The Manhattan district attorney has reportedly subpoenaed the firm in conjunction with a recent Senate report alleging wrongdoing

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The authorities' interest in Goldman Sachs doesn't appear to be waning. After settling a lawsuit with the Securities and Exchange Commission last year, reports today indicate that the Manhattan district attorney has subpoenaed the firm based on allegations contained in a recent Senate report (.pdf). Although the Senate's accusations are somewhat broad, most of them focus on Goldman's strategy to short the mortgage market while selling its clients exposure to the very mortgage losses from which it profited. Did the bank do anything wrong?

The Senate's report contains a "case study" of Goldman's shorting activity beginning in 2006. Throughout the narrative, it explains how the "Mortgage Department" sold securities to investors to either reduce its exposure to mortgage losses or create a net short position. In doing so, it did not disclose to these clients that it was engaging in a strategy to short mortgages or that the firm believed mortgages would sour and the products it was selling would produce losses.

To be sure, knowledge of this behavior might lead Goldman's clients to trust the firm even less than they did before. But did Goldman actually break any laws? To determine that, you have to look at how it shorted the market and understand any fiduciary duty requirements in place.

Goldman Sachs wears a number of different hats. As a broker-dealer, it underwrites securities, makes markets by bringing together buyers and sellers of securities, and managed its own book of assets through a proprietary trading function. Separately, it acts as an investment advisor to some clients, which are generally high net worth individuals, funds, or companies. The duty that Goldman had to clients differs depending on which of these hats it's wearing.

Broker-Dealer v. Investment Advisor

Financial advisors have a fiduciary duty to their clients. That is, they have to act in their clients' best interest. For example, if the advisor believes a security will fail, then it would be breaching its fiduciary duty to sell that security to its client.

Broker-dealers, however, are not subject to a fiduciary duty. "Under existing law, a broker-dealer doesn't actually have to act in its customers' best interest," says Anna T. Pinedo, a partner at law firm Morrison & Foerster who specializes in securities law. But standards of conduct do exist, she explains. The Financial Industry Regulatory Authority (FINRA) requires that broker-dealers adhere to a number of rules, including a "fair dealing with customers" rule. If parsed through, that rule may begin to look a little bit like a fiduciary duty, but falls short of establishing the same standard set for investment advisors.

First, broker-dealers must ensure that any conflicts-of-interest are disclosed. This concept is a bit fuzzy, as it does not define conflicts in the way some people might expect. In this context, the definition of a conflict-of-interest is somewhat limited to treating clients fairly. For example, one conflict-of-interest would be favoring one client over another by secretly charging different clients different fees for the same service, due to some bias. This standard would not necessarily apply to a situation in which a firm held a portfolio that would benefit if a security it sells to a client performs poorly.

Second, broker-dealers must only sell securities that are "suitable" for their clients. According to Pinedo, that suitability is determined by whether a product could be appropriate for a client and is not inherent flawed or designed to fail. This standard does not necessarily require that the broker-dealer must believe that the security will thrive, but that a reasonable investor could expect it to perform as advertised. As a part of this requirement, all information material to a security must also be disclosed.

Applying These Standards to Goldman

So how might these rules apply to Goldman? As explained above, the Senate refers to its "Mortgage Department" as responsible for the shorting strategy. So its investment advisory division does not appear to be implicated. Unless it did involve its advisory arm, fiduciary duty rules do not apply.

But FINRA's "fair dealing" requirements do come into play. Those apply to the broker-dealer, of which the Mortgage Department was a part.

Conflict-of-Interest?

Wasn't it a conflict-of-interest for Goldman to sell securities that it bet against. Probably not, FINRA designs this standard in such a way that it would not preclude such behavior on the part of a broker-dealer. Assuming that Goldman treated all of its clients fairly, then there was no conflict-of-interest in its mortgage securities dealings.

Suitable Investments?

Next, were the long positions that Goldman sold suitable? It depends on whether a reasonable investor could have believed that they would have performed well. In fact, these securities were not designed to fail: whether or not they provided investors with a windfall depended on how the mortgage market fared. Remember, at that time, Goldman was making a contrarian bet against the mortgage market. So a reasonable investor would have believed that the securities Goldman was selling were suitable. Indeed, if the mortgage market continued to flourish, then those investors would have been thrilled with the securities.

However, there's another wrinkle here. As part of this standard, Goldman also should have disclosed all material information to investors. Would a reasonable investor say it was material that Goldman was betting against the mortgage market when it sold these securities? This is a more difficult question. Do Goldman's strategies matter to clients to that it sells securities to in its broker-dealer capacity?

"Absolutely," says Blaine Aikin, CEO and president of fi360, a firm that advises on investment fiduciary issues. "If you were an investor working with Goldman Sachs, I think it would be certainly relevant to know that Goldman is trading for its own account in an opposite direction."

Any case brought against Goldman will likely hinge on this question: did it have a duty to disclose its shorting strategy to its clients? In theory, a sophisticated investor should buy a security based on assumptions about economics and the market -- not based on what any particular firm is doing. But, especially in the case of Goldman Sachs, that argument begins to break down. The firm's opinion can move markets. So its clients could argue that its strategies are clearly material to the market, and thus its shorting position would have been material to the securities it sold.

If a court agrees, then Goldman's failure to disclose its shorting strategy could get messy for the firm. If a case comes from the Manhattan DA's subpoena, then look for it to highlight this issue.

Image Credit: REUTERS/Brendan McDermid

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