-----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, Eq90oy81FYzfhPC0L2V+9mjINYmnFIdudG4QBeya/M30LJPpSCs2AzxXKrcMULXu hi6UhH9uOP/Ea3Cj9cN3lg== 0001047469-99-007702.txt : 19990301 0001047469-99-007702.hdr.sgml : 19990301 ACCESSION NUMBER: 0001047469-99-007702 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 9 CONFORMED PERIOD OF REPORT: 19981130 FILED AS OF DATE: 19990226 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: 99552698 BUSINESS ADDRESS: STREET 1: AMERICAN EXPRESS TWR STREET 2: 3 WORLD FINANCIAL CNTR CITY: NEW YORK STATE: NY ZIP: 10285 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 10-K405 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- 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, 1998 / / 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 Identification incorporation or organization) 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, $.10 par value New York Stock Exchange Pacific Exchange Depositary Shares representing 5.94% Cumulative Preferred Stock, Series C New York Stock Exchange Depositary Shares representing 5.67% Cumulative Preferred Stock, Series D New York Stock Exchange 8% Trust Preferred Securities, Series I of Subsidiary Trust (and Registrant's guarantee thereof) New York 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
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 voting and nonvoting common equity held by non-affiliates of the Registrant at February 9, 1999 was approximately $5,822,446.36. 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 9, 1999, 119,411,161 shares of the Registrant's Common Stock, $.10 par value per share, were issued and outstanding. DOCUMENTS INCORPORATED BY REFERENCE: (1) Lehman Brothers Holdings Inc. 1998 Annual Report to Stockholders (the "1998 Annual Report")-- Incorporated in part in Parts II and IV. (2) Lehman Brothers Holdings Inc. Proxy Statement for its 1999 Annual Meeting of Stockholders (the "Proxy Statement")--Incorporated in part in Parts I and III. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- 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 Lehman Brothers Inc., a Delaware corporation and the principal subsidiary of Holdings, 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 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 the United States, 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 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, 1998, November 30, 1997 and November 30, 1996, including the amount of revenue contributed by each class 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 1998 Annual Report and is incorporated herein by reference. Information with respect to the Company's operations by geographic area is set forth in Note 15 to the Notes to Consolidated Financial Statements on pages 90-91 of the 1998 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 revenues generally associated with the financial services industry. 1 LEHMAN BUSINESSES Lehman Brothers is a leading underwriter and market-maker of global fixed income and equity securities in the public and private markets. The Company is also a prominent advisor for corporations and governments around the world. 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, geographic and product coverage groups, enabling individual bankers to develop specific expertise in particular industries and markets. Industry coverage groups include Financial Institutions, Health Care, Industrial/Consumer, Media/Telecommunications, Natural Resources, Power, Real Estate, Retailing and Technology. Where appropriate, specialized product groups are partnered with the global industry and geographic groups to provide tailor-made solutions for Lehman Brothers' clients. These product groups include Equity Capital Markets, which includes equity and equity-related securities and derivatives; Debt Capital Markets, which incorporates expertise in syndicate, liability management, derivatives and private placements; Mergers and Acquisitions; Leveraged Finance, which includes high yield debt and bank loan syndication; Private Placements; and Financial Sponsors, which structures and executes leveraged acquisitions. Geographically, Lehman Brothers maintains investment banking offices in five cities in the U.S. and in twenty cities in Europe, the Middle East, Asia and Latin America. MERGERS AND ACQUISITIONS/STRATEGIC ADVISORY. Lehman Brothers has a long history of providing strategic advisory services to corporate, institutional and government clients around the world on a wide range of financial matters, including mergers and acquisitions, restructurings and spin-offs, targeted stock transactions, share repurchase strategies, takeover defenses and tax optimization strategies. During 1998, the Company expanded its global mergers and acquisitions presence, advising on 66 cross-border transactions. Linkages between strategic advisory services and the Firm's foreign exchange, derivatives and leveraged financing products are widely utilized. FIXED INCOME Lehman Brothers actively participates in all key fixed income markets worldwide and maintains a 24-hour trading presence in global fixed income securities. The Company combines professionals from the distribution, research and trading areas of the Fixed Income Division, together with investment bankers, into teams to serve the financial needs of the Company's clients and customers. The Company is a leading underwriter of new issues, and is also a preeminent market-maker in these and other fixed income securities. The Company's global presence facilitates client and customer transactions and provides liquidity in marketable fixed and floating rate debt securities. Fixed Income businesses include the following: GOVERNMENT AND AGENCY OBLIGATIONS. Lehman Brothers is one of the leading primary dealers in U.S. government securities, as designated by the Federal Reserve Bank of New York, participating in the underwriting and market-making of U.S. Treasury bills, notes and bonds, and securities of federal agencies. The Company is also a market-maker in the government securities of all G7 countries, and participates in other major European and Asian government bond markets. The Company is active in France as a reporting dealer and in Italy as a super-primary dealer. CORPORATE DEBT SECURITIES. Lehman Brothers engages in the underwriting and market making of fixed and floating rate investment grade debt worldwide. The Company is also a major participant in the preferred stock market, managing numerous offerings of long-term and perpetual preferreds and auction rate securities. 2 HIGH YIELD SECURITIES AND BANK LOANS. The Company also underwrites and makes markets in non-investment grade debt securities and bank loans. The Company provides "one-stop" leveraged finance solutions for corporate and financial acquirers and high yield issuers, including multi-step, multiproduct acquisition financing. MONEY MARKET PRODUCTS. Lehman Brothers holds dominant market positions in the origination and distribution of medium-term notes and commercial paper. The Company is an appointed dealer for over 600 active commercial paper programs on behalf of companies and government agencies worldwide. 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. 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. EMERGING MARKET SECURITIES. The Company engages in the trading, structuring and underwriting of Latin American, Eastern European, and Asian dollar and local currency instruments. 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 worldwide convergence of the cash and derivative markets. FOREIGN EXCHANGE. Lehman Brothers' global foreign exchange operations provide market access and liquidity in all currencies for spot, forward and over-the-counter options markets on a 24-hour-per-day basis. Lehman Brothers offers its customers superior execution, market intelligence, analysis and hedging capabilities, utilizing foreign exchange as well as foreign exchange options and derivatives. In collaboration with the Firm's emerging markets unit, the Firm's foreign exchange activities have diversified into Latin American, Eastern European and Asian currencies. Lehman Brothers also provides advisory services to central banks, corporations, investors worldwide, structuring innovative products to fit their specific needs. The Firm makes extensive use of its worldwide macroeconomics research to advise clients on the appropriate strategies to minimize interest rate and currency risk. In addition to the Company's traditional client/customer-driven foreign exchange activities, Lehman Brothers also trades foreign currencies for its own account. 3 EQUITIES Lehman Brothers combines professionals from the sales, trading, investment banking and research areas of its Equities Division into teams 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 also actively participates in assisting governments around the world in raising equity capital as part of their privatization programs. The Equities group is responsible for the Company's equity operations and all dollar and non-dollar equity and equity-related products worldwide. These products include listed and over-the-counter ("OTC") securities, American Depositary Receipts, convertibles, options, warrants and derivatives. The Company 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 and Milan. 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. The Firm's equity derivatives business is organized into two major product areas--a global volatility business, encompassing options-related products, and a global portfolio trading business that specializes in index arbitrage, agency/risk baskets and other structured products. EQUITY FINANCE. Lehman Brothers maintains an integrated Equity Financing and Prime Broker business to provide liquidity to its clients and customers and supply a source of secured financing for the Firm. MERCHANT BANKING AND PRIVATE EQUITY Lehman Brothers' merchant banking activities include making principal investments in partnership with clients of the Firm, raising capital from institutional and high-net-worth investors and managing these investments until they are realized. The Firm's Merchant Banking group has more than 20 dedicated professionals based in New York and London. Through its merchant banking funds, the Company invests in established companies worldwide. In 1998, the Company also formalized its venture capital activities, investing a total of $37 million in 10 companies across a broad range of industries. In addition, Lehman Brothers engages in select equity and equity-related investments in commercial and residential properties. Further information is contained in "Management's Discussion and Analysis of Financial Condition and Results of Operations--Merchant Banking and Related Lending Activities" on page 48 of the 1998 Annual Report. GLOBAL DISTRIBUTION Lehman Brothers' institutional and private client sales organizations encompass distinct global sales forces that have been integrated into the Fixed Income and Equities businesses to provide investors with the full array of products and research offered by the Firm. FIXED INCOME SALES. The Firm's Fixed Income sales force is one of the most productive in the industry, with approximately 278 professionals in 12 locations worldwide, serving the investing and liquidity needs of major institutional investors. Employing a relationship management approach that provides superior information flow and product opportunities for the Firm's customers, the Fixed Income sales organization covers the major share of the buying power in the global fixed income markets. EQUITY SALES. Lehman Brothers' institutional Equity sales group of over 345 professionals provides an extensive range of services to institutional investors through locations in the U.S., Europe and Asia. The 4 Equity sales organization focuses on developing long-term relationships though a comprehensive understanding of customers' investment objectives, while providing proficient execution and consistent liquidity in a wide range of global equity securities and derivatives. PRIVATE CLIENT SALES. The Company's Private Client Services group of 293 professionals serves the investment needs of private investors with substantial assets as well as over 1,000 mid-sized institutional accounts worldwide. The group has a global presence with investment representatives located in 11 offices worldwide. Among other services, investment professionals provide their clients with direct access to fixed income, equity, foreign exchange and derivative products, as well as the Firm's research and execution capabilities, thereby serving as a valuable extension of the Firm's institutional sales force. RESEARCH FIXED INCOME RESEARCH. Fixed Income research at Lehman Brothers encompasses the full range of research disciplines: quantitative, economic, strategic, credit, portfolio, relative value and market-specific analysis. Fixed Income research is integrated with the Company's investment banking, sales and trading activities. An important objective of Fixed Income research is to have in place high quality research analysts covering industry, geographic and economic sectors that support the activities of the Company's clients and customers. The department's 291 specialists provide expertise in U.S., European and Asian government and agency securities, derivatives, sovereign issues, corporate securities, high yield, asset- and mortgage-backed securities, real estate, emerging market debt and municipal securities. EQUITY RESEARCH. The Equity Research department, comprised of 120 analysts, is integrated with and supports the Company's investment banking, sales and trading activities. To ensure in-depth expertise within various markets, Equity Research has established regional teams on a worldwide basis that are staffed with industry and strategy specialists. OTHER BUSINESS ACTIVITIES While Lehman Brothers concentrates on its client/customer-driven strategy, the Company also participates in business opportunities such as arbitrage and proprietary trading that leverage the Company's expertise, infrastructure and resources. These businesses may generate substantial revenues but generally entail a higher degree of risk as the Company trades for its own account. ASSET MANAGEMENT. The Firm has several asset management related businesses. These include Investment Consulting Services, a wrap-fee series of third party managed products and management of multiple manager funds onshore and offshore. The Firm also has dealer agreements with a large number of mutual fund families. In addition, the Company packages internally managed product with emphasis on the various sectors of the private equity markets. ARBITRAGE. Lehman Brothers engages in a variety of arbitrage activities including "riskless" arbitrage, where the Company seeks to benefit from temporary price discrepancies that occur when a security is traded in two or more markets and "risk" arbitrage activities, which involve the purchase of securities at discounts from the expected values that would be realized if certain proposed or anticipated corporate transactions (such as mergers, acquisitions, recapitalizations, exchange offers, reorganizations, bankruptcies, liquidations or spin-offs) were to occur. To the extent that these anticipated transactions do not materialize in a manner consistent with the Company's expectations, the Company is subject to the risk that the value of these investments will decline. Lehman Brothers' arbitrage activities benefit from the Company's presence in the global capital markets, access to advanced information technology, in-depth market research, proprietary risk management tools and general experience in assessing rapidly changing market conditions. 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 5 account. The Company's proprietary trading activities bring together various research and trading disciplines allowing it to take market positions, which at times may be significant, consistent with the Company's expectations of future events (such as movements in the level of interest rates, changes in the shape of yield curves and changes in the value of currencies). The Company is subject to the risk that actual market events will be different from the Company's expectations, which may result in significant losses associated with such proprietary positions. TRADING SERVICES AND CORPORATE The Company's Trading Services and Corporate divisions provide support to its businesses through the processing of certain securities and commodities transactions; receipt, identification and delivery of funds and securities; safeguarding of customers' securities; and compliance with regulatory and legal requirements. In addition, this staff is responsible for technology infrastructure and systems development, treasury operations, financial control and analysis, tax planning and compliance, internal audit, expense management, career development and recruiting and other support functions. TECHNOLOGY AND YEAR 2000 READINESS During 1998, considerable technology resources were devoted to ensuring the Company's successful conversion to the Euro and addressing the Year 2000 issue. The Company's response to the Year 2000 issue is described under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations--Year 2000 Readiness Disclosure" on pages 53-56 of the 1998 Annual Report. RISK MANAGEMENT As a leading global investment banking company, risk is an inherent part of all of Lehman Brothers' businesses and activities. Lehman Brothers has developed policies and procedures to identify, measure and monitor each of the various types of risks involved in its trading, brokerage and investment banking activities on a global basis. The principal risks involved in Lehman Brothers' activities are market risk, credit or counterparty risk, liquidity, legal and operational risks. Lehman Brothers has developed a control infrastructure to monitor and manage each type of risk on a global basis throughout the Company. A full 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 51-53 of the 1998 Annual Report, and is incorporated herein by reference. COMPETITION All aspects of the Company's business are highly competitive. The Company competes in domestic and international markets directly with numerous other brokers and dealers in securities and commodities, investment banking firms, investment advisors and certain commercial banks and, indirectly for investment funds, with insurance companies and others. The financial services industry has become considerably more concentrated as numerous securities firms have either ceased operations or have been acquired by or merged into other firms. In addition, several small and specialized securities firms have been successful in raising significant amounts of capital for their merger and acquisition activities and merchant banking investment vehicles and for their own accounts. These developments have increased competition from other firms, many of whom have significantly greater equity capital than the Company. Pending legislative and regulatory changes in the United States may allow commercial banks to enter business previously limited to investment banks, further increasing competition. 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 6 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 LBl'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 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--Regulatory Capital" on pages 46-47 of the 1998 Annual Report, and Note 9 of Notes to Consolidated Financial Statements. EMPLOYEES As of November 30, 1998 the Company employed approximately 8,873 persons, including 6,316 in the Americas and 2,557 internationally. The Company considers its relationship with its employees to be good. 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, approximately 78,000 square feet of which has been subleased. 7 The Company entered into a lease for approximately 400,000 square feet for offices located at 101 Hudson Street in Jersey City, New Jersey (the "Operations Center"), of which approximately 67,000 square feet has been subleased. The Operations Center is used by systems, operations, and certain administrative personnel and contains certain back-up trading systems. The lease term expires in December, 2010. The Company leases approximately 338,000 square feet of office space in London, England of which approximately 105,000 square feet has been subleased and which lease expires in January 2017. 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 was appointed, who returned a report favorable to EFH. The Court ordered a review of additional documents and has set an April 1999 hearing date. ACTIONS RELATING TO FIRST CAPITAL HOLDINGS INC. Concurrent with the bankruptcy filing of First Capital Holdings ("FCH") in May, 1991 and the conservatorship and receivership of its two life insurance subsidiaries, First Capital Life Insurance Company and Fidelity Bankers Life Insurance Company ("Fidelity Bankers Life"), a number of lawsuits were commenced, naming one or more of Holdings, Lehman Brothers and American Express as defendants. Most of these actions have been subsequently settled and/or dismissed. The only material matter still pending is described below. 8 THE VIRGINIA COMMISSIONER OF INSURANCE ACTION. On December 9, 1992, a complaint was filed in the United States District Court for the Eastern District of Virginia (the "Virginia Court") by Steven Foster, the Virginia Commissioner of Insurance (the "Commissioner") as Deputy Receiver of Fidelity Bankers Life. The Complaint names Holdings and Weingarten, Ginsberg and Leonard Gubar, a former director of FCH and Fidelity Bankers Life, as defendants. The Complaint alleged that Holdings acquiesced in and approved the continued mismanagement of Fidelity Bankers Life and that it participated in directing the investment of Fidelity Bankers Life assets. The complaint asserted claims under the federal securities laws and asserts common law claims including fraud, negligence and breach of fiduciary duty and alleged violations of the Virginia Securities laws by Holdings. It sought no less than $220 million in damages to Fidelity Bankers Life and its present and former policyholders and creditors and punitive damages. On May 21, 1998, after trial, the Court entered a Judgment Order in accord with the jury verdict, ordering that the plaintiffs recover nothing and dismissing the complaint. On July 7, 1998, the Commissioner filed a Notice of Appeal to the United States Court of Appeals for the Fourth Circuit from such Judgment Order. EASTON & CO. V. MUTUAL BENEFIT LIFE INSURANCE CO., ET AL., EASTON & CO. V. LEHMAN BROTHERS INC. Lehman Brothers was named as a defendant in two consolidated class action complaints pending in the United States District Court for the District of New Jersey (the "N.J. District Court"). Easton & Co. v. Mutual Benefit Life Insurance Co., et al. ("Easton I"), and EASTON & CO. V. LEHMAN BROTHERS INC. ("Easton II"). The plaintiff in both of these actions is Easton & Co., which is a broker-dealer located in Fort Lee, New Jersey. Both of these actions allege federal securities law claims and pendent common law claims in connection with the sale of certain municipal bonds as to which Mutual Benefit Life Insurance Company ("MBLI") has guaranteed the payment of principal and interest. MBLI is an insurance company which was placed in rehabilitation proceedings under the supervision of the New Jersey Insurance Department on or about July 16, 1991. Easton I was commenced on or about September 17, 1991. The litigation was purportedly brought on behalf of a class consisting of all persons and entities who purchased DeKalb, Georgia Housing Authority MultiFamily Housing Revenue Refunding Bonds (North Hill Ltd. Project), Series 1991, due November 30, 1994 (the "DeKalb Bonds") during the period from May 3, 1991 (when the DeKalb bonds were issued) through July 16, 1991. Lehman Brothers acted as underwriter for this bond issue, which was in the aggregate principal amount of $18.7 million. 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. On or about February 9, 1993, the N.J. District Court granted plaintiffs' motion for class certification in Easton I. The parties agreed to certification of a class in Easton II for purchases of certain fixed-rate MBLI-backed bonds during the class period. LBI, together with the other defendants in Easton I and Easton II, has agreed to settle both cases, subject to court approval. ACTIONS RELATING TO THE SALES AND MARKETING OF LIMITED PARTNERSHIPS Under the terms of an agreement between American Express and Holdings, American Express has agreed to indemnify Holdings for liabilities which it may incur in connection with any action relating to any business conducted by The Balcor Company, a former Lehman Brothers subsidiary ("Balcor"), in which Holdings is named as a parent company or control person of Balcor. Holdings believes that some of the allegations in certain of the actions described below are covered by this indemnity. IN RE LEHMAN BROTHERS LIMITED PARTNERSHIP LITIGATION. On October 18, 1996, a purported first consolidated and amended class action complaint was filed in the Court of Chancery of the State of Delaware in and for New Castle County on behalf of all persons who purchased units in various public, proprietary limited partnerships organized by Shearson or E.F. Hutton & Co. or operated by affiliates of those entities between 1981 and the present (with certain exceptions). Defendants are LBI and 56 9 Lehman-affiliated general partners. The complaint alleges that defendants breached their fiduciary duties or aided and abetted such a breach by allegedly misrepresenting and or failing to disclose the nature of the risks and the status and financial condition of the partnerships; collecting excessive fees; failing to exercise due care in selecting investments for the partnerships; and recommending and selling the partnerships as suitable investments. The complaint seeks, among other things (1) to certify the case as a class action; (2) to declare that defendants breached their duties; (3) to enjoin defendants from operating the partnerships for their own benefit, (4) to account for all profits and impose a constructive trust on them; and (5) to award compensatory damages, costs and expenses and attorneys' fees. KLEIN, ET AL. V. LEHMAN BROTHERS, INC., ET AL. On January 15, 1998, a purported third amended class action complaint was filed in the Superior Court of New Jersey, Law Division: Union County on behalf of investors in certain specified limited partnerships sponsored by Balcor and sold by various entities, including, among others, Shearson and certain of its affiliates. Named as defendants are LBI, various affiliates of LBI, American Express Company, Smith Barney Holdings, Inc., Balcor, a number of Balcor-originated limited partnerships and various individuals and entities affiliated with Balcor. The complaint alleges claims in connection with the marketing, sale and operation of the limited partnerships for common law fraud and deceit, equitable fraud, negligent misrepresentation, breach of fiduciary duty and contract and violation of certain New Jersey statutes relating to the sale of securities. The complaint seeks compensatory damages for lost principal and interest, general damages and punitive damages, treble damages under the New Jersey statutes, and costs and attorneys' fees. On September 24, 1998, the Court filed an opinion dismissing the complaint, and plaintiffs have appealed that dismissal. BRUSS, ET AL. V. LEHMAN BROTHERS INC., ET AL. On January 25, 1999 a purported class action complaint was filed in the Superior Court of New Jersey, Law Division: Essex County on behalf of investors in certain specified limited partnerships sponsored by Balcor and sold by various entities, including, among others, Shearson and certain of its affiliates. The complaint mirrors the claims raised, the relief sought and the defendants named in KLEIN, ET AL. V. LEHMAN BROTHERS, INC., ET AL. COUNTY OF ORANGE ET AL. V. BEAR STEARNS & CO. ET AL. On December 6, 1996, the County of Orange, California (the "County") filed a complaint in the United States Bankruptcy Court for the Central District of California (the "Complaint"), naming 15 broker-dealers, along with various subsidiaries, including LBI, Lehman Brothers International (Europe), Lehman Capital Corp and Lehman Commercial Paper, Inc. (the "Lehman defendants"), as defendants. The Complaint alleges that defendants sold the County unsuitable securities and entered into unsuitable reverse repurchase transactions with the County that were ULTRA VIRES. The County seeks a declaration that the reverse repurchase agreements are void and unenforceable and violated the California Constitution and Government Code, and it claims that the defendants violated the California Constitution and Government Code and committed negligence. No damages are specified, and restitution is sought. Immediately after filing the Complaint, the parties entered into a stay of the action. On July 1, 1998, the case was transferred to the United States District Court for the Central District of California, and on August 21, 1998 the stay was lifted. On November 10, 1998 the Lehman defendants answered the Complaint, denying its material allegations. On December 21, 1998, the County moved to amend the Complaint to add breach of fiduciary duty and aiding and abetting breach of fiduciary duty claims, and the Court has ruled that plaintiff may file the amended complaint (the "Amended Complaint"). On January 5, 1999, the Court entered an order granting summary judgment for defendants on the ULTRA VIRES claims. 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 10 Minmetals International Non-Ferrous Metals Trading Company ("Minmetals") and China National Metals and Minerals Import and Export Company ("CNM") in the United States District Court for the Southern District of New York alleging breach of contract against Minmetals and breach of guarantee against CNM. The litigation arose from the refusal by Minmetals and CNM to honor their obligations with respect to certain foreign exchange and swap transactions. LBCC and LBSF seek to recover approximately $52.5 million from Minmetals and/or CNM. On June 26, 1995, the court granted CNM's motion to dismiss the claims against it, but also granted LBCC and LBSF leave to replead. Minmetals filed fourteen counterclaims against Lehman entities based on violations of federal securities and commodities laws and rules, and theories of fraud, breach of fiduciary duty and conversion. The court denied a motion by the Lehman counterclaim defendants to dismiss the six fraud-based counterclaims. On June 24, 1996, the court granted the motion of LBCC and LBSF to file an amended complaint naming CNM as an additional defendant. Discovery is complete, and summary judgment motions are pending before the court. ACTIONS RELATING TO NATIONAL ASSOCIATION OF SECURITIES DEALERS AUTOMATED QUOTATIONS SYSTEM ("NASDAQ") MARKET MAKER ANTITRUST AND SECURITIES LITIGATION. Beginning in May, 1994, several class actions were filed in various state and federal courts against various broker-dealers making markets in NASDAQ securities, including LBI. Plaintiffs in these cases alleged violations of the antitrust laws, securities laws and have pled a variety of other statutory and common law claims. All of these actions were based on the theory that because odd-eighth quotes occur less often than quarter quotes, NASDAQ market makers must be colluding wrongfully to maintain a wider spread. By Order filed October 14, 1994, the Judicial Panel on Multidistrict Litigation consolidated these actions in the Southern District of New York and ordered that all related actions be transferred and coordinated for all pretrial purposes. The case is captioned In Re NASDAQ Market-Makers Antitrust Litigation, MDL No. 1023. On December 16, 1994, plaintiffs served a consolidated Amended Complaint naming 33 defendants including LBI. Plaintiffs 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 repled and the defendants answered the amended complaint on November 17, 1995. On December 23, 1997, LBI settled the class action along with 29 other broker-dealers. The Court entered a Final Judgment and Order of Dismissal on November 9, 1998. AIA HOLDING SA ET AL. V. LEHMAN BROTHERS INC. AND BEAR STEARNS & CO., INC. On July 9, 1997, LBI was served with a complaint in the U.S. District Court for the Southern District of New York in which 277 named plaintiffs assert 24 causes of action against LBI and Bear Stearns & Co., Inc. The amount of damages claimed is unspecified. The claims arise from the activities of an individual named Ahmad Daouk, who was employed by an introducing broker which introduced accounts to Shearson Lehman Hutton between 1988 and 1992. Daouk allegedly perpetrated a fraud upon the claimants, who are mostly investors of Middle Eastern origin, and the complaint alleges that Shearson breached various contractual and common law duties owed to the investors. On March 27, 1998, the District Court dismissed without prejudice 18 of the 24 counts pleaded in the complaint. On July 3, 1998 the plaintiffs served their First Amended Complaint containing 18 causes of action against LBI and/or Bear Stearns. ACTIONS RELATING TO BRE-X MINERALS LTD. MCNAMARA ET AL. V. BRE-X MINERALS LTD. ET AL. On July 25, 1997, an Amended Class Action Complaint was filed in the United States District Court for the Eastern District of Texas against 16 defendants, including LBI, which seeks unspecified compensatory damages, interest, costs and attorney's fees on behalf 11 of purchasers of Bre-X common stock and/or Bresea common stock. The Complaint raises claims under the federal securities laws and the common law of fraud and negligent misrepresentation. The Complaint's stated basis for naming LBI is that one of its securities analysts published research on Bre-X. On or about November 21, 1997, several defendants, including LBI, moved to dismiss the Complaint, or, in the alternative, to transfer venue to the Southern District of New York. Plaintiffs have also filed a motion for class certification, which is stayed pending resolution of the motions to dismiss. On January 6, 1999, the Court issued an order dismissing the claims of Canadian plaintiffs who bought their shares on Canadian exchanges. The remaining motions to dismiss are still pending. KLAASEN V. LEHMAN BROTHERS INC. ET AL. On October 2, 1997, William L. Klaasen, "individually and for all those similarly situated within the State of California," filed a Complaint against LBI in the Superior Court for the State of California in and for the County of San Diego. The Complaint raises a claim for common law negligence, and seeks, on behalf of California purchasers of Bre-X and Bresea stock, class certification, rescission, interest, compensatory and punitive damages, disgorgement and restitution of profits and compensation received by LBI, and costs. The action is currently stayed by consent until the earlier of April 1, 1998 or 30 days following the decision on the motion to dismiss in the MCNAMARA case. CHOW ET AL. V. BRE-X MINERALS LTD. ET AL. On October 10, 1997, 125 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. IN RE MOBILEMEDIA SECURITIES LITIGATION LBI was named as a defendant in several purported class actions filed in December, 1996 in the United States District Court for the District of New Jersey in connection with (I) a November 7, 1995 offering of common stock of MobileMedia Corporation; and (ii) a November 7, 1995 offering of 9 3/8% senior subordinated notes of MobileMedia Communications Inc. due in 2007. On November 3, 1997, a consolidated amended class action complaint was filed naming certain of MobileMedia Corporation's officers and directors and the four co-lead underwriters of these offerings, including LBI. MobileMedia filed for Chapter 11 bankruptcy protection on January 30, 1997, and therefore is not named as a defendant. The complaint alleges that the underwriters violated Sections 11 and 12 of the Securities Act. Plaintiffs seek rescission and unspecified compensatory damages. HAROLD GILLET, ET AL. V. GOLDMAN SACHS & CO., ET AL., YAKOV PRAGER, ET AL. V. GOLDMAN, SACHS & CO., ET AL., DAVID HOLZMAN, ET AL. V. GOLDMAN, SACHS & CO., ET AL. Beginning in November, 1998, three class actions were filed in the United States District Court for the Southern District of New York against in excess of 25 underwriters of IPO securities including LBI. Plaintiffs in these cases seek compensatory and injunctive relief for alleged violations of the antitrust laws based on the theory that the defendant underwriters fixed and maintained fees for underwriting certain IPO securities at supracompetitive levels. Plaintiffs plan to file a Consolidated Amended Complaint. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. 12 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 28,137 at February 9, 1999. Information concerning the market for the Registrant's common equity and related stockholder matters is set forth on page 96 of the 1998 Annual Report and is hereby incorporated herein by reference. ITEM 6. SELECTED FINANCIAL DATA Selected financial data contained on pages 93-94 of the 1998 Annual Report is deemed a part of this Annual Report on Form 10-K and is hereby 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 35-57 of the 1998 Annual Report. Such information is hereby incorporated herein by reference and should be read in conjunction with the Consolidated Financial Statements and the Notes thereto contained on pages 59-92 of the 1998 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 51-53 of the 1998 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 1998 Annual Report on pages 58-92 and are hereby incorporated herein by reference. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 13 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 10 and 11 of the Proxy Statement and is hereby incorporated by reference. ITEM 11. EXECUTIVE COMPENSATION Information relating to executive compensation is set forth under the captions "Compensation of Directors", "Compensation Committee Report on Executive Officer Compensation", "Compensation of Executive Officers", "Pension Benefits" and "Employment Contracts, Termination of Employment and Change of Control Arrangements" on pages 9 and 13-18 of the Proxy Statement and is hereby incorporated by reference. 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 hereby 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" and "Certain Transactions with Other Institutional Investors and Their Subsidiaries" on pages 20-22 of the Proxy Statement and is hereby incorporated herein by reference. 14 PART IV ITEM 14. EXHIBITS AND 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 hereof 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 Certificate of Designations with respect to the Registrant's 5.94% Cumulative Preferred Stock, Series C (incorporated by reference to Exhibit 4.1 to the Registrant's Current Report on Form 8-K filed with the Commission on May 13, 1998) 3.3 Certificate of Designations with respect to the Registrant's 5.67% Cumulative Preferred Stock, Series D (incorporated by reference to Exhibit 4.2 to the Registrant's Current Report on Form 8-K filed with the Commission on July 23, 1998) 3.4 By-Laws of the Registrant, amended as of March 26, 1997 ((incorporated by reference to Exhibit 10 of the Registrant's Quarterly Report on Form 10-Q for the quarter ended February 28, 1997). 4.1 The instruments defining the rights of holders of the long-term debt securities of the Registrant and its subsidiaries are omitted pursuant to section (b) (4) (iii) (A) of Item 601 of Regulation S-K. The Registrant hereby agrees to furnish copies of these instruments to the Securities and Exchange Commission upon request. 10.1 Agreement of Tenants-In-Common by and among American Express Company, American Express Bank Ltd., American Express Travel Related Services Company, Inc., Shearson Lehman Brothers Inc., Shearson Lehman Government Securities, Inc. and Shearson Lehman Commercial Paper Incorporated (incorporated by reference to Exhibit 10.1 of 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).
15
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 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). 10.14+ 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)). 10.15+ 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)). 10.16+ 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)). 10.17+ 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).
16
EXHIBIT NO. - ----------- 10.18 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). 10.19+ Lehman Brothers Holdings Inc. Merchant Banking Long-Term Incentive Plan (for U.S. participants) (incorporated by reference to Exhibit 10.28 to the Registrant's Annual Report on Form 10-K for the fiscal year ended November 30, 1996). 10.20+ Lehman Brothers Holdings Inc. Merchant Banking Discretionary Incentive Compensation Plan (for non-U.S. participants) (incorporated by reference to Exhibit 10.29 to the Registrant's Annual Report on Form 10-K for the fiscal year ended November 30, 1996). 10.21 Agreement of Limited Partnership of Lehman Brothers Capital Partners IV, L.P. (incorporated by reference to Exhibit 10.30 to the Registrant's Annual Report on Form 10-K for the fiscal year ended November 30, 1997) 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 1998 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 35-57.* 13.2 "Consolidated Financial Statements", pages 59-92.* 13.3 "Market for Registrant"s Common Equity and Related Stockholder Matters", page 96.* 21. List of the Registrant's Subsidiaries*.* 23. Consent of Ernst & Young LLP.* 24. Powers of Attorney.* 27. Financial Data Schedule.*
(b) Reports on Form 8-K. 1. Form 8-K dated September 4, 1997, Item 7. 2. Form 8-K dated September 23, 1998, Items 5 and 7. 3. Form 8-K dated September 28, 1998, Items 5 and 7. 4. Form 8-K dated October 5, 1998, Items 5 and 7. - ------------------------ * Filed herewith. + Management contract or compensatory plan or arrangement reqired to be filed as an exhibit to this Form 10-K pursuant to Item 14(c) ** To be filed by amendment. 17 SIGNATURES Pursuant to the Requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report to be signed on its behalf by the undersigned, thereunto duly authorized. LEHMAN BROTHERS HOLDINGS INC. (REGISTRANT) FEBRUARY 26, 1999 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 * Chairman of the Board of - ------------------------------ Directors (principal February 26, 1999 Richard S. Fuld, Jr. executive officer) Chief Financial and * Administrative Officer - ------------------------------ (principal financial and February 26, 1999 John L. Cecil accounting officer) * Director - ------------------------------ February 26, 1999 Michael L. Ainslie * Director - ------------------------------ February 26, 1999 John F. Akers * Director - ------------------------------ February 26, 1999 Roger S. Berlind * Director - ------------------------------ February 26, 1999 Thomas H. Cruikshank * Director - ------------------------------ February 26, 1999 Henry Kaufman 18 SIGNATURES TITLE DATE - ------------------------------ --------------------------- ------------------- * Director - ------------------------------ February 26, 1999 Hideichiro Kobayashi * Director - ------------------------------ February 26, 1999 John D. Macomber * Director - ------------------------------ February 26, 1999 Dina Merrill /s/ KAREN M. MULLER Director - ------------------------------ Karen M. Muller February 26, 1999 (ATTORNEY-IN-FACT) February 26, 1999 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........................................................ 58 Consolidated Statement of Income for the Twelve Months Ended November 30, 1998, 1997, and 1996............................................................................ 59 Consolidated Statement of Financial Condition at November 30, 1998 and 1997........... 60 Consolidated Statement of Changes in Stockholders' Equity for the Twelve Months Ended November 30, 1998, 1997, and 1996................................................... 62 Consolidated Statement of Cash Flows for the Twelve Months Ended November 30, 1998, 1997, and 1996...................................................................... 64 Notes to Consolidated Financial Statements............................................ 66 FINANCIAL STATEMENT SCHEDULE Schedule I--Condensed Financial Information........................................... F-2
F-1 SCHEDULE I LEHMAN BROTHERS HOLDINGS INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENT OF INCOME (PARENT COMPANY ONLY) (IN MILLIONS)
TWELVE MONTHS ENDED NOVEMBER 30 ------------------------------- 1998 1997 1996 --------- --------- --------- Revenues Investment banking........................................................ $ 37 $ 140 $ 90 Principal transactions.................................................... (80) 193 23 Interest and dividends.................................................... 2,254 1,271 882 Other..................................................................... (71) 8 6 --------- --------- --------- Total revenues........................................................ 2,140 1,612 1,001 Interest expense.......................................................... 2,252 1,304 966 --------- --------- --------- Net revenues.......................................................... (112) 308 35 --------- --------- --------- Equity in net income of subsidiaries........................................ 942 492 454 --------- --------- --------- Non-interest expenses Compensation and benefits................................................. 135 113 64 Other..................................................................... 121 116 105 Management fees........................................................... 14 (28) (81) Severance charge.......................................................... 50 --------- --------- --------- Total non -interest expenses.......................................... 270 201 138 --------- --------- --------- Income before taxes......................................................... 560 599 351 Benefit from income taxes................................................. 176 48 65 --------- --------- --------- Net income.................................................................. $ 736 $ 647 $ 416 --------- --------- --------- --------- --------- --------- Net income applicable to common stock....................................... $ 649 $ 572 $ 378 --------- --------- --------- --------- --------- ---------
See notes to condensed financial information of Registrant. F-2 SCHEDULE I LEHMAN BROTHERS HOLDINGS INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT CONDENSED BALANCE SHEET (PARENT COMPANY ONLY) (IN MILLIONS, EXCEPT SHARE DATA)
NOVEMBER 30 -------------------- 1998 1997 --------- --------- ASSETS Cash and cash equivalents................................................................... $ 1,152 Securities and other financial instruments owned............................................ 10,561 $ 8,751 Securities purchased under agreements to resell............................................. 244 Equity in net assets of subsidiaries........................................................ 5,174 3,922 Accounts receivable and accrued interest.................................................... 490 596 Due from subsidiaries....................................................................... 23,149 17,230 Other assets................................................................................ 1,137 693 --------- --------- Total assets............................................................................ $ 41,907 $ 31,192 --------- --------- LIABILITIES AND STOCKHOLDERS' EQUITY Commercial paper and short-term debt........................................................ $ 3,596 $ 4,472 Securities and other financial instruments sold but not yet purchased....................... 81 122 Securities sold under agreeements to repurchase............................................. 11,162 8,758 Accrued liabilities, due to subsidiaries and other payables................................. 4,718 1,586 Senior notes................................................................................ 16,737 11,531 Subordinated indebtedness................................................................... 200 200 --------- --------- Total liabilities....................................................................... 36,494 26,669 --------- --------- Commitments and Contingencies Stockholders' equity: Preferred stock........................................................................... 908 508 Common stock, $0.10 par value; 300,000,000 shares authorized; Shares issued: 121,801,123 in 1998 and 119,513,337 in 1997; Shares outstanding: 113,657,877 in 1998 and 116,612,074 in 1997................................................................................. 12 12 Additional paid-in capital................................................................ 3,534 3,436 Accumulated other comprehensive income (net of tax)....................................... 15 12 Retained earnings......................................................................... 1,105 498 Other stockholders' equity, net........................................................... 269 155 Common stock in treasury, at cost: 8,143,246 shares in 1998 and 2,901,263 shares in 1997.................................................................................... (430) (98) --------- --------- Total stockholders' equity.............................................................. 5,413 4,523 --------- --------- Total liabilities and stockholders' equity.............................................. $ 41,907 $ 31,192 --------- ---------
See notes to condensed financial information of Registrant. F-3 SCHEDULE I LEHMAN BROTHERS HOLDINGS INC. CONDENSED FINANCIAL INFORMATION OF REGISTRANT STATEMENT OF CASH FLOWS (PARENT COMPANY ONLY) (IN MILLIONS)
TWELVE MONTHS ENDED NOVEMBER 30 ------------------------------- 1998 1997 1996 --------- --------- --------- CASH FLOWS FROM OPERATING ACTIVITIES Net income......................................................................... $ 736 $ 647 $ 416 Adjustments to reconcile net income to net cash provided by (used in)operating activities: Equity in net income of subsidiaries............................................. (942) (492) (454) Severance charge................................................................. 50 Compensation payable in common stock............................................. 221 162 136 Other adjustments................................................................ 178 24 (5) Net change in: Securities and other financial instruments owned................................. (1,810) (5,211) (945) Accounts receivable and accrued interest, due from subsidiaries and other assets......................................................................... (6,261) (6,380) (1,262) Securities and other financial instruments sold but not yet purchased............ (41) (76) 22 Accrued liabilities, due to subsidiaries and other payables...................... 2,978 770 (84) Dividends and capital distributions received..................................... 141 304 609 --------- --------- --------- Net cash provided by (used in) operating activities............................ (4,800) (10,252) (1,517) --------- --------- --------- CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from issuance of senior notes............................................. 8,298 3,925 2,686 Principal payments of senior notes................................................. (3,101) (1,689) (1,778) Proceeds from issuance of subordinated indebtedness................................ 200 Payments for commercial paper and short-term debt, net............................. (876) 1,297 1,073 Resale agreements net of repurchase agreements..................................... 2,160 6,140 545 Payment for repurchase of preferred stock.......................................... (50) (200) Payment for treasury stock purchases............................................... (411) (77) (130) Dividends paid..................................................................... (122) (58) (55) Issuances of common stock.......................................................... 61 23 6 Issuances of preferred stock....................................................... 444 --------- --------- --------- Net cash provided by (used in) financing activities............................ 6,403 9,561 2,347 --------- --------- --------- CASH FLOWS FROM INVESTING ACTIVITIES Equity in net assets of subsidiaries............................................... (451) 16 (173) --------- --------- --------- Net cash provided by (used in) investing activities............................ (451) 16 (173) --------- --------- --------- Net change in cash and cash equivalents........................................ 1,152 (675) 657 Cash and cash equivalents, beginning of period..................................... 675 18 --------- --------- --------- Cash and cash equivalents, end of period......................................... $ 1,152 $ 0 $ 675 --------- --------- --------- --------- --------- ---------
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION (IN MILLIONS) Interest paid totaled $2,121 in 1998, $1,277 in 1997 and $933 in 1996. Income taxes (received) paid totaled $(91) in 1998, $33 in 1997 and $(48) in 1996. See notes to condensed financial information of Registrant. F-4 LEHMAN BROTHERS HOLDINGS INC. NOTES TO CONDENSED FINANCIAL INFORMATION OF REGISTRANT (PARENT COMPANY ONLY) SCHEDULE I NOTE 1. BASIS OF PRESENTATION The condensed financial statements of Lehman Brothers Holdings Inc. ("Holdings") 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 1998 1997 --------- ----------- --------- ----------- --------- --------- (IN MILLIONS) Senior Notes Maturing in Fiscal 1998............................. $ 2,069 Maturing in Fiscal 1999............................. $ 1,536 $ 2,518 $ 623 $ 20 $ 4,697 2,612 Maturing in Fiscal 2000............................. 3,086 1,814 32 4,932 2,848 Maturing in Fiscal 2001............................. 1,017 608 1,625 510 Maturing in Fiscal 2002............................. 1,349 195 1,544 1,330 Maturing in Fiscal 2003............................. 1,660 383 15 2,058 489 December 1, 2003 and thereafter..................... 1,792 33 51 5 1,881 1,673 --------- ----------- --------- ----- --------- --------- Senior Notes...................................... 10,440 5,551 721 25 16,737 11,531 --------- ----------- --------- ----- --------- --------- Subordinated Indebtedness December 1, 2003 and thereafter................... 200 200 200 --------- ----------- --------- ----- --------- --------- Long-Term Debt...................................... $ 10,640 $ 5,551 $ 721 $ 25 $ 16,937 $ 11,731 --------- ----------- --------- ----- --------- --------- --------- ----------- --------- ----- --------- ---------
Of the Company's long-term debt outstanding as of November 30, 1998, $600 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 1999 to fiscal 2002, rather than at their contractual maturities, which range from fiscal 2000 to fiscal 2019. In addition, $920 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, 1998, the Company's U.S. dollar and non-U.S. dollar debt portfolios included approximately $238 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. 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, and swaptions as an end user to modify the interest rate characteristics of its long-term debt portfolio. The F-5 LEHMAN BROTHERS HOLDINGS INC. NOTES TO CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED) (PARENT COMPANY ONLY) 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, 1998 and November 30, 1997, the notional values of the Company's interest rate and currency swaps related to its long-term debt obligations were approximately $15.3 billion and $10.5 billion, respectively. In terms of notional amounts outstanding, these derivative products mature as follows:
NOVEMBER NON- U.S. CROSS -------------------- U.S. DOLLAR DOLLAR CURRENCY 1998 1997 ----------- ----------- ----------- --------- --------- (IN MILLIONS) Maturing in Fiscal 1998..................................... $ 1,760 Maturing in Fiscal 1999..................................... $ 2,864 $ 624 $ 3,488 2,324 Maturing in Fiscal 2000..................................... 4,709 32 4,741 2,454 Maturing in Fiscal 2001..................................... 1,579 1,579 468 Maturing in Fiscal 2002..................................... 1,609 1,609 1,167 Maturing in Fiscal 2003..................................... 1,968 $ 4 11 1,983 489 December 1, 2003 and thereafter............................. 1,921 56 1,977 1,812 ----------- --- ----- --------- --------- Total....................................................... $ 14,650 $ 4 $ 723 $ 15,377 $ 10,474 ----------- --- ----- --------- --------- Weighted-average interest rate at November 30:(1) Receive rate................................................ 6.54% 3.32% 4.43% 6.44% 6.97% Pay rate.................................................... 5.85% 0.64% 5.93% 5.86% 6.48%
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, 1998 ---------------------------------------------------- LONG-TERM DEBT WEIGHTED-AVERAGE(1) ------------------------ -------------------------- EFFECTIVE RATE BEFORE AFTER CONTRACTUAL AFTER END END USER END USER INTEREST USER ACTIVITIES ACTIVITIES RATE ACTIVITIES ----------- ----------- ----------- ------------- (IN MILLIONS) USD Obligations Fixed Rate................................................... $ 10,640 $ 156 Floating Rate................................................ 5,551 16,758 ----------- ----------- 16,191 16,914 Non-USD Obligations............................................ 746 23 ----------- ----------- ----------- ------ Total.......................................................... $ 16,937 $ 16,937 6.47% 5.93% ----------- ----------- ----------- ------
- ------------------------ (1) Weighted-average interest rates were calculated utilizing non-U.S. dollar interest rates, where applicable. F-6 LEHMAN BROTHERS HOLDINGS INC. NOTES TO CONDENSED FINANCIAL INFORMATION OF REGISTRANT (CONTINUED) (PARENT COMPANY ONLY)
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 Floating Rate.............................................. 1,712 11,602 ----------- ----------- 10,827 11,688 Non-USD Obligations.......................................... 904 43 ----------- ----------- ----------- ------ Total........................................................ $ 11,731 $ 11,731 6.93% 6.48% ----------- ----------- ----------- ------
- ------------------------ (1) Weighted-average interest rates were calculated utilizing non-US dollar interest rates, where applicable. NOTE 3. DIVIDENDS Dividends and capital distributions declared to Holdings by its subsidiaries and affiliates were $141 million in 1998, $304 million in 1997, and $609 million in 1996. NOTE 4. 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 on-going 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 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 Firm's New York Private Client Services offices. Additionally, the charge reflects various other strategic personnel reductions aimed at delayering management. 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 were paid as deferred payment arrangements were completed. 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 guaranteed certain of its subsidiaries' unsecured lines of credit and other contractual obligations. F-7 EX-12.1 2 COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES EXHIBIT 12.1 LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES COMPUTATION IN SUPPORT OF RATIO OF EARNINGS TO FIXED CHARGES (DOLLARS IN MILLIONS)
FOR THE FOR THE FOR THE FOR THE FOR THE ELEVEN MONTHS TWELVE TWELVE TWELVE TWELVE ENDED MONTHS ENDED MONTHS ENDED MONTHS ENDED MONTHS ENDED NOVEMBER 30 NOVEMBER 30 NOVEMBER 30 NOVEMBER 30 NOVEMBER 30 1994 1995 1996 1997 1998 ------------- ------------ ------------ ------------ ------------ Fixed Charges: Interest expense: Subordinated indebtedness............... $ 158 $ 206 $ 220 $ 240 $ 245 Bank loans and other borrowings*........................... 6,294 10,199 10,596 12,770 15,536 Interest component of rentals of office and equipment......................... 42 44 34 32 32 Other adjustments**..................... 4 28 16 9 15 ------ ------------ ------------ ------------ ------------ TOTAL (A)............................. $ 6,498 $ 10,477 $ 10,866 $ 13,051 $ 15,828 ------ ------------ ------------ ------------ ------------ ------ ------------ ------------ ------------ ------------ Earnings: Pretax income (loss) from continuing operations............................ $ 193 $ 369 $ 637 $ 937 $ 1,052 Fixed charges........................... 6,498 10,477 10,866 13,051 15,828 Other adjustments***.................... (4) (28) (14) (8) (15) ------ ------------ ------------ ------------ ------------ TOTAL (B)............................. $ 6,687 $ 10,818 $ 11,489 $ 13,980 $ 16,865 ------ ------------ ------------ ------------ ------------ ------ ------------ ------------ ------------ ------------ (B / A)................................... 1.03 1.03 1.06 1.07 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 3 COMPUTATION OF EARNINGS TO COMBINED FIXED CHARGES EXHIBIT 12.2 LEHMAN BROTHERS HOLDINGS INC. AND SUBSIDIARIES COMPUTATION IN SUPPORT OF RATIO OF EARNINGS TO COMBINED FIXED CHARGES AND PREFERRED DIVIDENDS (DOLLARS IN MILLIONS)
FOR THE FOR THE FOR THE FOR THE FOR THE ELEVEN MONTHS TWELVE TWELVE TWELVE TWELVE ENDED MONTHS ENDED MONTHS ENDED MONTHS ENDED MONTHS ENDED NOVEMBER 30 NOVEMBER 30 NOVEMBER 30 NOVEMBER 30 NOVEMBER 30 1994 1995 1996 1997 1998 ------------- ------------ ------------ ------------ ------------ Combined Fixed Charges and Preferred Dividends: Interest expense: Subordinated indebtedness............... $ 158 $ 206 $ 220 $ 240 $ 245 Bank loans and other borrowings*........ 6,294 10,199 10,596 12,770 15,536 Interest component of rentals of office and equipment......................... 42 44 34 32 32 Other adjustments**..................... 4 28 16 9 15 ------ ------------ ------------ ------------ ------------ Total fixed charges..................... 6,498 10,477 10,866 13,051 15,828 Preferred dividends (tax equivalent basis)................................ 58 64 58 109 124 ------ ------------ ------------ ------------ ------------ TOTAL (A)............................. $ 6,556 $ 10,541 $ 10,924 $ 13,160 $ 15,952 ------ ------------ ------------ ------------ ------------ ------ ------------ ------------ ------------ ------------ Earnings: Pretax income (loss) from continuing operations............................ $ 193 $ 369 $ 637 $ 937 $ 1,052 Fixed charges........................... 6,498 10,477 10,866 13,051 15,828 Other adjustments***.................... (4) (28) (14) (8) (15) ------ ------------ ------------ ------------ ------------ TOTAL (B)............................. $ 6,687 $ 10,818 $ 11,489 $ 13,980 $ 16,865 ------ ------------ ------------ ------------ ------------ ------ ------------ ------------ ------------ ------------ (B / A)................................... 1.02 1.03 1.05 1.06 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. EX-13.1 4 MD&A OF FINANCIAL CONDITION & RESULT OF OPERATIONS 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 generally favorable market and economic conditions that characterized fiscal 1997 continued throughout most of 1998, leading to increased industrywide revenues and to record levels of earnings and net revenues for the Company. The first eight months of fiscal 1998 were characterized by favorable fixed income spreads, strong investor demand, high valuations, low interest rates and significant merger and acquisition activity. However, by mid-August, instability in various emerging markets surfaced and dramatically changed the market landscape over the course of the next three months as spreads widened in core U.S. fixed income markets and major equity market indices experienced sharp declines. As a result of these factors, the IPO market was virtually halted in September, as investors sought safe havens. In response to fears that the global capital markets turmoil would impact the U.S. economy, the Federal Reserve (the "Fed") reduced interest rates three times. A number of European central banks also engaged in a coordinated series of interest rate cuts. The equity markets responded positively to the Fed easings, with the Dow Jones returning 21%, the S&P 22%, and the NASDAQ 30% from August 31 to November 30. The equity new issue market was revived in late October, initially by large, liquid issues and later by Internet-related IPOs. Despite the record levels of equity and equity- related issuance during the first eight months of fiscal 1998, total equity underwriting volume was significantly affected by the August-October slowdown. The total completed volume of equity-related offerings was 6.4% lower in fiscal 1998 than in fiscal 1997. FIXED INCOME Following relative stability for the first half of the year, turmoil erupted in many emerging markets in mid-August. Markets were buffeted by concerns about the lingering Asian economic troubles, which spread to Russia and still threaten Latin America, as well as political uncertainty in Washington. The trigger concerns were exacerbated by a Russian technical default on certain types of ruble-denominated debt and an effective devaluation of the ruble. As investors sought safe havens, U.S. Treasury and European government bond yields moved sharply lower, while spreads on core fixed income products widened dramatically. The widening of bond spreads prompted further concerns about a credit crunch that could threaten the continued expansion of the U.S. economy. The Fed, taking note of the increasing risks, stepped in to aggressively ease the Federal Funds rate by 75 basis points within two months to alleviate concern about the growth and stability of the U.S. and global economies. These factors influenced U.S. and European government bond markets. Ten-year U.S. Treasury yields touched a new historic low of 4.2% in early October -- a fall of 155 basis points from the beginning of the fiscal year before ending the year at just over 4.71%. The Fed's rate cuts coincided with a wave of international cuts that helped stabilize the higher yielding markets. Yields on ten-year German Bunds fell even more than comparable Treasuries -- by just under 170 basis points, to a new low of 3.77% before ending the fiscal year slightly off their global lows of 4%. EQUITIES In 1998, the U.S. equity markets experienced the most volatile year since the crash of 1987. Still, the major stock market indices established new records in 1998 despite suffering a 20% peak-to-trough decline that almost equaled the recession-related decline in 1990. For the year ended November 30, 1998, the S&P 500 Index returned 22%. Equity prices continued to be helped by a benign inflation and interest rate environment. Inflation remained below 2% for the year ended November 1998, while long-term interest rates declined. Given that there was no appreciable earnings growth, price/earnings multiple expansion was the primary driver of market performance. European equity markets performed strongly over the 12 months to November 1998, with the FT/S&P European Index achieving a handsome return of 27% in dollar terms. The domestic environment was highly supportive, with regional bond yields declining over 150 basis points in aggregate. However, the crisis across emerging markets and, in particular, events in Russia, resulted in extremely turbulent market conditions in the last four months of the year. From their peak in mid-July, European equities lost 26% of their value before recouping over half these losses, as a series of policy initiatives rebuilt market confidence. Despite the turmoil, European trading volumes remained healthy, with average turnover levels up on the previous year. Outside Europe, equity returns were negative for the year as a whole. In the Far East, equities lost 4% of their value in dollar terms (as measured by the FT/S&P Pacific Basin Index), although the equity markets outside of Japan experienced a dramatic turnaround in the last quarter. Sharp decreases in local interest and inflation rates, alongside some tentative signs of cyclical improvement and progress on fundamental reform allowed the region's equity markets to rise 46% from their trough at the start of September. The Japanese market failed to enjoy such a rebound, as economic output continued to contract and much of the corporate sector remained mired in excessive balance sheet leverage and low profitability. Latin American equities fared the worst over the year, declining 23% in dollar terms (as measured by the IFC Latin America Investable Index) as the Russian crises prompted investors to turn their attention to the fundamental imbalances in the region, especially Brazil's large fiscal deficit. CORPORATE FINANCE ADVISORY Corporate Finance Advisory activities continued at record levels throughout fiscal 1998, despite the global market turmoil caused by economic uncertainties throughout the world. Coming off a strong pace in 1997, the volume of announced transactions surged in 1998 to over $2.5 trillion while the volume of completed transactions totaled a record $2.1 trillion. This record volume of merger and acquisition activity continued to reflect the trend of consolidation, deregulation and globalization across industry sectors and across borders. The financial services industry is cyclical. Fiscal 1998 results reflected this as the Company alternated between eight strong months followed by three weak months only to end the year on a high note. As a result, the Company's businesses are evaluated across market cycles for operating profitability and their contribution to the Company's long-term strategic objectives. The Company strives to minimize the effects of economic downturns through its diversified revenue base; stringent cost controls, global presence, and risk management practices. - -------------------------------------------------------------------------------- Note: Except for the historical information contained herein, this Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that are based on current expectations, estimates and projections about the industries in which the Company operates. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions which are difficult to predict. The Company undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise. RESULTS OF OPERATIONS SUMMARY The Company reported record net income of $736 million and record earnings per share of $5.19 for 1998. These results built on the strong foundations for growth and profitability established in earlier years and demonstrate the impact of the Company's strategy to grow its high margin businesses within investment banking, equities, certain fixed income products, merchant banking and the high-net-worth retail business. The Company's shift in revenue mix in favor of these high margin businesses resulted in a more diversified revenue base and helped increase the Company's operating margin to 25.6% in 1998 from 24.2% in 1997. Also contributing to these record results was the Company's continued aggressive management of expenses. Non-personnel expenses were relatively flat even though revenues increased 6%. The compensation and benefits ratio remained constant at 50.7% of net revenues. For 1997, the Company reported net income of $647 million and earnings per share of $4.72, driven by continued strength in all of the Company's major businesses including equities, fixed income and investment banking. The Company began to realize the benefits associated with its strategy to grow certain high margin businesses. These results were achieved in worldwide markets which were extremely favorable during the early portion of the year and became volatile in the latter portion of the year. The overall favorable market conditions led to a second straight year of near-record industrywide underwriting volumes and a record year in worldwide merger and acquisition activity. For 1996, the Company reported net income of $416 million, including a $50 million after-tax severance charge. The Company's 1996 results reflected strong performances across all of the Company's major businesses. Fixed income sales and trading and investment banking activities were responsible for the majority of the increased net revenues and net income compared to 1995. The Company's results were positively affected by favorable market conditions, which led to near record underwriting volumes, record levels for many worldwide equity indices and a record year in worldwide merger and acquisition activity. NET REVENUES Net revenues were $4,113 million for 1998, $3,873 million for 1997 and $3,444 million for 1996. During 1998, the Company continued to build its global franchise. The increase in net revenues from 1997 levels reflects the Company's long-term strategy of growing high margin businesses, such as investment banking, equities and private client services. These businesses enjoyed strong results and helped to offset a difficult fixed income environment. In 1997, net revenues increased in all of the major business units led by increased customer flow activity, a strong global market for mergers and acquisitions and increased levels of worldwide debt and equity underwriting. The increase in net revenues in 1996 reflected a general strengthening in customer- related trading activities in a number of fixed income product areas, increased levels of worldwide debt and equity underwriting, and improved merger and acquisition results. Since 1990, Lehman Brothers has focused on a "client/customer-driven" strategy. Under this strategy, Lehman Brothers concentrates on serving the needs of major issuing and advisory clients and investing customers worldwide to build an increasing flow of business that leverages the Company's research, underwriting and distribution capabilities. Customer flow continues to be the primary source of the Company's net revenues. In addition to its customer flow activities, the Company also takes proprietary positions based upon expected movements in interest rate, foreign exchange, equity and commodity markets in both the short- and long-term. The Company's success in this area is dependent upon its ability to anticipate economic and market trends and to develop trading strategies that capitalize on these anticipated changes. Consistent with the Company's client/customer-driven strategy, proprietary trading activities accounted for only approximately 10% of net revenues in 1998, and 14% in both 1997 and 1996. 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 international securities and commodities exchanges, including the London, Tokyo, Hong Kong, Frankfurt, Milan and Paris stock exchanges. Net revenues from non-U.S. sources as a percentage of total net revenues were 35% for 1998. 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. Net revenues from the Company's market-making and trading activities in fixed income and equity products are recognized as either principal transactions or net interest revenues, depending upon the method of financing and/or hedging related to specific inventory positions. The Company evaluates its trading strategies on an overall profitability basis which combines both principal transactions revenues and net interest. Therefore, changes in net interest should not be viewed in isolation but should be viewed in conjunction with revenues from principal transactions. During 1998, combined principal transactions and net interest revenues decreased slightly from 1997. Principal transactions revenues declined due to decreased customer flow in fixed income driven by the severe spread widening in core U.S. fixed income markets in the later portion of the year. This was offset by improved performance in foreign exchange, high yield and equity derivatives. Net interest revenues increased as a result of an increase in interest bearing assets and a shift in the composition of the Company's fixed income portfolio towards higher yielding products. Combined principal transactions and net interest revenues 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. In the following table, the Company has been segregated into four major business units: Fixed Income, Equity, Corporate Finance Advisory and Merchant Banking. Each business unit represents a grouping of financial activities and products with similar characteristics. These business activities result in revenues from both institutional and high-net worth retail clients and customers that are recognized in multiple revenue categories contained in the Company's Consolidated Statement of Income. Net revenues by business unit contain certain internal allocations, including funding costs, which are centrally managed.
Twelve Months Ended November 30, 1998 Principal Transactions and Investment Net Interest Commissions Banking Other Total - ---------------------------------------------------------------------------------------------------- Fixed Income $1,638 $ 38 $ 581 $ (65) $2,192 Equity 351 458 309 3 1,121 Corporate Finance Advisory (5) 511 506 Merchant Banking (18) 181 163 Other 27 17 87 131 - ---------------------------------------------------------------------------------------------------- $1,993 $ 513 $1,582 $ 25 $4,113 - ---------------------------------------------------------------------------------------------------- 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 - ----------------------------------------------------------------------------------------------------
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. Fixed income revenues were $2,192 million for 1998, $2,186 million for 1997 and $2,165 million for 1996. During 1998 and 1997, the Company continued to focus its resources and efforts towards growing its market share in higher margin products. The Company's fixed income business benefited in 1998 from improved performance in high yield, primarily due to increased syndicate activity and increased revenues in foreign exchange from strong customer flow activity. High yield benefited from an increased volume of lead managed underwritings. Lehman acted as lead-manager for over $7.9 billion offerings in calendar 1998 up from $6.3 billion in calendar 1997. These improvements were offset in the latter part of the year by severe spread widening in core U.S. fixed income markets. Investment banking revenues as a component of fixed income revenues, increased to $581 million for the year ended 1998 from $380 million for the year ended 1997 primarily due to increased high yield related issuances. Lehman Brothers lead-managed fixed income offerings in calendar 1998 increased 38% with underwritings of $183 billion compared to underwritings of $133 billion in calendar 1997 based on information supplied by Securities Data Company. The Company's fixed income business benefited in 1997 from active customer trading combined with increased levels of worldwide debt underwriting which resulted from the favorable U.S. macroeconomic environment. 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. 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. 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 $1,121 million for 1998, $1,010 million for 1997 and $844 million for 1996. Equity revenues increased 11% versus fiscal 1997 primarily due to the successful redirection of the company's resources into higher margin businesses such as equity derivatives and equity finance, coupled with an overall favorable equities environment. Overall performance in equities withstood the economic turbulence suffered late in the year due to increased institutional and private client customer flow and favorable trading strategies, as well as the continued growth of the equity derivatives business. 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. CORPORATE FINANCE ADVISORY Corporate finance advisory net revenues, classified in the Consolidated Statement of Income as a component of investment banking revenues, result primarily from fees earned by the Company in its role as strategic advisor to its clients. This role primarily consists of advising clients on mergers and acquisitions, divestitures, leveraged buyouts, financial restructurings, and a variety of cross-border transactions. The net revenues for corporate finance advisory increased in 1998 to $506 million from $323 million in 1997 and from $249 million in 1996. The increased revenues reflected improved market share as a result of the Company's decision to invest additional resources in this business as well as continued strength in the overall merger and acquisition market environment. For completed M&A transactions, Lehman has improved its worldwide ranking from #10 to #6, increasing its market share from 5.2% to 13.2%, for the 1998 calendar year based on data supplied by Securities Data Company. The Company ended fiscal 1998 with a transaction pipeline which stood at $55 billion in terms of total dollar value based on information supplied by Securities Data Company. MERCHANT BANKING The Company is the general partner for 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 represent the Company's proportionate share of net realized and unrealized gains and losses from the sale and revaluation of investments held by the partnerships and advisory fees earned in its capacity as general partner to the partnerships. These gains generally fluctuate based on the number, type, age and performance of the underlying investments. Such amounts are classified in the Consolidated Statement of Income as a component of investment banking revenues. Merchant banking net revenues also reflect the net interest expense relating to the financing of the Company's investments in the partnerships. Merchant banking net revenues were $163 million, $260 million and $120 million for 1998, 1997 and 1996, respectively. NON-INTEREST EXPENSES During 1998, the Company's non-interest expenses totaled $3,061 million, an increase of 4% over 1997's non-interest expenses of $2,936 million. Non-interest expenses were $2,807 million for 1996, including a severance charge of $84 million. Excluding this special charge, non-interest expenses were $2,723 million for 1996. Twelve months ended November 30 [in millions] 1998 1997 1996 - ---------------------------------------------------------------------- Compensation and benefits $2,086 $1,964 $1,747 Nonpersonnel(1) 975 972 976 Severance 84 - ---------------------------------------------------------------------- Total non-interest expenses $3,061 $2,936 $2,807 - ---------------------------------------------------------------------- Compensation and benefits/ Net revenues 50.7% 50.7% 50.7% Nonpersonnel expenses(1)/ Net revenues 23.7% 25.1% 28.3% (1) Nonpersonnel expenses excluding severance charge. Compensation and benefits expenses increased in 1998 to $2,086 million from $1,964 million in 1997 and $1,747 million in 1996 as a result of higher net revenues. However, the Company maintained its compensation and benefits expense to net revenue ratio at 50.7% for 1998, 1997 and 1996. Nonpersonnel expenses were relatively unchanged at $975 million, $972 million and $976 million for 1998, 1997 and 1996, respectively. 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 reflecting the continued focus on expense management. This was all accomplished while net revenues increased 6% in 1998 compared to 1997 and 12% in 1997 compared to 1996. The benefits of the Company's reduction of its nonpersonnel expense level are that profit margins and earnings have improved significantly. 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. 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 were paid as deferred payment arrangements were completed. INCOME TAXES The Company had an income tax provision of $316 million, $290 million and $221 million for 1998, 1997 and 1996, respectively. The effective tax rate for the Company was 30% for 1998, 31% for 1997 and 35% for 1996. The lower effective tax rates in 1998 and 1997 reflect an increase in tax-exempt income. The 1996 income tax provision includes a tax benefit of $34 million related to the 1996 severance charge. The Company's net deferred tax assets increased by $281 million to $596 million at November 30, 1998 from $315 million at November 30, 1997. It is anticipated that the Company's net deferred tax assets will be realized through future earnings. LIQUIDITY AND CAPITAL RESOURCES OVERVIEW As a leading global investment bank that actively participates in the global capital markets, the Company has large and diverse capital requirements. Many of the business lines in which the Company operates are capital intensive. Capital is required to finance, among other things, the portion of the Company's securities inventories not funded on a secured basis, merchant banking activities and investments in fixed assets. The Company's primary activities are based on the execution of customer-related transactions. This flow of customer business supports the rapid asset turnover rate of the Company's inventory. The Company's balance sheet consists primarily of cash and cash equivalents, securities and other financial instruments owned, and collateralized short-term financing agreements. The liquid nature of these assets provides the Company with flexibility in financing and managing its business. The majority of these assets are funded on a secured basis through collateralized short-term financing agreements with the remaining assets being funded through unsecured financing and Capital. FUNDING AND CAPITAL POLICIES The Company's Finance Committee is responsible for establishing and managing the funding and liquidity policies of the Company. These policies include recommendations for capital and balance sheet size as well as the allocation of capital and balance sheet to product areas. Members of the Company's treasury department and business unit financing groups work with the Finance Committee to ensure coordination of global funding efforts and implementation of the funding and liquidity policies. Regional asset and liability committees aligned with the Company's geographic funding centers are responsible for implementing funding strategies for their respective regions. The primary goal of the Company's funding policies is to provide sufficient liquidity and availability of funding sources to meet the needs of the Company's businesses. The key elements of these policies are to: [GRAPHIC OMITTED] (1) Maintain a Total Capital structure that supports the business activities in which the Company is engaged. The Company is one of the most highly capitalized global investment banking firms with $32.8 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 primarily with secured liabilities. The Company continually reviews its mix of long- and short-term borrowings as it relates to maturity matching and the availability of secured and unsecured financing. In general, the Company finances its 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, long-term debt and stockholders' equity. Fixed assets, property, plant and equipment are generally financed with longer-dated fixed rate debt. Where the Company deems it to be appropriate and to minimize currency risks, foreign currency denominated assets are financed with corresponding foreign currency denominated liabilities. (3) Obtain diversified funding through a global investor base which increases liquidity and reduces concentration risk. The Company obtains global funding from both the banking community and short- and long-term investors 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 limits its exposure to any single investor or type of investor. (4) Maintain funding availability in excess of actual utilization. The Company maintains sizable uncommitted lines of credit from a broad range of banks and financial institutions from which it draws funds in a variety of currencies and which provide an additional source of liquidity. Uncommitted lines consist of facilities that the Company has been advised are available but for which no contractual lending obligations exist. Additionally, the Company maintains secured and unsecured committed revolving credit facilities as discussed in the following section. (5) Maintain sufficient financial resources to enable the Company to meet its obligations in periods of financial stress through a combination of collateralized short-term financings and Total Capital. Financial stress is defined as any event which severely constrains the Company's access to unsecured funding sources. To achieve this objective, the Company strives to maximize its use of global collateralized borrowing sources and reduce its reliance upon short-term unsecured borrowings. In this regard, the Company believes that increasing Total Capital will provide additional liquidity to cover periods of financial stress and further advance the Company's liquidity management objectives. Lastly, the Company periodically tests its secured and unsecured credit facilities to ensure availability and operational readiness. These policies position the Company to meet its liquidity requirements in all periods including those of financial stress. SHORT-TERM FUNDING The Company strives to maximize the portion of the Company's balance sheet that is funded through collateralized borrowing sources, which in turn minimizes the reliance placed upon unsecured short-term debt. Collateralized borrowing sources include cash market securities and other financial instruments sold but not yet purchased, as well as collateralized short-term financings, defined as securities sold under agreements to repurchase ("repos") and securities loaned. Because of their secured nature, OECD government repos and other investment grade types of collateralized borrowings are less credit-sensitive and have historically been a stable financing source irrespective of market conditions. The amount of the Company's collateralized borrowing activities will vary reflecting changes in the mix and overall levels of securities and other financial instruments owned which are driven by strategic business objectives and global market conditions. The majority of the Company's assets are funded with collateralized borrowing sources. At November 30, 1998 and 1997, $92 billion and $94 billion, respectively, of the Company's total balance sheet of $154 billion and $152 billion at November 30, 1998 and 1997, respectively, were financed using collateralized borrowing sources. As of November 30, 1998 and 1997, commercial paper and short-term debt outstanding was $6.7 billion and $7.8 billion, respectively. Of these amounts, commercial paper outstanding as of November 30, 1998 was $3.6 billion compared to $3.9 billion as of November 30, 1997. 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 for up to an additional year 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 July 1998, the Company entered into a new $1 billion Committed Securities Repurchase Facility (the "Facility") for LBIE, the Company's major operating entity in Europe. The Facility provides secured multi-currency financing for a broader range of collateral types than LBIE's previous committed secured credit facility. Under the terms of the Facility, the bank group will agree to provide funding for up to one year on a secured basis. Any loans outstanding on the commitment termination date may be extended for up to an additional year at the option of Holdings. The Facility contains covenants which require, among other things, that LBIE maintain specified levels of tangible net worth. There are no borrowings outstanding under either the Credit Agreement or the Facility. The Company may use the Credit Agreement and the Facility for general corporate purposes from time to time. The Company has maintained compliance with the applicable covenants for both the Credit Agreement and the Facility at all times. TOTAL CAPITAL As part of the Company's liquidity plan, the Company increased its Total Capital base in 1998 to $32.8 billion at November 30, 1998 from $24.8 billion at November 30, 1997 primarily due to an increase in long-term debt, preferred equity and the retention of earnings. November 30 [in millions] 1998 1997 1996 - ---------------------------------------------------------------------- LONG-TERM DEBT Senior Notes $23,873 $17,049 $12,571 Subordinated Indebtedness 3,468 3,212 3,351 - ---------------------------------------------------------------------- 27,341 20,261 15,922 STOCKHOLDERS' EQUITY Preferred Equity 908 508 508 Common Equity 4,505 4,015 3,366 - ---------------------------------------------------------------------- 5,413 4,523 3,874 - ---------------------------------------------------------------------- Total Capital $32,754 $24,784 $19,796 - ---------------------------------------------------------------------- [GRAPHIC OMITTED] During 1998, the Company issued $11.7 billion in long-term debt, which was $7.0 billion in excess of its maturing debt. Long-term debt increased to $27.3 billion at November 30, 1998 from $20.3 billion at November 30, 1997 with a weighted-average maturity of 3.5 years at November 30, 1998 and 4.1 years at November 30, 1997. At November 30, 1998, the Company had approximately $9.1 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 $5.4 billion at November 30, 1998 from $4.5 billion at November 30, 1997. The net increase in stockholders' equity was primarily due to the retention of earnings, the issuance of Preferred Stock (Series C and D) and 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 5.9 million, 3.8 million and 5.2 million RSUs were amortized into stockholders' equity in 1998, 1997 and 1996, respectively. RSU amortization was $221 million, $162 million and $136 million in 1998, 1997 and 1996, respectively, net of cancellations. During 1998 and 1997, the Company repurchased or acquired shares of its Common Stock at an aggregate cost of $469 million and $77 million (approximately 8.6 million shares and 1.6 million shares, respectively). These shares are being reserved for future issuances under employee stock-based compensation plans. During 1997, the Company established a trust (the "RSU Trust") in order to provide common stock voting rights to employees who hold outstanding RSUs and to encourage employees to think and act like owners. The RSU Trust was initially funded with a total of 16 million shares valued at $325 million 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. In 1998, the Company transferred an additional 2.5 million shares into the RSU Trust valued at $107 million. At November 30, 1998, approximately 18.1 million shares were held in the RSU Trust. In January 1998, the Company announced its intention to repurchase up to 4.5 million common shares during the fiscal year and to increase the common dividend by 25%. In September 1998, the Company announced its intention to repurchase an additional 7.5 million common shares. During 1998 the Company completed the repurchase of 8.6 million shares as part of its ongoing program to actively manage its capital position and common shares outstanding. In January 1999, the Company announced it was extending its previously announced 7.5 million share buyback program by an additional 2.0 million shares. Also announced in January 1999 was a 20% increase in the Company's dividend to $0.36 per share from $0.30 per share. [GRAPHIC OMITTED] 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 believes that the adjusted 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 20.6x and 23.9x at November 30, 1998 and 1997, respectively. The Company's average adjusted leverage ratio was 26.6x and 28.9x for the years ended November 30, 1998 and 1997, respectively. 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 averages. The Company also closely monitors its primary double leverage ratio. A primary 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 0.96 at November 30, 1998 compared to 0.87 at November 30, 1997. 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. On May 8, 1998, Thomson Bank Watch upgraded its ratings on the senior debt of LBHI to A from A-. On September 21, Moody's reaffirmed its "stable" long-term debt ratings of LBHI and changed its outlook on the Company from positive to stable. In December 1998, Standard & Poor's reaffirmed its long-term rating of LBHI at A. As of November 30, 1998, 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 INSURANCE SUBSIDIARY The Company has established a new subsidiary to underwrite and accumulate insurance and reinsurance risks. The new subsidiary, Lehman Re Ltd., is a Bermuda licensed Class 4 and long-term insurance company. Lehman Re Ltd. intends to underwrite property and casualty, as well as life and annuity insurance risks. It expects to focus its business initially in four areas: finite and structured financial products; political risk and trade credit insurance; property catastrophe reinsurance; and life and annuity reinsurance. LEHMAN BROTHERS DERIVATIVE PRODUCTS On July 16, 1998, the Company announced that it had established a special purpose subsidiary that will provide counterparties around the world with a wide variety of derivative products and services. The new company, Lehman Brothers Derivative Products Inc. ("LBDP") has been assigned Aaa and AAAt credit ratings by Moody's Investor Services Inc. and Standard & Poor's Corporation, respectively. LBDP was created to provide clients with the most efficient delivery of a broad range of derivative product opportunities. Its termination structure compliments the continuation structure of Lehman Brothers Financial Products Inc. ("LBFP"). REGULATORY CAPITAL 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, 1998, LBI's regulatory net capital, as defined, of $1,406 million exceeded the minimum requirement by $1,320 million. In addition to amounts presented in the accompanying Consolidated Statement of Financial Condition as cash and securities segregated and on deposit for regulatory and other purposes, securities with a market value of approximately $1,332 million and $1,290 million at November 30, 1998 and 1997, respectively, primarily collateralizing securities purchased under agreements to resell, have been segregated in a special reserve bank account for the exclusive benefit of customers pursuant to the Reserve Formula requirements of SEC Rule 15c3-3. 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, 1998, LBIE's financial resources of approximately $2.5 billion exceeded the minimum requirement by approximately $900 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, 1998, had net capital of approximately $320 million which was approximately $95 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, 1998, these other subsidiaries were in compliance with their applicable local capital adequacy requirements. The Company's "AAA" rated derivatives subsidiaries, LBFP and LBDP, have established certain capital and operating restrictions which are reviewed by various rating agencies. At November 30, 1998, LBFP and LBDP each had capital which exceeded the requirement of the most stringent rating agency by approximately $135 million and $27 million, respectively. 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, 1998, approximately $3.5 billion of net assets of subsidiaries were restricted as to the payment of dividends to Holdings. CASH FLOWS Cash and cash equivalents increased $1,370 million in 1998 to $3,055 million, as the net cash provided by financing activities exceeded the net cash used in operating and investing activities. Net cash used in operating activities of $10,060 million included income adjusted for non-cash items of $1,099 million for 1998. Net cash provided by financing activities was $11,549 million and net cash used in investing activities was $119 million. Cash and cash equivalents decreased $464 million in 1997 to $1,685 million, as net cash was used in operating, financing and investing activities. Net cash used in operating activities of $264 million included income adjusted for non-cash items of $675 million for 1997. Net cash used in financing activities was $126 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 $4,375 million included income adjusted for non-cash items of $889 million for 1996. Net cash provided by financing activities was $5,708 million and net cash used in investing activities was $58 million. HIGH YIELD SECURITIES The Company underwrites, trades, invests and makes markets in high yield corporate debt securities. The Company also syndicates, trades and invests in loans to below investment grade-rated companies. For purposes of this discussion, high yield debt instruments are defined as securities or loans to companies rated BB+ or lower, or equivalent ratings by recognized credit rating agencies, as well as non-rated securities or loans which, in the opinion of management, are non-investment grade. Non-investment grade securities generally involve greater risks than investment grade securities due to the issuer's creditworthiness and the liquidity of the market for such securities. In addition, these issuers have higher levels of indebtedness, resulting in an increased sensitivity to adverse economic conditions. The Company recognizes these risks and aims to reduce market and credit risk through the diversification of its products and counterparties. High yield debt instruments are carried at market value, and unrealized gains or losses for these securities are reflected in the Company's Consolidated Statement of Income. The Company's portfolio of such instruments at November 30, 1998 and 1997 included long positions with an aggregate market value of approximately $2.3 billion and $3.2 billion, respectively, and short positions with an aggregate market value of approximately $217 million and $172 million, respectively. The Company may, from time to time, mitigate its net exposure to any single issuer through the use of derivatives and other financial instruments. The Company, through its high yield sales and trading activities, makes commitments to extend credit in loan syndication transactions principally to below investment grade borrowers and participates out a significant portion of these commitments. These commitments, which are net of syndications and participations totaled $2.0 billion at November 30, 1998 and $1.6 billion at November 30, 1997, are typically secured against the borrower's assets and have fixed maturity dates. The utilization of these facilities is generally contingent upon certain representations, warranties and contractual conditions of the borrower. Total commitments may not be indicative of actual risk or funding requirements as the commitments may not be drawn or fully utilized and the Company intends to continue syndicating, selling, and/or participating in these commitments. The Company also had lending commitments to high grade borrowers of $675 million at November 30, 1998. These commitments are typically secured against the borrower's assets, have fixed maturity dates, and are generally contingent upon certain representations, warranties and contractual conditions of the borrower. In addition to these specific commitments, the Company had various other commitments of approximately $335 million at November 30, 1998. 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, 1998 and 1997, investments in merchant banking partnerships totaled $245 million and $167 million, respectively while direct investments totaled $207 million and $75 million, respectively. The Company's policy is to carry its investments, including its partnership interests, at fair value based upon the Company's assessment of the underlying investments. At November 30, 1998, the Company had commitments to invest up to $379 million in the partnerships, which in turn will make direct merchant banking related investments. These commitments will be funded as required through the end of the respective partnerships' investment periods, principally expiring in 2004. In addition, at November 30, 1998, the Company had no direct short-term bridge financings outstanding. NON-CORE ACTIVITIES AND INVESTMENTS In March 1990, the Company discontinued the origination of partnerships (the assets of which are primarily real estate) and investments in real estate. Currently, the Company acts as a general partner or co-general partner for approximately $1.6 billion of partnership investment capital and manages the remaining real estate investment portfolio. At November 30, 1998, the Company had $30 million of net exposure to these real estate activities, including investments, commitments and contingent liabilities under guarantees and credit enhancements. The Company believes any exposure under these commitments and contingent liabilities has been adequately reserved. In certain circumstances, the Company has elected to provide financial and other support and assistance to such investments to maintain investment values. There is no contractual requirement that the Company continue to provide this support. Management's intention with regard to non-core assets is the prudent liquidation of these investments as and when possible. OFF-BALANCE SHEET FINANCIAL INSTRUMENTS AND DERIVATIVES OVERVIEW Derivatives are financial instruments, which include swaps, options, futures, forwards and warrants, whose value is based upon an underlying asset (e.g., treasury bond), index (e.g., S&P 500) or reference rate (e.g., LIBOR). A derivative contract may be traded on an exchange or negotiated in the over-the-counter markets. Exchange-traded derivatives are standardized and include futures, warrants and certain option contracts listed on an exchange. Over-the-counter ("OTC") derivative contracts are individually negotiated between contracting parties and include forwards, swaps and certain options, including caps, collars and floors. The use of derivative financial instruments has expanded significantly over the past decade. One reason for this expansion is that derivatives provide a cost effective alternative for managing market risk. In this regard, derivative contracts provide a reduced funding alternative for managing market risk since derivatives are based upon notional amounts, which are generally not exchanged, but rather are used merely as a basis for exchanging cash flows during the duration of the contract. Derivatives are also utilized extensively as highly effective tools that enable users to adjust risk profiles, such as interest rate, currency, or other market risks, or to take proprietary trading positions, since OTC derivative instruments can be tailored to meet individual client needs. Additionally, derivatives provide users with access to market risk management tools which are often unavailable in traditional cash instruments. Derivatives are subject to various risks similar to non-derivative financial instruments including market, credit and operational risk. Market risk is the potential for a financial loss due to changes in the value of derivative financial instruments due to market changes, including changes in interest rates, foreign exchange rates and equity and commodity prices. Credit risk results from the possibility that a counterparty to a derivative transaction may fail to perform according to the terms of the contract. Therefore, the Company's exposure to credit risk is represented by its net receivable from derivative counterparties, after consideration of collateral. Operational risk is the possibility of financial loss resulting from a deficiency in the Company's systems for executing derivative transactions. In addition to these risks, counterparties to derivative financial instruments may also be exposed to legal risks related to derivative activities, including the possibility that a transaction may be unenforceable under applicable law. The risks of derivatives should not be viewed in isolation but rather should be considered on an aggregate basis along with the Company's other trading-related activities. As derivative products have continued to expand in volume, so has market participation and competition. As a result, additional liquidity has been added into the markets for conventional derivative products, such as interest rate swaps. Competition has also contributed to the development of more complex products structured for specific clients. It is this rapid growth and complexity of certain derivative products which has led to the perception, by some, that derivative products are unduly risky to users and the financial markets. In order to remove the public perception that derivatives may be unduly risky and to ensure ongoing liquidity of derivatives in the marketplace, the Company supports the efforts of the regulators in striving for enhanced risk management disclosures which consider the effects of both derivative products and cash instruments. In addition, the Company supports the activities of regulators which are designed to ensure that users of derivatives are fully aware of the nature of risks inherent within derivative transactions. As evidence of this support, the Company is an active participant in the Derivative Policy Group and has been actively involved with the various regulatory and accounting authorities in the development of additional enhanced reporting requirements related to derivatives. The Company strongly believes that derivatives provide significant value to the financial markets and is committed to providing its clients with innovative products to meet their financial needs. LEHMAN BROTHERS' USE OF DERIVATIVE INSTRUMENTS In the normal course of business, the Company enters into derivative transactions both in a trading capacity and as an end user. As an end user, the Company utilizes derivative products to adjust the interest rate nature of its funding sources from fixed to floating interest rates and vice versa, and to change the index upon which floating interest rates are based (e.g., Prime to LIBOR) (collectively, "End User Derivative Activities"). For a further discussion of the Company's End User Derivative Activities see Note 12 to the Consolidated Financial Statements. The Company utilizes derivative products in a trading capacity both as a dealer to satisfy the financial needs of its clients and in each of its trading businesses (collectively, "Trading-Related Derivative Activities"). The Company's use of derivative products in its trading businesses is combined with cash instruments to fully execute various trading strategies. The Company conducts its derivative activities through a number of wholly owned subsidiaries. The Company's fixed income derivative products business is conducted through its special purpose subsidiary, Lehman Brothers Special Financing Inc., and separately capitalized "AAA" rated subsidiaries, Lehman Brothers Financial Products Inc. and Lehman Brothers Derivative Products Inc. 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 51-53. The Company's Trading-Related Derivative Activities have increased during the current year to a notional amount of $2,398 billion at November 30, 1998 from $1,855 billion at November 30, 1997, primarily as a result of growth in the Company's activities as a dealer in fixed income derivative products. Notional amounts are not recorded on the balance sheet and are not indicative of actual or potential risk, but rather they provide a measure of the Company's involvement with such instruments. As a result of the Company's Trading-Related Derivative activities, the Company is subject to credit risk. With respect to OTC derivative contracts, the Company's credit exposure is directly with its counterparties and extends through the duration of the derivative contracts. The Company views its net credit exposure to be $6,939 million at November 30, 1998, 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, 1998 approximately 76% of the Company's net credit risk exposure related to OTC contracts was with counterparties rated "A-" or better. Additionally, the Company is exposed to credit risk related to its exchange-traded derivative contracts. Exchange-traded derivative contracts include futures contracts, warrants and certain options. Futures contracts and options on futures are transacted on the respective exchange. The exchange clearinghouse is a counterparty to the futures contracts and options. As a clearing member firm, the Company is required by the exchange clearinghouse to deposit cash or other securities as collateral for its obligation upon the origination of the contract and for any daily changes in the market value of open futures contracts. Unlike OTC derivatives which involve numerous counterparties, the number of counterparties from exchange-traded derivatives includes only those exchange clearinghouses of which the Company is a clearing member firm or other member firms the Company utilizes as agents. Substantially all of the Company's exchange-traded derivatives are transacted on exchanges of which the Company is a clearing member firm. To protect against the potential for a default, all exchange clearinghouses impose net capital requirements for their membership. Therefore, the potential for losses from exchange-traded products is limited. As of November 30, 1998, the Company had approximately $1,448 million on deposit with futures exchanges consisting of cash and securities (customer and proprietary), and had posted approximately $127 million of letters of credit. See Note 12 to the Consolidated Financial Statements for a further discussion of the Company's Trading-Related Derivative Activities. ACCOUNTING AND VALUATION The Company's accounting methodology for derivatives depends on both the type and purpose of the derivative financial instrument. The Company records its Trading-Related Derivative Activities on a mark-to-market or fair value basis. Under mark-to-market or fair value accounting, realized and unrealized gains and losses are recognized currently in Principal transactions, and resulting assets and liabilities are recorded in the Consolidated Statement of Financial Condition as Derivatives and other contractual agreements, as applicable. Derivative assets and liabilities are netted by counterparty, when permitted under a legally enforceable master netting agreement. Derivatives utilized in conjunction with the Company's End User Derivative Activities are generally recorded on an accrual basis. Interest is accrued into income or expense over the life of the contract, resulting in the net interest impact of the derivative and the underlying hedged item being recognized in income throughout the hedge period. Market or fair value for Trading-Related Derivative Activities is generally determined by either quoted market prices or pricing models. Pricing models utilize a series of market inputs to determine the present value of future cash flows, with adjustments, as required, for credit risk and liquidity risk. Further valuation adjustments may be recorded, as deemed appropriate, for new or complex products or for significant positions. These adjustments are integral components of the mark-to-market process. RISK MANAGEMENT As a leading global investment banking company, risk is an inherent part of the Company's businesses. Global markets, by their nature, are prone to uncertainty and subject participants to a variety of risks. The Company has developed policies and procedures to identify, measure and monitor each of the risks involved in its trading, brokerage and investment banking activities on a global basis. The principal risks of Lehman Brothers are market, credit, liquidity, legal and operational risks. Risk Management is considered to be of paramount importance. The Company devotes significant resources across all of its worldwide trading operations to the measurement, management and analysis of risk, including investments in personnel and technology. The Company seeks to reduce risk through the diversification of its businesses, counterparties and activities in geographic regions. The Company accomplishes this objective by allocating the usage of capital to each of its businesses, establishing trading limits for individual products and traders and setting credit limits for individual counterparties, including regional concentrations. The Company seeks to achieve adequate returns from each of its businesses commensurate with the risks that they assume. Overall risk management policy is established by a Risk Management Committee (the "Committee") comprised of the Chief Executive Officer, the Global Risk Manager, the Chief Financial and Administrative Officer, the Head of Equities, the Head of Fixed Income, the Head of Global Sales and Research and the Co-Heads of Investment Banking. The Committee brings together senior management with the sole intent of discussing risk related issues and provides an effective forum for managing risk at the highest levels within the Company. The Committee meets on a monthly basis, or more frequently if required, to discuss, among other matters, significant market exposures, concentrations of positions (e.g., counterparty, market risk), potential new transactions or positions and risk limit exceptions. The Global Risk Management Group (the "Group") supports the Committee, is independent of the trading areas and reports directly to the Chief Executive Officer. The Group combines two departments, credit risk management and market risk management, into one unit. This facilitates the analysis of counterparty credit and market risk exposures and leverages personnel and information technology resources in a cost-efficient manner. The Group maintains staff in each of the Company's regional trading centers and has daily contact with trading staff at all levels within the Company. These discussions include a review of trading positions and risk exposures. CREDIT RISK Credit risk represents the possibility that a counterparty will be unable to honor its contractual obligations to the Company. Credit risk management is therefore an integral component of the Company's overall risk management framework. The Credit Risk Management Department ("CRM Department") has global responsibility for implementing the Company's overall credit risk management framework. The CRM Department manages the credit exposure related to trading activities by giving initial credit approval for counterparties, establishing credit limits by counterparty, country and industry group and by requiring collateral in appropriate circumstances. In addition, the CRM Department strives to ensure that master netting agreements are obtained whenever possible. The CRM Department also considers the duration of transactions in making its credit decisions, along with the potential credit exposure for complex derivative transactions. The CRM Department is responsible for the continuous monitoring and review of counterparty credit exposure and creditworthiness and recommending, where appropriate, credit reserves. Credit limits and reserves are reviewed periodically to ensure that they remain appropriate in light of market events or the counterparty's financial condition. MARKET RISK Market risk represents the potential change in value of a portfolio of financial instruments due to changes in market rates, prices, and volatilities. Market risk management also is an essential component of the Company's overall risk management framework. The Market Risk Management Department ("MRM Department") has global responsibility for implementing the Company's overall market risk management framework. It is responsible for the preparation and dissemination of risk reports, developing and implementing the firmwide Risk Management Guidelines and evaluating adherence to these guidelines. These guidelines provide a clear framework for risk management decision-making. To that end the MRM Department identifies and quantifies risk exposures, develops limits, and reports and monitors these risks with respect to the approved limits. The identification of material market risks inherent in positions includes, but is not limited to, interest rate, equity, and foreign exchange risk exposures. In addition to these risks, the MRM Department also evaluates liquidity risks, credit and sovereign concentrations. The MRM Department utilizes qualitative as well as quantitative information in managing trading risk, believing that a combination of the two approaches results in a more robust and complete approach to the management of trading risk. Quantitative information is developed from a variety of risk methodologies based upon established statistical principles. To ensure high standards of qualitative analysis, the MRM Department has retained seasoned risk managers with the requisite experience and academic and professional credentials. Market risk is present in cash products, derivatives, and contingent claim structures that exhibit linear as well as non-linear profit and loss sensitivity. The Company's exposure to market risk varies in accordance with the volume of client driven market-making transactions, the size of the Company's proprietary and arbitrage positions, and the volatility of financial instruments traded. The Company seeks to mitigate, whenever possible, excess market risk exposures through the use of futures and option contracts and offsetting cash market instruments. The Company participates globally in interest rate, equity, and foreign exchange markets. The Company's Fixed Income division has a broadly diversified market presence in U.S. and foreign government bond trading, emerging market securities, corporate debt (investment and non-investment grade), money market instruments, mortgages and mortgage-backed securities, asset-backed securities, municipal bonds, and interest rate derivatives. The Company's Equities division facilitates domestic and foreign trading in equity instruments, indices, and related derivatives. The Company's foreign exchange businesses are involved in trading currencies on a spot and forward basis as well as through derivative products and contracts. The Company incurs short-term interest rate risk when facilitating the orderly flow of customer transactions through the maintenance of government and high-grade corporate bond inventories. Market-making in high yield instruments exposes the Company to additional risk due to potential variations in credit spreads. Trading in international markets exposes the Company to spread risk between the term structure of interest rates in differing countries. Mortgage-related securities are subject to prepayment risk and changes in the level of interest rates. Trading in derivatives and structured products exposes the Company to changes in the level and volatility of interest rates. The Company actively manages interest rate risk through the use of interest rate futures, options, swaps, forwards, and offsetting cash market instruments. Inventory holdings, concentrations, and agings are monitored closely and used by management to selectively hedge or liquidate undesirable exposures. The Company is a significant intermediary in the global equity markets by making markets in U.S. and non-U.S. equity securities, including common stock, convertible debt, exchange-traded and OTC equity options, equity swaps and warrants. These activities expose the Company to market risk as a result of price and volatility changes in its equity inventory. Inventory holdings are also subject to market risk resulting from concentrations, aging and liquidity that may adversely impact its market valuation. Equity market risk is actively managed through the use of index futures, exchange-traded and OTC options, swaps and cash instruments. Equity risk exposures are aggregated and reported to management on a regular basis. The Company enters into foreign exchange transactions in order to facilitate the purchase and sale of non-dollar instruments, including equity and interest rate securities. The Company is exposed to foreign exchange risk on its holdings of non-dollar assets and liabilities. The Company is active in many foreign exchange markets and has exposure to the Euro, Japanese yen, British pound, Swiss franc, and Canadian dollar, as well as, a variety of developed and emerging market currencies. The Company hedges its risk exposures primarily through the use of currency forwards, swaps, futures, and options. COMMERCIAL MORTGAGE BUSINESS The Company has one of the premier commercial mortgage-backed securities businesses. In this business, the Company buys commercial mortgages, converts them to securities, and then sells those securities. The Company's operating practices have served to mitigate a number of the risks in this business. First, the Company securitizes its commercial mortgage inventory frequently. This shortens holding periods and increases the turnover rate of the Company's mortgage inventory. Second, the bulk of the Company's origination has been floating rate mortgage product. Of the Company's current commercial mortgage inventory, approximately 85 percent is floating rate, or has been swapped into floating rates. These loans hold their value much better than fixed rate loans or hybrid products. VALUE AT RISK For purposes of Securities and Exchange Commission risk disclosure requirements, the Company disclosed an entity-wide value at risk analysis of virtually all of the Company's trading activities. The value at risk calculation measures the potential loss in expected revenues with a 95% confidence level. The methodology incorporates actual trading revenues over a standardized historical period. A confidence level of 95% implies, on average, that daily trading revenues or losses will exceed daily expected trading revenues by an amount greater than value at risk one out of every 20 trading days. Value at risk is one measurement of potential losses in revenues that may result from adverse market movements over a specified period of time with a selected likelihood of occurrence. Value at risk has substantial limitations, including its reliance on historical performance and data as valid predictors of the future. Consequently, value at risk is only one of a number of tools the Company utilizes in its daily risk management activities. The Company's average value at risk for each component of market risk, and in total was as follows: November 30 [in millions] 1998 1997 - ------------------------------------------------------- Interest rate risk $15.0 $12.8 Equity price risk 9.5 5.6 Foreign exchange risk 3.9 5.3 Diversification benefit (9.8) (8.6) - ------------------------------------------------------- Total Company $18.6 $15.1 - ------------------------------------------------------- During 1998, the Company's value at risk varied from a high of $32.8 million to a low of $14.2 million. During 1997, the Company's value at risk varied from a high of $16.4 million to a low of $13.7 million. Average value at risk during 1998 includes the effects of the extreme market volatility experienced during the August-October 1998 time period. Value at risk at November 30, 1998 and 1997 was $31.7 million and $14.8 million, respectively. Average daily trading revenue decreased to $8.6 million in 1998 from $10.0 million in 1997 as a result of difficult market conditions during the August-October period. As discussed throughout Management's Discussion and Analysis, the Company seeks to reduce risk through the diversification of its businesses and a focus on customer flow activities. This diversification and focus, combined with the Company's risk management controls and processes, helps mitigate the net revenue volatility inherent in the Company's trading activities. Although historical performance is not necessarily indicative of future performance, the Company believes its focus on business diversification and customer flow activities should continue to help mitigate the volatility of future net trading revenues. YEAR 2000 READINESS DISCLOSURE The year 2000 issue originates from computer programs and imbedded chips using two digits rather than four to define the year. Computer programs that have date-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. If not addressed and completed on a timely basis, failure of the Company's computer systems to process year 2000 related data correctly could have a material adverse effect on the Company's operations and financial condition. Failures of this kind could, for example, lead to incomplete or inaccurate accounting, settlement failures, trade processing or recording errors in securities, currencies, commodities or other assets. It could also lead to uncertainty regarding risk, exposures and liquidity. If not addressed, the potential risks to the Company include financial loss, legal liability, interruption of business and regulatory actions. The Company established a team in 1996 to modify or replace and then test the appropriate software and equipment to ensure that year 2000 issues are addressed. The Company presently believes that with modifications to existing software and conversions to new software, the year 2000 issue will be resolved for all the Company's own systems worldwide. In its approach to the year 2000 problem, Lehman Brothers has been guided by a three-step methodology. The steps are: - INVENTORY AND ASSESSMENT - REMEDIATION - TESTING Inventory and assessment consisted of initial technical and functional analysis across the Company's applications. Initial analysis identified systems and applications. Each application was then reviewed and classified as highly critical, critical or non-critical. This process is complete. Remediation is divided into three phases. Applications specified as year 2000 non-compliant have been analyzed to determine business impact and those that have been deemed critical were targeted for remediation. Selected Lehman Brothers mainframe applications were sent to an outside vendor for remediation, while the remaining applications have been repaired internally. It is 99% complete as of the end of 1998 and is expected to be 100% complete by the end of the first quarter of 1999. All remediated applications are tested for non-year 2000 functionality to confirm they still run correctly prior to year 2000 testing. At the time of remediation, applications are logged into a change management system to further ensure any additional changes are monitored and re-tested for year 2000 compliance. Testing for year 2000 compliance was also organized into three phases. Phase one involves testing individual applications or groups of applications on mainframe or on distributed platforms. Consultants were engaged to assist with the testing of distributed applications classified as highly critical. Phase two involves real-time testing across platforms (integration testing). Phase three involves testing applications between firms (external testing). Each of these phases has been pursued in a worldwide effort coordinated in New York, London and Tokyo where project teams and segregated lab environments have been established. The remediation and testing has been largely completed for core databases. External testing itself is being performed in three steps. "Point-to-point" testing confirms that application interfaces between the Company and individual services and utilities function correctly. Point-to-point testing began in February 1998. "Beta" testing for a product follows point-to-point testing and is a dress rehearsal for industrywide testing. Beta testing is only performed in the U.S. Many of the markets are not providing industrywide testing, but they are providing some amount of end-to-end testing, where data is passed to more than one exchange or utility. Industrywide testing follows beta testing as the final external testing step. In 1998, the Company participated in two Beta tests in the U.S., for the SIA and for the Futures Industry Association (FIA). The Company has also participated in the SIA Money Market Beta Test, the Mortgage-Backed Securities Clearing Corporation Test, the Participant Trust Company Mortgage Test and the Government Securities Clearing Corporation Test. Overseas tests in which the Company has participated include the Central Gilts Office (CGO) and CREST in the United Kingdom and the Singapore International Monetary Exchange (SIMEX) test in Singapore. The Company is scheduled to participate in numerous domestic tests in 1999, including the SIA Market Data Beta Test in February, the SIA Industrywide Test in March and April, the SIA Money Market and Stock Loan tests in May and the SIA Industrywide Market Data Test in May. In addition the Company is scheduled to participate in a wide range of overseas tests in 1999, specifically, Hong Kong and Tokyo tests planned for the first and second quarters. The Company plans to participate in European tests as they are announced. Industrywide testing is currently expected to be completed in the third quarter. The Company has taken a lead in the industry's efforts to deal with the year 2000 issue by actively participating and in some cases leading, industrywide testing efforts. Lehman Brothers chairs the Participants' Industrywide Testing Subcommittee of the Securities Industry Association (SIA) which with partners such as exchanges, depositories, market data vendors and buy-side firms sets up, refines and coordinates industrywide testing in the United States. Industrywide testing is the forum in which firms within the financial industry test the applications that transfer data between them. These tests are scheduled to start in March 1999. In addition to its leadership in U.S. testing efforts, through membership in the Executive Committee of Global 2000, a group of international financial firms, the Company is participating in the coordination of global year 2000 readiness in the financial community. The Company is also pursuing separate point-to-point testing with firms not participating in industrywide testing. Lehman Brothers also serves as a member of the Custody 2000 Working Group whose goal is to assist the financial community in the assessment of year 2000 readiness of custodians in a variety of global markets. The Custody 2000 Working Group will also conduct proxy testing of selected sub-custodians in a number of markets globally. Year 2000 also affects building and infrastructure systems. The Company is engaged in a global effort to address facilities issues. Critical areas include facilities components such as building management systems, elevators, heating systems, security and fire alarm systems, electrical and other building services. Facilities staff is surveying and testing equipment and components and, with the Third Party Vendor team, is working to ensure their vendors and suppliers are year 2000 ready. However, even if these changes are successful, the Company remains at risk from year 2000 failures caused by third parties. Externally, the Company is an active participant in the SIA Third Party Vendor Committee. Internally, the Company is evaluating efforts of key counterparties, banks, exchanges, agencies, utilities and suppliers, among others, to assess and remediate their year 2000 issues. As part of this effort the Third Party Vendor team has inventoried and has sent surveys to vendors whose software and hardware products the Company uses and whose services the Company employs to determine their year 2000 readiness. The team is also testing critical software and hardware products to ensure year 2000 readiness. To date the Company has received information from 95% of its vendors, including overseas vendors whose year 2000 awareness seems to be less advanced than in the United States. Examples of problems that could result from the failure by third parties with whom the Company interacts to remediate year 2000 bugs include: (i) in the case of exchanges and clearing agents, funding disruptions, failure to trade in certain markets and settlement failures; (ii) in the case of counterparties and clients, accounting and financial difficulties to those parties that may expose the Company to increased credit risk and lost business; (iii) in the case of vendors, service failures such as power, telecommunications, elevator operations and loss of security access control; (iv) in the case of banks and other lenders, the potential for liquidity stress due to disruptions to funding flows; and, (v) in the case of data providers, inaccurate or out of date information would impair the Company's ability to perform critical functions such as pricing securities and currencies. Additionally, general uncertainty regarding the success of remediation may cause many market participants to reduce their market activities temporarily as they address and assess their year 2000 efforts in 1999. This could result in a general reduction in market activities and revenue opportunities in late 1999 and early 2000. Management cannot predict the magnitude of any such reduction or its impact on the Company's financial results. However, the Company's Risk Management Department has undertaken a comprehensive review of third party and credit risks posed by year 2000. Recognizing the uncertainty of external dependencies, the Company is also preparing a contingency plan that identifies potential problems, actions to minimize the likelihood of them occurring and action plans to be invoked should they occur. These plans will include backup processes that do not rely on computer systems, where appropriate. The contingency plan will be complete by the end of April 1999. However, as stated above, there can be no guarantee or assurance that the systems of other companies on which the Company's systems rely will be remediated in a timely manner. This or a failure to remediate by another company or a remediation that is incompatible with the Company's systems may well have a material adverse effect on the Company. The Company has established an internal auditing plan to record results and ensure ongoing compliance of tested applications. It should be noted that efforts focused on addressing EMU have delayed the finalization of internal and industrywide testing in Europe. The Company's total year 2000 project cost is based on presently available information. The total remaining cost of the year 2000 project is estimated at approximately $38 million which will be funded through operating cash flows and expensed as incurred over the next one and one-half years. The Company has incurred and expensed approximately $16 million in 1997 and an additional $31 million through November 30, 1998, related to the year 2000 project. The costs of year 2000 testing, modifications and/or replacements and the date on which the Company plans to complete the project are based on management's best estimates. These estimates were derived using numerous assumptions of future events including the continued availability of certain resources, third party modification plans and other factors. EMU As of January 1, 1999, 11 European countries entered into the European economic and monetary union (the "EMU") and replaced their local currencies with a single currency, the Euro. The countries currently in the EMU are: Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. During a three-year transition period, the national currencies will continue to circulate but only as fixed denominations of the Euro. On January 1, 1999, the Euro became the predominant currency to settle non-cash transactions previously denominated in the participating national currencies. The Company needed to convert certain of its systems and processes to accommodate this currency change. In addition to systems changes, the Company reviewed all of its documentation in light of the changes arising from the introduction of the Euro. Documents affected by the conversion were revised and distributed to affected counterparties. The Company has adopted the EMU protocol agreement established by the International Swaps and Derivatives Association, Inc., and intends to participate in other market-initiated EMU annexes and amendments as they are developed by relevant industry associations. Many areas of the Company were affected by the introduction of the single currency. The conversion was completed well within the time frame of the planned conversion weekend. As transaction volumes had been reduced market-wide, the process actually ran more quickly than expected at approximately 56 hours. Success was over 98% and less than 100 positions/trades required manual adjustments. Of those, all were fixed by Monday morning on January 4. The changes to the Company's data and computer systems affected its clearance, settlement and financial reporting activities, among other key operations of the Company. The Company is also dependent for proper transactions clearance and reporting on many third parties, including counterparties, clearing agents, banks, exchanges, clearinghouses and providers of information. While the Company cannot guarantee that these third parties' systems all appropriately reflect the introduction of the Euro, to date Lehman has experienced no material post conversion problems, either with internal or external systems. In addition, the European markets have reacted favorably to the introduction of the Euro. While conversion to the Euro has reduced client demand for certain transactions, which has impacted our foreign exchange and fixed income activities in Europe, the Company anticipates that new opportunities in Europe will be created through an expansion of activities in both the investment grade and high yield debt capital markets as well as investment banking opportunities. Overall, management anticipates that the formation of EMU will not have a material adverse effect on the trend of earnings of the Company. The Company has incurred and expects to continue to incur expenses for the internal technology staff, as well as costs for outside consultants, in order to implement its EMU conversion plan and handle the aftermath of the conversion. Management currently estimates that the cost of its EMU conversion program will be approximately $30 million, of which approximately $23 million has been incurred to date. NEW ACCOUNTING DEVELOPMENTS In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information" ("SFAS No. 131"). SFAS No. 131 establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to shareholders. It also establishes standards for related disclosures about products and services, geographic areas, and major customers. SFAS No. 131 is effective for financial statements for fiscal years beginning after December 15, 1997 (Fiscal 1999 for the Company). Financial statement disclosures for prior periods are required to be restated. The adoption of SFAS No. 131 will have no impact on the Company's consolidated statement of income, financial condition or cash flows. In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and for Hedging Activities." SFAS No. 133 is effective for fiscal years beginning after June 15, 1999 (Fiscal 2000 for the Company). SFAS No. 133 is a complex accounting standard that requires all derivatives to be recorded at fair value on the balance sheet. Changes in the fair value of derivatives are to be recorded each period in earnings or Accumulated other comprehensive income, a classification within stockholders' equity, depending on the nature of the risks being hedged. As the Company already accounts for derivatives associated with its trading activities on a fair value basis, SFAS No. 133 will only impact the accounting for the Company's End User Derivative Activities. As an end user, the Company utilizes derivatives primarily to manage interest rate risk associated with its long-term debt and secured financing activities. (See Note 4 and Note 12 for a further discussion of the Company's End User Derivative Activities.) The Company has not yet determined the impact of adopting SFAS No. 133, which is difficult to predict, because the actual impact ultimately will hinge on market values at the date of adoption. However, the Company does not expect that adoption will have a material effect on its earnings or financial condition. EFFECTS OF INFLATION Because the Company's assets are, to a large extent, liquid in nature, they are not significantly affected by inflation. However, the rate of inflation affects the Company's expenses, such as employee compensation, office space leasing costs and communications charges, which may not be readily recoverable in the price of services offered by the Company. To the extent inflation results in rising interest rates and has other adverse effects upon the securities markets, it may adversely affect the Company's financial position and results of operations in certain businesses. EX-13.2 5 CONSOLIDATED FINANCIAL STATEMENTS Exhibit 13.2 - -------------------------------- CONSOLIDATED STATEMENT OF INCOME - --------------------------------
Twelve months ended November 30 ------------------------------------- [in millions, except per share data] 1998 1997 1996 - ------------------------------------------------------------------------------------------ REVENUES Investment banking $ 1,582 $ 1,318 $ 981 Principal transactions 1,232 1,418 1,579 Commissions 513 423 362 Interest and dividends 16,542 13,635 11,298 Other 25 89 40 - ------------------------------------------------------------------------------------------ Total revenues 19,894 16,883 14,260 Interest expense 15,781 13,010 10,816 - ------------------------------------------------------------------------------------------ Net revenues 4,113 3,873 3,444 - ------------------------------------------------------------------------------------------ NON-INTEREST EXPENSES Compensation and benefits 2,086 1,964 1,747 Brokerage, commissions and clearance fees 229 224 241 Professional services 171 173 150 Communications 146 141 147 Occupancy and equipment 138 141 151 Business development 115 103 101 Depreciation and amortization 91 86 91 Other 85 104 95 Severance charge 84 - ------------------------------------------------------------------------------------------ Total non-interest expenses 3,061 2,936 2,807 - ------------------------------------------------------------------------------------------ Income before taxes 1,052 937 637 Provision for income taxes 316 290 221 - ------------------------------------------------------------------------------------------ Net income $ 736 $ 647 $ 416 - ------------------------------------------------------------------------------------------ Net income applicable to common stock $ 649 $ 572 $ 378 - ------------------------------------------------------------------------------------------ Weighted-average shares Basic 120.9 118.2 115.3 Diluted 125.0 121.1 116.7 - ------------------------------------------------------------------------------------------ Earnings per common share Basic $ 5.37 $ 4.84 $ 3.27 Diluted $ 5.19 $ 4.72 $ 3.24 - ------------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements. - --------------------------------------------- CONSOLIDATED STATEMENT OF FINANCIAL CONDITION - ---------------------------------------------
November 30 ---------------------- [in millions] 1998 1997 - --------------------------------------------------------------------------- ASSETS Cash and cash equivalents $ 3,055 $ 1,685 Cash and securities segregated and on deposit for regulatory and other purposes 1,183 1,149 Securities and other financial instruments owned: Mortgages and mortgage-backed 23,458 11,455 Governments and agencies 23,000 33,037 Corporate debt and other 11,160 10,892 Derivatives and other contractual agreements 9,883 8,353 Corporate equities 8,217 10,877 Certificates of deposit and other money market instruments 1,282 2,248 - --------------------------------------------------------------------------- 77,000 76,862 - --------------------------------------------------------------------------- Collateralized short-term agreements: Securities purchased under agreements to resell 42,381 43,606 Securities borrowed 16,341 14,146 Receivables: Brokers, dealers and clearing organizations 2,298 2,193 Customers 7,758 9,105 Others 1,909 1,540 Property, equipment and leasehold improvements (net of accumulated depreciation and amortization of $810 in 1998 and $735 in 1997) 505 468 Other assets 1,297 787 Excess of cost over fair value of net assets acquired (net of accumulated amortization of $120 in 1998 and $111 in 1997) 163 164 - --------------------------------------------------------------------------- Total assets $153,890 $151,705 - ---------------------------------------------------------------------------
See Notes to Consolidated Financial Statements. - --------------------------------------------------------- CONSOLIDATED STATEMENT OF FINANCIAL CONDITION (continued) - ---------------------------------------------------------
November 30 ----------------------- [in millions, except share data] 1998 1997 - --------------------------------------------------------------------------- LIABILITIES AND STOCKHOLDERS' EQUITY Commercial paper and short-term debt $ 6,657 $ 7,818 Securities and other financial instruments sold but not yet purchased: Governments and agencies 14,963 16,201 Derivatives and other contractual agreements 8,064 7,367 Corporate equities 3,828 4,293 Corporate debt and other 1,948 2,219 - --------------------------------------------------------------------------- 28,803 30,080 - --------------------------------------------------------------------------- Collateralized short-term financing: Securities sold under agreements to repurchase 67,730 63,204 Securities loaned 3,165 7,846 Payables: Brokers, dealers and clearing organizations 1,322 2,155 Customers 9,203 11,702 Accrued liabilities and other payables 4,256 4,116 Long-term debt: Senior notes 23,873 17,049 Subordinated indebtedness 3,468 3,212 - --------------------------------------------------------------------------- Total liabilities 148,477 147,182 - --------------------------------------------------------------------------- Commitments and contingencies STOCKHOLDERS' EQUITY Preferred stock 908 508 Common stock, $0.10 par value; 300,000,000 shares authorized; Shares issued: 121,801,123 in 1998 and 119,513,337 in 1997; Shares outstanding: 113,657,877 in 1998 and 116,612,074 in 1997 12 12 Additional paid-in capital 3,534 3,436 Accumulated other comprehensive income (net of tax) 15 12 Retained earnings 1,105 498 Other stockholders' equity, net 269 155 Common stock in treasury, at cost: 8,143,246 shares in 1998 and 2,901,263 shares in 1997 (430) (98) - --------------------------------------------------------------------------- Total stockholders' equity 5,413 4,523 - --------------------------------------------------------------------------- Total liabilities and stockholders' equity $153,890 $151,705 - ---------------------------------------------------------------------------
See Notes to Consolidated Financial Statements. - --------------------------------------------------------- CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY - ---------------------------------------------------------
Twelve months ended November 30 ------------------------------------ [in millions] 1998 1997 1996 - ------------------------------------------------------------------------------------------ PREFERRED STOCK 5% Cumulative Convertible Voting, Series A: Beginning balance $ 1 $ 508 $ 508 Series A exchanged for Series B (507) - ------------------------------------------------------------------------------------------ Ending balance 1 1 508 - ------------------------------------------------------------------------------------------ 5% Cumulative Convertible Voting, Series B: Beginning balance 507 Series A exchanged for Series B 507 Repurchase (50) - ------------------------------------------------------------------------------------------ Ending balance 457 507 - ------------------------------------------------------------------------------------------ 5.94% Cumulative, Series C: Beginning balance Shares issued 250 - ------------------------------------------------------------------------------------------ Ending balance 250 - ------------------------------------------------------------------------------------------ 5.67% Cumulative, Series D: Beginning balance Shares issued 200 - ------------------------------------------------------------------------------------------ Ending balance 200 - ------------------------------------------------------------------------------------------ 8.44% Cumulative Voting: Beginning balance 200 Repurchase (200) - ------------------------------------------------------------------------------------------ Ending balance - ------------------------------------------------------------------------------------------ Redeemable Voting: Beginning and ending balance - ------------------------------------------------------------------------------------------ Total Preferred Stock, ending balance 908 508 508 - ------------------------------------------------------------------------------------------ COMMON STOCK Beginning balance 12 11 11 Shares issued to RSU Trust 1 - ------------------------------------------------------------------------------------------ Ending balance 12 12 11 - ------------------------------------------------------------------------------------------ ADDITIONAL PAID-IN CAPITAL Beginning balance 3,436 3,198 3,172 RSUs exchanged for Common Stock 8 21 Stock options exercised 99 33 6 Employee stock purchase plan (3) (3) (3) Shares issued to RSU Trust 199 Other, net 2 1 2 - ------------------------------------------------------------------------------------------ Ending balance 3,534 3,436 3,198 - ------------------------------------------------------------------------------------------ ACCUMULATED OTHER COMPREHENSIVE INCOME Beginning balance 12 20 9 Translation adjustment, net(1) 3 (8) 11 - ------------------------------------------------------------------------------------------ Ending balance 15 12 20 - ------------------------------------------------------------------------------------------
(1) Net of income taxes of $2 in 1998, $8 in 1997, and $(11) in 1996. See Notes to Consolidated Financial Statements. - --------------------------------------------------------------------- CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (continued) - ---------------------------------------------------------------------
Twelve months ended November 30 ------------------------------------ [in millions] 1998 1997 1996 - ------------------------------------------------------------------------------------------ RETAINED EARNINGS (ACCUMULATED DEFICIT) Beginning balance $ 498 $ (43) $ (397) Net income 736 647 416 Dividends declared: 5% Cumulative Convertible Voting Series A and B Preferred Stock (25) (25) (25) 5.94% Cumulative, Series C Preferred Stock (8) 5.67% Cumulative, Series D Preferred Stock (4) 8.44% Cumulative Voting Preferred Stock (3) Redeemable Voting Preferred Stock (50) (50) (8) Common Stock (37) (31) (24) Premium for repurchase of 8.44% Cumulative Voting Preferred Stock (2) Other (5) - ------------------------------------------------------------------------------------------ Ending balance 1,105 498 (43) - ------------------------------------------------------------------------------------------ COMMON STOCK ISSUABLE Beginning balance 911 532 302 RSUs exchanged for Common Stock (10) (8) (21) Deferred stock awards granted 417 387 251 - ------------------------------------------------------------------------------------------ Ending balance 1,318 911 532 - ------------------------------------------------------------------------------------------ COMMON STOCK HELD IN RSU TRUST Beginning balance (325) Shares issued to RSU Trust (107) (325) Shares issued from RSU Trust 10 - ------------------------------------------------------------------------------------------ Ending balance (422) (325) - ------------------------------------------------------------------------------------------ DEFERRED STOCK COMPENSATION Beginning balance (431) (206) (91) Deferred stock awards granted (417) (387) (251) Amortization of deferred compensation, net 221 162 136 - ------------------------------------------------------------------------------------------ Ending balance (627) (431) (206) - ------------------------------------------------------------------------------------------ COMMON STOCK IN TREASURY, AT COST Beginning balance (98) (146) (16) Treasury stock purchased (469) (77) (130) Stock options exercised 30 Shares issued to RSU Trust 107 125 - ------------------------------------------------------------------------------------------ Ending balance (430) (98) (146) - ------------------------------------------------------------------------------------------ Total Stockholders' Equity $5,413 $4,523 $3,874 - ------------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements. - ------------------------------------ CONSOLIDATED STATEMENT OF CASH FLOWS - ------------------------------------
Twelve months ended November 30 ------------------------------------ [in millions] 1998 1997 1996 - ------------------------------------------------------------------------------------------ CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 736 $ 647 $ 416 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation and amortization 91 86 91 Severance charge 84 Provisions for losses and other reserves 292 52 42 Deferred tax provision (benefit) (284) (60) 72 Compensation payable in common stock 221 162 136 Other adjustments 43 (212) 48 Net change in: Cash and securities segregated and on deposit (34) (461) 257 Securities and other financial instruments owned (138) (15,409) (8,432) Securities borrowed (2,195) 6,505 (4,361) Receivables from brokers, dealers and clearing organizations (105) 685 (1,318) Receivables from customers 1,347 (3,292) (2,336) Securities and other financial instruments sold but not yet purchased (1,277) 3,716 4,550 Securities loaned (4,681) 1,550 4,330 Payables to brokers, dealers and clearing organizations (833) 1,151 (99) Payables to customers (2,499) 4,120 1,821 Accrued liabilities and other payables (152) 782 217 Other operating assets and liabilities, net (592) (286) 107 - ------------------------------------------------------------------------------------------ Net cash provided by (used in) operating activities $(10,060) $(264) $(4,375) - ------------------------------------------------------------------------------------------
See Notes to Consolidated Financial Statements. - ------------------------------------------------ CONSOLIDATED STATEMENT OF CASH FLOWS (continued) - ------------------------------------------------
Twelve months ended November 30 ------------------------------------ [in millions] 1998 1997 1996 - ------------------------------------------------------------------------------------------ CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from issuances of senior notes $ 11,091 $ 7,242 $ 4,455 Principal payments of senior notes (4,298) (2,548) (2,411) Proceeds from issuances of subordinated indebtedness 600 407 1,330 Principal payments of subordinated indebtedness (356) (550) (246) Net proceeds from (payments for) commercial paper and short-term debt (1,161) (384) 1,981 Resale agreements net of repurchase agreements 5,751 (4,181) 978 Payment for repurchase of preferred stock (50) (200) Payments for treasury stock purchases (411) (77) (130) Issuances of common stock 61 23 6 Issuances of preferred stock 444 Dividends paid (122) (58) (55) - ------------------------------------------------------------------------------------------ Net cash provided by (used in) financing activities 11,549 (126) 5,708 - ------------------------------------------------------------------------------------------ CASH FLOWS FROM INVESTING ACTIVITIES Purchases of property, equipment and leasehold improvements, net (119) (74) (58) - ------------------------------------------------------------------------------------------ Net cash used in investing activities (119) (74) (58) - ------------------------------------------------------------------------------------------ Net change in cash and cash equivalents 1,370 (464) 1,275 - ------------------------------------------------------------------------------------------ Cash and cash equivalents, beginning of period 1,685 2,149 874 - ------------------------------------------------------------------------------------------ Cash and cash equivalents, end of period $ 3,055 $ 1,685 $ 2,149 - ------------------------------------------------------------------------------------------ SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION [in millions] Interest paid totaled $15,473 in 1998, $12,900 in 1997 and $10,852 in 1996. Income taxes paid totaled $541 in 1998, $371 in 1997 and $79 in 1996.
See Notes to Consolidated Financial Statements. - ------------------------------------------ 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 Accumulated other comprehensive income, a separate component of stockholders' equity. Gains or losses resulting from foreign currency transactions are included in the Consolidated Statement of Income. SECURITIES AND OTHER FINANCIAL INSTRUMENTS Securities and other financial instruments owned and securities and other financial instruments sold but not yet purchased are valued at market or fair value, as appropriate, with unrealized gains and losses reflected in Principal transactions in the Consolidated Statement of Income. Market value is generally based on listed market prices. If listed market prices are not available, fair value is determined based on other relevant factors, including broker or dealer price quotations and valuation pricing models which take into account time value and volatility factors underlying the financial instruments. DERIVATIVE FINANCIAL INSTRUMENTS Derivatives, typically defined as instruments whose value is "derived" from an underlying instrument, index or rate, include futures, forwards, swaps and options and other similar instruments. A derivative contract generally represents future commitments to exchange interest or other payment streams based on the contract or notional amount or to purchase or sell financial instruments at specified terms and future dates. In the normal course of business, the Company enters into derivative transactions both in a trading capacity and as an end user. Acting in a trading capacity, the Company enters into derivative transactions to satisfy the needs of its clients and to manage the Company's own exposure to market and credit risks resulting from its trading activities (collectively, "Trading-Related Derivative Activities"). The Company's accounting methodology for derivatives depends on both the type and purpose of the derivative financial instrument. Derivative transactions entered into for Trading-Related Derivative Activities are recorded at market or fair value with realized and unrealized gains and losses recognized currently in Principal transactions in the Consolidated Statement of Income. Market or fair value for trading related instruments is generally determined by either quoted market prices (for exchange-traded futures and options) or pricing models (for over-the-counter swaps, forwards and options). Pricing models utilize a series of market inputs to determine the present value of future cash flows, with adjustments, as required for credit risk and liquidity risk. Further valuation adjustments may be recorded, as deemed appropriate for new or complex products or for positions with significant concentrations. These adjustments are integral components of the mark-to-market process. The market or fair value associated with derivatives utilized for trading purposes is recorded in the Consolidated Statement of Financial Condition on a net by counterparty basis where a legal right of set-off exists and is netted across products when such provisions are stated in the master netting agreement. The market or fair value of swap agreements, caps and floors, and forward contracts in an unrealized gain position, as well as options owned and warrants held, are reported in the Consolidated Statement of Financial Condition as assets in Derivatives and other contractual agreements. Similarly, swap agreements, caps and floors, and forward contracts in an unrealized loss position, as well as options written and warrants issued, are reported in the Consolidated Statement of Financial Condition as liabilities in Derivatives and other contractual agreements. Margin on futures contracts is included in receivables and payables, as applicable. In addition to Trading-Related Derivative Activities, the Company enters into various derivative financial instruments for non-trading purposes as an end user to modify the market risk exposures of certain assets and liabilities. In this regard, the Company utilizes interest rate swaps, caps, collars and floors to manage the interest rate exposure associated with its long-term debt obligations and secured financing activities, including securities purchased under agreements to resell, securities borrowed, securities sold under agreements to repurchase and securities loaned. The Company also utilizes 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. The Company also utilizes equity derivatives to hedge its exposure to equity price risk embedded in certain of its debt obligations. In addition to modifying the interest rate 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. The Company actively monitors the level of anticipated secured financing transactions to ensure there is a high degree of certainty that such secured financing transactions will be executed at levels at least equal to the designated derivative product transactions. The Company also utilizes foreign exchange forward contracts to manage the currency exposure related to its net monetary investment in non-U.S. dollar functional currency operations. The gain or loss from revaluing these contracts is deferred and reported within Accumulated other comprehensive income in stockholders' equity. The related unrealized receivables or payables due from or to counterparties are included in receivables from or payables to brokers, dealers and clearing organizations. Derivatives that have been designated as non-trading related positions and are effective in modifying the interest rate characteristics of existing assets and liabilities or anticipated transactions are accounted for on an accrual basis. Under the accrual basis, interest is accrued into income or expense over the life of the contract, resulting in the net interest impact of the derivative and the underlying hedged item being recognized in income throughout the hedge period. Related unrealized receivables or payables due from or to counterparties are included in receivables from or payables to brokers, dealers and clearing organizations. The Company monitors the effectiveness of its end user hedging activities by periodically comparing the change in the value of the hedge instrument to the underlying item being hedged, and reassessing the likelihood of the occurrence of anticipated transactions. In the event the Company determines that a hedge is no longer effective, such as upon extinguishment of the underlying asset or liability or a change in circumstances whereby there is not a high degree of certainty that the anticipated transaction will occur, the derivative transaction is no longer accounted for as a hedge. Instead, the Company immediately recognizes the market or fair value of the derivative financial instrument through earnings. Changes in the fair value of the derivative contract would then be accounted for as a derivative used for trading purposes as discussed above. In the event that a derivative designated as a hedge is terminated early, any realized gain or loss on the termination would be deferred and amortized to interest income or interest expense over the remaining life of the instrument being hedged. REPURCHASE AND RESALE AGREEMENTS Securities purchased under agreements to resell and securities sold under agreements to repurchase, which are treated as financing transactions for financial reporting purposes, are collateralized primarily by government and government agency securities and are carried net by counterparty, when permitted, at the amounts at which the securities will be subsequently resold or repurchased plus accrued interest. It is the policy of the Company to take possession of securities purchased under agreements to resell. The Company monitors the market value of the underlying positions on a daily basis as compared to the related receivable or payable balances, including accrued interest. The Company requires counterparties to deposit additional collateral or return collateral pledged as necessary, to ensure that the market value of the underlying collateral remains sufficient. Securities and other financial instruments owned that are financed under repurchase agreements are carried at market value with changes in market value reflected in the Consolidated Statement of Income. SECURITIES BORROWED AND LOANED Securities borrowed and securities loaned are carried at the amount of cash collateral advanced or received plus accrued interest. It is the Company's policy to value the securities borrowed and loaned on a daily basis, and to obtain additional cash as necessary to ensure such transactions are adequately collateralized. MERCHANT BANKING INVESTMENTS The Company carries its merchant banking investments, including its partnership interests, at fair value based upon the Company's assessment of the underlying investments. INVESTMENT BANKING Underwriting revenues and fees for merger and acquisition advisory services are recognized when services for the transactions are substantially completed. Transaction-related expenses are deferred and subsequently expensed to match revenue recognition. INCOME TAXES The Company accounts for income taxes under the provisions of Statement of Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes." The Company recognizes the current and deferred tax consequences of all transactions that have been recognized in the financial statements using the provisions of the enacted tax laws. In this regard, deferred tax assets are recognized for temporary differences that will result in deductible amounts in future years and for tax loss carryforwards, if in the opinion of management, it is more likely than not that the deferred tax asset will be realized. SFAS 109 requires companies to set up a valuation allowance for that component of net deferred tax assets which does not meet the "more likely than not" criterion for realization. Deferred tax liabilities are recognized for temporary differences that will result in taxable income in future years. PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS Property, equipment, and leasehold improvements are recorded at historical cost, net of accumulated depreciation and amortization. Depreciation is recognized on a straight-line basis over the estimated useful lives of the related assets. Leasehold improvements are amortized over the lesser of their economic useful lives or the terms of the underlying leases. GOODWILL Excess of cost over fair value of net assets acquired (goodwill) is amortized using the straight-line method over periods not exceeding 35 years. Goodwill is evaluated periodically for impairment and also is reduced upon the recognition of certain acquired net operating loss carryforward benefits. STATEMENT OF CASH FLOWS The Company defines cash equivalents as highly liquid investments with original maturities of three months or less, other than those held for sale in the ordinary course of business. EARNINGS PER COMMON SHARE The Company computes earnings per common share in accordance with SFAS No. 128, "Earnings Per Share." Basic earnings per share is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the assumed conversion of all dilutive securities. ------ NOTE 2 ------ RECENTLY ISSUED ACCOUNTING STANDARDS In 1997, the Financial Accounting Standards Board (the "FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings Per Share," which is effective for fiscal periods ending after December 15, 1997. SFAS No. 128 replaced the presentation of primary and fully diluted earnings per common share ("EPS") with basic and diluted EPS. The Company adopted SFAS No. 128 during the first quarter of 1998 and restated EPS data for the prior periods to conform with the provisions of the Statement. On January 1, 1998, SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" became fully effective. Previously, the FASB had deferred until that date certain provisions of SFAS No. 125 pertaining to repurchase agreements, securities lending and similar financing transactions. As a result of adopting the deferred provisions of SFAS No. 125, the Company has recognized on its November 30, 1998 Consolidated Statement of Financial Condition, approximately $1.4 billion of collateral controlled on certain financing transactions and a corresponding obligation to return such collateral at the termination of such transactions. In March 1998, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use" (the "SOP"). The SOP requires that certain costs incurred in connection with developing or obtaining software for internal use be capitalized and subsequently amortized over the software's estimated useful life. The SOP requires prospective application as of the beginning of an entity's fiscal year without adjustment for costs that would have been capitalized had the SOP been in effect in prior periods. The Company has elected early adoption of this accounting pronouncement effective as of the beginning of its 1998 fiscal year and capitalized approximately $33.7 million of purchased software and other internal use software costs during fiscal 1998. In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income." SFAS No. 130 establishes standards for the reporting and display of comprehensive income and its components in the financial statements. SFAS No. 130 is effective for fiscal years beginning after December 15, 1997. Reclassification of financial statements for earlier periods provided is required for comparative purposes. The Company has elected early adoption of SFAS No. 130 for fiscal 1998. The adoption of SFAS No. 130 has no impact on the Company's consolidated statement of income, financial condition or cash flows. The only component of Accumulated other comprehensive income relates to foreign currency translation adjustments. SFAS No. 132, "Employer's Disclosures about Pensions and Other Postretirement Benefits," was issued in February 1998, and is effective for fiscal years beginning after December 15, 1997. SFAS No. 132 eliminates certain existing disclosures (such as the requirement to provide a description of the plan, including employee groups covered, type of benefit formula, funding policy, or the requirement to disclose alternative measures of the benefit obligation), but, at the same time, adds new disclosures (such as the requirement to disclose a reconciliation of beginning and ending balances of the benefit obligation and the fair value of plan assets). The Company has elected early adoption of this accounting pronouncement effective for its 1998 fiscal year. ------ NOTE 3 ------ SHORT-TERM FINANCINGS The Company obtains short-term financing on both a secured and unsecured basis. The secured financing is obtained through the use of repurchase agreements and securities loaned agreements, which are primarily collateralized by government, agency and equity securities. The unsecured financing is generally obtained through short-term debt and the issuance of commercial paper. The Company's commercial paper and short-term debt financing is comprised of the following:
November 30 --------------------- [in millions] 1998 1997 - --------------------------------------------------------------------------- Commercial paper $3,550 $3,866 Short-term debt Bank loans 1,288 959 Payables to banks 1,039 786 Other short-term debt(1) 780 2,207 - --------------------------------------------------------------------------- Total $6,657 $7,818 - ---------------------------------------------------------------------------
The Company's weighted-average interest rates were as follows:
November 30 ------------------- [in millions] 1998 1997 - --------------------------------------------------------------------------- Commercial paper(2) 5.5% 5.9% Short-term debt(3) 5.4% 4.7% Securities sold under agreements to repurchase 5.2% 5.0%
(1) Includes master notes, corporate loans, short-term medium-term notes and other short-term financings. (2) Including weighted-average interest rates of 5.6% and 2.6% as of November 30, 1998 and 6.0% and 2.2% as of November 30, 1997 related to U.S. dollar and non-U.S. dollar obligations, respectively. (3) Including weighted-average interest rates of 5.5% and 5.1% as of November 30, 1998 and 5.7% and 3.4% as of November 30, 1997 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 for up to an additional year 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 July 1998, the Company entered into a new $1 billion Committed Securities Repurchase Facility (the "Facility") for LBIE, the Company's major operating entity in Europe. The Facility provides secured multi-currency financing for a broader range of collateral types than LBIE's previous committed secured credit facility. Under the terms of the Facility, the bank group will agree to provide funding for up to one year on a secured basis. Any loans outstanding on the commitment termination date may be extended for up to an additional year at the option of Holdings. The Facility contains covenants which require among other things, that LBIE maintain specified levels of tangible net worth. There have been no borrowings outstanding under either the Credit Agreement or the Facility. The Company may use the Credit Agreement and the Facility for general corporate purposes from time to time. The Company has maintained compliance with the applicable covenants for both the Credit Agreement and the Facility at all times. ------ NOTE 4 ------
LONG-TERM DEBT U.S. Dollar Non-U.S. Dollar ------------------- ----------------- November 30 Fixed Floating Fixed Floating ---------------- [in millions] Rate Rate Rate Rate 1998 1997 - ------------------------------------------------------------------------------------------ SENIOR NOTES Maturing in Fiscal 1998 $ 2,710 Maturing in Fiscal 1999 $ 1,560 $ 2,664 $ 939 $ 172 $ 5,335 3,207 Maturing in Fiscal 2000 3,178 2,875 524 309 6,886 3,629 Maturing in Fiscal 2001 1,281 793 115 198 2,387 1,025 Maturing in Fiscal 2002 1,349 886 39 799 3,073 2,998 Maturing in Fiscal 2003 1,661 506 119 573 2,859 747 December 1, 2003 and thereafter 1,836 411 749 337 3,333 2,733 - ------------------------------------------------------------------------------------------ Senior Notes 10,865 8,135 2,485 2,388 23,873 17,049 - ------------------------------------------------------------------------------------------ SUBORDINATED INDEBTEDNESS Maturing in Fiscal 1998 359 Maturing in Fiscal 1999 334 7 341 334 Maturing in Fiscal 2000 192 192 192 Maturing in Fiscal 2001 194 194 200 Maturing in Fiscal 2002 250 42 292 291 Maturing in Fiscal 2003 475 475 475 December 1, 2003 and thereafter 1,755 201 18 1,974 1,361 - ------------------------------------------------------------------------------------------ Subordinated Indebtedness 3,200 250 18 3,468 3,212 - ------------------------------------------------------------------------------------------ Long-Term Debt $14,065 $ 8,385 $ 2,503 $ 2,388 $27,341 $20,261 - ------------------------------------------------------------------------------------------
Of the Company's long-term debt outstanding as of November 30, 1998, $800 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 1999 to fiscal 2003, rather than at their contractual maturities, which range from fiscal 2000 to fiscal 2026. In addition, $1,693 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 $175 million as of November 30, 1998. These notes are unconditionally guaranteed by American Express and collateralized by a first mortgage on the property. As of November 30, 1998, the Company had $9.1 billion available for the issuance of debt securities under various shelf registrations and debt programs, which includes $3.3 billion of issuance availability under the Company's Euro medium-term note program. As of November 30, 1998, the Company's U.S. dollar and non-U.S. dollar debt portfolios included approximately $940 million and $1,004 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 or events. Generally such notes 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, currency and equity swaps. END USER DERIVATIVE ACTIVITIES The Company utilizes a variety of derivative products including interest rate, currency and equity 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 amount of the derivative contracts may exceed the carrying value of the related long-term debt issuance. At November 30, 1998 and 1997, the notional amounts of the Company's interest rate, currency and equity swaps related to its long-term debt obligations were approximately $24.3 billion and $17.3 billion, respectively. In terms of notional amounts outstanding, these derivative products mature as follows:
November 30 U.S. Non-U.S. Cross- ---------------------- [in millions] Dollar Dollar Currency 1998 1997 - ---------------------------------------------------------------------------------------------------- Maturing in Fiscal 1998 $ 2,592 Maturing in Fiscal 1999 $ 3,689 $ 144 $1,147 $ 4,980 3,248 Maturing in Fiscal 2000 5,588 43 662 6,293 3,427 Maturing in Fiscal 2001 1,963 72 264 2,299 935 Maturing in Fiscal 2002 2,614 450 215 3,279 2,489 Maturing in Fiscal 2003 2,566 101 166 2,833 1,180 December 1, 2003 and thereafter 3,563 605 469 4,637 3,443 - ---------------------------------------------------------------------------------------------------- Total $19,983 $1,415 $2,923 $24,321 $17,314 - ---------------------------------------------------------------------------------------------------- Weighted-average interest rate at November 30(1): Receive rate 6.63% 5.93% 3.92% 6.26% 6.82% Pay rate 5.87% 3.99% 5.53% 5.72% 6.39%
(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 $84 million, $68 million and $81 million in 1998, 1997 and 1996, 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:
November 30, 1998 ---------------------------------------------------------------------- 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 $14,065 $420 Floating rate 8,385 24,106 - ---------------------------------------------------------------------------------------------------- 22,450 24,526 - ---------------------------------------------------------------------------------------------------- Non-USD Obligations 4,891 2,815 - ---------------------------------------------------------------------------------------------------- Total $27,341 $27,341 6.33% 5.83% - ---------------------------------------------------------------------------------------------------- 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 Floating rate 4,368 18,334 16,620 18,642 - ---------------------------------------------------------------------------------------------------- Non-USD Obligations 3,641 1,619 - ---------------------------------------------------------------------------------------------------- Total $20,261 $20,261 6.78% 6.42% - ----------------------------------------------------------------------------------------------------
(1) weighted-average interest rates were calculated using non-U.S. dollar interest rates, where applicable. ------ NOTE 5 ------ PREFERRED STOCK Holdings is authorized to issue a total of 38,000,000 shares of preferred stock. At November 30, 1998 and 1997, Holdings had 12,261,228 and 13,000,000 respectively, of such shares authorized, issued and outstanding under various series as described below. All preferred stock has a dividend preference over Holdings' common stock in the paying of dividends and a preference in the liquidation of assets. 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, 1998, 12,800 shares of the Series A and 11,708,428 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. As of November 30, 1998 Holdings has the right to redeem up to 3,836,317 Convertible Voting Preferred shares at the liquidation price, subject to adjustment and restrictions on redemption when dividends are in arrears. 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 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, 1998 was $123.02. During 1998, Holdings repurchased 1,278,772 shares of the Series B. SERIES C On May 11, 1998, Holdings issued 5,000,000 Depository Shares (each representing 1/10th of a share) of 5.94% Cumulative Preferred Stock, Series C ("Series C Preferred Stock"), $1.00 par value. These shares have a redemption price of $500 per share, together with accrued and unpaid dividends. Holdings may redeem any or all of the outstanding shares of Series C Preferred Stock after May 31, 2008. The $250 million redemption value of the shares outstanding at November 30, 1998 is classified on the Company's Consolidated Statement of Financial Condition as a component of Preferred stock. SERIES D On July 21, 1998, Holdings issued 4,000,000 Depository Shares (each representing 1/100th of a share) of 5.67% Cumulative Preferred Stock, Series D ("Series D Preferred Stock"), $1.00 par value. The Series D Preferred Stock has a redemption price of $5,000 per share, together with accrued and unpaid dividends. Holdings may redeem any or all of the outstanding shares of Series D Preferred Stock after August 31, 2008. The $200 million redemption value of the shares outstanding at November 30, 1998 is classified on the Company's Consolidated Statement of Financial Condition as a component of Preferred stock. 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 are entitled to receive annual dividends through May 31, 2002 in an amount 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, 1998 and 1997, the Company's net income of $736 million and $647 million, respectively, resulted in the recognition of dividends in the amount of $50 million 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 $150 million if such change of control occurs prior to November 30, 1999, declining by $50 million per year in each of the three years thereafter. If a change of control is not approved by a majority of Holdings' Board of Directors, the funds for redemption must be raised by an offering of Holdings' equity securities which are not redeemable. These shares are not convertible into common stock. ------ NOTE 6 ------ COMMON STOCK Changes in shares of Holdings' common stock (the "Common Stock") outstanding are as follows:
November 30 --------------------------------------------------- 1998 1997 1996 - --------------------------------------------------------------------------------------------------------- Shares outstanding, beginning of period 116,612,074 100,449,144 104,565,875 Exercise of stock options and other share issuances 3,129,883 1,719,799 1,108,973 Treasury stock purchases (8,584,080) (1,556,869) (5,225,704) Issuance of shares to the RSU Trust 2,500,000 16,000,000 - --------------------------------------------------------------------------------------------------------- Shares outstanding, end of period 113,657,877 116,612,074 100,449,144 - ---------------------------------------------------------------------------------------------------------
The Company has reserved for issuance approximately 1.2 million shares of Common Stock for conversion of the Convertible Voting Preferred. During the years ended November 30, 1998, 1997 and 1996, the Company repurchased or acquired shares of its Common Stock at an aggregate cost of approximately $469 million, $77 million and $130 million, respectively. These shares were acquired in the open market and from employees who had tendered mature shares to pay for the exercise cost of stock options and related tax withholding obligations. These shares are being reserved for future issuances under employee stock-based compensation plans. In 1997, the Company established an irrevocable grantor trust (the "RSU Trust") in order to provide common stock voting rights to employees who hold outstanding restricted stock units and to encourage employees to think and act like owners. The RSU Trust was initially funded in 1997 with a total of 16 million shares consisting of 5 million treasury shares for restricted stock unit ("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. In 1998, 2.5 million treasury shares were transferred into the RSU Trust. Shares transferred to the RSU Trust do not impact the total number of shares used in the computation of earnings per common share because the Company has historically viewed the RSUs as common stock equivalents for purposes of these computations. Accordingly, the establishment of the RSU Trust has had no effect on the total equity, net income or earnings per share of the Company. During fiscal year 1998, the FASB's Emerging Issues Task Force (EITF) reached a consensus on Issue No. 97-14, "Accounting for Deferred Compensation Arrangements Where Amounts Earned are Held in a Rabbi Trust and Invested" (EITF 97-14). The Task Force concluded that consolidation of irrevocable grantor trusts is required and that shares held by the grantor trust should be classified and accounted for in equity, such that changes in fair value are not recognized. Accordingly, the Company has adopted EITF 97-14. Adoption had no effect on net income, total assets or total equity of the Company. ------ NOTE 7 ------ 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, 1998 and 1997, 2.0 million shares and 1.6 million shares, respectively, of Common Stock had been purchased by eligible employees through the ESPP. 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, 1998, a total of 2.0 million awards had been granted under the Replacement Plan, including both stock options and restricted stock; 0.5 million were outstanding at November 30, 1998. No future awards will be granted under this plan. 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, 1998, RSU and stock option awards with respect to 15.6 million shares of Common Stock have been made under the 1994 Plan of which 12.8 million are outstanding and 2.8 million have been converted to freely transferable Common Stock. 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 15.5 million shares of Common Stock may be subject to awards. At November 30, 1998, RSU, PSU and stock option awards with respect to 8.4 million shares of Common Stock have been made under the 1996 Plan of which 6.9 million are outstanding and 1.5 million have been converted to freely transferable Common Stock. EMPLOYEE INCENTIVE PLAN The Employee Incentive Plan ("EIP") has provisions similar to the 1994 Plan and the 1996 Plan, and authorization for up to 50 million shares of Common Stock which may be subject to awards. At November 30, 1998, awards with respect to 33.6 million shares of Common Stock have been made under the EIP of which 32.7 million are outstanding and 0.9 million have been converted to freely transferable Common Stock. Approximately 26.9 million of the outstanding awards consist of RSUs and PSUs which have vesting and transfer restrictions extending through the year 2004. 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, 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 - ----------------------------------------------------------------------------------------------- Granted 83,866 611,400 11,400,151 12,095,417 Canceled (42,734) (112,477) (403,299) (558,510) Exchanged for stock without restrictions (243,791) (105,564) (90,317) (439,672) - ----------------------------------------------------------------------------------------------- Balance, November 30, 1998 11,695,516 1,586,238 26,895,122 40,176,876 - -----------------------------------------------------------------------------------------------
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, 1998, approximately 13.0 million RSUs were vested, approximately 2.6 million RSUs will vest during fiscal 1999, and the remaining RSUs will vest subsequent to November 30, 1999. Total compensation cost recognized during 1998, 1997 and 1996 for the Company's stock-based awards was approximately $221 million, $162 million and $136 million, respectively. In addition to the RSUs included in the previous table, the Company has awarded PSUs 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, 1998, approximately 0.7 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. STOCK OPTIONS
WEIGHTED- AVERAGE 1994 REPLACEMENT 1996 EXERCISE EXPIRATION PLAN PLAN PLAN EIP TOTAL PRICE DATES - ----------------------------------------------------------------------------------------------------------------------------------- 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 - ----------------------------------------------------------------------------------------------------------------------------------- Granted 7,212 3,475,000 7,374,170 10,856,382 $ 49.721 2/02-11/08 Exercised (989,401) (156,324) (1,275,165) (706,000) (3,126,890) $ 23.17 Canceled (417) (3,946,500) (3,946,917) $ 60.47 - ----------------------------------------------------------------------------------------------------------------------------------- Balance, November 30, 1998 1,143,451 472,153 5,274,835 5,771,670 12,662,109 $ 34.64 2/99-11/08 - -----------------------------------------------------------------------------------------------------------------------------------
At November 30, 1998 and 1997, approximately 8.3 million and 8.9 million stock options, respectively, were exercisable at weighted-average prices of $31.42 and $23.64, respectively. The weighted-average remaining contractual life of the stock options outstanding at November 30, 1998 is 5.30 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. The following table provides further details relating to Holdings' stock options outstanding as of November 30, 1998:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE ----------------------------------------------------------------------------------------------- WEIGHTED- WEIGHTED- WEIGHTED- AVERAGE WEIGHTED- AVERAGE AVERAGE REMAINING AVERAGE REMAINING RANGE OF NUMBER EXERCISE CONTRACTUAL NUMBER EXERCISE CONTRACTUAL EXERCISE PRICES OUTSTANDING PRICE LIFE (IN YEARS) EXERCISABLE PRICE LIFE (IN YEARS) - ------------------------------------------------------------------------------------------------------------------- $18.00-$19.99 1,138,392 $ 18.00 2.06 1,138,392 $ 18.00 2.06 $20.00-$29.99 2,813,835 $ 22.69 2.14 2,813,835 $ 22.69 2.14 $30.00-$39.99 2,050,000 $ 30.80 3.24 1,900,000 $ 30.53 3.11 $40.00-$49.99 6,659,882 $ 43.68 7.83 2,425,000 $ 48.56 4.03 - ------------------------------------------------------------------------------------------------------------------- 12,662,109 $ 34.64 5.30 8,277,227 $ 31.42 2.91 - -------------------------------------------------------------------------------------------------------------------
SFAS No. 123, "Accounting for Stock-Based Compensation," established 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 and outstanding during 1998 and 1997. Based on the results of the model, the weighted-average fair value of the stock options granted was $12.36 and $7.14 for 1998 and 1997, respectively. The weighted-average assumptions which were used for 1998 and 1997 included risk-free interest rates of 5.01% and 6.14%, an expected life of 4 and 3 years, and expected volatility of 30% and 29%, respectively. In addition, annual dividends of $0.30 and $0.24 were assumed for the 1998 and 1997 options, respectively. The Company's 1998, 1997 and 1996 pro forma net income would have been $723 million, $629 million and $413 million, respectively, compared to actual net income of $736 million, $647 million and $416 million, respectively. Pro forma earnings per common share for 1998, 1997 and 1996 would have been $5.09, $4.57 and $3.22, respectively, compared to actual earnings per common share of $5.19, $4.72 and $3.24, respectively. The pro forma amounts reflect the effects of the 1998 and 1997 stock option grants and the 15% purchase discount from market value offered to the Company's employees who participate in the ESPP. NOTE 8 Earnings Per Common Share Earnings per share was calculated as follows:
Three years ended [in millions, except for per share data] 1998 1997 1996 - --------------------------------------------------------------------------------------------------------------- Numerator: Net income $ 7 $ 6 $ 416 Preferred stock dividends 87 75 38 - --------------------------------------------------------------------------------------------------------------- Numerator for basic and diluted earnings per share = income available to common stockholders 649 572 378 - --------------------------------------------------------------------------------------------------------------- Denominator: Denominator for basic earnings per share = weighted-average shares 120.9 118.2 115.3 Effect of dilutive securities: Employee stock options 2.4 1.9 0.9 Common stock equivalents 1.7 1.0 0.5 - --------------------------------------------------------------------------------------------------------------- Dilutive potential common shares 4.1 2.9 1.4 - --------------------------------------------------------------------------------------------------------------- Denominator for diluted earnings per share = adjusted weighted-average shares 125.0 121.1 116.7 - --------------------------------------------------------------------------------------------------------------- Basic earnings per share $ 5.37 $ 4.84 $ 3.27 - --------------------------------------------------------------------------------------------------------------- Diluted earnings per share $ 5.19 $ 4.72 $ 3.24 - ---------------------------------------------------------------------------------------------------------------
NOTE 9 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, 1998, LBI's regulatory net capital, as defined, of $1,406 million exceeded the minimum requirement by $1,320 million. In addition to amounts presented in the accompanying Consolidated Statement of Financial Condition as cash and securities segregated and on deposit for regulatory and other purposes, securities with a market value of approximately $1,332 million and $1,290 million at November 30, 1998 and 1997, respectively, primarily collateralizing securities purchased under agreements to resell, have been segregated in a special reserve bank account for the exclusive benefit of customers pursuant to the Reserve Formula requirements of SEC Rule 15c3-3. 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, 1998, LBIE's financial resources of approximately $2.5 billion exceeded the minimum requirement by approximately $900 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, 1998, had net capital of approximately $320 million which was approximately $95 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, 1998, these other subsidiaries were in compliance with their applicable local capital adequacy requirements. The Company's "AAA" rated derivatives subsidiaries, Lehman Brothers Financial Products Inc. ("LBFP") and Lehman Brothers Derivative Products Inc. ("LBDP"), have established certain capital and operating restrictions which are reviewed by various rating agencies. At November 30, 1998, LBFP and LBDP each had capital which exceeded the requirement of the most stringent rating agency by approximately $135 million and $27 million, respectively. 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, 1998, approximately $3.5 billion of net assets of subsidiaries were restricted as to the payment of dividends to Holdings. NOTE 10 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 Postretirement BENEFITS Benefits November 30 November 30 [in millions, except for weighted-average] 1998 1997 1998 1997 - -------------------------------------------------------------------------------------------------------- Change in benefit obligation Benefit obligation at beginning of year $ 551 $ 479 $ 49 $ 49 Service cost before expenses 23 21 1 1 Interest cost 38 36 3 3 Actuarial (gain) loss 60 36 (1) Benefits paid (20) (21) (3) (3) Benefit obligation at end of year $ 652 $ 551 $ 50 $ 49 Change in plan assets Fair value of plan assets at beginning of year $ 747 $ 665 Actual return on plan assets, net of expenses 82 91 Employer contribution 9 13 Benefits paid (20) (21) Foreign currency exchange rate changes (1) (1) Fair value of plan assets at end of year $ 817 $ 747 Funded status (underfunded) $ 165 $ 196 $ (50) $ (49) Unrecognized net actuarial (gain) loss 79 39 (21) (22) Unrecognized prior service cost (credit) 2 (6) (7) Prepaid (accrued) benefit cost $ 246 $ 235 $ (77) $ (78) Weighted-average assumptions Discount rate 6.7% 7.2% 6.7% 7.0% Expected return on plan assets 8.8% 9.3% Rate of compensation increase 5.0% 5.1% 5.0% 5.1%
For measurement purposes, the annual health care cost trend rate was assumed to be 8.0% for the year ended November 30, 1999. The rate was assumed to decrease at the rate of 0.5% per year to 5.5% in the year ended November 30, 2004 and remain at that level thereafter.
PENSION Benefits Postretirement Benefits Twelve months ended November 30 Twelve months ended November 30 [in millions] 1998 1997 1996 1998 1997 1996 - ---------------------------------------------------------------------------------------------------------------------------- Components of net periodic benefit cost Service cost $ 24 $ 22 $ 18 $ 1 $ 1 $ 1 Interest cost 38 36 34 3 3 3 Expected return on plan assets (67) (63) (56) Recognized net actuarial (gain) loss (1) (1) 2 (1) (2) (1) - ---------------------------------------------------------------------------------------------------------------------------- Net periodic benefit (income) cost $ (6) $ (6) $ (2) $ 3 $ 2 $ 3 - ----------------------------------------------------------------------------------------------------------------------------
Assumed health care cost trend rates have a significant effect on the amount reported for postretirement benefits. A one-percentage-point change in assumed health care cost trend rates would have the following effects:
[in millions] 1% POINT INCREASE 1% POINT DECREASE - -------------------------------------------------------------------------------------------------------------------- Effect on total service and interest cost components in fiscal 1998 $ 0.4 $ (0.3) - -------------------------------------------------------------------------------------------------------------------- Effect on postretirement benefit obligation at November 30, 1998 $ 4.7 $ (4.5) - --------------------------------------------------------------------------------------------------------------------
NOTE 11 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] 1998 1997 1996 - ---------------------------------------------------------------------------------- Current Federal $ 238 $ 110 $ (20) State 63 58 36 Foreign 299 182 133 - -------------------------------------------------------------------------------- 600 350 149 - -------------------------------------------------------------------------------- Deferred Federal (239) (6) 61 State (6) (4) 11 Foreign (39) (50) (284) (60) 72 - -------------------------------------------------------------------------------- $ 316 $ 290 $ 221 - --------------------------------------------------------------------------------
Income before taxes included $270 million, $121 million, and $335 million that has also been subject to income taxes of foreign jurisdictions for 1998, 1997 and 1996, respectively. The income tax provision (benefit) differs from that computed by using the statutory federal income tax rate for the reasons shown below:
Twelve months ended November 30 [in millions] 1998 1997 1996 - ------------------------------------------------------------------------------------------------- Federal income taxes at statutory rate $ 368 $ 328 $ 223 State and local taxes 37 35 31 Tax-exempt income (71) (60) (24) Amortization of goodwill 3 3 3 Foreign operations 3 (3) (26) Other, net (24) (13) 14 - ------------------------------------------------------------------------------------------------- $ 316 $ 290 $ 221 - -------------------------------------------------------------------------------------------------
Deferred income taxes are provided for the differences between the tax basis of assets and liabilities and their reported amounts in the consolidated financial statements. These temporary differences will result in future income or deductions for income tax purposes and are measured using the enacted tax rates that will be in effect when such items are expected to reverse. The Company provides for deferred income taxes on undistributed earnings of foreign subsidiaries. At November 30, 1998 and 1997 the deferred tax assets and liabilities consisted of the following:
November 30 [in millions] 1998 1997 - --------------------------------------------------------------------------------------------------- Deferred tax assets Reserves not currently deductible $ 233 $ 185 Deferred compensation 413 325 Foreign tax credits 92 NOL carryforwards 9 15 Other 85 10 - --------------------------------------------------------------------------------------------------- 832 535 Less: Valuation allowance 19 43 - --------------------------------------------------------------------------------------------------- Total deferred tax assets net of valuation allowance $ 813 $ 492 - --------------------------------------------------------------------------------------------------- Deferred tax liabilities Excess tax over financial depreciation $ 114 $ 112 Pension and retirement costs 52 46 Unrealized trading and investment activity 39 8 Undistributed earnings of foreign subsidiaries (net of credits) (9) 7 Other 21 4 - --------------------------------------------------------------------------------------------------- Total deferred tax liabilities $ 217 $ 177 - --------------------------------------------------------------------------------------------------- Net deferred tax assets $ 596 $ 315 - ---------------------------------------------------------------------------------------------------
The net deferred tax assets are included in Other assets in the accompanying Consolidated Statement of Financial Condition. At November 30, 1998, the valuation allowance recorded against deferred tax assets was $19 million compared to $43 million at November 30, 1997, of which approximately $19 million and $27 million, respectively, will reduce goodwill if future circumstances permit recognition. The Company's Consolidated Statement of Income includes a $10 million net benefit from the reversal of a portion of this valuation allowance; the remaining decrease in the valuation allowance is associated with a corresponding decrease in the Company's net deferred tax assets. For tax return purposes, the Company has approximately $25 million of NOL carryforwards, substantially all of which are attributable to the 1988 acquisition of E.F. Hutton Group, Inc., (now known as LB I Group Inc.). Substantially all of the NOLs are scheduled to expire in the years 1999 through 2009. NOTE 12 DERIVATIVE FINANCIAL INSTRUMENTS Derivatives are financial instruments whose value is based upon an underlying asset (e.g., treasury bond), index (e.g., S&P 500) or reference rate (e.g., LIBOR). Over-the-counter ("OTC") derivative products are privately negotiated contractual agreements that can be tailored to meet individual client needs and include forwards, swaps and certain options including caps, collars and floors. Exchange-traded derivative products are standardized contracts transacted through regulated exchanges and include futures and certain option contracts listed on an exchange. In the normal course of business, the Company enters into derivative transactions both in a trading capacity and as an end user. Acting in a trading capacity, the Company enters into derivative transactions to satisfy the needs of its clients and to manage the Company's own exposure to market and credit risk resulting from its trading activities (collectively, "Trading-Related Derivative Activities"). As an end user, the Company primarily enters into interest rate swap and option contracts to adjust the interest rate nature of its funding sources from fixed to floating rates and vice versa, and to change the index upon which floating interest rates are based (e.g., Prime to LIBOR) (collectively, "End User Derivative Activities"). There is an extensive volume of derivative products available in the marketplace, which can vary from a simple forward foreign exchange contract to a complex derivative instrument with multiple risk characteristics involving the aggregation of the risk characteristics of a number of derivative product types including swap products, options and forwards. Listed below are examples of various derivative product types along with a brief discussion of the performance mechanics of certain specific derivative instruments. SWAP PRODUCTS Interest rate swap products include interest rate and currency swaps, leveraged swaps, swap options, and other interest rate option products including caps, collars, and floors. An interest rate swap is a negotiated OTC contract in which two parties agree to exchange periodic interest payments for a defined period, calculated based upon a predetermined notional amount. Interest payments are usually exchanged on a net basis throughout the duration of the swap contract. A currency swap is an OTC agreement to exchange a fixed amount of one currency for a specified amount of a second currency at the outset and completion of the swap term. Leveraged swaps involve the multiplication of the interest rate factor upon which the interest payment streams are based (e.g., Party A pays 3 times the six month LIBOR). Caps are contractual commitments that require the writer to pay the purchaser the amount by which an interest reference rate exceeds a defined contractual rate, if any, at specified times during the contract. Conversely, a floor is a contractual commitment that requires the writer to pay the amount by which a defined contractual rate exceeds an interest reference rate at specified times over the life of the contract, if any. Equity swaps are contractual agreements whereby one party agrees to receive the appreciation (or depreciation) value over a strike price on an equity investment in return for paying another rate, which is usually based upon equity index movements or interest rates. Commodity swaps are contractual commitments to exchange the fixed price of a commodity for a floating price (which is usually the prevailing spot price) throughout the swap term. OPTIONS Option contracts provide the option purchaser (holder) with the right but not the obligation to buy or sell a financial instrument, commodity or currency at a predetermined exercise price (strike price) during a defined period (American Option) or at a specified date (European Option). The option purchaser pays a premium to the option seller (writer) for the right to exercise the option. The option seller is obligated to buy (put) or sell (call) the item underlying the contract at a set price, if the option purchaser chooses to exercise. Option contracts also exist for various indices and are similar to options on a security or other instrument except that, rather than settling physical with delivery of the underlying instrument, they are cash settled. As a purchaser of an option contract, the Company is subject to credit risk, since the counterparty is obligated to make payments under the terms of the option contract, if the Company exercises the option. As the writer of an option contract, the Company is not subject to credit risk but is subject to market risk, since the Company is obligated to make payments under the terms of the option contract if exercised. Option contracts may be exchange-traded or OTC. Exchange-traded options are the obligations of the exchange and generally have standardized terms and performance mechanics. In contrast, all of the terms of an OTC option including the method of settlement, term, strike price, premium and security are determined by negotiation of the parties. FUTURES AND FORWARDS Futures contracts are exchange-traded contractual commitments to either receive (purchase) or deliver (sell) a standard amount or value of a financial instrument or commodity at a specified future date and price. Maintaining a futures contract requires the Company to deposit with the exchange an amount of cash or other specified assets as security for its obligation. Additionally, futures exchanges generally require the daily cash settlement of unrealized gains/losses on open contracts with the futures exchange. Therefore, futures contracts provide a reduced funding alternative to purchasing the underlying cash position in the marketplace. Futures contracts may be settled by physical delivery of the underlying asset or cash settlement (for index futures) on the settlement date or by entering into an offsetting futures contract with the futures exchange prior to the settlement date. Forwards are OTC contractual commitments to purchase or sell a specified amount of a financial instrument, foreign currency or commodity at a future date at a predetermined price. TBAs are forward contracts which give the purchaser/seller an obligation to obtain/deliver mortgage securities in the future. Therefore, TBAs subject the holder to both interest rate risk and principal prepayment risk. TRADING-RELATED DERIVATIVE ACTIVITIES Derivatives are subject to various risks similar to other financial instruments including market, credit, and operational risk. In addition, the Company may also be exposed to legal risks related to its derivative activities including the possibility that a transaction may be unenforceable under applicable law. The risks of derivatives should not be viewed in isolation, but rather should be considered on an aggregate basis along with the Company's other trading-related activities. The Company manages the risks associated with derivatives on an aggregate basis along with the risks associated with its proprietary trading and market-making activities in cash instruments as part of its firmwide risk management policies. Derivatives are generally based upon notional amounts. Notional amounts are not recorded on-balance sheet, but rather are utilized solely as a basis for determining future cash flows to be exchanged. Therefore, notional amounts provide a measure of the Company's involvement with such instruments, but are not indicative of actual or potential risk. The following table reflects the notional/contract amounts of the Company's Trading-Related Derivative Activities: Trading-Related Derivative Financial Instruments
NOTIONAL/ 1998 CONTRACT WEIGHTED- AMOUNTS AVERAGE November 30 November 30 MATURITY [in millions] 1998 1997 (IN YEARS) - ------------------------------------------------------------------------------------------------------------------------- Interest rate and currency swaps and options (including caps, collars and floors) $1,590,115 $ 961,762 4.77 Foreign exchange forward and future contracts and options 389,416 478,899 .32 Other fixed income securities contracts (including futures contracts and options, mortgage-backed securities forward contracts and options) 328,116 364,009 .71 Equity contracts (including equity swaps, futures, warrants and options) 88,604 40,522 .84 Commodity contracts (including swaps, futures, forwards and options) 1,544 10,292 1.72 - ----------------------------------------------------------------------------------------------------------------------- Total $2,397,795 $1,855,484 3.35 - -----------------------------------------------------------------------------------------------------------------------
Of the total notional amounts at November 30, 1998 and 1997, approximately $2,152 billion and $1,615 billion are over-the-counter and $246 billion and $240 billion are exchange-traded, respectively. The total weighted-average maturity at November 30, 1998, for over-the-counter and exchange-traded contracts was 3.62 years and 0.96 years, respectively. Approximately $1,053 billion of the notional/contract amount of the Company's Trading-Related Derivative Activities mature within the year ended November 30, 1999, of which approximately 30% have maturities of less than one month. The Company records its Trading-Related Derivative Activities on a mark-to-market basis with realized and unrealized gains and losses recognized currently in Principal transactions in the Consolidated Statement of Income. Unrealized gains and losses on derivative contracts are recorded on a net basis in the Consolidated Statement of Financial Condition for those transactions with counterparties executed under a legally enforceable master netting agreement and are netted across products when such provisions are stated in the master netting agreement. The Company offers equity, fixed income and foreign exchange products to its customers. Because of the integrated nature of the market for such products, each product area trades cash instruments as well as related derivative products. Principal transactions and net interest revenues related to the Company's fixed income business (which includes foreign exchange) were $1,638 million for 1998, $1,749 million for 1997 and $1,793 million for 1996. Principal transactions and net interest revenues related to the Company's equity business were $351 million for 1998, $296 million for 1997 and $275 million for 1996. Listed in the following table is the fair value of the Company's Trading-Related Derivative Activities as of November 30, 1998 and 1997 as well as the average fair value of these instruments. Average fair values of these instruments were calculated based upon month-end statement of financial condition values, which the Company believes do not vary significantly from the average fair value calculated on a more 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, 1998 November 30, 1998 [in millions] Assets Liabilities Assets Liabilities - -------------------------------------------------------------------------------------------------------------------------------- Interest rate and currency swaps and options (including caps, collars and floors) $5,877 $3,240 $ 5,550 $3,361 Foreign exchange forward contracts and options 1,583 1,367 1,724 1,558 Options on other fixed income securities, mortgage-backed securities forward contracts and options 224 214 288 264 Equity contracts (including equity swaps, warrants and options) 2,128 3,167 2,218 2,946 Commodity contracts (including swaps, forwards, and options) 71 76 147 146 - -------------------------------------------------------------------------------------------------------------------------------- Total $9,883 $8,064 $9,927 $8,275 - --------------------------------------------------------------------------------------------------------------------------------
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 - --------------------------------------------------------------------------------------------------------------------------
*Amounts represent carrying value (exclusive of non-cash collateral) and do not include receivables or payables related to exchange-traded futures contracts. Assets included in the 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, 1998 represents the Company's net receivable/payable for derivative financial instruments before consideration of collateral. Included within the $9,883 million fair value of assets at November 30, 1998 was $9,211 million related to swaps and other OTC contracts and $672 million related to exchange-traded option and warrant contracts. Included within the $8,353 million fair value of assets at November 30, 1997 was $8,016 million related to swaps and other OTC contracts and $337 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 $6,939 million at November 30, 1998, representing the fair value of the Company's OTC contracts in an unrealized gain position, after consideration of collateral. 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, 1998 for OTC contracts based upon actual ratings made by external rating agencies or by equivalent ratings established and utilized by the Company's Credit Risk Management Department.
COUNTERPARTY S&P/MOODY'S NET CREDIT RISK RATING EQUIVALENT EXPOSURE - -------------------------------------------------------------- 1 AAA/Aaa 15% 2 AA-/Aa3 or higher 25% 3 A-/A3 or higher 36% 4 BBB-/Baa3 or higher 12% 5 BB-/Ba3 or higher 5% 6 B+/B1 or lower 7%
The Company is also subject to credit risk related to its exchange-traded derivative contracts. Exchange-traded contracts, including futures and certain options, are transacted directly on the exchange. To protect against the potential for a default, all exchange clearinghouses impose net capital requirements for their membership. Additionally, the exchange clearinghouse requires counterparties to futures contracts to post margin upon the origination of the contract and for any changes in the market value of the contract on a daily basis (certain foreign exchanges provide for settlement within three days). Therefore, the potential for losses from exchange-traded products is limited. END USER DERIVATIVE ACTIVITIES The Company utilizes 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, 1998 and 1997, the notional amounts of the Company's end user activities related to its long-term debt obligations were approximately $24.3 billion and $17.3 billion, respectively. (For a further discussion of the Company's long-term debt related end user derivative activities see Note 4.) The Company also utilizes derivative products as an end user to modify its interest rate exposure associated with its secured financing activities, including securities purchased under agreements to resell, securities borrowed, securities sold under agreements to repurchase and securities loaned. At November 30, 1998 and 1997, the Company had $130 billion and $129 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. The Company actively monitors the level of anticipated secured financing transactions to ensure there is a high degree of certainty that such secured financing transactions will be executed at levels at least equal to the designated derivative product transactions. At November 30, 1998 and 1997, the Company, as an end user, utilized derivative financial instruments with an aggregate notional amount of $73.4 billion and $38.7 billion, respectively, to modify the interest rate characteristics of its secured financing activities. The total notional amount of these agreements had a weighted-average maturity of 1.0 years and 0.5 years as of November 30, 1998 and 1997, respectively. The Company terminated certain swaps designated as hedges of the Company's secured financing activities. At November 30, 1998 and 1997, a loss of approximately $2.8 million and $12.0 million, respectively, from these terminated contracts was deferred and will be amortized to interest expense over the original period of the hedge. On an overall basis, the Company's secured financing end user derivative activities increased (decreased) net revenues by approximately $4 million, $(10) million and $16 million for 1998, 1997 and 1996, respectively. NOTE 13 FAIR VALUE OF FINANCIAL INSTRUMENTS SFAS No. 107 "Disclosures about Fair Value of Financial Instruments" requires the Company to report the fair value of financial instruments, as defined. Assets and liabilities that are carried at fair value include all of the Company's trading assets and liabilities including derivative financial instruments used for trading purposes as described in Note 1, which are recorded as securities and other financial instruments owned and securities and other financial instruments sold but not yet purchased. Assets and liabilities, which are recorded at contractual amounts that approximate market or fair value include cash and cash equivalents, cash and securities segregated and on deposit for regulatory and other purposes, receivables, certain other assets, commercial paper and short-term debt, and payables. The market value of such items are not materially sensitive to shifts in market interest rates because of the limited term to maturity of these instruments and their variable interest rates. Financial instruments which are recorded at amounts that do not necessarily approximate market or fair value include long-term debt, certain secured financing activities and the related financial instruments utilized by the Company as an end user to manage the interest rate risk of these exposures. The Company's long-term debt is recorded at contractual or historical amounts. The following table provides a summary of the fair value of the Company's long-term debt and related end user derivative activities. The fair value of the Company's long-term debt was estimated using either quoted market prices or discounted cash flow analyses based on the Company's current borrowing rates for similar types of borrowing arrangements. The unrecognized net gain (loss) related to the Company's end user derivative activities reflects the esti- mated amounts the Company would receive (pay) if the derivative financial instruments were terminated based on market rates at November 30, 1998 and 1997, respectively.
November 30 ---------------------------- [in millions] 1998 1997 - ------------------------------------------------------------------------------------------------------ Carrying value of long-term debt $ 27,341 $ 20,261 Fair value of long-term debt 27,376 20,688 - ------------------------------------------------------------------------------------------------------ Unrecognized net gain (loss) on long-term debt $ (35) $ (427) - ------------------------------------------------------------------------------------------------------ Unrecognized net gain (loss) on long-term debt end user activities $ 385 $ 188 - ------------------------------------------------------------------------------------------------------
The Company carries its secured financing activities, including securities purchased under agreements to resell, securities borrowed, securities sold under agreements to repurchase, and securities loaned, at their original contract amount plus accrued interest. The majority of such financing activities are short-term in nature which approximates fair value. At November 30, 1998 and 1997, the Company had $130 billion and $129 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, 1998 and 1997, the Company, as an end user, utilized derivative financial instruments with an aggregate notional amount of $73.4 billion and $38.7 billion, respectively, to modify the interest rate characteristics of its secured financing activities. The unrecognized net losses related to these derivative financial instruments were $110 million and $6 million at November 30, 1998 and 1997, respectively, which were substantially offset by unrecognized net gains on the Company's secured financing activities. Additionally, at November 30, 1998 the Company had approximately $84 million of unrecognized losses related to approximately $4.4 billion of long-term fixed rate repurchase agreements. NOTE 14 OTHER COMMITMENTS AND CONTINGENCIES As of November 30, 1998 and 1997, the Company was contingently liable for $2.9 billion and $4.2 billion, respectively, of letters of credit, primarily used to provide collateral for securities and commodities borrowed and to satisfy margin deposits at option and commodity exchanges, and other guarantees. As of November 30, 1998 and 1997, in connection with its financing activities, the Company had outstanding commitments under certain lending arrangements of approximately $3.7 billion and $2.4 billion, respectively. These commitments require borrowers to provide acceptable collateral, as defined in the agreements, when amounts are drawn under the lending facilities. Advances made under the above lending arrangements are typically at variable interest rates and generally provide for over-collateralization based upon the borrowers' creditworthiness. As of November 30, 1998, the Company had pledged securities, primarily fixed income, having a market value of approximately $24.4 billion, as collateral for securities borrowed having a market value of approximately $23.8 billion. Securities and other financial instruments sold but not yet purchased represent obligations of the Company to purchase the securities at prevailing market prices. Therefore, the future satisfaction of such obligations may be for an amount greater or less than the amount recorded. The ultimate gain or loss is dependent upon the price at which the underlying financial instrument is purchased to settle its obligation under the sale commitment. In the normal course of business, the Company is exposed to off-balance sheet credit and market risk as a result of executing, financing and settling various customer security and commodity transactions. Off-balance sheet risk arises from the potential that customers or counterparties fail to satisfy their obligations and that the collateral obtained is insufficient. In such instances, the Company may be required to purchase or sell financial instruments at unfavorable market prices. The Company seeks to control these risks by obtaining margin balances and other collateral in accordance with regulatory and internal guidelines. The Company, through its high yield sales and trading activities, makes commitments to extend credit in loan syndication transactions principally to below investment grade borrowers and then participates a significant portion of these commitments. These commitments, net of syndications and participations, totaled $2.0 billion and $1.6 billion at November 30, 1998 and 1997, respectively, and are typically secured against the borrower's assets and have fixed maturity dates. The draw down of these facilities is generally contingent upon certain representations, warranties and contractual conditions of the borrower. Total commitments may not be indicative of actual risk or funding requirements as the commitments may not be drawn or fully utilized and the Company intends to continue syndicating, selling and/or participating in these commitments. The Company also had lending commitments to high grade borrowers of $675 million and $140 million at November 30, 1998 and 1997, respectively. These commitments also are typically secured against the borrower's assets, have fixed maturity dates, and are generally contingent upon certain representations, warranties and contractual conditions of the borrower. At November 30, 1998 and 1997, the Company had commitments to invest up to $379 million and $498 million in partnerships, respectively, which in turn will make direct merchant banking related investments. These commitments will be funded as required through the end of the respective partnerships' investment periods, principally expiring in 2004. In addition to these specific commitments, the Company had various other commitments of approximately $335 million at November 30, 1998. Subsidiaries of the Company, as general partner, are contingently liable for the obligations of certain public and private limited partnerships organized as pooled investment funds or engaged primarily in real estate activities. In the opinion of the Company, contingent liabilities, if any, for the obligations of such partnerships will not in the aggregate have a material adverse effect on the Company's consolidated financial position or results of operations. In the normal course of its business, the Company has been named a defendant in a number of lawsuits and other legal proceedings. After considering all relevant facts, available insurance coverage and the advice of outside counsel, in the opinion of the Company such litigation will not, in the aggregate, have a material adverse effect on the Company's consolidated financial position or results of operations. CONCENTRATIONS OF CREDIT RISK As 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. A substantial portion of the Company's securities and commodities transactions is collateralized and is executed with, and on behalf of, commercial banks and other institutional investors, including other brokers and dealers. The Company's exposure to credit risk associated with the non-performance of these customers and counterparties in fulfilling their contractual obligations pursuant to securities transactions can be directly impacted by volatile or illiquid trading markets, which may impair the ability of customers and counterparties to satisfy their obligations to the Company. Securities and other financial instruments owned by the Company include U.S. government and agency securities, and securities issued by non-U.S. governments which, in the aggregate, represented 15% of the Company's total assets at November 30, 1998. 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, 1998, consisted of securities issued by the U.S. government, federal agencies or non-U.S. governments. The Company's most significant industry concentration is financial institutions, which include other brokers and dealers, commercial banks and institutional clients. This concentration arises in the normal course of the Company's business. LEASE COMMITMENTS The Company leases office space and equipment throughout the world and is a party to a ground lease with the Battery Park City Authority covering its headquarters at 3 World Financial Center which extends through 2069. Total rent expense for 1998, 1997 and 1996 was $39 million, $42 million and $48 million, respectively. Certain leases on office space contain escalation clauses providing for additional rentals based upon maintenance, utility and tax increases. Minimum future rental commitments under non-cancellable operating leases (net of subleases of $102 million) are as follows:
[in millions] - ------------------------------------------------------------------------------- Fiscal 1999 $ 36 Fiscal 2000 35 Fiscal 2001 34 Fiscal 2002 34 Fiscal 2003 30 December 1, 2003 and thereafter 444 - ------------------------------------------------------------------------------- $ 613 - -------------------------------------------------------------------------------
NOTE 15 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 following amounts 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 domestic 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, 1998 International operations: Europe $ 1,378 $ 870 $ 111 $ 32,363 Asia Pacific 554 496 205 3,455 - ---------------------------------------------------------------------------------------------------------------------- Total international 1,932 1,366 316 35,818 Americas(1) 17,962 2,747 736 118,072 - ---------------------------------------------------------------------------------------------------------------------- Total $ 19,894 $ 4,113 $ 1,052 $ 153,890 - ----------------------------------------------------------------------------------------------------------------------
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(1) 15,363 2,779 794 106,259 - ---------------------------------------------------------------------------------------------------------------------- Total $ 16,883 $ 3,873 $ 937 $ 151,705 - ----------------------------------------------------------------------------------------------------------------------
GROSS NET INCOME (LOSS) IDENTIFIABLE [in millions] REVENUES REVENUES BEFORE TAXES ASSETS - ---------------------------------------------------------------------------------------------------------------------- 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(1) 12,328 2,059 191(2) 96,214 - ---------------------------------------------------------------------------------------------------------------------- Total $ 14,260 $ 3,444 $ 637 $ 128,596 - ----------------------------------------------------------------------------------------------------------------------
(1) Includes non-U.S. revenues of $55 million, $67 million and $42 million in 1998, 1997 and 1996, respectively. (2) Includes $84 million severance charge. NOTE 16 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 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. 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 were paid as deferred payment arrangements were completed. NOTE 17 QUARTERLY INFORMATION (UNAUDITED) The following information represents the Company's unaudited quarterly results of operations for 1998 and 1997. 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.
1998 1997 ----------------------------------------------------------------------------------------- [in millions, except per share amounts] Nov. 30 Aug. 31 May 31 Feb. 28 Nov. 30 Aug. 31 May 31 Feb. 28 - ----------------------------------------------------------------------------------------------------------------------------------- Total revenues $3,797 $5,963 $5,554 $4,580 $4,609 $4,469 $3,806 $3,999 Interest expense 3,132 5,033 4,081 3,535 3,586 3,398 2,952 3,074 - ----------------------------------------------------------------------------------------------------------------------------------- Net revenues 665 930 1,473 1,045 1,023 1,071 854 925 Non-interest expenses: Compensation and benefits 337 472 747 530 519 543 433 469 Other expenses 234 251 250 240 239 247 249 237 - ----------------------------------------------------------------------------------------------------------------------------------- Total non-interest expenses 571 723 997 770 758 790 682 706 - ----------------------------------------------------------------------------------------------------------------------------------- Income before taxes 94 207 476 275 265 281 172 219 Provision for income taxes 20 56 152 88 80 84 51 75 - ----------------------------------------------------------------------------------------------------------------------------------- Net income $ 74 $ 151 $ 324 $ 187 $ 185 $ 197 $ 121 $ 144 - ----------------------------------------------------------------------------------------------------------------------------------- Net income applicable to common stock $ 62 $ 139 $ 268 $ 180 $ 160 $ 160 $ 114 $ 138 - ----------------------------------------------------------------------------------------------------------------------------------- Weighted-average shares Basic 120.7 121.5 120.6 120.6 119.0 118.7 118.0 117.0 Diluted 122.5 126.2 126.3 124.8 123.0 122.4 120.4 118.5 - ----------------------------------------------------------------------------------------------------------------------------------- Earnings per common share Basic $ 0.51 $ 1.15 $ 2.22 $ 1.49 $ 1.34 $ 1.34 $ 0.97 $ 1.18 Diluted $ 0.51 $ 1.10 $ 2.12 $ 1.44 $ 1.30 $ 1.30 $ 0.95 $ 1.16 - ----------------------------------------------------------------------------------------------------------------------------------- Dividends per common share $0.075 $0.075 $0.075 $0.075 $ 0.06 $ 0.06 $ 0.06 $ 0.06 Book value per common share (at period end) $37.06 $36.35 $35.93 $34.56 $33.39 $31.86 $30.67 $29.76 - -----------------------------------------------------------------------------------------------------------------------------------
SELECTED FINANCIAL DATA The following table summarizes certain consolidated financial information included in the audited consolidated financial statements. 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 this reason, the Company's 1994 results are not fully comparable with the other periods presented.
Tweleve months ended Eleven November 30 months ended November 30 [in millions, except Per share, Other data and Financial ratios]1998 1997 1996 1995 1994 CONSOLODATED STATEMENT OF INCOME Revenues: Principal transactions $1,232 $1,418 $1,579 $1,393 $1,345 Investment banking 1,582 1,318 981 801 572 Commissions 513 423 362 450 445 Interest and dividends 16,542 13,635 11,298 10,788 6,761 Other 25 89 40 44 67 - --------------------------------------------------------------------------------------------------------------------------- Total revenues 19,894 16,883 14,260 13,476 9,190 Interest expense 15,781 13,010 10,816 10,405 6,452 - --------------------------------------------------------------------------------------------------------------------------- Net revenues 4,113 3,873 3,444 3,071 2,738 - --------------------------------------------------------------------------------------------------------------------------- Non-interest expenses: Compensation and benefits 2,086 1,964 1,747 1,544 1,413 Other expenses 975 972 976 1,061 1,084 Severance and other charges 84 97 48 - --------------------------------------------------------------------------------------------------------------------------- Total non-interest expenses 3,061 2,936 2,807 2,702 2,545 - --------------------------------------------------------------------------------------------------------------------------- Income from continuing operations before taxes and cummulative effect of change in accounting principle 1,052 937 637 369 193 Provision for income taxes 316 290 221 127 67 - --------------------------------------------------------------------------------------------------------------------------- Income (loss) from continuing operations before cummulative effect of change in accounting principle 736 647 416 242 126 Cummulative effect of change in accounting principle, net of taxes (13) - --------------------------------------------------------------------------------------------------------------------------- Net income (loss) $736 $647 $416 $242 $113 - --------------------------------------------------------------------------------------------------------------------------- Net income (loss) applicable to common stock $649 $572 $378 $200 $75 - --------------------------------------------------------------------------------------------------------------------------- CONSOLIDATED STATEMENT OF FINANCIAL CONDITION (AT PERIOD END) Total assets $153,890 $151,705 $128,596 $115,303 $109,947 Total assets excluding matched book(a) 111,509 108,099 96,256 79,069 72,457 Long-term debt(b) 27,341 20,261 15,922 12,765 11,321 Total stockholders' equity 5,413 4,523 3,874 3,698 3,395 Total capital(c) 32,754 24,784 19,796 16,463 14,716 - --------------------------------------------------------------------------------------------------------------------------- PER SHARE DATA Income (loss) from continuing operations before cumulative effect of change in accounting principle $5.19 $4.72 $3.24 $1.76 $0.81 Cumulative effect of change in accounting principle (0.12) Net income (loss) $5.19 $4.72 $3.24 $1.76 $0.69 Dividends declared per common share 0.30 0.24 0.20 0.20 0.175 Book value per common share (at period end) 37.06 33.39 28.84 25.67 24.35 - --------------------------------------------------------------------------------------------------------------------------- OTHER DATA (AT PERIOD END) Ratio of total assets to total stockholders' equity 28.4x 33.5x 33.2x 31.2x 32.4x Ratio of total assets excluding matched book to total stockholders' equity(a) 20.6x 23.9x 24.8x 21.4x 21.3x Employees 8,873 8,340 7,556 7,771 8,512 FINANCIAL RATIOS (%) Compensation and benefits/net revenues(d) 50.7 50.7 50.7 50.8 51.6 Pretax operating margin 25.6 24.2 18.5 12.0 7.0 Effective tax rate(d) 30.0 30.9 35.4 34.5 33.7 Return on common equity (annualized) 15.2 15.6 12.1 7.1 4.0 - ---------------------------------------------------------------------------------------------------------------------------
(a) Matched book represents "securites 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 simialr 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) For the twelve months ended November 30, 1995, excludes the effect of the sale of Omnitel. EX-13.3 6 MARKET FOR REGISTRANT'S COMMON EQUITY O T H E R S T O C K H O L D E R I N F O R M A T I O N CORPORATE HEADQUARTERS Lehman Brothers Holdings Inc. 3 World Financial Center New York, New York 10285 (212) 526-7000 (800) 666-2388 Fax Number: (212) 526-3738 ANNUAL MEETING The annual meeting of stockholders of Lehman Brothers will be held on Tuesday, March 30, 1999 at 10:30 a.m. at 3 World Financial Center, 26th Floor, 200 Vesey Street, New York, New York 10285. TRANSFER AGENT AND REGISTRAR Questions regarding dividends, transfer requirements, lost certificates, changes of address, direct deposit of dividends, the direct purchase and dividend reinvestment plan, or other inquiries should be directed to: The Bank of New York Shareholders Service Department P.O. Box 11258 Church Street Station New York, New York 10286-1258 Telephone: (800) 824-5707 E-mail: shareowner-svcs@bankofny.com Website: http://stock.bankofny.com 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 1998 was $0.30 per common share. The Company recently announced an increase in the fiscal 1999 common stock dividend to $0.36 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. DIRECT PURCHASE AND DIVIDEND REINVESTMENT PLAN Lehman Brothers' Direct Purchase and Dividend Reinvestment Plan provides both existing stockholders and interested first-time investors an alternative means of buying the Company's stock. The plan has no minimum stock ownership requirements for eligibility and enrollment. Plan participants may reinvest all or a portion of cash dividends and/or make optional cash purchases up to a maximum of $175,000 per year without incurring commission or service charges. Additional information and enrollment forms can be obtained from the Company's Transfer Agent listed above. ANNUAL REPORT AND FORM 10-K Lehman Brothers will make available upon request copies of this Annual Report and 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, New York 10285 Telephone: (212) 526-1936 E-mail: jennifer_marre@usccmail.lehman.com CONTACTS Investor Relations: Shaun K. Butler (212) 526-8381 Media Relations: William J. Ahearn (212) 526-4379 WEBSITE ADDRESS 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 P R I C E R A N G E OF C O M M O N S T O C K 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 19, 1999, there were 25,816 holders of record of the Company's common stock. On January 19, 1999, the last reported sales price of the Company's common stock was $51.125.
THREE MONTHS ENDED ----------------------------------------------------------------------------------- 1998 1997 ----------------------------------------------------------------------------------- Nov. 30 Aug. 31 May 31 Feb. 28 Nov. 30 Aug. 31 May 31 Feb. 28 - ------------------------------------------------------------------------------------------------ High $54 1/2 $85 $83 7/16 $63 1/2 $56 1/8 $52 $41 $36 3/8 Low $24 3/4 $39 3/8 $62 5/8 $47 3/4 $43 1/8 $37 3/4 $29 $29 1/8
EX-23 7 CONSENT OF ERNST & YOUNG EXHIBIT 23 CONSENT OF INDEPENDENT AUDITORS We consent to the incorporation by reference in this 1998 Annual Report on Form 10-K of Lehman Brothers Holdings Inc. (the "Company") of our report dated January 7, 1999, included in the 1998 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. 333-50197, 33-53651, 333-57238, 333-07875 and 33-53923 of Lehman Brothers Holdings Inc. and in the related Prospectuses, of our report dated January 7, 1999 with respect to the consolidated financial statements and financial statement schedule of Lehman Brothers Holdings Inc. included or incorporated by reference in this 1998 Annual Report on Form 10-K for the year ended November 30, 1998. /s/ Ernst & Young LLP ERNST & YOUNG LLP New York, New York February 26, 1999 EX-24 8 POWER OF ATTORNEY EXHIBIT 24 KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Thomas A. Russo, Karen M. Muller and Jennifer Marre and each of them, his or her true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for him or her and in his or her name, place and stead, in any and all capacities, to sign the Annual Report on Form 10-K of Lehman Brothers Holdings Inc., for the fiscal year ended November 30, 1998 and any and all amendments thereto, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their substitute or substitutes, may lawfully do or cause to be done by virtue hereof. Dated: As of February 26, 1999
SIGNATURES TITLE - ------------------------------ -------------------------- Chief Executive Officer and /s/ RICHARD S. FULD, JR. Chairman of the Board of - ------------------------------ Directors Richard S. Fuld Jr. (principal executive officer) Chief Financial and /s/ JOHN L. CECIL Administrative Officer - ------------------------------ (principal financial and John L. Cecil accounting officer) /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
EX-27 9 FINANCIAL DATA SCHEDULE
BD This Schedule contains summary financial information extracted from the Company's Consolidated Statement of Financial Condition at November 30, 1998 and the Consolidated Statement of Income for the twelve months ended November 30, 1998 and is qualified in its entirety by reference to such financial statements. 1,000,000 12-MOS NOV-30-1998 DEC-01-1997 NOV-30-1998 4,238 11,965 42,381 16,341 77,000 505 153,890 6,657 10,525 67,730 3,165 28,803 27,341 0 908 12 4,493 153,890 1,232 16,542 513 1,582 0 15,781 2,086 1,052 736 0 0 736 5.37 5.19
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