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GS announced a secondary offering to allow some of the ‘‘insiders’’ to sell some of their stock.

ž21.2% was owned by the non-partner employees.

ž17.9% was owned by retired partners, Sumitomo Bank and a Hawaiian concern, Kamehameha of Hawaii.

žOnly 12.6% of the firm was publicly owned, and most of these shares were placed in the hands of its own customers and long-term investors. However, in July 2000, it was announced that some partners, together with Sumitomo and Kamehameha, would sell 40 million shares, or 7.6% of the bank to institutions. According to GS, the main reason was to increase the percentage of free floating shares in the public domain – the sale would raise it to 17.4% and wider ownership of common stock. They emphasised that the choice of selling existing stock (rather than a new share issue) demonstrated the sale was not designed to raise capital.

Immediately after it went public, its activities were divided into two segments.

1. Global Capital Markets

Investment banking: financial advisory (M&As, financial restructuring, real estate), underwriting: equity and debt

Trading and principal investments: fixed income (bonds); equity, currency and commodities Principal investment (net revenues from merchant banking investments).

2. Asset Management & Securities Services

Asset management

Securities services (e.g. brokerage)

Commissions.

Some time in 2001/2, the structure was changed. The current structure consists of three segments:

1. Investment Banking

Financial advisory (including mergers and acquisitions)

Underwriting.

2. Trading and Principal Investments

Fixed income, currency and commodities (FICC) Equities

Principal investments: net revenues from merchant banking investments.

3. Asset Management and Securities

Asset management

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Securities

Commissions.

The operating results for 2000 to 2002 are reported in Table 10.2.

Controversy broke out in 2002 beginning with an investigation of Merrill Lynch by the New York Attorney General,16 Eliot Spitzer, and concluding in April 2003 when 10 of the top US investment banks settled with several regulatory bodies for just over $1.4 billion in penalties and other payments, for alleged conflicts of interest between banks’ analysts and their investment bank divisions. The case is discussed in Chapter 1, but there was a potential conflict of interest because the profits of the investment bank financed banks’ research departments. Thus, banks’ analysts were under pressure to support a particular company which was also giving underwriting, consulting or other business to the banks’ investment banking division. No bank, including Goldmans, admitted liability. In its Annual Report, GS refers to the incident as a ‘‘Research Settlement’’. It paid out a total of $110 million, broken down into (a) $50 million in retrospective compensation, (b) $50 million over 5 years to fund an independent research group, which will supply GS clients and the other

Table 10.2 Goldman Sachs: Operating Results ($m; year-end November)

For 2000– 03, the first number is operating expenses/pre-tax earnings as reported in the Annual Report, which includes expenses not incurred by any one sector, involving amortisation of employee IPO awards ($212, $363, $428 million in 2002, 2001, 2000, respectively) and acquisition expenses in 2000 (= $290 million). The second number is total operating expenses/pre-tax earnings, the sum of operating expenses/pre-tax earnings reported in each section.

( ): % of total pre-tax earnings based on the second number for total pre-tax earnings. Source: Goldman Sachs Annual Report, 2002.

16 The New York Attorney General is also the state’s securities regulator.

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investment banks with independent research, and (c) $10 million to go towards investor education. The firm has also agreed to:

‘‘adopt internal structural and other safeguards to further ensure the integrity of Goldman Sachs & Co investment research.’’17

Appendix

Traditional Investment Banking

What is now described as traditional ‘‘investment banking’’ consists of the following.

žUnderwriting: The bank ‘‘underwrites’’ a share or bond issue by guaranteeing a certain price for the shares or bonds. For example, if a government wants to issue new bonds, it will hire an investment bank to underwrite and sell the issue on the government’s behalf. The bank will guarantee the government a certain price, and hope to sell the bond at a higher price. Likewise with a share issue, or IPO, the bank will guarantee the firm a certain price for the share, and expect to place the share at or above that price. The bank earns a fee for the service. In addition, it earns the excess of a bond or share that is sold at a price higher than the amount it is underwritten for.

žMergers and Acquisitions: The bank, for a fee, will act on behalf of one firm which is planning to merge or acquire another. For example, when Richard Branson wanted to sell Virgin Music in 1991, Goldman Sachs valued the firm at £500 million, and then set out to find a firm interested in acquiring it. Initially, no firm appeared willing to pay £500 million, but by negotiating with two rival buyers, Goldman Sachs was able to sell it for £560 million.

Any bank has to have a good reputation to engage in underwriting and mergers and acquisitions, which takes time to earn. Clients must be given top priority and the client relationship developed over time. For example, when Mr Whitehead set up the Investment Banking Services division, the sales people in the division focused on large numbers of companies in a defined geographical area assigned to them, with the plan to develop relationships over a long period of time. Likewise, Sidney Weinberg organised Ford’s original share issue in 1956, but this was after years of cultivating a relationship with Henry Ford. Weinberg’s reputation for being on more than 30 Boards of Directors was also motivated by the need to cultivate relationships. The advantage of relationship banking is obtaining information on the firm over a long period of time, and for the client, getting to know the banker well. The drawback of relationship banking is that it can give rise to opportunistic behaviour by either party, that is taking advantage of the trust gained as a result of the relationship. Goldmans was to suffer this as a consequence of its dealings with Robert Maxwell (see case).

Fixed income, Foreign exchange and Equities Trading

This type of trading can be described as a flow business: On behalf of the bank’s clients, which may include other market makers, the bank ‘‘makes markets’’: making bid (in the

17 Source: Goldman Sachs, Annual Report 2002, p. 59.

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case of a sale) and offer (when the asset is bought) prices for equities, bonds, foreign exchange or commodities. The firm is exposed to price or market risk because it is quoting bid and offer prices for the asset in question. The market risk is hedged through deals with other market makers. The trader profits from the difference between the bid and offer price. Given the small margins, the trader relies on large volumes to make a reasonable profit on the small margin between the bid and offer price for each transaction. Traders are backed up by a sales team, whose job it is to find clients for the equities, bonds, foreign exchange or commodities. A bank such as Goldman Sachs will also use its large client base from other parts of the firm (e.g. investment banking) to provide business for this trading.

Proprietary Trading

With proprietary trading, the firm is trading on its own account: seeking to profit from trades. It is a logical extension of the traditional trading described above, because the firm is using the experience gained from the traditional forms of trading. Proprietary trading, if successful, can be very profitable but unlike the other types of trading, the capital of the firm is at risk. A bank engaging in proprietary trading will have two books, a banking book and a trading book. Though GS had engaged in some proprietary trading in the 1980s, it was after 1991 that the division began to make large amounts of money, after it hired a trader with a good track record, Larry Beccerra for the London office. Within 9 months, the trader had made a profit of $58 million for GS. This was followed by a profitable bet on interest rates prior to the election in April 1992 when the Conservatives won an unexpected victory. The price of government gilts (like US Treasury bonds) fell as the expectation of a Conservative defeat increased. The view of GS was that even if Labour did get in, they would use Conservative policies to manage the economy, and the decline in gilt prices was unwarranted, or put another way, the rising risk premium on UK government paper, too high. As most traders sold gilts, Henry Bedford held 5000 gilt contracts. The losses mounted as the election approached, but with the surprise victory, the $8 million loss on the day of the election turned into a $20 million profit within two days.

Unlike the other types of business, there is nothing to be gained by building up relationships18 in proprietary trading, and it is very much a short-term activity. Some partners expressed concern at the break with the GS tradition, but proprietary trading was here to stay. However, proprietary trading brought with it a new set of problems. First, there were new potential conflicts of interest, part of the wider principal agent problem, or more generally, agency problems.

With proprietary trading, agency problems arise because it can undermine relationship banking because of the conflict of interest: a bank can advise clients to invest in certain stock when it has purchased a large amount in that same stock. Or when underwriting, encourage its own book to purchase shares.

Example: Goldmans had the Whitehall Street Real Estate LP Fund. It invested in assets of troubled real estate and property development firms. This fund that was largely responsible for forcing Cadillac Fairview, a Toronto property developer, into bankruptcy. There was a

18 Though information is important for the traders, and the many clients GS was a good source of information.

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as American Express; (c) banks in relation to their customers; (d) bank management and employees.

5.Using the case, explain why reputation is important to the success of an investment bank.

6.Use the case to explain how volatile interest rates can affect the banks’ trading income. What action did the firm undertake to minimise the chance of a similar event occurring in the future?

7.Goldman Sachs took a relatively long period of time to seek a public listing. Based on the GS experience, identify the conditions needed for a successful IPO (initial public listing).

8.What is corporate governance and how did it change over time at Goldman Sachs? How has going public affected corporate governance?

9.The current organisational structure at GS consists of three segments: investment banking, trading and principal investments, asset management and securities. The operating results for GS appear in Table 10.2. Work out the percentage contribution to pre-tax earnings for each of the three segments over 2000, 2001 and 2002. Which segments have increased their pre-tax earnings since 2000; which have decreased? Why?

10.(a) In 2002/3, Goldman Sachs was one of 10 investment banks to pay a total $110 million in fines and related payments to US regulatory authorities. Why? What implications, if any, does this incident have for the future of Goldman Sachs?

(b)How will the Sarbanes – Oxley Act (July 2002) affect Goldman Sachs?19

11.Choose two other banks* which you consider to be major rivals to Goldman Sachs. Using their respective annual reports and sources such as Bankscope and The Banker, prepare a table comparing Goldman Sachs with the other firms for the most recent three years. Rank Goldman Sachs in terms of: total assets, net interest margin, return on average assets, return on average equity, and the ratio of operating expenses to net revenue (a measure of efficiency, sometimes called the ratio of cost to income).

(a)Are these major rivals strictly comparable, and if not, why not? What problems, if any, did you encounter with some of these banks when compiling the data?

(b)In recent annual reports (e.g. 2002), the banks report VaR figures for recent years. Briefly explain the meaning of value of risk, its advantages and limitations. Can the VaR figures reported by one bank be compared with those reported by the other two banks? If not, what are the differences?

*For example: Barclays Capital, Credit Suisse/Credit Suisse First Boston, Deutsche Bank, Dresdner Kleinwort Benson Wasserstein, HSBC, JP Morgan Chase, Lehman Brothers, Merrill Lynch, Morgan Stanley (Dean Witter), Schroder, Salomon Smith Barney, UBS Warburg.

19 See Chapter 5. For more background reading see a brief symposium paper, ‘‘Can Regulation Prevent Corporate Wrong-Doing?’’ (pp. 27–42), ‘‘Rush to Legislate’’ (pp. 43– 47) and ‘‘Sarbanes –Oxley in Brief ’’ (pp. 48–50). These papers appear in The Financial Regulator, 7(2), September, 2002.

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10.3. Kidder Peabody Group20

Relevant Parts of The Text: Chapters 1 (investment banks, financial conglomerates) 2 and 9 (synergy, strategy).

‘‘But Leo’’, said Alan Horrvich, a third-year financial analyst at General Electric Capital Corporation (GECC) in September 1987: ‘‘I don’t know anything about investment banking. If I walk in there with a lot of amateurish ideas for what he ought to do with Kidder, Cathart will rip me apart. OK, you’re the boss, but why me?’’

‘‘Look Alan’’, replied Mr Leo Halaran, Senior Vice-President, Finance of GECC: ‘‘we’ve got ten thousand things going on here right now and Cathart calls up and says, very politely, that he wants somebody very bright to work with him on a strategic review of Kidder Peabody. You’re bright, you spent a semester in the specialised finance MBA programme at City University Business School in London, you earned that fancy MBA from New York University down there in Wall Street, and you are available right now, so you’re our man. Relax, Si isn’t all that tough. If you make it through the first few weeks without getting sent back, you’ve got a friend for life. . .’’, he ended with a grin. ‘‘Me.’’

Mr Silas S. Cathart, 61, had retired as Chairman and CEO of Illinois Tool Works in 1986. He had been a director of the General Electric Company for many years and was much admired as a first-rate, tough though diplomatic results-oriented manager. After the resignation of Mr Ralph DeNunzio as Chairman and CEO of Kidder Peabody following the management shake-up in May 1987, Mr Cathart had been asked by Mr Jack Welch, GE’s hard-driving, young CEO, to set aside his retirement for a while and take over as CEO of Kidder Peabody, to give it the firm leadership it needed, particularly now. Cathart had not been able to say no. His first few months were spent trying to get a grip on the situation at Kidder, which had been traumatised by the insider trading problems, and by management uncertainty as to what GE and its outside CEO were going to do to Kidder next. After reporting substantial earnings of nearly $100 million in 1986, Kidder was expected to incur a significant loss in 1987.

Technically, Cathart and Kidder reported to Mr Gary Wendt, President and Chief Operating Officer of General Electric Financial Services (GEFC) and CEO of GECC, but Alan understood everyone believed that old Si reported only to himself and Mr Welch. Mr Cathart wasn’t going to be in the job for that long and could not care less about company politics. All he had to do was return Kidder to profitability, and set it on the right strategic course – one that made sense to both the Kidder shareholders and the GE crowd. After that, he could go back to his retirement and let someone else take over.

20 This case first appeared in the New York University Salomon Center Case Series on Banking and Finance (Case 26). Written by Roy Smith (1988). The case was edited and updated by Shelagh Heffernan; questions set by Shelagh Heffernan.

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Everyone Alan had talked to at GECC felt that the job would be very tough, and that Cathart might be at a big disadvantage because he did not have prior experience in the securities industry.

Alan’s plan was to play it dead straight with Mr Cathart, to work most of the night getting the basics under his belt, and to consider Kidder’s strategic position, and how to implement any proposed changes. If asked something he did not know, he would simply say he did not know but would try to find out. A chronology of significant events is summarised below.

10.3.1. Chronology of Significant Events, 1986–87

April 1986

General Electric Financial Services agreed to pay $600 million for an 80% interest in Kidder Peabody and Company, leaving the remaining 20% in the hands of the firm’s management. GEFS is a wholly owned subsidiary of General Electric Company. The price paid was about three times the book value – each shareholder was to receive a cash payment equal to 50% of the shares being sold, the remainder being paid out over three years. GEFS was to replace the shareholder capital with an initial infusion of $300 million, with more to follow. When the transaction closed in June 1986, GE and Kidder shareholders had invested more equity in the firm than previously announced – Kidder’s total capital was boosted to $700 million.

Mr Robert C. Wright, head of GEFS, claimed the expansion of investment banking activities would mean GEFS’s sophisticated financial products in leasing and lending could be combined with corporate financing, advisory services and trading capability at Kidders. There was no plan to institute any management changes.

Kidder ranked 15th among investment banks in terms of capital, and had 2000 retail brokers in 68 offices. The view was that it was too small to compete with the giants, but too large to be a niche player, making it an awkward size. Among analysts, it was generally accepted that Kidder had not been purchased for its retail network, but rather, for its institutional and investment banking capabilities.

Kidder initiated the talks with GE. It was believed the firm agreed to give up its independence as a means of using a more aggressive strategy to achieve a better image – there was a general perception that it was being left behind.

October 1986

Mr Ivan Boesky was arrested for insider trading. He implicated Mr Martin A. Siegel, a managing director of Drexel Burnham Lambert, who had been head of Kidder Peabody’s merger and acquisition department until his departure in February 1986 to join Drexel.

December 1986

Kidder reorganised its investment banking division. Eighty-five professionals were transferred to the merchant banking division, 45 of whom were placed in acquisition advisory,

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and another 40 in the high-yield junk bond department. The group was headed by Mr Peter Goodson, a Kidder managing director, who at the time noted the move was a fundamental change in management structure. Mr Goodson did not anticipate any long-term effects from the insider trading scandal.

February 1987

The 1986 Kidder Annual Report emphasised the importance of synergies apparent in the combination of Kidder Peabody and GEFS – it was believed the synergies far exceeded the firm’s expectations. A source of new business at Kidder was existing customer relationships with hundreds of middle-sized American firms at GEF. Additional capital from GEFC allowed Kidder to provide direct financing, picking up a sizeable number of new clients.

The Kidder Annual Report also revealed Kidder’s core business had been reorganised to reinforce competitive strengths and facilitate future growth. A global capital markets group was formed under Mr Max C. Chapman Jr (President of Kidder, Peabody and Co., Incorporated), to direct the investment banking, merchant banking, asset finance, fixed income and financial futures operations on a world-wide basis. Mr John T. Roche, President and Chief Operating Officer, Kidder Peabody Group Inc., established an equity group. Mr William Ferrell headed up a municipal securities group, formed from the merger of the public finance and municipal securities groups. The CEO, Mr Ralph DeNunzio, claimed these changes were made to ensure the firm was in a position to compete effectively in the global market place.

February 1987

Mr Richard B. Wigton, Managing Director, was arrested in his office by federal marshalls on charges of insider trading. A former employee, Mr Timothy Tabor, was also arrested. Both arrests were the result of allegations made against them and Mr Robert Freedman of Goldman Sachs and Company by Martin Siegel, who, next day, pleaded guilty to insider trading and other charges brought against him. Kidder’s accountants, Deloitte, Haskin and Sells, qualified Kidder’s 1986 financial statements because they were unable to evaluate the impact of insider trading charges. Kidder reported earnings of $90 million (compared to $47 million earned in 1985); ROE was 27%.

The New York Stock Exchange fined Kidder Peabody $300 000 for alleged violations of capital and other rules. Two senior officials, including the President, Mr Roche, were fined $25 000 each for their role in these violations.

The Wall Street Journal reported that Mr DeNunzio had instructed Martin Siegel to help start a takeover arbitrage department in March 1984; Mr DeNunzio had indicated that the role played by Mr Siegel should not be disclosed publicly – there were inherent conflicts in having the head of mergers and acquisitions directly involved in trading on takeover rumours. A Kidder spokesman said the report was a ‘‘misstatement’’, and denied that Mr DeNunzio had ordered the formation of such a unit.