What Happened to Goldman Sachs: An Insider's Story of Organizational Drift and Its Unintended Consequences
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The fact that it’s so difficult to adhere to the legal line makes maintaining a high ethical standard, and having a business mix that potentially reduces conflicts, all the more important if a bank wants to be sure not to violate the interests of its clients. But the sharing of information and teamwork are also operating principles at Goldman, and one of the firm’s biggest legal or compliance issues is that it shares information among different areas—something that clients love when it helps Goldman provide liquidity or improve execution for the client. Indeed, information sharing among different areas of specialty within the firm is one of the things clients value about Goldman and believe differentiates the firm (when the client believes it’s benefiting). But, paradoxically, that same information sharing can sometimes seems to place the client at a disadvantage.
This has made the ethical line also difficult to draw for Goldman. Clients and the public, and even some employees, seem genuinely confused about the firm’s relationships and responsibilities as an adviser, fiduciary, underwriter/structurer, and market participant.5 This is in part because Goldman has characterized its relationship to clients and its responsibilities to them differently in different circumstances. For example, in the congressional hearings investigating Goldman’s role in selling mortgage securities to clients, Goldman argued that its role was simply that of a market maker, toeing the legal line, which only requires that in such sales, the bank or broker inform the clients of the risks. But Goldman executives couldn’t really answer to some senators’ satisfaction why the executives instructed traders to “cause maximum pain” and “demoralize” market participants if they were simply matching buyers and sellers.6 Goldman also often touts the role it plays as a coinvestor with clients in certain deals, and how it will use its own money to facilitate certain transactions, and in those cases is acting as a principal in the deals. This has led some clients and regulators to make the point that the firm will point to whichever definition of its role, and associated responsibilities, allows it to justify, excuse, or rationalize whichever behavior it’s engaged in that is being questioned.
A recent example of Goldman’s allegedly inappropriate handling of information happened in April 2012. Civil charges were filed against Goldman arising from company procedures that allegedly created a risk that select clients would receive market-sensitive information, such as changes to Goldman’s recommendation lists of what clients should buy and sell and its ratings of stocks. Goldman ultimately paid $22 million to settle the charges, which the SEC and the Financial Industry Regulatory Authority (FINRA) said stemmed from Goldman’s weekly “huddles”—meetings set up for analysts to present their best ideas to the firm’s traders.7 Although the SEC claimed that the traders relayed those tips to a select group of Goldman’s best clients, Goldman was not charged with insider trading. The settlement with FINRA stated that Goldman sometimes did not monitor the huddle conversations to determine whether the analysts revealed or discussed any impending research changes regarding buy and sell recommendations. For example, FINRA stated that in late 2008, an analyst who had received approval to add a company to a Goldman list of best investment ideas told the huddle the next day that the company remained a “favorite idea.” One day later, Goldman published a report adding the stock to its “conviction buy list,” which is a list of recommendations about which Goldman has a stronger opinion than a recommendation.8 It was estimated in the press that Goldman could bring in enough money to pay for the sanction in about seven hours of trading and investing, highlighting the “fines as a cost of doing business” aspect of the mistake.
Goldman’s policy required that market-sensitive information from analysts be broadly distributed but did not apply to certain internal messages regarding general trading issues or market color. Regulators said that Goldman failed to clearly define the exceptions. One report quotes Robert Khuzami, the SEC’s enforcement director, as saying, “[H]igher-risk trading and business strategies require higher-order controls” and that “Goldman failed to implement policies and procedures that adequately controlled the risk that research analysts could preview upcoming ratings changes with select traders and clients.” Goldman agreed to pay the penalty, split between the SEC and FINRA, and to revise its policies.9
There are older examples as well. One is of allegations that Goldman mishandled information related to the Long-Term Capital Management (LTCM) books when Goldman was analyzing how it could potentially bail out LTCM in 1998. Roger Lowenstein writes in his account of the collapse of LTCM, When Genius Failed:
In Greenwich, Goldman’s sleuths, who had the run of the office, left no stone unturned … A key member of the Goldman team … [who] appeared to be downloading Long-Term’s positions, which the fund had so zealously guarded, from Long-Term’s own computers directly into an oversized laptop (a detail that Goldman later denied). Meanwhile, Goldman’s traders in New York sold some of the very same positions. At the end of one day, when the fund’s positions were worth a good deal less, some Goldman traders in Long-Term’s offices sauntered up to the trading desk and offered to buy them. Some questioned if, how and when and who had what information and how it was being used. Brazenly playing both sides of the street, Goldman represented investment banking at its mercenary ugliest … Goldman was raping Long-Term in front of their very eyes.10
In other words, the accusation was that Goldman was exploiting its privileged position of trust and confidentiality to identify exactly what LTCM would need to dump, thereby affecting the market price.11 As Lowenstein portrays it, when Rubin and Friedman took over in 1990, Goldman started getting over its previous inhibitions against using confidential information for proprietary trading. In effect, clients hadn’t fully realized that the public image of higher ethics was changing at the firm, and the firm slowly and covertly taking advantage of it.
Goldman’s Research Alignment Process
In 2003, the SEC announced that it had settled charges against Goldman, as well as nine other banks, arising from an investigation of research analyst conflicts of interest. As part of the settlement, Goldman agreed to pay a total of $110 million in fines. The settlement was related to the passage of the Sarbanes–Oxley Act in 2002, which was intended to restrict communication and influence between banking and research. The SEC acknowledged that Goldman strategically aligned its investment banking division, the equities division, and the research division to foster collaboration;12 the court acknowledged that Goldman’s research alignment process fostered collaboration among divisions “to insure a strategic alignment of [Goldman Sachs’] business.”13 So Goldman’s research alignment program was consistent with the firm’s teamwork approach, because it required different divisions to work together. But the SEC concluded that it violated securities laws requiring the firm to protect clients, even if there was an alignment that followed the principles of Goldman. To executives and board members, because Goldman had leading market share in IPOs and equity offerings, the collaboration seemed to be working effectively—it was an example of teamwork. One would have to believe that the lawyers in each division were also aware of the collaboration. Yet Goldman’s research alignment resulted in a fine. And not just for Goldman, but for nine other firms, totaling $1.435 billion. It shows the ambiguity in the law and people’s ability to rationalize and potentially abuse an interpretation of it.
In fact, in the findings included in the consent order, one of the pressures facing Goldman goes beyond its own self-interest: pressure from clients. In a section titled: “Influences of investment banking personnel on research and the timing of research coverage,” it stated that in early 2000, a Goldman investment banking client, Ask Jeeves, expressed concern that Goldman had yet to initiate research coverage. Typically a bank initiates research coverage as soon as it is legally able to do so after it participates in an equity offering. Ask Jeeves e-mailed its Goldman investment banker, saying its stock was “dropping like a rock,” and stating, “our hopes were that a buy coverage from our lead bank
er might help stabilize the stock.”14
While reviewing the findings, I discovered a reference to something I personally worked on. I was the only nonpartner on the firmwide marketing committee, which included some of the most respected partners. One of the initiatives of the committee was described: “Goldman Sachs introduced a new program in June 2000 to strengthen ‘firm-wide marketing … including how we leverage our brand, advertise, and in particular, cross-sell …’” Strengthening cross-selling efforts was defined as a “top strategic priority for 2000.” A $50,000 award was created “to recognize individuals across all divisions of the firm who ‘cross-sell or help deliver a significant mandate to another business unit or division.’”15
As the point person on the initiative, I can assure you that all the partners signed off on it. People in the legal department were aware of the initiative. The award was even named after John C. Whitehead.16 Because we thought that the award exemplified the concept of teamwork between one area and another, the only debate concerned the idea of a financial award to people for doing what many thought should be a natural part of their jobs, making it feel like a “brokerage commission.” The nominations themselves were helpful to Goldman in understanding and tracking the teamwork and collaboration that were happening.
I was part of a team that discussed the award and the committee’s initiatives with the management committee. I would have described the committee’s work as successful. As the firm expanded, it was more difficult for people to collaborate; people did not know each other as well as before, because there was a division of labor and specialization. These were all challenges of the firm’s organization and culture struggling with growth.17 At that point, the award was a way to get people to talk about collaborating. No one intended it to be an incentive for unethical behavior, nor did we consider that it could be perceived that way or could lead to unethical or illegal behavior.
In hindsight, I see that it might have encouraged a research analyst, for example, to suggest a transaction to Goldman bankers and then tout the idea in a written research piece to investing clients, impacting the stock price, or to write positive things about the company in order to make the company more receptive to Goldman’s bankers’ suggestions. There is a lot less room for conflicts when research analysts simply analyze companies and make buy or sell recommendations for the firm’s investing clients. It is also a lot cleaner if analysts’ interactions with banking personnel are monitored by compliance officials so the analysts can’t be influenced or pressured by banking personnel. The potential conflict introduced by offering the analyst an award is an example of an unintended consequence of a complex system.
Conflicts of Interest
In investment banking, a conflict means that the bank could have an incentive to act in a way contrary to the best interests, needs, or concerns of a client. Perceived conflict is defined as a situation in which one could argue it was possible that an investment bank had a conflict. Such conflicts, perceived or actual, are inevitable in large, global investment banks; it is the nature of the beast. Goldman and other banks regulate themselves internally, through processes such as conflict clearance, to avoid not only actual conflicts that could result in fines and penalties but also even the appearance of conflict, which can cause reputational loss (translating, of course, into other kinds of losses). As discussed earlier, actions can look bad to clients even if the firm does nothing legally wrong.18 For these reasons, the management of conflicts of interest is an important part of Goldman’s business model.
One can come up with an endless number of potential conflicts in all types of extremely hypothetical scenarios because there are so many different scenarios and possibilities as to what may happen in the future and so many different ways in which the parties may react. Because the possible scenarios are endless, and because investment banking is so complex, with numerous products, departments, divisions, and geographic regions, the timing or sequence of events and their consequences are challenging to completely evaluate and predict. No foolproof system can be designed to keep track of every potential conflict, and conflict management can never become a formula-driven science.19
As a result, Goldman, and all banks, must rely on judgment calls about when it might be crossing the line into a conflict, and those judgments are susceptible to pressure because of the strong incentives to always be making as much money for the firm and clients as possible. If the firm were to err on the side of being too cautious, it could risk missing opportunities and possibly alienating clients who want to work with it. If it were to err on the side of being too reckless, the firm could risk alienating its clients and hurting its reputation. Over time at Goldman, this is a key factor in the firm moving to the legal standard for making these judgment calls (and relying on “big boy” letters). The law is the standard that allows Goldman to maximize its business opportunities.
Consider a hypothetical example of a conflict and its resolution. A bank owns a position in company X through its private equity arm, and another client, company Y, now asks the bank to help it buy company X. The bank is in a potentially conflicted position. Its client, company Y, wants to pay the lowest price for company X. The bank’s private equity business manages money for itself and other clients; it has a fiduciary responsibility to clients from whom it takes money to get the highest price for company X.
This dilemma could be resolved if the bank turned down the opportunity to work with company Y and simply worked with company X to get the highest price. There would still be a small conflict in that the private equity arm would have to negotiate an appropriate fee with its own M&A department. However, the bank has a strong incentive to work with Company Y, because it might need financing (a lucrative fee opportunity) to fund the purchase price. How can the bank represent both? It can draft a legal letter explaining all the potential conflicts and risks and have both companies agree to indemnify Goldman if there is an issue. If the two clients sign big boy letters, then Goldman could argue that it had put the clients’ interests first—it told them about all the potential risks and conflicts and disclosed everything. This would fulfill its legal obligation.
Some might counter that the perception of conflict, regardless of the law, was so bad that the bank must work only for company X. In both cases, the bank will have done nothing illegal, and herein lies the problem: trying to maximize opportunities and shareholder returns in the short term may well be in conflict with the firm’s higher ethical principles. The interpretation of what is right and wrong can also change over time as the situation and facts evolve. And making things trickier is that shareholder returns are easily quantified, whereas the issue of putting clients’ interests first is more subjective, harder to measure. While measuring market share and superior returns is easy, judging what is right and wrong—gauging if you put your clients’ interests first—is tough. When a conflict situation has not been managed properly, any decision Goldman made may seem obviously inappropriate with the benefit of hindsight, but those decisions are much more difficult in the moment. Here’s an actual example.
“Hello, Doug, it’s been a long time since we have had the chance to visit,” say the notes Blankfein prepared for his call with Douglas L. Foshee, chief executive of El Paso Energy Corporation, a big energy company that was in talks in 2011 to be sold to Kinder Morgan.20 “I was very pleased you reached out to us on this most recent matter,” the script goes, and Blankfein went on to thank Foshee for using Goldman as El Paso’s adviser in the transaction. Blankfein added that he knew Foshee was aware of Goldman’s investment in Kinder Morgan “and that we are very sensitive to the appearance of conflict.”
Goldman’s private equity arm owned a 19.1 percent stake (worth about $4 billion) in Kinder Morgan, and had two seats on the Kinder Morgan board, making the situation of advising the buyer not only awkward but also full of at least perceived conflicts. The Goldman banker advising El Paso also owned $340,000 worth of Kinder Morgan stock (a fact that was not raised o
r disclosed in the call, and it’s unclear whether and when Goldman knew about the personal investment). The two Goldman board members recused themselves to reduce the perception of a conflict, and El Paso hired a second adviser, Morgan Stanley. Kinder Morgan soon announced it was about to acquire El Paso for $21.1 billion in cash and stock. Goldman, in its role as matchmaker for El Paso, received a $20 million fee.
When the matter ended up in court as a result of a shareholder lawsuit—alleging, among other things, that the merger was the product of breaches of fiduciary duty by the board of directors of El Paso, aided and abetted by Kinder Morgan and by El Paso’s financial adviser, Goldman—the judge made it clear that Goldman’s conflicts were not only a matter of appearance. For example, rather than walk away from the deal and lose its fee, Goldman recommended another adviser so that El Paso would receive impartial advice. But the judge, Chancellor Leo E. Strine Jr., of Delaware’s Court of Chancery, disagreed:
When a second investment bank was brought in to address Goldman’s economic incentive for a deal with, and on terms that favored, Kinder Morgan, Goldman continued to intervene and advise El Paso on strategic alternatives, and with its friends in El Paso management, was able to achieve a remarkable feat: giving the new investment bank an incentive to favor the merger by making sure that this bank got paid only if El Paso adopted the strategic option of selling to Kinder Morgan … In other words, the conflict-cleansing bank got paid only if the option Goldman’s financial incentives gave it a reason to prefer was the one chosen.21
Foshee also received the brunt of Strine’s judicial irritation because Foshee had, as it turns out, used a “velvet glove negotiating strategy … influenced by an improper motive” to get the deal he wanted, planning to later buy El Paso’s exploration and production unit from Kinder Morgan.