What Happened to Goldman Sachs: An Insider's Story of Organizational Drift and Its Unintended Consequences

by Steven G. Mandis

  Practical Drift

  You can see exactly this kind of drift in complex systems in Scott Snook’s analysis of the accidental shoot-down of two US Army Black Hawk helicopters over northern Iraq in 1994 by US Air Force F-15 fighters. All twenty-six UN peacekeepers onboard were killed. With almost twenty years in uniform and a PhD in organizational behavior, Lieutenant Colonel Snook, now a Harvard Business School professor, uses sociological analysis to thoroughly examine individual, group, and organizational accounts of the accident. Using his practical experience, combined with his academic training, he concludes that what happened was what he calls “practical drift”— the slow, steady uncoupling of practice from written procedure.8

  Snook describes the potential pitfalls of organizational complacency that every executive should take to heart. He insightfully applies several key sociological theories of organizational behavior, structure, and change to analyze how bad things can happen to good organizations. His resultant theory of practical drift provides dramatic insight into how such seemingly impossible events can be expected to occur in complex organizations. He describes how a practical drift of local adaptations and procedures can lead to a widening gap between safety regulations and practical operations. Individually, the adaptations can be inconsequential. But over a longer period, the accumulated drift results in a vulnerable system. Snook uses the word practical because he is looking at everyday practices. Culture and practice are interrelated. Also, Snook examines local practices and how a subunit changes and creates practices to adhere to its own norms but doesn’t necessarily coordinate with the dominant practices of the units they must connect with. So the expected coordinated action is not coordinated. The Black Hawk accident happened because, or perhaps in spite of, everyone behaving just the way we would expect them to behave, just the way rational theory would predict. Snook also points out that, depending on one’s perspective, the slow, steady uncoupling can seem random and dangerous in hindsight.9

  Social Normalization

  Why don’t those involved in organizational drift see what’s going on and correct for it? When norms for behavior shift within an organization, members of that organization can become so accustomed to deviant behavior that they don’t consider it abnormal, despite the fact that it strays far from their own codified rules or principles. The firm’s mission, its reason for existence, is assumed to be implicit in its business principles; it is those principles, together with the firm’s strategic decisions, that drive the actions of employees. Eventually, the execution of the strategy adapts to match incremental changes in the interpretation and meaning of the principles, but the perception remains one of business as usual. It is a complex process with a certain level of organizational acceptance: the people outside recognize the change, whereas the people inside get accustomed to it and do not. And new members accept it as standard practice.

  A number of sociologists have offered explanations as to why organizations drift: scarce resources, misaligned incentives, system complexity, multiple goal conflicts, and more. There rarely is a single moment or event that one can point to as that moment when change occurs, or a single individual that one can point to as the responsible party. Rather, multiple small steps occur over an extended period of time. Therefore, the effects go unnoticed, and norms are continuously and subtly redefined; a “new normal” is established with each incremental step. This is how a succession of small, everyday decisions can produce breakdowns that can be massive in scale.

  Man-Made Disasters, by Barry Turner, originally published in 1978, suggested the possibility of systematically analyzing the causes of a wide range of disasters. The working subtitle of the book was The Failure of Foresight, and in it, Turner gives a very good description of the successive stages that lead to failure, particularly what he calls the “incubation period,” during which the preconditions for disaster develop but go unnoticed.”10 The sequence of events is as follows: (1) A notionally normal starting point where culturally accepted beliefs about the world and its hazards are regulated by precautionary norms set out in rules and codes of practice; (2) An incubation period where the accumulation of an unnoticed set of events is at odds with accepted beliefs about norms; (3) Precipitating events bring attention to themselves and transform general perceptions of the incubation period; (4) The immediate consequence of the collapse of cultural elements becomes evident; (5) The change is recognized, and there is an ad hoc rescue and salvage mission to make adjustments; and (6) Real cultural readjustment occurs, where a serious inquiry and assessment is carried out and cultural elements are adjusted.11

  Lisa Redfield Peattie, a now-retired anthropology professor at MIT, uses the extreme example of the Nazi death camps to describe normalization. (And, no, I’m not comparing Goldman to the Nazis in any way.) The two key mechanisms through which normalization occurs, she states, are “division of labor, which separates, in understanding and potential for collective organization, what it makes interdependent in functioning” and “the structure of rewards and incentives which makes it to individuals’ personal and familiar to undermine daily, in countless small steps, the basis of common existence.”12 Peattie describes how work and daily routines, right down to scrubbing the cobblestones in the crematorium yard, were normalized for long-term prisoners and personnel alike by the division of labor, affording a degree of distance from personal responsibility for the atrocities being committed. People were simply doing their normal jobs and carrying out the normal routines established by those in charge; they had lost sight of all aspects of the big picture.

  Edward S. Herman, a retired professor of finance at the Wharton School who specialized in regulation, borrowed the term “normalizing the unthinkable” from Peattie to describe how once unthinkable acts become routine. Herman explains, “Normalization of the unthinkable comes easily when money, status, power, and jobs are at stake. Companies and workers can always be found to manufacture poison gases, napalm, or instruments of torture, and intellectuals will be dredged up to justify their production and use.”13

  Obviously these are extreme examples, but they are reminders that complicity, obscured by the routines of the work, the division of labor, and distance from the results, is possible even in the most egregious of acts. Herman goes on, “The rationalizations are hoary with age: government knows best; ours is a strictly defensive effort; or, if it wasn’t me, somebody else would do it. There is also the retreat to ignorance—real, cultivated, or feigned. Consumer ignorance of process is important.”14

  Diane Vaughan’s now classic investigation of the decision making that led to the launch of the space shuttle Challenger in 1986 focuses on organizational factors. Vaughan learned that work groups typically develop a concept of “acceptable risk” that becomes part of the culture.15 Managers pay attention to only a few parameters and do not develop a formal, systematic definition of what is acceptable risk for the organization. More troublesome, it is difficult for them to see the full implications of their actions. Deviance from the norm starts to become institutionalized, resulting in “an incremental descent into poor judgment.”16 The acceptance of risk sets a precedent, and it is repeated and becomes the norm. This process mushrooms as the organization becomes larger and more complex. To the outside world, what is going on in the organization may look deviant, but to the work group everything is normal, and people believe they are adhering to what the organization expects of them. Once produced, deviant interpretations are reinforced and maintained by what Vaughan describes as an “institutionalized belief system that shapes interpretation, meaning, and action at the local level.”17

  Initially, the regrettable decision to launch the Challenger and the ensuing tragedy appeared to be a case of individuals—NASA managers—who, under competitive pressure, violated rules in order to meet the launch schedule. But what at first appeared to be a clear case of misconduct proved to be something entirely different: Vaughan discovered that the managers had not violated rules at all, but had actually
conformed to all NASA requirements. Her work revealed, however, that they were also conforming to NASA’s need to meet schedules, which ended up affecting engineering rules about what constituted acceptable risks in space flight technologies and the decisions that were made regarding those risks. She discovered that NASA managers could set up rules that conformed to the basic engineering principles yet allowed them to accept more and more risk. A social normalization of that deviance occurred, meaning that once they accepted the first technical anomaly, they continued to accept more and more with each launch, because to do so was not deviant to them. In their view, they were conforming to engineering and organizational principles. As with practical drift, the normalization of deviance concerns practices.18

  Thus, the first time the O-rings were found to be damaged, the engineers found a solution and decided the shuttle could fly with acceptable risk. The second time that damage occurred, they thought the trouble came from something else. Believing that they had fixed the newest problem, they again defined it as an acceptable risk and just kept monitoring the situation. As they observed the problem recurring with no consequences, they got to the point that flying with the flaw was normal and acceptable. Of course, after the accident, they were horrified.

  Something similar happened at Goldman. There was a social normalization of the change as the culture slowly shifted; the changes were so subtle that everything seemed normal. On a virtually day-to-day basis, normal was redefined. Once the partners normalized a given deviation—a shift in policies related to recruiting, promotion, compensation, underwriting, client relations, risk management—the deviation became compounded. Goldman was experiencing the norm shift described by Diane Vaughan: “When the achievement of the desired goals receives strong cultural emphasis, while much less emphasis is placed on the norms regulating the means, these norms will tend to lose their power to regulate behavior.”19

  Vaughan explains why people within organizations do not pick up on the fact that drift has occurred: “Secrecy is built into the very structure of organizations. As organizations grow large, actions that occur in one part of the organization are, for the most part, not observable in others. Divisions of labor between subunits, hierarchy, and geographic dispersion segregate knowledge about tasks and goals. Distance—both physical and social—interferes with the efforts of those at the top to ‘know’ the behavior of others in the organization, and vice versa. Specialized knowledge further inhibits knowing. The language associated with a different task, even within the same organization, can conceal rather than reveal.”20

  She explains how “structural secrecy” develops within organizations, defining it as “the way that patterns of information, organizational structure, processes, and transactions and the structure of regulatory relations systematically undermine the attempt to know [the extent of the danger]” and the ability of people to make decisions on the basis of that knowledge to manage risk.21 Structural secrecy helps explain how people failed to notice the signs of impending disaster that were present during the incubation period first described by Turner, and it supports Peattie’s and Herman’s ideas regarding the normalization of the unthinkable. Vaughan explains that in the Challenger case, information was filtered as it moved up the chain of command, so people at the higher levels were largely unaware of events that may have been dealt with as “acceptable risk.”22 The managers missed signals because some signals were mixed, some were weak, and some seemed routine. Vaughan concludes that deep-rooted structural factors were responsible for the tragic decision to launch the Challenger. It is important to note that in the case of the Challenger disaster, the cause Vaughn identifies is not deviance from rules and norms, but conformity with them. In the case of Goldman, I have identified organizational drift from the principles, with some signals of that drift having been missed as people conformed to the incremental changes and rationalized their behavior.

  A Framework to Analyze Goldman and Organizational Drift

  Diane Vaughan’s work on the Challenger disaster offers a framework for examining the influences that cause organizations to deviate from “both formal design goals and normative standards or expectations … producing a ‘suboptimal outcome.’”23 Her framework is grounded in her observation that organizational deviation is systematically produced by the impact of the elements of environment and organization.24 Recognizing the commonalities found in organizations, Vaughan examines the interactions between an organization’s structure and processes, influences of the environment within which this system operates, and how both shape individual choice. It is this combination of competitive pressures, organizational characteristics, and regulatory factors, this “dynamic of competition and scarce resources, together with the unclear norms regulating business behavior,” that Vaughan believes “exerts structural pressures on organizations toward misconduct.”25

  To Vaughan’s framework of regulatory, organizational, and competitive pressures, I add technological pressure.26 Appendix B illustrates my adaptation of Vaughan’s causal framework for my analysis of Goldman.27 It highlights the interaction of the causative factors and pressures with key developments affecting Goldman and Wall Street over the past few decades. This appendix can be considered in tandem with the timeline in appendix G, which also identifies selected pressures (competitive, regulatory, technological, and organizational) associated with particular events. The result of the two is a clearer picture of the organizational changes and pressures as they developed over time. In addition, it supports my conclusion that the pressures and changes were happening before the IPO and before Blankfein became CEO.

  While the frameworks set forth by the authors discussed in this appendix offer valuable insights into the process of the drift at Goldman and constitute a promising starting point for analysis, their studies are primarily focused on analyzing organizational failure in retrospect from a specific event. This is different from the Goldman case, because what has happened and is happening is messy and, depending on one’s point of view, could be labeled a variety of things; but more importantly the outcome is unknown. To their analyses, I have added consideration of the role played by residual elements of the organization’s culture and structure that have made the organization successful; these elements may mitigate drift or regulate or impact the various processes. My analysis of Goldman encompasses a period of more than three decades because it is important to evaluate organizational elements and regulatory, technological, and competitive factors dynamically over time and to appreciate how change happens at different paces and with different emphases. My analysis illustrates that the process of change is not as simple as identifying an independent variable that affects a dependent variable in a direct chain of events. Examining the changes over time helps to illuminate how many factors interact in producing the change.

  Appendix B

  Analytical Framework Applied to Goldman

  Diane Vaughan’s analytical causal framework examines three main pressures—environmental and organizational (for simplicity, “organizational”); regulatory; and competitive—to analyze change over time.1 In order to analyze Goldman, I utilize Vaughan’s framework and add technological pressure.

  When the framework is applied to Goldman, as shown in Table B-1, the result illuminates changes more clearly over time. Even though the changes are presented in temporal sequence from 1979, when the firm’s business principles were written by John Whitehead, to today and are divided by who ran the firm or oversaw major changes, this is only for simplicity of presentation. The changes are related to each other, impact each other, and compound each other and have varying degrees of importance and significance. I selected 1979 because that is when the principles were written; 1990 because that year was when John L. Weinberg retired as senior partner (Whitehead had left in 1984); 1996 because it marked the legal structural change to a limited liability corporation; 1999 because it was the year of the IPO; and 2012 because it is the current year as this is written.

  To h
elp the reader understand the chart, I will give at least one example illuminated for each pressure.

  Organizational pressure: Goldman’s legal structure changed from a private partnership with full personal liability and illiquidity until retirement, to a limited liability private company with liability capped at the capital in the firm, and finally to a public company at the IPO with the liability capped at the capital in the firm, but with liquidity for shareholders. The firm changed from being completely privately held, to taking outside private capital, to taking outside public capital. The ownership changed from 100 percent Goldman partners to around 10 percent Goldman partners.

  Regulatory pressure: Goldman operated under Glass–Steagall before the law was repealed in 1999 through the Gramm–Leach–Bliley Act. In 1970, the NYSE changed a rule allowing investment banks to become public.

  Competitive pressure: The tech boom, the alternatives (hedge fund and private equity) boom, foreign competitors entering the US market, and US commercial banks were all factors that increased the search for talent. This impacted Goldman’s ability to attract and retain not only the best people but also people with the same values. The firm added a new level of executives, known as managing directors, in part to offer people a comparable title. The firm changed certain business practices in order to maintain and grow market share (e.g., no hostile raids, underwriting standards requiring at least three years of profits, and no gambling clients).

  Technological pressure: Technology made information more of a commodity, impacting the ability for people to add value to clients. Technology added transparency to markets, lowering profitability margins and emphasizing scale.

  Under the time frames, I provide some data to illustrate the changes in business mix. It’s important to keep in mind that before 1999, Goldman was a private firm and therefore not required to make certain information public.