In June 2011, a Truepoint Investor post titled “The Perils of Suitability” highlighted the importance of the fiduciary standard in the financial services industry. The commentary expanded on a 2009 post explaining the fiduciary principle (“The Wisdom to Know the Difference”). On Wednesday, Greg Smith, a Goldman Sachs executive director, reminded everyone what can happen when firms are not legally compelled to act in the best interests of their clients.
Smith publicly announced his resignation from Goldman Sachs in a scathing op-ed published in the New York Times titled “Why I Am Leaving Goldman Sachs.” Smith laments the decline in “moral fiber” at his employer of 12 years and states:
“To put the problem in the simplest terms, the interests of the client continue to be sidelined in the way the firm operates and thinks about money.”
While Goldman Sachs obviously disputes Smith’s depiction of the firm’s culture, what is indisputable is the conflict of interest inherent in the business model of any firm that competes with clients or profits from products sold to clients, while also positioning itself as an “advisor” to those same clients.
As you may recall, the fiduciary standard requires Registered Investment Advisors (including Truepoint) to act only in the best interest of the client, while brokerage and banking firms such as Goldman Sachs operate under the less-stringent “suitability standard.” The suitability standard provides leeway for the firm’s representatives to push products offered by their firm, even if similar investment options offered elsewhere are better aligned with the investor’s interests.
In Mr. Smith’s account, he states that his Goldman colleagues not only ignored client interests but also openly celebrated the profits gained from the “muppets.” Below are a few excerpts from his commentary:
“It makes me ill how callously people talk about ripping their clients off. Over the last 12 months I have seen five different managing directors refer to their own clients as “muppets,” sometimes over internal e-mail… No humility? I mean, come on. Integrity? It is eroding. I don’t know of any illegal behavior, but will people push the envelope and pitch lucrative and complicated products to clients even if they are not the simplest investments or the ones most directly aligned with the client’s goals? Absolutely. Every day, in fact.”
“These days, the most common question I get from junior analysts about derivatives is, ‘How much money did we make off the client?’ It bothers me every time I hear it, because it is a clear reflection of what they are observing from their leaders about the way they should behave.”
The negative publicity hit the financial giant swiftly, as Goldman Sachs’ market value plummeted $2.16 billion the day the op-ed went to press. Former Federal Reserve Chairman Paul Volcker commented that Smith was right in stating that Goldman Sachs has changed for the worse. He pointed out that the pitfall of Goldman Sachs was when it transitioned from a private partnership to a public company in 1999 and became a trading operation. “I’m afraid it’s a business that leads to a lot of conflicts of interest,” said Volcker.
Volcker has previously proposed that U.S. banks, such as Goldman Sachs, be banned from trading securities for the firm’s gain, an activity often referred to as proprietary trading. Volcker believes a ban on proprietary trading would help shift the focus of banks from their own profits to the interests of clients. Whether this is true or not, it is clear that the suitability standard does not protect clients from the conflicts of interest embedded within many large brokerage firms.