The court has ruled: Citigroup did not act improperly over the sale in 2007 of EMI to Guy Hands’ Terra Firma private equity group. Yet while the bank has been acquitted, the universal banking model has not. Citigroup was involved on both sides of the deal and it is the willingness of three financially sophisticated parties to countenance a blatant conflict of interest that is the real public policy issue to emerge from the New York case.
Conflict of interest pervades financial services. The practice of taking two or even three bites of the cherry, advising both sides of a transaction and taking a financing turn where possible, became accepted during the late 20th century. For years rising markets covered up any inequity in such arrangements but when the tide turned, we saw who was swimming naked. The practice was not confined to buy-outs and conflict of interest was probably a factor in many egregious deals, including rigged initial public offerings during the dotcom bubble, loaded collaterised debt obligations during the property boom and a string of ill-judged mergers.
The Citigroup-Terra Firma case is a timely reminder that a golden opportunity to address the problem has recently been missed. During the depths of the banking crisis, universal banking came under fire and there were calls to break it up, an outcome that would have tackled conflict of interest head on. The financial services industry argued that it should be trusted to handle conflict of interest, which it portrayed as an unavoidable and manageable consequence of a smoothly functioning market. Legislators had other things on their minds and, just as it did at the time of the Sarbanes-Oxley Act of 2002, the banking architecture escaped major change in the Dodd-Frank Act of 2010.
But the idea that consenting adults should be left to sort out conflict of interest between themselves is looking less and less credible. In most large financial transactions, the executives involved are not acting as private individuals but as agents or representatives of shareholders and investors. With so many personal and corporate objectives at stake, how can a single bank look after the interests of both parties to a trade while simultaneously achieving the maximum return for its own shareholders?
Investors, shareholders and their representatives should not tolerate this situation. They should insist that the managers of entities in which they have a financial interest take independent advice in every financial transaction and require conflicted parties to choose between one side and the other. This should extend to market trades, over-the-counter dealings and corporate finance. Rules prohibiting banks and brokers working on one side from working on the other could be introduced immediately; longer term, the objective of regulators and legislators should be to disaggregate trading and advice to create a totally conflict-free environment.
While such changes would be intended primarily to benefit the pension funds and savers that are the market’s end users, there would be a spin-off for the banks themselves. A cleaner structure would help them live up to their stated ethical frameworks and rebuild public trust in the industry. Under the currently convoluted business model, banks cannot truly walk their talk of right-minded ethical behaviour.
As the world’s leading investment bank, Goldman Sachs has been a target for ethical crusaders, but it also deserves credit for acting as an industry leader in setting out its values up front. That said, its value statements illustrate the difficulty of living up to high ethical standardsunder current banking structures.
Goldman publishes business principles that state: “Integrity and honesty are at the heart of our business. We expect our people to maintain high ethical standards.” Its Code of Business Conduct and Ethics (amended and restated as of May 2009) instructs employees on how to deal with issues such as compliance, conflict of interest and confidentiality, and reminds staff that: “We do not seek competitive advantages through illegal or unethical business practices.” But Goldman Sachs works in the real world where the structure of the integrated investment bank and presumably the requirements of its lawyers require it to add a rider: “From time to time the firm may waive certain provisions of this code.” That’s why we have to change.
The writer’s most recent book is Reckless: The Rise and Fall of the City
