What Happened to Goldman Sachs: An Insider's Story of Organizational Drift and Its Unintended Consequences (17 page)

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;
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the court acknowledged that Goldman’s research alignment process fostered collaboration among divisions “to insure a strategic alignment of [Goldman Sachs’] business.”
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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 banker might help stabilize the stock.”
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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.’”
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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.
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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.
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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.
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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.
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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.
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“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 or 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
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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.

In the press, Goldman’s conduct in the El Paso deal was portrayed as brazen, incestuous, and shameless. It was particularly shocking in that it occurred soon after Goldman issued its business standards report, a recommitment to its values and principles.
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It indicated that in some ways the organizational drift continued.

After Strine’s opinion was read, Goldman continued to claim that it had been completely transparent with El Paso regarding Goldman’s conflicts, and El Paso chose to continue to work with Goldman. Once again, Goldman claimed it completely fulfilled its legal responsibilities. Many observers found it hard to believe that Goldman would even get involved in the deal, with its $4 billion investment in Kinder Morgan on one side of the negotiating table, and a $20 million fee on the other, especially considering the scrutiny Goldman had been under since the congressional hearings.
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Lloyd Blankfein had clearly defined Goldman’s position on conflicts in an interview years before:

The crucial differentiating advantage of Goldman Sachs would be one that outsiders might find surprising: Its complex variety of many businesses was sure to have lots of conflicts. Goldman Sachs, Blankfein said, should embrace the challenge of those conflicts. Like market risk, the risk of conflicts would keep most competitors away—but by engaging actively with clients, Goldman Sachs would understand these conflicts better and could manage them better. Blankfein (who spends a significant part of his time managing real or perceived conflicts) said, “If major clients—governments, institutional investors, corporations, and wealthy families—believe they can trust our judgment, we can invite them to partner with us and share in their success
.”
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Blankfein’s concept of the relationship between an adviser (that is also an investor for itself and with clients) and its clients (that are not coinvesting) can be at very least confusing and have unintended consequences. The competitive, organizational, technological, and regulatory pressures are there to maximize opportunities in this confusion and ambiguity.
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And so the organization drifts, accepting a legal standard as its ethical base.