 $ 2,601
------ ----- ----- --- ---------
------ ----- ----- --- ---------
</TABLE>
16
<PAGE>
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>
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 $1,600 million for 1998, $1,412 million for 1997
and $1,566 million for 1996. During 1998 and 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 1998 from
improved performance in high yield, primarily due to increased syndicate
activity and increased revenues in foreign exchange from strong customer flow
activity. High yield benefited from an increased volume of lead managed
underwritings. Holdings and its subsidiaries acted as lead manager for over $7.9
billion offerings in calendar 1998 up from $6.3 billion in calendar 1997. These
improvements were offset in the latter part of the year by severe spread
widening in core U.S. fixed income markets.
Investment banking revenues as a component of fixed income revenues,
increased to $511 million for the year ended 1998 from $337 million from the
year ended 1997 primarily due to increased high yield related issuances.
Holdings and its subsidiaries lead-managed fixed income offerings in calendar
1998 increased 38% with underwritings of $183 billion compared to underwritings
of $133 billion in calendar 1997 based on information supplied by Securities
Data Company.
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 benefited
from an increased volume of lead managed underwritings and syndicated loans.
Reduced contributions from fixed income derivatives and foreign exchange
resulted from significant volatility in the Asian markets.
EQUITY Equity net revenues reflect customer flow activities (both
institutional and high-net-worth retail), secondary trading, equity
underwriting, equity finance, equity derivatives and arbitrage activities.
Equity revenues were $731 million for 1998, $773 million for 1997 and $528
million for 1996.
Equity revenues decreased 5% versus fiscal 1997 as improved institutional
and retail customers flow activity was offset by reduced investment banking and
trading revenue. 1997 results for the Company's equity business increased versus
1996 primarily due to the continued favorable equity markets which existed for
most of the year. Equity underwriting, equity arbitrage and improved customer
flow activities were the primary contributors to the increase in revenues for
1997.
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<PAGE>
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 1998 to $410 million from $246 million
in 1997 and from $200 million in 1996. The increased revenues reflected improved
market share as a result of the Company's decision to invest additional
resources in this business as well as continued strength in the overall merger
and acquisition market environment. For completed M&A transactions, Holdings and
its subsidiaries has improved its worldwide ranking from #10 to #6, increasing
its market share from 5.2% to 13.2%, for the 1998 calendar year based on data
supplied by Securities Data Company. Holdings and its subsidiaries ended fiscal
1998 with a transaction pipeline which stood at $55 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 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 and advisory fees earned in its capacity as general
partner to the partnerships. These gains generally fluctuate based on the
number, type, age and performance of the underlying investments. 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 investments in the
partnerships. Merchant banking net revenues were $51 million, $128 million and
$32 million for 1998, 1997 and 1996, respectively.
NON-INTEREST EXPENSES
During 1998, the Company's non-interest expenses totaled $2,024 million, an
increase of less than 1% over 1997's non-interest expenses of $2,008 million.
Non-interest expenses were $2,067 million for 1996, including a severance charge
of $23 million. Excluding this special charge, non-interest expenses were $2,044
million for 1996.
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 1998, 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.
1996 SEVERANCE CHARGE Holdings recorded an $84 million severance charge
($50 million after-tax) 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 a worldwide business unit economic performance
review that was undertaken in the fourth quarter of 1996 to focus the Company 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. Cash outlays relating to the charge were
approximately $12 million in the fourth quarter of 1996 and approximately $11
million during 1997. The remaining residual payments were paid as deferred
payment arrangements were completed.
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<PAGE>
INCOME TAXES
The Company had an income tax provision of $272 million, $202 million and
$120 million for 1998, 1997 and 1996, respectively. The effective tax rate for
the company 32%, 34% and 39% for 1998, 1997 and 1996, respectively. The lower
effective tax rates in 1998 and 1997 reflect an increase in tax-exempt income.
The 1996 income tax provision includes a tax benefit of $10 million related to
the 1996 severance charge.
The Company's net deferred tax assets increased by $68 million to $107
million at November 30, 1998 from $39 million at November 30, 1997. It is
anticipated that the Company's net deferred tax assets will be realized through
future earnings.
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 business lines in which the Company operates are
capital intensive. Capital is required to finance, among other things, the
portion of the Company's securities inventories not funded on a secured basis,
merchant banking activities and investments in fixed assets. 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 balance sheet 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 majority of these
assets are funded on a secured basis through collateralized short-term financing
agreements with the remaining assets being funded through unsecured financing
and Capital.
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. Members of
the Company's treasury department and business unit financing groups work with
the Finance Committee to ensure coordination of global funding efforts and
implementation of the funding and liquidity policies. Regional asset and
liability committees aligned with the Company's geographic funding centers 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 to meet the needs of the Company's
businesses. The key elements of these policies are to:
(1) Maintain a Total Capital structure that supports 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.
(2) Minimize liquidity and refinancing risk by funding the Company's assets on a
global basis primarily with secured liabilities.
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
19
<PAGE>
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, 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) Obtain diversified funding through a global investor base which increases
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 limits its exposure to
any single investor or type of investor.
(4) 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 exist.
(5) Maintain sufficient financial resources to enable the Company to meet its
obligations in periods of financial stress through a combination of
collateralized short-term financings and Total Capital. 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 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.
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.
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 other investment grade types of collateralized borrowings
are less credit-sensitive and have historically been a stable financing source
irrespective of 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 which are driven by strategic business objectives
and global market conditions. The majority of the Company's assets are funded
with collateralized borrowing sources. At November 30, 1998 and 1997, $80
billion and $77 billion, respectively, of the Company's total balance sheet of
$121 billion and $114 billion at November 30, 1998 and 1997, respectively, were
financed using collateralized borrowing sources.
20
<PAGE>
TOTAL CAPITAL As part of the Company's liquidity plan, the Company
increased its Total Capital base in 1998 to $6.8 billion at November 30, 1998
from $6.6 billion at November 30, 1997 primarily due to the retention of
earnings offset by a decrease in long-term debt.
<TABLE>
<CAPTION>
NOVEMBER 30
-------------------------------
1998 1997 1996
--------- --------- ---------
(IN MILLIONS)
<S> <C> <C> <C>
LONG-TERM DEBT
Senior Notes...................................................... $ 168 $ 229 $ 215
Subordinated Indebtedness......................................... 4,111 4,313 3,950
--------- --------- ---------
4,279 4,542 4,165
--------- --------- ---------
STOCKHOLDER'S EQUITY................................................ 2,528 2,011 1,692
--------- --------- ---------
TOTAL CAPITAL....................................................... $ 6,807 $ 6,553 $ 5,857
--------- --------- ---------
--------- --------- ---------
</TABLE>
During 1998, the Company issued $750 million in long-term debt. Long-term
debt decreased to $4.3 billion at November 30, 1998 from $4.5 billion at
November 30, 1997 with a weighted-average maturity of 4.6 years at November 30,
1998 and 4.5 years at November 30, 1997.
LONG-TERM DEBT
EDGAR REPRESENTATION OF DATA POINTS USED IN PRINTED GRAPHIC
<TABLE>
<CAPTION>
1996 1997 1998
<S> <C> <C>
4.165 4.542 4.277
</TABLE>
At November 30, 1998, the Company had approximately $2.0 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 $2.5 billion at November 30, 1998 from $2.0 billion at November 30,
1997. The net increase in stockholder's equity was primarily due to the
retention of earnings partially offset by the payment of $65 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
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<PAGE>
funding is generally dependent upon its short- and long- term debt ratings. As
of November 30, 1998, 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*/Baal
S&P................................................................... A-1 A+*/A
Thomson BankWatch..................................................... TBW-1 A+/A
</TABLE>
- ------------------------
* PROVISIONAL RATINGS ON SHELF REGISTRATION
** SENIOR/SUBORDINATED
LEHMAN BROTHERS DERIVATIVE PRODUCTS On July 16, 1998, the Company announced
that it had established a special purpose subsidiary that will provide
counterparties around the world with a wide variety of derivative products and
services. The new company, Lehman Brothers Derivative Products Inc. ("LBDP") has
been assigned Aaa and AAAt credit ratings by Moody's Investor Services Inc. and
Standard & Poor's Corporation, respectively. LBDP was created to provide clients
with the most efficient delivery of a broad range of derivative product
opportunities. Its termination structure compliments the continuation structure
of Lehman Brothers Financial Products Inc. ("LBFP").
REGULATORY CAPITAL LBI, as a registered broker dealer, 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, 1998, LBI's regulatory net capital, as defined, of
$1,406 million exceeded the minimum requirement by $1,320 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
$1,332 million and $1,290 million at November 30, 1998 and 1997, 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 subsidiaries, LBFP and LBDP, have
established certain capital and operating restrictions which are reviewed by
various rating agencies. At November 30, 1998, LBFP and LBDP each had capital
which exceeded the requirement of the most stringent rating agency by
approximately $135 million and $27 million, respectively.
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, 1998,
$2,132 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 increased $240 million in 1998 to $460
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 $10,610 million included income adjusted for non-cash items of
$675 million for 1998. Net cash provided by financing activities was $10,893
million and net cash used in investing activities was $43 million.
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<PAGE>
Cash and cash equivalents decreased $176 million in 1997 to $220 million, as
net cash used in financing and investing activities exceeded net cash provided
by operating activities. Net cash provided by operating activities of $7,540
million included income adjusted for non-cash items of $503 million for 1997.
Net cash used in financing activities was $7,697 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
$4,579 million included income adjusted for non-cash items of $174 million for
1996. Net cash provided by financing activities was $4,695 million and net cash
used in investing activities was $7 million.
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 instruments 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 instruments 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 instruments at November 30,
1998 and 1997 included long positions with an aggregate market value of
approximately $1.2 billion and $2.6 billion, respectively, and short positions
with an aggregate market value of approximately $200 million and $151 million,
respectively. The Company may, from time to time, mitigate its net exposure to
any single issuer through the use of derivatives and other financial
instruments.
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 out a significant portion of
these commitments. These commitments, which are net of syndications and
participations totaled $1.5 billion at November 30, 1998 and $1.6 billion at
November 30, 1997, are typically secured against the borrower's assets and have
fixed maturity dates. The utilization of these facilities is generally
contingent upon certain representations, warranties and contractual conditions
of the borrower. Total commitments may not be indicative of actual risk or
funding requirements as the commitments may not be drawn or fully utilized and
the Company intends to continue syndicating, selling, and/or participating in
these commitments.
The Company also has lending commitments to high grade borrowers of $610
million at November 30, 1998. These commitments are typically secured against
the borrower's assets, have fixed maturity dates, and are generally contingent
upon certain representations, warranties and contractual conditions of the
borrower.
In addition to these specific commitments, the Company had various other
commitments of approximately $305 million at November 30, 1998.
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,
1998 and 1997, investments in merchant banking partnerships totaled $61 million
and $47 million, respectively, while direct investments totaled $167 million and
$10 million, respectively. 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.
23
<PAGE>
At November 30, 1998, the Company had commitments to invest up to $238
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.
In addition, at November 30, 1998, the Company had no direct short-term
bridge financings outstanding.
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 acts as a
general partner or co-general partner for approximately $1.6 billion of
partnership investment capital and manages the remaining real estate investment
portfolio. At November 30, 1998, the Company had $47 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 amounts,
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.
24
<PAGE>
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 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 9 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 separately capitalized "AAA" rated subsidiaries, Lehman
Brothers Financial Products Inc. and Lehman Brothers Derivative 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--Risk Management pages
26-29.
The Company's Trading-Related Derivative Activities have increased during
the current year to a notional amount of $2,139 billion at November 30, 1998
from $1,524 billion at November 30, 1997, primarily as a result of growth in the
Company's activities as a dealer in fixed income derivative products. Notional
amounts 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 third
party net credit exposure to be $3,824 million at November 30, 1998,
representing the fair value of the Company's OTC contracts in an unrealized gain
position, after consideration of amounts due from affiliates of $936 million and
collateral of $573 million. Collateral held related to OTC contracts generally
25
<PAGE>
includes cash and U.S. government and federal agency securities. At November 30,
1998 approximately 82% 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
clearinghouse is a counterparty to the futures contracts and options. As a
clearing member firm, the Company is required by the exchange clearinghouse to
deposit cash or other securities as collateral for its obligation upon the
origination 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 clearinghouses 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 clearinghouses impose net capital requirements for
their membership. Therefore, the potential for losses from exchange-traded
products is limited. As of November 30, 1998, the Company had approximately $414
million on deposit with futures exchanges consisting of cash and securities
(customer and proprietary), and had posted approximately $120 million of letters
of credit.
See Note 9 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 and liquidity risk.
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 and technology.
26
<PAGE>
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.
Overall risk management policy is established by a Risk Management Committee
(the "Committee") comprised of the Chief Executive Officer, the Global Risk
Manager, the Chief Financial and Administrative Officer, the Head of Equities,
the Head of Fixed Income, the Head of Global Sales and Research and the Co-Heads
of Investment Banking. 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 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.
The Global Risk Management Group (the "Group") supports the Committee, is
independent of the trading areas and reports directly to the Chief Executive
Officer. The Group combines two departments, credit risk management and market
risk management, into one unit. This facilitates the analysis of counterparty
credit and market risk exposures and leverages personnel and information
technology resources in a cost-efficient manner. The Group maintains staff 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.
CREDIT RISK Credit risk represents the possibility that a counterparty will
be unable to honor its contractual obligations to the Company. Credit risk
management is therefore an integral component of the Company's overall risk
management framework. The Credit Risk Management Department ("CRM Department")
has global responsibility for implementing the Company's overall credit risk
management framework.
The CRM Department manages the credit exposure related to 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 creditworthiness and
recommending, where appropriate, credit reserves. Credit limits and reserves 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 management also is an essential component of the
Company's overall risk management framework. The Market Risk Management
Department ("MRM Department") has global responsibility for implementing the
Company's overall market risk management framework. It is responsible for the
preparation and dissemination of risk reports, developing and implementing the
firmwide Risk Management Guidelines and evaluating adherence to these
guidelines. These guidelines provide a clear framework for risk management
decision-making. To that end the MRM Department 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 MRM Department also
evaluates liquidity risks, credit and sovereign concentrations.
The MRM Department 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
27
<PAGE>
the management of trading risk. Quantitative information is developed from a
variety of risk methodologies based upon established statistical principles. To
ensure high standards of qualitative analysis, the MRM Department has retained
seasoned risk managers with the requisite experience and academic and
professional credentials.
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 Equities 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.
The Company incurs short-term interest rate risk when facilitating the
orderly flow of customer transactions through the maintenance 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.
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.
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 Euro, Japanese yen, British pound,
Swiss franc, and Canadian dollar as well as a variety of developed and emerging
market currencies. The Company hedges its risk exposures primarily through the
use of currency forwards, swaps, futures, and options.
VALUE AT RISK For purposes of Securities and Exchange Commission risk
disclosure requirements, the Company disclosed an entity-wide value at risk
analysis of virtually all of the Company's trading activities. The value at risk
calculation measures the potential loss in expected revenues with a 95%
confidence level. The methodology incorporates actual trading revenues over a
standardized historical period. A confidence level of 95% implies, on average,
that daily trading revenues or losses will exceed daily expected trading
revenues by an amount greater than value at risk one out of every 20 trading
days.
28
<PAGE>
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.
The Company's value at risk for each component of market risk, and in total,
was as follows (in millions):
<TABLE>
<CAPTION>
NOVEMBER 30
--------------------
1998 1997
--------- ---------
<S> <C> <C>
Interest rate risk............................................ $ 16.6 $ 9.8
Equity price risk............................................. 9.7 4.7
Foreign exchange risk......................................... 1.5 1.3
Diversification benefit....................................... (7.2) (4.8)
--------- ---------
Total Company................................................. $ 20.6 $ 11.0
--------- ---------
--------- ---------
</TABLE>
During 1998, the Company's value at risk averaged $13.5 million and varied
from a high of $21.3 million to a low of $10.8 million. Value at risk during
1998 was impacted by the extreme market volatility experienced during the
August-October 1998 time period. Average daily trading revenue decreased to $4.2
million in 1998 from $5.7 million in 1997 as a result of difficult market
conditions during the August-October period.
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. 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.
YEAR 2000 READINESS DISCLOSURE
The year 2000 issue originates from computer programs and imbedded chips
using two digits rather than four to define the year. Computer programs that
have date-sensitive software may recognize a date using "00"as the year 1900
rather than the year 2000.
If not addressed and completed on a timely basis, failure of the Company's
computer systems to process year 2000 related data correctly could have a
material adverse effect on the Company's operations and financial condition.
Failures of this kind could, for example, lead to incomplete or inaccurate
accounting, settlement failures, trade processing or recording errors in
securities, currencies, commodities or other assets. It could also lead to
uncertainty regarding risk, exposures and liquidity. If not addressed, the
potential risks to the Company include financial loss, legal liability,
interruption of business and regulatory actions.
The Company established a team in 1996 to modify or replace and then test
the appropriate software and equipment to ensure that year 2000 issues are
addressed. The Company presently believes that with modifications to existing
software and conversions to new software, the year 2000 issue will be resolved
for all the Company's own systems worldwide.
In its approach to the year 2000 problem, Lehman Brothers has been guided by
a three-step methodology. The steps are:
- Inventory and Assessment
29
<PAGE>
- Remediation
- Testing
Inventory and assessment consisted of initial technical and functional
analysis across the Company's applications. Initial analysis identified systems
and applications. Each application was then reviewed and classified as highly
critical, critical or non-critical. This process is complete.
Remediation is divided into three phases. Applications specified as year
2000 non-compliant have been analyzed to determine business impact and those
that have been deemed critical were targeted for remediation. Selected Lehman
Brothers mainframe applications were sent to an outside vendor for remediation,
while the remaining applications have been repaired internally. It is 99%
complete as of the end of 1998 and is expected to be 100% complete by the end of
the first quarter of 1999.
All remediated applications are tested for non-year 2000 functionality to
confirm they still run correctly prior to year 2000 testing. At the time of
remediation, applications are logged into a change management system to further
ensure any additional changes are monitored and re-tested for year 2000
compliance.
Testing for year 2000 compliance was also organized into three phases. Phase
one involves testing individual applications or groups of applications on
mainframe or on distributed platforms. Consultants were engaged to assist with
the testing of distributed applications classified as highly critical. Phase two
involves real-time testing across platforms (integration testing). Phase three
involves testing applications between firms (external testing).
Each of these phases has been pursued in a worldwide effort coordinated in
New York, London and Tokyo where project teams and segregated lab environments
have been established. The remediation and testing has been largely completed
for core databases.
External testing itself is being performed in three steps. "Point-to-point"
testing confirms that application interfaces between the Company and individual
services and utilities function correctly. Point-to-Point testing began in
February 1998. "Beta" testing for a product follows point-to-point testing and
is a dress rehearsal for industrywide testing. Beta testing is only performed in
the U.S. Many of the markets are not providing Industrywide testing, but they
are providing some amount of end-to-end testing, where data is passed to more
than one exchange or utility. Industrywide testing follows beta testing as the
final external testing step.
In 1998, the Company participated in two Beta tests in the U.S., for the SIA
and for the Futures Industry Association (FIA). The Company has also
participated in the SIA Money Market Beta Test, the Mortgage Backed Securities
Clearing Corporation Test, the Participant Trust Company Mortgage Test and the
Government Securities Clearing Corporation Test. Overseas tests in which the
Company has participated include the Central Gilts Office (CGO) and CREST in the
United Kingdom and the Singapore International Monetary Exchange (SIMEX) test in
Singapore.
The Company is scheduled to participate in numerous domestic tests in 1999,
including the SIA Market Data Beta Test in February, the SIA industrywide Test
in March and April, the SIA money market and Stock Loan Tests in May and the SIA
Industrywide Market Data Test in May. In addition the Company is scheduled to
participate in a wide range of overseas tests in 1999, specifically, Hong Kong
and Tokyo tests planned for the first and second quarters. The Company plans to
participate in European tests as they are announced. Industrywide testing is
currently expected to be completed in the third quarter.
The Company has taken a lead in the industry's efforts to deal with the year
2000 issue by actively participating and in some cases leading, industrywide
testing efforts. Lehman Brothers chairs the Participants' Industrywide Testing
Subcommittee of the Securities Industry Association (SIA) which with partners
such as exchanges, depositories, market data vendors and buy-side firms sets up,
refines and coordinates industrywide testing in the United States. Industrywide
testing is the forum in which firms within the
30
<PAGE>
financial industry test the applications that transfer data between them. These
tests are scheduled to start in March 1999.
In addition to its leadership in U.S. testing efforts, through membership in
the Executive Committee of Global 2000, a group of international financial
firms, the Company is participating in the coordination of global year 2000
readiness in the financial community. The Company is also pursuing separate
point-to- point testing with firms not participating in industrywide testing.
Lehman Brothers also serves as a member of the Custody 2000 Working Group whose
goal is to assist the financial community in the assessment of year 2000
readiness of custodians in a variety of global markets. The Custody 2000 Working
Group will also conduct proxy testing of selected sub-custodians in a number of
markets globally.
Year 2000 also affects building and infrastructure systems. The Company is
engaged in a global effort to address facilities issues. Critical areas include
facilities components such as building management systems, elevators, heating
systems, security and fire alarm systems, electrical and other building
services. Facilities staff is surveying and testing equipment and components
and, with the Third Party Vendor team, is working to ensure their vendors and
suppliers are year 2000 ready.
However, even if these changes are successful, the Company remains at risk
from year 2000 failures caused by third parties. Externally, the Company is an
active participant in the SIA Third Party Vendor Committee. Internally, the
Company is evaluating efforts of key counterparties, banks, exchanges, agencies,
utilities and suppliers, among others, to assess and remediate their year 2000
issues. As part of this effort the Third Party Vendor team has inventoried and
has sent surveys to vendors whose software and hardware products the Company
uses and whose services the Company employs to determine their year 2000
readiness. The team is also testing critical software and hardware products to
ensure year 2000 readiness. To date the Company has received information from
95% of its vendors, including overseas vendors whose year 2000 awareness seems
to be less advanced than in the United States.
Examples of problems that could result from the failure by third parties
with whom the Company interacts to remediate year 2000 bugs include: (i) in the
case of exchanges and clearing agents, funding disruptions, failure to trade in
certain markets and settlement failures; (ii) in the case of counterparties and
clients, accounting and financial difficulties to those parties that may expose
the Company to increased credit risk and lost business; (iii) in the case of
vendors, service failures such as power, telecommunications, elevator operations
and loss of security access control; (iv) in the case of banks and other
lenders, the potential for liquidity stress due to disruptions to funding flows;
and, (v) in the case of data providers, inaccurate or out of date information
would impair the Company's ability to perform critical functions such as pricing
securities and currencies.
Additionally, general uncertainty regarding the success of remediation may
cause many market participants to reduce their market activities temporarily as
they address and assess their year 2000 efforts in 1999. This could result in a
general reduction in market activities and revenue opportunities in late 1999
and early 2000. Management cannot predict the magnitude of any such reduction or
its impact on the Company "s financial results. However, the Company's Risk
Management Department has undertaken a comprehensive review of third party and
credit risks posed by year 2000. Recognizing the uncertainty of external
dependencies, the Company is also preparing a contingency plan that identifies
potential problems, actions to minimize the likelihood of them occurring and
action plans to be invoked should they occur. These plans will include backup
processes that do not rely on computer systems, where appropriate. The
contingency plan will be complete by the end of April 1999.
However, as stated above, there can be no guarantee or assurance that the
systems of other companies on which the Company's systems rely will be
remediated in a timely manner. This or a failure to remediate by another company
or a remediation that is incompatible with the Company's systems may well have a
material adverse effect on the Company.
31
<PAGE>
The Company has established an internal auditing plan to record results and
ensure ongoing compliance of tested applications. It should be noted that
efforts focused on addressing EMU have delayed the finalization of internal and
industrywide testing in Europe.
The Company's total year 2000 project cost is based on presently available
information. The total remaining cost of the year 2000 project is estimated at
approximately $5 million which will be funded through operating cash flows and
expensed as incurred over the next one and one-half years. The Company has
incurred and expensed approximately $2 million in 1997 and an additional $4
million through November 30, 1998, related to the year 2000 project.
The costs of year 2000 testing, modifications and/or replacements and the
date on which the Company plans to complete the project are based on
management's best estimates. These estimates were derived using numerous
assumptions of future events including the continued availability of certain
resources, third party modification plans and other factors.
EMU
As of January 1, 1999, 11 European countries entered into the European
economic and monetary union (the "EMU") and replaced their local currencies with
a single currency, the Euro. The countries currently in the EMU are: Austria,
Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands,
Portugal, and Spain. During a three-year transition period, the national
currencies will continue to circulate but only as fixed denominations of the
Euro. On January 1, 1999, the Euro became the predominant currency to settle
non-cash transactions previously denominated in the participating national
currencies. The Company needed to convert certain of its systems and processes
to accommodate this currency change.
In addition to systems changes, the Company reviewed all of its
documentation in light of the changes arising from the introduction of the Euro.
Documents affected by the conversion were revised and distributed to affected
counterparties. The Company has adopted the EMU protocol agreement established
by the International Swaps and Derivatives Association, Inc., and intends to
participate in other market-initiated EMU annexes and amendments as they are
developed by relevant industry associations.
Many areas of the Company were affected by the introduction of the single
currency. The conversion was completed well within the time frame of the planned
conversion weekend. As transaction volumes had been reduced market-wide, the
process actually ran more quickly than expected at approximately 56 hours.
Success was over 98% and less than 100 positions/trades required manual
adjustments. Of those, all were fixed by Monday morning on January 4.
The changes to the Company's data and computer systems affected its
clearance, settlement and financial reporting activities, among other key
operations of the Company. The Company is also dependent for proper transactions
clearance and reporting on many third parties, including counterparties,
clearing agents, banks, exchanges, clearinghouses and providers of information.
While the Company cannot guarantee that these third parties' systems all
appropriately reflect the introduction of the Euro, to date Lehman has
experienced no material post conversion problems, either with internal or
external systems. In addition, the European markets have reacted favorably to
the introduction of the Euro.
While conversion to the Euro has reduced client demand for certain
transactions, which has impacted foreign exchange and fixed income activities in
Europe, the Company anticipates that new opportunities in Europe will be created
through an expansion of activities in both the investment grade and high yield
debt capital markets as well as investment banking opportunities. Overall,
management anticipates that the formation of EMU will not have a material
adverse effect on the trend of earnings of the Company.
The Company has incurred and expects to continue to incur expenses for the
internal technology staff, as well as costs for outside consultants, in order to
implement its EMU conversion plan and handle the
32
<PAGE>
aftermath of the conversion. Management currently estimates that the cost of its
EMU conversion program will be approximately $7 million, of which approximately
$6 million have been incurred to date.
NEW ACCOUNTING DEVELOPMENTS
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 December 15, 1997 (Fiscal 1999 for the Company). 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 June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and for Hedging Activities". SFAS No. 133 is effective for fiscal
years beginning after June 15, 1999 (Fiscal 2000 for the Company). SFAS No.133
is a complex accounting standard that requires all derivatives to be recorded at
fair value on the balance sheet. Changes in the fair value of derivatives are to
be recorded each period in earnings or Accumulated other comprehensive income, a
classification within stockholders' equity, depending on the nature of the risks
being hedged. As the Company already accounts for derivatives associated with
its trading activities on a fair value basis, SFAS No. 133 will only impact the
accounting for the Company's End User Derivative Activities. As an end user, the
Company utilizes derivatives primarily to manage interest rate risk associated
with its long-term debt and secured financing activities. (See Note 4 and Note 9
for a further discussion of the Company's End User Derivative Activities).
The Company has not yet determined the impact of adopting SFAS No. 133,
which is difficult to predict, because the actual impact ultimately will hinge
on market values at the date of adoption. However, the Company does not expect
that adoption will have a material effect on its earnings or financial
condition.
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 26-29 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.
33
<PAGE>
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
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.
34
<PAGE>
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.
35
<PAGE>
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 to be
signed on its behalf by the undersigned, thereunto duly authorized.
LEHMAN BROTHERS INC.
(Registrant)
February 26, 1999
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.
SIGNATURES TITLE DATE
- ------------------------------ --------------------------- -------------------
Chief Executive Officer
* and, Chairman of the
- ------------------------------ Board of Directors February 26, 1999
Richard S. Fuld, Jr. (principal executive
officer)
* Chief Financial Officer
- ------------------------------ (principal financial February 26, 1999
David Goldfarb officer)
* Director
- ------------------------------ February 26, 1999
Roger S. Berlind
* Director
- ------------------------------ February 26, 1999
Howard L. Clark, Jr.
* Director
- ------------------------------ February 26, 1999
Frederick Frank
* Director
- ------------------------------ February 26, 1999
Harvey M. Krueger
* Director
- ------------------------------ February 26, 1999
Bruce R. Lakefield
* Director
- ------------------------------ February 26, 1999
Sherman R. Lewis, Jr.
<TABLE>
<S> <C>
/s/ KAREN M. MULLER
--------------------------------------
Karen M. Muller
(ATTORNEY-IN-FACT)
*By: February 26, 1999
</TABLE>
36
<PAGE>
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, 1998, 1997, and 1996............. F-3
Consolidated Statement of Financial Condition at November 30, 1998 and 1997................................ F-4
Consolidated Statement of Changes in Stockholder's Equity for the Twelve Months Ended November 30, 1998,
1997, and 1996........................................................................................... F-5
Consolidated Statement of Cash Flows for the Twelve Months Ended November 30, 1998, 1997, and 1996......... F-6
Notes to Consolidated Financial Statements................................................................. F-7
</TABLE>
F-1
<PAGE>
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, 1998 and 1997, 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, 1998. 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, 1998 and 1997, and the consolidated
results of its operations and its cash flows for each of the three years ended
November 30, 1998 in conformity with generally accepted accounting principles.
ERNST & YOUNG LLP
New York, New York
January 7, 1999
F-2
<PAGE>
LEHMAN BROTHERS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF INCOME
<TABLE>
<CAPTION>
TWELVE MONTHS ENDED NOVEMBER 30
-------------------------------
1998 1997 1996
--------- --------- ---------
(IN MILLIONS)
<S> <C> <C> <C>
REVENUES
Investment banking............................................. $ 1,256 $ 998 $ 779
Principal transactions......................................... 589 848 937
Commissions.................................................... 406 350 298
Interest and dividends......................................... 15,308 12,591 10,465
Other.......................................................... 42 30 18
--------- --------- ---------
Total revenues............................................... 17,601 14,817 12,497
Interest expense............................................... 14,730 12,216 10,121
--------- --------- ---------
Net revenues................................................. 2,871 2,601 2,376
--------- --------- ---------
NON-INTEREST EXPENSES
Compensation and benefits...................................... 1,445 1,288 1,219
Brokerage, commissions and clearance fees...................... 186 191 205
Communications................................................. 93 89 94
Business development........................................... 78 70 70
Professional services.......................................... 68 82 69
Occupancy and equipment........................................ 59 68 75
Depreciation and amortization.................................. 32 39 51
Management fees................................................ 13 101 213
Other.......................................................... 50 80 48
Severance charge............................................... 23
--------- --------- ---------
Total non-interest expenses.................................. 2,024 2,008 2,067
--------- --------- ---------
Income before taxes.............................................. 847 593 309
Provision for income taxes..................................... 272 202 120
--------- --------- ---------
Net income....................................................... $ 575 $ 391 $ 189
--------- --------- ---------
</TABLE>
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
F-3
<PAGE>
LEHMAN BROTHERS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF FINANCIAL CONDITION
<TABLE>
<CAPTION>
NOVEMBER 30
--------------------
1998 1997
--------- ---------
(IN MILLIONS)
<S> <C> <C>
ASSETS
Cash and cash equivalents.................................................................... $ 460 $ 220
Cash and securities segregated and on deposit for regulatory and other purposes.............. 909 1,128
Securities and other financial instruments owned:
Governments and agencies................................................................... 15,931 17,467
Mortgages and mortgage-backed.............................................................. 10,524 2,751
Corporate debt and other................................................................... 6,824 5,544
Corporate equities......................................................................... 5,694 5,439
Derivatives and other contractual agreements............................................... 5,580 5,528
Certificates of deposit and other money market instruments................................. 1,392 2,248
--------- ---------
45,945 38,977
--------- ---------
Collateralized short-term agreements:
Securities purchased under agreements to resell............................................ 47,913 49,610
Securities borrowed........................................................................ 14,760 13,661
Receivables:
Brokers, dealers and clearing organizations................................................ 2,154 3,148
Customers.................................................................................. 3,148 3,874
Others..................................................................................... 4,859 3,107
Property, equipment and leasehold improvements (net of accumulated depreciation and
amortization of $559 in 1998 and $533 in 1997)............................................. 272 262
Other assets................................................................................. 261 146
Excess of cost over fair value of net assets acquired (net of accumulated amortization of
$108 in 1998 and $102 in 1997)............................................................. 152 158
--------- ---------
Total assets................................................................................. $ 120,833 $ 114,291
--------- ---------
LIABILITIES AND STOCKHOLDER'S EQUITY
Commercial paper and short-term debt......................................................... $ 616 $ 740
Securities and other financial instruments sold but not yet purchased:
Governments and agencies................................................................... 12,028 8,556
Corporate debt and other................................................................... 1,761 1,664
Corporate equities......................................................................... 1,428 3,124
Derivatives and other contractual agreements............................................... 3,816 3,685
--------- ---------
19,033 17,029
--------- ---------
Collateralized short-term financing:
Securities sold under agreements to repurchase............................................. 58,905 56,017
Securities loaned.......................................................................... 5,474 7,764
Advances from Holdings and other affiliates.................................................. 21,560 14,777
Payables:
Brokers, dealers and clearing organizations................................................ 2,230 3,127
Customers.................................................................................. 4,540 6,118
Accrued liabilities and other payables....................................................... 1,668 2,166
Long-term debt:
Senior notes............................................................................... 168 229
Subordinated indebtedness.................................................................. 4,111 4,313
--------- ---------
Total liabilities........................................................................ 118,305 112,280
--------- ---------
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................................................................. 1,759 1,756
Accumulated other comprehensive income..................................................... 3 3
Retained earnings.......................................................................... 766 252
--------- ---------
Total stockholder's equity............................................................... 2,528 2,011
--------- ---------
Total liabilities and stockholder's equity............................................... $ 120,833 $ 114,291
--------- ---------
</TABLE>
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
F-4
<PAGE>
LEHMAN BROTHERS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDER'S EQUITY
<TABLE>
<CAPTION>
TWELVE MONTHS ENDED NOVEMBER 30
-------------------------------
1998 1997 1996
--------- --------- ---------
(IN MILLIONS)
<S> <C> <C> <C>
Additional paid-in capital
Beginning balance................................................. $ 1,756 $ 1,828 $ 2,353
Capital contributions............................................. 7 3 13
Capital distributions............................................. (4) (75) (538)
--------- --------- ---------
Ending balance...................................................... 1,759 1,756 1,828
--------- --------- ---------
Accumulated other comprehensive income
Beginning and ending balance...................................... 3 3 3
--------- --------- ---------
Retained earnings (accumulated deficit)
Beginning balance................................................. 252 (139) (328)
Net income........................................................ 575 391 189
Dividends......................................................... (61)
--------- --------- ---------
Ending balance...................................................... 766 252 (139)
--------- --------- ---------
Total stockholder's equity.......................................... $ 2,528 $ 2,011 $ 1,692
--------- --------- ---------
</TABLE>
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
F-5
<PAGE>
LEHMAN BROTHERS INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
<TABLE>
<CAPTION>
TWELVE MONTHS ENDED NOVEMBER 30
-------------------------------
1998 1997 1996
--------- --------- ---------
(IN MILLIONS)
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES
Net income....................................................... $ 575 $ 391 $ 189
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Depreciation and amortization.................................. 32 39 51
Severance charge............................................... 23
Provisions for losses and other reserves....................... 38 52 40
Deferred tax provision (benefit)............................... 1 (149)
Other adjustments.............................................. 29 21 20
Net change in:
Cash and securities segregated and on deposit.................. 219 (465) 122
Securities and other financial instruments owned............... (6,968) 1,349 (8,133)
Securities borrowed............................................ (1,099) 5,374 (2,473)
Receivables from brokers, dealers and clearing organizations... 994 1,761 (3,191)
Receivables from customers..................................... 726 82 (1,780)
Securities and other financial instruments sold but not yet
purchased.................................................... 2,004 (837) 5,469
Securities loaned.............................................. (2,290) (2,321) 7,436
Payables to brokers, dealers and clearing organizations........ (897) 927 (1,022)
Payables to customers.......................................... (1,578) (277) 739
Accrued liabilities and other payables......................... (536) (135) 360
Other operating assets and liabilities, net.................... (1,860) 1,579 (2,280)
--------- --------- ---------
Net cash provided by (used in) operating activities.......... $ (10,610) $ 7,540 $ (4,579)
--------- --------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES
Principal payments of senior notes............................... $ (80) $ (1) $ (210)
Proceeds from issuance of subordinated indebtedness.............. 750 1,108 1,130
Principal payments of subordinated indebtedness.................. (963) (750) (261)
Net proceeds from (payments for) commercial paper and short-term
debt........................................................... (124) (1,559) 1,290
Resale agreements net of repurchase agreements................... 4,585 (12,648) 3,137
Increase in advances from Holdings and other affiliates.......... 6,783 6,225 134
Capital contributions............................................ 7 3 13
Dividends and capital distributions paid......................... (65) (75) (538)
--------- --------- ---------
Net cash provided by (used in) financing activities.......... 10,893 (7,697) 4,695
--------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of property, equipment and leasehold improvements,
net............................................................ (43) (19) (7)
--------- --------- ---------
Net cash used in investing activities........................ (43) (19) (7)
--------- --------- ---------
Net change in cash and cash equivalents...................... 240 (176) 109
--------- --------- ---------
Cash and cash equivalents, beginning of period................... 220 396 287
--------- --------- ---------
Cash and cash equivalents, end of period..................... $ 460 $ 220 $ 396
--------- --------- ---------
</TABLE>
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION (IN MILLIONS)
Interest paid totaled $14,793 in 1998, $12,225 in 1997 and $10,104 in 1996.
Income taxes paid totaled $342 in 1998, $151 in 1997 and $45 in 1996.
SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
F-6
<PAGE>
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., a registered broker-dealer ("LBI") and subsidiaries
(collectively, the "Company"). LBI 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, are included in Accumulated other comprehensive income, a separate
component of stockholder's equity. 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 (collectively, "Trading-Related Derivative Activities"). The
Company's
F-7
<PAGE>
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
accounting methodology for derivatives depends on both the type and purpose of
the derivative financial instrument.
Derivative transactions entered into for Trading-Related Derivative
Activities are recorded at market or fair value with realized and unrealized
gains and losses recognized 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 and liquidity risk. Further valuation adjustments may
be recorded, as deemed appropriate for new or complex products or for positions
with significant concentrations. 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 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 market risk exposures 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. The Company also utilizes equity
derivatives to hedge its exposure to equity price risk embedded in certain of
its debt obligations.
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. The Company
actively monitors the level of anticipated secured financing transactions to
ensure there is a high degree of certainty that such secured financing
transactions will be executed at levels at least equal to the designated
derivative product transactions.
The Company also utilizes foreign exchange forward contracts to manage the
currency exposure related to its net monetary investment in non-U.S. dollar
functional currency operations. The gain or loss from revaluing these contracts
is deferred and reported within Accumulated other comprehensive income in
stockholder's equity. The related unrealized receivables or payables due from or
to counterparties are included in receivables from or payables to brokers,
dealers and clearing organizations.
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. Related unrealized receivables or payables due from
F-8
<PAGE>
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
or to counterparties are included in receivables from or payables to brokers,
dealers and clearing organizations.
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 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 termination would be deferred
and amortized to interest income or interest expense over the remaining life of
the instrument being hedged.
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 financed under repurchase agreements are carried at
market value with changes in market value reflected in the Consolidated
Statement of Income.
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.
MERCHANT BANKING INVESTMENTS
The Company carries its merchant banking investments, including its
partnership interests, at fair value based upon the Company's assessment of the
underlying investments.
INVESTMENT BANKING
Underwriting revenues and fees for merger and acquisition advisory services
are recognized when services for the transactions are substantially completed.
Transaction-related expenses are deferred and subsequently expensed to match
revenue recognition.
F-9
<PAGE>
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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. Deferred tax liabilities are recognized for temporary differences
that will result in taxable income in future years.
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 periods not exceeding 35 years.
Goodwill is evaluated periodically for impairment and also is reduced upon the
recognition of certain acquired net operating loss carryforward benefits.
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 on a consolidated basis in accordance
with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to
Employees" ("APB 25") and its related interpretations. The Company records as
compensation and benefits the allocated share of Holdings' stock-based
compensation cost.
NOTE 2. RECENTLY ISSUED ACCOUNTING STANDARDS
On January 1, 1998, SFAS No. 125, "Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities" became fully effective.
Previously, the Financial Accounting Standards Board (the "FASB") had deferred
until that date certain provisions of SFAS No. 125 pertaining to repurchase
agreements, securities lending and similar financing transactions. As a result
of adopting the deferred provisions of SFAS No. 125, the Company has recognized
on its November 30, 1998 Consolidated Statement of Financial Condition,
approximately $1.0 million of collateral controlled on certain financing
transactions and a corresponding obligation to return such collateral at the
termination of such transactions.
In March 1998, the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants issued Statement of Position 98-1,
"Accounting for the Costs of Computer Software Developed or Obtained for
Internal Use" (the "SOP"). The SOP requires that certain costs incurred in
F-10
<PAGE>
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
connection with developing or obtaining software for internal use be capitalized
and subsequently amortized over the software's estimated useful life. The SOP
requires prospective application as of the beginning of an entity's fiscal year
without adjustment for costs that would have been capitalized had the SOP been
in effect in prior periods. The Company has elected early adoption of this
accounting pronouncement effective as of the beginning of its 1998 fiscal year
and capitalized approximately $18.4 million of purchased software and other
internal use software costs during fiscal 1998.
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive
Income". 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 is
required for comparative purposes. The Company has elected early adoption of
SFAS No. 130 for fiscal 1998. The adoption of SFAS No. 130 has no impact on the
Company's consolidated statement of income, financial condition or cash flows.
The only component of Accumulated other comprehensive income relates to foreign
currency translation adjustments.
SFAS No. 132, "Employer's Disclosures about Pensions and Other
Postretirement Benefits", was issued in February 1998, and is effective for
fiscal years beginning after December 15, 1997. SFAS No. 132 eliminates certain
existing disclosures (such as the requirement to provide a description of the
plan, including employee groups covered, type of benefit formula, funding
policy, or the requirement to disclose alternative measures of the benefit
obligation), but, at the same time, adds new disclosures (such as the
requirement to disclose a reconciliation of beginning and ending balances of the
benefit obligation and the fair value of plan assets). The Company has elected
early adoption of this accounting pronouncement effective for its 1998 fiscal
year.
NOTE 3. 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
--------------------
<S> <C> <C>
1998 1997
--------- ---------
<CAPTION>
(IN MILLIONS)
<S> <C> <C>
Short-term debt
Payables to banks............................................................................... $ 377 $ 460
Master notes.................................................................................... 51 260
Bank loans...................................................................................... 188 20
--------- ---------
Total............................................................................................. $ 616 $ 740
--------- ---------
</TABLE>
F-11
<PAGE>
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The Company's weighted-average interest rates were as follows:
<TABLE>
<CAPTION>
NOVEMBER 30
--------------------
<S> <C> <C>
1998 1997
--------- ---------
Short-term debt(1)............................................................................... 5.1% 1.7%
Securities sold under agreements to repurchase................................................... 5.1% 5.2%
</TABLE>
- ------------------------
(1) Including weighted-average interest rates of 0.3% as of November 30, 1998
and 0.8% as of November 30, 1997 related to non-U.S. dollar obligations.
NOTE 4. LONG-TERM DEBT
<TABLE>
<CAPTION>
U.S. DOLLAR
---------------------- NOVEMBER 30
FIXED FLOATING --------------------
RATE RATE 1998 1997
--------- ----------- --------- ---------
<S> <C> <C> <C> <C>
(IN MILLIONS)
SENIOR NOTES
Maturing in Fiscal 1998.................................................... $ 78
Maturing in Fiscal 1999.................................................... $ 1 $ 1 1
Maturing in Fiscal 2000.................................................... 1 1 1
Maturing in Fiscal 2001.................................................... 165 165 148
Maturing in Fiscal 2002
Maturing in Fiscal 2003.................................................... 1 1 1
December 1, 2003 and thereafter
--------- ----------- --------- ---------
Senior Notes........................................................... 168 168 229
--------- ----------- --------- ---------
SUBORDINATED INDEBTEDNESS
Maturing in Fiscal 1998.................................................... 360
Maturing in Fiscal 1999.................................................... 334 $ 357 691 692
Maturing in Fiscal 2000.................................................... 193 193 192
Maturing in Fiscal 2001.................................................... 194 194 200
Maturing in Fiscal 2002.................................................... 250 605 855 1,305
Maturing in Fiscal 2003.................................................... 475 475 475
December 1, 2003 and thereafter............................................ 1,556 147 1,703 1,089
--------- ----------- --------- ---------
Subordinated Indebtedness.............................................. 3,002 1,109 4,111 4,313
--------- ----------- --------- ---------
Long-Term Debt............................................................. $ 3,170 $ 1,109 $ 4,279 $ 4,542
--------- ----------- --------- ---------
</TABLE>
Of the Company's long-term debt outstanding as of November 30, 1998, $200
million is repayable prior to maturity at the option of the holder, at par
value. These obligations are reflected in the above table as maturing at their
put dates, fiscal 2003, rather than at their contractual maturities, fiscal
2026.
The Company's interest in 3 World Financial Center is financed with U.S.
dollar fixed rate senior notes totaling $165 million as of November 30, 1998.
These notes are unconditionally guaranteed by American Express and
collateralized by a first mortgage on the property.
As of November 30, 1998, the Company had $2.0 billion available for the
issuance of debt securities under various shelf registrations.
F-12
<PAGE>
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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
and/or currency exposure of an individual long-term debt issuance. In these
cases, the notional amount of the derivative contracts may exceed the carrying
value of the related long-term debt issuance.
At November 30, 1998 and 1997, the notional amounts of the Company's
interest rate swaps related to its long-term debt obligations were approximately
$2.9 billion and $2.8 billion, respectively. In terms of notional amounts
outstanding, these derivative products mature as follows:
<TABLE>
<CAPTION>
NOVEMBER 30
--------------------
1998 1997
--------- ---------
(IN MILLIONS)
<S> <C> <C>
Maturing in Fiscal 1998..................................................... $ 419
Maturing in Fiscal 1999..................................................... $ 334 334
Maturing in Fiscal 2000..................................................... 192 192
Maturing in Fiscal 2001..................................................... 194 200
Maturing in Fiscal 2002..................................................... 250 250
Maturing in Fiscal 2003..................................................... 475 475
December 1, 2003 and thereafter............................................. 1,484 885
--------- ---------
Total................................................................... $ 2,929 $ 2,755
--------- ---------
Weighted-average interest rate at November 30:
Receive rate................................................................ 7.60% 7.79%
Pay rate.................................................................... 6.25% 6.81%
</TABLE>
On an overall basis, the Company's long-term debt-related end user
derivative activities resulted in reduced interest expense of approximately $24
million, $26 million and $20 million in 1998, 1997 and 1996,
F-13
<PAGE>
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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, 1998
--------------------------------------------------------
LONG-TERM DEBT WEIGHTED-AVERAGE
------------------------ ------------------------------
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.................................... $ 3,170 $ 241
Floating rate................................. 1,109 4,038
----------- ----------- --- ---
Total............................................. $ 4,279 $ 4,279 7.57% 6.65%
----------- ----------- --- ---
</TABLE>
<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
Floating rate................................. 1,556 4,310
----------- -----------
4,534 4,534
----------- -----------
Non-USD Obligations............................... 8 8
----------- ----------- --- ---
Total............................................. $ 4,542 $ 4,542 7.63% 7.04%
----------- ----------- --- ---
</TABLE>
- ------------------------
(1) Weighted-average interest rates were calculated using non-U.S. dollar
interest rates, where applicable.
NOTE 5. HOLDINGS' INCENTIVE PLANS
The Company's employees participate in Holdings' various incentive plans.
The Company records its allocated share of Holdings' stock-based compensation
cost. Holdings' stock-based compensation cost was $221 million, $162 million,
and $136 million for the years ended November 30, 1998, 1997 and 1996,
respectively. The Company's allocated cost was approximately $155 million, $113
million, and $95 million for the years ended November 30, 1998, 1997 and 1996,
respectively. In accordance with APB 25, Holdings has not recognized
compensation cost for its stock option awards and ESPP. The following is a
description of Holdings' various 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, 1998 and 1997, 2.0 million
shares and 1.6 million shares, respectively, of Common Stock had been purchased
by eligible employees of Holdings through the ESPP.
F-14
<PAGE>
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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, 1998, a total of 2.0 million awards had been
granted under the Replacement Plan, including both stock options and restricted
stock; 0.5 million were outstanding at November 30, 1998. 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, 1998, 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 12.8 million are outstanding and 2.8 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 15.5 million shares of Common Stock may be
subject to awards. At November 30, 1998, RSU, PSU and stock option awards by
Holdings with respect to 8.4 million shares of Common Stock have been made under
the 1996 Plan of which 6.9 million are outstanding and 1.5 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 for up to 50 million shares of Common
Stock which may be subject to awards. At November 30, 1998, awards with respect
to 33.6 million shares of Common Stock have been made under the EIP of which
32.7 million are outstanding and 0.9 million have been converted to freely
transferable Common Stock. Approximately 26.9 million of the outstanding awards
consist of RSUs and PSUs which have vesting and transfer restrictions extending
through the year 2004.
STOCK OPTIONS
In accordance with SFAS No. 123, "Accounting for Stock-Based Compensation",
Holdings utilized the Black-Scholes option-pricing model to quantify the
proforma effects of the fair value of the stock options granted and outstanding
during 1998 and 1997 on net income. The Company's 1998, 1997 and 1996 pro forma
net income would have been approximately $566 million, $378 million and $187
million, respectively, compared to actual net income of $575 million, $391
million and $189 million, respectively. The pro forma amounts reflect the
effects of the 1998 and 1997 stock option grants and the 15% purchase discount
from market value offered to the Company's employees who participate in the
ESPP.
NOTE 6. 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
F-15
<PAGE>
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
be segregated for customers' regulated commodity accounts, as defined. At
November 30, 1998, LBI's regulatory net capital, as defined, of $1,406 million
exceeded the minimum requirement by $1,320 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
$1,332 million and $1,290 million at November 30, 1998 and 1997, 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 subsidiaries, Lehman Brothers
Financial Products Inc. ("LBFP") and Lehman Brothers Derivative Products Inc.
("LBDP"), have established certain capital and operating restrictions which are
reviewed by various rating agencies. At November 30, 1998, LBFP and LBDP had
capital which exceeded the requirement of the most stringent rating agency by
approximately $135 million and $27 million, respectively.
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, 1998,
$2,132 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-16
<PAGE>
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 7. HOLDINGS' 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 Holdings' employee benefit plans in which the
Company's employees participate:
<TABLE>
<CAPTION>
PENSION BENEFITS POSTRETIREMENT
BENEFITS
NOVEMBER 30 NOVEMBER 30
-------------------- ----------------------
1998 1997 1998 1997
--------- --------- --------- -----------
<S> <C> <C> <C> <C>
(IN MILLIONS)
CHANGE IN BENEFIT OBLIGATION
Benefit obligation at beginning of year.......................................... $ 456 $ 399 $ 49 $ 49
Service cost before expenses..................................................... 9 8 1 1
Interest cost.................................................................... 32 29 3 3
Actuarial (gain) loss............................................................ 21 36 (1)
Benefits paid.................................................................... (16) (16) (3) (3)
--------- --------- --- ---
Benefit obligation at end of year................................................ $ 502 $ 456 $ 50 $ 49
--------- --------- --- ---
CHANGE IN PLAN ASSETS
Fair value of plan assets at beginning of year................................... $ 618 $ 560
Actual return on plan assets, net of expenses.................................... 70 74
Benefits paid.................................................................... (16) (16)
--------- ---------
Fair value of plan assets at end of year......................................... $ 672 $ 618
--------- ---------
Funded status (underfunded)...................................................... $ 170 $ 162 $ (50) $ (49)
Unrecognized net actuarial (gain) loss........................................... 55 50 (21) (22)
Unrecognized prior service cost (credit)......................................... (2) (3) (6) (7)
--------- --------- --- ---
Prepaid (accrued) benefit cost................................................... $ 223 $ 209 $ (77) $ (78)
--------- --------- --- ---
WEIGHTED-AVERAGE ASSUMPTIONS
Discount rate.................................................................... 6.8% 7.0% 6.8% 7.0%
Expected return on plan assets................................................... 8.8% 9.0%
Rate of compensation increase.................................................... 5.0% 5.0% 5.0% 5.0%
</TABLE>
F-17
<PAGE>
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
For measurement purposes, the annual health care cost trend rate was assumed
to be 8.0% for the year ended November 30, 1999. The rate was 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.
<TABLE>
<CAPTION>
POSTRETIREMENT BENEFITS
PENSION BENEFITS TWELVE MONTHS ENDED
TWELVE MONTHS ENDED NOVEMBER 30
NOVEMBER 30
------------------------------- -------------------------------------
1998 1997 1996 1998 1997 1996
--------- --------- --------- ----- ----- -----
(IN MILLIONS)
<S> <C> <C> <C> <C> <C> <C>
COMPONENTS OF NET PERIODIC BENEFIT COST
Service cost............................................ $ 10 $ 8 $ 7 $ 1 $ 1 $ 1
Interest cost........................................... 32 29 28 3 3 3
Expected return on plan assets.......................... (55) (50) (47)
Recognized net actuarial (gain) loss.................... (1) (1) 2 (1) (2) (1)
-- -- --
--- --- ---
Net periodic benefit (income) cost...................... $ (14) $ (14) $ (10) $ 3 $ 2 $ 3
-- -- --
--- --- ---
</TABLE>
Assumed health care cost trend rates have a significant effect on the amount
reported for postretirement benefits. A one-percentage-point change in assumed
health care cost trend rates would have the following effects:
<TABLE>
<CAPTION>
1% POINT 1% POINT
INCREASE DECREASE
------------- -------------
(IN MILLIONS)
<S> <C> <C>
Effect on total service and interest cost components in fiscal 1998....................... $ 0.4 $ (0.3)
Effect on postretirement benefit obligation at November 30, 1998.......................... $ 4.7 $ (4.5)
</TABLE>
NOTE 8. 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 agreement between
Holdings and its subsidiaries. In accordance with this agreement, the balances
due to Holdings at November 30, 1998 and 1997 were $158 million and $232
million, respectively.
The provision for income taxes consists of the following:
<TABLE>
<CAPTION>
TWELVE MONTHS ENDED NOVEMBER 30
-------------------------------
1998 1997 1996
--------- --------- ---------
(IN MILLIONS)
<S> <C> <C> <C>
CURRENT
Federal............................................................... $ 102 $ 84 $ 177
State................................................................. 88 66 86
Foreign............................................................... 81 52 6
--------- --------- ---------
271 202 269
--------- --------- ---------
DEFERRED
Federal............................................................... 16 1 (101)
State................................................................. (15) (1) (48)
--------- --------- ---------
1 (149)
--------- --------- ---------
$ 272 $ 202 $ 120
--------- --------- ---------
</TABLE>
F-18
<PAGE>
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Income before taxes included $79 million, $86 million, and $22 million that
has also been subject to income taxes of foreign jurisdictions for 1998, 1997
and 1996, 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
-------------------------------
1998 1997 1996
--------- --------- ---------
(IN MILLIONS)
<S> <C> <C> <C>
Federal income taxes at statutory rate.................................. $ 296 $ 208 $ 108
State and local taxes................................................... 47 42 24
Tax-exempt income (70) (45) (24)
Amortization of goodwill................................................ 3 3 3
Other, net.............................................................. (4) (6) 9
--------- --------- ---------
$ 272 $ 202 $ 120
--------- --------- ---------
</TABLE>
Deferred income taxes are provided for the differences between the tax basis
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 for deferred income taxes on undistributed earnings of foreign
subsidiaries.
At November 30, 1998 and 1997 the deferred tax assets and liabilities
consisted of the following:
<TABLE>
<CAPTION>
NOVEMBER 30
----------------------
1998 1997
--------- -----
(IN MILLIONS)
<S> <C> <C>
Deferred tax assets
Reserves not currently deductible............................................... $ 27
Unrealized trading and investment activity...................................... $ 98 38
Other........................................................................... 11 3
--------- ---
109 68
Less: Valuation allowance....................................................... 27
--------- ---
Total deferred tax assets net of valuation allowance........................ $ 109 $ 41
Deferred tax liabilities........................................................ (2) (2)
--------- ---
Net deferred tax assets......................................................... $ 107 $ 39
--------- ---
</TABLE>
The net deferred tax assets are included in Other assets in the accompanying
Consolidated Statement of Financial Condition. At November 30, 1998, there was
no valuation allowance recorded against deferred tax assets, compared to $27
million at November 30, 1997. The Company's Consolidated Statement of Income
includes a $10 million net benefit from the reversal of a portion of this
valuation allowance; the remaining decrease in the valuation allowance is
associated with a corresponding decrease in the Company's net deferred tax
assets.
For tax return purposes, the Company has approximately $25 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 NOL carryforward has been transferred to Holdings in accordance
F-19
<PAGE>
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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, LBI reimbursed
Holdings for $72 million of reversals of net deferred tax assets in 1998 and was
reimbursed for $36 million of net deferred tax assets in 1997.
NOTE 9. 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 (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 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 (e.g.,
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. Equity swaps are contractual agreements whereby one party
agrees to receive the appreciation (or depreciation) value over a strike price
on an equity investment in return for paying another rate, which is usually
based upon equity index movements or interest rates. 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.
F-20
<PAGE>
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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 (put) or sell (call) 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 assets 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.
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 amounts. Notional amounts are
not recorded on-balance sheet, but rather are utilized solely as a basis for
determining future cash flows to be
F-21
<PAGE>
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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 amounts of the Company's
Trading-Related Derivative Activities:
TRADING-RELATED DERIVATIVE FINANCIAL INSTRUMENTS
<TABLE>
<CAPTION>
NOTIONAL/CONTRACT AMOUNTS 1998
-------------------------- WEIGHTED-
NOVEMBER 30 NOVEMBER 30 AVERAGE
1998 1997 MATURITY
------------ ------------ -------------
<S> <C> <C> <C>
(IN MILLIONS)
Interest rate and currency swaps and options
(including caps, collars and floors).................................... $1,635,636 $ 990,893 4.83
Foreign exchange forward and future contracts and options................. 194,652 197,093 .24
Other fixed income securities contracts (including futures contracts and
options, mortgage-backed securities forward contracts and options)...... 305,096 330,081 .70
Equity contracts (including equity swaps, futures, warrants and
options)................................................................ 3,922 5,710 1.08
Commodity contracts (including swaps, futures, forwards and options)...... 565
------------ ------------ ---
TOTAL..................................................................... $2,139,306 $1,524,342 3.82
------------ ------------ ---
</TABLE>
Of the total notional amounts at November 30, 1998 and 1997, approximately
$1,961 billion and $1,324 billion are over-the-counter and $178 billion and $200
billion are exchange-traded, respectively. The total weighted-average maturity
at November 30, 1998, for over-the-counter and exchange-traded contracts was
4.07 years and 1.08 years, respectively. Approximately $868 billion of the
notional/contract amount of the Company's Trading-Related Derivative Activities
mature within the year ended November 30, 1999, of which approximately 29% 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 Statement of Financial Condition for those transactions with
counterparties executed under a legally enforceable master netting agreement and
are netted across products when such provisions are stated in the master netting
agreement. The Company offers equity, fixed income and foreign exchange products
to its customers. Because of the integrated nature of the market for such
products, each product area trades cash instruments as well as related
derivative products.
Principal transactions and net interest revenues related to the Company's
fixed income business (which includes foreign exchange) were $1,045 million for
1998, $1,030 million for 1997 and $1,236 million for 1996. Principal
transactions and net interest revenues related to the Company's equity business
were $106 million for 1998, $186 million for 1997 and $51 million for 1996.
Listed in the following table is the fair value of the Company's
Trading-Related Derivative Activities as of November 30, 1998 and 1997 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 do not vary significantly from the
average fair value calculated on a more
F-22
<PAGE>
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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*
TWELVE MONTHS ENDED
FAIR VALUE*
NOVEMBER 30, 1998 NOVEMBER 30, 1998
---------------------- ----------------------
ASSETS LIABILITIES ASSETS LIABILITIES
--------- ----------- --------- -----------
(IN MILLIONS)
<S> <C> <C> <C> <C>
Interest rate and currency swaps and options (including
caps, collars and floors).............................. $ 4,491 $ 2,371 $ 4,298 $ 2,283
Foreign exchange forward contracts and options........... 476 752 652 593
Options on other fixed income securities, mortgage-backed
securities forward contracts and options............... 217 211 281 256
Equity contracts (including equity swaps, warrants and
options)............................................... 385 473 188 246
Commodity contracts (including swaps, forwards, and
options)............................................... 11 9 24 7
--------- ----------- --------- -----------
TOTAL.................................................... $ 5,580 $ 3,816 $ 5,443 $ 3,385
--------- ----------- --------- -----------
</TABLE>
<TABLE>
<CAPTION>
AVERAGE FAIR VALUE*
TWELVE MONTHS ENDED
FAIR VALUE*
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 swaps, 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 non-cash collateral) and do
not include receivables or payables related to exchange-traded futures
contracts.
Assets included in the table above 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, 1998 represents the Company's net
receivable/payable for derivative financial instruments before consideration of
collateral. Included within the $5,580 million fair value of assets at November
30, 1998 was $5,333 million related to swaps and other OTC contracts and $247
million related to exchange-traded option and warrant contracts. Included within
the $5,528 million fair value of assets at November 30, 1997 was $5,444 million
related to swaps and other OTC contracts and $84 million related to
exchange-traded option and warrant contracts.
F-23
<PAGE>
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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 third
party net credit exposure to be $3,824 million at November 30, 1998,
representing the fair value of the Company's OTC contracts in an unrealized gain
position, after consideration of amounts due from affiliates of $936 million and
collateral of $573 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 third party net
credit exposure at November 30, 1998 for OTC contracts based upon actual ratings
made by external rating agencies or by equivalent ratings established and
utilized by the Company's Corporate Credit Department.
<TABLE>
<CAPTION>
COUNTERPARTY
RISK RATING S&P/MOODY'S
EXPOSURE EQUIVALENT NET CREDIT
- ------------------- ------------------------------------------------------ -------------
<S> <C> <C>
1 AAA/Aaa 23%
2 AA-/Aa3 or higher 23%
3 A-/A3 or higher 36%
4 BBB-/Baa3 or higher 12%
5 BB-/Ba3 or higher 4%
6 B+/B1 or lower 2%
</TABLE>
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 clearinghouses impose net capital
requirements for their membership. Additionally, the exchange clearinghouse
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, 1998 and 1997, the notional
amounts of the Company's end user activities related to its long-term debt
obligations were approximately $2.9 billion and $2.8 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, 1998 and 1997, the Company had $127 billion 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
F-24
<PAGE>
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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. The Company
actively monitors the level of anticipated secured financing transactions to
ensure there is a high degree of certainty that such secured financing
transactions will be executed at levels at least equal to the designated
derivative product transactions. At November 30, 1998 and 1997, the Company, as
an end user, utilized derivative financial instruments with an aggregate
notional amount of $73.4 billion and $38.7 billion, respectively, to modify the
interest rate characteristics of its secured financing activities. The total
notional amount of these agreements had a weighted-average maturity of 1.0 years
and 0.5 years as of November 30, 1998 and 1997, respectively.
The Company terminated certain swaps designated as hedges of the Company's
secured financing activities. At November 30, 1998 and 1997, a loss of
approximately $2.8 million and $12.0 million, respectively, 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 increased (decreased) net revenues by
approximately $4 million, $(10) million and $16 million for 1998, 1997 and 1996,
respectively.
NOTE 10. 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 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
F-25
<PAGE>
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
estimated amounts the Company would receive (pay) if the derivative financial
instruments were terminated based on market rates at November 30, 1998 and 1997,
respectively.
<TABLE>
<CAPTION>
NOVEMBER 30
--------------------
<S> <C> <C>
1998 1997
--------- ---------
<CAPTION>
(IN MILLIONS)
<S> <C> <C>
Carrying value of long-term debt............................................................... $ 4,279 $ 4,542
Fair value of long-term debt................................................................... 4,381 4,673
--------- ---------
Unrecognized net gain (loss) on long-term debt................................................. $ (102) $ (131)
--------- ---------
Unrecognized net gain (loss) on long-term debt end user activities............................. $ 155 $ 46
--------- ---------
</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. The majority of such financing activities are
short term in nature which approximates fair value. At November 30, 1998 and
1997, the Company had $127 billion 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, 1998 and 1997, the Company, as an end user, utilized
derivative financial instruments with an aggregate notional amount of $73.4
billion and $38.7 billion, respectively, to modify the interest rate
characteristics of its secured financing activities. The unrecognized net losses
related to these derivative financial instruments were $110 million and $6
million at November 30, 1998 and 1997, respectively, which were substantially
offset by unrecognized net gains on the Company's secured financing activities.
Additionally, at November 30, 1998 the Company had approximately $84 million of
unrecognized losses related to approximately $4.4 billion of long-term fixed
rate repurchase agreements.
NOTE 11. OTHER COMMITMENTS AND CONTINGENCIES
As of November 30, 1998 and 1997, the Company was contingently liable for
$1.7 billion and $3.2 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, 1998 and 1997, in connection with its financing
activities, the Company had outstanding commitments under certain lending
arrangements of approximately $3.0 billion and $1.9 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.
As of November 30, 1998, the Company had pledged securities, primarily fixed
income, having a market value of approximately $6.5 billion, as collateral for
securities borrowed having a market value of approximately $6.3 billion.
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.
F-26
<PAGE>
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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 trading activities, makes
commitments to extend credit in loan syndication transactions principally to
below investment grade borrowers and then participates a significant portion of
these commitments. These commitments, net of syndications and participations,
totaled $1.5 billion and $1.6 billion at November 30, 1998 and 1997,
respectively and 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. Total commitments may not be indicative of actual risk or funding
requirements as the commitments may not be drawn or fully utilized and the
Company intends to continue syndicating, selling, and/or participating in these
commitments.
The Company also had lending commitments to high-grade borrowers of $610
million and $140 million at November 30, 1998 and 1997, respectively. These
commitments also are typically secured against the borrower's assets, have fixed
maturity dates, and are generally contingent upon certain representations,
warranties and contractual conditions of the borrower.
At November 30, 1998 and 1997, the Company had commitments to invest up to
$238 million and $325 million in partnerships, respectively, 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.
In addition to these specific commitments, the Company had various other
commitments of approximately $305 million at November 30, 1998.
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.
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
F-27
<PAGE>
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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 13% of the Company's total assets at
November 30, 1998. In addition, primarily all of the collateral held by the
Company for resale agreements or securities borrowed, which together represented
52% of total assets at November 30, 1998, consisted of securities issued by the
U.S. government, federal agencies or non-U.S. governments. The Company's most
significant industry 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 1998, 1997 and 1996 was $12 million, $15 million and $21 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 non-cancellable operating leases
(net of subleases of $45 million) are as follows (in millions):
<TABLE>
<S> <C>
Fiscal 1999.......................................................... $ 15
Fiscal 2000.......................................................... 14
Fiscal 2001.......................................................... 13
Fiscal 2002.......................................................... 13
Fiscal 2003.......................................................... 9
December 1, 2003 and thereafter...................................... 183
---------
$ 247
---------
</TABLE>
NOTE 12. 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
services it provides. These reimbursements, a portion of which are variable in
nature, are classified in the Consolidated Statement of Income as a reduction of
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 subsidiaries. Advances from
Holdings and other affiliates were $21,560 million and $14,777 million at
November 30, 1998 and 1997, respectively.
F-28
<PAGE>
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
In connection therewith, advances from Holdings aggregating approximately
$18.3 billion and $12.3 billion at November 30, 1998 and 1997, 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, 1998 and 1997. In addition, the Company had
borrowings from Holdings and subsidiaries of Holdings comprised of approximately
$957 million and $1,414 million in subordinated indebtedness at November 30,
1998 and 1997, respectively. Total net interest charges incurred during the
twelve months ended November 30, 1998, 1997 and 1996 from Holdings amounted to
$996 million, $565 million and $492 million, respectively. In addition, the
Company has advances from other subsidiaries of Holdings aggregating
approximately $3.2 billion and $2.5 billion, at November 30, 1998 and 1997,
respectively, with various repayment terms. The Company had notes and other
receivables due from Holdings and subsidiaries of Holdings aggregating
approximately $4.3 billion and $3.0 billion at November 30, 1998 and 1997,
respectively, with various interest rates and repayment terms.
At November 30, 1998, the Company has $18.0 billion of securities purchased
under agreements to resell and $9.4 billion of securities sold under agreements
to repurchase with Holdings and subsidiaries of Holdings.
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 1998, the Company paid $65 million to Holdings, $4 million as a
return of capital and $61 million as dividends. In 1997 the Company paid $75
million to Holdings as a return of capital.
NOTE 13. 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 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.
NOTE 14. 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,
F-29
<PAGE>
LEHMAN BROTHERS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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>
1998 1997
------------------------------------------ ------------------------------------------
NOV. 30 AUG. 31 MAY 31 FEB. 28 NOV. 30 AUG. 31 MAY 31 FEB. 28
--------- --------- --------- --------- --------- --------- --------- ---------
(IN MILLIONS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Total revenues........................ $ 3,930 $ 4,766 $ 4,791 $ 4,102 $ 4,043 $ 3,927 $ 3,405 $ 3,440
Interest expense...................... 3,663 3,928 3,783 3,356 3,319 3,228 2,850 2,819
Net revenues.......................... 267 838 1,008 746 724 699 555 621
Non-interest expenses
Compensation and benefits........... 194 375 512 364 278 391 259 360
Other expenses...................... 56 165 166 180 119 197 210 192
--------- --------- --------- --------- --------- --------- --------- ---------
Total non-interest expenses........... 250 540 678 544 397 588 469 552
--------- --------- --------- --------- --------- --------- --------- ---------
Income (loss) before taxes............ 17 298 330 202 327 111 86 69
Provision for (benefit from) income
taxes............................... (40) 106 130 76 126 27 27 22
--------- --------- --------- --------- --------- --------- --------- ---------
Net income (loss)..................... $ 57 $ 192 $ 200 $ 126 $ 201 $ 84 $ 59 $ 47
--------- --------- --------- --------- --------- --------- --------- ---------
--------- --------- --------- --------- --------- --------- --------- ---------
</TABLE>
F-30
<PAGE>
EXHIBIT 12.1
LEHMAN BROTHERS INC. AND SUBSIDIARIES
COMPUTATION IN SUPPORT OF RATIO OF EARNINGS TO FIXED CHARGES
(DOLLARS IN MILLIONS)
<TABLE>
<CAPTION>
FOR THE FOR THE FOR THE FOR THE FOR THE
ELEVEN MONTHS TWELVE MONTHS TWELVE MONTHS TWELVE MONTHS TWELVE MONTHS
ENDED ENDED ENDED ENDED ENDED
NOVEMBER 30 NOVEMBER 30 NOVEMBER 30 NOVEMBER 30 NOVEMBER 30
1994 1995 1996 1997 1998
--------------- -------------- -------------- -------------- --------------
<S> <C> <C> <C> <C> <C>
Fixed Charges:
Interest expense:
Subordinated indebtedness....... $ 184 $ 204 $ 221 $ 236 $ 239
Bank loans and other
borrowings*................... 5,661 9,750 9,900 11,980 14,491
Interest component of rentals of
office and equipment.......... 27 25 18 16 16
Other adjustments**............. 53 2 7 3 4
------ ------- ------- ------- -------
TOTAL (A)................... $ 5,925 $ 9,981 $ 10,146 $ 12,235 $ 14,750
------ ------- ------- ------- -------
------ ------- ------- ------- -------
Earnings:
Pretax income (loss) from
continuing operations......... $ 1 $ 78 $ 309 $ 593 $ 847
Fixed charges................... 5,925 9,981 10,146 12,235 14,750
Other adjustments***............ (52) (1) (6) (2) (4)
------ ------- ------- ------- -------
TOTAL (B)................... $ 5,874 $ 10,058 $ 10,449 $ 12,826 $ 15,593
------ ------- ------- ------- -------
------ ------- ------- ------- -------
(B / A)........................... **** 1.01 1.03 1.05 1.06
</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 $51 million in 1994 in order to cover the
deficiencies.
<PAGE>
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 Nos. 333-08319 and 333-51913 of Lehman
Brothers Inc. and in the related Prospectuses, of our report dated January 7,
1999, with respect to the consolidated financial statements of Lehman Brothers
Inc. included in its 1998 Annual Report on Form 10-K for the year ended November
30, 1998.
/s/ Ernst & Young LLP
ERNST & YOUNG LLP
New York, New York
February 26, 1999
<PAGE>
Exhibit 24
POWER OF ATTORNEY
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Thomas A. Russo, Jennifer Marre and
Karen M. Muller and each of them, his or her true and lawful
attorneys-in-fact and agents, with full power of substitution and
resubstitution, for him or her and in his or her 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, 1998 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 be done, as fully to all intents and purposes as
he or she 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 26, 1999
SIGNATURES TITLE
---------- -----
/s/ Richard S. Fuld Jr.
--------------------------------- Chief Executive Officer and
Richard S. Fuld Jr. Chairman of the Board of Directors
(principal executive officer)
/s/ David Goldfarb
--------------------------------- Chief Financial Officer
David Goldfarb (principal financial 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
--------------------------------- Director
Sherman R. Lewis, Jr.
<TABLE> <S> <C>
<PAGE>
<ARTICLE> BD
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONSOLIDATED STATEMENT OF FINANCIAL CONDITION AT NOVEMBER 30, 1998 AND THE
CONSOLIDATED STATEMENT OF INCOME FOR THE TWELVE MONTHS ENDED NOVEMBER 30, 1998
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-30-1998
<PERIOD-START> DEC-01-1997
<PERIOD-END> NOV-30-1998
<CASH> 1,369
<RECEIVABLES> 10,161
<SECURITIES-RESALE> 47,913
<SECURITIES-BORROWED> 14,760
<INSTRUMENTS-OWNED> 45,945
<PP&E> 272
<TOTAL-ASSETS> 120,833
<SHORT-TERM> 616
<PAYABLES> 6,770
<REPOS-SOLD> 58,905
<SECURITIES-LOANED> 5,474
<INSTRUMENTS-SOLD> 19,033
<LONG-TERM> 4,279
0
0
<COMMON> 0
<OTHER-SE> 2,528
<TOTAL-LIABILITY-AND-EQUITY> 120,833
<TRADING-REVENUE> 589
<INTEREST-DIVIDENDS> 15,308
<COMMISSIONS> 406
<INVESTMENT-BANKING-REVENUES> 1,256
<FEE-REVENUE> 0
<INTEREST-EXPENSE> 14,730
<COMPENSATION> 1,445
<INCOME-PRETAX> 847
<INCOME-PRE-EXTRAORDINARY> 575
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 575
<EPS-PRIMARY> 0
<EPS-DILUTED> 0
</TABLE>
