Conflict of Interests Revisited
A New York Times article recently came out with the not-so-stunning revelation that resigning executive director of Goldman Sachs, Greg Smith, thought his firm was focused on making money for the firm's directors and employees with little or no concern for the well-being of its clients. Mr. Smith, who had been overseeing equity derivatives out of Goldman's London office, penned a provocative op-ed article (Why I am leaving Goldman Sachs, published March 14, 2012) in which he decried the firm's culture which he claims has changed drastically since he joined the firm 12 years ago.
Mr. Smith cites an environment that is "as toxic and destructive as I have ever seen it." He further describes the firm-wide practice of "persuading your clients to invest in the stocks or other products that we are trying to get rid of because they are not seen as having a lot of potential profit," which is known as executing "axes." Then there is "hunting elephants," which is the practice of getting unsophisticated clients to trade "whatever will bring the biggest profit to Goldman." He goes on to accuse five different managing directors of referring to clients as "muppets" and to treating them in manner described as "ripping eyeballs out." Goldman's clients ought to be thinking strongly about who represents them and their interests.
I can recall a scandal that came out back in the early 90s concerning a conflict of interest between Wall Street firms and their clients. To understand this conflict, one needs to understand that Wall Street firms represent at least two different types of clients. One is the retail investor to whom these firms sell securities to for a commission. The more they sell, the more they get paid. It is of course, expected that the firms will sell securities that they think will appreciate in value and thus make their client's portfolios grow. As we will see, this is not always the case. The other clients these firms represent are publicly traded corporations that hire them for a fee to do various things such as raise money in the markets through stock and bond offerings. Wall Street firms sometimes sell their research on publicly traded companies which is supposed to be objective. As the scandal unfolded, it became clear that much of their research was not objective. It was sometimes tainted because of the fee relationship with the corporations in question. In order to maintain a positive relationship with these corporations (and thus retain them as clients), Wall Street firms routinely dismissed or ignored negative information about these companies. They often rated them with a "buy" recommendation when their institutional analysts knew full well that they would never purchase the company's stock for their own accounts. They would, however, spare no effort to recommend them to the Wall Street firms retail brokers and the clients they represented. While I do not recall any one firm being singled out, the ensuing investigation revealed this was a systemic practice by all the major firms.
I remember laughing at the time at the supposed outrage of various security regulators. Wasn't it obvious that this had been going on for years? The conflict seemed so obvious to me that the only surprise in the whole episode was how surprised the regulators and the public were. If you give Wall Street firms the freedom to work both sides of a deal, how can you be shocked when they work those sides to their best advantage? The conflicts are so obvious and the money to be made is so tremendous, how can you expect them not to cheat? The punishments in the form of fines they receive for doing so amount to little more than the equivalent of a rap on the knuckles to a pickpocket! Reading Mr. Smith's letter, the only logical conclusion one can come to is that very little has changed. Why these firms still have clients who entrust so much money to them is a complete mystery to this veteran of the securities business.
One of the disclosures made following the arrest of Ponzi-scheme king, Bernie Madoff, was a comment by one of his clients that suggested they knew he must be doing something illegal, but as long as he made them money, they didn't really care. I guess that pretty much sums up the attitude of most Wall Street investors. Wall Street firms have done such a convincing job of marketing their supposed expertise that nobody really cares about their ethics. They have also, seemingly, convinced people of their trustworthiness. I guess one can feel sorry for Mr. Smith. After all, it took him 12 years to figure out what many of us have known for over 20: there is just too much money to be made by subtly cheating honest people out of their money and there is a seemingly endless supply of fools willing to trust these firms despite their history. I would suggest it's going to take more than a few letters like Mr. Smith's to change the environment.
In a further development, Goldman Sachs Chief Executive, Lloyd Blankfein issued a hasty rebuttal to Mr. Smith's letter. No less than a week later, he announced in a conference call to firm partners that the firm would commence scanning internal employee emails for signs of derogatory references to clients (muppets) by its employees. Need I say more?!
Chris Dowley
March 2012
Chris Dowley has spent the last 25 years as a financial advisor helping individuals and their families organize themselves financially and realize dreams. He has spent the last 14 years as the managing principal of Dowley & Company, Inc. in Marblehead, MA where he practices financial life planning and lives with his wife and son.
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