Firms offering comprehensive financial services scored a significant victory on April 9, 2013, when Judge Robert Sweet of the United States District Court for the Southern District of New York dismissed Capmark Financial Group Inc.’s (“Capmark”) insider preference action against four lender affiliates of The Goldman Sachs Group, Inc. (“Goldman Sachs”), which arose out of Capmark’s 2009 bankruptcy. [1] Davis Polk represented the Goldman Sachs lender affiliates and advanced the arguments adopted by Judge Sweet. The court’s opinion rejected Capmark’s attempt to cast the lenders as “insiders” of Capmark based on an indirect equity interest in Capmark held by funds managed by affiliates of Goldman Sachs and Goldman Sachs’s service as an advisor to Capmark. In doing so, Judge Sweet reaffirmed that corporate veils separating a lender from an affiliated entity holding equity positions or serving as advisor to the debtor will not lightly be disregarded, and that participation in an arm’s-length transaction as an ordinary commercial lender will not give rise to insider status. Furthermore, Judge Sweet held that reorganized debtors are judicially estopped from making an about-face on key factual issues underlying relief secured in bankruptcy court. In sum, the Capmark decision should pose a substantial obstacle to claims alleging that a lender is an “insider” by virtue of affiliated entities’ contacts with a debtor in the absence of evidence that the lender actually used the affiliates’ contacts to influence the debtor’s decisions.

…continue reading: Court Dismisses Insider Preference Claims Against Affiliates of Goldman Sachs

Goldman Sachs’ recent filing with the Securities and Exchange Commission (SEC) to launch a “business development company,” or BDC, should be of interest to financial services companies, particularly banking institutions structuring and restructuring their operations and product offerings to comply with the Volcker Rule’s prohibitions on investing in and sponsoring “covered funds.” A BDC is a closed-end investment company that elects to be regulated under the Investment Company Act of 1940 (1940 Act), and thus, like a 1940 Act closed-end fund or mutual fund, is not by definition a “covered fund,” which is defined generally as a vehicle that relies on the exception from the definition of investment company found in Section 3(c)(1) or Section 3(c)(7) of the 1940 Act. Below we discuss certain aspects of the operation and regulation of a BDC under the 1940 Act.

…continue reading: BDCs and 1940 Act Funds

Executive Summary

Recently issued rules by the Governmental Accounting Standards Board (GASB) will notably change the way state and local governments account for and report the results of their defined benefit pension plans. Some plans may see their reported funded percentages fall under the new requirements. A plan’s funded status will now be reflected on the balance sheet, increasing transparency as well as the focus on measures that plan sponsors are taking to address these shortfalls. Funded status and pension expense measures are also likely to be more volatile under the revised reporting standards.

While the new GASB rules change some important aspects of public DB plan reporting, they do not change others. In particular, they neither mandate use of a lower discount rate for calculating liabilities nor higher contribution requirements. These are changes to accounting and financial reporting, not economics. Nonetheless, they do represent a notable change to the calculation and reporting of various pension-related metrics.

Some public DB plan sponsors are already facing significant challenges, such as relatively low funded levels. In addition, given budgetary challenges, some state and local governments do not have the flexibility to increase contributions at this time. All of this is occurring in an environment where long-term expected returns across a wide variety of asset classes have been falling. The GASB changes may add yet another layer of stress, if not complexity, for some public plan sponsors.

This paper reviews the following aspects of the GASB changes:

…continue reading: A “Sea Change” in Public Pension Reporting on the Horizon

Judge Paul Crotty of the U.S. District Court for the Southern District of New York recently held that Goldman Sachs & Co. did not have a duty to publicly disclose the receipt of a Wells Notice from the Securities and Exchange Commission (“SEC”). Prior to this decision, no court had ever been asked to consider disclosure obligations with respect to Wells Notices. Going forward, this decision may inform companies’ consideration of whether and when to publicly disclose receipt of a Wells Notice.

The case, Richman v. Goldman Sachs Group, Inc., centered on allegations by class action plaintiffs against Goldman relating to the firm’s role in a synthetic collateralized debt obligation (“CDO”) called ABACUS 2007 AC-1 (“Abacus”). In January 2009, Goldman’s SEC filings disclosed ongoing governmental investigations related to the Abacus transaction. Between July 2009 and January 2010, the SEC issued Wells Notices to Goldman and two Goldman employees involved in the Abacus transaction, notifying them that Enforcement Division staff “intend[ed] to recommend an enforcement action.” The SEC filed a complaint against Goldman and one of its employees in April 2010, which Goldman settled for $550 million in July 2010. Plaintiffs alleged that Goldman’s failure to disclose its receipt of the Wells Notices was an actionable omission under Section 10(b) and Rule 10b-5 of the Exchange Act, and that Goldman had an affirmative legal obligation to disclose its receipt of the Wells Notices under applicable regulations.

…continue reading: Duty to Disclose SEC Wells Notices Rejected by Judge

In its recently issued report, Wall Street and the Financial Crisis: Anatomy of a Financial Collapse, the Senate Permanent Subcommittee on Investigations considered the conduct of Goldman Sachs in several transactions, including the ABACUS 2007-AC1 collateralized debt obligation. The report “examines Goldman’s conduct in the context of the law prevailing in 2007,” [1] and it asserts that the Volcker Rule provisions of the Dodd-Frank Act, “if well implemented, will protect market participants from the self-dealing that contributed to the financial crisis.” [2] But what justification exists for the conflict of interest restrictions in the Volcker Rule provisions, and how would the Volcker Rule provisions have applied to the ABACUS CDO had the provisions been in force at the time?

In my paper, Conflicted Gatekeepers: The Volcker Rule and Goldman Sachs, I consider the conflict of interest restrictions in the Volcker Rule provisions. These provisions, namely Sections 619 and 621 of the Dodd-Frank Act, purport to impose fiduciary-like standards on banks in their arm’s length relationships with sophisticated counterparties. Section 619 generally prohibits banks from engaging in proprietary trading and affiliating with certain private funds; it permits some activities as exceptions to this general prohibition, but subjects such activities to the requirement that they not give rise to material conflicts of interest, including conflicts between banks and their “counterparties.” Section 621 purports to ban material conflicts of interest between banks (in their capacity as underwriters) and investors in offerings of asset-backed securities.

…continue reading: The Volcker Rule and Goldman Sachs

In our essay Computerization and the Abacus: Reputation, Trust, and Fiduciary Duties in Investment Banking, recently posted to the SSRN, we analyze the 2007 synthetic collateralized debt obligation transaction, ABACUS 2007-AC1 SPV (ABACUS) and the subsequent SEC civil complaint against Goldman Sachs in connection with the ABACUS transaction. We use this analysis as a touchstone to examine the debate over whether to impose fiduciary duties or other heightened regulation upon investment bank/counter-party transactions, the subject of a recently released SEC study (available here).

…continue reading: Computerization and the Abacus: Reputation, Trust, and Fiduciary Duties in Investment Banking

(Editor’s Note: The post below by Lloyd Blankfein is a transcript of his remarks at the Handelsblatt Banking Conference on September 9.)

In the wake of the financial crisis, there has been no shortage of approaches to regulatory reform, both here in Germany and globally. In a relatively brief period, we have witnessed a number of proposed changes to the rules and regulations that govern our industry and markets more broadly.

Driving these are several common themes, but I want to touch on three that seem particularly prevalent: a backlash against complexity in financial products and markets, the need for macro-prudential regulation to address systemic risk and re-working compensation practices to dis-incentivize excessive risk taking.

First, the industry let the growth and complexity in new instruments outstrip their economic and social utility as well as the operational capacity to manage them. As a result, operational risk increased dramatically and this had a direct effect on the overall stability of the financial system.

That is one reason why Goldman Sachs supports the broad move to central clearing houses and exchange trading of standardized derivatives. Clearly, there is general agreement on the necessity of central clearing for derivatives. A central clearing house with strong operational and financial integrity will reduce bi-lateral credit risk, increase liquidity and enhance the level of transparency through enforced margin requirements and verified and recorded trades. This will do more to enhance price discovery and reduce systemic risk than perhaps any specific rule or regulation.

The debate gets harder when defining what should be traded on or off an exchange. We believe that all liquid OTC derivatives should be centrally cleared. And, where trading volumes are high enough and price discovery mechanisms can be established, regulators should strongly encourage exchange trading. In less liquid markets, prompt reporting of aggregated pricing and clearing is necessary to improve transparency.

More generally, it is incumbent upon financial institutions to recognize that we have a responsibility to the financial system which demands that we should not favor non-standard products when a client’s objective and the market’s interests can be met through a standardized product traded on an exchange.

But, we should also recognize that underlying the development of the derivatives markets was client demand for individually-tailored solutions. During the financial crisis, credit-default swaps, many of them customized, actually worked as they were intended to. They increased the ability of market participants to diversify their credit exposure in companies — some that were financially strained or ultimately went bankrupt — by swapping default risk with others. In that vein, these instruments represent an important economic and social purpose.

…continue reading: Elements of Effective Systemic Regulation

Last week, after reporting stellar second-quarter profit of $3.4 billion, Goldman announced the setting aside of $11.4 billion for compensation – which, broken down per employee, is similar to what Goldman set aside in the first half of the boom year of 2007.

Goldman’s CFO argued that its pay decisions reflect the firm’s “pay for performance culture.” However, if Goldman proceeds to pay record cash bonuses this year, as many now expect, these payments would reflect a return to flawed pay structures, as well as a failure to implement effectively the compensation principles Goldman recently put forward.

The setting aside of $11.4 billion for compensation, it should be stressed, doesn’t yet commit Goldman to any amounts of cash bonuses. Goldman still has time to determine the magnitude and structure of its 2009 compensation. In doing so, it should give substantial weight to lessons drawn from the financial crisis.

The crisis has highlighted a substantial flaw in compensation structures that provide rewards for short-term performance – which is what Goldman’s paying super cash bonuses for 2009 would do. Such rewards can over-compensate executives as well as produce excessive incentives to take risks.

Rewards for short-term results can produce over-compensation by enabling executives to cash out large amounts of compensation on account of results that are subsequently reversed. In many financial firms whose aggregate earnings over the past several years are negative, executives have still been able to cash out large amounts of bonus compensation during the first part of this period – and they kept these amounts despite the large losses subsequently borne by the firms.

In addition, and perhaps most importantly, bonuses for short-term results provide incentives to seek improvements in short-term results even at the expense of excessive taking of risks of an implosion later on. The short-term distortion caused by standard compensation structures, which Jesse Fried and I first highlighted in our “Pay without Performance” book, has recently become widely accepted. Treasury Secretary Geithner stated last month that “[s]ome of the decisions that contributed to this crisis occurred when people were able to earn immediate gains without their compensation reflecting the long-term risks they were taking for their companies and their shareholders.”

Indeed, the flaws in the standard compensation structures of financial firms have been explicitly recognized by Goldman’s own leaders. Last April, in a widely praised speech before the Council of Institutional Investors, Goldman’s CEO Lloyd Blankfein called for compensation reform, stating that “[financial firms'] decisions on compensation … look self-serving and greedy in hindsight.” Evaluation of employees’ performance, Blankfein stressed, “must be made on a multi-year basis to get a fuller picture of the effect of an individual’s decisions.”

Goldman subsequently adopted compensation principles and announced them in its annual shareholder meeting last May. According to these principles, “cash compensation in a single year should not be so much as to overwhelm the value ascribed to longer term stock incentives that can only be realized through longer term responsible behavior.”

…continue reading: Paying for Performance at Goldman

Like the companies they run and oversee, CEOs and boards of directors in the financial sector have been battered by the credit meltdown. The witch’s brew of high leverage, poor risk management, creation of toxic assets, and faulty business judgments—made more poisonous by excessive short-term executive pay—are seen as failures of an unprecedented magnitude. The result: Credibility has eroded, trust has dissolved, and financial re-regulation seems inevitable.

As Lloyd Blankfein, CEO of Goldman Sachs (GS), said recently in a speech to the
Council of Institutional Investors: “…[T]he past year has been deeply humbling for my industry…the loss of public confidence…will take years to rebuild…effective reform(s) are vital and should naturally emanate from the lessons learned.”

To this end, I believe there are four fundamental, interrelated governance changes inside corporations that are essential for enhancing accountability and increasing stakeholder confidence:

• Boards of directors must redefine the role of the CEO—and then choose leaders who meet the new specs.

Under this recast role, the CEO’s first foundational task is to achieve a balance between taking economic risk (promoting creativity and innovation) and managing economic risk (within a systemic framework of financial discipline) over a sustained period of time.

The second redefined foundational CEO task is to fuse this high performance with high integrity. That means adhering to the spirit and letter of formal rules, voluntary adoption of ethical standards that bind the company and its employees, and employee commitment to core values of honesty, candor, fairness, reliability, and trustworthiness— which together are in the enlightened self-interest of the corporation and reduce legal, ethical, and reputational risk.

…continue reading: Redefining the CEO Role

(Editor’s Note: The post below by Lloyd C. Blankfein is a transcript of remarks by him to the Council of Institutional Investors, Spring Meeting, April 2009.)

Good morning. I appreciate the opportunity to speak with you today. For more than two decades, the Council of Institutional Investors has committed itself to the values of accountability, transparency and responsible ownership. I’m pleased to be able to speak to those principles in front of a group that has played such a powerful role in advancing them over the years.

To begin with an obvious point, much of the past year has been deeply humbling for my industry. We held ourselves up as the experts, and the loss of public confidence from failing to live up to the expectations that we created will take years to rebuild. Worse, decisions on compensation and other actions taken and not taken, particularly at banks that rapidly lost a lot of shareholder value, look self-serving and greedy in hindsight.

Financial institutions have an obligation to the broader financial system. We depend on a healthy, well-functioning system, but we collectively neglected to raise enough questions about whether some of the trends and practices that became commonplace really served the public’s long-term interests.

Meaningful change and effective reform are vital and should naturally emanate from the lessons learned. I will discuss a few of the more important lessons from this crisis. I’d also like to highlight some of the regulatory guideposts that may help us to improve the broader systemic management of risk, increase the level of institutional accountability and enhance investor confidence.

Without trying to shed one bit of our industry’s accountability, we would also further our collective interests by recognizing other contributing causes to the severity of the cycle we are living through.

As a matter of policy, we allowed housing prices to be subsidized, including through implied government support of Fannie Mae and Freddie Mac. We watched as high consumption and low savings rates as well as entitlement spending were increasingly encouraged and financed through the twin deficits.

Factors from both Main Street and Wall Street contributed to today’s circumstances. Neither part of our economy acted completely independent of the other. So, any examination of how we got to this point must begin with an understanding of some of the global economic and financial dynamics of the last two decades.

…continue reading: Lessons from the Financial Crisis