Changes in the Social Network of Trust
The net $2.6 billion in proceeds raised by the IPO allowed Goldman to expand rapidly, and the partnership pool grew to meet the demands created by rapid growth, changing what had once been a close social network. The firm had started selectively hiring more lateral senior people in the mid-1980s, and this accelerated in the 1990s as the firm grew. But after the announced and expected retirements after the IPO, hiring outsiders as partners became a necessity. Within five years of the IPO, almost 60 percent of the original partners were gone. Goldman did not have the luxury of time to build product and geographic expertise from within.
According to the partners I interviewed, the priority of recruiting, training, and mentoring changed. The process of identifying and nurturing partner candidates was pushed aside in favor of those who could show immediate results—metrics, revenue production, and Super League relationships—and measurable results such as a trading P&L. And if the firm did not have the right people, the feeling was that it could hire them from other firms by using the valuable currency of Goldman stock. The firm’s executives did not want to wait and slowly develop people internally for partnership positions. It would constrain growth. According to my interviews, candidates for partner or lateral hires at the partnership level were not vetted as thoroughly for the match between their personal values and the firm’s business principles and culture—a consequence in part of the drop in financial interdependence and the greater emphasis on the financial contribution. Some partners I interviewed believed that this coincided with an increasing shift of balance in considering people for partner to more weight being given to a person’s ability to contribute commercially and less to other considerations, like values and culture.
The Effects of Wall Street Models
A distinct change as the result of going public was the deep effect of Wall Street investors and analysts on the firm. A partner who voted for the IPO, whom I interviewed, said that the firm way under-estimated the scrutiny it would receive as a public company. He said at the time of the IPO the firm had a handful of employees in public relations who essentially said “No comment” when the press asked about its business. Today, he estimated that over a dozen people were involved in public relations, talking to the press, investors, and analysts and preparing information for them.
The new scrutiny came from many camps. Each of these groups used different tools, including the firm’s valuation, to assess Goldman as an investment opportunity. Now having to compete in this way with other firms for investors’ cash and positive analyst assessments, Goldman became concerned with how it appeared when assessed by models, and therefore it instituted some new practices that made it more similar to its competitors. In a process that is described by academics as performativity, the models used by Wall Street to assess the firm had a reflexive effect on how the firm chose to perform. 16
Formerly, Goldman had generally held itself apart from the crowd, to a separate standard of its own devising. A colleague once explained to me in the mid-1990s during a late-night pizza break in a conference room, which Goldman regularly paid for in order to promote bonding, that at Goldman, people never spoke badly about other firms. (Goldman principle number 13 states, “Never denigrate other firms.”) According to him, Goldman employees didn’t really care what the other firms did, or that other firms badmouthed Goldman or told people they were better than Goldman. He said that Goldman was “the Harvard of investment banking.” I asked what he meant, and he elaborated by saying, “You know how people at very good colleges wear t-shirts saying things like ‘XYZ college, the Harvard of the Midwest? It’s like a subconscious insecurity about where they actually did go, or an acknowledgment that they wanted to go to Harvard instead.” He then asked rhetorically, “Have you ever seen anyone at Harvard wearing a shirt with the name of another college on it?” I thought the example was a little absurd, and in part to be a smart-aleck I asked him, “So do you think people at Morgan Stanley are wearing t-shirts saying, ‘Morgan Stanley, the Goldman Sachs of Midtown?’” Annoyed, he got up and walked away, and I couldn’t stop myself as I called out after him, “I am going to copyright that.”
While those at Goldman might still have thought of the firm as the Harvard of Wall Street after the IPO, they started to care a great deal about how the other firms were doing. According to interviews, after the IPO, both Goldman’s investors and its employees constantly compared its performance to that of other firms. In addition, partners’ and CEO compensation was compared to peers’. Before the IPO, Goldman was not required to report its earnings—and chose not to do so. Earnings, compensation, and similar information were closely guarded secrets and helped to add to the Goldman mystique. The prevailing sentiment was that the firm’s record of success meant it did not have to care how others were managing their business, the ratios they looked at, their margins, or their return on equity. Goldman might choose to compare itself to these models and benchmarks, but it did not have to manage to them to appease outsiders. The partners reported only to themselves and could choose to measure risk or performance however they saw fit. They did not have to explain their decisions to outside board members, and, because they did not have to answer to the outside world (the previous outside private investors had no say in management), the partners could make the decisions that were best for the partnership in the long term. This ability to protect confidential information was one of the arguments used for remaining a private partnership. “Are you ready to lose the flexibility we now have in reporting up and down earnings?” Whitehead and Weinberg wrote in a letter to Corzine and Paulson. 17
As a public company, in contrast, Goldman had to comply with the demands and requirements of the capital markets. Among these is the preference for all companies to have common measures, so Goldman was expected to employ the financial models used by the street and capital markets, including the desired measures of risk and performance. Ellis notes, “The persistent demand to meet or beat both internal and external expectations of excellence [is one of the] penalties of industry leadership.” 18
Traditionally, firms want to meet or exceed expectations, believing it demonstrates how well they are run. I analyzed Bear Stearns, Goldman, Lehman, Merrill Lynch, and Morgan Stanley’s ability to meet or beat analyst EPS and revenue published expectations from 1999 (when Goldman went public) to 2008 (the credit crisis). There was a statistically significant difference between the firms. Bear Stearns and Lehman more consistently met or exceeded analyst expectations and showed the highest correlations, implying that they were “managing to analyst models.” Obviously those two firms failed. Goldman showed a correlation to meeting or exceeding expectations (demonstrating the effect of analyst models) but actually had the least correlation among the firms; it was the worst, implying that it was willing to accept losses or deviate from the analysts more than the other firms. This may reflect cultural characteristics and possibly elements that helped Goldman do relatively better in the credit crisis (discussed later).
Source of Revenues
At the time of the IPO, analysts and investors wanted to see Goldman increase its asset management revenues because of the resulting more-consistent fees. They also discussed Goldman’s international growth and placed a premium on it, because Goldman had market share opportunities internationally. International growth had already been a priority, a benchmark by which the firm measured itself. Whitehead knew that if Goldman could not take care of its clients’ banking needs anywhere in the world, it risked losing them to firms that could. Rubin and Friedman pushed for more international growth and executed the vision. Corzine and Paulson had pushed even further. But still Wall Street wanted more, according to interviews from analyst investors at the time.
Analysts did not place a high value on the sales and trading revenues and revenues from private equity, even though they were highly profitable and important for Goldman, because of their volatility and inconsistency. Goldman made a larger perc
entage of its profits related to trading than its peers in 1998. Largely for this reason, the firm’s revenue mix became a topic of avid discussion among analysts and investors in the months leading up to the IPO, because the revenue mix was more volatile than that of firms that were less reliant on trading. The greater stability of asset management revenues can provide a cushion against market volatility, but in the mid- to late 1990s, the firm lagged behind its rivals in building its asset management business.
Only a few short years later, however, Goldman’s asset management business was strong enough to attract more of the firm’s top talent to move over from other areas of the firm, as well as some “outside honchos [brought in with] the promise that they [would] become partners (which is rarely done at Goldman).” 19
Thus, growth was particularly strong in both asset management and international expansion. Asset management grew faster than banking over time, and international growth was higher than domestic. Goldman even said so in its prospectus: “We pursue our strategy to grow our core business through an emphasis on: expanding high value-added businesses … increasing the stability of our earnings … pursuing international opportunities … [and] leveraging the franchise.” 20 When discussing “increasing the stability of our earnings,” Goldman said it would emphasize “growth in investment banking and asset management.” Goldman’s investment banking revenues, however, actually declined as a percentage over time. Growing banking was a good story for analysts and investors (though not necessarily a representation of reality), especially in light of potential investors worrying about the impact of trading. Analysts I interviewed said it was probably better to have Paulson, from a banking background, lead the firm during the IPO instead of Corzine, because it made Goldman’s story of emphasis on advisory businesses more believable, although some had their doubts.
What really happened in the following years, though, was that trading became an increasingly dominant part of Goldman’s business, and this had a significant impact on drift.
Chapter 7
From Principles to a Legal Standard
APPLYING A LEGAL STANDARD TO DEFINE WHAT IS RIGHT AND wrong, rather than an ethical standard higher than the law, helps managers maximize business opportunities, because the law allows for certain practices that a high ethical standard, in particular regarding clients’ interests, would preclude. Any standard above the law restricts opportunities.
At Goldman, my interviews and research made clear, over time, the interpretation of what the “clients’ interests first” principle meant changed from applying a higher ethical standard than that required by law to simply meeting those requirements. The standard changed to as long as one properly disclosed the risks to clients and followed all the legal rules and regulations, then one was ethically, morally, and responsibly adhering to the primary business principle. The “ethics” drifted closer to the legal definition over years, and the fundamental reasons were that the firm was seeking to maximize opportunities for rapid growth, which was an organizational goal.
What I concluded from my discussions and research was that many at Goldman don’t think they’re doing anything wrong, and that adherence to the first principle hasn’t changed.1 Most of the current partners I interviewed said that they were abiding not only by the firm’s business principles, including the first principle related to clients’ interests, but also by the law. My interviews made it clear that the two had become one in the same in their minds. When I asked them about accusations that the firm has behaved immorally and unethically, most countered that the definitions of those terms are highly subjective.
This is a far way from how John S. Weinberg described his father’s orientation to the question of morality and ethics: “He saw right and wrong clearly, with no shades of gray.” Those I interviewed also pointed to the many systems in place at Goldman that were implemented specifically to protect against misconduct, by which they meant illegal or criminal behavior, which they said Goldman takes very seriously. In addition, some of the partners I interviewed made the point that considering the large number of daily transactions and communications with clients by tens of thousands of Goldman people located in different countries with different legal jurisdictions, it is relatively rare that Goldman gets in legal trouble or is fined, in part because of the care the firm takes in dealing with clients. They said that misconduct or failure, when it happens, is more often a mistake than criminally intended: something was overlooked, some scenario was not considered, or someone was not consulted, because the person was not aware of the need to do so; something in a complex system that is designed to protect the firm and clients somehow failed.2
Most of the partners I interviewed said that, given Goldman’s volume of business, the depth of its client network, its leading market shares, and its various business activities, something is bound to happen. Most seemed to be implying that such errors are a cost of doing business. And my calculations indicate that it is a cost the firm can bear, in terms of finances. From reviewing publicly available documents, I estimate that Goldman has paid less than $1 billion in fines since 2003, compared with some $58 billion in net income over the same time period. The very year (2010) Goldman paid the largest fine in SEC history at the time ($550 million), the firm made almost $8 billion. Fines are almost like an expense that Goldman attempts to minimize but cannot avoid.3
However, many current partners also did generally admit that “mistakes” seem to be happening with greater frequency. Some suggested this might be attributed not to a change in behavior but to changes in the laws and in enforcement; that there may be no greater incidence of mistakes, it’s only that the authorities are more focused on them. But based on my interviews and a review of congressional testimony, changes in regulation have in general been more biased about the investment banks having more self-regulation. Regarding enforcement, the SEC has publicly stated that SEC staff levels have not kept pace with industry growth; in fact, with increased funding in 2009 and 2010, SEC staff levels are only returning to 2005 levels. Next, we’ll consider a number of the criticisms made against Goldman and several of the cases brought against them for alleged misconduct and Goldman’s general views about them.
Chinese Walls
Maintaining client confidentiality is crucial to any investment banking firm; it is one of Goldman’s stated principles. Client confidentiality is the principle that an institution or individual should not reveal information about clients to a third party (in a bank that can be another area within the firm) without the consent of the client or a clear legal reason. When firms are providing a wide range of services, clients must be able to trust that their information will not be used by other areas of the firm that do not need to know and exploited for the benefit of other clients or of the firm, which may have different interests. For this reason, banks say that they have erected so-called Chinese walls between departments, such as between investment advisors and traders.4 Given all of the Wall Street scandals in recent years, however, some people doubt the effectiveness of those Chinese walls, and even with effective barriers, how and when and what information may have been transferred from one part of a bank to another is difficult to follow and monitor, and even to understand, both for banks’ compliance departments and for regulators.
This makes enforcing the legal requirements difficult. From my interviews with regulators and corporate lawyers, it is not as simple as a bank asking a client to sign a waiver; rather, it is a matter of explaining to a client exactly how and when and what information Goldman learns is used and who knows it. As an easy and straightforward example, if Goldman was about to receive confidential information from a publicly traded company that was interested in potentially selling itself, then the team would have to check with a conflicts and compliance group to see if it is okay to receive such information. Technically there is a Chinese wall between banking and trading, so trading may not legally need to be restricted from trading the stock of the public company, because both sides shou
ld not know what the other is doing. The firm may place its own restrictions on trades of the stock or bonds of the company, however, from a proprietary basis for its own account.
Let’s now complicate the situation. Goldman’s private equity area may have at some time in the past talked to another client about jointly buying the company, and that should be logged into the system. But in order to see where those conversations are or went, the conflicts and compliance area needs to ask someone in the private equity group. The simple fact of asking could tip someone in the private equity group that banking may have a client interested in buying the company, or that the company may be looking to sell or doing something strategic. Who in private equity knows, and when, and then what they do in checking, is ambiguous. They may need to ask the team leader, also potentially tipping people off. So how you ask, when you ask, what you ask, and whom you ask is very subjective, and each request, while ensuring that private equity has no conflict, also adds to the risk that certain information may be passed on to someone the client might not want to know.
The banking team themselves may not know who knows what and when. What is legal or what or where the Chinese wall should be in this instance is very ambiguous. If, for instance, Goldman decides that because of prior conversations, the firm cannot work for the public company because its private equity group had verbally committed to work with a potential buyer, and then by coincidence a few months later Goldman’s potential coinvestment client calls the company saying it is interested in buying the company—the public company that spoke to Goldman about the idea may question whether Goldman shared confidential information. It could look bad, even if the Chinese wall was in place and no confidential information was shared with the Goldman client.
What Happened to Goldman Sachs: An Insider's Story of Organizational Drift and Its Unintended Consequences Page 18