The SEC V. Goldman Sachs: Reputation, Trust, and Fiduciary Duties in Investment Banking
Davidoff, Steven M., Morrison, Alan D., Wilhelm, William J., Journal of Corporation Law
I. Introduction II. THE ABACUS DEAL A. The Critical Dispute B. Deal Structure C. Justifying Complexity. III. CONFLICT AND AMBIGUITY IN ABACUS . A. Transactional Perspectives on Trade. B. Trust-Based Agreements IV. THE MANAGEMENT OF INVESTMENT BANKS V. REGULATING MODERN INVESTMENT BANKING RELATIONSHIPS. VI. CONCLUSION.
On April 16, 2010, the Securities and Exchange Commission (SEC) filed a civil complaint against Goldman Sachs in the U.S. District Court for the Southern District of New York. The complaint alleged that Goldman Sachs violated the anti-fraud provisions of the federal securities laws in connection with a 2007 synthetic collateralized debt obligation (CDO) transaction, ABACUS 2007-AC1 SPV (ABACUS). Goldman Sachs agreed to a $550 million settlement with the SEC on July 15, 2010. We analyze the ABACUS transaction and the SEC's complaint against Goldman Sachs in the context of recent technological changes within the investment banking market. Investment banking was historically a relationship-based business, sustained by reputationally intermediated tacit contracts. Recent advances in information technology and financial economics have codified many formerly tacit elements of investment banking. As a result, some investment banking deals are now transacted at arm's length and rely more upon formal contracts; we argue that, for this type of deal, there is a stronger case for legal rules regulating the investment bank counterparty relationship. However, some deals continue to be arbitrated by tacit rules and norms and, for these deals, legal rules are less appropriate, because it is very hard for a third party to ascertain tacit understandings made in the context of a long-lived relationship. An attempt to introduce legal rules into reputationally intermediated relationships may even impair the counterparties' ability to arrive at informal arrangements, and so to trade. The supervision of deals like ABACUS should therefore reflect the extent to which they are transactional or relational; we argue that in neither case is there justification for the application of legal rules or the gap-filling standard of fiduciary duties.
In a market system based on trust, reputation has a significant economic value. I am therefore distressed at how far we have let concern for reputation slip in recent years. (1)
On April 16, 2010, the SEC filed a civil complaint against Goldman Sachs in the U.S. District Court for the Southern District of New York. (2) The complaint alleged that Goldman Sachs violated the anti-fraud provisions of the federal securities laws in connection with a 2007 synthetic collateralized debt obligation (CDO) transaction, ABACUS. (3) The immediate capital market reaction was very negative: Goldman Sachs' share price closed down more than 13% on the day, reflecting a reduction in market valuation of about $10 billion. (4) This price reaction anticipated the hostile reception that the firm received in subsequent Congressional hearings, and, apparently, in the court of public opinion. (5) It was also well in excess of the $550 million settlement that Goldman Sachs agreed with the SEC on July 15, 2010. (6)
The SEC's complaint is likely to be a watershed event for the investment banking industry. We argue in this Article that, in turn, the complaint reflects far-reaching structural changes in investment banks. The changes predate the financial crisis, and they are likely to result in further significant upheavals in the banking industry. The political and regulatory response to this change will affect the path of future upheavals, and, hence, will have a profound impact upon the future evolution of the investment-banking sector. The $10 billion capital market reaction to the SEC's complaint reflects this impact.
Goldman Sachs remained committed to the partnership form longer than any of its bulge-bracket investment banking counterparts and in the wake of going public sharply increased its trading revenue relative to its traditional investment banking business. …