Goldman Sachs: Brokers vs. Fiduciaries

July 1st, 2010

The Goldman Sachs story is arguably the most important story on Wall Street because it calls into question the nature of how “markets are made” and the conflicts that exist between brokers and their clients.

Brokers operate under a “suitability” rule. Basically, the suitability standard requires a broker to make an assessment of an individual’s situation and to take a reasonable amount of care in ensuring that the investment he or she is selling to an individual is “suitable” for that person, and not in obvious conflict with the individual’s circumstances.

The broker owes no duty to the client beyond that defined by the suitability standard. No monitoring or follow-up is required of the broker. Furthermore, a “suitable” investment is merely one that is “okay” for the investor; it only has to be not inappropriate. (The “fiduciary” standard to always act in a client’s best interest, under which BWFA operates, is much more protective of investors’ interests than the suitability standard under which brokers operate.)

Goldman and Conflicts of Interest

Goldman was charged by the SEC in April for committing securities fraud in its mortgage-trading operations. The fraud charge is about whether Goldman disclosed important details of the transaction to its clients, so that its clients would understand the conflict of interest associated with the transaction.

While subject to the future findings of the court, the popular story goes that John Paulson, a hedge fund operator with a net worth of $12 billion (according to Forbes), approached Goldman and asked the firm to create a way for him to bet that the housing market was going to collapse. In response, Goldman created a fund, “Abacus,” comprised of subprime mortgages, and it sold units of Abacus (which was structured as a Collateralized Debt Security by Goldman) to two institutional investors: a large insurance company and a unit of Deutsche Bank.

The lawsuit alleges that Goldman was required to—but failed to—disclose to the purchasers of the fund that the investments which made up the fund were selected by Paulson, and that Paulson had “shorted” (bet against) the investments in the fund.

Importantly, the insurance company, the bank and Paulson were all Goldman’s clients in the transaction. Paulson shorted the investments by buying credit-default swaps, which paid off when the investments went belly up. While Paulson is not charged with any wrongdoing, his fund made $1 billion on these transactions. Further, the lawsuit alleges that Goldman misrepresented that the securities in the fund had been selected by ACA Management, a third party with expertise in assessing credit risk associated with mortgage securities.

The issues in the litigation center around the obligations that a broker has to a client. Goldman’s position is that the firm is a “market maker,” and making a market for its clients quite naturally puts it on the opposite side of a trade (in conflict) from its clients. However, the backbone of the SEC’s case, SEC Rule 10-5, says that a public company cannot “omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading….” So, it seems that Goldman misled investors in its press release when it stated that “…the accusations are unfounded in law….”

The other issue is that Goldman’s clients in this case are large institutional players. An argument can be made that these “big boys” do not need the same rights to disclosure as do retail investors. The thinking goes that big boys have an obligation to assume more responsibility (risk) in transactions.

Our guess is that this case will be settled outside of court. But our hope is that it will be settled by the courts in a way that establishes clear rules for behavior for all market participants. The application of fiduciary principles would have prohibited this type of transaction.