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Does Wall Street Have a Fiduciary Duty to Investors?

Mary-Jo Kranacher, MBA, CPA, CFE

Last month, I spoke to the employees of a major investment bank on the topic of ethics. After reading their portrayal in the media over the past few years, it might be easy to be skeptical of the concept of an ethical investment banker. But the timing of that seminar was fortuitous in that the SEC's civil charges and the U.S. Attorney's criminal investigation of Goldman Sachs were still fresh in the minds of the attendees.

One issue that clearly hit home with this group was whether Goldman had a fiduciary responsibility to its clients, an obligation to act in the best interest of another party. The SEC complaint alleges that Goldman neglected to inform investors that Paulson & Co., a hedge fund firm, handpicked the mortgages that became part of Abacus, the collateralized debt obligation (CDO), and then bet against it (i.e., the hedge fund shorted the financial instrument). Although many people believe that Goldman's actions in this case may have been unethical and possibly even fraudulent, some in the audience at this event could see possible justifications for Goldman's actions. In the world of fraud, we'd call that rationalization.

If Goldman materially misstated or withheld information from its Abacus investors. … then that's fraud, and there are laws that address it.

An Investment Bank's Role

Large investment banks such as Goldman generally offer a variety of services, including acting as a middleman to facilitate transactions between buyers and sellers of various types of financial products. They also research the future economic prospects of companies to 1) assist in the investment bank's proprietary trading activities—in which the investment bank's traders actively buy and sell securities with the firm's own money, and 2) provide investment advice to outside clients. This is where it gets tricky. SEC regulations require that a “Chinese wall” must separate those individuals acting as middlemen in “market making” deals from those who advise clients about buying securities. This imaginary wall is intended to protect sensitive information from those in other areas of the firm in order to prevent conflicts of interest, in much the same way that accounting firms are required to separate the consulting arm of their practices from the attest function.

While investment advisors have an obligation to act in a fiduciary capacity for their clients, an investment banker—whose role is that of a market maker and an unbiased middleman in a transaction—has no such duty under federal or state law. In fact, an investment banker couldn't act as a fiduciary for one side and not the other and couldn't be a fiduciary to both. Nevertheless, there has recently been escalating rhetoric by regulators and legislators about imposing fiduciary standards on investment bankers. Opponents contend that we already have the tools to fix the problem—if indeed one exists.

Full Disclosure

Despite the fact that Goldman may not have a fiduciary duty to its clients in its role as a market maker, the firm has a legal and ethical responsibility to provide full disclosure to both parties—buyer and seller—so they can each make an informed investment decision. So, if Goldman materially misstated or withheld information from its Abacus investors in the disclosure documents, or if it misrepresented to clients that an independent selection agent (ACA Management LLC) had reviewed the mortgage package underlying the credit default obligation—then that's fraud, and there are laws that address it.

The investigation has just begun, and there's no telling how things may unfold. Will Goldman be the next Enron—or will the SEC's case fall flat? Stay tuned for the next episode of “Wall Street: As the Stomach Turns.”

As always, I welcome your comments.

Mary-Jo Kranacher, MBA, CPA, CFE. Editor-in-Chief. mkranacher@nysscpa.org.

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