Authors: Steven G. Mandis
What Happened to Goldman Sachs: An Insider's Story of Organizational Drift and Its Unintended Consequences (16 page)
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 percentage 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
A
PPLYING 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 should 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.
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.
