He spoke about the need for Goldman to develop further its “proprietary businesses,” those where the firm took risks as principals—whether in trading or in private equity or in hedge funds—and wanted to have “a unique blend of client and proprietary businesses” because Goldman was “uniquely positioned” to do it. Corzine’s vision was for Goldman’s “proprietary activities” to “tie to and support our client focus. And they can.” His logic was simple. “It is certain that we will know markets better and can give better advice by being a participant rather than an observer,” he said. “It is certain that many of our clients expect and welcome the firm’s use of its capital to facilitate meeting their objectives.” Corzine wanted Goldman to be “a recognized leader in financial and quantitative research,” in the “development and use of technology,” and in “innovating products and in solving financial problems.” When conflicts arose—as they inevitably would between acting as an agent and acting as a principal—Corzine argued that the conflicts could be managed if the right “checks and balances” were in place. “That is execution,” he said.
The “biggest challenge” of leadership, he said, was “getting the right balance between the energy of the enterprise and the hustle of 174 partners, especially in the context of a firm with the potency and reach of Goldman Sachs.” Then he explained how he intended to keep the balance. “Risk control is fundamental,” he said. “Legal, credit, market, operational, reputational, expense, and liquidity provision must have first-order priority. A breakdown here can be fatal.” Next, “performance accountability must be accepted” and focus on total profits, profit margins, and return on equity. But was this relentless focus on profit a recipe for dispensing with the system of “checks and balances” that was in place to prevent conflicts between client needs and Goldman’s own trading accounts? This question would come back to haunt Goldman with a vengeance in 2010.
To Corzine, the lessons of 1994 were clear. “Permanency of capital was essential,” he said. “You could not have everybody’s life at risk because people have different risk tolerances and can take their capital out at a moment’s notice. I didn’t have religious fervor [about an IPO] in 1986, but I was supportive. I had religious fervor after 1994 because you can’t have a two-hundred-and-fifty-billion-dollar balance sheet stretched around the world, operating twenty-four hours a day built on capital that could walk out the door and have no real transparency whatsoever about what you’re doing.” What he could also have mentioned—but didn’t—was that Goldman’s balance sheet was increasingly leveraged, risky, and costly, chock-full of capital invested from Sumitomo and the Bishop Estate (which were taking away a combined 25 percent of the firm’s profits annually) and with capital borrowed from institutional investors at rates of interest averaging around 10 percent.
By 1996, the firm was the only major Wall Street securities firm that still operated as a private partnership, and there was no longer any doubt that the firm needed more capital to compete and also needed a new corporate structure to shield the partners from potential catastrophic liabilities.
Before turning the podium over to Paulson, Corzine broached the delicate subject of the Goldman IPO. “We are the strongest and best firm in our business,” Corzine said. “The question for us is how to assure that Goldman Sachs continues to optimize its strengths. In that regard, we must ask now—when our health is strong—the question of where our future weaknesses might arise. The experiences of 1994 and the events of the last decade raise long-term questions with respect to our jugular vein—our capital structure.” During the next day, the conversation would be about Goldman’s capital structure and whether to keep things the same, “create an enhanced partnership,” or go public, via an initial public offering of stock.
Corzine knew the issue was contentious. He had quickly lost support for an IPO the year before—the firm was in no shape for it then, of course—and in the interim year, he had been lobbying his partners relentlessly in order to build support for the idea. By then, the tension was well known between those who wanted to keep Goldman private and those who believed the firm needed ready access to capital to compete. Left unarticulated was that every Goldman partner present on the day of the IPO, as well as every limited partner (albeit to a lesser degree), would become mind-bogglingly rich as a result. “Goldman Sachs had been a partnership for well over one hundred years,” Paulson said, “and so for one generation to reap the rewards, and sell it, so that no other generation could do what the one generation had done, when you do it you’d better do it in a first-rate way, and it better be driven by strategic reasons, not by one group wanting to harvest the rewards that were built for those who went before them and take the opportunity away from those that came after them. You had to have a good strategic reason for doing it.”
That fact cast a pall over the group. “The important thing is to keep an open, dispassionate mind,” Corzine said. For Corzine, the matter came down to one question: “What’s in the best interest of the firm and its people—all 8,200?” He said, “The question should not and cannot be what’s in your own self-interest.”
For his part, Paulson barely mentioned the possibility of the IPO, thinking that it would be the main subject for the following day. Instead, he spoke about the need for “paced expansion” and to continue the firm’s growth outside the United States in a more judicious manner while not neglecting its backyard. He also mentioned a number of opportunities the firm was seeing in trading—high-yield debt, syndicated bank loans, foreign exchange—and described two strategic initiatives the firm would focus on in the coming year: growing Goldman’s asset management business and building up its electronic distribution system.
Finally, Paulson spoke about the problem of managing the firm’s increasing number of conflicts, as Corzine had, but with considerably more concern. “In order to realize our strategic objective of creating a unique blend of client and proprietary businesses,” he said, “we must develop a sophisticated management approach for ‘relationship’ conflicts as well as legal conflicts.” This had not been going too well in recent years. In 1996, he said, Goldman needed “to do a much better job of managing conflicts” internally and in how “we articulate our business principles, policies and procedures.” He wondered, rhetorically, why the firm was experiencing increasing problems with conflicts and then answered that the reasons were the firm’s “growing principal investing business,” its “growing market share and increasing global reach,” and the efforts by competitors to “use conflicts as a ploy to take business from us or tarnish our reputation directly with clients or indirectly through the media.” He also thought it was partly because clients “seem to be more sensitive about their competitors” and had been demanding “exclusive relationships” with their bankers. But, he said, the problems stemmed, too, from “our own inability to understand, articulate and manage these issues as well as we should.” He said the firm owed its clients “full disclosure” about conflicts, “100% dedication to achieving their interest,” and “professional execution.” One thing “we don’t owe them,” he said, was the “pledge to never work with anyone else who may have a competing economic interest.” The key to success, he concluded, was “keeping our momentum, our hustle, and executing with intensity.”
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PAULSON WAS RIGHT to be worried about the firm’s increasing problem with conflicts of interest. Goldman had been confronting the issue of conflicts for years, ever since Levy set up the risk arbitrage department in the 1950s. Time and time again the firm had to decide whether to arb a merger or advise on a merger. Sometimes the decision would be complicated by timing, as in the case of KKR’s interest in Beatrice Foods. In that case, Goldman had been hired to work with Beatrice’s management to take the company private and, at that moment, Bob Freeman put Beatrice on the gray list, which theoretically prevented Goldman from trading its securities. But after that management-led buyout failed, Beatrice came off the gray list and Freeman started tra
ding the Beatrice stock (much to his own personal misfortune, it turned out). But in the late 1980s and 1990s, as Goldman’s principal business exploded—among them private equity, hedge funds, and the Special Situations Group, or SSG, a little-known fund of partners’ money run by Mark McGoldrick—the potential for conflicts exploded, too. Increasingly, the joke around Goldman was, “If you have a conflict, we have an interest.” The updated version of Goldman’s conflict with KKR over Beatrice came in May 1995 when KKR hired Goldman to represent it in the purchase of Westin Hotels & Resorts from Aoki, a strapped Japanese company that needed to sell. Peter Weinberg, the grandson of Sidney Weinberg, was KKR’s banker at Goldman at the time. This was his first assignment working for KKR since he had joined Goldman from Morgan Stanley, and he had never met Henry Kravis before. The two firms signed an engagement letter for the Westin deal and Weinberg went to see Kravis. As he was walking in to the KKR offices, Goldman put out a press release that its private-equity arm had joined with two other investors to buy Westin. “You got to be kidding me!” Kravis said to Weinberg. Indeed, “the stress between KKR as a principal and Goldman Sachs as a principal was always enormous,” according to someone familiar with their relationship.
There were also many examples of unethical behavior. For instance, in 1995, government regulators forced ITT Corporation to divest its financial services business, known as ITT Financial Corporation. There were several different pieces to the business, and Goldman, along with Lazard Frères & Co., was hired to sell it all off. A big chunk, known as ITT Commercial Finance, was sold to Deutsche Bank’s U.S. subsidiary in December 1994. Six months later, in June 1995, ITT announced it had sold the rest of the division off in various pieces to buyers it did not identify. According to a former Goldman executive, one of the pieces of ITT Financial was a portfolio of “really weird” consumer loans that the Goldman banking team studied and decided might be an interesting acquisition for Goldman’s partners themselves, perhaps through SSG, the secret fund of partners’ money. Once the decision was made that Goldman wanted to buy the loan portfolio, word was that Goldman then slow-rolled the sale process, minimized its efforts to find a buyer, and eventually reported back to the ITT executives involved that no buyer could be found for the portfolio. That was the bad news. The good news was that the Goldman partners’ fund had agreed to buy the portfolio at a price at least $100 million below what the loans were worth. According to the former Goldman executive, when this was reported to the client, the ITT executive went ballistic—because there was the sense that Goldman had not been forthright in its marketing effort. But, instead of contrition, the Goldman banker involved expressed his own fury. “He screamed to the [ITT executive] that he had been busting his ass for nearly a year trying to sell the assets and if he heard one more word along those lines he was going to talk to Jon Corzine, who would talk to Rand Araskog [the ITT CEO],” the former Goldman executive said. “And that was the end of that. When he got off the phone, everyone was giving each other high-fives because they knew they had just made $100 million. That was not an uncommon M.O. at Goldman.” So much for checks and balances.
Paulson said he understood clearly that as the firm ratcheted up its principal activity, the likelihood of conflicts of interest would rise exponentially. He said some people urged him to wall off the principal investing businesses completely from the banking and trading businesses. “You could have someone up in the Arctic Circle and if he’s doing the Water Street activities, clients are going to be angry at you,” he said. “You had to do it with great transparency and with just a high level of integrity, and for people to know what it is you’re doing.” As the firm got bigger and bigger and more deeply involved in trading and principal activities, the task got even harder. “There’s more room to do something that’s unethical,” one senior-level partner said. “In other words, when you’re doing things in securities areas—not that the traders or salesmen are less ethical than bankers—but the markets give you an opportunity every second of the day to misbehave. You just have to look for behaviors. You have to look for people who are listening into conversations they shouldn’t be listening in on. You need to force traders to go on vacation so you can monitor their books. You’ve got to rotate people all the time. You’ve got to have fresh eyes. You’ve just got to look for people that are acting differently. And then when you see something that’s not right, you’ve got to take action.” As always, the defense against conflicts of interest on Wall Street seems to boil down to the old adage “Trust me, I’m honest.”
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THE FRIDAY SESSION at Arrowwood was plenty intense, and while the vast majority of the partners went off to dinner and to the bar to unwind, Corzine convened the newly reconstituted six-member Executive Committee to discuss further the prospect of the Goldman IPO. He was still intending to make his case for it, explicitly, the next morning. He wanted to know he had the support of the senior managers of the firm before proceeding. “I got a little more preachy about it,” Corzine recalled, “and that undoubtedly didn’t set well with guys who said, ‘Well, we don’t need all this trading,’ and so that created a [negative] dynamic [about an IPO] even when we were becoming increasingly successful.” Corzine was right. The support was not there: Paulson, Hurst, and Thain were against the IPO, and Eric Dobkin, who had been asked to do the financial analysis about the IPO, believed Goldman would trade at a discount to Morgan Stanley because its earnings were so volatile and so heavily dependent on trading. By the time Corzine arrived at Arrowwood’s bar at 2:00 a.m., after a long battle inside the Executive Committee, he got an earful from a number of his inebriated partners: Drop the plan for the IPO.
After a few hours of sleep, Corzine succumbed to the inevitable, yet again. Although no vote was taken (again), he quickly ditched the printed agenda for Saturday—which had him arguing for the IPO—and scratched out a new speech. As the Saturday session opened, the opponents of the IPO had mobilized and one after another gave brief speeches in opposition. After an hour, Corzine proclaimed: “There will be no IPO. The IPO is off the table. It’s over.” With the IPO once again rejected, the Arrowwood retreat ended early on Saturday afternoon. But the issue was hardly resolved. “He isn’t going to jam it down the partners’ throats,” one partner said of Corzine. “Like anyone in that kind of position, he wants to keep his job. But he won’t give up on the idea.”
CHAPTER 16
THE GLORIOUS REVOLUTION
While the passion inside Goldman about the IPO had—once again—been doused, the rancor between Corzine and Paulson was heating up. The first bone of contention between the two alpha males was, of course, size. “Everything to him, if it was a position, if it was a hundred, he liked it better at two hundred and he liked three hundred better than two hundred,” explained one partner who knew Corzine well. From the outset, Corzine also seemed infatuated with making Goldman Sachs a bigger firm, through acquisition. During 1995, he spoke with Deryck Maughan, the CEO of Salomon Brothers, about a merger. He spoke with Sanford “Sandy” Weill, the CEO of Travelers Insurance (which owned Smith Barney) about a merger. He spoke with Douglas A. “Sandy” Warner, the CEO of J.P. Morgan & Co., about merging their two firms. He had these exploratory, preliminary conversations quietly and on his own and then asked Paulson to go meet with these executives further to see if any of the deals made sense. Paulson said he basically thought one potential deal was more ridiculous than the next.
Paulson’s first shock came in early 1995 when Corzine told him about his interest in buying Salomon Brothers. The news “just hit me like cold water in the face,” Paulson said, but he resolved to do what Corzine asked him to do—meet with Maughan and discuss the idea—and then to use the experience to try to educate Corzine about why putting the two firms together was not such a great idea. One senior Goldman partner remembered thinking about why Corzine seemed to be so keen on a Salomon deal. “He was a government bond trader,” he said. “We hit Salomon Brothers at about the knees. And
so he sort of looked up to them. They were the heroes for what he did.” Paulson did the analysis for a potential merger with Salomon and talked with Maughan. Salomon had barely survived a scandal involving trading in Treasury securities, after investor Warren Buffett came to its rescue. But by 1995, Buffett had had enough of the business and wanted to sell Salomon and recoup his investment. But to Paulson the deal made no economic sense. “Their trading businesses overlapped with our trading businesses,” he said, without passing judgment on Salomon Brothers. “So do you want to be twice as big in the government bond business? This is not two plus two equals four. It’s two plus two equals three.” Then there was the fact that the firms had duplicative offices around the globe, which would have to be closed and scores of people dismissed. “It just was so obvious that it was absurd on the face,” one person said.
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