What's an Investment Bank's Fiduciary Duty to Clients?
The widespread media coverage of the Securities and Exchange Commission's case against Goldman Sachs has created some public interest about how Wall Street works. To many Main Street observers, the deal looks pretty shady. There's some possibility that Goldman misled investors, but a new report about Deutsche Bank doing largely the same thing makes it appear that the SEC's case could be based on a mere technicality. Goldman referred to an independent collateral agent having created the portfolio for the security purchased by investors, though a hedge fund manager was also involved. Deutsche Bank employed no such third-party, so there could have been no such deceit on its part.
Whether or not Goldman is ultimately found to have committed fraud, many people who have read some details of the case likely believe that there were ethics violations, given the appearance that Goldman believed the security would perform poorly. Shouldn't an investment bank that creates a security have an obligation to only sell it if the bank believes it will perform well? Not necessarily.
The Role of an Investment Bank
First, it's important to understand the role of an investment bank. It's a glorified middle man. Its job is to bring together buyers and sellers and facilitate a transaction. This involves all sorts of financial products. Here are a few examples:
- M&A: If a firm is looking to be acquired or acquire another, an investment bank can advise it on its options, pricing, etc. It can also solicit offers and facilitate the transaction's closing.
- Equity/Debt Sales: If a company wants to sell some stock or bonds, it can go to an investment bank. The bank can then work with the company to create an offering and find investors to purchase the resulting securities.
- Derivatives: If a company or investor wants some kind of financial exposure, an investment bank can find another company or investor who wants the opposite exposure. It can then create a derivative to satisfy the demands of both parties.
An investment bank shouldn't be confused with a personal financial advisor. The latter is a professional who generally provides investment advice to clients, like to buy or sell a stock. An investment bank isn't there to provide its opinion when selling securities. Its job is just to provide sufficient information to all parties so they can make their own investment decision. The exception to this rule is the equity or debt research groups that sometimes exist in investment banks specifically to provide investment advice. They are required to be isolated from the investment bank's other activities.
An Example: Derivatives
Let's imagine an example where an investment bank is creating a derivative based on subprime mortgage-backed securities in early 2007 -- right before the market collapsed. One long investor believes the mortgage market will continue to do well, the other short investor thinks it will do poorly. What the bank believes will occur is entirely irrelevant: it's just there to create a deal that satisfies the demands of both parties and disclose all the data they need to analyze it. If each obtains the information associated with the deal, finds it appropriate, and buys the securities offered, then the bank's job is done.
If the bank has a fiduciary duty, which investor does it have a duty to protect? For example, imagine that the bank believed that the mortgage market was about to go bust. If it advised the long investor not to buy the security, it would be breaching its duty to the short investor. Alternatively, what if the bank believed the mortgage market would continue to thrive? Then, if it advised the short investor accordingly, it would breach its duty to the long investor. These investors' interests necessarily conflict. The bank can't give preference to one client over the other. For it to do its job best, it must create a security, disclose all of its characteristics, and allow investors to decide on their own whether to buy.
In fact, in this example, it would be impossible for the bank to sell both securities if it had to believe anything it sold would perform well. One security will necessarily do poorly. It's a zero-sum trade.
Where an Investment Bank Can Go Wrong
Of course, that doesn't mean it's impossible for a bank to act in an ethically reprehensible way. If a bank misleads a client, then that's fraud. But if a bank happens to believe a security might not do poorly, based on its interpretation of future events, then that's irrelevant. Its job is just to provide sufficient information for the investors to evaluate the security within their own interpretation of future events. After all, the investment bank could very well be incorrect. Fraud would occur if the information it presents is false or inaccurate, because then investors could not have fairly assessed the security based on their own assumptions. If the data is accurate and complete, then the investors can successfully perform their analysis, and the investment bank has done its job.