At a congressional hearing a couple of weeks ago, Sen. Susan Collins of Maine asked a lineup of current and former Goldman Sachs executives a simple question: Did they have a duty to act in their clients', not their firm's, best interest?
The query elicited some impressive verbal contortions. "I believe we have a duty to serve our clients well," one witness replied to the Republican senator. "It's our responsibility . . . in helping them transact at levels that are fair market prices and help meet their needs," said another. "Conceptually it seems like an interesting idea," said a third.
The witnesses could have avoided their discomfiture by sticking to the simple truth. The correct answer to the question of whether investment bankers have a duty to act in their clients' best interest is "no."
We may have put our finger here on one of the major problems with the state of our financial rules and regulations. Investment bankers and their professional cousins, broker-dealers, don't generally owe what's known as a "fiduciary duty" to their clients under federal or state laws (New York's state law is what normally applies).
Efforts in Washington to expand the fiduciary rule beyond its existing application to registered investment advisors have been consistently fought off by Wall Street and the insurance industry. But a new effort to add it to the financial reform bill now being debated by Congress is being mounted by Sen. Ted Kaufman (D-Del.), among others.
Acting in a client's best interest wasn't a burning issue in simpler times, when investment bankers raised capital for their clients through stock or bond offerings, and brokers brought buyers and sellers together for deals in conventional securities. Everyone knew where the dividing line ran between the client's interest and the firm's interest, and how to stay on the right side.
Those days are past. In 2001, Goldman Sachs reported pre-tax earnings of $719 million from investment banking (helping clients raise capital), $2.1 billion from providing brokerage services and $1.2 billion from trading.
Last year, it reported $1.3 billion from investment banking, $1.3 billion from brokerage and $17.3 billion from trading. Anyone detect a trend line there?
A great deal of that trading involved derivatives, which are financial instruments so esoteric that their buyers' and sellers' investment goals, and even the size of their holdings, can be concealed.
"Conflicts of interest have been exponentially exacerbated by the rise of derivatives trading," says John C. Coffee Jr., a Columbia University law professor who recently testified before Congress on the need to tighten fiduciary rules on Wall Street. "Investment banks are no longer in the old world of raising capital. Now you can have a party in a transaction who wants the price to go down."
There's nothing wrong with taking a negative view of the market. Nor, when you're buying or selling, is there anything wrong with obscuring what you really think an asset is worth — skill in doing so is what makes some people better dealmakers, or salespersons, than others.
The problem arises when the broker or banker is the creator of the asset or the deal, and misleads clients about what he thinks is its true nature or true value. This is the sort of thing the Securities and Exchange Commission has accused Goldman Sachs of doing when it marketed a billion-dollar investment linked to subprime mortgage securities without divulging that the deal had been partially crafted by a client who wanted the package to fail.
In that case, the SEC said in its lawsuit over the so-called Abacus deal, Goldman yoked its fortunes to one client at the expense of another. The firm's conflict of interest might have been evident to the buyers if they had been dealing in plain-vanilla securities, an SEC official said, rather than the tutti-frutti mishmash Goldman helped concoct.
That's just the latest example. In 2008, New York Atty. Gen. Andrew Cuomo and the SEC extracted settlements worth more than $50 billion from Bank of America, Goldman Sachs and other institutions over their sales of auction-rate securities. These were investments the banks suggested were as liquid as cash or money-market funds, until the banks pulled the rug out from under the auction-rate market, rendering the securities about as liquid as concrete.
There's no dearth of evidence that Wall Street's definition of "conflict of interest" has gotten looser over the years, like an old sweater stretched hopelessly out of shape. Investment firms' growth strategies call for them to be in so many businesses at once that it's almost inevitable that one department is undermining the interests of the clients of another.
Sometimes the firms admit this is troubling, sometimes they say it's progress. In his testimony, Coffee cited a famous observation by Jack Grubman — who played the dual role of telecom dealmaker and "independent" telecom stock analyst at Salomon Smith Barney during the go-go 1990s — that "what used to be a conflict is now a synergy."
Advocates of extending the fiduciary rule to brokers and investment bankers say the goal is to reacquaint them with traditional morality. Fiduciary duty is not always easy to define, but lawyers often cite the words of Supreme Court Justice Benjamin Cardozo, who described it in 1928 as "not honesty alone, but the punctilio of an honor the most sensitive."
They also maintain that the "suitability" or "know your customer" standard customarily applied to brokers and bankers isn't enough anymore. That rule is designed to keep brokers from putting customers into deals they can't afford or can't understand — like selling an options straddle to an elderly widow, say.
The suitability rule wouldn't stop Goldman Sachs from selling a bucket of subprime mortgage investments to a supposedly sophisticated major European bank with billions in assets, as it did in the Abacus deal. But a fiduciary standard might lead the firm to think twice before forgetting to mention that some of the securities involved in the deal might have been picked because they were expected to lose money.
Not everybody thinks a fiduciary standard will work. "Fiduciary rules are much too vague to have a deterrent effect," says Larry Ribstein, a law professor at the University of Illinois, who testified at the same hearing as Coffee. "They're too nebulous to apply across the board in a statute that applies to the spectrum of relationships" in the financial industry. He says that's particularly true if, as Congress is contemplating, you're going to impose criminal penalties for violations. "There you have a special need to be clear."
Ribstein also contends that applying fiduciary standards to investment bankers would be solving a problem that doesn't exist. If Goldman Sachs withheld from its Abacus clients information it should have disclosed (as the SEC contends), that's fraud, and laws exist to punish it.
Coffee responds that any new law can give financial regulators the power to define how fiduciary rules should apply in any given category of transactions. "Any time you come up with a new statutory scheme you can imagine problems," he told me. "But this is a way for the SEC to get a handle on the growing problem of conflicts of interest."