by James B. Stewart
"Surreal" was the word Goldman Sachs Group's (NYSE: GS - News) Fabrice Tourre used to describe a meeting in which the firm of hedge-fund billionaire John Paulson discussed with an investor a portfolio of mortgage-backed securities it eventually planned to short. That Goldman Sachs, a name once synonymous with professionalism and integrity, now stands accused by the Securities and Exchange Commission of fraud also might be deemed surreal.
It's hard to imagine the damage that these developments have done already to Goldman Sachs's reputation. The company has always maintained a public position that the business of investment banking depends on trust, integrity and putting clients' interests first.
Whether those clients remain loyal to Goldman, and whether the firm can attract new ones, remain to be seen. Investors' reaction to the news was swift and negative: Goldman shares closed down 13% Friday after the SEC filed its suit. Goldman says it is innocent and will fight the accusations. The bank deserves its day in court, and legal experts have said the SEC faces a tough task in proving the company misled investors about how its complex investment vehicles were constructed. Given the public anger at Wall Street, and the criticism of the SEC's failure to regulate more effectively before the financial crisis struck, it's worth considering that Goldman makes an enticing political target, regardless of the suit's merits.
Goldman hasn't disputed the basic facts in the SEC's narrative: (1) that the company allowed its client Mr. Paulson, who famously made billions betting that subprime mortgages would default, to play a role in the selection of a portfolio of the worst imaginable subprime mortgages that would be packaged into a collateralized-debt obligation, and (2) that the bank failed to disclose to clients to whom it sold those CDOs that it had, in effect, let the fox into the henhouse. Goldman claims its sophisticated clients wouldn't have cared about such information or considered it important, but if that's the case, why did Goldman conceal it? Goldman collected millions of dollars in fees from Mr. Paulson, who bet against the doomed securities, and from the clients who invested in them.
For many years, I was a Goldman Sachs shareholder. I bought shares soon after the firm went public in 1999 and held them until I sold them last year, as I reported in this column. I owned them and recommended them on several occasions because I believed in Goldman's integrity and the culture that fostered it. I have had friends who work at Goldman or who have worked there. To me, they embody the best of Wall Street. They're smart, well-educated, thoughtful, professional and hard-working. This is the Goldman I invested in, not the Goldman alleged to have collaborated with someone like Mr. Paulson to hoodwink investors. I'm not even that concerned about whether the Paulson deal passes legal muster. To me, it fails the higher standards of honesty and professionalism that Goldman once embodied and urgently needs to restore. Then, and only then, would I want to own Goldman shares again.
In its first-quarter earnings conference call Tuesday morning, the company continued to deny wrongdoing and cited its net losses on the deal. Greg Palm, the firm's general counsel, said Goldman "would never intentionally mislead anyone," and that the company "would never condone inappropriate behavior."
To regain investor trust, Goldman must abandon conventional public relations and legal strategies that call for an all-out defense. It should stop saying it will fight the charges aggressively and that the SEC's suit is "completely unfounded." No matter how wronged Goldman officials now feel, they must put those feelings aside and view this matter from the perspective of clients, investors, politicians and the public. Goldman's mantra should be cooperation, not defiance.
When an institution depends on trust and is accused of wrongdoing, it needs to get ahead of the investigators. It needs to learn the facts, share them with the public, impose accountability on its employees, and take any steps necessary to remedy the problem and restore trust. I say this as someone who has written about wrongdoing on Wall Street for years and watched once-venerable firms like Kidder Peabody and Drexel Burnham Lambert ignore such advice and pass into oblivion.
This needn't be Goldman's fate. It's already unfortunate that we've learned about the Paulson deals from the SEC and the press rather than from Goldman itself, especially because the firm says it's been on notice since last July that it might be sued. But it isn't too late for the firm to move boldly to restore trust. Goldman needs to explain:
• Why was a firm like Mr. Paulson's allowed to choose the securities in the CDO it was planning to bet against? Although Mr. Paulson's firm may have been smart to bet against subprime mortgages, this deal was like shooting fish in a barrel. Who else gets this kind of access, what does Goldman receive in return, and are their roles disclosed? (Though Mr. Paulson hasn't been accused of any wrongdoing, it would be interesting to know how much money from the Troubled Asset Relief Program paid to Amercan International Group (NYSE: AIG - News), Goldman and others ended up going to him.)
• Who at Goldman was responsible for giving Mr. Paulson such extraordinary access and then failing to disclose it? Surely it wasn't Mr. Tourre, the 31-year-old Stanford graduate named as a defendant in the SEC suit. Who did he report to? What was the hierarchy of oversight? In other words, where does the buck stop?
• Legal issues aside, does Goldman really believe this deal meets its own standards of integrity, fairness and professionalism? The notion that purchasers of the securities wouldn't care about Mr. Paulson's role already fails the common-sense test. Such an argument would be far more persuasive if it came from the clients who bought them rather than Goldman. And it's no excuse that other firms were carrying out similar deals with comparable disclosure.
• If Goldman concludes such a deal didn't meet its standards, it needs to acknowledge that and take whatever steps are necessary to prevent it from happening again. Someone has to be responsible and held accountable, perhaps even a highly valued and revered high-level official. Goldman needs to do this before it is forced to do so by a court, regulators or Congress. This will be painful. It takes courage, objectivity, vision, and perhaps most of all, humility.
• How will Goldman prevent such conflicts in the future? What is it doing internally to restore a culture of integrity? If Mr. Tourre or any other employee thought he was caught in a "surreal" situation, to whom could he take such concerns and get a fair hearing?
• The SEC suit isn't Goldman's only potential scandal. The Wall Street Journal reported last week that Goldman director Rajat Gupta is being investigated as part of the sprawling Galleon insider-trading investigation. In the article, Goldman declined to comment on whether Mr. Gupta informed the company about having received a notice from prosecutors. What does Goldman know about possible leaks of inside information? Why, when Mr. Gupta told Goldman in March he wouldn't be standing for re-election, did Goldman chief executive Lloyd Blankfein issue a public statement lavishing praise for his service? And why, for that matter, wasn't Mr. Gupta asked to resign immediately? Mr. Gupta hasn't been accused of wrongdoing, and Goldman is right not to prejudge him. But that doesn't mean Goldman should ignore the evidence or that someone under investigation is entitled to a board seat.
• Are there other investigations we should know about?
These may well be isolated incidents, confined to a few individuals, their timing an unfortunate coincidence. If so, Goldman has all the more reason to get ahead of the scandal, get the facts and disclose them. It may require swallowing some pride and suffering some criticism. It's also the right thing to do.