While getting pilloried in hearings before the Senate Permanent Subcommittee on Investigations, representatives from The Goldman Sachs Group Inc. characterized their firm as a market maker, denied that they had fiduciary status, and displayed apparent bewilderment at the senators' questions about legal or ethical obligations to place clients' interests first.
The contention that Goldman merely acted as a market maker is at the core of the firm's defense of its reputation and in the suit brought against it by the Securities and Exchange Commission. But is it credible?
The primary responsibility of a market maker is to maintain an orderly market by matching buyers and sellers of securities, and to stand ready to buy or sell for their accounts when there are price imbalances.
Based on the testimony before the Senate subcommittee, Goldman clearly often acted as more than a traditional market maker. Sen. John Ensign, R-Nev., went so far as to suggest that Goldman's role frequently appeared to be “market manipulator” rather than market maker.
If the charges leveled against Goldman by the SEC are substantiated, the senator's characterization may be accurate, as the firm's actions would be diametrically opposed to those expected of a market maker.
Whereas traditional market makers promote price and market efficiency, a firm such as Goldman, as an active trader for its own account, can maximize its opportunity for profits by promoting price and market inefficiency. Goldman has unparalleled access to information about buyers and sellers when the firm is engaged by both parties in the same transaction.
It also usually knows far more about the underlying securities in the products it structures and packages than the clients who end up owning them. This knowledge gap is referred to in the marketplace as information asymmetry, and it is money in the bank (literally) for an organization that is willing and able to trade ahead of other market participants — its own clients included.
The Abacus 2007-ACI deal, which is the subject of the SEC lawsuit, offers an apt case study.
According to the SEC, Goldman didn't merely match the orders of anonymous traders who could legitimately be characterized as counterparties, it facilitated the creation of a customized product for one client who wanted to go short, and it solicited other clients to go long. The complaint alleges that Goldman improperly withheld material information from the buyers by not revealing the role of the short-seller in picking the securities that went into the deal.
It also appears that Goldman took large short positions in deals it facilitated while at the same time actively solicited clients to go long in those same deals. This is a conflict of interest that provides a huge incentive for Goldman to take advantage of its superior position of knowledge by sharing as little information as possible with either counterparties or clients, thus gaining a trading advantage that in turn promotes inefficient and volatile or disorderly markets.
The SEC suit will address the legality of Goldman's actions in the Abacus deal, but it will be up to legislators to address whether financial services firms should be held to higher standards. Legislators would undoubtedly find it far easier to accept the status quo if the subcommittee's review of Goldman's activities uncovered evidence that existing laws, regulations or professional standards provided sufficient motivation for the company to promote the integrity of the financial markets and serve the best interests of clients.
But the hearings yielded no such evidence; on the contrary, Goldman's representatives seemed oblivious to the negative ramifications of self-serving corporate conduct on the markets and couldn't or wouldn't answer direct questions from senators about whether they had an obligation, legal or ethical, to place clients' interests ahead of their own.
Legislative action is necessary, but not sufficient, to protect both investors and the markets. As Sen. Tom Coburn, R-Okla., emphasized, “Markets ... are built on three simple concepts: truth, trust and transparency. Without them, the cost of doing business is too high, and markets cannot function properly.”
Financial services firms and their representatives must embrace standards of conduct that are aligned to these concepts. Unless and until they can confidently and articulately talk the talk of a fiduciary ethic, they won't be able to walk the walk of fiduciary conduct.
Blaine F. Aikin is chief executive of Fiduciary360 LLC.
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