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In the Goldman Sachs Case, the Media is Asking the Wrong Question

On April 16, 2010, the Securities & Exchange Commission commenced a civil action against Goldman Sachs and one of its employees alleging that they misled investors that purchased CDOs (collateralized debt obligations) from the firm. The SEC claims that the offering memorandum and related documents that Goldman Sachs distributed to investors failed to disclose that Paulson & Co. Inc. (”Paulson”) played a significant role in the portfolio selection process. The complaint also states that Goldman Sachs failed to disclose that Paulson was concurrently shorting this investment through credit default swaps that it bought from Goldman Sachs. This would suggest that Paulson had an interest in choosing mortgage backed securities that would fail. The end result: investors lost more than $1 billion.

As any lawyer that has dealt with the media likely knows, the press usually treats the alleged facts in a regulatory complaint as true. Thus, it is important to stress that the SEC has made these factual allegations, but they are in dispute. Yet, even assuming that they are true, the media debate regarding this case is focusing on the wrong question. Instead of asking, “Did Goldman Sachs break the law?”, the media, and society for that matter, should be asking, “Did Goldman Sachs act ethically?”

While it is true that the answer to the first question may be more important to an investor in determining the value of Goldman Sachs stock in the short term, the latter question is more important for long term investors. Why? History shows that a pattern of corporate ethical breaches often lead over time to serious legal transgressions, and ultimately, company implosion. This is usually a slow progression, but the warning signs build over time. Then, one day, á la Bernie Madoff, you wake up and realize that instead of being a NASDAQ executive, you’re the head of the world’s biggest Ponzi scheme. Eventually, everything goes wrong and your life has degenerated to prison yard fights. If one compares the Madoff situation to the demise of companies such as Enron, WorldCom, and Tyco, there are reoccurring parallels. One of these is that management in these cases did not set out initially to defraud investors. It happened gradually and began with ethical breaches that compounded over time and led down the slippery slope towards outright fraud, imprisonment, and sometimes death.

Another common thread in these investment disasters was a consistency in what is known as the “tone at the top”, the ethical messages that upper management sends to the corporation, which tend to permeate the firm’s culture over time. For all of these now defunct firms, top executives sent the message to employees that ethical breaches, and ultimately legal ones, were acceptable or required.

So what does this all have to do with Goldman Sachs? During his Senate testimony, Lloyd Blankfein, the CEO and Chairman of the firm, stated that Goldman Sachs does not have a legal duty to disclose its own position in a security, even if it is betting against investments that it is selling. Maybe he is correct. A court will answer that question. However, the more fundamental question is whether Goldman Sachs has an ethical duty to disclose this information to investors. I think that most people’s intuition would suggest that it does. As well, history suggests that Blankfein’s flippant attitude towards such ethical issues could foretell future problems for the company.

In ethical considerations such as these that can impact businesses, many would agree with the following general guide posts:

1. Employees and directors should strive to identify and raise potential issues before they lead to problems;

2. Service to the firm should never be subordinated to personal gain and advantage.
Conflicts of interest should, to the extent possible, be avoided;

3. Information in public communications, including SEC filings, should be full, fair, accurate, timely and understandable; and

4. Firms should not seek competitive advantages through illegal or unethical business practices.

Where did I find such common sense grains of wisdom? They are all contained in the Goldman Sachs Code of Ethics.

About the Author

Greg Yanke is a semi-retired corporate and securities lawyer who studies topics in the fields of law, ethics, investing, and business, and observes how they interrelate. Greg writes a blog that discusses these issues at http://www.investmentrethink.blogspot.com.  He holds political science and law degrees from the University of British Columbia in Vancouver, Canada and an MBA from Arizona State University in Tempe, Arizona.