-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, MgOy/y0wxr7m/6MjJ+kUAaC49CGisPDY3Zgf/h/EoAIHgHeZzxeWBKonsWE6gCco XT5ngN1VYdggcKFEhheQHw== 0000950123-98-002086.txt : 19980302 0000950123-98-002086.hdr.sgml : 19980302 ACCESSION NUMBER: 0000950123-98-002086 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 13 CONFORMED PERIOD OF REPORT: 19971130 FILED AS OF DATE: 19980227 SROS: NYSE FILER: COMPANY DATA: COMPANY CONFORMED NAME: LEHMAN BROTHERS HOLDINGS INC CENTRAL INDEX KEY: 0000806085 STANDARD INDUSTRIAL CLASSIFICATION: SECURITY BROKERS, DEALERS & FLOTATION COMPANIES [6211] IRS NUMBER: 133216325 STATE OF INCORPORATION: DE FISCAL YEAR END: 1130 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 001-09466 FILM NUMBER: 98552280 BUSINESS ADDRESS: STREET 1: AMERICAN EXPRESS TWR STREET 2: 3 WORLD FINANCIAL CNTR CITY: NEW YORK STATE: NY ZIP: 10048 BUSINESS PHONE: 2125267000 MAIL ADDRESS: STREET 1: AMERICAN EXPRESS TOWER 15TH FL STREET 2: 2 WORLD TRADE CENTER CITY: NEW YORK STATE: NY ZIP: 10048 FORMER COMPANY: FORMER CONFORMED NAME: SHEARSON LEHMAN HUTTON HOLDINGS INC DATE OF NAME CHANGE: 19901017 10-K405 1 LEHMAN BROTHERS HOLDINGS INC. 1 ================================================================================ SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------------------ FORM 10-K (MARK ONE) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED NOVEMBER 30, 1997 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 COMMISSION FILE NUMBER 1-9466 LEHMAN BROTHERS HOLDINGS INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 13-3216325 (STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.) 3 WORLD FINANCIAL CENTER 10285 NEW YORK, NEW YORK (ZIP CODE) (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (212) 526-7000 SECURITIES REGISTERED PURSUANT TO SECTION 12(b)OF THE ACT:
NAME OF EACH EXCHANGE TITLE OF EACH CLASS ON WHICH REGISTERED - ------------------------------------------------------------------------------------------------------ Common Stock, $0.10 par value New York Stock Exchange Pacific Stock Exchange Select Technology Index Call Warrants Expiring May 15, 1998 American Stock Exchange Global Telecommunications Stock Upside Note Securities(SM) Due 2000 American Stock Exchange 8 3/4% Notes Due 2002 New York Stock Exchange 8.30% Quarterly Income Capital Securities Series A, Due December 31, 2035 New York Stock Exchange $55 Million Serial Zero Coupon Senior Notes Due May 16, 1998 American Stock Exchange
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 (section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X] Aggregate market value of the common equity held by non-affiliates of the Registrant at February 10, 1998 was approximately $6,868,507,423. For purposes of this information, the outstanding shares of common stock owned by certain executive officers of the Registrant were deemed to be shares of common stock held by affiliates. As of February 10, 1998, 119,097,077 shares of the Registrant's Common Stock, $0.10 par value per share, were issued and outstanding. DOCUMENTS INCORPORATED BY REFERENCE: (1) Lehman Brothers Holdings Inc. 1997 Annual Report to Stockholders (the "Annual Report") -- Incorporated in part in Form 10-K, Parts I, II and IV. (2) Lehman Brothers Holdings Inc. Proxy Statement for its 1998 Annual Meeting of Stockholders (the "Proxy Statement") -- Incorporated in part in Form 10-K, Parts I and III. ================================================================================ 2 PART I ITEM 1. BUSINESS GENERAL DEVELOPMENT OF BUSINESS As used herein, "Holdings" or the "Registrant" means Lehman Brothers Holdings Inc., a Delaware corporation, incorporated on December 29, 1983. Holdings and its subsidiaries are collectively referred to as the "Company", the "Firm" or "Lehman Brothers," and the principal subsidiary of Holdings, Lehman Brothers Inc., a Delaware corporation, is referred to herein as "LBI." 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. 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 acts as a market-maker 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"), and holds memberships or associate memberships on several principal international securities and commodities exchanges, including the London, Tokyo, Hong Kong, Frankfurt, Paris, Stockholm and Milan stock exchanges. The Company's business activities are highly integrated and constitute a single industry segment. Financial information concerning the Company for the fiscal years ended November 30, 1997, November 30, 1996 and November 30, 1995, including the amount of revenue contributed by classes of similar products or services that accounted for 10% or more of the Company's consolidated revenues in any one of those periods, is set forth in the Consolidated Financial Statements and the Notes thereto in the 1997 Annual Report and is incorporated herein by reference. Information with respect to the Company's operations by geographic area are set forth in Note 14 to the Notes to Consolidated Financial Statements on pages 92-93 of the 1997 Annual Report and is incorporated herein by reference. Since 1990, Lehman Brothers has focused on a "client/customer-driven" strategy. Under this strategy, Lehman Brothers concentrates on serving the needs of major issuing and advisory clients and investing customers worldwide to build an increasing flow of business that leverages the Company's research, underwriting and distribution capabilities. Customer flow continues to be the primary source of the Company's net revenues. Developing long-term relationships with issuing clients and investing customers is a central premise of the Company's client/customer-driven strategy. Based on management's belief that each client and customer directs a majority of its financial transactions to a limited number of investment banks, Lehman Brothers' investment banking and institutional and private client sales professionals focus on a targeted group of clients and customers worldwide to identify and develop lead relationships. The Company believes that such relationships position Lehman Brothers to receive a substantial portion of its clients' and customers' financial business and lessen the volatility of net revenues generally associated with the financial services industry. LEHMAN BUSINESSES Lehman Brothers is a leading underwriter of global fixed income and equity securities in the public and private markets. The Company is also a prominent advisor for corporations and governments around the world. 1 3 INVESTMENT BANKING Lehman Brothers' Investment Banking professionals are responsible for developing and maintaining relationships with issuing clients, gaining a thorough understanding of their specific needs and bringing together the full resources of Lehman Brothers to accomplish their financial objectives. Investment Banking is organized into industry, product and geographic coverage groups, enabling individual bankers to develop specific expertise in particular industries and markets. Global industry coverage groups include Financial Services, Healthcare, Industrial, Media and Telecommunications, Natural Resources, Power, Real Estate and Technology. Where appropriate, specialized product groups are partnered with the industry and geographic groups to provide tailor-made solutions for Lehman Brothers' clients. These groups include Equity Capital Markets, which includes equity and equity-related securities and derivatives; Debt Capital Markets, which incorporates expertise in syndicate, liability management, derivatives and private placements; Mergers and Acquisitions; and Leveraged Finance, which includes high yield debt and bank loan syndication. Mergers and Acquisitions/Strategic Advisory. Lehman Brothers has a long history of providing strategic advisory services to corporate, institutional and government clients around the world on a wide range of financial matters, including mergers and acquisitions, restructurings and spin-offs, targeted stock transactions, share repurchase strategies, takeover defenses, corporate governance issues and tax optimization strategies. Linkages between strategic advisory services and the Firm's foreign exchange, derivatives and leveraged financing products are widely utilized. The Company's Mergers and Acquisitions group works closely with product, industry and geographic coverage bankers around the world. Geographically, Lehman Brothers maintains investment banking offices in six cities within the U.S. and in 18 cities in Europe, Canada, the Middle East, Asia and Latin America. FIXED INCOME Lehman Brothers actively participates in all key fixed income markets worldwide and maintains a 24-hour trading presence in global fixed income securities. The Company combines professionals from the distribution, research and trading areas of Fixed Income, together with investment bankers, into teams to serve the financial needs of the Company's clients and customers. The Company is a leading underwriter of new issues, and is also a preeminent market-maker in these and other fixed income securities. The Company's global presence facilitates client and customer transactions and provides liquidity in marketable fixed and floating rate debt securities. Fixed Income businesses include the following: Government and Agency Obligations. Lehman Brothers is one of the leading primary dealers in U.S. government securities, as designated by the Federal Reserve Bank of New York, participating in the underwriting and market-making of U.S. Treasury bills, notes and bonds, and securities of federal agencies. The Company is also a market-maker in the government securities of all G7 countries, and participates in other major European and Asian government bond markets. The Company is active in the Canadian market through its Toronto office, in France as a reporting dealer and in Italy as a super-primary dealer. Money Market Products. Lehman Brothers holds a dominant market position in the origination and distribution of commercial paper. The Company is an appointed dealer for over 600 commercial paper programs on behalf of companies and government agencies worldwide. Corporate Debt Securities. Lehman Brothers engages in the underwriting and market making of fixed and floating rate investment grade debt worldwide. Since 1995, the Company has received global medium-term note mandates for over 270 programs with a borrowing capacity of $657 billion. The Company is also a major participant in the preferred stock market, managing numerous offerings of long-term and perpetual preferreds and auction rate securities. High Yield Securities and Bank Loans. The Company also underwrites and makes markets in non-investment grade debt securities and bank loans. The Company now provides a "one-stop" leveraged finance solution for corporate and financial acquirers and high yield issuers. 2 4 Emerging Market Securities. The Company is active in the trading, structuring and underwriting of Latin American, Eastern European, and Asian dollar and local currency instruments. The Company maintains investment banking offices in Mexico City, Sao Paulo, Buenos Aires and New Delhi, among other locations. Mortgage and Asset-Backed Securities. The Company is a leading underwriter of and market-maker in residential and commercial mortgage- and asset-backed securities and is active in all areas of secured lending, structured finance and securitized products. Lehman Brothers underwrites and makes markets in the full range of U.S. agency-backed mortgage products, mortgage-backed securities, asset-backed securities and whole loan products. The Company also is engaged in principal real estate investments. Internationally, the Firm has expanded its capabilities in mortgage and asset-backed securities, leases, mortgages, multi-family financing and commercial loans. Municipal and Tax-Exempt Securities. Lehman Brothers is a major dealer in municipal and tax-exempt securities, including general obligation and revenue bonds, notes issued by states, counties, cities, and state and local governmental agencies, municipal leases, tax-exempt commercial paper and put bonds. Lehman Brothers is also a leader in the structuring, underwriting and sale of tax-exempt and taxable securities and derivative products for city, state, not-for-profit and other public sector clients. Financing. The Company's Financing unit engages in three primary functions: managing the Company's matched book activities, supplying secured financing to customers, and providing funding for the Company's activities. Matched book funding involves lending cash on a short-term basis to institutional customers collateralized by marketable securities, typically government or government agency securities. The Company enters into these agreements in various currencies and seeks to generate profits from the difference between interest earned and interest paid. The Financing unit works with the Company's institutional sales force to identify customers that have cash to invest and/or securities to pledge to meet the financing and investment objectives of the Company and its customers. Financing also coordinates with the Company's treasury area to provide collateralized financing for a large portion of the Company's securities and other financial instruments owned. In addition to its activities on behalf of its U.S. clients and customers, the Company is a major participant in the European and Asian repurchase agreement markets, providing secured financing for the Firm's customers in those regions. Fixed Income Derivatives. The Company offers a broad range of derivative product services in all major currencies on a 24-hour-per-day global basis. Derivatives professionals are integrated into all of the Company's fixed income areas in response to the continued convergence of the cash and derivative markets worldwide. Foreign Exchange. Lehman Brothers' global foreign exchange operation provides its customers with 24-hour access and trade execution in all currencies for spot, forward and over-the-counter option markets. In a collaboration with the Firm's emerging markets unit, the Firm's foreign exchange activities have increasingly diversified into Latin America, Eastern Europe and Asian currencies. Lehman Brothers also provides advisory services to central banks, corporations and investors worldwide, structuring innovative products to fit their specific needs. The Firm makes extensive use of its worldwide macroeconomics research to advise clients on the appropriate strategies to minimize interest rate and currency risk. In addition to the Company's traditional client/customer-driven foreign exchange activities, Lehman Brothers also trades foreign exchange for its own account. EQUITIES Lehman Brothers has integrated professionals from the Equities sales, trading, investment banking and research areas to serve the financial needs of the Company's equity clients and customers. The Company's equity expertise and the integrated nature of the Company's global operations enable Lehman Brothers 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. 3 5 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 participates in the global equity and equity-related markets in all major currencies through its worldwide presence and membership in major stock exchanges, including among others, those in New York, London, Tokyo, Hong Kong, Frankfurt, Paris, Milan and Stockholm. Equity Derivatives. Lehman Brothers offers equity derivative capabilities across a wide spectrum of products and currencies, including domestic and international program trading, listed options and futures and structured derivatives. In 1997, Lehman Brothers reorganized its equity derivatives business into two major product areas - a global volatility business, encompassing options-related products, and a global portfolio trading business that specializes in index arbitrage, agency/risk baskets and other structured products. Equity Finance. Lehman Brothers maintains an extensive Equity Financing and Prime Broker business to provide liquidity to its clients and customers and supply a source of secured financing for the Firm. Equity Finance provides margin lending for the purchase of equities and other capital markets' products as well as securities lending and short selling facilitation. The Prime Broker business, which significantly increased its global business in 1997, engages in full operations, clearing and processing services for that unit's customers. MERCHANT BANKING Lehman Brothers' merchant banking activities include making principal investments in corporations in partnership with clients of the Firm, raising capital from institutional and high-net-worth investors and managing these investments until they are realized. The Firm's Merchant Banking group has more than 20 dedicated professionals based in New York, London and Hong Kong. In September 1997, the Firm established a new $2 billion merchant banking fund, for which a subsidiary of LBI will act as general partner. The Company has commitments to invest up to an additional $498 million in the partnerships, which in turn will make direct merchant banking related investments. The Company's current merchant banking activities include investments in nine active partnerships, for which the Company acts as general partner, as well as direct investments. These merchant banking investments include both publicly traded and privately held companies diversified on a geographic and industry basis. At November 30, 1997, the investment in merchant banking partnerships was $167 million and direct investments were $75 million. GLOBAL DISTRIBUTION Lehman Brothers' institutional and private client sales organizations encompass distinct global sales forces that have been integrated into the Fixed Income and Equities businesses to provide investors with the full array of products and research offered by the Firm. Fixed Income Sales. The Firm's Fixed Income sales force is one of the largest in the industry, with approximately 325 professionals in 14 locations worldwide, serving the investing and liquidity needs of major institutional investors. Employing a relationship management approach that provides superior information flow and product opportunities for the Firm's customers, the Fixed Income sales organization covers the major share of the buying power in the global fixed income markets. Further, the Firm's expertise in foreign exchange and derivatives provides customers with comprehensive solutions to their global risk management needs. Equity Sales. Lehman Brothers' institutional Equity sales group of over 315 professionals provides an extensive range of services to institutional investors through locations in the U.S., Europe and Asia. The Equity sales organization focuses on developing long-term relationships though a comprehensive understanding of customers' investment objectives, while providing proficient execution and consistent liquidity in a wide range of global equity securities and derivatives. 4 6 Private Client Sales. The Company's Private Client Services group of 288 professionals serves the investment needs of private investors with substantial assets as well as over 1,000 mid-sized institutional accounts worldwide. The group has a global presence with investment representatives located in 12 offices worldwide. Among other services, investment professionals provide their clients with direct access to fixed income, equity, foreign exchange and derivative products, as well as the Firm's research and execution capabilities, thereby serving as a valuable extension of the Firm's institutional sales force. RESEARCH Fixed Income Research. Fixed Income research at Lehman Brothers encompasses the full range of research disciplines: quantitative, economic, strategic, credit, portfolio, relative value and market-specific analysis. Fixed Income research is integrated with and supports the Company's investment banking, sales and trading activities. An important objective of Fixed Income research is to have in place high quality research analysts covering industry, geographic and economic sectors that support the activities of the Company's clients and customers. The department's 275 specialists provide expertise in U.S., European and Asian government and agency securities, derivatives, sovereign issues, corporate securities, high yield, asset- and mortgage-backed securities, real estate, emerging market debt and municipal securities. Equity Research. The Equity Research department, comprised of 260 professionals, is integrated with and supports the Company's investment banking, sales and trading activities. To ensure in-depth expertise within various markets, Equity Research has established regional teams on a worldwide basis that are staffed with industry and strategy specialists. OTHER BUSINESS ACTIVITIES Lehman Brothers also participates in business opportunities such as arbitrage and proprietary trading that leverage the Company's expertise, infrastructure and resources. These businesses may generate substantial revenues but generally entail a higher degree of risk as the Company trades for its own account. Arbitrage. Lehman Brothers engages in a variety of arbitrage activities. In traditional or "riskless" arbitrage, the Company seeks to benefit from temporary price discrepancies that occur when a security is traded in two or more markets, or when a convertible or derivative security is trading at a price disparate from its underlying security. The Company's "risk" arbitrage activities involve the purchase of securities at discounts from the expected values that would be realized if certain proposed or anticipated corporate transactions (such as mergers, acquisitions, recapitalizations, exchange offers, reorganizations, bankruptcies, liquidations or spin-offs) were to occur. To the extent that these anticipated transactions do not materialize in a manner consistent with the Company's expectations, the Company is subject to the risk that the value of these investments will decline. Lehman Brothers' arbitrage activities benefit from the Company's presence in the global capital markets, access to advanced information technology, in-depth market research, proprietary risk management tools and general experience in assessing rapidly changing market conditions. Asset Management. In 1997, the Firm launched a series of 12 onshore and offshore funds managed by 25 third-party managers. The Firm also offers a number of tailored products to its client base, including an array of single client funds, managed accounts and advisory services. Proprietary Trading. In addition to its customer-flow activities, Lehman Brothers also takes proprietary positions in interest rates, foreign exchange, various securities, derivatives and commodities for its own account. The Company's proprietary trading activities bring together various research and trading disciplines allowing it to take market positions, which at times may be significant, consistent with the Company's expectations of future events (such as movements in the level of interest rates, changes in the shape of yield curves and changes in the value of currencies). The Company is subject to the risk that actual market events will be different from the Company's expectations, which may result in significant losses associated with such proprietary positions. The Company's proprietary trading activities are generally carried out in consultation with personnel from the relevant major product areas (e.g., mortgages, derivatives and foreign exchange). 5 7 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. In 1997, the Company invested in a strategic global foundation for information technology upon which all future investments in technology will be leveraged. The Company's response to the Year 2000 issue is described under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Other -- Impact of the Year 2000" on page 59 of the Annual Report, and is incorporated herein by reference. RISK MANAGEMENT As a leading global investment banking company, risk is an inherent part of the Company's businesses. Global markets, by their nature, are prone to uncertainty and subject participants to a variety of risks. The Company has developed policies and procedures to identify, measure and monitor each of the risks involved in its trading, brokerage and investment banking activities on a global basis. The principal risks of Lehman Brothers are market, credit, liquidity, legal and operational risks. Risk Management is considered to be of paramount importance. The Company devotes significant resources across all of its worldwide trading operations to the measurement, management and analysis of risk, including investments in personnel, information technology infrastructure and systems. A complete description of the Firm's Risk Management procedures is contained in "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Risk Management" on pages 55-58 of the Annual Report, and is incorporated herein by reference. NON-CORE ASSETS Prior to 1990, the Company participated in a number of activities that were not central to its current business as an institutional investment banking firm. As a result of these activities, the Company carries on its balance sheet a number of relatively illiquid assets (the "Non-Core Assets"), including a number of individual real estate assets, limited partnership interests and a number of smaller investments. Subsequent to their purchase, the values of certain of these Non-Core Assets declined below the recorded values on the Company's balance sheet, which necessitated the write-down of the carrying values of these assets and corresponding charges to the Company's Consolidated Statement of Income. Certain of these activities have resulted in various legal proceedings. Since 1990, management has devoted substantial resources to reducing the Company's Non-Core Assets. At November 30, 1997, the Company had $48 million of net exposure to these real estate activities, including investments, commitments and contingent liabilities under guarantees and credit enhancements. The value of the Company's Non-Core Assets includes carrying value plus contingent exposures net of reserves. Management's intention with regard to these Non-Core Assets is the prudent liquidation of these investments as and when possible. COMPETITION All aspects of the Company's business are highly competitive. The Company competes in domestic and international markets directly with numerous other brokers and dealers in securities and commodities, investment banking firms, investment advisors and certain commercial banks and, indirectly for investment funds, with insurance companies and others. The financial services industry has become considerably more concentrated as numerous securities firms have either ceased operations or have been acquired by or merged into other firms. In addition, several small 6 8 and specialized securities firms have been successful in raising significant amounts of capital for their merger and acquisition activities and merchant banking investment vehicles and for their own accounts. These developments have increased competition from firms, a number of whom have significantly greater equity capital than the Company. 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. The Company does business in the international fixed income, equity and commodity markets and undertakes investment banking activities through its 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, the Company is 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). Holdings' subsidiary, Lehman Brothers Japan Inc., is a licensed securities company in Japan and a member of the Tokyo Stock Exchange, the Osaka Stock Exchange and the Tokyo Financial Futures Exchange and, as such, is regulated by the Japanese Ministry of Finance, the Japan Securities Dealers Association and such exchanges. The Company believes that it is in material compliance with the regulations described herein. CAPITAL REQUIREMENTS LBI, Lehman Brothers International (Europe) ("LBIE"), the Tokyo branch of Lehman Brothers Japan Inc. ("LBJTB") and other of Holdings' subsidiaries are subject to various securities, commodities and banking regulations and capital adequacy requirements promulgated by the regulatory and exchange authorities of the countries in which they operate. Reference is made to "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources -- Regulatory Capital" on page 51 of the 1997 Annual Report, and Note 8 of Notes to Consolidated Financial Statements. EMPLOYEES As of November 30, 1997 the Company employed approximately 8,340 persons, including 5,832 in the U.S. and 2,508 internationally. The Company considers its relationship with its employees to be good. 7 9 ITEM 2. PROPERTIES The Company's headquarters occupy approximately 1.1 million square feet of space at 3 World Financial Center in New York, New York, which is owned by the Company as tenants-in-common with American Express and various other American Express subsidiaries, and approximately 77,000 square feet of which has been subleased. The Company leases approximately 405,000 square feet for offices located at 101 Hudson Street in Jersey City, New Jersey (the "Operations Center"), of which approximately 63,000 square feet has been subleased. The Operations Center is used by systems, operations, and certain administrative personnel and contains certain back-up trading systems. The lease expires in December 2010. The Company leases approximately 338,000 square feet of office space in London, England. Most of the Company's other offices are located in leased premises, the leases for which expire at various dates through the year 2007. Facilities owned or occupied by the Company and its subsidiaries are believed to be adequate for the purposes for which they are currently used and are well maintained. ITEM 3. LEGAL PROCEEDINGS The Company is involved in a number of judicial, regulatory and arbitration proceedings concerning matters arising in connection with the conduct of its business. Such proceedings include actions brought against the Company and others with respect to transactions in which the Company acted as an underwriter or financial advisor, actions arising out of the Company's activities as a broker or dealer in securities and commodities and actions brought on behalf of various classes of claimants against many securities and commodities firms, including the Company. Although there can be no assurance as to the ultimate outcome, the Company has denied, or believes it has a meritorious defense and will deny, liability in all significant cases pending against it including the matters described below, and intends to defend vigorously each such case. Although there can be no assurance as to the ultimate outcome, based on information currently available and established reserves, the Company believes that the eventual outcome of the actions against it, including the matters described below, will not, in the aggregate, have a material adverse effect on the consolidated financial condition of the Company. Bamaodah v. E.F. Hutton & Company Inc. In April 1986, Ahmed and Saleh Bamaodah commenced an action against E.F. Hutton & Company Inc., ("EFH") to recover all losses the Bamaodahs had incurred since May 1981 in the trading of commodity futures contracts in a nondiscretionary EFH trading account. The Dubai Civil Court ruled that the trading of commodity futures contracts constituted illegal gambling under Islamic law and that therefore the brokerage contract was void. In January 1987, a judgment was rendered against EFH in the amount of $48,656,000. On January 5, 1991, the Dubai Court of Appeals affirmed the judgment. On March 22, 1992, the Court of Cassation, Dubai's highest court, revoked and quashed the decision of the Court of Appeals and ordered that the case be remanded to the Court of Appeals for a further review. On April 26, 1994, the Dubai Court of Appeals again affirmed the judgment of the Dubai Civil Court. The Company appealed the judgment to the Court of Cassation, which reversed the Court of Appeals on November 27, 1994 and ordered that a new expert be appointed to review the case. A new expert has been appointed, with instructions to report back to the Court of Cassation. Actions Relating To First Capital Holdings Inc. Concurrent with the bankruptcy filing of First Capital Holdings ("FCH") in May, 1991 and the conservatorship and receivership of its two life insurance subsidiaries, First Capital Life Insurance Company ("First Capital Life") and Fidelity Bankers Life Insurance Company ("Fidelity Bankers Life") (First Capital Life and Fidelity Bankers Life collectively, the "Insurance Subsidiaries"), a number of lawsuits were commenced, naming one or more of Holdings, Lehman Brothers and American Express as defendants 8 10 (individually or collectively, as the case may be, the "American Express Defendants"). Most of these actions have been subsequently settled and/or dismissed. The matter still pending is described below. The Virginia Commissioner of Insurance Action. On December 9, 1992, a complaint was filed in the United States District Court for the Eastern District of Virginia (the "Virginia Court") by Steven Foster, the Virginia Commissioner of Insurance (the "Commissioner") as Deputy Receiver of Fidelity Bankers Life. The Complaint names Holdings and Weingarten, Ginsberg and Leonard Gubar, a former director of FCH and Fidelity Bankers Life, as defendants. The Complaint alleges that Holdings acquiesced in and approved the continued mismanagement of Fidelity Bankers Life and that it participated in directing the investment of Fidelity Bankers Life assets. The complaint asserts claims under the federal securities laws and asserts common law claims including fraud, negligence and breach of fiduciary duty and alleges violations of the Virginia Securities laws by Holdings. It allegedly seeks no less than $220 million in damages to Fidelity Bankers Life and its present and former policyholders and creditors and punitive damages. Holdings has answered the complaint, denying its material allegations. As a result of Holdings' motion for summary judgment, the court limited the damages the Commissioner may seek to less than approximately $30 million. Easton & Co. v. Mutual Benefit Life Insurance Co., et al., Easton & Co. v. Lehman Brothers Inc. Lehman Brothers was named as a defendant in two consolidated class action complaints pending in the United States District Court for the District of New Jersey (the "N.J. District Court"). Easton & Co. v. Mutual Benefit Life Insurance Co., et al. ("Easton I"), and Easton & Co. v. Lehman Brothers Inc. ("Easton II"). The plaintiff in both of these actions is Easton & Co., which is a broker-dealer located in Fort Lee, New Jersey. Both of these actions allege federal securities law claims and pendent common law claims in connection with the sale of certain municipal bonds as to which Mutual Benefit Life Insurance Company ("MBLI") has guaranteed the payment of principal and interest. MBLI is an insurance company which was placed in rehabilitation proceedings under the supervision of the New Jersey Insurance Department on or about July 16, 1991. Easton I was commenced on or about September 17, 1991. The litigation was purportedly brought on behalf of a class consisting of all persons and entities who purchased DeKalb, Georgia Housing Authority MultiFamily Housing Revenue Refunding Bonds (North Hill Ltd. Project), Series 1991, due November 30, 1994 (the "DeKalb Bonds") during the period from May 3, 1991 (when the DeKalb bonds were issued) through July 16, 1991. Lehman Brothers acted as underwriter for this bond issue, which was in the aggregate principal amount of $18.7 million. The complaint alleged that Lehman Brothers violated Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder, and sought damages in an unspecified amount or rescission. The complaint also alleged a common law negligent misrepresentation claim against Lehman Brothers and the other defendants. Easton II was commenced on or about May 18, 1992, and named Lehman Brothers as the only defendant. Plaintiff purported to bring this second lawsuit on behalf of a class composed of all persons who purchased "MBLI-backed Bonds" from Lehman Brothers during the period April 19, 1991 through July 16, 1991. The complaint alleged that Lehman Brothers violated Section 10(b) and Rule 10b-5, and seeks monetary damages in an unspecified amount, or rescission pursuant to Section 29(b) of the Exchange Act. The complaint also contained a common law claim of alleged breach of duty and negligence. On or about February 9, 1993, the N.J. District Court granted plaintiffs' motion for class certification in Easton I. The parties agreed to certification of a class in Easton II for purchases of certain fixed-rate MBLI-backed bonds during the class period. LBI, together with the other defendants in Easton I and Easton II, has agreed to settle both cases, subject to court approval. Warren D. Chisum, et al. v. Lehman Brothers Inc. et al. On February 28, 1994 a purported class action was filed in the United States District Court for the Northern District of Texas. An amended complaint was filed on December 15, 1994. The amended complaint names LBI and two former EFH employees as defendants. The complaint alleges that defendants violated Section 10(b) of the Exchange Act and RICO, breached their fiduciary duties and the limited partners' 9 11 contract and committed fraud in connection with the origination, sale and operation of nine EFH net lease real estate limited partnerships. Plaintiffs seek: (i) to certify a class of all persons who purchased limited partnership interests in the nine partnerships at issue, (ii) unspecified damages, plus interest or rescission, (iii) treble damages, (iv) punitive damages and (v) accounting and attorneys' fees. On April 2, 1996 the Court filed an opinion and order certifying the litigation as a class action, consisting of all persons who purchased interests in the nine EFH net lease limited partnerships. On July 11, 1996, the Court issued a memorandum and order dismissing plaintiffs' RICO claim. Defendants answered the complaint and denied its material allegations. The parties have entered into a settlement agreement which was preliminarily approved by the Court on February 20, 1998 and is subject to the Court's final approval. Actions Relating to the Sales and Marketing of Limited Partnerships Subsequent to a January 26, 1996 article in the Wall Street Journal entitled "SEC, Brokers Study Pact on Partnerships," various putative class actions were filed in different state courts relating to the sales and marketing of limited partnerships by E.F. Hutton & Co. and Shearson and their affiliates during the 1980s. Thereafter all of these actions were consolidated into the two actions described below, or were effectively stayed while these actions proceed. Under the terms of an agreement between American Express and Holdings, American Express has agreed to indemnify Holdings for liabilities which it may incur in connection with any action relating to any business conducted by The Balcor Company, a former Lehman Brothers subsidiary ("Balcor"), in which Holdings is named as a parent company or control person of Balcor. Holdings believes that some of the allegations in certain of the actions described below are covered by this indemnity. In re Lehman Brothers Limited Partnership Litigation. On October 18, 1996, a purported first consolidated and amended class action complaint was filed in the Court of Chancery of the State of Delaware in and for New Castle County on behalf of all persons who purchased units in various public, proprietary limited partnerships organized by Shearson or E.F. Hutton & Co. or operated by affiliates of those entities between 1981 and the present (with certain exceptions). Defendants are LBI and 56 Lehman-affiliated general partners. The complaint alleges that defendants breached their fiduciary duties or aided and abetted such a breach by allegedly misrepresenting and or failing to disclose the nature of the risks and the status and financial condition of the partnerships; collecting excessive fees; failing to exercise due care in selecting investments for the partnerships; and recommending and selling the partnerships as suitable investments. The complaint seeks, among other things (1) to certify the case as a class action; (2) to declare that defendants breached their duties; (3) to enjoin defendants from operating the partnerships for their own benefit; (4) to account for all profits and impose a constructive trust on them; and (5) to award compensatory damages, costs and expenses and attorneys' fees. Klein, et al. v. Lehman Brothers, Inc., et al. On January 15, 1998, a purported third amended class action complaint was filed in the Superior Court of New Jersey, Law Division: Union County on behalf of investors in certain specified limited partnerships sponsored by Balcor and sold by various entities, including, among others, Shearson and certain of its affiliates. Named as defendants are LBI, various affiliates of LBI, American Express Company, Smith Barney Holdings, Inc., Balcor, a number of Balcor-originated limited partnerships and various individuals and entities affiliated with Balcor. The complaint alleges claims in connection with the marketing, sale and operation of the limited partnerships for common law fraud and deceit, equitable fraud, negligent misrepresentation, breach of fiduciary duty and contract and violation of certain New Jersey statutes relating to the sale of securities. The complaint seeks compensatory damages for lost principal and interest, general damages and punitive damages, treble damages under the New Jersey statutes, and costs and attorneys' fees. Maxwell Related Litigation There is one remaining lawsuit arising out of transactions entered into with the late Robert Maxwell or entities controlled by Maxwell interests. 10 12 MCC Proceeds Inc. v. Lehman Brothers International (Europe). This action was commenced by issuance of a writ in the High Court of Justice in London, England on July 14, 1995. In this action, MCC Proceeds Inc., as successor to Macmillan, Inc., seeks a declaration of the rightful ownership of approximately 10.6 million shares of Berlitz International Inc. common stock. The High Court granted LBIE's application to dismiss the proceeding and assessed costs against MCC Proceeds. On December 19, 1997, the Court of Appeal affirmed the dismissal of this proceeding. Lehman Brothers Commercial Corporation and Lehman Brothers Special Financing Inc. v. Minmetals International Non-Ferrous Metals Trading Company On November 15, 1994, two Lehman Brothers subsidiaries, Lehman Brothers Commercial Corporation ("LBCC") and Lehman Brothers Special Financing Inc. ("LBSF"), commenced an action against Minmetals International Non-Ferrous Metals Trading Company ("Minmetals") and China National Metals and Minerals Import and Export Company ("CNM") in the United States District Court for the Southern District of New York alleging breach of contract against Minmetals and breach of guarantee against CNM. The litigation arose from the refusal by Minmetals and CNM to honor their obligations with respect to certain foreign exchange and swap transactions. LBCC and LBSF seek to recover approximately $52.5 million from Minmetals and/or CNM. On June 26, 1995, the court granted CNM's motion to dismiss the claims against it, but also granted LBCC and LBSF leave to replead. Minmetals filed fourteen counterclaims against Lehman entities based on violations of federal securities and commodities laws and rules, and theories of fraud, breach of fiduciary duty and conversion. The court denied a motion by the Lehman counterclaim defendants to dismiss the six fraud-based counterclaims. On June 24, 1996, the court granted the motion of LBCC and LBSF to file an amended complaint naming CNM as an additional defendant. Discovery is progressing. Actions Relating to National Association of Securities Dealers Automated Quotations System ("NASDAQ") Market Maker Antitrust and Securities Litigation. Beginning in May, 1994, several class actions were filed in various state and federal courts against various broker-dealers making markets in NASDAQ securities. With respect to a number of those actions LBI was either specifically named as a defendant or was not specifically named as a defendant but could be deemed to be a member of the defendant class as defined in the complaints. Plaintiffs in these cases have alleged violations of the antitrust laws, securities laws and have pled a variety of other statutory and common law claims. All of these actions are based on the theory that because odd-eighth quotes occur less often than quarter quotes, NASDAQ market makers must be colluding wrongfully to maintain a wider spread. By Order filed October 14, 1994, the Judicial Panel on Multidistrict Litigation consolidated these actions in the Southern District of New York and ordered that all related actions be transferred and coordinated for all pretrial purposes. The case is captioned In Re NASDAQ Market-Makers Antitrust Litigation, MDL No. 1023. On December 16, 1994, plaintiffs served a consolidated Amended Complaint naming 33 defendants including LBI. Plaintiffs claim violations of the federal antitrust laws including Section I of the Sherman Antitrust Act. Plaintiffs seek unspecified compensatory damages trebled in accordance with the antitrust laws, costs including attorneys' fees as well as injunctive relief. The court dismissed the action with leave to replead, stating that the complaint failed to identify the securities involved with sufficient specificity. The plaintiffs replied and the defendants answered the amended complaint on November 17, 1995. On December 23, 1997, LBI settled the class action along with 29 other broker-dealers. The settlement is subject to final approval by the court. LBI entered into a Stipulation and Order resolving a civil complaint filed by the U.S. Department of Justice alleging that LBI and 23 other NASDAQ market makers violated Section 1 of the Sherman Act in connection with certain market making practices. In entering into the Stipulation and Order the parties agreed that the defendants would not engage in certain types of market making activities and the defendants undertook specified steps to assure compliance with their agreement. The Stipulation and Order were approved by the United States District Court for the Southern District of New York, which decision is on 11 13 appeal to the Second Circuit Court of Appeals. If the approval is affirmed throughout the appellate process, the complaint will be dismissed with prejudice. Sonnenfeld v. The City and County of Denver, Colorado, et al. On August 4, 1995, a Consolidated Amended Class Action Complaint (the "Complaint") was filed in the United States District Court for the District of Colorado, consolidating and amending previously filed complaints and adding, among other defendants, LBI. The Complaint was purportedly brought on behalf of all persons, other than defendants, who purchased Denver Airport System Revenue Bonds during the period February 27, 1992 through May 3, 1994 that were issued by the City and County of Denver and who were damaged by their investments. The parties entered into a settlement of the action which was approved by the Court on December 8, 1997. AIA Holding SA et al. v. Lehman Brothers Inc. and Bear Stearns & Co., Inc. On July 9, 1997, LBI was served with a complaint in the U.S. District Court for the Southern District of New York in which 277 named plaintiffs assert 24 causes of action against LBI and Bear Stearns & Co., Inc. The amount of damages claimed is unspecified. The claims arise from the activities of an individual named Ahmad Daouk, who was employed by an introducing broker which introduced accounts to Shearson Lehman Hutton between 1988 and 1992. Daouk allegedly perpetrated a fraud upon the claimants, who are mostly investors of Middle Eastern origin, and the complaint alleges that Shearson breached various contractual and common law duties owed to the investors. LBI and Bear Stearns & Co., Inc. have filed a motion to dismiss the complaint and expect a ruling on such motion within the next several months. Actions Relating to Bre-X Minerals Ltd. McNamara et al. v. Bre-X Minerals Ltd. et al. On July 25, 1997, an Amended Class Action Complaint was filed in the United States District Court for the Eastern District of Texas against 16 defendants, including LBI, which seeks unspecified compensatory damages, interest, costs and attorney's fees on behalf of purchasers of Bre-X common stock and/or Bresea common stock. The Complaint raises claims under the federal securities laws and the common law of fraud and negligent misrepresentation. The Complaint's stated basis for naming LBI is that one of its securities analysts published research on Bre-X. On or about November 21, 1997, several defendants, including LBI, moved to dismiss the Complaint, or, in the alternative, to transfer venue to the Southern District of New York. Plaintiffs have also filed a motion for class certification, which is stayed pending resolution of the motions to dismiss. Klaasen v. Lehman Brothers Inc. et al. On October 2, 1997, William L. Klaasen, "individually and for all those similarly situated within the State of California," filed a Complaint against LBI in the Superior Court for the State of California in and for the County of San Diego. The Complaint raises a claim for common law negligence, and seeks, on behalf of California purchasers of Bre-X and Bresea stock, class certification, rescission, interest, compensatory and punitive damages, disgorgement and restitution of profits and compensation received by LBI, and costs. The action is currently stayed by consent until the earlier of April 1, 1998 or 30 days following the decision on the motion to dismiss in the McNamara case. Chow et al. v. Bre-X Minerals Ltd. et al. On October 10, 1997, 125 named plaintiffs filed an action in the Court of Queen's Bench of Alberta, in Calgary, Canada, against 35 named defendants, including LBI. Plaintiffs' claim against LBI, which has not yet been served, is for common law negligence. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. 12 14 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The approximate number of holders of record of the Registrant's Common Stock was 25,332 at February 10, 1998. Information concerning the market for the Registrant's common equity and related stockholder matters is set forth on page 98 of the Annual Report and is incorporated herein by reference. ITEM 6. SELECTED FINANCIAL DATA Selected financial data contained on pages 95-96 of the Annual Report is deemed a part of this Annual Report on Form 10-K and is incorporated herein by reference. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management's Discussion and Analysis of Financial Condition and Results of Operations is set forth under the same caption on pages 36-61 of the Annual Report. Such information is hereby incorporated herein by reference and should be read in conjunction with the Consolidated Financial Statements of the Registrant and its Subsidiaries together with the Notes thereto contained on pages 63-94 of the Annual Report. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The information under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Risk Management" on pages 55-58 of the Annual Report is incorporated herein by reference. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Consolidated Financial Statements of the Registrant and its Subsidiaries together with the Notes thereto and the Report of Independent Auditors thereon required by this Item are contained in the Annual Report on pages 62-94 and are incorporated herein by reference. 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 Information relating to Directors of the Registrant is set forth under the caption "Election of Directors" on pages 5-8 of the Proxy Statement and information relating to Executive Officers of the Registrant is set forth under the caption "Executive Officers of the Company" on pages 11-12 of the Proxy Statement and is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION Information relating to executive compensation is set forth under the captions "Compensation of Directors", "Compensation Committee Report of Executive Officer Compensation", "Compensation of Executive Officers", "Pension Benefits" and "Employment Contracts, Termination of Employment and Change of Control Arrangements" on pages 10, 13-18 of the Proxy Statement and is incorporated herein by reference. 13 15 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information relating to security ownership of management and certain beneficial owners is set forth under the caption "Security Ownership of Directors and Executive Officers" on page 12 of the Proxy Statement and is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information relating to certain relationships and related transactions is set forth under the captions "Certain Transactions and Agreements with Directors and Executive Officers", "Certain Transactions and Agreements with American Express and Subsidiaries", "Certain Transactions and Agreements with Nippon Life" and "Certain Transactions with Other Institutional Investors and Their Subsidiaries" on pages 19-22 of the Proxy Statement and is incorporated herein by reference. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) 1. Financial Statements: The Financial Statements and the Notes thereto and the Report of Independent Auditors thereon and filed as a part hereof are listed on page F-1 hereof by reference to the corresponding page number in the Annual Report. 2. Financial Statement Schedules: The financial statement schedule and the notes thereto filed as a part are listed on page F-1 hereof. 3. Exhibits:
EXHIBIT NO. - ------- 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. 9.1 1997 Trust under Lehman Brothers Holdings Inc. Incentive Plans (incorporated by reference to the Registrant's Form 8-K dated September 4, 1997). 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 the Registrant's Transition Report on Form 10-K for the eleven months ended November 30, 1994). 10.2 Tax Allocation Agreement between Shearson Lehman Brothers Holdings Inc. and American Express Company (incorporated by reference to Exhibit 10.2 of the Registrant's Transition Report on Form 10-K for the eleven months ended November 30, 1994). 10.3 Transaction Support Services Agreement dated as of September 30, 1994 by and between Bear, Stearns Securities Corp. and Lehman Brothers Inc. (incorporated by reference to Exhibit 10.15 of the Registrant's Transition Report on Form 10-K for the eleven months ended November 30, 1994).
14 16
EXHIBIT NO. - ------- 10.4 Lease dated as of October 13, 1993 between 101 Hudson Leasing Associates and Lehman Brothers Holdings Inc. (incorporated by reference to Exhibit 10 of Holdings' Quarterly Report on Form 10-Q for the quarter ended September 30, 1993). 10.5 Lehman Brothers Inc. Executive and Select Employees Plan (incorporated by reference to Exhibit 10.4 of the Registrant's Registration Statement on Form S-1 (Reg. No. 33-12976)). 10.6 Lehman Brothers Holdings Inc. Deferred Compensation Plan for Non-Employee Directors (incorporated by reference to Exhibit 10.11 of the Registrant's Registration Statement on Form S-1 (Reg. No. 33-12976)). 10.7 Amended and Restated Agreements of Limited Partnership of Shearson Lehman Hutton Capital Partners II (incorporated by reference to Exhibit 10.48 of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1988). 10.8 Lehman Brothers Holdings Inc. 1994 Management Ownership Plan (incorporated by reference to Exhibit 10.25 of the Registrant's Registration Statement on Form S-1 (Reg. No. 33-52977)). 10.9 Lehman Brothers Holdings Inc. 1996 Management Ownership Plan (incorporated by reference to Exhibit 10.1 of the Registrant's Quarterly Report on Form 10-Q for the quarter ended August 31, 1996). 10.10+ Lehman Brothers Holdings Inc. Short-Term Executive Compensation Plan (incorporated by reference to Exhibit 10.2 of the Registrant's Quarterly Report on Form 10-Q for the quarter ended August 31, 1996). 10.11+ Lehman Brothers Holdings Inc. 1996 Short-Term Executive Compensation Plan (incorporated by reference to Exhibit 10.26 of the Registrant's Registration Statement on Form S-1 (Reg. No. 33-52977)). 10.12+ Lehman Brothers Holdings Inc. 1994 Employee Stock Purchase Plan (incorporated by reference to Exhibit 10.27 of the Registrant's Registration Statement on Form S-1 (Reg. No. 33-52977)). 10.13 Purchase and Exchange Agreement dated April 28, 1994, between the Registrant and American Express Company (incorporated by reference to Exhibit 10.29 of the Registrant's Transition Report Form 10-K for the Eleven Months ended November 30, 1994). 10.14 Option Agreement, dated May 27, 1994, by and among American Express Company, American Express Bank Ltd., American Express Travel Related Services Company, Inc., Lehman Brothers Inc., Lehman Government Securities, Inc. and Lehman Commercial Paper Incorporated (incorporated by reference to Exhibit 10.31 of the Registrant's Transition Report Form 10-K for the Eleven Months ended November 30, 1994). 10.15+ Lehman Brothers Inc. Voluntary Deferred Compensation Plan (For Select Executives) (incorporated by reference to Exhibit 10.33 of the Registrant's Registration Statement on Form S-1 (Reg. No. 33-52977)). 10.16+ Lehman Brothers Inc. Voluntary Deferred Compensation Plan (For Transferred Participants' Vested Amounts as of July 31, 1993) (incorporated by reference to Exhibit 10.34 of the Registrant's Registration Statement on Form S-1 (Reg. No. 33-52977)). 10.17+ Lehman Brothers Inc. Executive and Select Employees Plan (For Transferred Participants) (incorporated by reference to Exhibit 10.35 of the Registrant's Registration Statement on Form S-1 (Reg. No. 33-52977)). 10.18+ Lehman Brothers Holdings Inc. Cash Award Plan. (incorporated by reference to Exhibit 10.36 of the Registrant's Transition Report on Form 10-K for the Eleven Months ended November 30, 1994).
15 17
EXHIBIT NO. - ------- 10.19 Amended and Restated Agreement of Limited Partnership of Lehman Brothers Capital Partners III, L.P. (incorporated by reference to Exhibit 10.27 to the Registrant's Annual Report on Form 10-K for the fiscal year ended November 30, 1995). 10.20 Agreement of Limited Partnership of Lehman Brothers Capital Partners IV, L.P.* 11.1 Computation of per share Earnings.* 12.1 Computation in support of ratio of earnings to fixed charges.* 12.2 Computation in support of ratio of earnings to combined fixed charges and preferred dividends.* 13. The following portions of the Company's 1997 Annual Report to Stockholders, which are incorporated by reference herein: 13.1 "Management's Discussion and Analysis of Financial Condition and Results of Operations", pages 36-61.* 13.2 Consolidated Financial Statements of the Registrant and its Subsidiaries together with the Notes thereto and the Report of Independent Auditors thereon, pages 62-94.* 13.3 "Selected Financial Data", pages 95-96.* 13.4 "Other Stockholder Information" and "Price Range of Common Stock", page 98.* 21.1 List of the Registrant's Subsidiaries.* 23.1 Consent of Ernst & Young LLP.* 24.1 Powers of Attorney.* 27.1 Financial Data Schedule.* (b) Reports on Form 8-K. 1. Form 8-K dated March 24, 1997, Items 5 and 7. 2. Form 8-K dated June 26, 1997, Items 5 and 7. 3. Form 8-K dated September 4, 1997, Item 7. 4. Form 8-K dated September 30, 1997, Items 5 and 7. 5. Form 8-K dated January 7, 1998, Items 5 and 7.
- --------------- * Filed herewith. + Management contract or compensatory plan or arrangement required to be filed as an exhibit to this Form 10-K pursuant to Item 14(c). 16 18 SIGNATURES Pursuant to the Requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized. LEHMAN BROTHERS HOLDINGS INC. Dated: February 27, 1998 By: /s/ KAREN M. MULLER ------------------------------------ Title: Vice President 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 February 27, 1998 - --------------------------------------------- Chairman of the Board of Richard S. Fuld, Jr. Directors (principal executive officer) * Chief Financial Officer February 27, 1998 - --------------------------------------------- (principal financial and Charles B. Hintz accounting officer) * Director February 27, 1998 - --------------------------------------------- Michael L. Ainslie * Director February 27, 1998 - --------------------------------------------- John F. Akers * Director February 27, 1998 - --------------------------------------------- Roger S. Berlind * Director February 27, 1998 - --------------------------------------------- Thomas H. Cruikshank * Director February 27, 1998 - --------------------------------------------- Henry Kaufman * Director February 27, 1998 - --------------------------------------------- Hideichiro Kobayashi * Director February 27, 1998 - --------------------------------------------- John D. Macomber * Director February 27, 1998 - --------------------------------------------- Dina Merrill * Director February 27, 1998 - --------------------------------------------- Masahiro Yamada *By: /s/ KAREN M. MULLER - --------------------------------------------- Attorney-in-Fact February 27, 1998
17 19 LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULE
PAGE -------------------------- FORM 10-K ANNUAL REPORT --------- ------------- FINANCIAL STATEMENTS Report of Independent Auditors....................................... 62 Consolidated Statement of Income for the Twelve Months Ended November 30, 1997, November 30, 1996 and November 30, 1995.................. 63 Consolidated Statement of Financial Condition at November 30, 1997 and November 30, 1996.............................................. 64 Consolidated Statement of Changes in Stockholders' Equity for the Twelve Months Ended November 30, 1997, November 30, 1996 and November 30, 1995.................................................. 66 Consolidated Statement of Cash Flows for the Twelve Months Ended November 30, 1997, November 30, 1996 and November 30, 1995......... 67 Notes to Consolidated Financial Statements........................... 69 FINANCIAL STATEMENT SCHEDULE Schedule I -- Condensed Financial Information of Registrant.......... F-2
F-1 20 SCHEDULE I LEHMAN BROTHERS HOLDINGS INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENT OF INCOME (PARENT COMPANY ONLY)
TWELVE MONTHS ENDED NOVEMBER 30 -------------------------- 1997 1996 1995 ------ ------ ------ (IN MILLIONS) Revenues Principal transactions......................................... $ 193 $ 23 $ 152 Investment banking............................................. 140 90 90 Interest and dividends......................................... 1,271 882 804 Other.......................................................... 8 6 1 ----- ----- ----- Total revenues............................................ 1,612 1,001 1,047 Interest expense............................................... 1,304 966 899 ----- ----- ----- Net revenues.............................................. 308 35 148 ----- ----- ----- Non-interest expenses Compensation and benefits...................................... 113 64 70 Other.......................................................... 116 105 87 Management fees................................................ (28) (81) (94) Severance charge............................................... 50 Restructuring charge........................................... 27 ----- ----- ----- Total non-interest expenses............................... 201 138 90 ----- ----- ----- Income (loss) before taxes.......................................... 107 (103) 58 Provision for (benefit from) income taxes...................... (48) (65) 47 ----- ----- ----- Income (loss) before equity in net income of subsidiaries........... 155 (38) 11 ----- ----- ----- Equity in net income of subsidiaries........................... 492 454 231 ----- ----- ----- Net income (loss)................................................... $ 647 $ 416 $ 242 ----- ----- ----- Net income (loss) applicable to common stock........................ $ 572 $ 378 $ 200 ----- ----- -----
See notes to condensed financial information of Registrant. F-2 21 SCHEDULE I LEHMAN BROTHERS HOLDINGS INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEET (PARENT COMPANY ONLY)
NOVEMBER 30 ------------------- 1997 1996 ------- ------- (IN MILLIONS, EXCEPT PER SHARE DATA) ASSETS Cash and cash equivalents............................................... $ 675 Securities and other financial instruments owned........................ $ 8,751 3,540 Equity in net assets of subsidiaries.................................... 3,922 3,755 Accounts receivable and accrued interest................................ 596 513 Due from subsidiaries................................................... 17,230 11,048 Other assets............................................................ 693 586 ------- ------- Total assets.................................................. $31,192 $20,117 ------- ------- LIABILITIES AND STOCKHOLDERS' EQUITY Commercial paper and short-term debt.................................... $ 4,472 $ 3,175 Securities and other financial instruments sold but not yet purchased... 122 198 Securities sold under agreements to repurchase.......................... 8,758 2,618 Accrued liabilities, due to subsidiaries and other payables............. 1,586 766 Senior notes............................................................ 11,531 9,286 Subordinated indebtedness............................................... 200 200 ------- ------- Total liabilities............................................. 26,669 16,243 ------- ------- Commitments and Contingencies Stockholders' equity: Preferred stock, $1.00 par value; 38,000,000 shares authorized: 5% Cumulative Convertible Voting, 13,000,000 shares authorized; $39.10 liquidation preference per share Series A -- shares issued and outstanding: 33,050 in 1997 and 13,000,000 in 1996........................................... 1 508 Series B -- shares issued and outstanding: 12,966,950 in 1997......................................................... 507 Redeemable Voting, 1,000 shares issued and outstanding; $1.00 liquidation preference per share Common stock, $0.10 par value; 300,000,000 shares authorized; Shares issued: 119,513,337 in 1997 and 106,793,538 in 1996; Shares outstanding: 116,612,074 in 1997 and 100,449,144 in 1996.............. 12 11 Common stock issuable................................................... 155 326 Additional paid-in capital.............................................. 3,436 3,198 Foreign currency translation adjustment................................. 12 20 Retained earnings (accumulated deficit)................................. 498 (43) Common stock in treasury, at cost: 2,901,263 shares in 1997 and 6,344,394 shares in 1996.............................................. (98) (146) ------- ------- Total stockholders' equity.................................... 4,523 3,874 ------- ------- Total liabilities and stockholders' equity.................... $31,192 $20,117 ------- -------
See notes to condensed financial information of Registrant. F-3 22 SCHEDULE I LEHMAN BROTHERS HOLDINGS INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENT OF CASH FLOWS (PARENT COMPANY ONLY)
TWELVE MONTHS ENDED NOVEMBER 30 ----------------------------- 1997 1996 1995 ------- ------- ------- (IN MILLIONS) CASH FLOWS FROM OPERATING ACTIVITIES Net income................................................................. $ 647 $ 416 $ 242 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Equity in net income of subsidiaries.................................. (492) (454) (231) Severance charge...................................................... 50 Restructuring charge.................................................. 27 Other adjustments..................................................... 186 131 126 Net change in: Securities and other financial instruments owned...................... (5,211) (945) (778) Accounts receivable and accrued interest, due from subsidiaries and other assets........................................................ (6,380) (1,262) 945 Securities and other financial instruments sold but not yet purchased and Securities sold under agreements to repurchase................... 6,064 567 858 Accrued liabilities, due to subsidiaries and other payables........... 770 (84) (576) Dividends and capital distributions received.......................... 304 609 851 ------- ------- ------- Net cash provided by (used in) operating activities.............. (4,112) (972) 1,464 ------- ------- ------- CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from issuance of senior notes..................................... 3,925 2,686 4,226 Principal payments of senior notes......................................... (1,689) (1,778) (3,196) Proceeds from issuance of subordinated indebtedness........................ 200 Principal payments of subordinated indebtedness............................ (150) Payments for commercial paper and short-term debt, net..................... 1,297 1,073 (1,670) Payment for repurchase of preferred stock.................................. (200) Payment for treasury stock purchases....................................... (77) (130) (1) Dividends paid............................................................. (58) (55) (64) Issuance of common stock................................................... 23 6 1 ------- ------- ------- Net cash provided by (used in) financing activities.............. 3,421 1,802 (854) ------- ------- ------- CASH FLOWS FROM INVESTING ACTIVITIES Equity in net assets of subsidiaries....................................... 16 (173) (610) ------- ------- ------- Net cash provided by (used in) investing activities.............. 16 (173) (610) ------- ------- ------- Net change in cash and cash equivalents.......................... (675) 657 Cash and cash equivalents, beginning of period............................. 675 18 18 ------- ------- ------- Cash and cash equivalents, end of period......................... $ 0 $ 675 $ 18 ------- ------- ------- SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION (IN MILLIONS) Interest paid totaled $1,277 in 1997, $933 in 1996 and $884 in 1995. Income taxes (received) paid totaled $33 in 1997, $(48) in 1996 and $(163) in 1995.
See notes to condensed financial information of Registrant. F-4 23 SCHEDULE I LEHMAN BROTHERS HOLDINGS INC. NOTES TO CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT COMPANY ONLY) NOTE 1. BASIS OF PRESENTATION The condensed financial statements of Lehman Brothers Holdings Inc. (the "Company") should be read in conjunction with the consolidated financial statements of Lehman Brothers Holdings Inc. and subsidiaries and the notes thereto. Certain amounts reflect reclassifications to conform to the current period's presentation. NOTE 2. LONG-TERM DEBT
U.S. DOLLAR NON-U.S. DOLLAR ---------------- ---------------- NOVEMBER 30 FIXED FLOATING FIXED FLOATING ----------------- RATE RATE RATE RATE 1997 1996 ------ ------ ------ ------ ------- ------ (IN MILLIONS) Senior Notes Maturing in Fiscal 1997.................... $1,626 Maturing in Fiscal 1998.................... $1,559 $ 371 $ 68 $ 71 $ 2,069 2,051 Maturing in Fiscal 1999.................... 1,516 402 674 20 2,612 2,082 Maturing in Fiscal 2000.................... 2,178 638 32 2,848 1,229 Maturing in Fiscal 2001.................... 440 70 510 91 Maturing in Fiscal 2002.................... 1,132 198 1,330 895 December 1, 2002 and thereafter............ 2,090 33 39 2,162 1,312 ------ ------ ------ ------ ------- ------ Senior Notes.......................... $8,915 $1,712 $ 781 $ 123 $11,531 $9,286 ------ ------ ------ ------ ------- ------ Subordinated Indebtedness December 1, 2002 and thereafter............ $ 200 $ 200 $ 200 ------ ------ ------ ------ ------- ------ Long-Term Debt............................. $9,115 $1,712 $ 781 $ 123 $11,731 $9,486 ====== ====== ====== ====== ======= ======
Of the Company's long-term debt outstanding as of November 30, 1997, $642 million is repayable prior to maturity at the option of the holder, at par value. These obligations are reflected in the above table at their put dates, which range from fiscal 1998 to fiscal 2002, rather than at their contractual maturities, which range from fiscal 2000 to fiscal 2019. In addition, $415 million of the Company's long-term debt is redeemable prior to maturity at the option of the Company under various terms and conditions. These obligations are reflected in the above table at their contractual maturity dates. As of November 30, 1997, the Company's U.S. dollar and non-U.S. dollar debt portfolios included approximately $134 million and $54 million, respectively, of debt for which the interest rates and/or redemption values have been linked to various indices including industry baskets of stocks or commodities. END USER DERIVATIVE ACTIVITIES The Company utilizes a variety of derivative products including interest rate and currency 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 addition, the Company utilizes cross-currency swaps to hedge its exposure to foreign currency risk as a result of its non-U.S. dollar debt obligations, after consideration of non-U.S. dollar assets which are funded with long-term debt obligations in the same currency. F-5 24 SCHEDULE I LEHMAN BROTHERS HOLDINGS INC. NOTES TO CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT COMPANY ONLY) At November 30, 1997 and 1996, the notional values of the Company's interest rate and currency swaps related to its long-term debt obligations were approximately $10.5 billion and $8.6 billion, respectively. In terms of notional amounts outstanding, these derivative products mature as follows:
NOVEMBER 30 NON-U.S. CROSS- ----------------- U.S. DOLLAR DOLLAR CURRENCY 1997 1996 ----------- -------- -------- ------- ------ (IN MILLIONS) Maturing in Fiscal 1997........................ $1,302 Maturing in Fiscal 1998........................ $ 1,640 $120 $ 1,760 1,773 Maturing in Fiscal 1999........................ 1,650 674 2,324 1,992 Maturing in Fiscal 2000........................ 2,422 32 2,454 1,112 Maturing in Fiscal 2001........................ 468 468 56 Maturing in Fiscal 2002........................ 1,167 1,167 845 December 1, 2002 and thereafter................ 2,262 $ 4 35 2,301 1,496 ----------- -------- -------- ------- ------ Total.......................................... $ 9,609 $ 4 $861 $10,474 $8,576 ----------- -------- -------- ------- ------ Weighted average rate(1)....................... Receive rate................................... 7.21% 3.32% 4.30% 6.97% 6.88% Pay rate....................................... 6.49% 0.77% 6.43% 6.48% 6.24%
- --------------- (1) Weighted average interest rates were calculated utilizing non-U.S. dollar interest rates, where applicable. F-6 25 SCHEDULE I LEHMAN BROTHERS HOLDINGS INC. NOTES TO CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT COMPANY ONLY) 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:
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) USD Obligations Fixed Rate................................... $ 9,115 $ 86 7.39% 9.34% Floating Rate................................ 1,712 11,602 6.03% 6.47% -------- -------- ----------- ------- 10,827 11,688 7.17% 6.50% Non-USD Obligations............................... 904 43 4.03% 1.12% -------- -------- ----------- ------- Total............................................. $11,731 $11,731 6.93% 6.48% -------- -------- ----------- -------
NOVEMBER 30, 1996 ----------------------------------------------------- LONG-TERM DEBT WEIGHTED AVERAGE(1) -------------------- ----------------------------- BEFORE AFTER CONTRACTUAL EFFECTIVE RATE END USER END USER INTEREST AFTER END USER ACTIVITIES ACTIVITIES RATE ACTIVITIES -------- -------- ----------- -------------- (IN MILLIONS) USD Obligations Fixed Rate................................... $ 6,810 $ 122 7.77% 9.22% Floating Rate................................ 1,566 9,210 5.79% 6.39% -------- -------- ----------- ------- 8,376 9,332 7.40% 6.42% Non-USD Obligations............................... 1,110 154 3.73% 2.74% -------- -------- ----------- ------- Total............................................. $ 9,486 $ 9,486 6.97% 6.36% -------- -------- ----------- -------
- --------------- (1) Weighted average interest rates were calculated utilizing non-US dollar interest rates, where applicable. NOTE 3. NET REVENUES Net revenues in 1995 include a special revenue gain of $129 million related to the sale of the Company's interest in Omnitel Sistemi Radiocellullari Italiani S.p.A. ("Omnitel"), recognized in the Statement of Income in Principal transactions. Following recognition of related compensation and taxes, the Company recognized a $47 million gain in 1995 related to the Omnitel sale transaction. NOTE 4. OTHER CHARGES 1996 Severance Charge In the fourth quarter of 1996, Lehman Brothers Holdings Inc. and subsidiaries (collectively, "LBHI") 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 LBHI's worldwide business unit economic performance review that was undertaken in the fourth quarter of 1996 to focus LBHI 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 equities businesses, including exiting the precious metals business in the U.S., Europe and Asia; exiting energy F-7 26 SCHEDULE I LEHMAN BROTHERS HOLDINGS INC. NOTES TO CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT COMPANY ONLY) 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 Firm's New York Private Client Services offices. Additionally, the charge reflects various other strategic personnel reductions aimed at delayering management. The LBHI severance charge has led to personnel cost savings of approximately $90 million annually. The LBHI severance charge also resulted in a permanent decrease in nonpersonnel expenses of approximately $20 million annually. LBHI intends to reinvest substantially all these savings into certain businesses to expedite LBHI's strategic initiatives; these actions are expected to result in improved operating revenues. The Company recorded a $50 million severance charge ($30 million aftertax) in the fourth quarter of 1996 related to these actions. The Company's cash outlays relating to the charge were approximately $9 million in the fourth quarter of 1996 and approximately $38 million during fiscal 1997. The remaining residual payments will be paid as deferred payment arrangements are completed. 1995 Restructuring Charge During the fourth quarter of 1995, the Company recorded a charge of $27 million pretax ($16 million aftertax) for occupancy-related real estate expenses. This charge resulted from a complete global review of the Company and its affiliates' real estate requirements at current headcount levels and the elimination of excess real estate primarily in its New York location. The charge included the cost to write-down the carrying value of leasehold improvements as well as the difference between expected operating costs and projected sublease recoveries. NOTE 5. MANAGEMENT FEES The Company incurs charges including occupancy, administration and computer processing, which are related to its activities and that of certain of its subsidiaries (the "Related Parties"). Such charges are allocated between the Related Parties, based upon specific identification and allocation methods. The allocation of such charges to other affiliates is recognized as management fees. NOTE 6. COMMITMENTS AND CONTINGENCIES The Company has fully guaranteed certain of its subsidiaries and guaranteed certain unsecured lines of credit and other contractual obligations of other subsidiaries. F-8 27 EXHIBIT INDEX
EXHIBIT NO. DESCRIPTION - ------- ------------------------------------------------------------------------------------ 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. 9.1 1997 Trust under Lehman Brothers Holdings Inc. Incentive Plans (incorporated by reference to the Registrant's Form 8-K dated September 4, 1997). 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 the Registrant's Transition Report on Form 10-K for the eleven months ended November 30, 1994). 10.2 Tax Allocation Agreement between Shearson Lehman Brothers Holdings Inc. and American Express Company (incorporated by reference to Exhibit 10.2 of the Registrant's Transition Report on Form 10-K for the eleven months ended November 30, 1994). 10.3 Transaction Support Services Agreement dated as of September 30, 1994 by and between Bear, Stearns Securities Corp. and Lehman Brothers Inc. (incorporated by reference to Exhibit 10.15 of the Registrant's Transition Report on Form 10-K for the eleven months ended November 30, 1994). 10.4 Lease dated as of October 13, 1993 between 101 Hudson Leasing Associates and Lehman Brothers Holdings Inc. (incorporated by reference to Exhibit 10 of Holdings' Quarterly Report on Form 10-Q for the quarter ended September 30, 1993). 10.5 Lehman Brothers Inc. Executive and Select Employees Plan (incorporated by reference to Exhibit 10.4 of the Registrant's Registration Statement on Form S-1 (Reg. No. 33-12976)). 10.6 Lehman Brothers Holdings Inc. Deferred Compensation Plan for Non-Employee Directors (incorporated by reference to Exhibit 10.11 of the Registrant's Registration Statement on Form S-1 (Reg. No. 33-12976)). 10.7 Amended and Restated Agreements of Limited Partnership of Shearson Lehman Hutton Capital Partners II (incorporated by reference to Exhibit 10.48 of the Registrant's Annual Report on Form 10-K for the year ended December 31, 1988). 10.8 Lehman Brothers Holdings Inc. 1994 Management Ownership Plan (incorporated by reference to Exhibit 10.25 of the Registrant's Registration Statement on Form S-1 (Reg. No. 33-52977)). 10.9 Lehman Brothers Holdings Inc. 1996 Management Ownership Plan (incorporated by reference to Exhibit 10.1 of the Registrant's Quarterly Report on Form 10-Q for the quarter ended August 31, 1996). 10.10+ Lehman Brothers Holdings Inc. Short-Term Executive Compensation Plan (incorporated by reference to Exhibit 10.2 of the Registrant's Quarterly Report on Form 10-Q for the quarter ended August 31, 1996). 10.11+ Lehman Brothers Holdings Inc. 1996 Short-Term Executive Compensation Plan (incorporated by reference to Exhibit 10.26 of the Registrant's Registration Statement on Form S-1 (Reg. No. 33-52977)).
28
EXHIBIT NO. DESCRIPTION - ------- ------------------------------------------------------------------------------------ 10.12+ Lehman Brothers Holdings Inc. 1994 Employee Stock Purchase Plan (incorporated by reference to Exhibit 10.27 of the Registrant's Registration Statement on Form S-1 (Reg. No. 33-52977)). 10.13 Purchase and Exchange Agreement dated April 28, 1994, between the Registrant and American Express Company (incorporated by reference to Exhibit 10.29 of the Registrant's Transition Report Form 10-K for the Eleven Months ended November 30, 1994). 10.14 Option Agreement, dated May 27, 1994, by and among American Express Company, American Express Bank Ltd., American Express Travel Related Services Company, Inc., Lehman Brothers Inc., Lehman Government Securities, Inc. and Lehman Commercial Paper Incorporated (incorporated by reference to Exhibit 10.31 of the Registrant's Transition Report Form 10-K for the Eleven Months ended November 30, 1994). 10.15+ Lehman Brothers Inc. Voluntary Deferred Compensation Plan (For Select Executives) (incorporated by reference to Exhibit 10.33 of the Registrant's Registration Statement on Form S-1 (Reg. No. 33-52977)). 10.16+ Lehman Brothers Inc. Voluntary Deferred Compensation Plan (For Transferred Participants' Vested Amounts as of July 31, 1993) (incorporated by reference to Exhibit 10.34 of the Registrant's Registration Statement on Form S-1 (Reg. No. 33-52977)). 10.17+ Lehman Brothers Inc. Executive and Select Employees Plan (For Transferred Participants) (incorporated by reference to Exhibit 10.35 of the Registrant's Registration Statement on Form S-1 (Reg. No. 33-52977)). 10.18+ Lehman Brothers Holdings Inc. Cash Award Plan. (incorporated by reference to Exhibit 10.36 of the Registrant's Transition Report on Form 10-K for the Eleven Months ended November 30, 1994). 10.19 Amended and Restated Agreement of Limited Partnership of Lehman Brothers Capital Partners III, L.P. (incorporated by reference to Exhibit 10.27 to the Registrant's Annual Report on Form 10-K for the fiscal year ended November 30, 1995). 10.20 Agreement of Limited Partnership of Lehman Brothers Capital Partners IV, L.P.* 11.1 Computation of per share Earnings.* 12.1 Computation in support of ratio of earnings to fixed charges.* 12.2 Computation in support of ratio of earnings to combined fixed charges and preferred dividends.* 13. The following portions of the Company's 1997 Annual Report to Stockholders, which are incorporated by reference herein: 13.1 "Management's Discussion and Analysis of Financial Condition and Results of Operations", pages 36-61.* 13.2 Consolidated Financial Statements of the Registrant and its Subsidiaries together with the Notes thereto and the Report of Independent Auditors thereon, pages 62-94.* 13.3 "Selected Financial Data", pages 95-96.* 13.4 "Other Stockholder Information" and "Price Range of Common Stock", page 98.* 21.1 List of the Registrant's Subsidiaries.* 23.1 Consent of Ernst & Young LLP.* 24.1 Powers of Attorney.*
29
EXHIBIT NO. DESCRIPTION - ------- ------------------------------------------------------------------------------------ 27.1 Financial Data Schedule.*
- --------------- * Filed herewith. + Management contract or compensatory plan or arrangement required to be filed as an exhibit to this Form 10-K pursuant to Item 14(c). EX-10.20 2 AGREEMENT OF LIMITED PARTNERSHIP 1 EXHIBIT 10.20 ================================================================================ LEHMAN BROTHERS CAPITAL PARTNERS IV, L.P. AGREEMENT OF LIMITED PARTNERSHIP ---------------------------- OCTOBER 21, 1997 ---------------------------- ================================================================================ 2 TABLE OF CONTENTS Page ARTICLE 1 Certain Defined Terms ..................................................... 1 ARTICLE 2 Formation, Name and Place of Business; Purpose and Limitation on Operations; Term; Conversion to Corporate Form .............................................. 7 2.1. Formation ............................................... 7 2.2. Name .................................................... 7 2.3. Place of Business ....................................... 7 2.4. Purpose ................................................. 7 2.5. Term .................................................... 7 2.6. Conversion to Corporate Form ............................ 7 ARTICLE 3 General Partner; Relationship with Lehman Brothers ........................ 8 3.1. General Partner, Management of General Partner .......... 8 3.2. No Compensation of Officers and Directors; Expenses ..... 8 3.3. Day-to-Day Operations; Acts of Investment Committee ..... 8 3.4. Services by Lehman Brothers; Charges and Expenses ....... 8 3.5. Related Partnerships .................................... 9 ARTICLE 4 Limited Partners .......................................................... 9 4.1. Initial Limited Partner ................................. 9 4.2. Additional Limited Partners ............................. 9 4.3. List of Limited Partners ................................ 9 4.4. No Management by Limited Partners ....................... 9 4.5. Limitation on Transfer of Limited Partners' Units ....... 10 ARTICLE 5 Liability of Partners ..................................................... 10 5.1. General Partner ......................................... 10 5.2. Limited Partners ........................................ 10 ARTICLE 6 Powers of General Partner; Prohibited Transactions and Restrictions; Duties of General Partner; Indemnification and Contribution .......................................... 10 6.1. Powers .................................................. 10 6.2. Prohibited Transactions ................................. 11 6.3. Restrictions on the Authority of the General Partner .... 12 6.4. Duties .................................................. 12 6.5. Exculpation, Indemnification and Contribution ........... 12 6.6. General Partner Loans ................................... 12 (i) 3 Page ARTICLE 7 Capital Contributions and Accounts; No Further Contributions Required; Interest; Accounting and Valuation ................ 13 7.1. Capital Contributions and Accounts ...................... 13 7.2. Further Capital Contributions ........................... 14 7.3. Interest ................................................ 15 7.4. Fixed Return ............................................ 15 7.5. Accounting Periods and Taxable Years .................... 15 ARTICLE 8 Allocations ............................................................... 15 8.1. Allocation of Profits and Losses; Other Allocations ..... 15 8.2. Special Allocation Provisions ........................... 16 8.3. Tax Allocations ......................................... 17 8.4. Allocation among Limited Partners, Transfers ............ 17 8.5. Tax Elections ........................................... 17 8.6. Other Allocation Provisions ............................. 17 ARTICLE 9 Distributions; Withdrawal ................................................. 18 9.1. General Partner Discretion .............................. 18 9.2. Distributions ........................................... 18 9.3. Non-Cash Distributions .................................. 18 9.4. Withholding ............................................. 19 9.5. Withdrawal .............................................. 19 ARTICLE 10 Transferability of Interests; Vesting; Termination of Employment ................................................. 19 10.1. Restrictions and Conditions on Transfers of Units ...... 19 10.2. Assignees .............................................. 20 10.3. Substituted Limited Partners ........................... 20 10.4. Termination of Employment, Death, Disability, Retirement of Limited Partner ..................................... 21 10.5. Disposition of General Partner's Interest .............. 24 ARTICLE 11 Dissolution and Liquidation of the Partnership ............................ 24 11.1. Events Causing Dissolution ............................. 24 11.2. Liquidation ............................................ 24 ARTICLE 12 Books and Records; Accounting; Appraisal; Tax Matters and Elections ...................................... 26 12.1. Books and Records ...................................... 26 12.2. Accounting Basis, Fiscal Year .......................... 26 12.3. Bank Accounts .......................................... 26 12.4. Appraisal .............................................. 26 12.5. Reports ................................................ 27 12.6. Tax Matters and Elections .............................. 27 (ii) 4 Page ARTICLE 13 Miscellaneous Provisions .................................................. 27 13.1. Appointment of the General Partner as Attorney-in-Fact . 27 13.2. Amendments of this Agreement ........................... 28 13.3. Arbitration ............................................ 29 13.4. Notices ................................................ 29 13.5. Binding Provisions ..................................... 30 13.6. Interest as Security for UCC Purposes .................. 30 13.7. Applicable Law ......................................... 30 13.8. Counterparts ........................................... 30 13.9. Separability of Provisions ............................. 30 13.10. Entire Agreement ...................................... 31 13.11. Section Titles ........................................ 31 13.12. Waiver of Right of Partition .......................... 31 13.13 Effectiveness ......................................... 31 (iii) 5 AGREEMENT OF LIMITED PARTNERSHIP LEHMAN BROTHERS CAPITAL PARTNERS IV, L.P. AGREEMENT OF LIMITED PARTNERSHIP, dated as of October 21, 1997, by and among LB I Group Inc., a corporation organized under the laws of the State of Delaware, as general partner hereunder (the "General Partner"), the Initial Limited Partner (as described in Section 4.1 hereof) and the persons who are admitted as additional limited partners on the Closing Date (as defined herein) in accordance with the terms hereof (the "Limited Partners") (the General Partner and the Limited Partners are collectively referred to as the "Partners"). ARTICLE 1 CERTAIN DEFINED TERMS As used in this Agreement, the following terms shall have the following meanings: 1940 Act The United States Investment Company Act of 1940, as amended Act Delaware Revised Uniform Limited Partnership Act, 6 Del. C. ss.ss. 17-101. et seq., as amended from time to time and any successor to said act Affiliate Any person or entity that controls, is controlled by, or is under common control with, any other person or entity Agreement This Agreement of Limited Partnership, as the same may be amended, modified or supplemented from time to time Capital Account As defined in Section 7.1(f) Capital Commitment Aggregate amount the Limited Partner has agreed to pay to the Partnership as the purchase price for his or her Units Capital Contributions Amounts contributed to the Partnership by the Partners, which do not include any amount invested in the Money Funds or the Escrow Account Capital Partners III Lehman Brothers Capital Partners III, L.P., a limited partnership formed under the laws of the State of Delaware Carrying Value With respect to any Partnership asset, the asset's adjusted basis for federal income tax purposes, except that the Carrying Values of all Partnership assets shall be adjusted to equal their respective fair market values (as determined by the General Partner), in accordance with the rules set forth in Treasury Regulations Section l.704-1(b)(2)(iv)(f), except as otherwise provided herein, immediately prior to: (a) the date of the acquisition of any additional Partnership -1- 6 interest by any new or existing Partner in exchange for more than a de minimis Capital Contribution or (b) the date of the distribution of more than a de minimis amount of Partnership property (other than a pro rata distribution) to a Partner; provided that adjustments pursuant to clauses (a) and (b) above shall be made only if the General Partner determines in its sole discretion that such adjustments are necessary or appropriate to reflect the relative economic interests of the Partners. The Carrying Value of any Partnership asset distributed to any Partner shall be adjusted immediately prior to such distribution to equal its fair market value. In the case of any asset that has a Carrying Value that differs from its adjusted tax basis, Carrying Value shall be adjusted by the amount of depreciation calculated for purposes of the definition of "Profits and Losses" rather than the amount of depreciation determined for U.S. federal income tax purposes Cause Termination of employment of a Limited Partner by Lehman Brothers due to a material breach by a Limited Partner of his or her employment contract or other agreement with Lehman Brothers, failure by a Limited Partner to devote substantially all business time exclusively to the performance of his or her employment duties for Lehman Brothers, willful misconduct, dishonesty related to the business and affairs of Lehman Brothers, commission of a felony, misdemeanor or any other action which in the opinion of Lehman Brothers constitutes a statutory disqualification under U.S. securities laws (or a failure to contest prosecution for a felony or such misdemeanor), habitual or gross negligence in the performance of his or employment duties, engaging in Detrimental Activity, or a material violation of Lehman Brothers' conflict of interest, proprietary information, business ethics policies or other policies set out in the Code of Conduct of Lehman Brothers Closing The admission of Eligible Investors as Limited Partners of the Partnership following the receipt by Lehman Brothers of the Exemptive Order Closing Date The date of the Closing Code Internal Revenue Code of 1986, as amended Commitment Period The period from the date hereof until the earlier of (i) July 25, 2002 or January 31, 2003 (with respect to any proposed Portfolio Investment for which, on or prior to July 25, 2002, the Partnership has entered into a letter of intent, agreement in principle or definitive agreement to invest) and (ii) any date as of which the General Partner has determined in its sole discretion to terminate the obligation of Limited Partners to make Capital Contributions Competitive Activity Involvement, at any time following the date of termination of the Limited Partner's employment with Lehman Brothers, whether as an -2- 7 employee, proprietor, consultant or otherwise, with any person or entity engaged in any business activity which is materially competitive with any business carried on by Lehman Brothers at such time, as determined in the sole discretion of the General Partner Cost of Funds Rate Average daily cost of funds of LBHI as determined by its Treasurer's Office Detrimental Activity (a) Using information that was received by or disclosed to such Limited Partner during his or her employment with Lehman Brothers relating to the business affairs of Lehman Brothers or any of its clients, in breach of his or her undertakings to keep such information confidential, (b) directly or indirectly by any means persuading or attempting to persuade any employee of Lehman Brothers to terminate his or her employment or any customer or client of Lehman Brothers to terminate or curtail its business relationship with Lehman Brothers or to breach any term of any agreement with Lehman Brothers or (c) any activity deemed to be detrimental to Lehman Brothers, in each case as determined in the sole discretion of the General Partner Disability A disability which meets the criteria under both the Lehman Brothers Group Long Term Disability Plan and the Social Security Disability Act Eligible Investors (a) Managing directors, senior vice presidents and certain other key officers, employees, consultants and directors of Lehman Brothers designated by Lehman Brothers in its sole discretion, provided such person has (i) an individual net worth or net worth with his or her spouse that exceeds $1 million or (ii) an individual income in excess of $200,000 in each of 1995 and 1996 or joint income with his or her spouse in excess of $300,000 in each of such years and has a reasonable expectation of reaching the same income level in 1997, and (b) any other persons designated by the General Partner in its sole discretion who are eligible investors under the Exemptive Order Escrow Account A segregated interest-bearing deposit account denominated in U.S. dollars established at an entity that is not affiliated with Lehman Brothers Exemptive Order A new order of the SEC to be received by Lehman Brothers exempting the Partnership and certain other similar investment partnerships from the registration and certain other requirements of the 1940 Act Fixed Return A cumulative annual return equal to the Cost of Funds Rate plus 0.50% or, if higher, an amount determined by the General Partner with reference to the applicable United States federal rate for interest on loans then utilized by the Internal Revenue Service in connection with below-market loans to employees with a maturity date of July 25, 2009 -3- 8 Follow-on Investment Any Portfolio Investment in an existing Portfolio Company General Partner LB I Group Inc., a corporation organized under the laws of the State of Delaware and a subsidiary of LBHI, as general partner of the Partnership Initial Limited Partner First Cap IV, Inc., a corporation organized under the laws of the State of Delaware, as the Initial Limited Partner of the Partnership Initial Payment One-quarter (25%) of the amount of the aggregate Capital Commitment represented by the Units subscribed for; except as otherwise provided in the subscription agreement relating to such Units, the Initial Payment is unconditionally due and payable upon execution and delivery of the subscription agreement Investment Committee The Investment Committee of LBHI LB Fund II Lehman Brothers Merchant Banking Partners II L.P., a limited partnership formed under the laws of the State of Delaware, together with its affiliated investment entities LBHI Lehman Brothers Holdings Inc., a corporation organized under the laws of the State of Delaware Lehman Brothers LBHI and its subsidiaries Limited Partners Persons who are admitted as additional limited partners to the Partnership on the Closing Date, and any other person who may be admitted as a substituted or additional Limited Partner of the Partnership in accordance with this Agreement Memorandum Confidential Private Placement Memorandum dated October 1997 relating to the Partnership, as amended or supplemented from time to time Merchant Banking Group The Merchant Banking Group of Lehman Brothers Money Fund Any money market fund or any interest bearing account denominated in U.S. dollars selected by the General Partner, in which payments by Limited Partners are deposited pending contribution to the Partnership Nonrecourse Deductions As defined in U.S. Treasury Regulations Section 1.704-2(b). The amount of Partnership Nonrecourse Deductions for a fiscal year equals the net increase, if any, in the amount of Partnership minimum gain during that fiscal year, determined according to the provisions of U.S. Treasury Regulations Section 1.704-2(c) Partner Nonrecourse Debt Minimum Gain An amount with respect to each partner nonrecourse debt (as defined in Treasury Regulations Section 1.704-2(b)(4)) equal to the Partnership Minimum Gain that would result if such partner -4- 9 nonrecourse debt were treated as a nonrecourse liability (as defined in Treasury Regulations Section 1.752-l(a)(2)) determined in accordance with Treasury Regulations Section 1.704-2(i)(3) Partner Nonrecourse Deductions As defined in U.S. Treasury Regulations Section l.704-2(i)(2) Partners Collectively, the General Partner and the Limited Partners Partnership Lehman Brothers Capital Partners IV, L.P., the limited partnership formed by the General Partner and the Initial Limited Partner and continued by the General Partner and the parties hereto under the Act in accordance with this Agreement, under the laws of the State of Delaware Partnership Minimum Gain As defined in Treasury Regulations Section l.704-2(b)(2) and 1.704-2(d) Portfolio Companies The issuers of the Partnership's Portfolio Investments Portfolio Investments The securities or rights in which the Partnership actually has invested or the securities or rights issued as a dividend or distribution thereon, in a reclassification with respect thereto or in an exchange therefor Profits and Losses For each fiscal year or other period, the taxable income or loss of the Partnership, or particular items thereof, determined in accordance with the accounting method used by the Partnership for federal income tax purposes with the following adjustments: (a) all items of income, gain, loss or deduction allocated pursuant to Section 8.2 shall not be taken into account in computing such taxable income or loss; (b)any income of the Partnership that is exempt from federal income taxation and not otherwise taken into account in computing Profits and Losses shall be added to such taxable income or loss; (c) if the Carrying Value of any asset differs from its adjusted tax basis for federal income tax purposes, any gain or loss resulting from a disposition of such asset shall be determined with reference to such Carrying Value; (d) upon an adjustment to the Carrying Value of any asset, pursuant to the definition of Carrying Value (other than an adjustment in respect of depreciation), the amount of the adjustment shall be included as gain or loss in computing such taxable income or loss; (e) if the Carrying Value of any asset differs from its adjusted tax basis for U.S. federal income tax purposes the amount of depreciation, amortization or cost recovery deductions with respect to such asset shall for purposes of determining Profits and Losses be an amount which bears the same ratio to such Carrying Value as the federal income tax depreciation, amortization or other cost recovery deductions bears to such adjusted tax basis (provided that if the federal income tax depreciation, amortization or other cost recovery deduction is zero, the General Partner may use any reasonable method for purposes of determining depreciation, amortization or other cost recovery deductions in calculating Profits and Losses); and -5- 10 (f) except for items in (a) above, any expenditures of the Partnership not deductible in computing taxable income or loss, not properly capitalizable and not otherwise taken into account in computing Profits and Losses pursuant to this definition shall be treated as deductible items Representative Any executor, administrator, trustee, committee, guardian, conservator or representative appointed by a court of competent jurisdiction to act on behalf of a Limited Partner or the estate of a Limited Partner Repurchase Notice Following the termination of a Limited Partner's employment with Lehman Brothers, a writing in which the General Partner will notify such Limited Partner by certified mail (or its equivalent) or via overnight courier of its determination whether to purchase such Limited Partner's Units Retirement Termination of employment with Lehman Brothers which meets the criteria for retirement under the qualified defined benefit pension plan of LBHI or the criteria for retirement under any other pension plan in a territory outside the United States which is sponsored by Lehman Brothers, provided the individual has at least five years of service with Lehman Brothers Returned Capital Contributions The sum of (A) the amounts distributed pursuant to clause (iv) of Section 9.2(a) and (B) the amounts distributed pursuant to clause (vi) thereunder, but not in excess of amounts distributed pursuant to clause (i) thereunder SEC The United States Securities and Exchange Commission Transfer As defined in Section 10.1(a) Transfer Application Written and dated notification of a Transfer of all or any portion of the Units of a Limited Partner Transferring Limited Partner As defined in Section 10.1(c) Units Units of limited partnership interests in the Partnership, each Unit representing a Capital Commitment of $20,000 Unvested Interest The unvested portion of such Limited Partner's interest in the Partnership, determined in accordance with Section 10.4 Vesting Schedule The schedule according to which a Limited Partner's interest in the Partnership generally will vest, as set forth in Section 10.4(a) -6- 11 ARTICLE 2 FORMATION, NAME AND PLACE OF BUSINESS; PURPOSE AND LIMITATION ON OPERATIONS; TERM; CONVERSION TO CORPORATE FORM 2.1. Formation. The General Partner and the Initial Limited Partner have formed the Partnership under the Act. In the event that it shall be necessary for the Partnership to exist in or qualify to do business under the laws of any state or states other than, or in addition to, the State of Delaware, the parties hereby agree that the Partnership shall take such action as may be necessary to exist or qualify to do business in any state in which such existence or qualification shall be required, provided that in any such event the Partnership shall at all times continue to be a limited partnership formed under and governed by the provisions of the Act. 2.2. Name. The name of the Partnership shall be "Lehman Brothers Capital Partners IV, L.P." The business of the Partnership may be conducted under any other name deemed necessary or desirable by the General Partner in order to comply with local law. 2.3. Place of Business. The principal place of business of the Partnership shall be at 3 World Financial Center, New York, New York 10285, and/or at such other place within or without the State of New York as the General Partner hereafter may designate in writing to the Limited Partners. 2.4. Purpose. (a) The purpose and character of the business of the Partnership is to achieve capital appreciation through equity-oriented investments. The Partnership also may make debt investments with a view to a restructuring in which the Partnership would receive an equity interest, and, in connection with equity-oriented investments, may make investments in debt securities or preferred stock. The Partnership may engage in such other activities as are permitted hereby or are incidental or ancillary to the foregoing as the General Partner shall deem necessary or appropriate. (b) The Partnership will invest in all investments to be made by LB Fund II, subject to the requirement that the Investment Committee determine that the terms of each Portfolio Investment are fair and reasonable and consistent with the best interests of the Limited Partners and otherwise are in compliance with any applicable provisions or requirements of the Exemptive Order. Each Portfolio Investment by the Partnership generally will be made pro rata with LB Fund II based on the available and unfunded Capital Commitments to the Partnership relative to the aggregate amount of unfunded capital commitments to LB Fund II. 2.5. Term. (a) The Partnership shall continue until July 25, 2009 or upon earlier termination by the General Partner in its sole discretion, unless the Partnership is dissolved prior to such date or dates pursuant to the provisions of Article 11 hereof or as otherwise provided by operation of law. (b) No Limited Partner's death, incapacity or bankruptcy, resignation or retirement from Lehman Brothers or other termination of employment with Lehman Brothers shall result in the dissolution or termination of the Partnership as among the remaining Partners. 2.6 Conversion to Corporate Form. In the event of changes in the law, regulations or interpretations applicable to the Partnership or its operations or changes in other circumstances which, in the sole judgment of the General Partner, render it desirable or helpful for the business of the Partnership to be conducted in a corporate rather than in a partnership form (including without limitation a limited liability company), the General Partner, without the approval of the Limited Partners, shall have the power to incorporate the Partnership or take such other action as it may deem advisable in light of such changed conditions, including, without limitation, dissolving the Partnership, -7- 12 transferring its assets as an entirety to a successor investment vehicle or causing it to merge with a successor investment vehicle. ARTICLE 3 GENERAL PARTNER; RELATIONSHIP WITH LEHMAN BROTHERS 3.1. General Partner; Management of General Partner. LB I Group Inc. is the sole general partner of the Partnership. The General Partner will have complete control of the Partnership's business. Such control shall be exercised by LB I Group Inc., in its capacity as general partner of the Partnership, by the appropriate officers of the General Partner or their designees. 3.2 No Compensation of Officers and Directors; Expenses. (a) No compensation shall be paid by the Partnership to the General Partner or to its officers and directors solely for their services as General Partner and officers and directors thereof, respectively, other than reimbursement for out-of-pocket expenses incurred in the course of conducting the business of the Partnership. The General Partner shall be reimbursed for (i) fees paid to others for Partnership accounting and communication services and (ii) certain other fees and expenses (including those paid to consultants, attorneys, accountants or other professionals) incurred by it on behalf of the Partnership, including, but not limited to, all fees and expenses of litigation and tax audits of the Partnership and for the outside valuation of securities or property obtained by the Partnership, whether in a merger, sale or otherwise. The General Partner shall not be reimbursed for payroll and other costs of salaried personnel and rent or general office overhead of the General Partner, which will be borne by the General Partner. (b) The costs and expenses incurred on behalf of the Partnership with respect to the organization of the Partnership, pre-offering activities and offering activities and the selling of Units including, but not limited to, travel, telephone, postage, legal and accounting expenses, shall be paid by the Partnership. Except as otherwise provided herein to the contrary, the Partnership will bear all other expenses of its operations including fees and expenses of attorneys, accountants and experts, commitment and investment banking fees, and interest and all expenses related to Portfolio Investments or potential Portfolio Investments and to the acquisition, holding and sale or other disposition of Portfolio Investments. 3.3. Day-to-Day Operations; Acts of Investment Committee. The day-to-day operations of the Partnership, including the identification, review and structuring of, and analysis and recommendations with respect to, proposed Portfolio Investments and realizations will be managed by the Merchant Banking Group. All final investment and realization decisions will be made on behalf of the General Partner, in its capacity as general partner of the Partnership, by members of the Investment Committee. In connection with Partnership matters, the Investment Committee will operate in accordance with its corporate authorization. 3.4. Services by Lehman Brothers; Charges and Expenses. (a) Investment advisory services for the Partnership will be performed by or on behalf of the General Partner, and brokerage, custody and other administrative and similar services for the Partnership may be performed by Lehman Brothers, and in connection therewith no charge shall be made to the Partnership for the time of any employee of Lehman Brothers although the Partnership may be charged customary fees for such services. (b) The Partnership may borrow funds from Lehman Brothers in order to provide funds for purposes of covering Partnership expenses or providing interim financing to the extent necessary to consummate the purchase of Portfolio Investments prior to the receipt of Capital Contributions, and Lehman Brothers shall be entitled to receive interest on amounts loaned at the prime rate as charged -8- 13 from time to time by a major money center bank or at the Cost of Funds Rate, as determined by Lehman Brothers in its discretion at the time any such loan is made (but in no event less than the rate required under United States tax law to avoid compensation income to the Limited Partners). In connection with the investment activities of the Partnership, Lehman Brothers and its Affiliates shall be entitled to receive certain fees, brokerage commissions or other benefits from purchasers, sellers and Portfolio Companies in connection with services rendered to these companies, which fees may be higher or lower than market rates for similar services to third parties. 3.5. Related Partnerships. A portion of the available capital of Capital Partners III will be invested side by side with LB Fund II and the Partnership. With the exception of Capital Partners III, Lehman Brothers will not originate or offer to its employees another employee investment vehicle during the Commitment Period which has an investment objective substantially similar to that of the Partnership unless at least 50% of the aggregate Capital Commitments have been called. Any employee investment vehicle that is established primarily to make investments restricted by or otherwise excluded from LB Fund II (including without limitation venture capital or real estate investments) is not subject to the foregoing limitation. ARTICLE 4 LIMITED PARTNERS 4.1. Initial Limited Partner. (a) The Initial Limited Partner has become such only for the purpose of organizing the Partnership. Immediately subsequent to the admission of one or more additional Limited Partners on the Closing Date, the Initial Limited Partner shall withdraw from the Partnership, the Initial Limited Partner's capital contribution, if any, shall be returned and it shall have no other rights or liabilities with respect to the Partnership in its capacity as Initial Limited Partner. (b) Unless the context otherwise specifically requires, references in this Agreement to the Limited Partners, their capital and their rights and obligations shall not be references to the Initial Limited Partner. 4.2. Additional Limited Partners. Following receipt by Lehman Brothers of the Exemptive Order, the General Partner is authorized to admit Eligible Investors as additional Limited Partners to the Partnership pursuant to the terms of the Memorandum and this Agreement and upon execution and delivery by each Eligible Investor of a subscription agreement and such other documents as the General Partner deems necessary or advisable, each in form satisfactory to the General Partner, relating to the Units. The manner of the offering of the Units, the terms and conditions under which subscriptions for such Units will be accepted, and the manner of and conditions to the sale of Units to subscribers therefor will be as provided in this Agreement and in the Memorandum and the various subscription agreements between the Partnership and each Limited Partner, and subject to any provisions of any of them. A person shall be admitted as a Limited Partner on the day his or her admission is reflected on the books and records of the Partnership. 4.3. List of Limited Partners. The name, residence and business address of each additional Limited Partner and the aggregate amount of such Limited Partner's Capital Commitment is set forth on Schedule A hereto, as amended from time to time. 4.4. No Management by Limited Partners. No Limited Partner as such shall take part in the management of the Partnership's business, transact any business in the Partnership's name or have the power to sign documents for or otherwise bind the Partnership. Limited Partners will not participate in any investment decisions made on behalf of the Partnership, although members of the Merchant -9- 14 Banking Group and the Investment Committee may invest in the Partnership if they are Eligible Investors. 4.5. Limitation on Transfer of Limited Partners' Units. Except as set forth in Article 10 herein, no Limited Partner shall, directly or indirectly, Transfer any Units. ARTICLE 5 LIABILITY OF PARTNERS 5.1. General Partner. Except as provided in Section 11.2(e), the General Partner shall not be required to contribute to the capital of, or lend, the Partnership any funds other than the General Partner's Capital Contribution. Neither the General Partner nor any of its Affiliates shall have any personal liability for the return or repayment of the aggregate Capital Contributions of any Limited Partner. 5.2. Limited Partners. Except as otherwise provided under Delaware law, no Limited Partner shall be liable for the debts, liabilities, contracts or any other obligations of the Partnership, except to the extent of such Limited Partner's Capital Commitment, or for the debts or liabilities of any other Partner. No Limited Partner shall be required to lend the Partnership any funds. ARTICLE 6 POWERS OF GENERAL PARTNER; PROHIBITED TRANSACTIONS AND RESTRICTIONS; DUTIES OF GENERAL PARTNER; INDEMNIFICATION AND CONTRIBUTION 6.1. Powers. (a) In addition to and not in limitation of any rights and powers conferred by law or other provisions of this Agreement, and except as limited, restricted or prohibited by the express provisions of this Agreement, the General Partner shall have and may exercise on behalf of the Partnership all powers and rights necessary, proper, convenient or advisable to effectuate and carry out the purpose and business of the Partnership. These powers shall include, without limitation, the following powers: (i) to borrow money in the name of the Partnership from any person, including Lehman Brothers, or guarantee loans or other extensions of credit for purposes of covering Partnership expenses or providing interim financing to the extent necessary to consummate the purchase of Portfolio Investments prior to the receipt of Capital Contributions, and, if security is required therefor, to mortgage or subject to any other security device any portion of the assets of the Partnership, to obtain replacements of any mortgage or other security device, and to prepay, in whole or in part, refinance, increase, modify, consolidate or extend any mortgage or other security device; (ii) to enter into transactions and make investments with or through Affiliates of the General Partner, including LB Fund II, and to participate in investment transactions sponsored, managed or underwritten by Affiliates of the General Partner, including LB Fund II, or in entities as to which Affiliates of the General Partner serve as investment adviser or placement agent; -10- 15 (iii) prior to making Portfolio Investments or pending cash distributions to the Partners, to make temporary investments of Partnership capital in all types of securities, including, without limitation, short-term United States government and agency securities, certificates of deposit, interest-bearing deposits in United States banks, securities issued by or on behalf of states, municipalities and their instrumentalities, the interest from which is exempt from federal income tax, prime-grade commercial paper, repurchase agreements with respect to any of the foregoing, securities prime-grade commercial paper issued by other investment companies (including unit investment trusts and taxable and tax-exempt money market funds sponsored and/or advised by Affiliates of the General Partner); (iv) to enter into contracts (including, without limitation, insurance policies and contracts, of any type and coverage) and make commitments on behalf of the Partnership and, in general, to do and perform everything which may be necessary, advisable, suitable or proper for the conduct of the Partnership's business and for the carrying out of the purposes and objects herein before enumerated, including the delegation to any person or persons of such functions and authority as the General Partner may determine; and (v) to employ attorneys and accountants to represent and audit the books of the Partnership, which attorneys and accountants may also serve as counsel and auditors to the General Partner and any of its Affiliates. (b) Any person not a party to this Agreement dealing with the Partnership shall be entitled to rely conclusively upon the power and authority of any officer or director of the General Partner to bind the Partnership in all respects, and to execute agreements, instruments and other writings on behalf of and in the name of the Partnership. 6.2. Prohibited Transactions. Notwithstanding anything to the contrary contained herein, the following transactions are specifically prohibited to the Partnership: (i) the Partnership shall not engage in any transaction otherwise prohibited by Section 17(a) or Section 17(d) of the 1940 Act and Rule 17d-1 thereunder unless the following conditions are satisfied: (A) the Investment Committee shall have determined, on behalf of the Partnership, that the terms of the transaction, including the consideration to be paid, are fair and reasonable to the Limited Partners and do not involve overreaching of the Partnership or the Limited Partners on the part of any person concerned, and that the transaction is consistent with the interests of the Limited Partners, this Agreement and the Partnership's reports to the Limited Partners; and (B) affiliated co-investors of the Partnership give the General Partner at least one day's notice of their intent to dispose of any joint investment with the Partnership and refrain from disposing of their joint investment unless the Partnership has the opportunity to dispose of its investment prior to or concurrently with, and on the same terms as, the co-investors; and (ii) the Partnership shall not engage in any other transaction prohibited by the 1940 Act unless such transaction is permitted by the Exemptive Order or an exemption therefor has otherwise been duly obtained. -11- 16 6.3. Restrictions on the Authority of the General Partner. Without the approval of a majority in interest of the Limited Partners, the General Partner shall not have the authority to alter the purpose of the Partnership. 6.4. Duties. (a) Other than with respect to temporary investments, and after setting aside suitable reserves, the General Partner shall invest the Capital Contributions of the Partners in Portfolio Investments in accordance with the purposes of the Partnership, monitor and dispose of such Portfolio Investments and manage the related affairs of the Partnership. (b) Except as otherwise expressly provided herein, the General Partner shall take all action that may be necessary or appropriate for the continuation of the Partnership's valid existence as a limited partnership under the laws of the State of Delaware, and for the acquisition, holding and disposition, in accordance with the provisions of this Agreement and applicable laws and regulations, of the Portfolio Investments and any other investments of the Partnership. (c) The General Partner shall prepare or cause to be prepared and shall file on or before the due date (or any extension thereof) any United States federal, state or local tax returns required to be filed by the Partnership. The General Partner shall cause the Partnership to pay, from Partnership funds, any taxes payable by the Partnership. (d) The General Partner shall be under a fiduciary duty and obligation to conduct the affairs of the Partnership in the best interest (or not opposed to the best interest) of the Partnership, including the safekeeping and use of all Partnership funds and assets (whether or not in the immediate possession or control of the General Partner) for the benefit of the Partnership. (e) The General Partner may delegate or assign any action which may be or is required to be taken by the General Partner to any third party, including without limitation, an Affiliate of the General Partner. 6.5. Exculpation, Indemnification and Contribution. Neither the General Partner, any of its officers, directors, agents or representatives (including any members of the Merchant Banking Group or the Investment Committee) nor any person who controls the General Partner (a "control person") within the meaning of Section 15 of the Securities Act of 1933, as amended, shall be liable to the Partnership or the Limited Partners for any act or failure to act relating in any way to the Partnership, its assets, business or affairs so long as such act or failure to act does not constitute such person's willful misconduct, bad faith or gross negligence or reckless disregard of the duties involved in the conduct of the Partnership or such person's office. The General Partner and its officers, directors, agents, representatives (including members of the Merchant Banking Group and the Investment Committee) and control persons shall be indemnified by the Partnership to the fullest extent permitted by law for any and all losses, claims, damages and expenses arising out of or incurred in connection with any claim, action or demand against the General Partner, the Partnership or any such indemnified person relating to the Partnership, its assets, business or affairs (including, without limitation, attorneys' fees and expenses and any amounts paid in settlement or compromise of any such claim, action or demand); provided, however, that the foregoing indemnification shall not apply if a court of competent jurisdiction makes a final decision that such claim, action or demand resulted directly from such indemnified person's willful misconduct, bad faith, gross negligence or reckless disregard of the duties involved in the conduct of the Partnership or such person's office. 6.6. General Partner Loans. Subject to the provisions of Sections 3.4 and 6.2, in the event that the Partnership at any time lacks sufficient funds to meet its financial obligations, the General Partner shall have the right to, but shall not be required to, lend money to the Partnership at an interest rate -12- 17 equal to the prime rate as charged from time to time by a major money center bank or at the Cost of Funds Rate, as determined by Lehman Brothers in its discretion at the time any such loan is made (but in no event less than the rate required under United States tax law to avoid compensation income to the Limited Partners) and on other terms that are fair and reasonable to the Partnership without any approval of the Limited Partners. The General Partner may execute written agreements governing any such loans on behalf of the Partnership. ARTICLE 7 CAPITAL CONTRIBUTIONS AND ACCOUNTS; NO FURTHER CONTRIBUTIONS REQUIRED; INTEREST; ACCOUNTING AND VALUATION 7.1. Capital Contributions and Accounts. (a) Subscriptions for Units shall be accepted or rejected by the General Partner as it determines in its sole discretion. The minimum Capital Commitment of each Limited Partner is one Unit ($20,000). Additional whole Units may be purchased up to a maximum Capital Commitment as determined on a case-by-case basis by the General Partner in its sole discretion. Unless otherwise provided in the Eligible Investor's subscription agreement, the Initial Payment for each Unit is unconditionally due and payable upon execution and delivery of the related subscription agreement and shall be deposited by the General Partner in the Escrow Account pending receipt by Lehman Brothers of the Exemptive Order. Upon receipt of the Exemptive Order by Lehman Brothers, such funds shall be transferred by the General Partner to the Money Fund until needed to fund one or more Portfolio Investments or to pay any Partnership expenses. The balance of the Capital Commitment is due at any time upon subsequent call dates to be determined by the General Partner upon 30 days' prior written notice to the Limited Partners. Any Capital Contributions made to the Partnership by a Limited Partner must be paid in cash. The obligation of a Limited Partner to make Capital Contributions in respect of such Limited Partner's Units shall be limited by the provisions of Section 10.4. (b) Except as provided below with respect to Follow-on Investments, the Limited Partners' commitment to provide funds for Portfolio Investments will expire upon the expiration or termination of the Commitment Period. Upon the expiration or termination of the Commitment Period, the Limited Partners shall not be required to make any further Capital Contributions to the Partnership, except to the extent necessary to (i) cover Partnership expenses and (ii) make Follow-on Investments in an aggregate amount of up to 10% of the Partnership's initial Capital Commitments for a period of two years after the expiration or termination of the Commitment Period; provided that in no event will a Limited Partner be required to make a Capital Contribution at any time in excess of the unpaid portion of his or her Capital Commitment at such time. (c) In the event that any Limited Partner fails to pay in full any Capital Contribution as the installment becomes due, the General Partner shall send to the Limited Partner a written notice by certified mall (or its equivalent) or via overnight courier stating that the installment is overdue. If the Limited Partner fails to pay the installment in full within ten business days following the General Partner's mailing of the notice, the Limited Partner will be in breach of this Agreement and: (i) such Limited Partner's entire interest in any Money Fund, if any, shall be applied in partial satisfaction of such installment; (ii) the General Partner will have the right, exercisable in its sole discretion at any time thereafter, to require that such Limited Partner's entire interest in the Partnership, including the positive balance of his or her Capital Account, be reduced by one-fourth (1/4) as liquidated damages; -13- 18 (iii) the General Partner will have the right, exercisable in its sole discretion at any time thereafter, to terminate such defaulting Limited Partner's right or obligation to make future Capital Contributions; and (iv) except as required under the Act, any vote, approval or decision by the Limited Partners provided for in this Agreement shall be tabulated or made as though such defaulting Limited Partner were not a Limited Partner. The defaulting Limited Partner shall continue to share in allocations of Partnership income, gain, loss, deduction or credit with respect to his or her remaining three-fourths (3/4) interest in the Partnership. The powers conferred upon the General Partner in this Article 7 shall not limit any actions available at law or in equity or by statute that the General Partner may undertake against a defaulting Limited Partner. (d) Pending the making of Portfolio Investments for which the Partnership requires capital, installment payments for the purchase price of each Limited Partner's Units will be invested in the Money Fund. Shares in the Money Fund may not be redeemed by Limited Partners, although dividends paid by the Money Fund will be paid to the Limited Partners periodically. The General Partner will redeem Money Fund shares from time to time as needed to fund specific Portfolio Investments. Amounts remaining in the Money Fund at the end of the Commitment Period that have not been used for Partnership purposes and which the Partnership has not committed for future use (including for potential Follow-on Investments) shall be distributed to the Limited Partners in proportion to their allocable share of amounts remaining in the Money Fund. (e) The General Partner shall contribute to the capital of the Partnership an amount equal to 25% of the aggregate amount contributed by the Limited Partners ($5,000 per Unit). The General Partner shall make its Capital Contributions in installments by contributing 25% of the aggregate amounts withdrawn from the Money Funds and the contributions by Limited Partners which are funded by Lehman Brothers from time to time to fund specific Portfolio Investments or pay Partnership expenses. (f) A separate capital account (the "Capital Account") shall be established and maintained for each Partner. The Capital Account of each Partner shall be credited with such Partner's aggregate Capital Contributions, all Profits allocated to such Partner pursuant to Section 8.1 and any items of income or gain which are specially allocated pursuant to Section 8.2; and shall be debited with all Losses allocated to such Partner pursuant to Section 8.1, any items of loss or deduction of the Partnership specially allocated to such Partner pursuant to Section 8.2, and all cash and the Carrying Value of any property (net of liabilities assumed by such Partner and the liabilities to which such property is subject) distributed by the Partnership to such Partner. To the extent not provided for in the preceding sentence, the Capital Accounts of the Partners shall be adjusted and maintained in accordance with the rules of Treasury Regulations Section 1.704-l(b)(2)(iv), as the same may be amended or revised, provided that such adjustment and maintenance does not have a material adverse effect on the economic interests of the Partners. Any references in any section of this Agreement to the Capital Account of a Partner shall be deemed to refer to such Capital Account as the same may be credited or debited from time to time as set forth above. In the event of any Transfer of any interest in the Partnership in accordance with the terms of this Agreement, the transferee shall succeed to the Capital Account of the transferor to the extent it relates to the transferred interest. 7.2. Further Capital Contributions. No Limited Partner shall be required to purchase additional Units or make any Capital Contribution to the Partnership at any time in excess of such Limited Partner's Capital Commitment at such time. After all Capital Contributions in respect of Capital -14- 19 Commitments have been made and all contributions, including required General Partner contributions, have been invested by the Partnership, if the General Partner determines it to be in the best interests of the Partnership, the Partnership may offer all Limited Partners the opportunity to make additional contributions to the Partnership's capital on a pro rata basis, as determined by the General Partner. 7.3. Interest. No Limited Partner shall receive interest on amounts credited to such Limited Partner's Capital Account. 7.4. Fixed Return. The General Partner shall determine the amount of the Fixed Return using the Cost of Funds Rate plus 0.50% per annum for the applicable period of time or, if higher, an amount determined by the General Partner with reference to the applicable United States federal rate for interest on loans then utilized by the Internal Revenue Service in connection with below-market loans to employees with a maturity date of July 25, 2009. The General Partner's determination of the Fixed Return shall be final and binding on the Partners absent a finding of manifest error. 7.5. Accounting Periods and Taxable Years. An accounting period and taxable year shall mean the calendar year, except that the last accounting period and taxable year shall mean the period ending with the termination of the Partnership. ARTICLE 8 ALLOCATIONS 8.1. Allocation of Profits and Losses; Other Allocations. Except as otherwise provided in this Agreement, Profit or Loss of the Partnership for each taxable year shall be allocated annually at the end of the Partnership's fiscal year in the following order and priority: (i) Profits shall be allocated as follows: (A) first, if on a cumulative basis the General Partner has had Losses previously allocated to it pursuant to clause (ii)(D) below in excess of Profits previously allocated to it pursuant to this clause (i)(A), to the General Partner to the extent of such excess; (B) then, if on a cumulative basis the Limited Partners have had Losses previously allocated to them pursuant to clause (ii)(C) below in excess of Profits previously allocated to them pursuant to this clause (i)(B), to the Limited Partners to the extent of such excess; (C) then, if on a cumulative basis the General Partner has had Losses previously allocated to it pursuant to clause (ii)(B) below in excess of Profits previously allocated to it pursuant to this clause (i)(C), to the General Partner to the extent of such excess; (D) then, to the General Partner until it has been allocated an aggregate amount of Profits in excess of Losses equal to the Fixed Return on its aggregate unreturned Capital Contributions; (E) then, to the Limited Partners until they have received an aggregate amount of Profits in excess of Losses equal to the Fixed Return on (x) 75% of their -15- 20 aggregate Capital Contributions less (y) the amount of their Returned Capital Contributions; and (F) thereafter, any remaining Profits shall be allocated 90% to the Limited Partners and 10% to the General Partner. (ii) Losses of the Partnership shall be allocated as follows: (A) first, 90% to the Limited Partners and 10% to the General Partner in an amount equal to the excess, if any, of (x) the cumulative Profits previously allocated to the Partners pursuant to clause (i)(F) above over (y) the cumulative Losses previously allocated to the Partners pursuant to this clause (ii)(A); (B) then, 100% to the General Partner until the Capital Account of the General Partner is reduced to zero; (C) then, 100% to the Limited Partners until the Capital Accounts of the Limited Partners are reduced to zero; and (D) thereafter, 100% to the General Partner; provided, however, that in no event shall Losses be allocated to a Limited Partner if the effect of such allocation would be to cause a negative balance in such Limited Partner's Capital Account. Any such Losses shall be allocated to the other Limited Partners to the extent of their positive Capital Account balances and thereafter to the General Partner. 8.2. Special Allocation Provisions. Notwithstanding anything to the contrary in this Agreement, the following special allocations shall be made: (a) Minimum Gain Chargeback. Notwithstanding any other provision in this Article 8, if there is a net decrease in Partnership minimum gain or partner nonrecourse debt minimum gain (determined in accordance with the principles of U.S. Treasury Regulations Sections 1.704-2(d) and 1.704-2(i)) during any Partnership taxable year, the Partners shall be specially allocated items of Partnership income and gain for such year (and, if necessary, subsequent years) in an amount equal to their respective shares of such net decrease during such year, determined pursuant to U.S. Treasury Regulations Sections 1.704-2(g) and 1.704-2(i)(5). The items to be so allocated shall be determined in accordance with U.S. Treasury Regulations Section 1.704-2(f). This Section 8.2(a) is intended to comply with the minimum gain chargeback requirements in such U.S. Treasury Regulations Sections and shall be interpreted consistently therewith; including that no chargeback shall be required to the extent of the exceptions provided in U.S. Treasury Regulations Sections 1.704-2(f) and 1.704-2(i)(4). (b) Qualified Income Offset. In the event any Limited Partner unexpectedly receives any adjustments, allocations, or distributions described in Treasury Regulation Section 1.704-1(b)(2)(ii)(d)(4), (5) or (6), items of Partnership income and gain shall be specially allocated to such Limited Partner in an amount and manner sufficient to eliminate the deficit balance in his or her Capital Account created by such adjustments, allocations or distributions as promptly as possible. (c) Gross Income Allocation. In the event any Limited Partner has a deficit Capital Account at the end of any Fiscal Year which is in excess of the amount such Partner is deemed to be -16- 21 obligated to restore pursuant to the penultimate sentences of Treasury Regulations Section 1.704-2(g)(1) and 1.704-2(i)(5), each such Limited Partner shall be specially allocated items of Partnership income and gain in the amount of such excess as quickly as possible, provided that an allocation pursuant to this Section 8.2(c) shall be made only if and to the extent that a Limited Partner would have a deficit Capital Account in excess of such amount after all other allocations provided for in this Article 8 have been tentatively made as if Section 8.2(a) and this Section 8.2(c) were not in this Agreement. (d) Nonrecourse Deductions. Nonrecourse Deductions shall be allocated 10% to the General Partner and 90% among the Limited Partners in accordance with their respective Capital Account balances. (e) Partner Nonrecourse Deductions. Partner Nonrecourse Deductions for any taxable period shall be allocated to the Partner who bears the economic risk of loss with respect to the liability to which such Partner Nonrecourse Deductions are attributable in accordance with U.S. Treasury Regulations Section 1.704-2(j). 8.3. Tax Allocations. For income tax purposes only, each item of income, gain, loss and deduction of the Partnership shall be allocated among the Partners in the same manner as the corresponding items of Profits and Losses and specially allocated items are allocated for Capital Account purposes; provided that in the case of any Partnership asset the Carrying Value of which differs from its adjusted tax basis for United States federal income tax purposes, income, gain, loss and deduction with respect to such asset shall be allocated solely for income tax purposes in accordance with the principles of Sections 704(b) and (c) of the Code (in any manner determined by the General Partner) so as to take account of the difference between Carrying Value and adjusted basis of such asset. 8.4. Allocation among Limited Partners, Transfers. (a) Profits and Losses allocated to Limited Partners will be apportioned among each Limited Partner based upon a fraction, the numerator of which is the Capital Account balance of such Limited Partner (or his or her predecessor in interest) and the denominator of which is the aggregate Capital Account balances of all Limited Partners, taking into account any change in such ratio during the period. (b) In the event of a permitted Transfer of a Unit or the termination or reduction of a Partner's interest in his or her Capital Account in the Partnership during a taxable year of the Partnership, allocations of income, gain, loss, deductions and credits of the Partnership will be based on an interim closing of the Partnership's books or such other method as is determined by the General Partner. 8.5. Tax Elections. The General Partner is hereby authorized and empowered to make on behalf and in the name of the Partnership any election, and to prepare or have prepared, to execute or have executed and to file, on behalf and in the name of the Partnership, any returns, applications and other instruments and documents, under the Code and the regulations thereunder, as in effect from time to time, which the General Partner determines in its sole discretion are desirable or advisable in connection with determining such allocations. 8.6. Other Allocation Provisions. The foregoing provisions and the other provisions of this Agreement relating to the maintenance of Capital Accounts are intended to comply with U.S. Treasury Regulations Section 1.704-1(b) and shall be interpreted and applied in a manner consistent with such regulations. Sections 8.1 to 8.5 may be amended at any time by the General Partner, if necessary, in the view of the General Partner, to comply with such regulations. -17- 22 ARTICLE 9 DISTRIBUTIONS; WITHDRAWAL 9.1. General Partner Discretion. Distributions may be made at any time as determined by the General Partner. The General Partner in its sole discretion will determine the aggregate amount of and payment dates for any cash and non-cash distributions to Partners after establishing such reasonable reserves as the General Partner deems appropriate in its sole discretion for working capital, vesting or other contingencies or other items and for the satisfaction of liabilities (including, without limitation, contingent liabilities) as they come due or may come due. 9.2. Distributions. (a) Distributions from the Partnership shall be made in the following order and priority: (i) first, to the Limited Partners to the extent of available cash in an amount equal to 35% of the taxable ordinary income and capital gain allocated by the Partnership to them pursuant to clauses (i)(E) and (F) under Section 8.1 above for the current taxable year; provided that the General Partner in its sole discretion may adjust the rate at which such distributions are made to take into account changes in tax rates applicable to individuals or for any other reason; (ii) then, to the General Partner until it has received cumulative distributions equal to the Fixed Return on its aggregate unreturned Capital Contributions; (iii) then, to the Limited Partners until they have received cumulative distributions (excluding amounts distributed pursuant to clause (i)) equal to the Fixed Return on (x) 75% of their aggregate Capital Contributions less (y) the amount of their Returned Capital Contributions; (iv) then, to the Limited Partners until they have received cumulative distributions (other than pursuant to clause (iii)) equal to the sum of their aggregate Capital Contributions; (v) then, to the General Partner until it has received cumulative distributions (other than pursuant to clause (ii)) equal to the sum of its aggregate Capital Contributions; and (vi) thereafter, to the Limited Partners and to the General Partner in accordance with the ratio which each Partner's positive Capital Account balance bears to the sum of all Partners' positive Capital Account balances. (b) Distributions to Limited Partners will be apportioned among each Limited Partner based upon a fraction, the numerator of which is the Capital Account balance of such Limited Partner (or his or her predecessor in interest) and the denominator of which is the aggregate Capital Account balances of all Limited Partners, taking into account any change in such ratio during the period. 9.3. Non-Cash Distributions. Distributions from the Partnership may be made in cash or in kind in the General Partner's sole discretion. The General Partner may in its sole discretion offer Limited Partners the right to elect whether to receive cash or in kind distributions in connection with any distribution and, following any such election, may (but shall not be required to) make a distribution to some Limited Partners in cash and to others in kind. The value of any non-cash assets that are distributed shall be determined by the General Partner in accordance with Section 12.4 hereof. -18- 23 9.4. Withholding. The Partnership shall withhold from any amounts otherwise distributable to any Partner the amounts required by law to be withheld for income tax or other purposes; any amounts so withheld shall be treated as having been distributed to such Partner for all purposes of this Agreement. 9.5. Withdrawal. No Partner shall have the right to withdraw such Partner's Capital Contribution or any part thereof from the Partnership or to receive a return of such Partner's Capital Contribution or any part thereof except upon termination and dissolution of the Partnership, except as may be permitted by the General Partner in its sole discretion. ARTICLE 10 TRANSFERABILITY OF INTERESTS; VESTING; TERMINATION OF EMPLOYMENT 10.1. Restrictions and Conditions on Transfers of Units. (a) Except for Transfers permitted under Section 10.4, no direct or indirect sale, exchange, transfer, assignment, pledge, creation of a security interest in, or encumbrance on, or other disposition by a Limited Partner of all or any portion of such Limited Partner's Units or any economic interest therein (including without limitation by means of any participation or swap transaction) (each, a "Transfer") shall be made without the prior written consent of the General Partner (which consent may be withheld in the sole discretion of the General Partner). Any Units acquired by the General Partner may be transferred to any Eligible Investor, subject to the restrictions contained in Section 10.1(b), provided that the General Partner does not own more than 80% of the Units. (b) Any Transfer otherwise permitted under this Article 10 may only be made if: (i) such Transfer, when added to the total of all other Transfers of Units within the preceding twelve months, would not result in the Partnership being considered to have terminated within the meaning of Section 708 of the Code; (ii) such Transfer would not violate any United States securities laws, or any state securities or "blue sky" laws (including any investor suitability standards) or the laws of any jurisdiction outside the United States applicable to the Partnership or the Units to be Transferred; (iii) such Transfer would not cause the Partnership to lose its status as a partnership for United States federal income tax purposes; (iv) such Transfer would not in the judgement of the General Partner, pose a risk that the Partnership would be treated as a publicly traded partnership; and (v) such Transfer is made to an eligible investor under the terms of the Exemptive Order. (c) The General Partner, each Limited Partner, the Partnership and their respective officers, directors, agents and control persons shall be indemnified by a Limited Partner (the "Transferring Limited Partner") to the fullest extent permitted by law for any and all losses, claims, damages and expenses arising out of or reasonably incurred in connection with any claim, action or demand against the General Partner, the Partnership or any such indemnified person relating to the Partnership, its properties, business or affairs (including, without limitation, attorneys' fees and expenses and any amounts paid in settlement or compromise of any such claim, action or demand) for which the Partnership, the General Partner or such other person has not otherwise been reimbursed actually and -19- 24 reasonably incurred by them in connection with such action, suit or proceeding and arising out of, relating to, or in connection with, any Transfer of all or any portion of such Transferring Limited Partner's Units, or in connection with the admission of a substituted Limited Partner to the Partnership; provided, however, that the foregoing indemnification shall not apply if a court of competent jurisdiction makes a final decision that such claim, action or demand resulted primarily from such indemnified person's willful misconduct, bad faith, gross negligence or reckless disregard of the duties involved in the conduct of the Partnership or such person's office. (d) Subject to Section 10.4, no Unit may be subdivided into fractional Units. 10.2. Assignees. (a) The Partnership shall not recognize for any purpose any purported Transfer of all or any portion of the Units of a Limited Partner unless the provisions of Section 10.1 shall have been complied with and there shall have been filed with the Partnership a Transfer Application, in form satisfactory to the General Partner, executed and acknowledged by both the seller, transferor or assignor and the purchaser, transferee or assignee and such Transfer Application (i) contains the acceptance by the purchaser, transferee or assignee of all of the terms and provisions of this Agreement, (ii) contains an assumption by the purchaser, transferee or assignee of the obligations of the Transferring Limited Partner to pay any unpaid portion of his or her Capital Commitment, (iii) contains a representation of the seller, transferor or assignor that such Transfer was made in accordance with all applicable laws and regulations, (iv) contains a representation of the purchaser, transferee or assignee that he or she is an eligible investor under the terms of the Exemptive Order and (v) contains the purchaser's, transferee's or assignee's power of attorney identical to that provided in Section 13.1 and, in addition, appoints the General Partner his or her attorney-in-fact to execute this Agreement on behalf of such purchaser, transferee or assignee. Any Transfer shall be recognized by the Partnership as effective as of the date on which such Transfer Application is filed with the Partnership. (b) Any Limited Partner who shall assign all of his or her Units shall not cease to be a Limited Partner unless and until a substituted Limited Partner is admitted in his or her stead. (c) A person who is the assignee of all or any portion of the Units of a Limited Partner, but does not become a substituted Limited Partner and desires to make a further assignment of such Units, shall be subject to all the provisions of this Article 10 to the same extent and in the same manner as any Limited Partner desiring to effect a Transfer of his or her Units. 10.3. Substituted Limited Partners. (a) No Limited Partner shall have the right to substitute a purchaser, assignee, transferee, donee, heir, legatee, distributee or other recipient of all or any portion of such Limited Partner's Units as a Limited Partner in his or her place. Any such purchaser, assignee, transferee, donee, heir, legatee, distributee or other recipient of Units shall be admitted to the Partnership as a substituted Limited Partner only (i) with the consent of the General Partner, which consent shall be granted or withheld in the sole and absolute discretion of the General Partner and may be arbitrarily withheld, and (ii) by an amendment to Schedule A to this Agreement executed by all necessary parties and recorded, as and to the extent required by law, in the proper records of each jurisdiction in which such recordation is necessary to qualify the Partnership to conduct business or to preserve the limited liability of the Limited Partners. The Limited Partners hereby consent to the admission of a substituted Limited Partner whose admission has been consented to by the General Partner. Any such consent by the General Partner and the Limited Partners may be evidenced by the execution by the General Partner of an amendment to this Agreement on its behalf and on behalf of all Limited Partners evidencing the admission of such person as a Limited Partner and the making of any filing required by law. -20- 25 (b) To the extent required by law, the General Partner shall file an amended certificate of limited partnership with the appropriate authorities of each state in which the Partnership transacts business for the purpose of adding as substituted Limited Partners all assignees of Units previously approved by the General Partner for admission as substituted Limited Partners and deleting any person who is no longer a Limited Partner or reflecting accurately Capital Contributions of the Limited Partners or to receive any interest thereon. (c) No person shall become a substituted Limited Partner until such person shall have delivered a Transfer Application as provided in Section 10.2(a) and become a party to this Agreement; provided, however, that for the purpose of allocating profits, losses and distributable cash, a person shall be treated as having become, and as appearing in the records of the Partnership as, a Limited Partner on such date as the Transfer to such person was recognized by the Partnership pursuant to Section 10.2(a). 10.4. Termination of Employment, Death, Disability, Retirement of Limited Partner. (a) Vesting Schedule. To the extent a Limited Partner's interest in his or her Capital Account has vested, such Limited Partner will be entitled to continue to share in allocations of Partnership income, gain, expense, loss or deduction. As more fully described below, a Limited Partner's interest generally will vest according to the following schedule (the "Vesting Schedule"): (i) In the case of a Limited Partner's voluntary resignation from Lehman Brothers or termination of employment by Lehman Brothers without Cause, provided the Limited Partner is not determined to have engaged in Competitive Activity or Detrimental Activity in the case of voluntary resignation or Detrimental Activity in the case of a termination without Cause:
PERCENTAGE OF INTEREST ON OR AFTER BUT PRIOR TO THAT IS VESTED UNVESTED INTEREST - -------------------------- ----------------- ---------------------- ----------------- The date of this Agreement November 30, 1998 0% 100% November 30, 1998 November 30, 1999 50% 50% November 30, 1999 100% 0%
(ii) In the case of a Limited Partner's voluntary resignation involving Competitive Activity or Detrimental Activity, or it otherwise being determined that the Limited Partner engaged in such activity, or termination of employment by Lehman Brothers for Cause:
PERCENTAGE OF INTEREST ON OR AFTER BUT PRIOR TO THAT IS VESTED UNVESTED INTEREST - -------------------------- ----------------- ---------------------- ----------------- The date of this Agreement November 30, 1998 0% 100% November 30, 1999 100% 0%
provided that the General Partner shall have authority to accelerate (but not otherwise modify) the Vesting Schedule at any time, for any and all of the Limited Partners, in its sole discretion. (b) Voluntary Resignation; Competitive Activity and Detrimental Activity. (i) In the event that a Limited Partner voluntarily resigns his or her employment with Lehman Brothers at any time, (A) such Limited Partner shall not have any obligation to make and shall not have any right or otherwise be permitted to make any additional Capital Contributions on and after the date of such resignation, and (B) the General Partner shall have the right, exercisable in its sole discretion by written notice sent by certified mail (or its equivalent) or via overnight courier (the "Repurchase Notice") to such Limited Partner (or his or her Representative) within 60 days following such resignation (which right may be assigned by the General Partner in its sole discretion to any of its Affiliates, including the Partnership), -21- 26 to purchase the unvested portion, if any, of such Limited Partner's Capital Account (the "Unvested Interest") as of the date of such resignation determined in accordance with the Vesting Schedule. The purchase price of such Unvested Interest shall be an amount payable in cash equal to the sum of (x) the aggregate amount of such Limited Partner's Capital Contributions, less the amount of his or her Returned Capital Contributions, in respect of such Unvested Interest plus (y) a rate of return on the amount determined in clause (x) equal to the Fixed Return to (but not including) the date the Unvested Interest is purchased. (ii) If at any time following such resignation and prior to November 30, 1999, the General Partner determines in good faith that such Limited Partner has engaged in any Competitive Activity or any Detrimental Activity, whether before or after such resignation, the General Partner shall have the right, exercisable in its sole discretion by delivering a Repurchase Notice to such Limited Partner (or his or her Representative) within 60 days following such determination (which right may be assigned by the General Partner in its sole discretion to any of its Affiliates, including the Partnership), to purchase the entire interest of such Limited Partner in his or her Capital Account as of the date of such determination. The purchase price of such interest shall be an amount payable in cash equal to the sum of (x) the aggregate amount of such Limited Partner's Capital Contributions, less the amount of his or her Returned Capital Contributions, in respect of such interest plus (y) a rate of return on the amount determined in clause (x) equal to the Fixed Return to (but not including) the date such interest is purchased. (c) Termination by Lehman Brothers Without Cause. (i) In the event that the employment of a Limited Partner is terminated by Lehman Brothers without Cause at any time, (A) such Limited Partner shall not have any obligation to make and shall not have any right or otherwise be permitted to make any additional Capital Contributions on and after the date of such termination, and (B) the General Partner shall have the right, exercisable in its sole discretion by delivering a Repurchase Notice to such Limited Partner (or his or her Representative) within 60 days following such termination (which right may be assigned by the General Partner in its sole discretion to any of its Affiliates, including the Partnership), to purchase such Limited Partner's Unvested Interest as of the date of such termination at the purchase price specified in paragraph (b)(i) above. (ii) If at any time following termination of such Limited Partner's employment without Cause and prior to November 30, 1999, the General Partner determines in good faith that such Limited Partner has engaged in any Detrimental Activity, whether before or after such termination, the General Partner shall have the right, exercisable in its sole discretion by delivering a Repurchase Notice to such Limited Partner (or his or her Representative) within 60 days following such determination (which right may be assigned by the General Partner in its sole discretion to any of its Affiliates, including the Partnership), to purchase the entire interest of such Limited Partner in his or her Capital Account as of the date of such determination at the purchase price specified in paragraph (b)(ii) above. (d) Termination by Lehman Brothers for Cause. (i) In the event that the employment of a Limited Partner is terminated by Lehman Brothers for Cause at any time, such Limited Partner shall not have any obligation to make and shall not have any right or otherwise be permitted to make any additional Capital Contributions on and after the date of such termination. (ii) If such Limited Partner's employment is terminated by Lehman Brothers for Cause prior to November 30, 1999, the General Partner shall have the right, exercisable in its sole discretion by delivering a Repurchase Notice to such Limited Partner (or his or her Representative) within 60 days following such termination (which right may be assigned by the General Partner in its sole discretion to any of its Affiliates, including the Partnership), to purchase the entire interest of such Limited -22- 27 Partner in his or her Capital Account as of the date of such termination at the purchase price specified in paragraph (b)(ii) above. (e) Termination Due to Death, Disability or Retirement. (i) In the event that a Limited Partner's employment with Lehman Brothers is terminated due to such Limited Partner's death, Disability or Retirement, (A) such Limited Partner's Units will immediately become fully vested and (B) such Limited Partner or his or her Representative will have the right (but not the obligation) to continue making Capital Contributions as required pursuant to this Agreement. In such case, promptly following any such termination of employment, the General Partner will send such Limited Partner or his or her Representative a notice by certified mail (or its equivalent) or via overnight courier requesting such Limited Partner's election with respect to whether such Limited Partner wishes to continue making Capital Contributions in the future pursuant to this Agreement. If such Limited Partner or his or her Representative, as the case may be, does not elect, by notice to the General Partner within the time specified for acceptance in such notice (which date will not be less than 30 days from the date of the notice (or, if earlier, the date the next Capital Contribution is due)), to continue making Capital Contributions, such Limited Partner or his or her Representative will be deemed to have elected not to exercise such right and will not be permitted to make any further Capital Contributions and the Partnership will return any of such Limited Partner's remaining interest in any Money Fund. (ii) Notwithstanding the foregoing, if at any time following such termination of employment and prior to November 30, 1999, the General Partner determines in good faith that such Limited Partner has engaged in any Competitive Activity or any Detrimental Activity, whether before or after such termination, (A) such Limited Partner shall not have any obligation to make and shall not have any right or otherwise be permitted to make any additional Capital Contributions on and after the date of such termination, and (B) the General Partner shall have the right, exercisable in its sole discretion by delivering a Repurchase Notice to such Limited Partner or his or her Representative within 60 days following such determination (which right may be assigned by the General Partner in its sole discretion to any of its Affiliates, including the Partnership), to purchase the entire interest of such Limited Partner in his or her Capital Account as of the date of such determination at the purchase price specified in paragraph (b)(ii) above. (f) Required Affidavit. In the event that a Limited Partner's employment with Lehman Brothers is terminated for any reason, from time to time thereafter, Lehman Brothers may require such Limited Partner to complete and sign an affidavit with respect to whether such Limited Partner has engaged in any Competitive Activity or Detrimental Activity. Such affidavit would include certain representations by the Limited Partner and authorize Lehman Brothers to verify such representations. In the event that such Limited Partner fails to complete, sign and return such affidavit within 60 days, the General Partner may conclusively presume that such Limited Partner has engaged in Competitive Activity or Detrimental Activity and, accordingly, will have the right to repurchase the entire interest of such Limited Partner in his or her Capital Account as provided above. (g) Repurchases Generally. In the event the General Partner or its assignee acquires the interest (or the unvested portion thereof) of a Limited Partner in his or her Capital Account pursuant to this Section 10.4, the General Partner will pay for such interest (or such unvested portion) in cash as soon as practicable but in no event later than 30 days following the date of the Repurchase Notice. The determination of the General Partner of the purchase price for such interest (or such unvested portion) shall be determined in good faith by the General Partner and shall be final and binding on the Limited Partner. The General Partner in its sole discretion may assign all or any part of its right to purchase such interest (or such unvested portion) to any of its Affiliates or any Eligible Investor (including, without limitation, any Limited Partner) or, if the General Partner determines a purchase of such interest by the Partnership to be in the best interests of the Partnership, to the Partnership. Units -23- 28 representing any Partnership interests (or portions thereof) which are acquired for the account of the Partnership will be retired. (h) Death; Incompetency; Bankruptcy. If a Limited Partner dies or becomes an adjudicated incompetent (or equivalent under the laws of any jurisdiction other than the United States) or bankrupt, as the case may be, then for purposes of this Agreement the Representative shall have all the rights of a Limited Partner for the purpose of settling or managing the Units of such Limited Partner, and such power as such Limited Partner possessed to assign all or any part of such Limited Partner's Units and to join with such assignee in satisfying conditions precedent to such assignee becoming a substituted Limited Partner as provided in Section 10.3. 10.5. Disposition of General Partner's Interest. The General Partner shall not dispose of its interest in the Partnership as a general partner except to an entity controlled by, or affiliated with, Lehman Brothers, executive officers and directors of which are Eligible Investors. No disposition of the General Partner's interest shall be effective, and the General Partner shall not cease to be a general partner of the Partnership, unless and until the transferee thereof is admitted as a general partner of the Partnership and agrees in writing to continue the business of the Partnership with itself as general partner and to be bound by the provisions of this Agreement. ARTICLE 11 DISSOLUTION AND LIQUIDATION OF THE PARTNERSHIP 11.1 Events Causing Dissolution. The Partnership shall be dissolved upon the expiration of its term as set forth in Section 2.5 hereof, or sooner upon the happening of any of the following events: (a) the resignation, withdrawal, dissolution or bankruptcy of the General Partner or the occurrence of any other event that causes the General Partner to cease to be a general partner of the Partnership under the Act; provided that the Partnership shall not be dissolved or required to be wound up upon the happening of such event if within 90 days after such event, all remaining Partners agree in writing to continue the business of the Partnership and to the appointment, effective as of the date of such event, of one or more additional general partners; (b) the insolvency or bankruptcy of the Partnership; (c) the sale of all or substantially all of the Partnership's assets other than in the ordinary course of business; or (d) the conversion of the Partnership to corporate form pursuant to Section 2.6 hereof. Dissolution of the Partnership shall be effective, on the date on which the event occurs giving rise to the dissolution, but the Partnership shall not terminate until the Partnership's certificate of limited partnership has been canceled and the assets of the Partnership have been distributed as provided in Section 11.2. 11.2. Liquidation. (a) Upon dissolution of the Partnership, its liabilities shall be paid in the order provided herein. The General Partner shall cause Partnership assets to be sold in such manner as the General Partner, in its sole discretion, shall determine. The General Partner or its Affiliates may, to the extent permitted by applicable law, purchase from the Partnership any Partnership investments upon which there are significant restrictions or for which another purchaser willing to pay fair market value is not readily obtainable. Payment of the fair market value of any such investment at the time of -24- 29 the transfer determined by the General Partner in accordance with this Section 11.2 shall be deemed fair and reasonable and not a violation of the General Partner's fiduciary duty to the Partnership. Pending sale of Partnership assets, the General Partner shall have the right to continue to operate and otherwise to deal with Partnership assets. In the event that the General Partner has resigned, withdrawn, dissolved or is bankrupt, or has otherwise ceased to be a general partner of the Partnership. The majority in interest of the Limited Partners shall elect a person (the "liquidating trustee") who is hereby authorized to perform the functions of the General Partner in liquidating the assets of the Partnership and in winding up its affairs. (b) Profits and Losses arising from sales (or distributions) upon liquidation shall be allocated in the manner set forth in Article 8. If, over the term of the Partnership, (i) the amounts distributed to the General Partner in respect of the Fixed Return pursuant to Sections 9.2(a)(ii) and 11.2(c)(ii) exceed the profits allocated to the General Partner pursuant to Section 8.1(i)(D) or (ii) the amounts distributed to a Limited Partner in respect of the Fixed Return pursuant to Sections 9.2(a)(iii) and 11.2(c)(iii) exceed the Profits allocated to such Limited Partner pursuant to Section 8.1(i)(E), then the amount of such excess shall be treated as a guaranteed payment and the Partners' Capital Accounts shall be adjusted accordingly. (c) Proceeds received upon the liquidation of Partnership assets shall be applied and distributed in the following order: (i) to the payment of debts and liabilities of the Partnership (whether by payment or establishment of reasonable reserves), including those to Partners who are creditors, to the extent required by law, in the order of priority as provided by law, and to the payment of the expenses of liquidation; (ii) then, to the payment to the General Partner until it has received an aggregate amount equal to the Fixed Return on its aggregate unreturned Capital Contributions; (iii) then, to the payment to the Limited Partners until they have received an aggregate amount equal to the Fixed Return on (x) 75% of their aggregate Capital Contributions less (y) the amount of their Returned Capital Contributions; (iv) then, to the Limited Partners until they have received cumulative distributions pursuant to this clause (iv) and clauses (i), (iv) and (vi) of Section 9.2(a) equal to their aggregate Capital Contributions; (v) then, to the General Partner until it has received cumulative distributions pursuant to this clause (v) and clauses (v) and (vi) of Section 9.2(a) equal to its aggregate Capital Contributions; (vi) then, to the Partners pro rata in accordance with their positive Capital Account balances to the extent thereof (after giving effect to any allocation of Profits or Losses arising from sales (or distributions) on liquidation); and (vii) thereafter 100% to the Limited Partners pro rata in accordance with their positive Capital Account balances immediately prior to any distributions pursuant to clause (vi). (d) In the sole discretion of the General Partner, payments in liquidation may be made either in cash or in non-cash assets designated by the General Partner, or partly in cash and partly in non-cash assets. If payment is made in non-cash assets, the value of such assets shall be determined by the -25- 30 General Partner in accordance with Section 12.4 hereof. In the event of any distribution of non-cash assets to any Limited Partner, such Limited Partner agrees, if requested by the General Partner at the time of such distribution, to deliver to the Partnership a letter in form and substance satisfactory to the General Partner, or which may be deemed necessary or desirable by the General Partner, to comply with any legal requirements or governmental regulations, including restrictions on the resale of securities. (e) In the event that following the final distribution under Section 11.2(c) above, the General Partner has a deficit balance in its capital account balance, the General Partner shall contribute cash to the Partnership in an amount equal to the deficit balance. ARTICLE 12 BOOKS AND RECORDS; ACCOUNTING; APPRAISAL; TAX MATTERS AND ELECTIONS 12.1. Books and Records. The books and records of the Partnership, including information relating to the sale by the General Partner or any of its Affiliates of securities, property, goods or services to the Partnership, and a list of the name, residence or business address and Units of each Limited Partner, shall be maintained by the General Partner at the office of the Partnership or of the General Partner and shall be available for examination there by any Limited Partner or his or her duly authorized Representatives at any and all reasonable times for any purpose reasonably related to the Limited Partner's interest as a limited partner of the Partnership. Any Limited Partner, or his or her duly authorized Representatives, upon paying the costs of collection, duplication and mailing, shall be entitled to a copy of the list of the names, residence or business addresses and Units of the Limited Partners. Such information shall be used only for a purpose reasonably related to the Limited Partner's interest as a limited partner of the Partnership. The Partnership may maintain such other books and records and may provide such financial or other statements as the General Partner in its sole discretion deems advisable. 12.2. Accounting Basis, Fiscal Year. The books and records and the financial statements and reports of the Partnership shall be kept on such basis as the General Partner shall determine. The fiscal year of the Partnership shall be the calendar year. 12.3. Bank Accounts. The General Partner shall maintain the Partnership bank account, and withdrawals shall be made only in the regular course of the Partnership business on such signature or signatures as the General Partner may determine. Temporary investments are deemed activities in the ordinary course of Partnership business. 12.4. Appraisal. If at any time the value of one or more non-cash assets of the Partnership is required to be determined under this Agreement, the General Partner shall value such assets, taking into account all relevant factors, including without limitation restrictions on transfer, other legal or contractual restrictions and the costs and expenses of disposition of such assets. In the sole discretion of the General Partner, the valuation of any non-cash assets may be made by independent third parties appointed by the General Partner and deemed qualified by the General Partner to render an opinion as to the value of Partnership assets, using such methods and considering such information relating to such assets as such persons may deem appropriate. The valuation of Partnership assets reflected in an appraisal made in good faith by the General Partner or any adviser or consultant retained for such purpose shall be conclusive and binding on the Limited Partners. -26- 31 12.5. Reports. Within 90 days after the end of each fiscal year, or as soon as practicable thereafter, the General Partner shall send to each person who was a Limited Partner at any time during the fiscal year then ended (i) a statement (which shall be audited by independent certified public accountants) showing the cash (or assets distributed in kind) distributed in respect of such year; (ii) such tax information as shall be necessary for the preparation by such Limited Partner of his or her United States federal and state income tax returns; (iii) a report of the investment activities of the Partnership during such year, and (iv) financial statements of the Partnership audited by its accountants. 12.6 Tax Matters and Elections. (a) Each Limited Partner hereby appoints and designates the General Partner as tax matters partner of the Partnership, as such term is defined under the Code, and hereby agrees that any action taken by the General Partner in connection with audits of the Partnership under the Code will be binding upon the Limited Partners. Each Limited Partner further agrees that he or she will not treat any Partnership item on his or her individual income tax return in a manner inconsistent with the treatment of the item on the Partnership's tax return and that he will not act independently with respect to tax audits or tax litigation affecting the Partnership, unless, in either case, previously authorized to do so in writing by the General Partner, which authorization may be withheld in the sole discretion of the General Partner. (b) As such tax matters partner, the General Partner may cause the Partnership to make all elections required or permitted to be made by the Partnership under the Code (including an election under Section 754 thereof permitting the adjustment in basis of Partnership assets upon the occurrence of certain events, such as a sale of Units or the death of a Limited Partner) and not otherwise expressly provided for in this Agreement in the manner that the General Partner believes will be most advantageous to individual taxpayers who (i) are married and filing joint United States federal income tax returns and (ii) are not "dealers" for United States federal income tax purposes. ARTICLE 13 MISCELLANEOUS PROVISIONS 13.1. Appointment of the General Partner as Attorney-in-Fact. (a) Each Limited Partner, by his or her execution of this Agreement (which execution may be by his or her attorney-in-fact pursuant to a power of attorney contained in a subscription agreement or Transfer Application), hereby makes, constitutes and appoints the General Partner, acting by any of its officers or their designees, his or her true and lawful agent and attorney-in-fact, with full power of substitution and full power and authority in his or her name, place and stead to make, execute, sign, acknowledge, swear to, record and file, on his or her behalf and on behalf of the Partnership such documents, instruments and conveyances that may be necessary or appropriate to carry out the provisions or purposes of this Agreement, including, without limitation: (i) the original certificate of limited partnership of the Partnership and all amendments thereto required or permitted by law or the provisions of this Agreement including, without limitation, the admission to the Partnership of additional Limited Partners and substituted Limited Partners, and any certificate of cancellation with respect thereto and modifications of Schedule A hereto and all other instruments that the General Partner deems appropriate to reflect a change or modification or amendment of this Agreement, in accordance with this Agreement; (ii) all certificates and other instruments deemed advisable by the General Partner to carry out the provisions of this Agreement or to permit the Partnership to become or to -27- 32 continue in the jurisdictions where the Partnership may be doing business as a limited partnership or partnership wherein the Limited Partners have limited liability; (iii) all conveyances and other instruments or papers deemed advisable by the General Partner to effect the dissolution and termination of the Partnership; (iv) all fictitious or assumed name certificates required or permitted to be filed on behalf of the Partnership; and (v) all other instruments, documents, undertakings, certificates, agreements or papers which may be required or permitted by law to be filed on behalf of the Partnership. (b) The foregoing power of attorney: (i) is coupled with an interest, shall be irrevocable, shall not be affected by and shall survive the subsequent death, disability, incapacity or incompetence of each Limited Partner; (ii) may be exercised by the General Partner either by signing separately as attorney-in-fact for each Limited Partner or by a single signature of the General Partner acting as attorney-in-fact for all of them or by any other legally acceptable means; and (iii) shall survive the delivery of an assignment by a Limited Partner of the whole or any portion of his or her Units; except that, where the assignee of the whole of such Limited Partner's Units has been approved by the General Partner for admission to the Partnership as a substituted Limited Partner, the power of attorney of the assignor shall survive the delivery of such assignment for the sole purpose of enabling the General Partner to execute, swear to, acknowledge and file any instrument necessary or appropriate to effect such substitution. (c) Each Limited Partner shall execute and deliver to the General Partner within five days after receipt of the General Partner's request therefor such further designations, powers-of-attorney and other instruments as the General Partner deems necessary or appropriate to carry out the terms of this Agreement. 13.2. Amendments of this Agreement. (a) An amendment to this Agreement may be proposed by the General Partner by submitting to all Limited Partners (i) the text of such amendment and (ii) a statement of the purpose of such amendment. Subject to paragraph (d) below, the proposed amendment shall be deemed adopted (A) 30 days after the General Partner submits such notice, unless Limited Partners holding two-thirds of the outstanding Units have, by the end of such notice period, delivered their written disapproval thereof to the General Partner or (B) if earlier, upon the delivery by Limited Partners holding a majority of the outstanding Units of their written approval thereof to the General Partner. (b) An amendment to this. Agreement may be proposed by Limited Partners holding 25% of the outstanding Units. The Limited Partner or Limited Partners proposing such amendment shall submit to the General Partner (i) the text of such amendment, (ii) a statement of the purpose of such amendment, (iii) an opinion of counsel obtained by the Limited Partner or Partners proposing such amendment to the effect that such amendment is permitted by the Act and the laws of any other jurisdiction where the Partnership is qualified to do business, will not impair the limited liability of the Limited Partners and will not adversely affect the classification of the Partnership as a partnership for United States federal income tax purposes. The General Partner shall, within 20 days after receipt of any proposal -28- 33 under this Section 13.2, give notice to all Limited Partners of such proposed amendment, which notice shall include all items submitted by the Limited Partners with respect to such proposed amendment and a statement of the General Partner with respect to such proposed amendment. Subject to paragraph (d) below, the proposed amendment shall be deemed adopted upon the written consent of the General Partner and upon the delivery by Limited Partners holding two-thirds of the outstanding Units of their written approval thereof to the General Partner. (c) This Agreement and the terms of the offering of Units may be amended by the General Partner without the consent of any Limited Partner to conform any of the provisions of this Agreement to any requirements or conditions that may be imposed by the SEC under the terms of the Exemptive Order. (d) Notwithstanding any other provision of this Section to the contrary, no amendment may: (i) expand the obligations of any Partner under this Agreement or convert the Units of any Limited Partner into the interest of a General Partner or adversely affect the limited liability of any Limited Partner, in each case without the approval of such Partner; (ii) amend Section 6.3 or this Section 13.2; or (iii) subject to Section 8.6, modify the method provided in Article 8 or 9 of determining and allocating or distributing, as the case may be, Profits and Losses and distributable cash; without the approval of the General Partner and Limited Partners holding 75% of the outstanding Units that are adversely affected by such modification. (e) Notwithstanding the foregoing, this Agreement may be amended by the General Partner without the consent of the Limited Partners (i) to cure any ambiguity or correct or supplement any provision hereof which is incomplete or inconsistent with any other provision hereof or correct any printing, stenographic or clerical error or omissions or (ii) to amend Sections 8.1 to 8.5 pursuant to Section 8.6. (f) Upon the adoption of any amendment to this Agreement, the amended Agreement shall be executed by the General Partner for itself and on behalf of the Limited Partners pursuant to the power of attorney granted in Section 13.1, and, if such amendment affects the certificate of limited partnership of the Partnership under the Act, or any other filing made in any other state, the General Partner, pursuant to the power of attorney granted in Section 13.1, shall execute and file proper amendments and filings in the State of Delaware and in each jurisdiction in which such action is necessary for the Partnership to conduct business or to preserve the limited liability of the Limited Partners. 13.3 Arbitration. Any dispute, controversy or claim arising out of or in connection with or relating to this Agreement or any breach or alleged breach hereof shall (to the extent not prohibited by governing law) be determined and settled by arbitration in The City of New York pursuant to the rules then in effect of the American Arbitration Association. Any award rendered shall be final and conclusive upon the parties and a judgment thereon may be entered in the highest court of the forum, state or federal, having jurisdiction. 13.4. Notices. Except as otherwise specifically provided herein, all notices, requests, demands and other communications hereunder shall be in writing and shall be deemed to have been duly given if (i) delivered or mailed, certified or registered mail, first-class postage paid or via overnight courier -29- 34 or (ii) transmitted via facsimile, if to any Limited Partner, at such Limited Partner's business address, or to such Limited Partner's facsimile number, set forth in the Partnership's records, and if to the Partnership, to the General Partner at the General Partner's address, or to the General Partner's facsimile number, set forth on Schedule A, Attention: Fred Steinberg, or to such other person or address as any Partner shall have last designated by notice to the Partnership, and in the case of a change in address by the General Partner, by notice to the Limited Partners. Any notice shall be deemed to have been duly given if personally delivered or sent by the mails or by facsimile and will be deemed received, unless earlier received, (i) if sent by certified or registered mail, return receipt requested, or via overnight courier, one business day after mailing, (ii) if sent by overnight mail or courier, when actually received, (iii) if sent by facsimile transmission, on the date sent provided confirmatory notice is sent by first-class mail, postage prepaid, and (iv) if delivered by hand, on the date of receipt. 13.5. Binding Provisions. The covenants and agreements contained herein shall be binding upon and inure to the benefit of the heirs, executors, administrators, successors and assigns of the respective parties hereto. 13.6. Interest as Security for UCC Purposes. Pursuant to section 8-103(c) of the New York Uniform Commercial Code (and any analogous provision of any other applicable law), the Partnership interests are hereby expressly declared to be securities governed by Article 8 of the New York Uniform Commercial Code (and any analogous provision of any other applicable law). 13.7. Applicable Law. This Agreement shall be construed and enforced in accordance with the laws of the State of Delaware. Notwithstanding the foregoing, the law of the State of New York shall govern: (a) the rights and duties of the Partnership with respect to registration of transfer (as defined in Article 8 of the New York Uniform Commercial Code) of Partnership interests; (b) the effectiveness of registration of transfer (as defined in Article 8 of the New York Uniform Commercial Code) of Partnership interests; (c) whether the Partnership owes any duties to an adverse claimant to any Partnership interests; and (d) whether an adverse claim can be asserted against a person to whom transfer (as defined in Article 8 of the New York Uniform Commercial Code) of Partnership interests is registered or who obtains control (as defined in Article 8 of the New York Uniform Commercial Code) of any Partnership interests. 13.8 Counterparts. This Agreement may be executed in several counterparts, all of which together shall constitute one agreement binding on all parties hereto, notwithstanding that not all the parties have signed the same counterpart. The General Partner may execute any document by facsimile signature of a duly authorized officer. 13.9. Separability of Provisions. If for any reason any provision or provisions hereof that are not material to the purposes or business of the Partnership or the Limited Partners' Units are determined to be invalid and contrary to any existing or future law, such invalidity shall not impair the operation of or affect those portions of this Agreement that are valid. -30- 35 13.10. Entire Agreement This Agreement constitutes the entire agreement among the parties. This Agreement supersedes any prior agreement or understanding among the parties and may not be modified or amended in any manner other than as set forth herein. 13.11. Section Tides. Article, section and paragraph titles are for descriptive purposes only and shall not control or alter the meaning of this Agreement as set forth in the text. 13.12. Waiver of Right of Partition. Each Partner hereby waives its right of partition. 13.13. Effectiveness. This Agreement shall become effective as of the day and year first above written upon execution hereof by the General Partner and the Initial Limited Partner and, as to each additional Limited Partner, when the prescribed subscription hereto by such party has been accepted by the General Partner. -31- 36 IN WITNESS WHEREOF, the parties hereto have executed this Agreement as of the date first above written. GENERAL PARTNER LB I GROUP INC. By: /s/ Karen M. Muller ----------------------------------- Vice President INITIAL LIMITED PARTNER: FIRST CAP IV, INC. By: /s/ Jennifer Marre ----------------------------------- Vice President ADDITIONAL LIMITED PARTNERS: All Limited Partners now and hereafter admitted as limited partners of the Partnership pursuant to powers of attorney now and hereafter executed in favor of and delivered to the General Partner. By: GENERAL PARTNER, as Attorney-in-Fact: LB I GROUP INC. By: /s/ Karen M. Muller ------------------------------ Vice President -32- 37 SCHEDULE A GENERAL PARTNER: Name: LB I Group Inc. Registered Office: c/o Prentice-Hall Corporation System, Inc. 1013 Center Road Wilmington, Delaware 19805 Business Address: 3 World Financial Center New York, New York 10285 INITIAL LIMITED PARTNER: First Cap IV, Inc. Registered Office: c/o Prentice-Hall Corporation System, Inc. 1013 Center Road Wilmington, Delaware 19805 Business Address: 3 World Financial Center New York, New York 10285 -33- EX-11.1 3 COMPUTATION OF PER SHARE EARNINGS 1 EXHIBIT 11.1 LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES COMPUTATION OF PER SHARE EARNINGS
TWELVE MONTHS ENDED NOVEMBER 30 ----------------------------------------- 1997 1996 1995 ----------- ----------- ----------- (IN MILLIONS, EXCEPT SHARE DATA) PRIMARY: Weighted average shares outstanding: Common stock..................................... 105,193,272 101,548,947 104,535,218 Common stock issuable............................ 13,812,029 13,779,315 8,420,122 Common stock equivalents......................... 2,059,628 1,045,323 459,344 ----------- ----------- ----------- Total common stock and common stock equivalents.................................... 121,064,929 116,373,585 113,414,684 ----------- ----------- ----------- Net income............................................ $ 647 $ 416 $ 242 Preferred dividends................................... (75) (38) (42) ----------- ----------- ----------- Net income applicable to common stock................. $ 572 $ 378 $ 200 ----------- ----------- ----------- Earnings per common share............................. $ 4.72 $ 3.24 $ 1.76 ----------- ----------- ----------- FULLY DILUTED: Weighted average shares outstanding: Common stock..................................... 105,193,272 101,548,947 104,535,218 Common stock issuable............................ 13,919,446 13,779,315 8,420,122 Common stock equivalents......................... 2,256,587 1,252,138 551,936 ----------- ----------- ----------- Total common stock and common stock equivalents.................................... 121,369,305 116,580,400 113,507,276 ----------- ----------- ----------- Net income............................................ $ 647 $ 416 $ 242 Preferred dividends................................... (75) (38) (42) ----------- ----------- ----------- Net income applicable to common stock................. $ 572 $ 378 $ 200 ----------- ----------- ----------- Earnings per common share............................. $ 4.71 $ 3.24 $ 1.76 ----------- ----------- -----------
EX-12.1 4 COMPUTATION OF PER SHARE EARNINGS 1 EXHIBIT 12.1 LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES COMPUTATION IN SUPPORT OF RATIO OF EARNINGS TO FIXED CHARGES
FOR THE FOR THE FOR THE FOR THE FOR THE TWELVE ELEVEN TWELVE TWELVE TWELVE MONTHS MONTHS MONTHS MONTHS MONTHS ENDED ENDED ENDED ENDED ENDED DECEMBER 31 NOVEMBER 30 NOVEMBER 30 NOVEMBER 30 NOVEMBER 30 1993 1994 1995 1996 1997 ----------- ----------- ----------- ----------- ----------- (DOLLARS IN MILLIONS) Fixed Charges: Interest expense: Subordinated indebtedness....... $ 144 $ 158 $ 206 $ 220 $ 240 Bank loans and other borrowings*................... 5,224 6,294 10,199 10,596 12,770 Interest component of rentals of office and equipment.......... 76 42 44 34 32 Other adjustments**............. 7 4 28 16 9 ----------- ----------- ----------- ----------- ----------- TOTAL (A).................. $ 5,451 $ 6,498 $10,477 $10,866 $13,051 ----------- ----------- ----------- ----------- ----------- Earnings: Pretax income (loss) from continuing operations......... $ 27 $ 193 $ 369 $ 637 $ 937 Fixed charges................... 5,451 6,498 10,477 10,866 13,051 Other adjustments***............ (6) (4) (28) (14) (8) ----------- ----------- ----------- ----------- ----------- TOTAL (B).................. $ 5,472 $ 6,687 $10,818 $11,489 $13,980 ----------- ----------- ----------- ----------- ----------- (B / A).............................. 1.00 1.03 1.03 1.06 1.07
- --------------- * Includes amortization of long-term debt discount. ** Other adjustments include capitalized interest and debt issuance costs and amortization of capitalized interest. *** 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 and debt issuance costs and undistributed net income of affiliates accounted for at equity. EX-12.2 5 COMPUTATION OF EARNINGS TO COMBINED FIXED CHARGES 1 EXHIBIT 12.2 LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES COMPUTATION IN SUPPORT OF RATIO OF EARNINGS TO COMBINED FIXED CHARGES AND PREFERRED DIVIDENDS
FOR THE FOR THE FOR THE FOR THE FOR THE TWELVE ELEVEN TWELVE TWELVE TWELVE MONTHS MONTHS MONTHS MONTHS MONTHS ENDED ENDED ENDED ENDED ENDED DECEMBER 31 NOVEMBER 30 NOVEMBER 30 NOVEMBER 30 NOVEMBER 30 1993 1994 1995 1996 1997 ----------- ----------- ----------- ----------- ----------- (DOLLARS IN MILLIONS) Combined Fixed Charges and Preferred Dividends: Interest expense: Subordinated indebtedness............. $ 144 $ 158 $ 206 $ 220 $ 240 Bank loans and other borrowings*.............. 5,224 6,294 10,199 10,596 12,770 Interest component of rentals of office and equipment................ 76 42 44 34 32 Other adjustments**............. 7 4 28 16 9 ----------- ----------- ----------- ----------- ----------- Total fixed charges............. 5,451 6,498 10,477 10,866 13,051 Preferred dividends (tax equivalent basis)............. 48 58 64 58 109 ----------- ----------- ----------- ----------- ----------- TOTAL (A).................. $ 5,499 $ 6,556 $10,541 $10,924 $13,160 ----------- ----------- ----------- ----------- ----------- Earnings: Pretax income (loss) from continuing operations......... $ 27 $ 193 $ 369 $ 637 $ 937 Fixed charges................... 5,451 6,498 10,477 10,866 13,051 Other adjustments***............ (6) (4) (28) (14) (8) ----------- ----------- ----------- ----------- ----------- TOTAL (B).................. $ 5,472 $ 6,687 $10,818 $11,489 $13,980 ----------- ----------- ----------- ----------- ----------- (B / A).............................. **** 1.02 1.03 1.05 1.06
- --------------- * Includes amortization of long-term debt discount. ** Other adjustments include capitalized interest and debt issuance costs and amortization of capitalized interest. *** 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 and debt issuance costs and undistributed net income of affiliates accounted for at equity. **** Earnings were inadequate to cover fixed charges and preferred dividends and would have had to increase $27 million in 1993 in order to cover the deficiency. EX-13.1 6 MANAGEMENT'S DISCUSSION 1 EXHIBIT 13.1 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS BUSINESS ENVIRONMENT The principal business activities of Lehman Brothers Holdings Inc. ("Holdings") 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. The favorable market and economic conditions that characterized fiscal 1996 continued throughout most of 1997, leading to increased industrywide revenues and to record levels of earnings and net revenues for the Company. Similar to the 1996 market environment, improved valuations and strong investor demand in worldwide equity markets led to a second consecutive year of record levels of corporate finance advisory activities and near-record underwriting volumes. During 1997, however, volatility became more persistent than in either 1996 or 1995. Investors focused more than ever on worldwide market conditions and uncertainty about future valuation levels for their investments. The unraveling of deep-seated structural and financing problems in Asia, which for years had been masked by strong economic growth, sent stock markets and currencies plummeting. The year 1997 ended with uncertainty surrounding the world markets. Bond markets in the developed countries were strong, while the equity markets were hesitant with investors still assessing the impact that events in Asia had on the rest of the world. Fixed Income > During 1997, global fixed income markets were robust, with heavy trading volumes in both the U.S. and Europe. The year began with fears of a rate hike in the U.S. which kept global bond markets in retreat until mid-year. Ultimately, there was only one rate action by the U.S. Federal Reserve Board ("Fed") during 1997 which occurred in March when the overnight lending rate was raised by 0.25% to 5.50%. There were no long-term effects from this event. For most of 1997, trading activity in the U.S. continued to reflect investor optimism that the environment of sustained growth and low levels of inflation would continue. During this period, U.S. trading activity was bolstered by active purchases of U.S. securities by foreign investors due to the favorable U.S. macroeconomic environment and the strong dollar. However, by the end of 1997, the forced devaluation of Thailand's currency during July triggered a chain reaction of currency depreciations across the Asian region. Heightened uncertainty about the extent of the exchange rate volatility caused foreign and domestic investors to sell their Asian holdings and move into U.S. dollar-denominated assets which, in turn, led to further pressure on Asian exchange rates. Consequently, the fixed income markets suffered as credit spreads on corporate, Eurobonds and emerging market issuers widened dramatically. Issuers sat on the sidelines as spreads became unattractive. By the end of 1997, investors' flight to quality caused the 30-year U.S. treasury bond to rally to rates not seen since 1993. While many of the peripheral European bond markets outperformed the U.S. market in local currency terms in 1997, only the U.K. gilt market did so in U.S. dollar terms. In the U.K., the yield curve flattened dramatically. This was in response to the new Labour government granting independence to the Bank of England which then implemented four interest rate increases. In Germany, an interest rate hike in October 1997, combined with the Asian crisis, led to a flattening of the German yield curve. For 1997, this amounted to just under one percentage point between 10-year and two-year bonds. Also, several countries seeking to enter the EMU on January 1, 1999 (e.g., Italy, Spain and Finland) exhibited strength during 1997 as a result of reduced inflation and budget deficits during the year. LEHMAN BROTHERS 1997 ANNUAL REPORT 36 2 During 1997, yields in Japan fell as a recovery in domestic demand following an April tax hike proved elusive, Japanese banking problems intensified, and the Asian crisis spread. By November 1997, yields on 10-year bonds had fallen to below 2% -- a decline of 50 basis points for the year. Fixed income markets in Southeast Asia were highly volatile in 1997 as the Asian crisis depressed trading volumes and prices. By mid-December 1997, the International Monetary Fund had negotiated medium-term funding agreements with Thailand, Indonesia and Korea to supply much-needed foreign exchange liquidity. However, this failed to stabilize Asia's currency markets; and the major rating agencies lowered the bond ratings of several Asian nations to below investment grade levels. Equity > During 1997, all major U.S. equity indices established new records, although they ended the year off from these highs. For fiscal 1997, the S&P 500 return was 29%, making it the third consecutive year of double-digit returns. Equity prices were helped by a benign inflation and interest rate environment accompanied by good corporate earnings growth; inflation fell below 2% for the year; long-term interest rates declined to below 6%; and profit growth was double-digit. However, the equity market was also more volatile in 1997, suffering through two corrections. The first one in March reflected the interest rate hike by the Fed combined with investor concerns about earnings performance in the technology sector. After the markets recovered strongly, the Asian crisis occurred and the market suffered a second correction, culminating in a record drop of more than 550 points in the Dow Jones Industrial Average on October 27. By the end of 1997, the markets had recovered once again, but worries about the fallout from the Asian crisis persisted. Equity trading volumes remained brisk as did inflows of capital into mutual funds. The European equity markets performed extremely well during 1997, with returns from the region as a whole much in line with those of the U.S. markets. The Financial Times-S&P European Index rose 20% in dollar terms, supported by currency depreciation, which strengthened expectations of economic recovery and boosted corporate earnings prospects, and by falling bond yields. Within Europe, the smaller markets achieved the highest returns, reflecting narrowing bond spreads over German yields and declines in short-term interest rates. Healthy market conditions were reflected in strong trading volumes. The situation in Asia, however, sharply contrasted with the performance of the U.S. and European equity markets. In Japan, the Nikkei 225 Index fell by 17% due to a deteriorating banking environment, major corporate bankruptcies, and an economy on the verge of a recession. Similar to 1996, the Japanese market rose over the first half of 1997 as investors looked for the economic recovery to continue, but recorded losses in the second half as it became clear that the fiscal tightening hurt economic growth and the banking crisis was intensifying. Excluding Australia, the markets of southeast Asia were even more turbulent, as one country after another became embroiled in the region's crisis. In local currency terms, the worst-hit markets (e.g., Thailand, Malaysia, Indonesia, Philippines and Korea) fell between 35% and 60% versus the prior year, with returns in dollar terms recording even weaker results. Latin American EMG markets, which realized a broad recovery in 1996, posted very strong gains through much of 1997. These gains resulted from a continuation of the process of economic reform and financial consolidation coupled with an acceleration of economic growth in the region. As compared to the end of 1996, Latin American equities rose over 50% in dollar terms to a peak during October 1997, as measured by the IFC Latin American Investable Index. However, the escalating Asian crisis negatively impacted performance towards the end of 1997, as global investors reined in their appetite for emerging markets. Despite the year end weakening, these markets returned over 25% for the year. Investment Banking > Combined worldwide underwriting volumes for fixed income and equities continued on a torrid pace during 1997. Despite the turbulence of the global stock markets in 1997, global equity underwritings reached new highs. Significant merger and acquisition activity and continued inflows into equity mutual funds led to a record $156 billion of common stock underwritings. Worldwide fixed income underwriting surpassed 1996 levels led by the issuance of corporate, asset-backed and mortgage-backed bonds. Issuers came to market to take advantage of the historically attractive yields as well as favorable LEHMAN BROTHERS 1997 ANNUAL REPORT 37 3 pricing in the spread sectors. However, as with many other businesses, the Asian crisis caused credit spreads to widen, leading issuers to postpone offerings in the latter part of the year. Corporate Finance Advisory activities set another record in 1997, with the level of announced merger and acquisition activity reaching historic levels following strong performances in both 1996 and 1995. The increased activity reflected the continuing trend of consolidation and globalization across industry sectors and the overall strength in the global capital markets. Reflecting the strength of advisory activities was the wide range of industry sectors participating and the broad global and cross-border orientation of that activity. Furthermore, the scale of advisory activity was unprecedented. Four of the top ten domestic M&A deals of all time were announced in the past twelve months and three of the top seven announced worldwide M&A transactions involved a foreign target. Fiscal 1997 was characterized by strong financial markets, nevertheless, the financial services industry is cyclical. As a result the Company's businesses are evaluated across market cycles for operating profitability and their contribution to the Company's long-term strategic objectives. The Company strives to minimize the effects of economic downturns through its diversified product base, stringent cost controls, global presence and risk management practices. - -------------------------------------------------------------------------------- Note: Except for the historical information contained herein, this Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that are based on current expectations, estimates and projections about the industries in which the Company operates. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions which are difficult to predict. The Company undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise. ================================================================================ RESULTS OF OPERATIONS - -------------------------------------------------------------------------------- [Line Graph Omitted] RESULTS OF OPERATIONS Summary > The Company reported record net income of $647 million and earnings per share of $4.72 for 1997, driven by continued strength in all of the Company's major businesses including equities, fixed income and investment banking. These results were achieved in worldwide markets which were extremely favorable during the early portion of the year and became volatile in the latter portion of the year. Despite market volatility, many equity indices in the U.S. and Europe reached all-time highs during 1997. The overall favorable market conditions led to a second straight year of near-record industrywide underwriting volumes and a record year in worldwide merger and acquisition activity. The Company's continued focus on growing higher margin businesses contributed to record revenues and a return on common equity of 15.6% and a pretax margin of 24.2% for 1997 compared to 12.1% and 18.5%, respectively, in 1996. Also contributing to these record results was the Company's continued aggressive management of expenses. Nonpersonnel expenses decreased even though revenues increased significantly. The compensation and benefits ratio remained constant at 50.7% of net revenues. The Company's 1996 net income was $416 million, including a $50 million after tax severance charge. The Company's 1996 results reflect strong performances across all of the Company's major businesses. The 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 LEHMAN BROTHERS 1997 ANNUAL REPORT 38 4 led to near record underwriting volumes, record levels for many worldwide equity indices and a record year in worldwide merger and acquisition activity. The Company reported net income of $242 million for 1995, including a $47 million after tax gain related to the Company's sale of its interest in Omnitel Sistemi Radiocellullari Italiani S.p.A. ("Omnitel") and a $58 million after tax charge for occupancy-related real estate expenses and severance. The Company's 1995 results reflect improved performance in corporate finance advisory activity and in fixed income and equity origination as well as higher levels of customer activity in a number of businesses. The Company benefited from the continuing increase in merger and acquisition activity throughout 1995 and from a stronger market climate beginning in the second quarter of the year. Net Revenues > Net revenues were $3,873 million for 1997, $3,444 million for 1996 and $3,071 million for 1995. During 1997, the Company continued to build its global franchise. Net revenues increased from 1996 levels in all of the major business units led by increased customer related trading activity, a strong global market for mergers and acquisitions and increased levels of worldwide debt and equity underwriting. During the second half of 1997, the Company recorded net revenues of $2,094 million, its highest level of net revenues for any six-month period since becoming a public company. 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 worldwide debt and equity underwriting, and improved corporate finance advisory results. Net revenues in 1995, excluding a special revenue item of $129 million from the sale of the Company's investment in Omnitel, were $2,942 million. Revenues in 1995 were positively affected by increased underwriting volumes and customer flow activity due to strong rallies in the stock and bond markets during the last three quarters of the year. Net revenues from international sources as a percentage of total net revenues (excluding Omnitel in 1995) were 30% for 1997, 41% for 1996 and 44% for 1995, reflecting the global scope of the Company's business activities. This includes approximately $432 million, $363 million and $368 million of revenues that were associated with domestic products and services in 1997, 1996 and 1995, respectively, that the Company estimates resulted from relationships with international clients and customers. The decreased level of international revenues for 1997 was directly correlated to the severe market depression in Asia and the resulting contagion it had on worldwide markets which occurred in the second half of the year. As a result of these market events, Asia and Europe generated fewer revenue opportunities than in both 1996 and 1995. 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. Consistent with the Company's client/customer-driven strategy, proprietary trading activities accounted for approximately 14% of net revenues in 1997, 14% in 1996 and 9% in 1995. The Company believes its client/customer-driven strategy has historically mitigated the level of net trading revenue volatility. The Company, through its subsidiaries, is a market-maker in all major equity and fixed income products in both the domestic and international markets. In order to facilitate its trading activities, the Company is a member of all principal securities and commodities exchanges in the United States and holds memberships or associate memberships on several principal inter- LEHMAN BROTHERS 1997 ANNUAL REPORT 39 5 national securities and commodities exchanges, including the London, Tokyo, Hong Kong, Frankfurt, Milan and Paris stock exchanges. As part of its market-making activities, the Company maintains inventory positions of varying amounts across a broad range of financial instruments, which are marked-to-market on a daily basis and, along with the Company's proprietary trading positions, give rise to principal transactions revenues. The Company utilizes various hedging strategies to minimize its exposure to significant movements in interest and foreign exchange rates and the equity markets. Net revenues from the Company's market-making and trading activities in fixed income and equity products are recognized as either principal transactions or net interest revenues, depending upon the method of financing and/or hedging related to specific inventory positions. The Company evaluates its trading strategies on an overall profitability basis which includes both principal transaction revenues and net interest. Therefore, changes in net interest should not be viewed in isolation but should be viewed in conjunction with revenues from principal transactions. Combined principal transactions and net interest revenues were relatively flat in 1997 as compared to 1996. Increased principal transactions and net interest revenues across many of the Company's fixed income and equity product lines were offset by lower results in certain fixed income and equity derivative products in Europe and Asia and with higher interest expenses resulting from the Company's increased level of long-term debt outstanding. During 1996, combined principal transactions and net interest revenues increased $285 million from 1995, resulting from a shift in the composition of the Company's fixed income portfolio, an increase in net dividend revenue related to certain structured transactions in equity derivatives, and improved spreads an certain higher margin matched book financing transactions. The following table of net revenues by business unit and the accompanying discussion have been prepared in order to present the Company's net revenues in a format that reflects the manner in which the Company manages its businesses. For internal management purposes, the Company has been segregated into four major business units: Fixed Income, Equity, Corporate Finance Advisory and Merchant Banking. Each business unit represents a grouping of financial activities and products with similar characteristics. These business activities result in revenues that are recognized in multiple revenue categories contained in the Company's Consolidated Statement of Income. Net revenues by business unit contain certain internal allocations, including funding costs, which are centrally managed. LEHMAN BROTHERS 1997 ANNUAL REPORT 40 6
================================================================================ TWELVE MONTHS ENDED NOVEMBER 30, 1997 - -------------------------------------------------------------------------------- PRINCIPAL TRANSACTIONS AND INVESTMENT NET INTEREST COMMISSIONS BANKING OTHER TOTAL ================================================================================ Fixed Income $1,749 $ 41 $ 380 $16 $2,186 Equity 296 365 342 7 1,010 Corporate Finance Advisory (5) 328 323 Merchant Banking (6) 266 260 Other 9 17 2 66 94 - -------------------------------------------------------------------------------- $2,043 $423 $1,318 $89 $3,873 ================================================================================
================================================================================ TWELVE MONTHS ENDED NOVEMBER 30, 1996 - -------------------------------------------------------------------------------- PRINCIPAL TRANSACTIONS AND INVESTMENT NET INTEREST COMMISSIONS BANKING OTHER TOTAL ================================================================================ Fixed Income $1,793 $57 $307 $8 $2,165 Equity 275 286 280 3 844 Corporate Finance Advisory 249 249 Merchant Banking (18) 138 120 Other 11 19 7 29 66 - -------------------------------------------------------------------------------- $2,061 $362 $981 $40 $3,444 ================================================================================
================================================================================ TWELVE MONTHS ENDED NOVEMBER 30, 1995 - -------------------------------------------------------------------------------- PRINCIPAL TRANSACTIONS AND INVESTMENT NET INTEREST* COMMISSIONS BANKING OTHER TOTAL ================================================================================ Fixed Income $1,373 $ 92 $178 $ 8 $1,657 Equity 418 330 215 3 964 Corporate Finance Advisory 231 231 Merchant Banking (26) 172 146 Other 11 28 5 29 73 - -------------------------------------------------------------------------------- $1,776 $450 $801 $40 $3,071 ================================================================================
* 1995 equity revenues include $129 million from the sale of Omnitel. 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 and is a market-maker in the government securities of all major industrial countries. The Company, through its subsidiaries, is also a dominant market-maker for a broad range of fixed income products. LEHMAN BROTHERS 1997 ANNUAL REPORT 41 7 Fixed income revenues were $2,186 million for 1997, $2,165 million for 1996 and $1,657 million for 1995. During 1997, the Company continued to focus its resources and efforts towards growing its market share in higher margin products. The Company's fixed income business benefited in 1997 from active customer trading combined with increased levels of worldwide debt underwriting which resulted from the favorable U.S. macroeconomic environment. Mortgage revenues increased significantly during 1997 as the Company profited from its diversified product mix including several large conduit transactions, commercial mortgage-backed deals and real estate transactions. High yield benefited from an increased volume of lead-managed underwritings and syndicated loans. The Company lead-managed over $4.3 billion of offerings in fiscal 1997 up from $2.3 billion in fiscal 1996. Revenues from the emerging markets business improved significantly during 1997 as a result of the Company's successful expansion into new European markets. These improvements were partially offset by reduced contributions from fixed income derivatives and foreign exchange which were negatively impacted by significant volatility in the Asian markets. Lehman Brothers lead-managed fixed income offerings in fiscal 1997 increased 29% with the underwritings of $132 billion compared to underwritings of $102 billion in fiscal 1996 based on information supplied by Securities Data Company. During 1996, fixed income revenues increased from 1995, primarily as a result of stronger customer trading volumes reflecting a strengthening in the global economy, a reduced U.S. federal deficit and relatively low levels of inflation. The improved market conditions in both the U.S. and Europe led to a significant increase in worldwide debt underwriting revenues and greater contributions from customer flow and trading activities in a number of fixed income products including mortgages, emerging markets, fixed income derivatives and high yield and high-grade corporate bonds. The Company's emerging markets and high yield revenues increased during 1996, primarily as a result of increased debt underwritings compared to 1995. Fixed income derivative revenues in 1996 were driven by improved results in Europe, as the Company continued to benefit from its concerted effort to globalize this business. 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 $1,010 million for 1997, $844 million for 1996 and $964 million for 1995. Included in the 1995 results were net revenues of $129 million resulting from the Company's sale of its stake in Omnitel. Excluding the Omnitel transaction, equity revenues were $835 million for 1995. The results for the Company's equity business increased 20% versus 1996 primarily due to the continued favorable worldwide equity markets which existed for most of the year combined with the successful redirection of the Company's resources into higher margin products. Worldwide equity underwriting volumes for 1997 were at an all-time high for the securities industry. Equity underwriting, equity arbitrage and improved customer flow activities were the primary contributors to the increase in revenues for 1997, while equity derivative revenues trailed 1996 levels. The improvement in equity underwriting revenues during fiscal 1997 resulted from an improved product mix as the Company increased its common stock lead-managed underwriting volume by 27% with a 4.6% market share which was improved from the 3.7% market share attained in fiscal 1996. Equity cash products benefited in 1997 from the record-setting year in many of the world's financial markets which was fueled by a benign inflation and interest rate environment accompanied by strong earnings growth in the U.S. In particular, the Company's equity cash product revenues improved in 1997 primarily from an increased level of institutional and retail customer flow. During 1997, the revenues from the Company's equity financing business also improved as a result of successful trading strategies implemented in the United Kingdom. The equity derivative revenues in 1997 were reduced from the prior year's level due to the market volatility experienced in Asia. LEHMAN BROTHERS 1997 ANNUAL REPORT 42 8 Equity revenues increased slightly in 1996 (as compared to the 1995 amount excluding Omnitel) as a result of improved underwriting results combined with increased contributions from the equity derivative business, convertible securities and international equities. The improved underwriting volumes reflected the favorable global economic environment in 1996, with generally increased trading volumes on most major domestic and international listed exchanges and record flows of capital into U.S. equity mutual funds. The improved equity derivatives results in 1996 were primarily from the Company's Asian business activities, reflecting the continued emphasis on the globalization of certain high margin businesses. During the second half of 1996, the Company's efforts to reposition its equity business resulted in the realization of stronger results as it lead-managed transactions valued at over $5 billion, representing an 87% increase over the comparable amount for the first half of 1996. The Company ranked third in total NYSE listed trading volume throughout all of 1997, 1996 and 1995. Corporate Finance Advisory. Corporate finance advisory net revenues, classified in the Consolidated Statement of Income as a component of investment banking revenues, result primarily from fees earned by the Company in its role as strategic advisor to its clients. This role primarily consists of advising clients on mergers and acquisitions, divestitures, leveraged buyouts, financial restructurings, and a variety of cross-border transactions. The net revenues for corporate finance advisory increased in 1997 to $323 million from $249 million in 1996 and from $231 million in 1995. The increased revenues reflected the closing of several large deals in 1997 and continued strength in the overall merger and acquisition market environment. The Company ended fiscal 1997 with a strong transaction pipeline which stood at $81 billion in terms of total dollar value based on information supplied by Securities Data Company. Merchant Banking. The Company is the general partner for nine active merchant banking partnerships. Current merchant banking investments held by the partnerships include both publicly traded and privately held companies. Merchant banking net revenues primarily represent the Company's proportionate share of net realized and unrealized gains and losses from the sale and revaluation of investments held by the partnerships. Such amounts are classified in the Consolidated Statement of Income as a component of investment banking revenues. Merchant banking net revenues also reflect the net interest expense relating to the financing of the Company's investment in the partnerships. Merchant banking net revenues were $260 million, $120 million and $146 million for 1997, 1996 and 1995, respectively. The increase in 1997 compared to 1996 was principally due to realized gains on the sales of the partnerships' interests in certain investments. The decrease in 1996 compared to 1995 was principally due to a reduction in the net gains recognized on the publicly traded investments held by the partnerships. Non-Interest Expenses > During 1997, the Company's non-interest expenses totaled $2,936 million. Non-interest expenses were $2,807 million for 1996, including a severance charge of $84 million. Non-interest expenses were $2,702 million for 1995, including a restructuring charge of $97 million and compensation and benefits expenses of $50 million attributable to Omnitel. Excluding these special charges, non-interest expenses were $2,723 million for 1996, and $2,555 million for 1995.
TWELVE MONTHS ENDED NOVEMBER 30 ----------------------------------- (in millions) 1997 1996 1995(1) ================================================================================ Compensation and benefits $1,964 $1,747 $1,494 Nonpersonnel(2) 972 976 1,061 Severance and restructuring charges 84 97 - -------------------------------------------------------------------------------- Total non-interest expenses $2,936 $2,807 $2,652 ================================================================================ Compensation and benefits/Net revenues 50.7% 50.7% 50.8% Nonpersonnel expenses(2)/Net revenues 25.1% 28.3% 36.1% ================================================================================
(1) 1995 amounts exclude revenues and expenses related to the Omnitel transaction. (2) Nonpersonnel expenses excluding severance and restructuring charges. LEHMAN BROTHERS 1997 ANNUAL REPORT 43 9 Compensation and benefits expenses increased in 1997 to $1,964 million from $1,747 million in 1996 as a result of higher revenues. However, the Company maintained its compensation and benefits expense to net revenue ratio at 50.7% for both 1997 and 1996. Nonpersonnel expenses were relatively unchanged at $972 million for 1997 compared to $976 million for 1996. More significantly, the Company was able to effectively control its level of nonpersonnel expenses as evidenced by a decline in the nonpersonnel expense to net revenue ratio to 25.1% for 1997 from 28.3% for 1996. Professional services expenses increased to $173 million in 1997 from $150 million in 1996 as a result of increased system development costs which includes costs associated with the Year 2000 initiative. Brokerage, commissions and clearance fees declined to $224 million in 1997 from $241 million in 1996 as a result of the renegotiation of certain contracts partially off-set by increased customer trading volumes. Compensation and benefits expenses increased in 1996 to $1,747 million from $1,494 million in 1995 as a result of higher revenues. Excluding severance and restructuring charges, nonpersonnel expenses decreased 8% to $976 million in 1996 as compared to $1,061 million in 1995. The Company's nonpersonnel expense to net revenue ratio dropped dramatically to 28.3% for 1996 versus 36.1% for 1995 reflecting the continued focus on expense management as well as cost savings realized from the 1995 restructuring charge. Cost Reduction Effort. At year-end 1994, the Company announced a cost reduction program aimed at reducing its expenses by a target of $300 million on an annualized basis. The targets included personnel cost savings of $100 million, nonpersonnel cost savings of $150 million and interest and tax expense savings of $50 million. By year-end 1995, the Company surpassed its targets and achieved $326 million of cost savings. During 1996, the Company achieved an additional $56 million of cost savings across numerous expense categories as a result of the continued systematic and comprehensive global review of all major expense categories. During 1997, the Company continued to closely monitor its expense levels and maintain strong controls over its cost structure. This is best evidenced by the reduction of nonpersonnel expenses in 1997 to $972 million versus $976 million for 1996 while net revenues increased 12% during the same period. The benefits of the Company's reduction of its nonpersonnel expense level are that profit margins and earnings have improved significantly. The Company believes that while the absolute level of its expense base may increase in response to related increases in revenue levels (due to the variability of certain expenses), the cost savings achieved as a result of its cost reduction efforts are permanent. 1996 Severance Charge. The Company 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. 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 Company's New York Private Client Services offices. Additionally, the charge reflects various other strategic personnel reductions aimed at delayering management. The 1996 severance charge has led to LEHMAN BROTHERS 1997 ANNUAL REPORT 44 10 personnel cost savings of approximately $90 million annually. The charge also resulted in a permanent decrease in nonpersonnel expenses of approximately $20 million annually. The Company intends to reinvest substantially all these savings into certain businesses to expedite the Company's strategic initiatives; these actions are expected to result in improved operating revenues. Cash outlays relating to the charge were approximately $19 million in the fourth quarter of 1996 and approximately $59 million during 1997. The remaining residual payments will be paid as deferred payment arrangements are completed. 1995 Restructuring Charge. The restructuring charge in 1995 included an $80 million occupancy-related real estate charge and a $17 million severance charge. The real estate component of the charge resulted from a complete review of the Company's real estate requirements at current headcount levels and the elimination of excess real estate, primarily in New York, London and Tokyo. This charge included costs to write-down the carrying value of leasehold improvements, as well as projected shortfalls of sublease rentals versus expected operating costs related to the Company's excess capacity. The excess real estate capacity resulted from headcount reductions associated with the Company's cost reduction efforts. The severance component of the charge related to payments made to terminated personnel arising from a formalized fourth quarter business unit productivity review. Income Taxes > The Company had an income tax provision of $290 million, $221 million and $127 million for 1997, 1996 and 1995, respectively. The effective tax rate for the Company was 31% for 1997, 35% for 1996 and 34% for 1995. The lower tax rate in 1997 versus 1996 reflects an increase in tax-exempt income as well as a reduction in the state and local effective tax rate. The 1996 income tax provision includes a tax benefit of $34 million related to the 1996 severance charge. The higher rate in 1996 versus 1995 reflects a decrease in tax exempt income partially offset by benefits generated from the restructuring of certain legal entities to assure that the Company operates in the most tax efficient manner. The 1995 income tax provision includes a $32 million charge related to the sale of the Company's investment in Omnitel and a tax benefit of $39 million related to the restructuring charge. The Company's net deferred tax asset increased by $61 million to $315 million at November 30, 1997 from $254 million at November 30, 1996. It is anticipated that the Company's net deferred tax asset will be realized through future earnings. The Company's net deferred tax asset decreased by $55 million to $254 million at November 30, 1996 from $309 million at November 30, 1995. As of November 30, 1997, the Company had approximately $44 million of net operating loss carryforwards available to offset future taxable income. ================================================================================ LIQUIDITY AND CAPITAL RESOURCES - -------------------------------------------------------------------------------- Overview > As a leading global investment bank that actively participates in the global capital markets, the Company has large and diverse capital requirements. Many of the businesses in which the Company operates are capital intensive. Capital is required to finance, among other things, the Company's securities inventories, underwriting activities, principal investments, merchant banking activities and investments in fixed assets. The Company's balance sheet is liquid and consists primarily of cash and cash equivalents, securities and other financial instruments owned, and collateralized short-term financing agreements. The liquid nature of these assets provides the Company with flexibility in financing and managing its business. The Company's primary activities are based on the execution of customer-related transactions. This flow of customer business supports the rapid asset turnover rate of the Company's inventory. LEHMAN BROTHERS 1997 ANNUAL REPORT 45 11 The Company's total assets increased to $151.7 billion at November 30, 1997 from $128.6 billion at November 30, 1996 reflecting the strategic expansion of certain business lines. This increase in total assets is consistent with the growth of stockholders' equity and, accordingly, did not significantly change the level of balance sheet leverage. In addition, the Company's continued focus on growing higher margin businesses resulted in increased levels of mortgages, corporate bonds and stocks, and derivative inventory positions at November 30, 1997 compared to November 30, 1996. The Company also positioned itself to benefit from favorable conditions in the worldwide fixed income markets by increasing its government and agency inventory and increasing its customer financing activities. Funding and Capital Policies > The Company's Finance Committee is responsible for establishing and managing the funding and liquidity policies, of the Company. These policies include recommendations for capital and balance sheet size as well as the allocation of capital and balance sheet to product areas. Under the authority of the Finance Committee, members of the Company's treasury department work with Regional Asset and Liability Committees to ensure coordination of global funding efforts and implementation of the funding and liquidity policies. The Regional Asset and Liability Committees are aligned with the Company's geographic funding centers and are responsible for implementing funding strategies for their respective regions. The primary goal of the Company's funding policies is to provide sufficient liquidity and availability of funding sources across a wide range of market environments. There are five key elements of its funding strategy that the Company attempts to achieve: (1) Maintain an appropriate Total Capital structure to support the business activities in which the Company is engaged. The Company is one of the most highly capitalized global investment banking firms with $24.8 billion in Total Capital. The Company manages Total Capital, defined as long-term debt, preferred stock and common stockholders' 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 with secured and unsecured liabilities, which have maturities equal to or exceeding the anticipated liquidation period of the assets. The Company continually reviews its mix of long- and short-term borrowings as it relates to maturity matching and the availability of secured and unsecured financing. In general, the Company finances its equity investments in its subsidiaries with stockholders' equity and the subordinated capital of subsidiaries is financed with a combination of subordinated and senior long-term debt. Inventories and other short-term assets are financed with a combination of short-term funding, floating rate long-term debt and stockholders' equity. Fixed assets, property, plant and equipment are generally financed with longer-dated fixed rate debt. TOTAL CAPITAL [Bar Graph Omitted] LEHMAN BROTHERS 1997 ANNUAL REPORT 46 12 Where the Company deems it to be appropriate and to minimize currency risks, foreign currency denominated assets are financed with corresponding foreign currency denominated liabilities. (3) Maintain sufficient financial resources to enable the Company to meet its obligations in a period of financial stress through a combination of collateralized short-term financings and Total Capital, as well as the implementation of a contingency funding plan. Financial stress is defined as any event which severely constrains the Company's access to unsecured funding sources. To achieve this objective, the Company strives to maximize its use of global collateralized borrowing sources and reduce its reliance upon short-term unsecured borrowings. In addition, the Company's liquidity policies include maintaining sufficient excess unencumbered securities to use as collateral, if necessary, to obtain secured financing to meet maturities of short-term unsecured liabilities as well as current maturities of long-term debt. Also, the Company strives to maintain a sufficient amount of Total Capital to enable the Company to support all assets not readily pledgeable to counterparties and to meet secured borrowing advance rates as determined by reference to the Company's bank lenders and other secured lending counterparties, should unsecured sources of borrowings no longer be available. In this regard, the Company believes that increasing Total Capital will provide additional liquidity to cover periods of financial stress and further advance the Company's liquidity management objectives. Lastly, the Company periodically tests its secured and unsecured credit facilities to ensure availability and operational readiness. These policies position the Company to meet its liquidity requirements in all periods including those of financial stress. The Company maintains a comprehensive one-year contingency funding plan. The plan is reviewed and approved by the Company's Finance Committee annually. (4) Obtain diversified funding through a global investor base which maximizes liquidity and reduces concentration risk. The Company obtains global funding from both the banking community and short- and long-term investors through its centers in New York, London, Tokyo, Hong Kong and Frankfurt. In addition to maintaining geographic diversification, the Company also utilizes a broad range of debt instruments, which it issues in varying maturities and currencies. The Company issues both commercial paper and other short-term debt instruments, including master notes, corporate and retail deposits, and bank borrowings under uncommitted lines of credit and other uncommitted arrangements. To reduce liquidity and concentration risk, the Company carefully manages its maturities to avoid large refinancings on any one given day, and limits its exposure to any single investor or type of investor. (5) Maintain funding availability in excess of actual utilization. The Company maintains sizable uncommitted lines of credit from a broad range of banks and financial institutions from which it draws funds in a variety of currencies and which provide an additional source of liquidity. Uncommitted lines consist of facilities that the Company has been advised are available but for which no contractual lending obligations exist. Additionally, the Company maintains secured and unsecured committed revolving credit facilities as discussed in the following section. 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 certain other types of collateralized borrowing sources are less credit-sensitive and have historically been a more stable financing source under adverse market conditions. The amount of the Company's collateralized borrowing activities will vary reflecting changes in the mix and overall levels of securities and other financial instruments owned and global market conditions. The majority of the Company's assets are LEHMAN BROTHERS 1997 ANNUAL REPORT 47 13 funded with collateralized borrowing sources. At November 30, 1997 and 1996, $94 billion and $82 billion, respectively, of the Company's total balance sheet was financed using collateralized borrowing sources. As of November 30, 1997 and 1996, commercial paper and short-term debt outstanding was $7.8 billion and $8.2 billion, respectively. Of these amounts, commercial paper outstanding as of November 30, 1997 was $3.9 billion with an average maturity of 73 days, compared to $3.1 billion with an average maturity of 64 days as of November 30, 1996. At November 30, 1997, Holdings maintained a Revolving Credit Agreement (the "Credit Agreement") with a syndicate of banks. Under the terms of the Credit Agreement, the banks have committed to provide up to $2 billion for up to 364 days. Any loans outstanding on the commitment termination date may be extended to the first anniversary of the commitment termination date at the option of Holdings. The Credit Agreement contains covenants which require, among other things, that the Company maintain specified levels of liquidity and tangible net worth, as defined. In addition, the Company maintained a $1 billion Secured Revolving Credit Facility (the "Facility") for Lehman Brothers International (Europe) ("LBIE"), the Company's major operating entity in Europe. Under the terms of the committed Facility, the bank group has committed to provide up to $1 billion for up to six months on a secured basis. Any loans outstanding on the commitment termination date may be extended to the first anniversary of the commitment termination date at the option of LBIE. The loans provided by the bank group are available in several currencies, including U.S. dollar, British pound sterling, Deutsche mark, ECU, French franc, and Italian lira, as requested. The Facility contains covenants which require, among other things, that LBIE maintain specified levels of tangible net worth, and regulatory capital, and that the Company maintain specified levels of consolidated stockholders' equity and tangible net worth, as defined. There were no borrowings outstanding under either the Credit Agreement or the Facility at November 30, 1997. The Company may use the Credit Agreement and the Facility for general corporate purposes from time to time. The Company maintained compliance with the applicable covenants for both the Credit Agreement and the Facility at all times. Total Capital > In accordance with the Company's liquidity plan, the Company increased its Total Capital base in 1997 to $24.8 billion at November 30, 1997 from $19.8 billion at November 30, 1996. Total Capital increased primarily due to an increase in long-term debt and the retention of earnings.
NOVEMBER 30 ------------------------------------- (in millions) 1997 1996 1995 ================================================================================ Long-term Debt Senior Notes $17,049 $12,571 $10,505 Subordinated Indebtedness 3,212 3,351 2,260 - -------------------------------------------------------------------------------- 20,261 15,922 12,765 - -------------------------------------------------------------------------------- Stockholders' Equity Preferred Equity 508 508 708 Common Equity 4,015 3,366 2,990 - -------------------------------------------------------------------------------- 4,523 3,874 3,698 - -------------------------------------------------------------------------------- Total Capital $24,784 $19,796 $16,463 ================================================================================
LEHMAN BROTHERS 1997 ANNUAL REPORT 48 14 LONG-TERM DEBT [Bar Graph Omitted] During 1997, the Company issued $7.6 billion in long-term debt, which was $4.6 billion in excess of its maturing debt. Long-term debt increased to $20.3 billion at November 30, 1997 from $15.9 billion at November 30, 1996 with a weighted average maturity of 4.1 years at November 30, 1997 and 1996. At November 30, 1997, the Company had approximately $7.3 billion available for the issuance of debt securities under various shelf registrations and debt programs. The increase in Total Capital also reflects an increase in stockholders' equity to $4.5 billion at November 30, 1997 from $3.9 billion at November 30, 1996. The net increase in stockholders' equity was primarily due to the retention of earnings and the amortization of RSU awards under the Company's employee stock award plans, partially offset by the repurchase of treasury stock and the payment of both common and preferred dividends. To broaden and increase the level of employee ownership in Holdings, the Company utilizes several stock-based compensation plans. Since 1994, the Company has made Restricted Stock Unit ("RSU") awards to its employees as a portion of total compensation in lieu of cash, subject to vesting and transfer restrictions. Approximately 3.8 million, 5.2 million and 6.1 million RSUs were amortized into stockholders' equity in 1997, 1996 and 1995, respectively. As a result of the RSU amortization, stockholders' equity increased by approximately $162 million, $136 million and $124 million in 1997, 1996 and 1995, respectively, net of cancellations. During 1997, the Company repurchased or acquired shares of its Common Stock in the open market at an aggregate cost of $77 million (approximately 1.6 million shares). These shares are being reserved for future issuances under employee stock-based compensation plans. During January 1998, the Company's Board of Directors authorized the repurchase of up to 4.5 million common shares in 1998 as part of its ongoing program to actively manage its capital position and common shares outstanding. In addition, the Company announced that it increased its annual dividend rate by 25% to $0.30 per common share. During 1997, the Company established a trust (the "RSU Trust") in order to provide common stock voting rights to employees who hold outstanding RSUs, in furtherance of the Company's stated goal when RSU awards were initiated in June 1994, to encourage employees to think and act like owners. The RSU Trust was initially funded with a total of 16 million shares consisting of 5 million treasury shares for RSU awards under the Employee Incentive Plan and 11 million new issue shares of Common Stock, for RSU awards under the 1994 Management Ownership Plan. There was no effect on total stockholders' equity as the decrease in common stock issuable and treasury stock was offset by a corresponding increase in common stock and additional paid-in capital. Capital Resources and Capital Adequacy > Balance sheet leverage ratios are one measure used to evaluate the capital adequacy of a company. Leverage ratios are commonly calculated using either total assets or adjusted total assets divided by total stockholders' equity. The Company's gross leverage ratios, based on total assets, were 33.5x and 33.2x at November 30, 1997 and 1996, respectively. The Company believes that the adjusted leverage ratio, rather than the gross leverage ratio, is a more effective measure of financial risk when comparing companies in the securities industry. Adjusted total assets represent total assets less the lower of securities purchased under agreements to resell or securities sold under agreements to repurchase. The Company's adjusted leverage ratios based on adjusted total assets were 23.9x and 24.8x at November 30, 1997 and 1996, respectively. LEHMAN BROTHERS 1997 ANNUAL REPORT 49 15 Due to the nature of the Company's sales and trading activities, the overall size of the Company's assets and liabilities fluctuates from time to time and at specific points in time may be higher than the fiscal quarter ends or the quarterly average. The Company's average gross leverage ratio and average adjusted leverage ratio for the year ended November 30, 1997 were 41.3x and 28.9x, respectively. In early 1997, the Company implemented a business performance measurement system. This system is a management reporting tool which charges for capital utilization across the Company's products. It provides detailed profitability and return on equity information for each of the Company's lines of business. The results of charging each of the respective businesses for its capital utilization are that businesses have begun to optimize their use of balance sheet and capital resources resulting in an improved return on assets and decreased levels of both quarterly average gross and adjusted leverage. QUARTERLY AVERAGE GROSS LEVERAGE Fiscal Quarters [Bar Graph Omitted] QUARTERLY AVERAGE ADJUSTED LEVERAGE Fiscal Quarters [Bar Graph Omitted] The Company also closely monitors its primary double leverage ratio. A double leverage ratio in excess of 1.0 arises from the funding of equity investments in subsidiaries with the debt of the parent. One of the Company's objectives is to maintain its primary double leverage ratio at no more than 1.0. Primary double leverage, defined as Holdings' investment in subsidiaries divided by Holdings' stockholders' equity, was 0.87 at November 30, 1997 compared to 0.97 at November 30, 1996. Credit Ratings > The Company, like other companies in the securities industry relies on external sources to finance a significant portion of its day-to-day operations. The Company's access to and cost of funding is generally dependent upon its short- and long-term debt ratings. In November 1997, Fitch IBCA, Inc. upgraded its long-term debt rating of Holdings to "A" from "A-". Additionally, during January 1998, S&P upgraded its ratings outlook on the Company to "stable" and reaffirmed the Company's long-term debt rating. As of November 30, 1997, the short- and long-term senior debt ratings of Holdings and Lehman Brothers Inc. ("LBI") were as follows:
HOLDINGS LBI --------------------- --------------------- SHORT-TERM LONG-TERM SHORT-TERM LONG-TERM** ================================================================================ Duff & Phelps Credit Rating Co. D-1 A D-1 A/A- Fitch IBCA, Inc. F-1 A F-1 A/A- Moody's P2 Baa1 P2 A3*/Baa1 S&P A-1 A A-1 A+*/A Thomson BankWatch TBW-1 A- TBW-1 A/A-
* Provisional ratings on shelf registration ** Senior/subordinated LEHMAN BROTHERS 1997 ANNUAL REPORT 50 16 Regulatory Capital > The Company operates globally through a network of subsidiaries with several subject to regulatory requirements. In the United States, LBI, as a registered broker-dealer, is subject to SEC Rule 15c3-1, the Net Capital Rule, which requires LBI to maintain net capital of not less than the greater of 2% of aggregate debit items arising from customer transactions, as defined, or 4% of funds required to be segregated for customers' regulated commodity accounts, as defined. At November 30, 1997, LBI's regulatory net capital, as defined, of $1,484 million exceeded the minimum requirement by $1,359 million. Lehman Brothers International (Europe) ("LBIE"), a United Kingdom registered broker-dealer and subsidiary of Holdings, is subject to the capital requirements of the Securities and Futures Authority ("SFA") of the United Kingdom. Financial resources, as defined, must exceed the total financial resources requirement of the SFA. At November 30, 1997, LBIE's financial resources of approximately $2.3 billion exceeded the minimum requirement by approximately $500 million. Lehman Brothers Japan Inc.'s Tokyo branch, a regulated broker-dealer, is subject to the capital requirements of the Japanese Ministry of Finance and, at November 30, 1997, had net capital of approximately $400 million which was approximately $100 million in excess of the specified levels required. Certain other non-U.S. subsidiaries are subject to various securities, commodities and banking regulations and capital adequacy requirements promulgated by the regulatory and exchange authorities of the countries in which they operate. At November 30, 1997, these other subsidiaries were in compliance with their applicable local capital adequacy requirements. The Company's "AAA" rated derivatives subsidiary, Lehman Brothers Financial Products Inc. ("LBFP"), has established certain capital and operating restrictions which are reviewed by various rating agencies. At November 30, 1997, LBFP had capital which exceeded the requirement of the most stringent rating agency by approximately $100 million. The regulatory rules referred to above, and certain covenants contained in various debt agreements may restrict Holdings' ability to withdraw capital from its regulated subsidiaries, which in turn could limit its ability to pay dividends to shareholders. At November 30, 1997, approximately $2.9 billion of net assets of subsidiaries were restricted as to the payment of dividends to Holdings. Cash Flows > Cash and cash equivalents decreased $464 million in 1997 to $1,685 million, as the net cash used in operating and investing activities exceeded the net cash provided by financing activities. Net cash used in operating activities of $4,445 million included income adjusted for non-cash items of $675 million for 1997. Net cash provided by financing activities was $4,055 million and net cash used in investing activities was $74 million. Cash and cash equivalents increased $1,275 million in 1996 to $2,149 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 $3,397 million included income adjusted for non-cash items of $889 million for 1996. Net cash provided by financing activities was $4,730 million and net cash used in investing activities was $58 million. Cash and cash equivalents decreased $90 million in 1995 to $874 million, as the net cash used in financing and investing activities exceeded the net cash provided by operating activities. Net cash provided by operating activities of $1,854 million included income adjusted for non-cash items of $439 million for 1995. Net cash used in financing and investing activities was $1,892 million and $52 million, respectively. High Yield Securities > The Company underwrites, trades, invests and makes markets in high yield corporate debt securities. The Company also syndicates, trades and invests in loans to below investment grade-rated companies. For purposes of this discussion, high yield debt securities are defined as securities or loans to companies rated BB+ or lower, or equivalent ratings LEHMAN BROTHERS 1997 ANNUAL REPORT 51 17 by recognized credit rating agencies, as well as non-rated securities or loans which, in the opinion of management, are non-investment grade. Non-investment grade securities generally involve greater risks than investment grade securities due to the issuer's creditworthiness and the liquidity of the market for such securities. In addition, these issuers have higher levels of indebtedness, resulting in an increased sensitivity to adverse economic conditions. The Company recognizes these risks and aims to reduce market and credit risk through the diversification of its products and counterparties. High yield debt securities are carried at market value and unrealized gains or losses for these securities are reflected in the Company's Consolidated Statement of Income. The Company's portfolio of such securities at November 30, 1997 and 1996 included long positions with an aggregate market value of approximately $3.2 billion and $1.7 billion, respectively, and short positions with an aggregate market value of approximately $172 million and $127 million, respectively. The portfolio may, from time to time, contain concentrated holdings of selected issues. The Company's largest high yield position was $438 million at November 30, 1997. The Company, subsequent to year end, participated a significant portion of this position. Lending Activities > The Company, through its high yield sales and trading activities, makes commitments to extend credit in loan syndication transactions principally to below investment grade borrowers and participates a significant portion of these commitments. These commitments, which totaled $1.4 billion at November 30, 1997, are typically secured against the borrower's assets and have fixed maturity dates. The draw down of these facilities is generally contingent upon certain representations, warranties and contractual conditions of the borrower. The total commitments may not be indicative of actual funding requirements as they may expire without being drawn upon and the Company may participate additional amounts in the normal course of its business. Merchant Banking and Related Lending Activities > The Company's merchant banking activities include investments in nine partnerships, for which the Company acts as general partner, as well as direct investments. At November 30, 1997, the investment in merchant banking partnerships was $167 million and direct investments were $75 million. The Company's policy is to carry its investments, including its partnership interests, at fair value based upon the Company's assessment of the underlying investments. In September 1997, the Company established a $2.0 billion fund for which the Company will act as general partner. The Company has commitments to invest up to an additional $498 million in the partnerships, which in turn will make direct merchant banking related investments. These commitments will be funded as required through the end of the respective partnerships' investment periods, principally expiring in 2004. The Company is also a sponsor of a fund to provide interim acquisition facilities. In connection therewith, the Company may provide up to $150 million to be used by the fund to provide short-term acquisition financing. Any draw downs under the facility are expected to be repaid within a short-term period. In addition, at November 30, 1997, the Company had no 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, the Company acts as a general partner or co-general partner for approximately $2.3 billion of partnership investment capital and manages the remaining real estate investment portfolio. At November 30, 1997, the Company had $48 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. LEHMAN BROTHERS 1997 ANNUAL REPORT 52 18 ================================================================================ OFF BALANCE SHEET FINANCIAL INSTRUMENTS AND DERIVATIVES - -------------------------------------------------------------------------------- Overview > Derivatives are financial instruments, which include swaps, options, futures, forwards and warrants, whose value is based upon an underlying asset (e.g., treasury bond), index (e.g., S&P 500) or reference rate (e.g., LIBOR). A derivative contract may be traded on an exchange or negotiated in the over-the-counter markets. Exchange-traded derivatives are standardized and include futures, warrants and certain option contracts listed on an exchange. Over-the-counter ("OTC") derivative contracts are individually negotiated between contracting parties and include forwards, swaps and certain options, including caps, collars and floors. The use of derivative financial instruments has expanded significantly over the past decade. One reason for this expansion is that derivatives provide a cost effective alternative for managing market risk. In this regard, derivative contracts provide a reduced funding alternative for managing market risk since derivatives are based upon notional values, which are generally not exchanged, but rather are used merely as a basis for exchanging cash flows during the duration of the contract. Derivatives are also utilized extensively as highly effective tools that enable users to adjust risk profiles, such as interest rate, currency, or other market risks, or to take proprietary trading positions, since OTC derivative instruments can be tailored to meet individual client needs. Additionally, derivatives provide users with access to market risk management tools which are often unavailable in traditional cash instruments. Derivatives are subject to various risks similar to non-derivative financial instruments including market, credit and operational risk. Market risk is the potential for a financial loss due to changes in the value of derivative financial instruments due to market changes, including changes in interest rates, foreign exchange rates and equity and commodity prices. Credit risk results from the possibility that a counterparty to a derivative transaction may fail to perform according to the terms of the contract. Therefore, the Company's exposure to credit risk is represented by its net receivable from derivative counterparties, after consideration of collateral. Operational risk is the possibility of financial loss resulting from a deficiency in the Company's systems for executing derivative transactions. In addition to these risks, counterparties to derivative financial instruments may also be exposed to legal risks related to derivative activities, including the possibility that a transaction may be unenforceable under applicable law. The risks of derivatives should not be viewed in isolation but rather should be considered on an aggregate basis along with the Company's other trading-related activities. As derivative products have continued to expand in volume, so has market participation and competition. As a result, additional liquidity has been added into the markets for conventional derivative products, such as interest rate swaps. Competition has also contributed to the development of more complex products structured for specific clients. It is this rapid growth and complexity of certain derivative products which has led to the perception, by some, that derivative products are unduly risky to users and the financial markets. In order to remove the public perception that derivatives may be unduly risky and to ensure ongoing liquidity of derivatives in the marketplace, the Company supports the efforts of the regulators in striving for enhanced risk management disclosures which consider the effects of both derivative products and cash instruments. In 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 LEHMAN BROTHERS 1997 ANNUAL REPORT 53 19 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 11 to the Consolidated Financial Statements. The Company utilizes derivative products in a trading capacity both as a dealer to satisfy the financial needs of its clients and in each of its trading businesses (collectively, "Trading-Related Derivative Activities"). The Company's use of derivative products in its trading businesses is combined with cash instruments to fully execute various trading strategies. The Company conducts its derivative activities through a number of wholly owned subsidiaries. The Company's fixed income derivative products business is conducted through its special purpose subsidiary, Lehman Brothers Special Financing Inc., and a separately capitalized "AAA" rated subsidiary, Lehman Brothers Financial Products Inc. The Company's equity derivative product business is conducted through Lehman Brothers Finance S.A. In addition, as a global investment bank, the Company is also a market-maker in a number of foreign currencies and actively trades in the global commodity markets. Counterparties to the Company's derivative product transactions are primarily financial intermediaries (U.S. and foreign banks), securities firms, corporations, governments and their agencies, finance companies, insurance companies, investment companies and pension funds. The Company manages the risks associated with derivatives on an aggregate basis, along with the risks associated with its proprietary trading and market-making activities in cash instruments, as part of its firmwide risk management policies. For a further discussion of the Company's risk management policies refer to Management's Discussion and Analysis pages 55-58. The Company's Trading-Related Derivative Activities have increased during the current year to a notional value of $1,855 billion at November 30, 1997 from $1,517 billion at November 30, 1996, primarily as a result of growth in the Company's activities as a dealer in fixed income derivative products. Notional values are not recorded on the balance sheet and are not indicative of actual or potential risk, but rather they provide a measure of the Company's involvement with such instruments. As a result of the Company's Trading-Related Derivative activities, the Company is subject to credit risk. With respect to OTC derivative contracts, the Company's credit exposure is directly with its counterparties and extends through the duration of the derivative contracts. The Company views its net credit exposure to be $5,252 million at November 30, 1997, representing the fair value of the Company's OTC contracts in an unrealized gain position, after consideration of collateral and master netting agreements. Collateral held related to OTC contracts generally includes cash and U.S. government and federal agency securities. At November 30, 1997 approximately 77% of the Company's net credit risk exposure related to OTC contracts was with counterparties rated "A-" or better. Additionally, the Company is exposed to credit risk related to its exchange-traded derivative contracts. Exchange-traded derivative contracts include futures contracts, warrants and certain options. Futures contracts and options on futures are transacted on the respective exchange. The exchange clearing house is a counterparty to the futures contracts and options. As a clearing member firm, the Company is required by the exchange clearing house to deposit cash or other securities as collateral for its obligation upon the origination of the contract and for any daily changes in the market value of open futures contracts. Unlike OTC derivatives which involve numerous counterparties, the number of counterparties from exchange-traded derivatives includes only those exchange clearing houses of which the Company is a clearing member firm or other member firms the Company utilizes as agents. Substantially all of the Company's exchange-traded derivatives are transacted on exchanges of which the Company is a clearing member firm. To protect against the potential for a default, all exchange clearing houses LEHMAN BROTHERS 1997 ANNUAL REPORT 54 20 impose net capital requirements for their membership. Therefore, the potential for losses from exchange-traded products is limited. As of November 30, 1997, the Company had approximately $1,177 million on deposit with futures exchanges consisting of cash and securities (customer and proprietary), and had posted approximately $221 million of letters of credit. Included within these amounts was $458 million and $719 million of cash and securities related to domestic and foreign futures exchanges, respectively, and $157 million and $64 million of letters of credit to domestic and foreign exchanges, respectively. As of November 30, 1997, the following significant amounts of cash and securities were on deposit with foreign futures exchanges: $206 million with the Tokyo Stock Exchange, $136 million with Deutsche Termin Boerse, $132 million with the Osaka Securities Exchange, $69 million with the Singapore International Monetary Exchange, $42 million with the London Clearing House, and $21 million with the Marche a Terme International de France. In addition, the Company had letters of credit of approximately $49 million on deposit with the London Clearing House. See Note 11 to the Consolidated Financial Statements for a further discussion of the Company's Trading-Related Derivative Activities. Accounting and Valuation > The Company's accounting methodology for derivatives depends on both the type and purpose of the derivative financial instrument. The Company records its Trading-Related Derivative Activities on a mark-to-market or fair value basis. Under mark-to-market or fair value accounting, realized and unrealized gains and losses are recognized currently in Principal transactions, and resulting assets and liabilities are recorded in the Consolidated Statement of Financial Condition as Derivatives and other contractual agreements, as applicable. Derivative assets and liabilities are netted by counterparty, when permitted under a legally enforceable master netting agreement. Derivatives utilized in conjunction with the Company's End User Derivative Activities are generally recorded on an accrual basis. Interest is accrued into income or expense over the life of the contract, resulting in the net interest impact of the derivative and the underlying hedged item being recognized in income throughout the hedge period. Market or fair value for Trading-Related Derivative Activities is generally determined by either quoted market prices or pricing models. Pricing models utilize a series of market inputs to determine the present value of future cash flows, with adjustments, as required, for credit risk, liquidity risk, and ongoing costs. Further valuation adjustments may be recorded, as deemed appropriate, for new or complex products or for significant positions. These adjustments are integral components of the mark-to-market process. ================================================================================ RISK MANAGEMENT - -------------------------------------------------------------------------------- As a leading global investment banking company, risk is an inherent part of the Company's businesses. Global markets, by their nature, are prone to uncertainty and subject participants to a variety of risks. The Company has developed policies and procedures to identify, measure and monitor each of the risks involved in its trading, brokerage and investment banking activities on a global basis. The principal risks of Lehman Brothers are market, credit, liquidity, legal and operational risks. Risk Management is considered to be of paramount importance. The Company devotes significant resources across all of its worldwide trading operations to the measurement, management and analysis of risk, including investments in personnel, information technology infrastructure and systems. The Company seeks to reduce risk through the diversification of its businesses, counterparties and activities in geographic regions. The Company accomplishes this objective by allocating the usage of capital to each of its businesses, establishing trading limits for individual products and traders and setting credit limits for individual counterparties, including regional LEHMAN BROTHERS 1997 ANNUAL REPORT 55 21 concentrations. The Company seeks to achieve adequate returns from each of its businesses commensurate with the risks that they assume. The Company periodically reallocates capital to its businesses based on their ability to obtain returns consistent with the established guidelines, opportunities in the marketplace and the Company's long term strategy. The Company's risk management strategy is headed by a Risk Management Committee (the "Committee") comprised of the Chief Executive Officer, the Chief Administrative Officer, Global Equity Division Head, Global Fixed Income Division Head, European Senior Manager, Asian Senior Manager, Chief Financial Officer, and Global Risk Manager. The Committee brings together senior management with the sole intent of discussing risk related issues and provides an effective forum for managing risk at the highest levels within the Company. The Committee reviews risk exposures, ratifies division risk limits and signs-off on risk management guidelines. The Committee meets on a monthly basis, or more frequently if required, to discuss, among other matters, significant market exposures, concentrations of positions (e.g., counterparty, market risk), potential new transactions or positions and risk limit exceptions. Senior management plays a critical role in the ongoing evaluation of risks and adjusts risk management policies when necessary. Overall risk management is based on a multi-tiered approach which includes many independent groups (i.e., the Risk Management Committee, the Global Risk Management Group, Operations, Audit, Finance, Legal and Treasury) that assist in the identification, assessment and control of risk. Senior representatives from these groups meet formally on a regular basis and on an ad hoc basis as necessary. Global Risk Management Group > The Global Risk Management Group (the "Group") is independent of the trading areas and reports directly to the Chief Executive Officer. The Group combines two disciplines, market risk management and credit risk management, into one unit. This facilitates the analysis of market and counterparty credit risk exposures and leverages personnel and information technology resources in a cost-efficient manner. The Group also functions as the executive branch of the Risk Management Committee. In addition to regular meetings at the senior management level, the Group operates in each of the Company's regional trading centers and has daily contact with trading staff at all levels within the Company. These discussions include a review of trading positions and risk exposures. The Group utilizes qualitative as well as quantitative information in managing trading risk, believing that a combination of the two approaches results in a more robust and complete approach to the management of trading risk. Quantitative information is developed from a variety of risk methodologies based upon established statistical principles. These methodologies have been financially engineered across a global technology platform, enabling the Company to view risk from a number of perspectives, from the trade level to the desk level and, ultimately, across the Company. To ensure high standards of qualitative analysis, the Company has retained seasoned market and credit risk managers with the requisite experience, academic and professional credentials. The Company is committed to ensuring that individuals within the Group are qualified with the skills necessary to assess the Company's risk exposures. The Group is responsible for the preparation and dissemination of risk reports, developing and implementing the firmwide Risk Management Guidelines and evaluating adherence to these guidelines. The purpose of market risk management guidelines is to address the review and approval of risk limits, the monitoring and reporting of risks against such limits, the reporting of risk limit exceptions, the review and approval of risk limit exceptions, as well as identifying the requisite authorities governing these processes. These guidelines provide a clear framework for risk management decision-making. To that end, the Group identifies and quantifies risk exposures, develops limits, and reports and monitors these risks with respect to the approved limits. The identification of material market risks inherent in positions includes, but is not limited to, interest rate, equity, and foreign exchange risk exposures. In addition to these risks, the Group also evaluates liquidity risks, credit and sovereign concentrations. LEHMAN BROTHERS 1997 ANNUAL REPORT 56 22 Credit risk management is an integral component of the Company's overall risk management framework. The Credit Risk Management Department ("CRM Department"), part of the Global Risk Management Group, has global responsibility for establishing credit risk standards and defining the Company's overall credit risk management framework. The Company recognizes that the credit "risk appetite" is a finite resource and emphasizes the importance of allocating this resource in such a way as to maximize the Company's profitability. The CRM Department is independent from the business units and reports directly to the Global Risk Manager, who, in turn, reports to the Chief Executive Officer. Corporate Credit is a global department centered in and managed from New York, with credit officers operating in each of the Company's regional trading centers. The CRM Department manages the credit exposure related to its trading activities by giving initial credit approval for counterparties, establishing credit limits by counterparty, country and industry group and by requiring collateral in appropriate circumstances. In addition, the CRM Department strives to ensure that master netting agreements are obtained whenever possible. The CRM Department also considers the duration of transactions in making its credit decisions, along with the potential credit exposure for complex derivative transactions. The CRM Department is responsible for the continuous monitoring and review of counterparty credit exposure and counterparty creditworthiness. Credit limits are reviewed periodically to ensure that they remain appropriate in light of market events or the counterparty's financial condition. Market Risk > Market risk represents the potential change in value of a portfolio of financial instruments due to changes in market rates, prices, and volatilities. Market risk is present in cash products, derivatives, and contingent claim structures that exhibit linear as well as nonlinear profit and loss sensitivity. The Company's exposure to market risk varies in accordance with the volume of client driven market-making transactions, the size of the Company's proprietary and arbitrage positions, and the volatility of financial instruments traded. The Company seeks to mitigate, whenever possible, excess market risk exposures through the use of futures and option contracts and offsetting cash market instruments. The Company participates globally in interest rate, equity, and foreign exchange markets. The Company's fixed income division has a broadly diversified market presence in U.S. and foreign government bond trading, emerging market securities, corporate debt (investment and non-investment grade), money market instruments, mortgages and mortgage-backed securities, asset-backed securities, municipal bonds, and interest rate derivatives. The Company's equity division facilitates domestic and foreign trading in equity instruments, indices, and related derivatives. The Company's foreign exchange businesses are involved in trading currencies on a spot and forward basis as well as through derivative products and contracts. Interest Rate Risk. The Company incurs short-term interest rate risk when facilitating the orderly flow of customer transactions through the management of government and high-grade corporate bond inventories. Market-making in high yield instruments exposes the Company to additional risk due to potential variations in credit spreads. Trading in international markets exposes the Company to spread risk between the term structure of interest rates in differing countries. Mortgage related securities are subject to prepayment risk and changes in the level of interest rates. Trading in derivatives and structured products exposes the Company to changes in the level and volatility of interest rates. The Company actively manages interest rate risk through the use of interest rate futures, options, swaps, forwards, and offsetting cash market instruments. Inventory holdings, concentrations, and agings are monitored closely and used by management to selectively hedge or liquidate undesirable exposures. Equity Price Risk. The Company is a significant intermediary in the global equity markets by making markets in U.S. and non-U.S. equity securities, including common stock, convertible debt, exchange-traded and OTC equity options, equity swaps and warrants. These activities expose the Company to market risk as a result of price and volatility changes in its equity inventory. Inventory holdings are also subject to market risk resulting from concentrations, aging and liquidity that may adversely impact LEHMAN BROTHERS 1997 ANNUAL REPORT 57 23 its market valuation. Equity market risk is actively managed through the use of index futures, exchange-traded and OTC options, swaps and cash investments. Equity risk exposures are aggregated and reported to management on a regular basis. Foreign Exchange Risk. The Company enters into foreign exchange transactions in order to facilitate the purchase and sale of non-dollar instruments, including equity and interest rate securities. The Company is exposed to foreign exchange risk on its holdings of non-dollar assets and liabilities. The Company is active in many foreign exchange markets and has exposure to the German mark, Japanese yen, British pound, Swiss franc, French franc, Canadian dollar and Italian lira. The Company hedges its risk exposures primarily through the use of currency forwards, swaps, futures, and options. Value at Risk > For purposes of new Securities and Exchange Commission disclosure requirements, the Company has elected to disclose an entity-wide value at risk analysis of virtually all of the Company's trading activities. The value at risk related to non-trading financial instruments has been excluded from this analysis and not reported separately because the amounts were not material. The value at risk calculation measures potential losses in expected revenues and is based on a methodology which uses a one-day holding period and a 95% confidence level. Value at risk was measured by analyzing the distribution of actual trading revenues during the year and assumes a relatively consistent portfolio mix. Value at risk is one measurement of potential losses in revenues that may result from adverse market movements over a specified period of time with a selected likelihood of occurrence. Value at risk has substantial limitations, including its reliance on historical performance and data as valid predictors of the future. Consequently, value at risk is only one of a number of tools the Company utilizes in its daily risk management activities. At November 30, 1997, the Company's value at risk for each component of market risk, and in total was as follows (in millions):
================================================================================ Interest rate risk $12.2 Equity price risk 7.1 Foreign exchange risk 4.5 Diversification benefit (9.0) - -------------------------------------------------------------------------------- Total Company $14.8 - --------------------------------------------------------------------------------
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. The Company's performance in mitigating this volatility is illustrated by the chart which depicts the distribution of 1997 weekly trading revenue. The chart was prepared from the weekly operating and financial performance report, one of the tools used by senior management in the risk control process. Average weekly trading revenue was $48.3 million in 1997. Although historical performance is not necessarily indicative of future performance, the Company believes its focus on business diversification and customer flow activities should continue to help mitigate the volatility of future net trading revenues. DISTRIBUTION OF 1997 WEEKLY TRADING REVENUE In Millions [Bar Graph Omitted] LEHMAN BROTHERS 1997 ANNUAL REPORT 58 24 ================================================================================ OTHER - -------------------------------------------------------------------------------- Impact of the Year 2000 > The Year 2000 issue is the result of many computer programs being written using two digits rather than four to define the applicable year. Any of the Company's computer programs that have date-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions or engage in normal business activities. The Company has determined that it will be required to modify or replace portions of its software so that its computer systems will properly utilize dates beyond December 31, 1999. The Company presently believes that with modifications to existing software and conversions to new software, the Year 2000 issue will be mitigated. However, if such modifications and conversions are not made, or are not completed on a timely basis, the Year 2000 issue could have a material impact on the operations of the Company. The Company has initiated formal communications with all of its suppliers (hardware, software, market data, voice and data communications, facility components and services) to determine the extent to which the Company is vulnerable to those third parties' failure to remediate their respective Year 2000 issue. The Company has taken a lead in industry efforts to deal with the Year 2000 issue by actively participating in the planning of industrywide testing in 1998 and 1999. Industrywide testing is the forum in which firms within the financial industry test the applications that transfer data between them. However, there can be no guarantee that the systems of other companies on which the Company's systems rely will be timely converted, or that a failure to convert by another company, or a conversion that is incompatible with the Company's systems, would not have a material adverse effect on the Company. The Company will utilize both internal and external resources to reprogram, or replace, and test software for Year 2000 modifications. The Company plans to complete the Year 2000 project, including industrywide testing, no later than August 1999. The Company's total Year 2000 project cost includes the estimated costs and time associated with the impact of a third party's Year 2000 issue, and are based on presently available information. The total remaining cost of the Year 2000 project is estimated at approximately $60 million which will be funded through operating cash flows and expensed as incurred over the next two and one-half years. To date, the Company has incurred and expensed approximately $16 million related to the Year 2000 project. The costs of the project and the date on which the Company plans to complete the Year 2000 modifications are based on management's best estimates, which were derived utilizing numerous assumptions of future events including the continued availability of certain resources, third party modification plans and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ materially from those plans. Specific factors that might cause such material differences include, but are not limited to, the availability and cost of personnel trained in this area, the ability to locate and correct all relevant computer codes, and similar uncertainties. New Accounting Developments > In June 1996, the Financial Accounting Standards Board (the "FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" ("SFAS No. 125"), which is effective for transactions occurring after December 31, 1996. In LEHMAN BROTHERS 1997 ANNUAL REPORT 59 25 December 1996, the FASB issued SFAS No. 127, "Deferral of the Effective Date of Certain Provisions of FASB Statement No. 125," which defers the effective date until January 1, 1998 for certain provisions of SFAS No. 125. SFAS No. 125 provides accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities. Those standards are based on consistent application of a financial component's approach that focuses on control. Under that approach, after a transfer of financial assets, an entity recognizes the financial and servicing assets it controls and the liabilities it has incurred, derecognizes the financial assets when control has been surrendered, and derecognizes liabilities when extinguished. This statement provides consistent standards for distinguishing transfers of financial assets that are sales from transfers that are secured borrowings. The Company expects that the full adoption of SEAS No. 125 will not result in the material recognition of additional assets and liabilities on its Consolidated Statement of Financial Condition, and will have no effect on the equity or results of operations of the Company. In February 1997, the FASB issued SFAS No. 128, "Earnings Per Share" ("SFAS No. 128"). SFAS No. 128 simplifies the standards for computing earnings per share and is effective for financial statements for both interim and annual periods ending after December 15, 1997. Earlier application is not permitted. SFAS No. 128 will require the Company to present basic and dilutive earnings per share; see Note 7 to the Consolidated Financial Statements for a discussion about the impact. In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income" ("SEAS No. 130"). SFAS No. 130 establishes standards for the reporting and display of comprehensive income and its components in the financial statements. SFAS No. 130 is effective for fiscal years beginning after December 15, 1997. Reclassification of financial statements for earlier periods provided for comparative purposes is required. The adoption of SFAS No. 130 will have no impact on the Company's consolidated statement of income, financial condition or cash flows. In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS No. 131"). SFAS No. 131 establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to shareholders. It also establishes standards for related disclosures about products and services, geographic areas, and major customers. SFAS No. 131 is effective for financial statements for fiscal years beginning after December 15, 1997. Financial statement disclosures for prior periods are required to be restated. The adoption of SFAS No. 131 will have no impact on the Company's consolidated statement of income, financial condition or cash flows. In August 1997, the FASB released for comment portions of its proposed standard entitled "Accounting for Derivative Instruments and for Hedging Activities" (the "Draft Standard"). The Draft Standard provides comprehensive accounting guidance for the recognition and measurement of derivatives and other similar financial instruments used in hedging activities (collectively referred to as "derivatives"). The Draft Standard also would require all derivatives to be recorded on the Consolidated Statement of Financial Condition as assets or liabilities at fair value. The Draft Standard also would require recognition of changes in the fair value of derivatives either in net income or in a separate component of stockholders' equity, depending on the designation of the derivative. The accounting basis for the hedged item would be adjusted, depending on LEHMAN BROTHERS 1997 ANNUAL REPORT 60 26 the designation of the derivative, by an amount offsetting the gain or loss on the derivative instrument to the extent it is considered an effective hedge. As currently proposed, the Company would be required to adopt this Draft Standard in fiscal year 2000. The Company is monitoring the development of final rules and their potential impact on the Company's accounting for its end user activities. In December 1996, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants released for comment a proposed statement of position "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use" (the "Proposed SOP"). In December 1997, the FASB gave approval for its final issuance, which is expected in the first calendar quarter of 1998. The Proposed SOP would require the capitalization of certain costs, incurred in connection with developing or obtaining software for internal use. The Proposed SOP would be effective for years ending after December 15, 1998 with earlier application encouraged. When adopted, the rule would be applied prospectively as of the beginning of an entity's fiscal year. The Company is currently considering early adoption of these rules once they become finalized. Recent Developments > In December 1997, the Company, without admitting or denying any wrongdoing, announced that it, along with 29 other broker-dealers settled a class action alleging violations of the antitrust law with respect to certain practices on the NASDAQ market, in the late 1980's and early 1990's, primarily when the Firm operated as Shearson Lehman Brothers. The Company's share of the settlement cost was approximately $95 million and was charged against existing reserves. In addition, this amount may be reduced by a recovery from a third party. Effects of Inflation > Because the Company's assets are, to a large extent, liquid in nature, they are not significantly affected by inflation. However, the rate of inflation affects the Company's expenses, such as employee compensation, office space leasing costs and communications charges, which may not be readily recoverable in the price of services offered by the Company. To the extent inflation results in rising interest rates and has other adverse effects upon the securities markets, it may adversely affect the Company's financial position and results of operations in certain businesses. LEHMAN BROTHERS 1997 ANNUAL REPORT 61 EX-13.2 7 CONSOLIDATED FINANCIAL STATEMENTS 1 EXHIBIT 13.2 REPORT OF INDEPENDENT AUDITORS The Board of Directors and Stockholders of Lehman Brothers Holdings Inc. We have audited the accompanying consolidated statement of financial condition of Lehman Brothers Holdings Inc. and Subsidiaries (the "Company") as of November 30, 1997 and 1996, and the related consolidated statements of income, changes in stockholders' equity, and cash flows for each of the three years in the period ended November 30, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Lehman Brothers Holdings Inc. at November 30, 1997 and 1996, and the consolidated results of its operations and its cash flows for each of the three years in the period ended November 30, 1997, in conformity with generally accepted accounting principles. /s/ Ernst & Young LLP New York, New York January 7, 1998 LEHMAN BROTHERS 1997 ANNUAL REPORT 62 2 CONSOLIDATED STATEMENT OF INCOME
TWELVE MONTHS ENDED NOVEMBER 30 ------------------------------- 1997 1996 1995 (in millions, except per share data) ========================================================================================== Revenues Principal transactions $ 1,418 $ 1,579 $ 1,393 Investment banking 1,318 981 801 Commissions 423 362 450 Interest and dividends 13,635 11,298 10,788 Other 89 40 44 - ------------------------------------------------------------------------------------------ Total revenues 16,883 14,260 13,476 Interest expense 13,010 10,816 10,405 - ------------------------------------------------------------------------------------------ Net revenues 3,873 3,444 3,071 - ------------------------------------------------------------------------------------------ Non-interest expenses Compensation and benefits 1,964 1,747 1,544 Brokerage, commissions and clearance fees 224 241 241 Professional services 173 150 159 Occupancy and equipment 141 151 174 Communications 141 147 180 Business development 103 101 110 Depreciation and amortization 86 91 105 Other 104 95 92 Severance charge 84 Restructuring charge 97 - ------------------------------------------------------------------------------------------ Total non-interest expenses 2,936 2,807 2,702 - ------------------------------------------------------------------------------------------ Income before taxes 937 637 369 Provision for income taxes 290 221 127 - ------------------------------------------------------------------------------------------ Net income $ 647 $ 416 $ 242 - ------------------------------------------------------------------------------------------ Net income applicable to common stock $ 572 $ 378 $ 200 - ------------------------------------------------------------------------------------------ Average common and common equivalent shares outstanding 121.1 116.4 113.4 - ------------------------------------------------------------------------------------------ Earnings per common share $ 4.72 $ 3.24 $ 1.76 - ------------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements. LEHMAN BROTHERS 1997 ANNUAL REPORT 63 3 CONSOLIDATED STATEMENT OF FINANCIAL CONDITION
NOVEMBER 30 ------------------ (in millions) 1997 1996 ================================================================================ Assets Cash and cash equivalents $ 1,685 $ 2,149 Cash and securities segregated and on deposit for regulatory and other purposes 1,149 688 Securities and other financial instruments owned: Governments and agencies 33,037 26,638 Corporate stocks 10,877 6,937 Corporate debt and other 10,892 8,821 Mortgages and mortgage-backed 11,455 8,314 Derivatives and other contractual agreements 8,353 6,909 Certificates of deposit and other money market instruments 2,248 3,834 - -------------------------------------------------------------------------------- 76,862 61,453 - -------------------------------------------------------------------------------- Collateralized short-term agreements: Securities purchased under agreements to resell 43,606 32,340 Securities borrowed 14,146 20,651 Receivables: Brokers, dealers and clearing organizations 2,193 2,878 Customers 9,105 5,813 Others 1,540 1,253 Property, equipment and leasehold improvements (net of accumulated depreciation and amortization of $735 in 1997 and $668 in 1996) 468 477 Other assets 787 722 Excess of cost over fair value of net assets acquired (net of accumulated amortization of $111 in 1997 and $103 in 1996) 164 172 - -------------------------------------------------------------------------------- Total assets $151,705 $128,596 ================================================================================
See Notes to Consolidated Financial Statements. LEHMAN BROTHERS 1997 ANNUAL REPORT 64 4 CONSOLIDATED STATEMENT OF FINANCIAL CONDITION
NOVEMBER 30 ----------------------- (in millions, except share data) 1997 1996 ================================================================================================= Liabilities and Stockholders' Equity Commercial paper and short-term debt $ 7,818 $ 8,202 Securities and other financial instruments sold but not yet purchased: Governments and agencies 16,201 13,202 Corporate stocks 4,293 4,971 Corporate debt and other 2,219 1,375 Derivatives and other contractual agreements 7,367 6,816 - ------------------------------------------------------------------------------------------------- 30,080 26,364 - ------------------------------------------------------------------------------------------------- Collateralized short-term financing: Securities sold under agreements to repurchase 63,204 56,119 Securities loaned 7,846 6,296 Payables: Brokers, dealers and clearing organizations 2,155 1,004 Customers 11,702 7,582 Accrued liabilities and other payables 4,116 3,233 Long-term debt: Senior notes 17,049 12,571 Subordinated indebtedness 3,212 3,351 - ------------------------------------------------------------------------------------------------- Total liabilities 147,182 124,722 - ------------------------------------------------------------------------------------------------- Commitments and contingencies Stockholders' Equity Preferred stock, $1.00 par value; 38,000,000 shares authorized: 5% Cumulative Convertible Voting, 13,000,000 shares authorized; $39.10 liquidation preference per share Series A - shares issued and outstanding: 33,050 in 1997 and 13,000,000 in 1996 1 508 Series B - shares issued and outstanding: 12,966,950 in 1997 507 Redeemable Voting, 1,000 shares issued and outstanding; $1.00 liquidation preference per share Common stock, $.10 par value; 300,000,000 shares authorized; shares issued: 119,513,337 in 1997 and 106,793,538 in 1996; shares outstanding: 116,612,074 in 1997 and 100,449,144 in 1996 12 11 Common stock issuable 155 326 Additional paid-in capital 3,436 3,198 Foreign currency translation adjustment 12 20 Retained earnings (accumulated deficit) 498 (43) Common stock in treasury, at cost: 2,901,263 shares in 1997 and 6,344,394 shares in 1996 (98) (146) - ------------------------------------------------------------------------------------------------- Total stockholders' equity 4,523 3,874 - ------------------------------------------------------------------------------------------------- Total liabilities and stockholders' equity $ 151,705 $ 128,596 =================================================================================================
See Notes to Consolidated Financial Statements. LEHMAN BROTHERS 1997 ANNUAL REPORT 65 5 CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
TWELVE MONTHS ENDED NOVEMBER 30 ------------------------------- (in millions) 1997 1996 1995 ======================================================================================== Preferred Stock 5% Cumulative Convertible Voting, Series A: Beginning balance $ 508 $ 508 $ 508 Series A exchanged for Series B (507) - ---------------------------------------------------------------------------------------- Ending balance 1 508 508 - ---------------------------------------------------------------------------------------- 5% Cumulative Convertible Voting, Series B: Beginning balance Series A exchanged for Series B 507 - ---------------------------------------------------------------------------------------- Ending balance 507 - ---------------------------------------------------------------------------------------- 8.44% Cumulative Voting: Beginning balance 200 200 Repurchase (200) - ---------------------------------------------------------------------------------------- Ending balance 200 - ---------------------------------------------------------------------------------------- Redeemable Voting: Beginning and ending balance - ---------------------------------------------------------------------------------------- Total Preferred Stock, ending balance 508 508 708 - ---------------------------------------------------------------------------------------- Common stock Beginning balance 11 11 11 Shares issued to RSU Trust 1 - ---------------------------------------------------------------------------------------- Ending balance 12 11 11 - ---------------------------------------------------------------------------------------- Common stock issuable Beginning balance 326 211 87 RSUs amortized, net of cancellations 162 136 124 RSUs exchanged for Common Stock (8) (21) Shares issued to RSU Trust (325) - ---------------------------------------------------------------------------------------- Ending balance 155 326 211 - ---------------------------------------------------------------------------------------- Additional paid-in capital Beginning balance 3,198 3,172 3,172 RSUs exchanged for Common Stock 8 21 Stock options exercised 33 6 1 Employee stock purchase plan (3) (3) (1) Shares issued to RSU Trust 199 Other, net 1 2 - ---------------------------------------------------------------------------------------- Ending balance 3,436 3,198 3,172 - ---------------------------------------------------------------------------------------- Foreign currency translation adjustment Beginning balance 20 9 6 Translation adjustment, net (1) (8) 11 3 - ---------------------------------------------------------------------------------------- Ending balance 12 20 9 - ---------------------------------------------------------------------------------------- Retained earnings (accumulated deficit) Beginning balance (43) (397) (574) Net income 647 416 242 Dividends declared: 5% Cumulative Convertible Voting Preferred Stock (25) (25) (25) 8.44% Cumulative Voting Preferred Stock (3) (17) Redeemable Voting Preferred Stock (50) (8) Common Stock (31) (24) (23) Premium for repurchase of 8.44% Cumulative Voting Preferred Stock (2) - ---------------------------------------------------------------------------------------- Ending balance 498 (43) (397) - ---------------------------------------------------------------------------------------- Common stock in treasury, at cost Beginning balance (146) (16) (15) Treasury stock purchased (77) (130) (1) Shares issued to RSU Trust 125 - ---------------------------------------------------------------------------------------- Ending balance (98) (146) (16) - ---------------------------------------------------------------------------------------- Total Stockholders' Equity $ 4,523 $ 3,874 $ 3,698 ========================================================================================
(1) Net of income taxes of $8 in 1997, $(11) in 1996, and $(2) in 1995. See Notes to Consolidated Financial Statements. LEHMAN BROTHERS 1997 ANNUAL REPORT 66 6 CONSOLIDATED STATEMENT OF CASH FLOWS
TWELVE MONTHS ENDED NOVEMBER 30 ------------------------------------- (in millions) 1997 1996 1995 - ---------------------------------------------------------------------------------------------------------------- Cash Flows from Operating Activities Net Income $647 $416 $242 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation and amortization 86 91 105 Severance charge 84 Restructuring charge 80 Provisions for losses and other reserves 52 42 38 Deferred tax provision (benefit) (60) 72 (195) Other adjustments (50) 184 169 Net change in: Cash and securities segregated and on deposit (461) 257 475 Securities and other financial instruments owned (15,409) (8,432) (5,548) Securities purchased under agreements to resell (11,266) 3,894 1,256 Securities borrowed 6,505 (4,361) (5,673) Receivables from brokers, dealers and clearing organizations 685 (1,318) 3,374 Receivables from customers (3,292) (2,336) (683) Securities and other financial instruments sold but not yet purchased 3,716 4,550 4,784 Securities sold under agreements to repurchase 7,085 (2,916) 616 Securities loaned 1,550 4,330 339 Payables to brokers, dealers and clearing organizations 1,151 (99) (1,494) Payables to customers 4,120 1,821 2,368 Accrued liabilities and other payables 782 217 165 Other operating assets and liabilities, net (286) 107 1,436 - ---------------------------------------------------------------------------------------------------------------- Net cash provided by (used in) operating activities ($4,445) ($3,397) $1,854 - ----------------------------------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements. LEHMAN BROTHERS 1997 ANNUAL REPORT 67 7 CONSOLIDATED STATEMENT OF CASH FLOWS
TWELVE MONTHS ENDED NOVEMBER 30 ------------------------------------- (in millions) 1997 1996 1995 - ---------------------------------------------------------------------------------------------------------------- Cash Flows from Financing Activities Proceeds from issuance of senior notes $ 7,242 $ 4,455 $ 5,033 Principal payments of senior notes (2,548) (2,411) (3,725) Proceeds from issuance of subordinated indebtedness 407 1,330 258 Principal payments of subordinated indebtedness (550) (246) (214) Net proceeds from (payments for) commercial paper and short-term debt (384) 1,981 (3,180) Payment for repurchase of preferred stock (200) Payments for treasury stock purchases (77) (130) (1) Dividends paid (58) (55) (64) Issuance of common stock 23 6 1 - ---------------------------------------------------------------------------------------------------------------- Net cash provided by (used in) financing activities 4,055 4,730 (1,892) - ---------------------------------------------------------------------------------------------------------------- Cash Flows from Investing Activities Purchase of property, equipment and leasehold improvements (74) (58) (52) - ---------------------------------------------------------------------------------------------------------------- Net cash used in investing activities (74) (58) (52) - ---------------------------------------------------------------------------------------------------------------- Net change in cash and cash equivalents (464) 1,275 (90) - ---------------------------------------------------------------------------------------------------------------- Cash and cash equivalents, beginning of period 2,149 874 964 - ---------------------------------------------------------------------------------------------------------------- Cash and cash equivalents, end of period $ 1,685 $ 2,149 $ 874 - ----------------------------------------------------------------------------------------------------------------
Supplemental Disclosure of Cash Flow Information (in millions) Interest paid totaled $12,900 in 1997, $10,852 in 1996 and $10,372 in 1995. Income taxes paid totaled $371 in 1997, $79 in 1996 and $149 in 1995. See Notes to Consolidated Financial Statements. LEHMAN BROTHERS 1997 ANNUAL REPORT 68 8 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 Holdings Inc. ("Holdings") and subsidiaries (collectively, the "Company" or "Lehman Brothers"). Lehman Brothers 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 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. The Company is engaged primarily in providing financial services. The principal U.S. subsidiary of Holdings is Lehman Brothers Inc. ("LBI"), a registered broker-dealer. All material intercompany accounts and transactions have been eliminated in consolidation. The consolidated financial statements are prepared in conformity with generally accepted accounting principles which require management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Management believes that the estimates utilized in preparing its financial statements are reasonable and prudent. Actual results could differ from these estimates. The Company uses the trade date basis of accounting. Certain prior period amounts reflect reclassifications to conform to the current period's presentation. Translation of Foreign Currencies > Assets and liabilities of foreign subsidiaries having non-U.S. dollar functional currencies are translated at exchange rates at the statement of financial condition date. Revenues and expenses are translated at average exchange rates during the period. The gains or losses resulting from translating foreign currency financial statements into U.S. dollars, net of hedging gains or losses and related tax effects, are included in a separate component of stockholders' equity, the Foreign currency translation adjustment. Gains or losses resulting from foreign currency transactions are included in the Consolidated Statement of Income. Securities and Other Financial Instruments > Securities and other financial instruments owned and securities and other financial instruments sold but not yet purchased are valued at market or fair value, as appropriate, with unrealized gains and losses reflected in Principal transactions in the Consolidated Statement of Income. Market value is generally based on listed market prices. If listed market prices are not available, fair value is determined based on other relevant factors, including broker or dealer price quotations and valuation pricing models which take into account time value and volatility factors underlying the financial instruments. Derivative Financial Instruments > Derivatives, typically defined as instruments whose value is "derived" from an underlying instrument, index or rate, include futures, forwards, swaps and options and other similar instruments. A derivative contract generally represents future commitments to exchange interest or other payment streams based on the contract or notional amount or to purchase or sell financial instruments at specified terms and future dates. In the normal course of business, the Company enters into derivative transactions both in a trading capacity and as an end user. Acting in a trading capacity, the Company enters into derivative transactions to satisfy the needs of its clients and to manage the Company's own exposure to market and credit LEHMAN BROTHERS 1997 ANNUAL REPORT 69 9 risks resulting from its trading activities in cash instruments (collectively, "Trading-Related Derivative Activities"). The Company's accounting methodology for derivatives depends on both the type and purpose of the derivative financial instrument. Derivative transactions entered into for Trading-Related Derivative Activities are recorded at market or fair value with realized and unrealized gains and losses reflected currently in Principal transactions in the Consolidated Statement of Income. Market or fair value for trading related instruments is generally determined by either quoted market prices (for exchange-traded futures and options) or pricing models (for over-the-counter swaps, forwards and options). Pricing models utilize a series of market inputs to determine the present value of future cash flows, with adjustments, as required for credit risk, liquidity risk and ongoing costs. Further valuation adjustments may be recorded, as deemed appropriate for new or complex products or for significant positions. These adjustments are integral components of the mark-to-market process. The market or fair value associated with derivatives utilized for trading purposes is recorded in the Consolidated Statement of Financial Condition on a net by counterparty basis where a legal right of set-off exists and is netted across products and against cash collateral when such provisions are stated in the master netting agreement. The market or fair value of swap agreements, caps and floors, and forward contracts in an unrealized gain position, as well as options owned and warrants held, are reported in the Consolidated Statement of Financial Condition as assets in Derivatives and other contractual agreements. Similarly, swap agreements, caps and floors, and forward contracts in an unrealized loss position, as well as options written and warrants issued, are reported in the Consolidated Statement of Financial Condition as liabilities in Derivatives and other contractual agreements. Margin on futures contracts is included in receivables and payables, as applicable. In addition to Trading-Related Derivative Activities, the Company enters into various derivative financial instruments for non-trading purposes as an end user to modify the interest rate exposure of certain assets and liabilities. In this regard, the Company utilizes interest rate and currency 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 cross-currency swaps to hedge its exposure to foreign currency risk as a result of its non-U.S. dollar debt obligations, after consideration of non-U.S. dollar assets which are funded with long-term debt obligations in the same currency. In addition to modifying the interest rate and foreign currency exposure of existing assets and liabilities, the Company utilizes derivative financial instruments as an end user to modify the interest rate characteristics of certain anticipated transactions related to its secured financing activities, where there is a high degree of certainty that the Company will enter into such contracts. These derivative financial instruments are designated against existing secured financing transactions based upon their applicable maturity. The remaining term of the derivative financial instruments is designated against anticipated secured financing transactions which will replace the existing secured financing transactions upon maturity. The Company monitors the level of secured financing transactions to ensure that there is a high degree of certainty that it will enter into the anticipated secured financing transactions at a level in excess of the designated derivative product transactions. Derivatives that have been designated as non-trading related positions and are effective in modifying the interest rate characteristics of existing assets and liabilities or anticipated transactions are accounted for on an accrual basis. Under the accrual basis, interest is accrued into income or expense over the life of the contract, resulting in the net interest impact of the derivative and the underlying hedged item being recognized in income throughout the hedge period. The Company monitors the effectiveness of its end user hedging activities by periodically comparing the change in the value of the hedge instrument to the underlying item being hedged and reassessing the likelihood of the occurrence of anticipated LEHMAN BROTHERS 1997 ANNUAL REPORT 70 10 transactions. In the event that the Company determines that a hedge is no longer effective, such as upon extinguishment of the underlying asset or liability or a change in circumstances whereby there is not a high degree of certainty that the anticipated transaction will occur, the derivative transaction is no longer accounted for as a hedge. Instead, the Company immediately recognizes the market or fair value of the derivative financial instrument through earnings. Changes in the fair value of the derivative contract would then be accounted for as a derivative used for trading purposes as discussed above. In the event that a derivative designated as a hedge is terminated early, any realized gain or loss on the termination would be deferred and amortized to interest income or interest expense over the original period of the hedge. Repurchase and Resale Agreements > Securities purchased under agreements to resell and securities sold under agreements to repurchase, which are treated as financing transactions for financial reporting purposes, are collateralized primarily by government and government agency securities and are carried net by counterparty, when permitted, at the amounts at which the securities will be subsequently resold or repurchased plus accrued interest. It is the policy of the Company to take possession of securities purchased under agreements to resell. The Company monitors the market value of the underlying positions on a daily basis as compared to the related receivable or payable balances, including accrued interest. The Company requires counterparties to deposit additional collateral or return collateral pledged as necessary, to ensure that the market value of the underlying collateral remains sufficient. Securities and other financial instruments owned that are sold under repurchase agreements are carried at market value with changes in market value reflected in the Consolidated Statement of Income. Securities purchased under agreements to resell and securities sold under agreements to repurchase for which the resale/repurchase date corresponds to the maturity date of the underlying securities are accounted for as purchases and sales, respectively. At November 30, 1997, such resale and repurchase agreements that had not yet matured aggregated $3.0 billion and $279 million, respectively. Securities Borrowed and Loaned > Securities borrowed and securities loaned are carried at the amount of cash collateral advanced or received plus accrued interest. It is the Company's policy to value the securities borrowed and loaned on a daily basis and to obtain additional cash as necessary to ensure such transactions are adequately collateralized. Income Taxes > The Company accounts for income taxes under the provisions of Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." The Company recognizes the current and deferred tax consequences of all transactions that have been recognized in the financial statements using the provisions of the enacted tax laws. In this regard, deferred tax assets are recognized for temporary differences that will result in deductible amounts in future years and for tax loss carryforwards, if in the opinion of management, it is more likely than not that the deferred tax asset will be realized. SFAS 109 requires companies to set up a valuation allowance for that component of net deferred tax assets which does not meet the "more likely than not" criterion for realization. Property, Equipment and Leasehold Improvements > Property, equipment and leasehold improvements are recorded at historical cost, net of accumulated depreciation and amortization. Depreciation is recognized on a straight-line basis over the estimated useful lives of the related assets. Leasehold improvements are amortized over the lesser of their economic useful lives or the terms of the underlying leases. Goodwill > Excess of cost over fair value of net assets acquired (goodwill) is amortized using the straight-line method over a period of 35 years and is evaluated periodically for impairment. Goodwill is also reduced upon the recognition of certain acquired net operating loss carryforward benefits. 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. LEHMAN BROTHERS 1997 ANNUAL REPORT 71 11 Earnings Per Common Share > Earnings per common share was computed by dividing net income applicable to common stock by the weighted average number of shares of common stock and common stock equivalents outstanding. ================================================================================ note 2 SHORT-TERM FINANCINGS - -------------------------------------------------------------------------------- The Company obtains short-term financing on both a secured and unsecured basis. The secured financing is obtained through the use of repurchase agreements and securities loaned agreements, which are primarily collateralized by government, agency and equity securities. The unsecured financing is generally obtained through short-term debt and the issuance of commercial paper. The Company's commercial paper and short-term debt financing is comprised of the following:
NOVEMBER 30 ------------------ (in millions) 1997 1996 ================================================================================ Commercial paper $3,866 $3,074 Short-term debt Master notes 1,752 2,190 Bank loans 1,414 2,278 Payables to banks 786 660 - -------------------------------------------------------------------------------- Total $7,818 $8,202 - --------------------------------------------------------------------------------
The Company's weighted average interest rates were as follows:
NOVEMBER 30 ------------------ 1997 1996 ================================================================================ Commercial paper(1) 5.9% 5.1% Short-term debt(2) 4.7% 5.2% Securities sold under agreements to repurchase 5.0% 5.1% - --------------------------------------------------------------------------------
(1) Including weighted average interest rates of 6.O% and 2.2% as of November 30, 1997 and 5.7% and 1.2% as of November 30, 1996 related to U.S. dollar and non-U.S. dollar obligations, respectively. (2) Including weighted average interest rates of 5.7% and 3.4% as of November 30, 1997 and 5.6% and 4.1% as of November 30,1996 related to U.S. dollar and non-U.S. dollar obligations, respectively. Holdings maintains a Revolving Credit Agreement (the "Credit Agreement") with a syndicate of banks. Under the terms of the Credit Agreement, the banks have committed to provide up to $2 billion for up to 364 days. Any loans outstanding on the commitment termination date may be extended to the first anniversary of the commitment termination date at the option of Holdings. The Credit Agreement contains covenants which require, among other things, that the Company maintain specified levels of liquidity and tangible net worth, as defined. In addition, the Company maintains a $1 billion Secured Revolving Credit Facility (the "Facility") for Lehman Brothers International (Europe) ("LBIE"), the Company's major operating entity in Europe. Under the terms of the committed Facility, the bank group has committed to provide up to $1 billion for up to six months on a secured basis. Any loans outstanding on the commitment termination date may be extended to the first anniversary of the commitment termination date at the option of LBIE. The loans provided by the bank group are available in several currencies, including U.S. dollar, British pound ster- LEHMAN BROTHERS 1997 ANNUAL REPORT 72 12 ling, Deutsche mark, ECU, French franc and Italian lira, as requested. The Facility contains covenants which require, among other things, that LBIE maintain specified levels of tangible net worth and regulatory capital and that the Company maintain specified levels of consolidated stockholders' equity and tangible net worth, as defined. There were no borrowings outstanding under either the Credit Agreement or the Facility at November 30, 1997. The Company may use the Credit Agreement and the Facility for general corporate purposes from time to time. The Company maintained compliance with the applicable covenants for both the Credit Agreement and the Facility at all times. ================================================================================ note 3 LONG-TERM DEBT - --------------------------------------------------------------------------------
U.S. DOLLAR NON-U.S. DOLLAR ---------------------- --------------------- NOVEMBER 30 FIXED FLOATING FIXED FLOATING ----------------------- (in millions) RATE RATE RATE RATE 1997 1996 ======================================================================================================================== Senior Notes Maturing in Fiscal 1997 $ 2,254 Maturing in Fiscal 1998 $ 1,738 $ 606 $ 100 $ 266 $ 2,710 2,532 Maturing in Fiscal 1999 1,526 532 964 185 3,207 2,418 Maturing in Fiscal 2000 2,178 1,159 171 121 3,629 1,932 Maturing in Fiscal 2001 594 218 43 170 1,025 603 Maturing in Fiscal 2002 1,137 1,026 50 785 2,998 924 December 1,2002 and thereafter 2,122 590 707 61 3,480 1,908 - ------------------------------------------------------------------------------------------------------------------------ Senior Notes 9,295 4,131 2,035 1,588 17,049 12,571 - ------------------------------------------------------------------------------------------------------------------------ Subordinated Indebtedness Maturing in Fiscal 1997 550 Maturing in Fiscal 1998 350 9 359 360 Maturing in Fiscal 1999 334 334 334 Maturing in Fiscal 2000 192 192 192 Maturing in Fiscal 2001 200 200 200 Maturing in Fiscal 2002 250 41 291 250 December 1,2002 and thereafter 1,631 187 18 1,836 1,465 - ------------------------------------------------------------------------------------------------------------------------ Subordinated Indebtedness 2,957 237 18 3,212 3,351 - ------------------------------------------------------------------------------------------------------------------------ Long-Term Debt $12,252 $4,368 $2,053 $1,588 $20,261 $15,922 - ------------------------------------------------------------------------------------------------------------------------
Of the Company's long-term debt outstanding as of November 30, 1997, $842 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, which range from fiscal 1998 to fiscal 2003, rather than at their contractual maturities, which range from fiscal 2000 to fiscal 2026. In addition, $1,031 million of the Company's long-term debt is redeemable prior to maturity at the option of the Company under various terms and conditions. These obligations are reflected in the above table at their contractual maturity dates. The Company's interest in 3 World Financial Center is financed with U.S. dollar fixed rate senior notes totaling $236 million as of November 30, 1997. Of this amount, $80 million was redeemed prior to maturity in December 1997 and is reflected in the above table as maturing in fiscal 1998. These notes are unconditionally guaranteed by American Express with a portion of these notes being collateralized by certain mortgage obligations. As of November 30, 1997, the Company had $7.3 billion available for the issuance of debt securities under various shelf registrations and debt programs, which includes $1.1 billion of issuance availability under the Company's Euro medium-term note program. LEHMAN BROTHERS 1997 ANNUAL REPORT 73 13 As of November 30, 1997, the Company's U.S. dollar and non-U.S. dollar debt portfolios included approximately $461 million and $269 million, respectively, of debt for which the interest rates and/or redemption values or maturity have been linked to the performance of various indices including industry baskets of stocks or commodities. Generally, such rates are issued as floating rate notes or the interest rates on such index notes are effectively converted to floating rates based primarily on LIBOR through the use of interest rate and currency swaps. End User Derivative Activities > The Company utilizes a variety of derivative products including interest rate and currency 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 addition, the Company utilizes cross-currency swaps to hedge its exposure to foreign currency risk as a result of its non-U.S. dollar debt obligations, after consideration of non-U.S. dollar assets which are funded with long-term debt obligations in the same currency. 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 value of the derivative contracts may exceed the carrying value of the related long-term debt issuance. At November 30, 1997 and 1996, the notional values of the Company's interest rate and currency swaps related to its long-term debt obligations were approximately $17.3 billion and $15.1 billion, respectively. In terms of notional amounts outstanding, these derivative products mature as follows:
NOVEMBER 30 ---------------------- (in millions) U.S. DOLLAR NON-U.S. DOLLAR CR0SS CURRENCY 1997 1996 ================================================================================================================== Maturing in Fiscal 1997 $ 3,363 Maturing in Fiscal 1998 $ 2,253 $ 6 $ 333 $ 2,592 2,454 Maturing in Fiscal 1999 2,119 152 977 3,248 2,651 Maturing in Fiscal 2000 3,136 57 234 3,427 2,008 Maturing in Fiscal 2001 722 31 182 935 535 Maturing in Fiscal 2002 1,823 482 184 2,489 1,152 December 1, 2002 and thereafter 3,837 584 202 4,623 2,937 - ------------------------------------------------------------------------------------------------------------------ Total $13,890 $1,312 $2,112 $17,314 $15,100 - ------------------------------------------------------------------------------------------------------------------ Weighted average rate(1) Receive rate 7.23% 6.10% 4.55% 6.82% 6.61% Pay rate 6.52% 5.17% 6.27% 6.39% 6.11%
(1) Weighted average interest rates were calculated utilizing non-U.S. dollar interest rates, where applicable. On an overall basis, the Company's long-term debt related end user derivative activities resulted in reduced interest expense of approximately $68 million, $81 million and $74 million in 1997, 1996 and 1995, respectively. In addition, the Company's end user derivative activities resulted in the following changes to the Company's mix of fixed and floating rate debt and effective weighted average rates of interest: LEHMAN BROTHERS 1997 ANNUAL REPORT 74 14
NOVEMBER 30, 1997 ---------------------------------------------------------- LONG-TERM DEBT WEIGHTED AVERAGE(1) ------------------------ ------------------------------ BEFORE AFTER CONTRACTUAL EFFECTIVE RATE END USER END USER INTEREST AFTER END USER (in millions) ACTIVITIES ACTIVITIES RATE ACTIVITIES ================================================================================ USD Obligations Fixed rate $12,252 $ 308 7.54% 10.56% Floating rate 4,368 18,334 6.18% 6.48% - -------------------------------------------------------------------------------- 16,620 18,642 7.18% 6.55% - -------------------------------------------------------------------------------- Non-USD Obligations 3,641 1,619 4.97% 4.94% - -------------------------------------------------------------------------------- Total $20,261 $20,261 6.78% 6.42% - --------------------------------------------------------------------------------
NOVEMBER 30, 1996 ---------------------------------------------------------- LONG-TERM DEBT WEIGHTED AVERAGE(1) ------------------------ ------------------------------ BEFORE AFTER CONTRACTUAL EFFECTIVE RATE END USER END USER INTEREST AFTER END USER (in millions) ACTIVITIES ACTIVITIES RATE ACTIVITIES ================================================================================ USD Obligations Fixed rate $10,100 $ 529 7.84% 8.95% Floating rate 2,779 14,633 6.02% 6.39% - -------------------------------------------------------------------------------- 12,879 15,162 7.45% 6.48% - -------------------------------------------------------------------------------- Non-USD Obligations 3,043 760 4.23% 3.36% - -------------------------------------------------------------------------------- Total $15,922 $15,922 6.83% 6.33% - --------------------------------------------------------------------------------
(1) Weighted average interest rates were calculated using non-U.S. dollar interest rates, where applicable. ================================================================================ note 4 PREFERRED STOCK - -------------------------------------------------------------------------------- Cumulative Convertible Voting, Series A and Series B > The Cumulative Convertible Voting Preferred Stock, Series A and Series B (together the "Convertible Voting Preferred") have a liquidation preference of $39.10 per share. The Series A was issued in 1987. The Series B was issued in exchange for the Series A, on July 11, 1997. As of November 30, 1997, 33,050 shares of the Series A and 12,966,950 shares of the Series B were outstanding. The holders of the Convertible Voting Preferred are entitled to receive preferred dividends at an annual rate of 5%, on the liquidation preference, payable quarterly before any dividends are paid to the holders of Common Stock. The Company has the right to redeem up to 10,400,000 shares of the Convertible Voting Preferred up to and including June 15, 1998. On June 16, 1998, the Company will have the right to redeem up to 13,000,000 shares subject to adjustment and restrictions on redemption when dividends are in arrears. Such redemption will be at a price per preferred share equal to $39.10. Each share of the Convertible Voting Preferred is convertible, at any time prior to the date of redemption, into 0.3178313 of a share of Common Stock. The Series A is convertible provided that at least 250,000 shares (or such lesser number of such LEHMAN BROTHERS 1997 ANNUAL REPORT 75 15 shares then outstanding) are converted each time. Each share of the Series B is convertible without limitations. In each case, the conversion rate at November 30, 1997 was $123.02. As of November 30, 1997, Nippon Life held 9,163,683 shares of the Series B. The remaining 3,836,317 shares of the Convertible Voting Preferred were held by various institutional investors. During December 1997, Nippon Life exercised its right to exchange the 9,163,683 shares of the Series B for American Express Company ("American Express") common shares. As a result, American Express owns 9,163,683 shares of the Series B. The exercise had no impact on the Company's capital. Redeemable Voting > In 1994, Holdings issued the Redeemable Preferred Stock to American Express and Nippon Life for $1,000. The holders of the Redeemable Preferred Stock will be entitled to receive annual dividends through May 31, 2002 equal to 50% of the amount, if any, by which the Company's net income for the preceding year exceeds $400 million, up to a maximum of $50 million, prorated in the case of the last dividend period, which runs from December 1, 2001 to May 31, 2002. For the years ended November 30, 1997 and 1996, the Company's net income of $647 million and $416 million, respectively, resulted in the recognition of dividends in the amount of $50 million and $8 million, respectively, on the Redeemable Voting Preferred Stock. Holdings may not redeem shares of the Redeemable Preferred Stock prior to the final dividend payment date. However, in the event of a change of control of the Company, holders of the Redeemable Preferred Stock will have the right to require Holdings to redeem all of this stock for an aggregate redemption price equal to $200 million if such change of control occurs prior to November 30, 1998, declining $50 million per year in each of the four years thereafter. If a change of control is not approved by a majority of the Company's Board of Directors, the funds for redemption must be raised by an offering of the Company's equity securities which are not redeemable. These shares are not convertible into Common Stock. ================================================================================ note 5 COMMON STOCK - -------------------------------------------------------------------------------- Changes in shares of Holdings' common stock (the "Common Stock") outstanding are as follows:
NOVEMBER 30 ----------------------------------------------- 1997 1996 1995 ============================================================================================================== Shares outstanding, beginning of period 100,449,144 104,565,875 104,537,690 Exercise of stock options and other share issuances 1,719,799 1,108,973 76,142 Treasury stock purchases (1,556,869) (5,225,704) (47,957) Issuance of shares to the RSU Trust 16,000,000 - -------------------------------------------------------------------------------------------------------------- Shares outstanding, end of period 116,612,074 100,449,144 104,565,875 - --------------------------------------------------------------------------------------------------------------
The Company has reserved for issuance approximately 4.1 million shares of Common Stock for conversion of the Convertible Voting Preferred. During the years ended November 30, 1997 and 1996, the Company repurchased or acquired shares of its Common Stock in the open market and through an odd-lot buy back program at an aggregate cost of approximately $77 million and $130 million, respectively. These shares are being reserved for future issuances under employee stock-based compensation plans. The Company established a trust (the "RSU Trust") in order to provide common stock voting rights to employees who hold outstanding restricted stock units ("RSU"), in furtherance of the Company's stated goal when RSU awards were initiated in LEHMAN BROTHERS 1997 ANNUAL REPORT 76 16 June 1994, to encourage employees to think and act like owners. The RSU Trust was initially funded with a total of 16 million shares consisting of 5 million treasury shares for RSU awards under the Employee Incentive Plan and 11 million new issue shares of Common Stock for RSU awards under the 1994 Management Ownership Plan. The establishment of the RSU Trust did not impact the total number of shares used in the computation of earnings per common share because the RSUs have historically been viewed as common stock equivalents for purposes of these computations. Accordingly, there was no effect on total equity, net income and earnings per share of the Company. ================================================================================ note 6 INCENTIVE PLANS - -------------------------------------------------------------------------------- Employee Stock Purchase Plan > The Employee Stock Purchase Plan (the "ESPP") allows employees to purchase Common Stock at a 15% discount from market value, with a maximum of $25,000 in annual aggregate purchases by any one individual. The number of shares of Common Stock authorized for purchase by eligible employees is 6 million. As of November 30, 1997 and 1996, 1.6 million shares and 1.2 million shares, respectively, of Common Stock had been purchased by eligible employees through the ESPP. The Company controls the dilutive impact of the ESPP through open market purchases. 1994 Incentive Plans > The 1994 Management Replacement Plan (the "Replacement Plan") provided awards similar to the American Express common shares granted to Company employees which were canceled as of the date of the spin-off from American Express. Through November 30, 1997, a total of 2.0 million awards had been granted under the Replacement Plan, including both stock options and restricted stock; 0.6 million were outstanding at November 30, 1997. No future awards will be granted under this plan. The Lehman Brothers Holdings Inc. 1994 Management Ownership Plan (the "1994 Plan") provides for the issuance of RSUs, performance stock units ("PSUs"), stock options and other equity awards for a period of up to ten years to eligible employees. A total of 16.6 million shares of Common Stock may be granted under the 1994 Plan. At November 30, 1997, RSU and stock option awards with respect to 15.6 million shares of Common Stock have been made under the 1994 Plan of which 14.0 million are outstanding and 1.6 million have been converted to freely transferable Common Stock. The Company 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 the Company's non-employee directors. 1996 Management Ownership Plan > During 1996, the Company's stockholders approved the 1996 Management Ownership Plan (the "1996 Plan") under which awards similar to those of the 1994 Plan may be granted and under which up to 10 million shares of Common Stock may be subject to awards. At November 30, 1997, RSU and stock option awards with respect to 4.4 million shares of Common Stock have been made under the 1996 Plan, of which 4.3 million are outstanding and 0.1 million have been converted to freely transferable Common Stock. Employee Incentive Plan > The Employee Incentive Plan ("EIP") has provisions similar to the 1994 Plan and the 1996 Plan and authorization for up to 30 million shares of Common Stock which may be subject to awards. The Company controls the dilutive impact of these awards through open market purchases. At November 30, 1997, awards with respect to 19.1 million shares of Common Stock have been made under the EIP of which 19.0 million are outstanding and 0.1 million have been converted to freely transferable Common Stock. Approximately 16.0 million of the outstanding awards consist of RSUs which have vesting and transfer restrictions extending through the year 2004. LEHMAN BROTHERS 1997 ANNUAL REPORT 77 17 The following is a summary of RSUs outstanding under Holdings' stock-based incentive plans:
======================================================================================================================== RESTRICTED STOCK UNITS - ------------------------------------------------------------------------------------------------------------------------ 1994 1996 PLAN PLAN EIP TOTAL ======================================================================================================================== Balance, November 30, 1994 4,605,105 4,605,105 - ------------------------------------------------------------------------------------------------------------------------ Granted 8,021,784 2,039,220 10,061,004 Canceled (586,092) (586,092) - ------------------------------------------------------------------------------------------------------------------------ Balance, November 30, 1995 12,040,797 2,039,220 14,080,017 - ------------------------------------------------------------------------------------------------------------------------ Granted 419,614 7,130,720 7,550,334 Canceled (801,614) (405,575) (1,207,189) Exchanged for stock without restrictions (474,222) (474,222) - ------------------------------------------------------------------------------------------------------------------------ Balance, November 30, 1996 11,184,575 8,764,365 19,948,940 - ------------------------------------------------------------------------------------------------------------------------ Granted 1,814,685 1,332,250 8,810,609 11,957,544 Canceled (846,191) (1,530,562) (2,376,753) Exchanged for stock without restrictions (254,894) (139,371) (55,825) (450,090) - ------------------------------------------------------------------------------------------------------------------------ Balance, November 30, 1997 11,898,175 1,192,879 15,988,587 29,079,641 - ------------------------------------------------------------------------------------------------------------------------
Eligible employees receive RSUs as a portion of their total compensation in lieu of cash. There is no further cost to employees associated with the RSU awards. The Company records compensation expense for RSUs based on the market value of its Common Stock and the applicable vesting provisions. RSU awards made to employees have various vesting provisions and generally convert to unrestricted freely transferable Common Stock five years from the grant date. Holdings pays a dividend equivalent on each RSU outstanding based on dividends paid on its Common Stock. Of the RSUs outstanding at November 30, 1997, approximately 13.8 million RSUs were vested, approximately 1.4 million RSUs will vest during fiscal 1998, and the remaining RSUs will vest subsequent to November 30, 1998. Total compensation cost recognized during 1997 and 1996 for the Company's stock-based awards was approximately $162 million and $136 million, respectively. In addition to the RSUs included in the above table, as of December 31,1997, the Company has awarded PSUs under the 1996 Plan and under the EIP to certain senior officers. The number of PSUs which may be earned is dependent upon the achievement of certain performance levels within predetermined performance periods. At the end of a performance period, any PSUs earned will convert one-for-one to RSUs which then vest in three, four or five years. As of December 31,1997, approximately 1.7 million PSUs have been earned to date, subject to vesting and transfer restrictions. The compensation cost for the RSUs payable in satisfaction of PSUs is accrued over the combined performance and vesting periods. LEHMAN BROTHERS 1997 ANNUAL REPORT 78 18 ================================================================================ STOCK OPTIONS - --------------------------------------------------------------------------------
WEIGHTED- AVERAGE 1994 REPLACEMENT 1996 EXERCISE EXPIRATION PLAN PLAN PLAN EIP TOTAL PRICE DATES ========================================================================================================================= Balance, November 30, 1994 1,960,720 1,789,769 3,750,489 $ 18.00 2/95-5/04 - ------------------------------------------------------------------------------------------------------------------------- Granted 1,125,000 1,400,000 2,525,000 $ 20.875 10/00 Exercised (68,996) (68,996) $ 18.00 Canceled (7,040) (291,588) (298,628) $ 18.00 - ------------------------------------------------------------------------------------------------------------------------- Balance, November 30, 1995 3,078,680 1,429,185 1,400,000 5,907,865 $ 18.68 5/96-5/04 - ------------------------------------------------------------------------------------------------------------------------- Granted 825,000 2,650,000 3,475,000 $ 24.16 3/01-5/01 Exercised (93,333) (251,909) (345,242) $ 18.00 Canceled (116,667) (22,247) (850,000) (988,914) $ 22.83 - ------------------------------------------------------------------------------------------------------------------------- Balance, November 30, 1996 2,868,680 1,155,029 825,000 3,200,000 8,048,709 $ 20.58 2/97-5/04 - ------------------------------------------------------------------------------------------------------------------------- Granted 2,250,000 2,250,000 $ 30.52 1/02-3/02 Exercised (743,040) (521,192) (1,264,232) $ 18.85 Canceled (4,943) (150,000) (154,943) $ 23.81 - ------------------------------------------------------------------------------------------------------------------------- Balance, November 30, 1997 2,125,640 628,894 3,075,000 3,050,000 8,879,534 $ 23.64 1/98-5/04 - -------------------------------------------------------------------------------------------------------------------------
At November 30, 1997 and 1996, approximately 8.9 million and 2.6 million stock options, respectively, were exercisable at weighted-average prices of $23.64 and $18.00, respectively. The weighted average remaining contractual life of the stock options outstanding at November 30, 1997 is 3.3 years. The exercise price for all stock options awarded has been equal to 100% of the market price of Common Stock on the day of grant. As a result of Holdings' stock price exceeding specific target prices, all stock options outstanding as of November 30, 1997 are exercisable. In October 1995, the Financial Accounting Standards Board issued SFAS No. 123, "Accounting for Stock-Based Compensation" ("SFAS No. 123"). SFAS No. 123 establishes financial accounting and reporting standards for stock-based employee compensation plans. The financial accounting standards of SFAS No. 123 permit companies to either continue accounting for stock-based compensation under existing rules or adopt SFAS No. 123 and begin reflecting the fair value of stock options and other forms of stock-based compensation in the results of operations as additional expense. The disclosure requirements of SFAS No. 123 require companies which elect not to record the fair value in the Consolidated Statement of Income to provide pro forma disclosures of net income and earnings per share in the notes to the consolidated financial statements as if the fair value of stock-based compensation had been recorded. The Company will continue to follow Accounting Principles Board No. 25 and its related interpretations in accounting for its stock-based compensation plans. Accordingly, no compensation cost has been recognized in the Consolidated Statement of Income for its stock option awards and employee stock purchase plan. The Company utilized the Black-Scholes option-pricing model to quantify the pro forma effects on net income and earnings per common share of the fair value of the stock options granted during 1997 and 1996. Based on the results of the model, the fair value of the stock options granted was $7.14 and $5.41 for 1997 and 1996, respectively. The weighted average assumptions which were used for 1997 and 1996 included risk-free interest rates of 6.14% and 5.35%, respectively, an expected life of 3 years for both years and expected volatility of 29% for both years. In addition, annual dividends of $0.24 (increasing 10% per year beginning in 1998) and $0.20 were assumed for the 1997 and 1996 options, respectively. LEHMAN BROTHERS 1997 ANNUAL REPORT 79 19 The Company's 1997 and 1996 pro forma net income would have been $629 million and $413 million, respectively, compared to actual net income of $647 million and $416 million, respectively. Pro forma earnings per common share for 1997 and 1996 would have been $4.57 and $3.22, respectively compared to actual earnings per common share of $4.72 and $3.24, respectively. The pro forma amounts reflect the effects of the 1997 and 1996 stock option grants and the 15% purchase discount from market value offered to the Company's employees who participate in the ESPP. The pro forma effect in 1997 increased compared to 1996 due to all stock options becoming exercisable in 1997. ================================================================================ note 7 EARNINGS PER COMMON SHARE - -------------------------------------------------------------------------------- The weighted average number of shares of common stock and common stock equivalents included in the calculations of earnings per common share is as follows:
TWELVE MONTHS ENDED NOVEMBER 30 ------------------------------------------------ 1997 1996 1995 ================================================================================ Common stock 105,193,272 101,548,947 104,535,218 Common stock issuable 13,812,029 13,779,315 8,420,122 Other share equivalents 2,059,628 1,045,323 459,344 - -------------------------------------------------------------------------------- Total 121,064,929 116,373,585 113,414,684 - --------------------------------------------------------------------------------
In February 1997, the Financial Accounting Standards Board ("FASB") issued SFAS No. 128, "Earnings Per Share," which is effective for annual and interim financial statements issued for periods ending after December 15, 1997. SFAS No. 128 was issued to simplify the standards for calculating earnings per share ("EPS") previously found in APB No. 15, "Earnings Per Share." SFAS No. 128 replaces the presentation of primary EPS with a presentation of basic EPS. The new rules also require dual presentation of basic and diluted EPS on the face of the statement of income for companies with a complex capital structure. For the Company, basic EPS will exclude the dilutive effects of stock options and certain non-vested RSUs. Diluted EPS for the Company will reflect all potential dilutive securities (similar to fully diluted EPS under APB No. 15). Under the provisions of SFAS No. 128, basic EPS would have been $0.37, $0.26 and $0.06 higher than the amounts reported for 1997, 1996 and 1995, respectively. Diluted EPS would have been the same as the reported amounts. ================================================================================ note 8 CAPITAL REQUIREMENTS - -------------------------------------------------------------------------------- The Company operates globally through a network of subsidiaries with several subject to regulatory requirements. In the United States, 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, 1997, LBI's regulatory net capital, as defined, of $1,484 million exceeded the minimum requirement by $1,359 million. In addition to amounts presented in the accompanying Consolidated Statement of Financial Condition as cash and securities segregated and on deposit for regulatory and other purposes, securities with a market value of approximately $1,290 million and $345 million at November 30, 1997 and 1996, respectively, primarily collateralizing securities purchased under agreements to resell, have been segregated in a special reserve bank account for the exclusive benefit of customers pursuant to the Reserve Formula requirements of SEC Rule 15c3-3. LEHMAN BROTHERS 1997 ANNUAL REPORT 80 20 Lehman Brothers International (Europe) ("LBIE"), a United Kingdom registered broker-dealer and subsidiary of Holdings, is subject to the capital requirements of the Securities and Futures Authority ("SFA") of the United Kingdom. Financial resources, as defined, must exceed the total financial resources requirement of the SFA. At November 30, 1997, LBIE's financial resources of approximately $2.3 billion exceeded the minimum requirement by approximately $500 million. Lehman Brothers Japan Inc.'s Tokyo branch, a regulated broker-dealer, is subject to the capital requirements of the Japanese Ministry of Finance and at November 30, 1997, had net capital of approximately $400 million which was approximately $100 million in excess of the specified levels required. Certain other non-U.S. subsidiaries are subject to various securities, commodities and banking regulations and capital adequacy requirements promulgated by the regulatory and exchange authorities of the countries in which they operate. At November 30, 1997, these other subsidiaries were in compliance with their applicable local capital adequacy requirements. The Company's "AAA" rated derivatives subsidiary, Lehman Brothers Financial Products Inc. ("LBFP"), has established certain capital and operating restrictions which are reviewed by various rating agencies. At November 30, 1997, LBFP had capital which exceeded the requirement of the most stringent rating agency by approximately $100 million. The regulatory rules referred to above, and certain covenants contained in various debt agreements may restrict Holdings' ability to withdraw capital from its regulated subsidiaries, which in turn could limit its ability to pay dividends to shareholders. At November 30, 1997, approximately $2.9 billion of net assets of subsidiaries were restricted as to the payment of dividends to Holdings. ================================================================================ note 9 EMPLOYEE BENEFIT PLANS - -------------------------------------------------------------------------------- The Company provides various pension plans for the majority of its employees worldwide. In addition, the Company provides certain other postretirement benefits, primarily health care and life insurance to eligible employees. The following summarizes these plans: Pension Plans > The Company sponsors several noncontributory defined benefit pension plans which cover substantially all employees. The cost of pension benefits for eligible employees, measured by length of service, compensation and other factors, is currently being funded through trusts established under the plans. Funding of retirement costs for the applicable plans complies with the minimum funding requirements specified by the Employee Retirement Income Security Act of 1974, as amended, and other statutory requirements. Net (income) expense related to pension benefits for 1997, 1996 and 1995 consisted of the following components:
TWELVE MONTHS ENDED NOVEMBER 30 ------------------------------- (in millions) 1997 1996 1995 ================================================================================ Service cost--benefits earned during the period $ 22 $ 18 $ 13 Interest cost on projected benefit obligation 36 34 31 Actual return on plan assets (91) (101) (77) Net amortization and deferral 27 47 36 - -------------------------------------------------------------------------------- Net (income) expense $ (6) $ (2) $ 3 - --------------------------------------------------------------------------------
Plan assets within the trusts consist principally of equities and bonds. The actual return on plan assets for 1997, 1996 and 1995 reflects the favorable market environments in those years. In addition, Company contributions increased assets under investment in 1997, 1996 and 1995. LEHMAN BROTHERS 1997 ANNUAL REPORT 81 21 The following table sets forth the funded status of the Company's defined benefit plans:
NOVEMBER 30 ------------------ (in millions) 1997 1996 ================================================================================ Actuarial present value of benefit obligations Vested benefit obligation $(526) $(452) - -------------------------------------------------------------------------------- Accumulated benefit obligation $(530) $(456) - -------------------------------------------------------------------------------- Projected benefit obligation $(560) $(480) Plan assets at fair value 747 667 - -------------------------------------------------------------------------------- Plan assets in excess of projected benefit obligation 187 187 Unrecognized net loss 39 20 - -------------------------------------------------------------------------------- Prepaid pension asset recognized in the Consolidated Statement of Financial Condition $226 $207 - --------------------------------------------------------------------------------
The weighted average assumed discount rate used in determining the actuarial present value of the projected benefit obligation for the Company's plans was 7.2% and 7.5% in 1997 and 1996, respectively. The weighted average rate of increase in future compensation levels used was 5.1% and 5.0% for 1997 and 1996, respectively. The weighted average expected long-term rate of return on assets was 9.3% in 1997, 9.5% in 1996 and 9.75% in 1995. Postretirement Benefits > The Company sponsors several defined benefit health care plans that provide health care, life insurance and other postretirement benefits to substantially all eligible retired employees. The health care plans include participant contributions, deductibles, co-insurance provisions and service-related eligibility requirements. The Company funds the cost of these benefits as they are incurred. Net periodic postretirement benefits cost for 1997, 1996 and 1995 consisted of the following components:
TWELVE MONTHS ENDED NOVEMBER 30 ------------------------------- (in millions) 1997 1996 1995 ================================================================================ Service cost $ 1 $ 1 $ 1 Interest cost 3 3 4 Amortization of unrecognized net reduction in prior service cost and unrecognized gain (2) (1) (1) - -------------------------------------------------------------------------------- Net periodic postretirement benefits cost $ 2 $ 3 $ 4 - --------------------------------------------------------------------------------
The following table sets forth the amount recognized in the Consolidated Statement of Financial Condition for the Company's postretirement benefit plans (other than pension plans):
NOVEMBER 30 ------------------ (in millions) 1997 1996 ================================================================================ Accumulated postretirement benefit obligation Retirees $36 $36 Fully eligible active plan participants 3 3 Other active plan participants 10 10 - -------------------------------------------------------------------------------- 49 49 - -------------------------------------------------------------------------------- Unrecognized net gain 22 21 Unrecognized net reduction in prior service cost 7 8 - -------------------------------------------------------------------------------- Accrued postretirement liability recognized in the Consolidated Statement of Financial Condition $78 $78 - --------------------------------------------------------------------------------
LEHMAN BROTHERS 1997 ANNUAL REPORT 82 22 The discount rate used in determining the accumulated postretirement benefit obligation was 7.0% and 7.5% in 1997 and 1996, respectively. The annual assumed health care cost trend rate is 8.5% for the year ended November 30, 1998 and is assumed to decrease at the rate of 0.5% per year to 5.5% in the year ended November 30, 2004 and remain at that level thereafter. An increase in the assumed health care cost trend rate by one percentage point in each period would increase the accumulated postretirement benefit obligation as of November 30, 1997 by approximately $5 million. ================================================================================ note 10 INCOME TAXES - -------------------------------------------------------------------------------- The Company files a consolidated U.S. federal income tax return reflecting the income of Holdings and its subsidiaries. The provision for income taxes consists of the following:
TWELVE MONTHS ENDED NOVEMBER 30 ------------------------------- (in millions) 1997 1996 1995 ================================================================================ Current Federal $110 $(20) $170 State 58 36 80 Foreign 182 133 72 - -------------------------------------------------------------------------------- 350 149 322 - -------------------------------------------------------------------------------- Deferred Federal (6) 61 (144) State (4) 11 (51) Foreign (50) - -------------------------------------------------------------------------------- $290 $221 $127 - --------------------------------------------------------------------------------
Income before taxes included $121 million, $335 million and $173 million that is subject to income taxes of foreign jurisdictions for 1997, 1996 and 1995, respectively The income tax provision (benefit) differs from that computed by using the statutory federal income tax rate for the reasons shown below:
TWELVE MONTHS ENDED NOVEMBER 30 ------------------------------- (in millions) 1997 1996 1995 ================================================================================ Federal income taxes at statutory rate $328 $223 $129 State and local taxes 35 31 18 Tax-exempt income (60) (24) (31) Amortization of goodwill 3 3 2 Foreign operations (3) (26) (1) Other, net (13) 14 10 - -------------------------------------------------------------------------------- $290 $221 $127 - --------------------------------------------------------------------------------
Deferred income taxes are provided for the differences between the tax bases of assets and liabilities and their reported amounts in the consolidated financial statements. These temporary differences will result in future income or deductions for income tax purposes and are measured using the enacted tax rates that will be in effect when such items are expected to reverse. The Company provides deferred income taxes on undistributed earnings of foreign subsidiaries. LEHMAN BROTHERS 1997 ANNUAL REPORT 83 23 At November 30, 1997 and 1996 the deferred tax assets and liabilities consisted of the following:
NOVEMBER 30 ------------------- (in millions) 1997 1996 ============================================================================================== Deferred tax assets Reserves not currently deductible $185 $245 Deferred compensation 325 258 Tax return NOLs 15 66 Other 10 26 - ---------------------------------------------------------------------------------------------- 535 595 Less: Valuation allowance 43 83 - ---------------------------------------------------------------------------------------------- Total deferred tax assets net of valuation allowance $492 $512 - ---------------------------------------------------------------------------------------------- Deferred tax liabilities Undistributed earnings of foreign subsidiaries (net of credits) $ 7 $ 23 Excess tax over financial depreciation 112 102 Unrealized trading and investment activity 8 88 Pension and retirement costs 46 41 Other 4 4 - ---------------------------------------------------------------------------------------------- Total deferred tax liabilities $177 $258 - ---------------------------------------------------------------------------------------------- Net deferred tax asset $315 $254 - ----------------------------------------------------------------------------------------------
The net deferred tax assets are included in Other assets in the accompanying Consolidated Statement of Financial Condition. At November 30, 1997, the valuation allowance recorded against deferred tax assets was $43 million compared to $83 million at November 30, 1996, of which approximately $27 million and $51 million, respectively, will reduce goodwill if future circumstances permit recognition. The Company's Consolidated Statement of Income includes a $10 million 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 asset. For tax return purposes, the Company has approximately $44 million of NOL carryforwards, substantially all of which are attributable to the 1988 acquisition of EF Hutton Group, Inc. (now known as LB I Group Inc.). Substantially all of the NOLs are scheduled to expire in the years 1999 through 2009. ================================================================================ note 11 DERIVATIVE FINANCIAL INSTRUMENTS - -------------------------------------------------------------------------------- Derivatives are financial instruments whose value is based upon an underlying asset (e.g., treasury bond), index (e.g., S&P 500) or reference rate (e.g., LIBOR). Over-the-counter ("OTC") derivative products are privately negotiated contractual agreements that can be tailored to meet individual client needs and include forwards, swaps and certain options including caps, collars and floors. Exchange-traded derivative products are standardized contracts transacted through regulated exchanges and include futures and certain option contracts listed on an exchange. In the normal course of business, the Company enters into derivative transactions both in a trading capacity and as an end user. Acting in a trading capacity, the Company enters into derivative transactions to satisfy the needs of its clients and to manage the Company's own exposure to market and credit risk resulting from its trading activities in cash instruments (collectively, "Trading-Related Derivative Activities"). As an end user, the Company primarily enters into interest rate swap and option contracts to adjust the interest rate nature of its funding sources from fixed to floating rates and vice versa, and to change the index upon which floating interest rates are based (e.g., Prime to LIBOR) (collectively, "End User Derivative Activities"). LEHMAN BROTHERS 1997 ANNUAL REPORT 84 24 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 (i.e., Party A pays 3 times the six month LIBOR). Caps are contractual commitments that require the writer to pay the purchaser the amount by which an interest reference rate exceeds a defined contractual rate, if any, at specified times during the contract. Conversely, a floor is a contractual commitment that requires the writer to pay the amount by which a defined contractual rate exceeds an interest reference rate at specified times over the life of the contract, if any. 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. Options > Option contracts provide the option purchaser (holder) with the right but not the obligation to buy or sell a financial instrument, commodity or currency at a predetermined exercise price (strike price) during a defined period (American Option) or at a specified date (European Option). The option purchaser pays a premium to the option seller (writer) for the right to exercise the option. The option seller is obligated to buy (call) or sell (put) the item underlying the contract at a set price, if the option purchaser chooses to exercise. Option contracts also exist for various indices and are similar to options on a security or other instrument except that, rather than settling physical with delivery of the underlying instrument, they are cash settled. As a purchaser of an option contract, the Company is subject to credit risk, since the counterparty is obligated to make payments under the terms of the option contract, if the Company exercises the option. As the writer of an option contract, the Company is not subject to credit risk but is subject to market risk, since the Company is obligated to make payments under the terms of the option contract if exercised. Option contracts may be exchange-traded or OTC. Exchange-traded options are the obligations of the exchange and generally have standardized terms and performance mechanics. In contrast, all of the terms of an OTC option including the method of settlement, term, strike price, premium and security are determined by negotiation of the parties. Futures and Forwards > Futures contracts are exchange-traded contractual commitments to either receive (purchase) or deliver (sell) a standard amount or value of a financial instrument or commodity at a specified future date and price. Maintaining a futures contract requires the Company to deposit with the exchange an amount of cash or other specified asset as security for its obligation. Additionally, futures exchanges generally require the daily cash settlement of unrealized gains/losses on open contracts with the futures exchange. Therefore, futures contracts provide a reduced funding alternative to purchasing the underlying cash position in the marketplace. Futures contracts may be settled by physical delivery of the underlying asset or cash settlement (for index futures) on the settlement date or by entering into an offsetting futures contract with the futures exchange prior to the settlement date. LEHMAN BROTHERS 1997 ANNUAL REPORT 85 25 Forwards are OTC contractual commitments to purchase or sell a specified amount of a financial instrument, foreign currency or commodity at a future date at a predetermined price. TBAs are forward contracts which give the purchaser/seller an obligation to obtain/deliver mortgage securities in the future. Therefore, TBAs subject the holder to both interest rate risk and principal prepayment risk. Trading-Related Derivative Activities > Derivatives are subject to various risks similar to other financial instruments including market, credit and operational risk. In addition, the Company may also be exposed to legal risks related to its derivative activities including the possibility that a transaction may be unenforceable under applicable law. The risks of derivatives should not be viewed in isolation, but rather should be considered on an aggregate basis along with the Company's other trading-related activities. The Company manages the risks associated with derivatives on an aggregate basis along with the risks associated with its proprietary trading and market-making activities in cash instruments as part of its firmwide risk management policies. Derivatives are generally based upon notional values. Notional values are not recorded on-balance sheet, but rather are utilized solely as a basis for determining future cash flows to be exchanged. Therefore, notional amounts provide a measure of the Company's involvement with such instruments, but are not indicative of actual or potential risk. The following table reflects the notional/contract value of the Company's Trading-Related Derivative Activities:
========================================================================================== TRADING-RELATED DERIVATIVE FINANCIAL INSTRUMENTS - ------------------------------------------------------------------------------------------ 1997 NOTIONAL/CONTRACT VALUE WEIGHTED ------------------------- AVERAGE NOVEMBER 30 NOVEMBER 30 MATURITY (in millions) 1997 1996 (IN YEARS) ========================================================================================== Interest rate and currency swaps and options (including caps, collars and floors) $ 961,762 $ 686,932 4.53 Foreign exchange forward and future contracts and options 478,899 378,314 .40 Other fixed income securities contracts (including futures contracts and options), mortgage-backed securities forward contracts and options 364,009 374,048 .91 Equity contracts (including equity swaps, futures, warrants and options) 40,522 30,582 .94 Commodity contracts (including swaps, futures, forwards and options) 10,292 46,946 .78 - ------------------------------------------------------------------------------------------ Total $1,855,484 $1,516,822 2.65 - ------------------------------------------------------------------------------------------
Of the total notional value at November 30, 1997 and 1996, approximately $1,615 billion and $1,186 billion are over-the-counter and $240 billion and $331 billion are exchange-traded, respectively. The total weighted average maturity at November 30, 1997, for over-the-counter and exchange-traded contracts was 2.93 years and 0.77 years, respectively. Approximately $952 billion of the notional/contract value of the Company's Trading-Related Derivative Activities mature within the year ended November 30, 1998, of which approximately 34% 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 and against cash collateral when such provisions are stated in the master netting agreement. While the Company may utilize deriv- LEHMAN BROTHERS 1997 ANNUAL REPORT 86 26 ative products in all its businesses, the Company views its derivative product revenues as the revenues earned from the Company's fixed income and equity derivative products businesses and foreign exchange and commodity derivatives. Principal transactions and net interest revenues related to the Company's fixed income derivative products business were $362 million for 1997, $541 million for 1996 and $409 million for 1995. Principal transactions and net interest (loss) revenues related to the Company's equity derivative products business were $(41) million for 1997, $116 million for 1996 and $65 million for 1995. The losses in equity derivatives were attributable to the volatility in the Asian markets during the latter portion of fiscal 1997. Principal transactions and net interest revenues related to foreign exchange and commodity derivatives were $92 million for 1997, $147 million for 1996 and $72 million for 1995. Listed in the following table is the fair value of the Company's Trading-Related Derivative Activities as of November 30, 1997 and 1996 as well as the average fair value of these instruments. Average fair values of these instruments were calculated based upon month-end statement of financial condition values, which the Company believes does not vary significantly from the average fair value calculated on a more frequent basis. Variances between average fair values and period-end values are due to changes in the volume of activities in these instruments and changes in the valuation of these instruments due to variations in market and credit conditions.
================================================================================================== FAIR VALUE OF TRADING-RELATED DERIVATIVE FINANCIAL INSTRUMENTS AVERAGE FAIR VALUE* FAIR VALUE* TWELVE MONTHS ENDED NOVEMBER 30, 1997 NOVEMBER 30, 1997 -------------------- -------------------- (in millions) ASSETS LIABILITIES ASSETS LIABILITIES ================================================================================================== Interest rate and currency swaps and options (including caps, collars and floors) $4,704 $3,303 $4,306 $3,224 Foreign exchange forward contracts and options 1,840 1,885 1,236 1,532 Options on other fixed income securities, mortgage-backed securities forward contracts and options 310 297 275 246 Equity contracts (including equity swaps, warrants and options) 1,304 1,696 2,134 1,681 Commodity contracts (including swaps, forwards and options) 195 186 304 465 - -------------------------------------------------------------------------------------------------- Total $8,353 $7,367 $8,255 $7,148 - --------------------------------------------------------------------------------------------------
AVERAGE FAIR VALUE* FAIR VALUE* TWELVE MONTHS ENDED NOVEMBER 30, 1996 NOVEMBER 30, 1996 -------------------- -------------------- (in millions) ASSETS LIABILITIES ASSETS LIABILITIES ================================================================================================== Interest rate and currency swaps and options (including caps, collars and floors) $4,008 $3,185 $3,446 $1,945 Foreign exchange forward contracts and options 970 1,206 903 1,200 Options on other fixed income securities, mortgage-backed securities forward contracts and options 226 286 239 238 Equity contracts (including equity swaps, warrants and options) 1,167 1,304 1,118 1,076 Commodity contracts (including swaps, forwards and options) 538 835 451 587 - -------------------------------------------------------------------------------------------------- Total $6,909 $6,816 $6,157 $5,046 - --------------------------------------------------------------------------------------------------
* Amounts represent carrying value (exclusive of collateral) and do not include receivables or payables related to exchange-traded futures contracts. LEHMAN BROTHERS 1997 ANNUAL REPORT 87 27 Assets included in the preceding table represent the Company's unrealized gains, net of unrealized losses for situations in which the Company has a master netting agreement. Similarly, liabilities represent net amounts owed to counterparties. Therefore, the fair value of assets/liabilities related to derivative contracts at November 30, 1997 represents the Company's net receivable/payable for derivative financial instruments before consideration of collateral. Included within the $8,353 million fair value of assets at November 30,1997 was $8,016 million related to swaps and OTC contracts and $337 million related to exchange-traded option and warrant contracts. Included within the $6,909 million fair value of assets at November 30, 1996 was $6,537 million related to swaps and OTC contracts and $372 million related to exchange-traded option and warrant contracts. The primary difference in risks related to OTC and exchange-traded contracts is credit risk. OTC contracts contain credit risk for unrealized gains from various counterparties for the duration of the contract, net of collateral. With respect to OTC contracts, including swaps, the Company views its net credit exposure to be $5,252 million at November 30, 1997, representing the fair value of the Company's OTC contracts in an unrealized gain position, after consideration of collateral of $2,764 million. Counterparties to the Company's OTC derivative products are primarily financial intermediaries (U.S. and foreign banks), securities firms, corporations, governments and their agencies, finance companies, insurance companies, investment companies and pension funds. Collateral held related to OTC contracts generally includes cash and U.S. government and federal agency securities. Presented below is an analysis of the Company's net credit exposure at November 30, 1997 for OTC contracts based upon internal designations of counterparty credit quality.
COUNTERPARTY S&P/MOODY'S NET CREDIT RISK RATING EQUIVALENT EXPOSURE ================================================================================ 1 AAA/Aaa 18% 2 AA-/Aa3 or higher 19% 3 A-/A3 or higher 40% 4 BBB-/Baa3 or higher 12% 5 BB-/Ba3 or higher 7% 6 B+/B1 or lower 4% - --------------------------------------------------------------------------------
These designations are based on actual ratings made by external rating agencies or by equivalent ratings established and utilized by the Company's Corporate Credit Department. The Company is also subject to credit risk related to its exchange-traded derivative contracts. Exchange-traded contracts, including futures and certain options, are transacted directly on the exchange. To protect against the potential for a default, all exchange clearing houses impose net capital requirements for their membership. Additionally, the exchange clearing house requires counterparties to futures contracts to post margin upon the origination of the contract and for any changes in the market value of the contract on a daily basis (certain foreign exchanges provide for settlement within three days). Therefore, the potential for losses from exchange-traded products is limited. End User Derivative Activities > The Company utilizes a variety of derivative products as an end user to modify the interest rate characteristics of its long-term debt portfolio. The Company actively manages the interest rate exposure on its long-term debt portfolio to more closely match the terms of its debt portfolio to the assets being funded and to minimize interest rate risk. At November 30, 1997 and 1996, the notional value of the Company's end user activities related to its long-term debt obligations was approximately $17.3 billion and $15.1 billion, respectively. (For a further discussion of the Company's long-term debt related end user derivative activities see Note 3.) LEHMAN BROTHERS 1997 ANNUAL REPORT 88 28 The Company also utilizes derivative products as an end user to modify its interest rate exposure associated with its secured financing activities, including securities purchased under agreements to resell, securities borrowed, securities sold under agreements to repurchase and securities loaned. At November 30, 1997 and 1996, the Company had $129 billion and $115 billion, respectively, of such secured financing activities. As with the Company's long-term debt, its secured financing activities expose the Company to interest rate risk. The Company, as an end user, manages the interest rate risk related to these activities by utilizing derivative financial instruments, including interest rate swaps and purchased options. The Company designates certain specific derivative transactions against specific assets and liabilities with matching maturities. In addition, the Company manages the interest rate risk of anticipated secured financing transactions with derivative products. These derivative products are designated against the existing secured financing transactions for their applicable maturity. The remaining term of these transactions is designated against the anticipated secured financing transactions which will replace the existing secured financing transactions at their maturity. The Company monitors the level of secured financing transactions to ensure that there is a high degree of certainty that the Company will enter into the anticipated secured financing transactions at a level in excess of the designated derivative product transactions. At November 30, 1997 and 1996, the Company, as an end user, utilized derivative financial instruments with an aggregate notional amount of $38.7 billion and $47.6 billion, respectively, to modify the interest rate characteristics of its secured financing activities. The total notional value of these agreements had a weighted average maturity of 0.5 years as of November 30, 1997 and 1996. The Company terminated certain swaps designated as hedges of the Company's secured financing activities. At November 30, 1997, a loss of approximately $12 million from these terminated contracts was deferred and will be amortized to interest expense over the original period of the hedge. On an overall basis, the Company's secured financing end user derivative activities (decreased) increased net interest income by approximately $(10) million, $16 million and $39 million for 1997, 1996 and 1995, respectively. ================================================================================ note 12 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 is 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. LEHMAN BROTHERS 1997 ANNUAL REPORT 89 29 The unrecognized net gain (loss) related to the Company's end user derivative activities reflects the estimated amounts the Company would receive (pay) if the derivative financial instruments were terminated based on market rates at November 30, 1997 and 1996, respectively.
NOVEMBER 30 ------------------------ (in millions) 1997 1998 ================================================================================ Carrying value of long-term debt $20,261 $15,922 Fair value of long-term debt 20,688 16,415 - -------------------------------------------------------------------------------- Unrecognized net gain (loss) on long-term debt $ (427) $ (493) - -------------------------------------------------------------------------------- Unrecognized net gain (loss) on long-term debt end user activities $ 188 $ 153 - --------------------------------------------------------------------------------
The Company carries its secured financing activities, including securities purchased under agreements to resell, securities borrowed, securities sold under agreements to repurchase and securities loaned, at their original contract amount plus accrued interest, which for the majority of such financing activities is an approximation of fair value. At November 30, 1997 and 1996, the Company had $129 billion and $115 billion, respectively, of such secured financing activities. As with the Company's long-term debt, its secured financing activities expose the Company to interest rate risk. At November 30, 1997 and 1996, the Company, as an end user, utilized derivative financial instruments with an aggregate notional amount of $38.7 billion and $47.6 billion, respectively, to modify the interest rate characteristics of its secured financing activities. The unrecognized net losses related to these derivative financial instruments were $6 million and $10 million at November 30, 1997 and 1996, respectively. ================================================================================ note 13 OTHER COMMITMENTS AND CONTINGENCIES - -------------------------------------------------------------------------------- As of November 30, 1997 and 1996, the Company was contingently liable for $4.2 billion and $3.0 billion, respectively, of letters of credit, primarily used to provide collateral for securities and commodities borrowed and to satisfy margin deposits at option and commodity exchanges and other guarantees. As of November 30, 1997 and 1996, in connection with its financing activities, the Company had outstanding commitments under certain lending arrangements of approximately $2.4 billion and $2.1 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, 1997 and 1996, the Company had pledged or otherwise transferred securities, primarily fixed income, having a market value of approximately $49.9 billion and $37.2 billion, respectively, as collateral for securities borrowed or otherwise received having a market value of approximately $49.3 billion and $36.9 billion, respectively. Securities and other financial instruments sold but not yet purchased represent obligations of the Company to purchase the securities at prevailing market prices. Therefore, the future satisfaction of such obligations may be for an amount greater LEHMAN BROTHERS 1997 ANNUAL REPORT 90 30 or less than the amount recorded. The ultimate gain or loss is dependent upon the price at which the underlying financial instrument is purchased to settle its obligation under the sale commitment. In the normal course of business, the Company is exposed to off-balance sheet credit and market risk as a result of executing, financing and settling various customer security and commodity transactions. Off-balance sheet risk arises from the potential that customers or counterparties fail to satisfy their obligations and that the collateral obtained is insufficient. In such instances, the Company may be required to purchase or sell financial instruments at unfavorable market prices. The Company seeks to control these risks by obtaining margin balances and other collateral in accordance with regulatory and internal guidelines. The Company, through its high yield sales and trading activities, makes commitments to extend credit in loan syndication transactions principally to below investment grade borrowers and participates a significant portion of these commitments. These commitments, which totaled $1.4 billion at November 30, 1997, are typically secured against the borrower's assets and have fixed maturity dates. The draw down of these facilities is generally contingent upon certain representations, warranties and contractual conditions of the borrower. The total commitments may not be indicative of actual funding requirements as they may expire without being drawn upon and the Company may participate additional amounts in the normal course of its business. The Company has commitments to invest up to $498 million in partnerships, which in turn will make direct merchant banking related investments. These commitments will be funded as required through the end of the respective partnerships' investment periods, principally expiring in 2004. The Company is also a sponsor of a fund to provide interim acquisition facilities. In connection therewith, the Company may provide up to $150 million to be used by the fund to provide short-term acquisition financing. Any draw downs under the facility are expected to be repaid within a short-term period. Subsidiaries of the Company, as general partner, are contingently liable for the obligations of certain public and private limited partnerships organized as pooled investment funds or engaged primarily in real estate activities. In the opinion of the Company, contingent liabilities, if any, for the obligations of such partnerships will not in the aggregate have a material adverse effect on the Company's consolidated financial position or results of operations. In the normal course of its business, the Company has been named a defendant in a number of lawsuits and other legal proceedings. After considering all relevant facts, available insurance coverage and the advice of outside counsel, in the opinion of the Company such litigation will not, in the aggregate, have a material adverse effect on the Company's consolidated financial position or results of operations. Concentrations of Credit Risk > As one of the leading global investment banks, 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. LEHMAN BROTHERS 1997 ANNUAL REPORT 91 31 A substantial portion of the Company's securities and commodities transactions is collateralized and is executed with, and on behalf of, commercial banks and other institutional investors, including other brokers and dealers. The Company's exposure to credit risk associated with the non-performance of these customers and counterparties in fulfilling their contractua1 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 (principally Germany and Japan) which, in the aggregate, represented 22% of the Company's total assets at November 30, 1997. In addition, primarily all of the collateral held by the Company for resale agreements or securities borrowed, which together represented 38% of total assets at November 30, 1997, consisted of securities issued by the U.S. government, federal agencies or non-U.S. governments. In addition to these specific exposures, the Company's most significant concentration is financial institutions, which include other brokers and dealers, commercial banks and institutional clients. This concentration arises in the normal course of the Company's business. Lease Commitments > The Company leases office space and equipment throughout the world and is a party to a ground lease with the Battery Park City Authority covering its headquarters at 3 World Financial Center which extends through 2069. Total rent expense for 1997, 1996 and 1995 was $42 million, $48 million and $67 million, respectively. Certain leases on office space contain escalation clauses providing for additional rentals based upon maintenance, utility and tax increases. Minimum future rental commitments under noncancellable operating leases (net of subleases of $182 million) are as follows:
(in millions) ================================================================================ Fiscal 1998 $ 36 Fiscal 1999 33 Fiscal 2000 31 Fiscal 2001 32 Fiscal 2002 32 December 1, 2002 and thereafter 463 - -------------------------------------------------------------------------------- $627 - --------------------------------------------------------------------------------
================================================================================ note 14 INTERNATIONAL OPERATIONS - -------------------------------------------------------------------------------- Although the Company's business activities are highly integrated and constitute a single industry segment for the purposes of SFAS No. 14, "Financial Reporting for Segments of a Business Enterprise," they can be broadly categorized into the three major geographic areas in which it conducts operations: the Americas, Europe and Asia Pacific. The Company manages its businesses with the goal of maximizing worldwide profitability by product line. Activities such as the global distribution of underwritings and the twenty-four hour risk management of trading positions render geographic profitability to be highly subjective, since it is the result of numerous estimates and assumptions. The amounts presented below provide a broad indication of each region's contribution to the consolidated results. The method of allocation is as follows: Gross and Net Revenues, if syndicate or trading-related, have been distributed based upon the location where the primary or secondary position was fundamentally risk managed; if fee-related, by the location of the senior coverage banker, if commission-related, by the location of the salespeople. In addition, certain revenues associated with domes- LEHMAN BROTHERS 1997 ANNUAL REPORT 92 32 tic products and services which resulted from relationships with international clients and customers have been reclassified as international revenues using an allocation consistent with the Company's internal reporting. The expenses associated with these revenues have also been reclassified. Income (Loss) Before Taxes includes expenses associated with generating the revenues reflected in each region. Identifiable Assets represent essentially those recorded in the legal entities in which the Company does business within the respective region.
GROSS NET INCOME (LOSS) IDENTIFIABLE (in millions) REVENUES REVENUES BEFORE TAXES ASSETS ================================================================================================== Twelve months ended November 30, 1997 International operations: Europe $ 1,190 $ 812 $ 179 $ 37,571 Asia Pacific 330 282 (36) 7,875 - -------------------------------------------------------------------------------------------------- Total international 1,520 1,094 143 45,446 Americas(3) 15,363 2,779 794 106,259 - -------------------------------------------------------------------------------------------------- Total $16,883 $3,873 $ 937 $151,705 - -------------------------------------------------------------------------------------------------- Twelve months ended November 30, 1996 International operations: Europe $ 1,373 $ 972 $ 346 $ 25,553 Asia Pacific 559 413 100 6,829 - -------------------------------------------------------------------------------------------------- Total international 1,932 1,385 446 32,382 Americas(3) 12,328 2,059 191(2) 96,214 - -------------------------------------------------------------------------------------------------- Total $14,260 $3,444 $ 637 $128,596 - -------------------------------------------------------------------------------------------------- Twelve months ended November 30, 1995 International operations: Europe $ 1,067 $ 750 $ 127 $ 27,844 Asia Pacific 475 455 173 5,513 - -------------------------------------------------------------------------------------------------- Total international 1,542 1,205 300 33,357 Americas(3) 11,934(1) l,866(1) 69 81,946 - -------------------------------------------------------------------------------------------------- Total $13,476 $3,071 $ 369 $115,303 - --------------------------------------------------------------------------------------------------
(1) Includes $129 million resulting from the Company's sale of its stake in Omnitel. (2) Includes $84 million severance charge. (3) Includes non-U.S. revenues of $67 million, $42 million and $93 million in 1997, 1996 and 1995, respectively. ================================================================================ note 15 OTHER CHARGES - -------------------------------------------------------------------------------- 1996 Severance Charge > The Company recorded an $84 million severance charge ($50 million aftertax) in the fourth quarter of 1996 related to certain strategic actions taken to improve ongoing profitability. 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 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 Company's New York Private Client Services offices. Additionally, the charge reflects various other strategic personnel reductions aimed at delayering management. The severance charge has led to personnel cost savings of approximately $90 million annually. The charge also resulted in a permanent decrease in nonpersonnel expenses of approximately $20 million annually. The Company intends to reinvest substantially all these LEHMAN BROTHERS 1997 ANNUAL REPORT 93 33 savings into certain businesses to expedite the Company's strategic initiatives; these actions are expected to result in improved operating revenues. Cash outlays relating to the charge were approximately $19 million in the fourth quarter of 1996 and approximately $59 million during fiscal 1997. The remaining residual payments will be paid as deferred payment arrangements are completed. 1995 Restructuring Charge > During the fourth quarter of 1995, the Company recorded a charge of $97 million pretax ($58 million aftertax) for occupancy-related real estate and severance expenses. The occupancy-related real estate component of the charge, $80 million pretax ($48 million aftertax), resulted from a complete global review of the Company's real estate requirements at current headcount levels and the elimination of excess real estate, primarily in its New York, London and Tokyo locations. The charge included the cost to write-down the carrying value of leasehold improvements as well as the difference between expected operating costs and projected sublease recoveries. In addition, the restructuring charge included a $17 million pretax ($10 million aftertax) component related to severance payments made during the fourth quarter. The severance component of the charge related to payments made to terminated personnel arising from a fourth quarter formalized business unit productivity review. ================================================================================ note 16 QUARTERLY INFORMATION (UNAUDITED) - -------------------------------------------------------------------------------- The following information represents the Company's unaudited quarterly results of operations for 1997 and 1996. Certain amounts reflect reclassifications to conform to the current period's presentation. These quarterly results reflect all normal recurring adjustments which are, in the opinion of management, necessary for a fair presentation of the results. Revenues and earnings of the Company can vary significantly from quarter to quarter due to the nature of the Company's business activities.
1997 1996 ---------------------------------------- ---------------------------------------- (in millions, except per share amounts) NOV. 30 AUG. 31 MAY 31 FEB. 28 NOV. 30 AUG. 31 MAY 31 FEB. 29 =============================================================================================================================== Total revenues $4,609 $4,469 $3,806 $3,999 $3,813 $3,585 $3,476 $3,386 Interest expense 3,586 3,398 2,952 3,074 2,745 2,863 2,643 2,565 - ------------------------------------------------------------------------------------------------------------------------------- Net revenues 1,023 1,071 854 925 1,068 722 833 821 Non-interest expenses: Compensation and benefits 519 543 433 469 542 366 422 416 Other expenses 239 247 249 237 247 240 242 246 Severance 84 - ------------------------------------------------------------------------------------------------------------------------------- Total non-interest expenses 758 790 682 706 873 606 664 662 - ------------------------------------------------------------------------------------------------------------------------------- Income before taxes 265 281 172 219 195 116 169 159 Provision for income taxes 80 84 51 75 68 39 61 55 - ------------------------------------------------------------------------------------------------------------------------------- Net income $ 185 $ 197 $ 121 $ 144 $ 127 $ 77 $ 108 $ 104 - ------------------------------------------------------------------------------------------------------------------------------- Net income applicable to common stock $ 160 $ 160 $ 114 $ 138 $ 113 $ 71 $ 102 $ 93 - ------------------------------------------------------------------------------------------------------------------------------- Average common and common equivalent shares outstanding 123.0 122.4 120.4 118.5 116.9 117.2 114.8 116.9 - ------------------------------------------------------------------------------------------------------------------------------- Earnings per common share $ 1.30 $ 1.30 $ 0.95 $ 1.16 $ 0.96 $ 0.60 $ 0.89 $ 0.79 Dividends per common share $ 0.06 $ 0.06 $ 0.06 $ 0.06 $ 0.05 $ 0.05 $ 0.05 $ 0.05 Book value per common share (at period end) $33.39 $31.86 $30.67 $29.76 $28.84 $27.74 $27.29 $26.41 - -------------------------------------------------------------------------------------------------------------------------------
LEHMAN BROTHERS 1997 ANNUAL REPORT 94 EX-13.3 8 SELECTED FINANCIAL STATEMENTS 1 EXHIBIT 13.3 SELECTED FINANCIAL DATA The following table summarizes certain consolidated financial information based upon the Company's historical results included in the audited consolidated financial statements. During 1993, the Company completed the sales of three businesses: The Boston Company on May 21; LBI's domestic retail brokerage business (except for such business conducted under the Lehman Brothers' name) and substantially all of its asset management business (collectively, "Shearson") on July 31; and Shearson Lehman Hutton Mortgage Corporation ("SLHMC") on August 31. In the Company's historical consolidated financial statements, the operating results of The Boston Company are accounted for as a discontinued operation while the operating results of Shearson and SLHMC are included in the Company's results from continuing operations through their respective sale dates. In addition, the Company's 1994 results presented below are for the eleven month period ended November 30, due to the Company's decision to change its year-end from December 31. For these reasons, the Company's 1994 results are not fully comparable with the prior year period.
HISTORICAL FINANCIAL DATA -------------------------------------------------------------- ELEVEN MONTHS TWELVE MONTHS ENDED ENDED TWELVE MONTHS ENDED NOVEMBER 30 NOVEMBER 30 DECEMBER 31 -------------------------------- ------------- ------------- (in millions, except Per share and Other data) 1997 1996 1995 1994 1993 ====================================================================================================================== Consolidated statement of income Revenues: Principal transactions $ 1,418 $ 1,579 $ 1,393 $ 1,345 $ 2,055 Investment banking 1,318 981 801 572 972 Commissions 423 362 450 445 1,316 Interest and dividends 13,635 11,298 10,788 6,761 5,840 Other 89 40 44 67 491 - ---------------------------------------------------------------------------------------------------------------------- Total revenues 16,883 14,260 13,476 9,190 10,674 Interest expense 13,010 10,816 10,405 6,452 5,368 - ---------------------------------------------------------------------------------------------------------------------- Net revenues 3,873 3,444 3,071 2,738 5,306 - ---------------------------------------------------------------------------------------------------------------------- Non-interest expenses: Compensation and benefits 1,964 1,747 1,544 1,413 2,989 Other expenses 972 976 1,061 1,084 1,603 Loss on sale of Shearson 535 Severance and other charges 84 97 48 152 - ---------------------------------------------------------------------------------------------------------------------- Total non-interest expenses 2,936 2,807 2,702 2,545 5,279 - ---------------------------------------------------------------------------------------------------------------------- Income from continuing operations before taxes and cumulative effect of changes in accounting principles 937 637 369 193 27 Provision for income taxes 290 221 127 67 318 - ---------------------------------------------------------------------------------------------------------------------- Income (loss) from continuing operations before cumulative effect of changes in accounting principles 647 416 242 126 (291) Income from discontinued operations 189 Cumulative effect of changes in accounting principles, net of taxes (13) - ---------------------------------------------------------------------------------------------------------------------- Net income (loss) $ 647 $ 416 $ 242 $ 113 $ (102) - ---------------------------------------------------------------------------------------------------------------------- Net income (loss) applicable to common stock $ 572 $ 378 $ 200 $ 75 $ (150) - ---------------------------------------------------------------------------------------------------------------------- Consolidated statement of financial condition (at period end) Total assets $ 151,705 $ 128,596 $ 115,303 $ 109,947 $ 80,474 Total assets excluding matched book(a) 108,099 96,256 79,069 72,457 54,428 Long-term debt(b) 20,261 15,922 12,765 11,321 9,899 Total stockholders' equity 4,523 3,874 3,698 3,395 2,052 Total capital(c) 24,784 19,796 16,463 14,716 11,951 - ---------------------------------------------------------------------------------------------------------------------- Per share data(d) Income (loss) from continuing operations before cumulative effect of change in accounting principle $ 4.72 $ 3.24 $ 1.76 $ 0.81 $ (3.20) Discontinued operations 1.79 Cumulative effect of change in accounting principle (0.12) Net income (loss) $ 4.72 $ 3.24 $ 1.76 $ 0.69 $ (1.41) Dividends declared per common share 0.24 0.20 0.20 0.175 Book value per common share (at period end) 33.39 28.84 25.67 24.35 - ---------------------------------------------------------------------------------------------------------------------- Other data (at period end) Ratio of total assets to total stockholders' equity 33.5x 33.2x 31.2x 32.4x 39.2x Ratio of total assets excluding matched book to total stockholders' equity (a) 23.9x 24.8x 21.4x 21.3x 26.5x Return on common equity (annualized) 15.6% 12.1% 7.1% 4.0% Employees 8,340 7,556 7,771 8,512 9,300 - ----------------------------------------------------------------------------------------------------------------------
LEHMAN BROTHERS 1997 ANNUAL REPORT 95 2 As noted previously, the Company's historical consolidated financial statements are not fully comparable, due to the sales of three significant businesses in 1993 and the eleven month reporting period presented for 1994. To facilitate an understanding of the Company's results, included below is a table reflecting the results of the ongoing businesses of the Company (the "Lehman Businesses") for the twelve months ended November 30, 1997, 1996 and 1995, the eleven months ended November 30, 1994 and the year ended December 31, 1993.
LEHMAN BUSINESSES ---------------------------------------------------------------- ELEVEN MONTHS TWELVE MONTHS ENDED ENDED TWELVE MONTHS ENDED NOVEMBER 30 NOVEMBER 30 DECEMBER 31 ------------------------------- ------------- ------------- (in millions, except Financial ratios) 1997 1996 1995 1994 1993 ================================================================================================================== Consolidated statement of income Revenues: Principal transactions $ 1,418 $ 1,579 $ 1,393 $ 1,345 $ 1,732 Investment banking 1,318 981 801 572 802 Commissions 423 362 450 445 488 Interest and dividends 13,635 11,298 10,788 6,761 5,679 Other 89 40 44 67 79 - ------------------------------------------------------------------------------------------------------------------ Total revenues 16,883 14,260 13,476 9,190 8,780 Interest expense 13,010 10,816 10,405 6,452 5,225 - ------------------------------------------------------------------------------------------------------------------ Net revenues 3,873 3,444 3,071 2,738 3,555 - ------------------------------------------------------------------------------------------------------------------ Non-interest expenses: Compensation and benefits 1,964 1,747 1,544 1,413 1,825 Other expenses 972 976 1,061 1,084 1,133 Severance and other charges 84 97 48 32 - ------------------------------------------------------------------------------------------------------------------ Total non-interest expenses 2,936 2,807 2,702 2,545 2,990 - ------------------------------------------------------------------------------------------------------------------ Income from continuing operations before taxes and cumulative effect of changes in accounting principles 937 637 369 193 565 Provision for income taxes 290 221 127 67 210 - ------------------------------------------------------------------------------------------------------------------ Income from continuing operations before cumulative effect of changes in accounting principles $ 647 $ 416 $ 242 $ 126 $ 355 - ------------------------------------------------------------------------------------------------------------------ Financial ratios (%): Compensation and benefits/net revenues(e) 50.7 50.7 50.8 51.6 5l.4 Pretax operating margin 24.2 18.5 12.0 7.0 15.9 Effective tax rate(e) 31 35 35 34 37 Return on common equity (annualized) 15.6 12.1 7.1 4.0 - ------------------------------------------------------------------------------------------------------------------
(a) Matched book represents "securities purchased under agreements to resell" ("reverse repos") to the extent that such balance is less than "securities sold under agreements to repurchase" ("repos") as of the statement of financial condition date. Several nationally recognized rating agencies consider such reverse repos to be a proxy for matched book assets when evaluating the Company's capital strength and financial ratios. Such agencies consider matched book assets to have a low risk profile and exclude such amounts in the calculation of leverage (total assets divided by total stockholders' equity). Although there are other assets with similar risk characteristics on the Company's Consolidated Statement of Financial Condition, the exclusion of reverse repos from total assets in this calculation reflects the fact that these assets are matched against liabilities of a similar nature, and therefore require minimal amounts of capital support. Accordingly, the Company believes the ratio of total assets excluding matched book to total stockholders' equity to be a more meaningful measure of the Company's leverage. (b) Long-term debt includes senior notes and subordinated indebtedness. (c) Total capital includes total stockholders' equity and long-term debt. (d) Earnings per common share data for the year ended 1993 includes Common Stock issued as of May 31, 1994. (e) For the twelve months ended November 30,1995, excludes the effect of the sale of Omnitel. LEHMAN BROTHERS 1997 ANNUAL REPORT 96 EX-13.4 9 OTHER STOCKHOLDER INFORMATION 1 EXHIBIT 13.4 ================================================================================ OTHER STOCKHOLDER INFORMATION - -------------------------------------------------------------------------------- ANNUAL MEETING The annual meeting of stockholders of Lehman Brothers Holdings Inc. will be held on Tuesday, March 31, 1998 at 10:30 a.m. at 3 World Financial Center, 26th Floor, 200 Vesey Street, New York, NY 10285. TRANSFER AGENT AND REGISTRAR Questions regarding dividends, transfer requirements, lost certificates, changes of address, direct deposit of dividends, the dividend reinvestment and optional cash purchase program, or other inquiries from registered stockholders should be directed to: Bank of Boston c/o Boston EquiServe, L.P. Mailstop 45-02-64 P.O. Box 644 Boston, MA 02102-0644 Telephone: (800) 730-6001 DIVIDEND PAYMENTS Dividends on common stock are generally payable, following declaration by the Board of Directors, on the last business day of February, May, August and November. The annual dividend rate for fiscal 1997 was $0.24 per common share. The Company recently announced an annual common stock dividend policy of $0.30 per share. Direct deposit of dividends is available to registered stockholders with U.S. bank accounts. For more information regarding this program, contact the Company's Transfer Agent listed above. DIVIDEND REINVESTMENT AND OPTIONAL CASH PURCHASE PROGRAM This program allows registered stockholders of twenty-five or more shares to automatically reinvest their dividends. The program also permits voluntary optional cash purchases of common stock up to a maximum of $15,000 a quarter. All stockholders of record are eligible to participate in the optional cash purchase program. Lehman Brothers absorbs all bank service charges and stock purchase fees under the terms of the program. Additional information and enrollment forms can be obtained from the Company's Transfer Agent listed above. FORM 10-K Lehman Brothers will make available upon request copies of the Annual Report on Form 10-K as filed with the Securities and Exchange Commission. Requests may be directed to: Jennifer Marre Corporate Secretary Lehman Brothers Holdings Inc. 3 World Financial Center, 24th Floor New York, NY 10285 Telephone: (212) 526-1936 E-mail: jennifer_marre@usccmail.lehman.com INVESTOR INQUIRIES Investor inquiries may be directed to: Shaun K. Butler Investor Relations Lehman Brothers Holdings Inc.: 3 World Financial Center, 10th Floor New York, NY 10285 Telephone: (212) 526-8381 E-mail: shaun_k._butler@usccmail.lehman.com Additional copies of this Annual Report may be obtained through: Corporate Communications Lehman Brothers Holdings Inc. 3 World Financial Center, 10th Floor New York, NY 10285 Telephone: (212) 526-1829 E-mail: melody_fitzgerald@usccmail.lehman.com WORLD WIDE WEB Financial statement filings, stockholder information, press releases and general news about the Company also may be accessed via the World Wide Web at the following address: http://www.lehman.com ================================================================================ PRICE RANGE OF COMMON STOCK - -------------------------------------------------------------------------------- The common stock of Lehman Brothers Holdings Inc. is listed on the New York and Pacific Stock Exchanges under the trading symbol LEH. As of January 14, 1998, there were 25,480 holders of record of the Company's common stock. On January 14, 1998, the last reported sales price of the Company's common stock was $52.6875.
THREE MONTHS ENDED ----------------------------------------------------------------------------- 1997 1996 ------------------------------------ ------------------------------------- NOV. 30 AUG. 31 MAY 31 FEB. 28 NOV. 30 AUG. 31 MAY 31 FEB. 29 ========================================================================================== High $56 1/8 $52 $41 $36 3/8 $29 3/8 $26 $27 $26 Low $43 1/8 $37 3/4 $29 $29 1/8 $20 7/8 $21 1/8 $22 1/8 $20 1/4
LEHMAN BROTHERS 1997 ANNUAL REPORT 98 EX-21.1 10 LIST OF REGISTRANT'S SUBSIDIARIES 1 EXHIBIT 21.1 Subsidiary List Name Place of Incorporation 305 W. Due West Ave. Inc. Delaware 314 Commonwealth Ave. Inc. Delaware 72nd Street Premises, Inc. Delaware Americal GP Corp. Delaware American Entertainment Depositary Corp. Delaware American Entertainment Depositary Corp. II Delaware American Entertainment Partners II L.P. Delaware American Entertainment Partners L.P. Delaware American Storage Properties L.P. Delaware ASAS Investment Company Delaware Asesoria Empresarial ICC, S.A. de C.V. Mexico Aurora Loan Services Inc. Delaware Banque Lehman Brothers S.A. France Boulevard Investors, Inc. Delaware Boulevard Real Estate Corp. Delaware Broad OK Corp. Delaware Broadway Oklahoma Associates Delaware Burlington Investors Inc. Delaware CA Victory Assignor Corp. Delaware CA Victory Inc. Delaware Cable Income Services Inc. Delaware Canyon Terrace Inc. Delaware Canyon Terrace Ltd. Delaware Casitas Associates, Inc. California CG California Commercial Lending Inc. Delaware CG Realty Funding Inc. Delaware 2 Name Place of Incorporation CG Zero Coupon Depositary Corp. Delaware Client Account Protection Insurance Company Vermont Cobex Realty Inc. Texas Commerical Asset Liability Management Limited England Consolidated Real Property Corp. Nevada Creekside Inc. Delaware Crescent Gardens Inc. Delaware DA Group Holdings Inc. Delaware DAG Lending Corp. Delaware DAG Realty Brokerage Inc. New York Diogenes Holdings Inc. Delaware Diogenes Investments Ltd. Bermuda Diogenes Management Company Inc. Delaware E.H.P. Depositary Corp. Delaware Fiduciaria Lehman Brothers SPA Societa` di Intermediazione Mobiliare Italy First Cap IV, Inc. Delaware First Dallas Associates Inc. Delaware Fundimmo Limited England GA Wildwood I Inc. Georgia 3 Name Place of Incorporation GLG Partners Asset Management Limited Ireland Grass Valley/Marguerite, Inc. California Heritage Park II Inc. Delaware Heritage Park Inc. Delaware HillCreste Properties Inc. Delaware Hollywood Partners Inc. Delaware Indian Oaks Inc. Delaware Industrial Holdings Corporation New York Jackson Capitol Inc. Delaware L Ram I, Inc. Delaware L Ram II, Inc. Delaware La Jolla GP Inc. Delaware Laurel Capital Growth Investors Corporation Delaware Laurel Centre Depositary Corp. Delaware LB 1997-N1 Inc. Delaware LB 400 I Inc. Delaware LB 400 II Inc. Delaware LB 400 III Inc. Delaware 4 Name Place of Incorporation LB 500 I Inc. Delaware LB 500 II Inc. Delaware LB 500 III Inc. Delaware LB Austin Hotel I Inc. Delaware LB Austin Hotel II Inc. Delaware LB BBB I Inc. Delaware LB BBB II Inc. Delaware LB BBB III Inc. Delaware LB Energy Inc. Delaware LB Funding Corp. II Delaware LB II 1997-N1 Inc. Delaware LB Impala Associates Inc. Delaware LB Midlands I Inc. Delaware LB North Hills II Inc. Delaware LB North Hills Inc. Delaware LB Richmond I Inc. Delaware LB Saddleback I Inc. Delaware LB Saddleback Inc. Delaware LB Wellington Tower Associates Inc. Delaware LB West 45th Street Associates Inc. Delaware LB Westbury I Inc. Delaware LB Worldwide Services Co. Delaware LBAC Holdings I Inc. Delaware LBTS1, Inc. Delaware LBTS2, Inc. Delaware Lehman ALI Inc. Delaware 5 Name Place of Incorporation Lehman Brothers (Luxembourg) S.A. Luxembourg Lehman Brothers (Taiwan) Ltd. Taiwan Lehman Brothers (Thailand) Limited Thailand Lehman Brothers Argentina S.A. Argentina Lehman Brothers Asia Capital Company Hong Kong Lehman Brothers Asset Trading Inc. Delaware Lehman Brothers Bankhaus Aktiengesellschaft Germany Lehman Brothers Canada Inc. New Brunswick Lehman Brothers Capital GmbH Germany Lehman Brothers Commercial Corporation Delaware Lehman Brothers Commercial Corporation Asia Limited Hong Kong Lehman Brothers Commodities Far East Inc. Delaware Lehman Brothers do Brasil Ltda Brazil Lehman Brothers EBS Limited United Kingdom Lehman Brothers Finance S.A. Switzerland Lehman Brothers Futures Asia Limited Hong Kong Lehman Brothers Futures Asset Management Corp. Delaware Lehman Brothers Gilts Ltd. United Kingdom Lehman Brothers Global Asset Management Inc. Delaware Lehman Brothers Global Finance Limited United Kingdom Lehman Brothers Global Managers Inc. Delaware Lehman Brothers Holdings Plc United Kingdom Lehman Brothers Inc. Delaware Lehman Brothers International (Europe) United Kingdom Lehman Brothers International S.A. Spain Lehman Brothers International S.P.A. Italy Lehman Brothers Investments PTE Limited Singapore Lehman Brothers Japan Inc. Delaware Lehman Brothers Limited United Kingdom Lehman Brothers Merchant Banking Advisors II Inc. Delaware 6 Name Place of Incorporation Lehman Brothers Merchant Banking Advisors Inc. Delaware Lehman Brothers Merchant Banking Partners II Inc. Delaware Lehman Brothers Nominees Limited United Kingdom Lehman Brothers Offshore Partners II Ltd. Bermuda Lehman Brothers Pera Cable Inc. Delaware Lehman Brothers Pera Inc. Delaware Lehman Brothers Power Inc. Delaware Lehman Brothers Realty Corp. Delaware Lehman Brothers Services SNC France Lehman Brothers South Asia Limited Hong Kong Lehman Brothers SpA Societa Di Intermediazione Mobiliare Italy Lehman Brothers TB Inc. Delaware Lehman Brothers Trading Services B.V. Netherlands Lehman Brothers Treasury Co. B.V. Netherlands Lehman Brothers Trust Company New York Lehman Brothers Trustees S.A. Switzerland Lehman Brothers U.K. Holdings (Delaware) Inc. Delaware Lehman Brothers UK Holdings Ltd. England Lehman Brothers Verwaltungs-und Beteiligungsgesellschaft mbH Germany Lehman Brothers/FW Inc. Delaware Lehman Brothers/MBGP Inc. Delaware Lehman Brothers/MBLP Inc. Delaware Lehman Brothers/Rosecliff Inc. Delaware Lehman Electric Inc. Delaware Lehman Housing Capital Inc. Delaware Lehman Housing Lending Corp. Delaware Lehman Investments Inc. Delaware Lehman JFK MM Inc. Delaware Lehman JFK Non-MM Inc. Delaware 7 Name Place of Incorporation Lehman Lending Corp. Delaware Lehman Ltd. I Inc. Delaware Lehman Management Company (Ireland) Limited Ireland Lehman Structured Assets Inc. Delaware Lehman Syndicated Loan Inc. Delaware Lehman Tax Credit Advisor Inc. Delaware Lehman/SDI Inc. Delaware LHCI GP IX Inc. Delaware LHCI GP VI Inc. Delaware LHCI GP VII Inc. Delaware LHCI GP VIII Inc. Delaware LIBRO Holdings I Inc. Delaware LIBRO Holdings II Inc. Delaware Lowell Investors Inc. Delaware Lowell Real Estate Corp. Delaware Malibu Canyon Inc. Delaware Manhattan Beach Commercial Properties III Depositary Inc. Delaware Manhattan Beach Commercial Properties III Inc. Delaware Medical Office Properties Depositary Inc. Delaware Medical Office Properties Inc. Delaware Messal Nominees Limited United Kingdom Midwest Centers Depositary Inc. Delaware Morgan Drive Property Co. Delaware MTGCO Inc. Delaware N.P. Investment XIX Co. Delaware N.P. Investment XV Co. Delaware 8 Name Place of Incorporation N.P. Investment XVI Co. Delaware N.P. Investment XVII Co. Delaware N.P. Investment XVII Co. Florida N.P. Investment XVIII Co. Delaware N.P. Investment XX Co. Delaware N.P. Investment XXI Co. Delaware NGP Inc. Delaware NJ Atlantic Inc. Delaware NJ Somerset Inc. Delaware Novacorp Realty/GP Inc. Canada Pacific Village Inc. Delaware PAMCO (No. 2) Limited United Kingdom PAMCO (UK) Limited United Kingdom PAMI Central Islip Inc. Delaware PAMI Michigan Inc. Delaware PAMI Newark Inc. Delaware PAMI Nominee Corporation Delaware PAMI Raymond Inc. Delaware PDF86 Depositary Corp. Delaware Platform Finance Limited United Kingdom Platform Home Mortgage Securities No. 1 Plc United Kingdom Platform Home Mortgage Securities No. 2 Plc United Kingdom Platform Home Mortgage Securities No. 4 Limited United Kingdom Platform Home Mortgage Securities No. 5 Limited England Platform Investments England Platform Mortgage United Kingdom Playa Blanca Inc. Delaware Prime Depositary Corp. Delaware Principal Growth Realty Funding, Inc. Delaware Principal Growth Realty Management Inc. Delaware Prometheus GP Inc. Delaware Prometheus II Inc. Delaware Property Asset Management Inc. Delaware 9 Name Place of Incorporation Raintree GP Inc. Delaware Regional Malls Depositary Corp. Delaware Regional Malls Inc. Delaware Research Partners Inc. Washington Revival Holdings Limited Cayman Islands Rock Hill Investors, Inc. Delaware Senior Income Depositary, Inc. Delaware Sharpstown Center Inc. New York SM7 Apartment Investors Inc. Texas South Cobb Land Inc. Georgia Stamford Real Estate Corporation Delaware Stamford Towers Depositary Corp. Delaware Stamford Towers Inc. Delaware Storage Inc. Delaware Storm Funding Ltd. England Sunrise Finance Co., Ltd. Japan 10 Name Place of Incorporation Tower Investors, Inc. Delaware Tower Real Estate Corporation Delaware Trans Orbital Sciences Inc. Delaware Union Square Depositary Corp. Delaware Walnut Grove GP Corp. Delaware Warner Center Inc. Delaware Warner Center/MGP Inc. Delaware Warren Atlantic Inc. Delaware Warren/GP Corp. Delaware Wellington-Medford III Properties, Inc. Massachusetts Winter Garden, Inc. Delaware Working Interest Inc. Delaware EX-23.1 11 CONSENT OF ERNST & YOUNG 1 EXHIBIT 23.1 CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in this 1997 Annual Report on Form 10-K of Lehman Brothers Holdings Inc. (the "Company") of our report dated January 7, 1998, included in the 1997 Annual Report to Stockholders of Lehman Brothers Holdings Inc. Our audits also included the financial statement schedule of Lehman Brothers Holdings Inc. listed in Item 14(a). This schedule is the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, the financial statement schedule referred to above, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein. We also consent to the incorporation by reference in the Registration Statements and Post Effective Amendments on Form S-3 File Nos. 333-44771, 333-38227, 333-14791 and 33-53651 of the Company and in the related Prospectuses, of our report dated January 7, 1998 with respect to the consolidated financial statements and financial statement schedule of Lehman Brothers Holdings Inc. included or incorporated by reference in this 1997 Annual Report on Form 10-K for the year ended November 30, 1997. ERNST & YOUNG LLP New York, New York February 27, 1998 EX-24.1 12 POWERS OF ATTORNEY 1 EXHIBIT 24.1 KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Thomas A. Russo, Marc A. Silverman and Karen M. Muller and each of them, his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign the Annual Report on Form 10-K of Lehman Brothers Holdings Inc., for the fiscal year ended November 30, 1997 and any and all amendments thereto, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Dated: As of February 27, 1998
SIGNATURES TITLE - ------------------------------------- --------------------------------------------- /s/ RICHARD S. FULD, JR. Chief Executive Officer and, - ------------------------------------- Chairman of the Board of Richard S. Fuld, Jr. Directors (principal executive officer) /s/ CHARLES B. HINTZ Chief Financial Officer - ------------------------------------- (principal financial and accounting officer) Charles B. Hintz /s/ MICHAEL L. AINSLIE Director - ------------------------------------- Michael L. Ainslie /s/ JOHN F. AKERS Director - ------------------------------------- John F. Akers /s/ ROGER S. BERLIND Director - ------------------------------------- Roger S. Berlind /s/ THOMAS H. CRUIKSHANK Director - ------------------------------------- Thomas H. Cruikshank /s/ HENRY KAUFMAN Director - ------------------------------------- Henry Kaufman /s/ HIDEICHIRO KOBAYASHI Director - ------------------------------------- Hideichiro Kobayashi /s/ JOHN D. MACOMBER Director - ------------------------------------- John D. Macomber /s/ DINA MERRILL Director - ------------------------------------- Dina Merrill /s/ MASAHIRO YAMADA Director - ------------------------------------- Masahiro Yamada
EX-27.1 13 FINANCIAL DATA SCHEDULE
BD This schedule contains summary financial information extracted from the Company's Consolidated Statement of Financial Condition at November 30, 1997 and the Consolidated Statement of Income for the twelve months ended November 30, 1997 and is qualified in its entirety by reference to such financial statements. 1,000,000 12-MOS NOV-30-1997 DEC-01-1996 NOV-30-1997 2,834 12,838 43,606 14,146 76,862 468 151,705 7,818 13,857 63,204 7,846 30,080 20,261 0 508 12 4,003 151,705 1,418 13,635 423 1,318 0 13,010 1,964 937 647 0 0 647 $4.72 $4.71
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