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Wednesday, March 21, 2012

Departing director’s letter indicts money-grubbing Goldman

Scott Flegal

Many of us have resigned from jobs at some point during our careers. Few of us, however, have resigned like Greg Smith did last week.

Smith was a London-based, 12-year employee and director for Goldman Sachs. He was responsible for the oversight of equity derivatives for Goldman. Last Wednesday, Smith submitted his resignation. But he did so accompanied by his own op-ed piece in the New York Times. In the piece, he blasted Goldman for having devolved from a company with an identity of integrity and doing right by clients, to one where the focus was on squeezing every last drop of money from clients every single time. Goldman Sachs, he wrote, had become “toxic.”

Smith said that at one time, he took pride in Goldman’s culture, which was grounded on always doing right by its clients, even if it meant less fee income for Goldman. Leadership positions were filled by people with demonstrated integrity, good ideas and a commitment to doing the right thing. Now, Smith wrote, positions of influence were parceled out based on a person’s ability to produce fee income for the firm. The letter was a brutal indictment of Goldman Sachs management and stopped just short of predicting the demise of the firm.

In some respects, the piece didn’t surprise me. This is, after all, the same firm that was charged with fraud by the SEC in the wake of the financial crisis. Goldman had sold clients mortgage-backed securities knowing at the same time that the investments were lousy. How do we know they knew the investments were lousy? We know because at the same time, Goldman was using its own money to hedge against them. By some miracle, Goldman managed to escape criminal liability for that escapade. So the fact that culture at Goldman is suspect is no great revelation. But what is a revelation to me is the fact that at least according to Smith, the financial crisis had little or no impact on that culture. The beat just went on.

What happened to Goldman? It probably comes as no surprise that our government regulators played a significant role in the devolution of the business culture at Goldman and other Wall Street firms. They did so by permitting these firms to become publicly traded companies. That was a monumental mistake.

Historically, these firms were structured as privately owned partnerships. Partnerships are distinct from corporations and limited liability companies in one very important respect: partners are individually liable for partnership losses. Before it went public, Goldman’s capital for investing was home-grown. If investments failed, owners took the hit directly. One way of describing the situation is to say that as a partnership, Goldman had a lot of skin in the game. Profits came from long-term relationships with loyal clients. Taken together, these were powerful incentives for Goldman to think long term and to do the right thing.

As a publicly traded company, Goldman’s capital is now in the billions, and it comes from thousands of shareholders, most of whom have no role and very little say in Goldman operations. At the same time, Goldman management no longer has to absorb losses personally. After going public, Goldman management had much less skin in the game.

Going public realigned the incentives for investment bankers. Massive capital became available from outside sources. Investments could be bigger, and riskier. With individual leaders no longer having their feet held to the fire financially, the firms went looking for the big score. To paraphrase Hunter S. Thompson, this turned out to be like giving whiskey and car keys to teenage boys. The equation is pretty simple: tons of capital + decreased personal liability = greed.

On Wall Street, it used to be said that a bit of greed was good. But that was then. Now, in the era of publicly traded investment banks, greed is dangerous and potentially explosive. Investment bankers at these firms have to wrestle with two competing duties. On the one hand, they have a duty to shareholders to maximize share value. That duty instructs them to maximize firm profits. But they also have a duty as advisers to clients who have entrusted them with their money. That duty instructs them to put the client first. It is clear now that when investment bankers get greedy, the lure of maximizing profit cannot be resisted. It rules the roost. I am sure that Greg Smith would agree that greed caused Goldman to subjugate its duty to its clients to its competing duty to maximize shareholder value. But that method of operation is not only unethical; it could be actionable. If Smith’s writing is accurate, he was smart to get out.

I do want to be clear about one thing. Greg Smith is no hero.

He’s not volunteering to return any of his ill-gotten gains from his years at Goldman. His story doesn’t appear to be one of him constantly seeking to change the culture at Goldman for the greater good. Rather, he just seems to have burned out on it.

He makes it clear in his letter that he doesn’t view Goldman’s activities as criminal – a self-serving statement on a couple of levels if there ever was one. In the end, perhaps ironically, his words punished Goldman investors. The day after the letter was published, Goldman lost $2.15 billion of its market value. Clearly, investors lost faith in Goldman as a result of Smith’s words.

But if what Smith wrote is true, it should be Goldman’s clients heading for the hills. As he eloquently stated, “If clients don’t trust you, they will eventually stop doing business with you. It doesn’t matter how smart you are.”

Right you are, Mr. Smith. Right you are.

Scott Flegal is a business lawyer and mediator. Visit him online at or Follow him on Twitter at and read his blog at