This certainly isn’t the first time banks have been accused of letting interests collide in ways large and small. Conflicts can be as basic as sharing one customer’s information with another customer. Reports by Reuters and Dow Jones suggest that Goldman Sachs resigned from its role as mergers-and-acquisitions adviser to Mirant Corp. in its takeover bid for NRG Corp. after being accused of leaking secrets from a previous engagement with NRG (although both companies ended up denying it). More-complex conflicts stem from the Graham-Leach-Bliley Act of 1999, which erased what legal boundaries remained against engaging in both investment and commercial banking, allowing the potential for information to flow within bank divisions. Even when banks are acting well within the law, there is always the likelihood that traders might take positions against former and future clients.
“Most of our firms are conflict-making machines,” remarked then–vice chair of The Bond Market Association and Goldman Sachs chief administrative officer Ed Forst at TBMA’s last annual meeting. “The question is how we manage those conflicts.”
Most, of course, would say that market forces give banks plenty of incentive to manage those conflicts well. “In 99 percent of cases, banks want to do the right thing, because companies are much more likely to do business with them if they feel the banks are carefully enforcing these lines,” says Mitchell Petersen, finance professor at Northwestern’s Kellogg School of Management. “There’s a trust factor with underwriters, and you have to rely on that,” says Greg Heinlein, treasurer of Austin, Texas-based Freescale Semiconductor. Certainly most banks have strict policies against leaking client information, and the metaphorical “Chinese wall” often has a physical manifestation, as when banks keep proprietary traders on limited-access floors and investment bankers on others.
Compliance departments also monitor proprietary stock trades for companies involved in M&A or underwriting for excessive trading ahead of a deal’s announcement, according to one industry source, and then freeze their banks’ trading rights immediately after the deal. (Banks contacted by CFO, including Goldman Sachs, Morgan Stanley, and JPMorgan Chase, declined to comment on any specific measures they take to keep divisions separate.) But, as the blurred lines between underwriters and research analysts revealed, keeping boundaries within a firm “isn’t a simple thing to set up,” says Petersen.
As the Pequot case highlights, one of the problems with hedge funds being large clients of banks is that the funds may pressure banks to give them nonpublic information about underwriting deals. Or, they may illegally use information that was obtained legally, as British regulators concluded last summer. The Financial Services Authority (FSA) fined London-based hedge fund GLG Partners and one of its top traders a combined $2.8 million (its largest fine ever) for trading on embargoed information from Goldman Sachs regarding a forthcoming equity offering in 2003. According to the FSA, the trader shorted shares of Sumitomo Mitsui Financial Group ahead of a preferred-stock offering and made a “substantial profit” when the shares dropped after the stock’s debut. “We have become increasingly concerned about the risks generated by institutions exploiting legitimately received information for illegitimate purposes,” said Hector Sants, FSA managing director for wholesale and institutional markets, in a June speech.