The latest government case against Goldman Sachs, and possibly other brokerage firms, regarding alleged conflicts of interest around Collateralized Debt Obligations (CDO), bears an eerie resemblance to similar charges that were brought against many of the same Wall Street players nearly a decade ago, after the last great bubble burst. (If you want to learn about the major crashes throughout history, check out our Crash Tutorial.)
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The technology bubble burst quite loudly in March 2000, when the Nasdaq index reached just over 5,000. It then began its long decline over the next two years.
In the aftermath of the bubble, the regulatory authorities in the United States, led by the Securities and Exchange Commission (SEC), and Eliot Spitzer, the Attorney General of New York, targeted the research departments of major Wall Street investment firms. (For background reading, check out Wall Street Post Spitzer and Eliot Spitzer - Man Of A Thousand Scandals.)
The government charged 10 firms with a conflict of interest, or in legalese "undue influence of investment banking interests on securities research." The SEC alleged that the firms violated the Securities Act of 1933, the Securities Exchange Act of 1934 and countless rules established by the New York Stock Exchange (NYSE), and the National Association of Securities Dealers (NASD).
These violations involved the issuance of fraudulent research reports, or reports that were not based on "principles of fair dealing and good faith," and contained "exaggerated or unwarranted claims." Several firms were also charged with receiving payments for research without disclosing them to clients and failure to supervise the research and investment banking departments.
The SEC settled with the firms involved in early 2003, and the 10 firms paid a total of $875 million in fines and disgorgement of profits, with some pledged to the victims of the actions. Two influential analysts were also banned for life from the industry. (Check out Why is Frank Quattrone credited with contributing to the growth of the dotcom bubble?)
The SEC also attempted to change the way business is conducted on Wall Street as structural reforms and enhanced disclosures were also agreed to by the firms involved in the settlement.
The firms involved agreed to a complete separation of research and investment banking areas of the company. While this was always supposed to be the case, additional restrictions imposed included a separate physical location, separate legal and compliance staffs and separate budgeting processes. Also, investment banking was restricted in deciding what companies to cover, and an analyst's pay was no longer based on banking revenues generated - it was to be linked to the accuracy and quality of research.
The firms also agreed to disclose in each research report the existence of a possible conflict of interest by the company, and publish quarterly details on the performance of each analyst. The companies also had to fund third-party independent research and make it available to its clients. (Find out more about disclosure in What Would Full Disclosure Mean For The Market?)
Well, it looks like Wall Street certainly learned its lesson, right? Not quite. Fast-forward seven years and the SEC has charged Goldman Sachs with fraud in structuring a CDO tied to the subprime housing market. The government charges that the company did not disclose relevant facts to investors who purchased this security. The facts omitted were that the CDO had been shorted by a major hedge fund client who had influence in the portfolio selection process and included residential mortgage-backed securities. (Check out The Goldman Sachs Accusation Explained.)
It would seem that there is something wrong with the government's approach to regulation, as the settlement back in 2003 was announced with great fanfare and was supposed to teach Wall Street a lesson. It was hailed as "historic," which certainly implies that it should have some sort of deterrent effect.
William H. Donaldson, the Chairman of the SEC at the time, gushed in the press release:
"These cases reflect a sad chapter in the history of American business, a chapter in which those who reaped enormous benefits from the trust of investors profoundly betrayed that trust. These cases also represent an important new chapter in our ongoing efforts to restore investors' faith in the fairness and integrity of our markets"
The Bottom Line
I think it's fair to say that there is less faith in the fairness and integrity of the market now than ever before. The SEC case that arose after the internet and technology bubble popped ten years ago is becoming a distant memory to many investors preoccupied with the current volatile investment environment. This is unfortunate as perhaps if they had remembered this earlier conflict of interest, they would have been wary of yet another one practiced by some of the same firms.
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