Business Law Prof Blog

Too Much Gleaning in Goldman

This response started as a comment, but grew and grew . . .

I think Stefan hit the nail on the head in his post when he said Washington Mutual's discomfort with Goldman had nothing to do with inside information. I do think there was (1) a concern that Goldman's "routine hedging would put unwelcome downward pressure on WaMu," and (2) a real trust issue. However, I'm not at all clear the trust problem is necessarily related to the use of "inside information." That is, I think that the Times reporters were reading more into the e-mail from former WaMu CEO Kerry K. Killinger than I would have when they wrote that Killinger "was concerned about how [Goldman] would use knowledge it gleaned from that relationship."

I pulled the referenced Killinger e-mail from the 666 (coincidence?) pages of the exhibits released by the subcommittee, and what I see is Killinger saying he doesn't trust Goldman. Period. He doesn't say why. To me, this is just like when I drove 2+ hours to buy my car from another dealer even though I had a dealer 3 miles from my house. After repeated interaction, I did not trust the local dealer. The dealer never did anything clearly illegal, I can look at the paperwork myself, and I know the product, but I still did not feel right about it, so I looked elsewhere.  (Car dealers, by the way are still angling for an exemption from the new Consumer Financial Protection Agency created by the Restoring American Financial Stability Act.) 

I agree that what the reporters saw in the e-mail COULD be what Killinger meant, but I also think it would be more accurate to say the article reflects what the reporters gleaned from the Killinger e-mail. Too much gleaning for me. 

In fairness, though, here's the e-mail so everyone can draw their own conclusions:

From: Killinger, Kerry K. . . . . 

Sent: Friday, October 12,20073:51 PM 

Subject: Re: Can you take a look at this before Monday and give your blessing? 

I don't trust Goldy on this. They are smart, but this is swimming with the sharks. They were shorting mortgages big time while they were giving CfC advice. I trust Lehman more for something this sensitive. But we would need to assess if they have the smarts we need.

Incidentally, to be clear, I don't mean to give Goldman a pass, at least at an ethical level.  I'm just not sure we've found the right lens through which to view their behavior.  For now, though, in my book they're right up there with my local car dealer. 

--Josh Fershee

Senate Passes "Restoring American Financial Stability Act"

The Senate has passed the Restoring American Financial Stability Act.  Next up is reconciliation with the House version.  Some of the key provisions (summarized here) include:

• Creation of a Consumer Financial Protection Agency (housed in the Fed--let the fox and hen house jokes begin).
• A variety of provisions designed to mitigate the systemic risk posed by "too big to fail" institutions.
• Creation of an over-arching systemic risk regulator.
• Funneling federal bank oversight to a single regulator.
• Increasing shareholder oversight of corporations (via increasing federalization of corporate law).
• Strengthening regulation of the derivatives market.
• Increasing oversight and regulation of hedge funds, credit rating agencies, and the insurance industry.
• Imposing fiduciary duties on broker-dealers, as well as investment advisers.
• Allowing for private aiding and abetting claims under the securities laws.  (UPDATE: Apparently, this part of the bill failed to go forward.)
• Requiring issuers of securitized products to keep some "skin in the game".

Jim Hamilton provides a much more in-depth analysis of the legislation here.  You can also find a series of posts by Stephen Bainbridge analyzing a variety of the underlying issues here.

SJP

When It Comes to Responsibility, Primary Does Not Mean Exclusive

The Wall Street Journal (among other sources) reports the BP and Transocean are back to fighting about who was responsible for one of the worst oil spill disasters in history. Obviously, this will be contentious, but I always find the public relations fights both amusing and disappointing.  

BP is saying it was Transocean's fault because they were "in charge" at the time. I don't know if that is true, but I suspect this will be the one of the key points of litigation down the road. Transocean's response is:  "As the operator of the well, BP has repeatedly acknowledged—under oath and in advertisements—that it is assuming full responsibility for this matter." 

On that one, all I have to say is: "And?"  

One can assume full financial responsibility for something without giving up their right to seek indemnity or contribution.  I certainly may have missed something, but I have not once heard BP it was their fault, simply that it was their responsibility. I agree that it is their responsibility (and it may be their fault, I just don't know), but I find the argument that BP's "assumption" of responsibility makes BP solely liable laughable, both from a legal and a PR perspective.  

I have lots of complaints about how BP has handled this matter, both before and after the spill, but I certainly hope taking primary responsibility for this disaster does not preclude BP from seeking contribution from others at fault.  If it's all on BP, so be it, but I want nothing out there discouraging people from taking responsibility for bad things that happen on their watch, even if it's not their fault.  

--Josh Fershee

Falaschetti on Corporate Governance

Dino Falaschetti has posted Democratic Governance and Economic Performance: How Accountability Can Go Too Far in Politics, Law, and Business on SSRN with the following abstract:

Conventional wisdom warns that unaccountable political and business agents can enrich a few at the expense of many. But logically extending this wisdom implies that associated principals – voters, consumers, shareholders – will favor themselves over the greater good when ‘rules of the game’ instead create too much accountability. Democratic Governance and Economic Performance rigorously develops this hypothesis, and finds statistical evidence and case study illustrations that democratic institutions at various governance levels (e.g., federal, state, corporation) have facilitated opportunistic gains for electoral, consumer, and shareholder principals. To be sure, this conclusion does not dismiss the potential for democratic governance to productively reduce agency costs. Rather, it suggests that policy makers, lawyers, and managers can improve governance by weighing the agency benefits of increased accountability against the distributional costs of favoring principal stakeholders over more general economic opportunities. Carefully considering the fundamentals that give rise to this tradeoff should interest students and scholars working at the intersection of social science and the law, and can help professionals improve their own performance in policy, legal, and business settings.

ECC

Goldman and the Use of Non-Public Information

I second Josh's recommendation of the recent New York Times article discussing Goldman's penchant for betting against clients.  It makes it almost impossible not to see Goldman as fueling the financial crisis, rather than merely responding to it.  The discussion of Goldman buying up default protection on A.I.G. while at the same time pushing that company closer to insolvency by demanding more cash to shore up an existing account smacks of manipulation. 

But the part of the article that stuck out to me the most was the report of an email message sent by Washington Mutual's former CEO in 2007:

In that message, Mr. Killinger noted that he had avoided retaining Goldman’s investment bankers in the fall of 2007 because he was concerned about how the firm would use knowledge it gleaned from that relationship. He pointed out that Goldman was “shorting mortgages big time” even while it had been advising Countrywide, a major mortgage lender.

What struck me about that passage was the reference to the use of knowledge "gleaned from" Goldman's relationship with WaMu.  To the extent this is related to WaMu's issuance of mortgage-related securities, I thought all the smart people agreed that all the material information needed to evaluate those securities was generally available.  If, on the other hand, the concern was simply that Goldman was such a big player that its routine hedging would put unwelcome downward pressure on WaMu--what does that have to do with inside information?  I'd be very curious to know what material information Goldman gleaned from its relationships with insiders.

SJP

Questioning Broker-Dealer Fiduciary Duties

The Wall Street Journal has an interesting Q&A with J.W. Verret regarding the proposal to impose fiduciary duties on broker-dealers.  Verret is against the proposal.

Verret is quoted as saying that Sen. Arlen Specter, the amendment's sponsor, "suffers from a fundamental misunderstanding of how markets function."  But wasn't it the people who claimed to know precisely how markets function who told us that banker self-interest would sufficiently manage risk-taking?

Verret also claims that if the proposal were adopted, it could "freeze up markets" and "destroy the market for some risky assets."  This seems a bit extreme to me.  As Bainbridge notes (quoting Justice Frankfurter):

[T]o say that a man is a fiduciary only begins analysis; it gives direction to further inquiry. To whom is he a fiduciary? What obligations does he owe as a fiduciary? In what respect has he failed to discharge these obligations? And what are the consequences of his deviation from duty?

In the corporate fiduciary context, we already have a great example of how the alleged costs of fiduciary duties can be mitigated by things like the business judgment rule and a 102(b)(7) waiver.  If necessary, the proposal could be modified to allow for similar concessions. 

Finally, Verret claims that: "We don't need new laws to go after fraud.  We haven't seen widespread securities fraud with one exception: Bernie Madoff."  Given the litigation yet to be resolved, I think it's a little too soon to be calling "game over" on that issue just yet.

SJP

Botchway on Negotiations

Francis N. Botchway has posted Can the Law Compel Business Parties to Negotiate? on SSRN with the following abstract:

Many businesses, national or international, would opt to negotiate differences between or among themselves. There are circumstances, however, where disputing parties are compelled to negotiate or re-negotiate out of necessity induced by law, by custom or by comparative efficiency expectations. This work evaluates the legal basis of international business negotiations and argues that negotiation is not always a choice, in many cases, it is the choice. It also argues that even though English law is quite ambivalent about the place of good faith in negotiations, contractual negotiations, including those mandated by the law, must be carried out in good faith.

ECC

Do Market Principles Apply to Market Makers?

The New York Times reports that some customers of Goldman Sachs (and other investment banks) are “worried” about the dual, and often conflicting, role the banks play in the market. The report indicates that executives at some of Goldman’s clients, including the failed bank Washington Mutual, were concerned about working with Goldman at least as early as 2007. 

And, while the S.E.C.’s fraud complaint questions whether Goldman’s actions were illegal, their actions were at least questionable from a moral and ethical perspective, even as measured by Goldman’s own Business Principles. As an example: “Our clients' interests always come first.” Another of Goldman’s principles is “Integrity and honesty are at the heart of our business.” Unfortunately, to continue the analogy, it’s a lot less clear what is at the limbs.

As I’ve noted before, I am not sure there is a legal problem with Goldman’s behavior (at least as currently alleged). I do, however, think that there could be significant repercussions from a business perspective, as this report seems to indicate. I don’t think Goldman is going anywhere, but I do think that they may lose some clients or have others less inclined to work with them as often as they might have previously. That certainly won’t help the bottom line.

Just like auto mechanics, restaurants, and other service industries, Goldman is in a market with significant competitors for clients. If most clients actually care about Goldman’s behavior (a point about which I am not entirely clear), Goldman will either have to convince them that they have changed or the clients will go somewhere else. If they are unable (or unwilling) to change, Goldman will have done well in the short term, but sacrificed significant long-term gains by taking positions against their clients. Of course, this assumes the market for investment banking services operates like other services markets. Only time will tell on that one.

--Josh Fershee

The Risk of Emphasizing Disclosure

The financial page of this week's New Yorker magazine points out that exotics such as junk bonds and credit default swaps have helped people on occasion, and that "financial innovation" cannot be universally condemned.

Maybe so, but the piece goes on to quote two economists who argue the following with regard to CDOs:

...If investors had known the risks they were taking in the pursuit of greater returns, they would have been more prepared for failure  --- and presumably have put less money into the housing market.

To the extent such language refers to the average stock market participant, the article thus presents a premise that's outright dangerous.  Has anybody heard of a retail investor buying a tranche of a CDO?  Cost aside, would a brokerage even dare to sell one to such a customer?  The complex, mortgage-related products were sold, packaged and warehoused by investment banking houses.  They were purchased by the government, banks, institutions and municipalities.  Correspondingly, the more immediate focus needs to be placed on remedies that protect titans from themselves, as opposed to the age-old emphasis on creating more boilerplate to perpetuate what Homer Kripke coined "the myth of the informed layman" nearly 40 years ago.

---JSC, 5/18/10

Profs to figure prominently...

...on the new joint SEC-CFTC panel addressing regulatory issues confronting the two agencies.

While the early days of the present financial crisis perhaps augured an SEC-CFTC consolidation, that notion quickly yielded to thoughts of a more cooperative union between the two market watchdogs.  To be sure, the problem of distinguishing securities-based and commodities-based derivative swaps constitutes only a part of a list of persisting questions concerning resource allocation and jurisdictional reach; those problems have traditionally evaded resolution by government officials depending upon the testimony of market players. It is thus encouraging that more than half of the members of the "Joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues" are business or finance professors.

The first meeting, which will address the largely inexplicable market swoon of May 6th and be broadcast live on the Internet, is set for Monday, May 24th.  Further details are available at http://www.sec.gov/news/press/2010/2010-79.htm.

---JSC, 5/18/10

General Motors' First Profit (Ever)

General Motors posted a profit ($865 million) for the first quarter of 2010, which (according to the New York Times) is the company's first profit since 2007. Despite the success, G.M. (wisely) did not provide a timeline about when the company might go public. Recall that the U.S. government holds a 61% stake of the company, so U.S. taxpayers certainly have an interest in a wildly successful initial public offering. 

Not to be nit picky, but this company never had never posted a profit until this past quarter. Recall that General Motors Corporation became Motors Liquidation Company (MTLQQ) in mid-2008. The new General Motors is a new company that was formed in 2008 to receive the good assets G.M. sold to the U.S. government. 

The new company may look like the old G.M., with its Chevrolet, Cadillac, and GMC nameplates, but it's clearly a new company. Just ask anyone holding shares of MTLQQ.

--Josh Fershee

Speed, the new market enemy

Remember when it was disclosed last summer that the stock exchanges were granting a millisecond advantage to certain traders?  "Flash trading," as we all learned, accorded some market players a sneak peak at order flow under a dated exemption to an SEC Rule designed to facilitate cross-market trading and generate liquidity.  The Commission moved quickly to eliminate the exemption in an effort to ban the notorious practice.

But last week's market free fall has highlighted the dangers generally attending a market in which  advantages are increasingly measured in time fragments normally reserved for the Olympics.  A New York Times article from yesterday described in detail the extent of the computerized "high frequency trading" trend (100-200 firms), its daily market share (40-70%), and the dangers of reliance thereon (these firms mostly shut down during the 900-point decline of May 6th, owning no legal duty to keep trading).  See Julie Creswell, "Speedy New Traders Make Waves Far From Wall Street" (May 16, 2010).

So let's see: We have a daily market comprised of 20-40% program trading, 40-70% high-frequency trading - exactly where's the retail investor?  Overall, this stock exchange business model is beginning to resemble the bowling team that re-staffs with ringers for the championship match: The pros play away, while all those for whom the league was formed watch in awe from the seats.  I somehow just know who's going to end up holding the trophy...

---JSC, 5/17/10 

Bodie on Shareholder Proposals

Matthew T. Bodie has posted The Case for Employee Referenda on Transformative Transactions as Shareholder Proposals on SSRN with the following abstract:

This Comment describes and advocates for employee referenda as implemented through a SEC Rule 14a-8 shareholder proposal. The proposal provides for a nonbinding referendum amongst all employees whenever the corporation's shareholders must vote to approve a merger, acquisition, sale of substantially all assets, or other transformative transaction. The purpose of the referendum is to provide employees with a voice in the transaction and to provide shareholders with a mechanism for tapping into employee sentiment. Because the referendum would be nonbinding, it is best viewed as an informational tool for shareholders and employees to use in policing management's transactions. Given the flaws in the market for friendly mergers and acquisitions (as developed in the finance literature), this tool could be a helpful corrective for the incentives and biases behind many ill-fated transactions.

ECC

Branson on Short Selling

Douglas M. Branson has posted More Muscle Behind Regulation SHO? Short Selling and the Regulation of Stock Borrowing Programs on SSRN with the following abstract:

Recent amendments to SEC Regulation SHO (originally adopted in 2004) have implemented hard close requirements for fails to deliver which often follow the naked short selling of stock (selling short without having borrowed the shares). Naked short selling is frequently a central plank in a program designed to manipulate (illegally) securities prices. Hard close requirements have cut the fails to deliver by 50 percent, or more, from considerably over 1 billion shares per day. Those requirements have also created, however, before the fact, added impetus for the borrowing of stock. Recently, a middleman for a stock borrowing agency was convicted of securities fraud in the Eastern District of New York. By and large, though, regulation of stock borrowing and stock borrowing programs are unregulated, with the result that individual investors who lend shares of stock receive little or no disclosure and are often pigeons waiting to be plucked by short sellers and others. This article advocates regulation by the SEC of stock borrowing programs. Alternatively, the article argues that under existing law, stock borrowing programs and participation in them are investment contracts, and therefore securities. The ramification is that as a matter of common law stock lenders are entitled to full and fair disclosure by those who offer to borrow, or do borrow, shares.

ECC