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Friday, May 27, 2011

Earmarks and Congressional Campaign Fundraising: A Structural Conflict of Interest

In 2009, Congress appropriated $16 billion in earmarks. In March of the following year, the U.S. House of Representatives eliminated earmarks to for-profit companies. However, enterprising managers soon found a way to get around the new obstacle by creating related non-profits. As long as companies can make political contributions to Congressional campaigns, there will be a structural conflict of interest in the legislators legislating on earmarks.  

In Rep. Marcy Kaptur’s (D-OH) district, for example, a defense contracting company incorporated a nonprofit organization, the Great Lakes Research Center, at the same address and doing the same work. The center received earmarks of $10.4 million to sell the Pentagon small hollow metal spheres for body armor. Kaptur, who had received tens of thousands of dollars in campaign contributions from the owner’s family and the company’s lobbyist told the media that the center “met the requirements of the Reform.” If this is true, the reform was in effect nugatory—so one might ask: why did the House go to the trouble unless for the short-term PR benefit?

There is a deeper problem in even the appearance of a conflict of interest wherein a lawmaker has a role, whether direct or indirect, in money going to an organization that has contributed to the lawmaker’s campaign. The conflict is structural, rather than hinging on an individual’s personal use.  That is to say, the relationship between legislating on earmarks and campaign finance does not depend on the particular interests of individual legislators; rather, the conflict of interest is in the arrangement itself wherein companies benefitting from earmarks are allowed to contribute to electoral campaigns of candidates or office-holders in the legislative body. Such a body may want to consider legislating to obviate structural conflicts of interest involving it. Otherwise, members will be continually subject to pressure to unethically use their offices at the expense of their obligation to their constituents as a whole.

Click to add a question or comment on the structural conflict of interest involving earmarks and Congress.

Source: Eric Lipton and Ron Nixon, “Companies Find Ways to Bypass Earmarks Ban,” The New York Times, July 5, 1010, p. 1A. 

Related Essay: "Institutional Conflicts of Interest"

A Structural Conflict of Interest in Deutche Bank: Beyond Proprietary Holdings

While creating and selling mortgage-based securities to some of its clients, Deutsche Bank AG was not only advising other clients to bet the other way, but also sometimes doing it itself, according to the Wall Street Journal. A trader at the bank would help create an index that made it easy for the bank to bet against housing even as sales people at the bank were selling the securities as if there were no downside to the American housing market. Then some of the tax-payer money was paid by the US Government to AIG to reimburse Deutsche’s hedge-fund clients who had bought the mortgage securities. American regulators looked at whether there were misrepresentations made to the hedge fund managers who bought the mortgage-backed securities even as Deutsche Bank was betting against the housing market.

The structural conflict of interest wherein a bank’s interest is antipodal to that of its clients raises the specter of misrepresentation. A spokesperson for Deutsche said, "We served clients whatever their investment objective, but only after being satisfied that they had arrived at their view after thorough consideration.” Furthermore, although Deutsche made tens of millions of dollars betting against the housing market, overall it “maintained a net long position in the housing market and ultimately suffered billions in losses, even after factoring in our hedges and offsetting positions.”  The more even proprietary position would relieve the bank of the conflict of interest; it is where the bank’s own position is skewed dramatically in one direction while it sells to clients in the other that at the very least the appearance of a conflict of interest arises. 

One way out of the problem is to severely limit proprietary trades to those that are needed for clients (i.e., to manufacture a counter-party for a transaction desired by a client rather than the bank itself).  A second way out may have been illustrated by Deutsche Bank. Specifically, a bank can hold a relatively balanced proprietary position such that the bank itself does not have an interest in the market going one way or the other. However, even with a balanced position, bankers can believe that a market will go down and lie to potential clients in order to sell long. 

For example, the Wall Street Journal reports that Deutsche trader Greg Lippmann encouraged an investor to go short against subprime bonds, telling him, “you should get some [courage] and do some shorts” because “these bonds are going much lower.” Deutsche, however, continued to market new mortgage-bond deals predicated on the mortgage-securities market staying strong. The next day, M&T Bank of Buffallo, New York paid $82 million into a Deutsche deal known as Gemstone 7. Within ten months, the company had lost 98% of its investment. 

A Deutsche spokesperson claims that employees bearish on the housing market had spoken at client meetings to make their views known and there is no indication that Lippmann was among those in sales urging clients to buy.  Even so, it would be odd were M&T managers willing to sink so much money into mortgage bonds after being told that the bonds would go much further down. Even if the bank’s proprietary interest was balanced, the information it had on the housing market went against its profit-motive in sales, so there may have been a conflict of interest even without a proprietary position to back it up. 

Telling M&T managers that the “underlying structures in these bonds are built to withstand” adverse conditions shortly before the value of M&T’s holdings go from $82 million to $1.9 million strongly suggests that Deutsche’s bankers were at the very least incompetent. Given Lippmann’s email, there is evidence that Deutsche bankers knew that the bond’s underlying structures were vulnerable.  Withholding information in order to lie in order to profit is of course fraud. My point is that it can be looked at as a structural conflict of interest between one’s belief in one’s opinion and one’s profit-motive that can exist even where there is no (or a balanced) proprietary financial interest.

Click to add a question or comment on a structural conflict of interest in Deutsche Bank.


Carrick Mollenkamp and Serena Ng, “Dual Role in Housing Deals Puts Spotlight on Deutsche,” The Wall Street Journal, August 3, 2010, p. A1.

Related essay: "Institutional Conflicts of Interest"

When Corporate Governance Gets Cozy: Chair/CEO Combo as a Structural Conflict of Interest

Eric Jackson, an activist investor and hedge fund manager, charged Goldman’s board as being too cozy and too lacking in financial know-how to diligently oversee the top management. He claimed the board was packed with honchos who led companies that had paid large fees to Goldman. Allowing clients representation on a board is itself a structural conflict of interest because the client role is not in line with acting in the stockholders’ interest on the board. The hedge fund manager pointed to Indian steel magnate Lakshmi Mittal and former Fannie Mae chief James Johnson as cases in point. Related to the client orientation is an affinity to the management, whose managerial decisions bear on the clients. Indeed, Jackson noted that “these people seem to be favorably disposed to senior management’s way of thinking,” and are therefore unlikely to act as a check on CEO Lloyd Blankfein and his team.

Colin Barr of Fortune argued that Goldman’s system of corporate governance was behind the times. He pointed out that Lloyd Blankfein continued to serve as chairman and CEO, even as the trend in recent years had been toward independent board leadership and thus away from one person holding the dual roles of chair and CEO. Combining these roles by having them held by one person simultaneously evinces still another structural conflict of interest. According to Business Ethics for Dummies, “In terms of structure, many corporate governance experts believe that the CEO of a public company should not serve as chairman of the board because the position can give the CEO undue influence over other directors” (p. 325). In fact, the experts “recommend that at least the majority of a corporate board’s directors should be outsiders” as a matter of policy as a check against a CEO’s influence (Ibid.).

One of a board's main functions is to oversee and evaluate the CEO as well as the other top executives. A CEO who is also chair of the group whose job it is to evaluate the CEO is presuming to evaluate him or herself, in effect. The sheer existence of such an obvious conflict of interest can be viewed as presumptuousness itself surrounding such a figure. That is to say, “I presume to be a check on myself, institutionally. I’m that good.” Furthermore, the arrangement itself is an incentive to engage in duplicitous subterfuge, using the board as cover for engaging in a recklessly risky strategy.

A board of directors is by definition independent of the management because the board’s function is to oversee it.  Overseeing and being cozy are like oil and water.  A “trend” away from conflating the two minimizes the decadence in the problem.  Instead, corporate governance ought to require independence.

When Armstrong was chair/CEO of ATT, I asked him whether giving up the chairmanship wouldn't enable his board to better evaluate him as there would not be the suspicion of a conflict of interest. He replied as though he were president of the United States, saying "the buck stops here."  He went on to say that he had to have complete control or he could not rightly be blamed if his strategy (which was broadband at the time) didn't work.  If his board said no to part of his strategy, it would not be fair to blame him for the failure of his entire strategy. Of course, he could have presented his strategy to his board and if it objected to part of it, the resultant strategy, it could be agreed, would not be considered to be his; he would be evaluated on how well he implemented it.

The notion that any sort of check on power renders the power compromised or impotent ignores the basic difference between a board and a management. Managers work within broad strategic guidelines that are set as a matter of policy by a board, and managerial implementation can indeed be evaluated without compromising it.  In effect, Armstrong wanted to go beyond managing to the property-rights goal-level of owning.  That he was overreaching is all the more reason why an independent board would have been a valuable commodity for ATT.

To be sure, it is difficult to counter the influence that a management has on account of its position vis á vis the company and its board. As a starting point, people having former ties to the management—or even hand-picked by the CEO—ought to be barred from serving as directors. So too should existing customers. Furthermore, a CEO ought to be barred from serving as the chair of the board. Conflating the two roles is tantamount to suggesting that a CEO can (and should) oversee himself, which is nonsensical.

For there simply to be a mere trend away from this duality essentially “normalizes” that which ought to be approached as an oxymoron--a contradiction in terms. That such a phenomenon would be allowed to exist in the first place points to the power that CEOs have had. That society (and government) have accepted it (or looked the other way) attests to the stature of the modern CEO, allowing the occupants to define social reality for themselves, their companies, and even society as a whole. Such power is very dangerous, especially if left unchecked even if ostensively justified by "the buck stops here." Power itself can be an intoxicant, and thus ought to be checked institutionally rather than left to the whims and caprice of the powerful.


Colin Barr, “Why Goldman Should Overhaul Its Board,” CNN Money, April 20, 2010.

Norman Bowie and Meg Schneider, Business Ethics for Dummies (Hoboken, NJ: Wiley, 2011).

An Institutional Conflict of Interest at the New York Federal Reserve

According to The New York Times, even after taxpayers rescued Citigroup, regulators at the New York Federal Reserve failed to monitor the company adequately. The regulators, although adequately staffed and proficient in training, failed to move swiftly as the bank’s financial condition deteriorated from as early as 2005, and were overly optimistic about the bank’s prospects as late as December, 2009. From 2006 to 2007, decisions on poorly underwritten loans were changed from “turned down” to “approved.” As many as 80 percent of the loans that Citigroup sold to Fannie Mae, Ginnie Mae and other investors were defective. “Although the dedicated supervisory team is well-qualified and generally has sound knowledge of the organization, there have been significant weaknesses in the execution of the supervisory program,” according to one excerpt of the 2009 review. Tim Geithner, who as president of the New York Fed from 2003 to 2008 was in charge of overseeing Citigroup, went on to become the US Secretary of the Treasury.

In questioning a panel testifying before the Financial Crisis Inquiry Commission on April 7, 2010, Brooksley E. Born, the former regulator in the Clinton administration who had lost the battle over derivatives regulation to Alan Greenspan, Robert Rubin, and Larry Summers, called on Greenspan in his testimony to defend his longtime deregulatory bent. “The Fed utterly failed to prevent the financial crisis,” she said. She went on to claim, “The Fed and the banking regulators failed to prevent the housing bubble. They failed to prevent the predatory lending scandal. They failed to prevent our biggest banks and bank holding companies from engaging in activities that would bring them to the verge of collapse without massive taxpayer bailouts… . Didn’t the Federal Reserve fail to meet its mandates, fail to meet it responsibilities?” Greenspan replied that there was a failure: an underestimation of the “state and extent” of financial risks and the ability of private counterparties to assess them, but he added that, “(t)he notion that somehow my views on regulation were predominant and effective at influencing the Congress is something you may have perceived,” he said. “But it didn’t look that way from my point of view.” However, according to other accounts, the trioka of Summers, Rubin and Greenspan had gone after Born for wanted to regulate the derivatives (see, for example, Sorkin’s Too Big To Fail). The three did indeed lobby Congress in an effort to sabatage Born’s proposal. Besides reporting this, Sorkin also points out that Citigroup’s CEO and its major stockholder were instrumental in getting Geithner appointed as President of the New York Fed. Is this a coincidence with the overly optimistic view of the Fed’s regulators regarding Citi?

In questioning Robert Rubin on April 8th, Born (and other commissioners) asked why derivatives were kept unregulated. Rubin replied that the bankers were strongly opposed to such regulation, and they were able to effect their stand in Congress. Rubin did not go into the efforts of him, Summers and Greenspan to lobby Congress to keep the instruments unregulated; instead, he claimed that he favored regulating the derivatives even when he was at Goldman Sachs supervising the bank’s trading desk, and that when at Treasury he was merely concerned that regulating the instruments under the existing regulatory structure could cause delaying legal challenges. While Rubin’s frankness concerning the influence of the bankers in the US Government is useful, his testimony regarding himself seems less than forthcoming. Presumably he could have lobbied Congress as the Treasury Secretary for a new regulatory authority to regulate the derivatives on a solid legal basis. Instead, he lobbied against Born’s efforts to get the instruments regulated. He admitted that the financial sector would have been strongly opposed to such a regulatory authority. Also, he had been on the board of Citigroup and an executive at Goldman Sachs. The conflict of interest is too strong in his case for his asseverations that he had always acted in favor of regulating the instruments to be believable. His “worry of legal challenges” strikes me as a technical excuse that he was using as a subterfuge to “explain” his opposition to Born’s efforts to regulate the derivatives. Doubtless he could count on the American public and its media for not digging sufficiently to expose his duplicity. That is to say, it is likely that Rubin got away with protecting his ex-bank’s interests when he was Secretary of the Treasury and was strategically able to come off as having advocated the public interest all along. Hence, in general, the culprits were able to maintain their credibility and position themselves to be the officials we turn to fix the problem.

The influence of the bankers in the halls of government (and its central bank) is perhaps the cause of the Fed’s deficiencies in regulating Citigroup (and in the Clinton Administration’s position against regulating the sub-prime mortgage derivative securities). In the case of the New York Fed, the board that appoints the NY Fed President consists of Wall Street bankers. There is a structural conflict of interest in having the regulated appoint the regulator. This structural conflict of interest manifested itself materially in the case of Tim Geithner and Citigroup. This is a textbook example of a conflict of interest, and yet it went under the radar screen. The focus in regulatory deficiency is typically instead on whether the regulators are sufficiently staffed and trained, and perhaps on whether they are relying too much on information from the regulatees. The more basic structural conflicts of interest are rarely made transparent, yet we will continue to see regulatory “deficiencies” manifest from them unless structural or institutional reforms are made.

Click to add a question or comment on the institutional conflict of interest involving the NY Federal Reserve Bank.


Sewell Chan and Eric Dash, “Fed Reviews Find Errors in Oversight of Citigroup,” The New York Times, April 7, 2010.

CSPAN Television.

Related essay: "Institutional Conflicts of Interest"

Rating Moody’s and S & P: A Structural Conflict of Interest

For years, banks and other issuers have paid rating agencies to rate their securities. This is a bit like restaurants paying food critics to write on their food.  In the wake of the SEC’s charge that  people at Goldman Sachs built the Abacus investment to fall apart so a hedge fund manager, John A. Paulson, could bet against it, the Senate’s Permanent Subcommittee on Investigations questioned representatives from Moody’s and Standard & Poor’s about how they rate risky securities. Carl M. Levin, the Michigan Democrat who heads the Senate panel, said in a statement: “A conveyor belt of high-risk securities, backed by toxic mortgages, got AAA ratings that turned out not to be worth the paper they were printed on.” Throughout the testimony, the institutional conflict of interest was salient whereby credit-rating agencies put market-share considerations foremost in rating securities presented by the banks that are paying the agencies.

A banker at J. P. Morgan went so far as to communicate to one of the agencies that the agency’s ratings should reflect market-share considerations.  Essentially, the bank was reminding the agency that the bank was a client. To be fair, the agency replied that such considerations are not part of the ratings process.  However, the testimony before the committee suggested that the reality has often been quite otherwise. The upper managements of the agencies in particular regularly pressure their ratings analysts to rate in such a way that the agency’s market share does not suffer.  In other words, the message is: “Rate so we don’t lose any clients.”

In fact, the agencies even shared their models with the banks.  As a result, the banks could game the models so the securities would get high ratings.  To be sure, there was also fraud involved, such as making it seem like the mortgages in a CDO came from different servicers or different regions of the US.  Some bankers relabeled parts of collateralized debt obligations in two ways so they would not be recognized by the computer models as being the same. Others were also able to get more favorable ratings by adding a small amount of commercial real estate loans to a mix of home loans, thus making the entire pool appear safer. “If you dug into it, if you had the time, you would see errors that magically favored the banker,” said one former ratings executive.  The asymmetry was no accident, for there is an underlying structural conflict of interest at the core of the ratings system.

The actual clients–the general public that relies on the ratings–are not the parties paying the agencies.  Also, the agencies get more when their ratings are higher because more of the underlying securities are sold.   To demand that an agency be independent of the “client” paying it is to place the agency in a structural or institutional conflict of interest that cannot be effectively remedied by subjecting the agency to higher regulatory standards. Worse still, often times the underlying structure is ignored.

Although not made transparent in the Senate hearing, I want to point to the assumption that the agencies would be able to handle their conflict of interest, even in the face of rising pressure for profits as increasing attention was directed to their stock prices. There seems to be a belief in American society that businesses can rise to the occasion when a structural conflict of interest is involved.  In other words, we tend to mitigate the force of such ethical dilemmas, essentially assuming that human nature can be relied upon to surmount them.  Even in the committee testimony, former employees from the rating agencies suggested that common regulatory standards for rating, similar to the FASB standards in accounting, would suffice. This is actually a rather poor choice of comparison, for the public accounting profession is rife with its own conflict of interest that has thus far been shoved under the rug.  One need only look to Arthur Andersen in giving the go-ahead to Enron’s use of “unrelated” partnerships to hide debt or to Arthur Young knowing of the Repo 105 device at Goldman Sachs to question whether using regulatory standards goes far enough.

Institutional conflicts of interest are not solved by common regulatory standards because they too can be gamed. The incentives have not been changed, so we can expect the pent-up water to eventually make its way through the muddy dams we construct.  In both public accounting and securities rating, the “independent” assessors cannot be paid by the institutions whose books or products are being assessed.  The unwarranted assumption that turning these functions over the government is the only alternative adds to the easy decision that simply creating or tweeking regulatory standards must suffice.

As an alternative to having the government rate securities, the financial industry as a whole could be required to contribute to a pool that would fund the rating agencies. The SEC would assess the agencies periodically and decide how much each would receive.  Essentially, the government would be the umpire rather than perform the rating function itself.  As long as the banks do not capture the SEC (which is another problem in need of a solution), those private actors would not be able to pressure the rating agencies.  It might be suggested that industry self-regulation could work. That is, the banks altogether would assess the rating agencies.  However, this alternative would simply allow the banks to collude to pressure the agencies.  We ought not replace the government with one of the teams in performing the role of umpire.

It is unlikely that Congress will go beyond mandating stricter disclosure statements and allowing plaintiffs to sue the agencies. On May 18, 2011, the SEC proposed rule changes bearing on the rating agencies as per the Dodd-Frank Act of 2010. The changes bearing on the conflict of interest include mandating that the rating agencies have effective internal control structures governing the way in which the credit ratings are determined (See Section 932 (a) (2) (B) of the Act). The Act forbids the agencies from taking into account "sales and marketing" considerations. Accordingly, no employee can serve in the dual functions of sales or marketing of a product or service and determining or monitoring a credit-rating.

However, it was clear from the Senate hearing on the agencies in 2010 that the CEOs had pushed employees who determined or monitored the credit-ratings to rate some of the sub-prime CDOs as AAA. A firewall does not extend to a CEO, who can use the "good of the whole organization" rationale to decide in the direction of sales at the expense of determining authentic credit ratings. It is folly to suppose that separating departmental-level employees and improving internal control systgems can trump the incentives proffered by the issuer-pays system. Essentially, the Dodd-Frank Act does not deal with the underlying problem occasioning the structural conflict of interest.

Within the fecklessness of Congress in extracting the structural conflicts of interest from the rating function is a fear that tampering with it might risk the salubrity of the credit markets.   Under this logic, riding the ratings function of a structural bias would somehow compromise the function because the public might get a true look at the lack of credit-worthiness of some of the securities currently deemed credit-worthy. An illusion is thought better, or more expedient, than a solid economy. Besides the dubiousness of such reasoning, there is the argument more generally that we can’t afford to tamper with our financial system as long as it is still at risk.  However, before assuming power, Barak Obama argued that the only time when real change can happen is during a crisis–while the forces of the status quo are temporarily marginalized.   So it would seem that we are in a catch 22–or, more accurately, we have put ourselves in one.   In actuality, riding our financial system of institutional conflicts of interest would strengthen rather than risk our economy.

I suspect that the true reason why neither the ratings nor the public accounting structural conflicts of interest have been removed goes beyond our collective ignorance of the nature of an institutional conflict of interest.  As Dick Durbin said after the  banking industry scuttled foreclosure reform, “the banking industry owns Congress.”  Apparently it owns the credit-rating agencies too, as well as the public accounting firms. The wolves are paying the guards of the chicken coop.  Regulating the pay does not go far enough; we need to address the question of the payer.  Until we do so, we are bound to keep scratching our heads as chickens continue to come up missing.

Click to add a question or comment on the institutional conflict of interest involving rating agencies.


Gretchen Morgenson and Louise Story, “Rating Agency Data Aided Wall Street in Deals,” The New York Times, April 23, 2010.

David Segal, “Debt Raters Avoid Overhaul After Crisis,” The New York Times, December 7, 2009.

Related essay: "Institutional Conflicts of Interest"

Morrison/Foerster, "SEC Proposes New Rules and Amendments to Implement: Dodd-Frank Provisions Concerning Nationally Recognized Statistical Rating Organizations," Newsletter, May 26, 2011.

Paper Tigers: Firewalls Forestalling Institutional Conflicts of Interest

Structural, or institutional, conflicts of interest are of great significance in applied ethics, even though they often play second fiddle to the conflicts centered on a person’s particular interests. An organizational or institutional conflict of interest, whether within one organization or in the arrangements between organizations, is not any less unethical than a personal conflict of interest.  Therefore, when we take the claims of vested organizational interests that their internal firewalls are more than just paper tigers at face value, our foolhardiness can really be at our detriment. I present a few cases to suggest that “firewalls” in an organization to prevent it from a conflict of interest are, in general, insufficient and thus ought not be relied on. Instead, the public (or government regulatory agencies) should insist that one of the two interests in an institutional conflict of interest be given up.

In the E.U., the European Commission (the executive branch of the E.U. Government) sued four elevator companies that were part of a cartel in Belgium and Luxemburg.  Essentially, the Commission was seeking anti-trust damages—a first in EU jurisprudence.  Benoit Allemeersch, attorney for one of the companies, argued that the jurisdiction of the commercial court of Brussels, the Tribunal of Commerce, violated the jurisdictional clauses in the contracts between the companies and the Commission. 

Allemeersch argued that the Commission acted as “police officer, prosecutor, jury and sentencing judge” in finding the existence of a cartel, and then used its own decision to make a private claim for itself before the commercial court. He maintained that “the mere statement by the Commission that they respected their own ‘Chinese walls’ in making their decision and bringing the claim is not a sufficient guarantee to the defendants nor to any other citizen.” He claimed that in the case being argued, there was no “equality of arms” between the two sides, given the commission’s privileged position. He added that “the European Court of Human Rights requires that justice is not only done, but is also seen to be done.”  In other words, even the appearance of a conflict of interest, which can be in an institutional arrangement even if not acted upon, is enough to dismiss claims. The existence of “firewalls” within an organization does not sufficiently mitigate either the dismissal or, more generally, the institutional conflict of interest.

Even though the commission had previously argued that its own “Chinese walls” ensured the independence of the claim, Allemeersch correctly maintained that these safeguards could not be proven, tested or substantiated. I contend that his counsel is correct. Even if the Commission could show policies and procedures that act as its safeguards, such internal guidelines do not have the force of law and thus are insufficient to be relied upon—especially by external parties.  It cannot be assumed, moreover, that an organization’s policies and procedures outweigh whatever internal interest happens to be dominant in the organization, given the nature of power to overflow its boundaries.

To say that the most powerful person a room is constrained by parchment alone is to be woefully ignorant of the reality of human nature.  Even if there are two equally-powerful people in the room with antipodal objectives, institutional checks and balances can only work as long as too great of a power imbalance does not exist.  If a U.S. President is intent on invading a country, for example, and the Congress does not have sufficient power over his, the separation of powers institutionally could not be counted upon to keep Congress from rubber-stamping the President’s declaration of war.  For the President to be able to effectively declare war while being the commander in chief of the U.S. army and those of the union’s republics is itself a structural conflict of interest.

Essentially, I am making a Nietzschean and Hobbesian argument that the most powerful person in the room is not apt to be constrained by invisible ”firewalls” in the room that are intended to level the powers of that person and a weaker person.  As Nietzsche writes, the strong must be strong and the weak cannot be other than weak.  To ask the strong to be weak or treat the weak as though it were strong goes against the nature of power.  In my analogy of the room, the two persons can represent heads of departments whose respective goals are at odds with each other.

A “firewall” of policies and procedures is not sufficient to inhibit the more powerful head from pressuring the other.  Furthermore, the existence of a person whose authority includes both departments relativizes the firewall.  To bring in this element, I turn to the roles of rating agencies and Goldman Sachs in the American financial crisis of 2008.

In the case of Goldman, the bank sold what its salespeople referred to as “crap” because the bank’s own proprietary position profited by the sales. In the case of the rating agencies, they were paid by the issuers of the securities that they were rating.  That either of these two institutional conflicts of interest were allowed to exist at all points to a proclivity among the general public to relegate or ignore institutional conflicts of interest—focusing instead on individual-level conflicts of interest, such as an employee of a purchasing department choosing his wife’s company as a major vender.

In listening to and reading about the banks and rating agencies culpable in the American financial crisis, I had severe reservations regarding the “firewalls” argument proffered by the rating agencies.  The CEO of Moody’s for example, stated in Congressional testimony that he placed an equal emphasis on market-share and the quality of the ratings.  However, several of his former employees testified that they had been pressured not to lose a client to a competitor.  They stated that when ratings were changed, it was typically to protect the firm’s market-share (i.e., out of fear of losing the issuer).  The CEO’s faith in his own equipoise based on his firm’s “firewalls” was mistaken, even if he didn’t realize the canard.  To be sure, he may not have been aware of a more-powerful department putting such pressure on a less-powerful one.  It is possible, however, that the CEO was actively pushing his subordinates behind the scenes for more market-share, essentially profiting from the conflict of interest in the issuer-pays system.

In general, because an organization has at least one position whose authority is above the departments being separated by a firewall, it is possible, even legitimate in terms of that position’s authority, for that official to put pressure on one side of the wall to capitulate in the interest of the whole (i.e., the entire organization).  A CEO, for example, is supposed to make judgments between the competing interests of different departments. It could be that acting contrary to a firewall is in a company’s short-term (and even medium-term) financial interests (as well as in the CEO’s personal vested-stock interests—which bring in an individual-level conflict of interest). The loss of reputational capital from a pattern of relegating an internal firewall may be realized long after even the current stockholders have traded their shares; stockholders do not pay for any cost to society from the breached paper wall.

Consider, for example, Lloyd Blankfein, who was CEO of Goldman Sachs at the time of the financial crisis.  He was over both the market-making and proprietary-trading units.  He could therefore have put pressure on the units selling securities to do so in a way that complements the bank’s own proprietary holdings.  For example, he (or his VP’s) could have pushed shorting sub-prime mortgage-backed derivatives in market-making (the clients taking long positions) because the proprietary interests of the bank would benefit from a fall in the housing market.  The bank’s sales people did indeed clients to go long even as the bank itself was going short in the belief that the housing market bubble was headed for a hard landing. 

Before a US Senate committee, Blankfein claimed that the market-making and bank’s trading on its own books were unrelated unless the bank took out a position on its books as a counter-party needed by a client.  However, the bank sold clients on taking long rather than short positions on the housing-based securities even as the bank was taking a net short position on its own books above and beyond what was necessary to be a counter-party to its clients’ transactions.  This conflict of interest manifested in the duplicity involved in selling clients on what the sales people knew privately was “crap.”  As one of them wrote, if the clients knew the bank’s reason for going short, that would interfere with the bank’s ability to profit from the shorts.  Structural conflicts of interest are designed such that there is an incentive in favor of duplicity. Given a company’s overall interest and the fact that senior managers have authority over the entire firm, firewalls should not be relied upon by outside parties (or by those inside).

In the end, given the nature of human beings and power, we ought not be blindsided by claims of the efficacy of paper “firewalls.”  We ought not assume that the most powerful person or coalition in an organization will necessarily be voluntarily restrained by a weaker party in the same organization.  Moreover, we ought to take more seriously institutional or structural conflicts of interest in how we design and reform arrangements between institutions.  Where the status quo contains a structural conflict of interest, that condition ought to be put on a limited lifeline, with a deadline set for changing the arrangements.  Even if the alternative is not as efficient (it would doubtlessly not be flawless), it would be better than the status quo.  Charges of an institutional conflict of interest can be treated as red flags that instantly move to the front burner on people’s agendas.  We need not be hoodwinked by the duplicitous and self-interested into believing their asseverations concerning their own paper “firewalls.”

Click to add a question or comment on the efficacy of organizational firewalls.

Related essay: "Institutional Conflicts of Interest"

A Structural Conflict of Interest in BP

Mark Bly, BP’s head of safety and operations, released on September 7, 2010 an internal report blaming not only the company, but also its partners for the Deepwater Horizon rig explosion and oil spill. A spokesman at Transocean quickly lashed out, calling it a “self-serving report” that minimized what was critical: BP’s “fatally flawed” well design. Behind the self-serving aspect was a larger conflict of interest—one premised on the structure of two functions: an “objective” investigation and efforts to minimize legal damages.

“Over a 40-minute period,” for example, “the Transocean rig crew failed to recognize and act on the influx of hydrocarbons into the well,” the report states. A BP spokesman declined comment on whether BP staff were also supposed to be monitoring the pressure. Companies such as Royal Dutch Shell monitor all their wells in real time from central locations. Also, the “unstable” cement mixture used by contractor Halliburton allowed hydrocarbons to leak into the well, the report said. However,  BP managers decided to use a long production string rather than a casing tie-back, decreasing the number of barriers to gas flow. Plus, BP employees neglected to run a cement bond log (CBL) to test the integrity of the cement. They installed fewer than one third of the recommended number of centralizers, dramatically increasing the risk of cement channeling and gas flow Failing to conduct a complete “bottoms up” circulation of the well to insure the quality of the cement seal. Lastly, they did not run a lockdown sleeve to secure the production string to the well head, eliminating yet another barrier to a blowout.

In his report, Bly defended the well’s design, which has been criticized by industry experts. “The investigation team reviewed the decision to install a 97/8 in. x 7 in. long string production casing rather than a 7 in. production liner, which would have been tied back to the wellhead later, and concluded that both options provided a sound basis of design.” To relegate or ignore the contributing factors of design while pointing to Halliburton’s “unstable” cement mixture suggests a subterranean motive. A likely candidate is minimizing damages from the many legal challenges facing BP. 

Mark Bly was essentially trying to spread the blame in order to spread the damages so his company could limit its losses from the well explosion. Such a purpose deviates from BP’s commercials wherein BP managers protest that they are doing everything they can to take responsibility for the disaster. Even as BP’s media blitz was extolling the company’s responsibility, claims were being so scrutinized that the US Government pressured the company to allow an independent party deal with the claims. Sadly, some people are doubtlessly being taken in by the commercials. Just being on the air proffers a certain degree of legitimacy. It is more difficult to discern how a report is being used. To expect a company to suddenly lose sight of its profit-motive is to be blind to the conflict of interest involved in this case.

In short, a company claiming to do an objective investigation even as it is seeking to minimize legal damages is a structural conflict of interest; the investigation is apt to be biased in order to minimize damages because the company has a stronger interest in minimizing damages than in getting at what really happened. The ethics officer at BP should have blown the whistle on the company’s determination to do both. Moreover, the media should have blown the whistle on the company's conflicted functions rather than blindly accept the company’s asseverations that it could viably do both without the one caving into the other. Even had the media put pressure on BP to give up the pretence of both, I suspect that BP still would claim to have done both--as if the internal firewall should be relied on by society (and the firm). I'm afraid that when it comes to structural conflicts of interest, we as a society are too gullible—too willing to discount such conflicts of interest when a vested interest claims that such a conflict does not apply to it.

Click to add a question or comment on the structural conflict of interest in BP.

MSNBC.com, “Transocean: BP Probe ‘Self-Serving’ and Misleading

See related essay: "Institutional Conflicts of Interest"

Thursday, May 26, 2011

The U.S. Supreme Court Deciding Federalism Cases: A Structural Conflict of Interest

Regarding the US Supreme Court being the decider of last resort, Madison’s Report of 1800 reads in part, “this resort must necessarily be deemed the last in relation to the authorities of the other departments of the government; not in relation to the rights of the parties to the constitutional compact, from which the judicial as well as the other departments hold their delegated trusts.”  The government being referred to is the U.S. The parties to the compact are the states.  Therefore, the theory here is that the U.S. Supreme Court can have its say after the U.S. President and the Congress, but not as binding on the States.  John Breckinridge, who sponsored the Kentucky Resolutions in the Kentucky House, wrote, “Who are the judiciary? Who are they, but a part of the servants of the people created by the Federal compact?” (Kilpatrick, p. 75). The Federal Courts are part of the US Government that was created by the states, so those courts can’t be the final deciders with respect to the states.

Historically, nullification of US Law by a State has been urged by some (such as by South Carolina in 1832). In his book, Nullification, Woods argues that the Virginia and Kentucky Resolutions of 1798, the Report of 1800, and the Kentucky Resolutions of 1799 hold that the federal government had been created when sovereign states granted it a few enumerated powers. Also, should the federal (general) government exercise a power it had not been delegated, the states ought to interpose.

The Virginia Resolutions of 1798 read in part, “the powers of the federal government, as resulting from the compact, to which the states are parties.” The Kentucky Resolutions of 1799 read in part, “that the general government is the exclusive judge of the extent of the powers delegated to it, stop nothing short of despotism; since the discretion of those who administer the government, and not the constitution, would be the measure of their powers: That the several states who formed that instrument, being sovereign and independent, have the unquestionable right to judge of its infraction; and that a nullification, by those sovereignties, of all unauthorized acts done under colour of that instrument, is the rightful remedy” (Woods, p. 50).

It seems to me that there is indeed a conflict of interest in having the US Supreme Court be the umpire of conflicts between the federal and state governments.  However, nullification presumes that the states did not cede part of their sovereignty.  In other words, were nullification to be allowed, there would be no compact, as any state could exempt itself from any federal law it didn’t like under the claim that the law exceeds the enumerated powers. The states are semi-sovereign, so there must be a means of holding them against their will.

I contend that the final decider of contests between the U.S. Government and any of the states should be composed of judges selected from the state supreme courts. That way, the conflict of interest would be eliminated and an individual state could still be held against its will. In other words, we need not succumb to either the hegemony of the U.S. Supreme Court whose members are selected and paid by the US Government, or to the destructive effects of nullification on the federal compact itself.


Thomas Woods, Nullification: How to Resist Tyranny in the 21st Century (Regency, 2010).

James J. Kilpatrick, The Sovereign States: Notes of a Citizen of Virginia (Chicago: Henry Regnery, 1957).

Institutional Conflicts of Interest

Although conflicts of interest do not inevitably lead to unethical conduct, they raise the probability that it will occur. Just as a tornado watch indicates that conditions are favorable to the formation of a twister, a conflict of interest evinces conditions favorable to unethical decisions. Interests conflicting in a conflict of interest pit an obligation against either another obligation or self-interest. That is to say, such conflicts tend to involve deontology and egoism.

Typically, conflicts of interest are thought of as centered on a particular person’s interests. Such interests are set against obligations pertaining to a job or to others. Typical examples of unethical behavior stemming from such conflicts of interest include favoritism, cronyism and nepotism, as well as accounting fraud and outright embezzlement. Typically, a person acting unethical in a conflict of interest situation is portrayed as advancing his or her own interests even apart from those of his or her job at the expense of obligations of his or her job, company or the general public. Whether a person is in a conflict of interest depends on the person’s idiosyncratic self-interest.

For example, a certain employee is in a conflict of interest because he works in purchasing and his wife works for one of the venders. There could be no such conflict of interest for another employee in purchasing. In other words, the conflict is not inherent in the institutional or organizational structure in which the purchasing department, or the company itself, is a part. To be sure, institutional or “structural,” conflicts of interest also exist. Unlike the former kind, they do not depend on the particular interests of particular people.

One of the foremost institutional conflicts of interest involves public accounting firms that audit companies that pay them. To be both a client of a company and that company’s public accounting firm puts the CPA firm’s financial interest structurally in conflict with the firm’s obligation to the general public. Even if the CPA firm gives an unqualified opinion based on the audit unfettered by a desire to retain the client, the firm is subject to the “gravity” of the conflict of interest. It makes no difference whether a partner has a friend or relative in the company being audited; the conflict is institutional.

Unlike person-level conflicts of interest, institutional conflicts of interest do not go away in a change of personnel. That is, the persons may differ, but the temptation to act unethically continues as long as the arrangement of the institutions remains intact. In the case of CPA firms, being a client is inherently antipodal to being a public accountant. To obviate this institutional conflict of interest, one of the two roles must be severed. For example, an independent party could assign CPA firms to companies—the CPA firms still competing though to get assigned more companies from the independent party.  It goes without saying that the CPA firms could not have relations in terms of persons or institutionally with the independent party—or with the companies being audited; the institutional interests of the CPA firms must be aligned with representing the public in order for the structural conflict of interest to be eviscerated.

Institutional conflicts of interests are of course not limited to the business realm of CPA firms and rating agencies (e.g., paid by investment banks to rate their securities—as in rating sub-prime CDOs as AAA). A governmental system may include institutional conflicts of interest, which also do not depend on the particular interests of persons.

For example, the U.S. Supreme Court is both a branch of the U.S. Government and the final decider of cases between any of the state governments and the U.S. Government. This conflict of interest exists even if a particular U.S. Supreme Court justice happens to favor the states. Besides leaning toward unfair decisions, the conflict of interest is inherently unfair, and thus unethical. Generally speaking, institutional conflicts of interest are themselves unethical because they are unfair to some institutional or constituency. Consider, for example, a rule by which the third-base coach of one of two baseball teams playing each other must be the final umpire. The rule itself is inherently unfair to the other baseball team; it doesn’t matter whether the coach actually makes any calls (even in favor of the other team!) because the rule itself is unfair, and thus unethical. Akin to the institutional of slavery, such a rule institutionally relegates one party or organization as inferior.

Therefore, I contend that institutional conflicts of interest are deserving of more attention, particularly as most conflicts of interest are understood to hinge on particular persons’ interests. The way business institutions relate in procedure or law, and the way governmental institutions relate to each other and to others in society, should be examined from the standpoint of conflicts of interest wherein unfairness is implied. Abstractly speaking, a conflict between obligations or between an obligation and self-interest can apply at the organizational and inter-organizational levels. Such a conflict can be obviated by redesigning the organizational or inter-institutional arrangements or procedures such that structurally incentives do not involve such conflicts of interest. As such conflicts do not depend on particular persons, the long-standing nature alone warrants more attention.

Religious Sources of Business Ethics: How Far Along Are We?

If Business Ethics for Dummies is any indication, the topic of religious sources for business ethics must have gained steam through the first decade of the twenty-first century. Increasing interest in such a topic in the midst of modernity is ironic, or counter-intuitive. For philosophers without any degrees in religion, the temptation might be to dilettante over to this topic in order to proffer an opinion. The result for the rest of us could well be a false sense of the extent of knowledge on the topic.

The entire essay is at "Religious Sources of Business Ethics"

Wednesday, May 25, 2011

Writing an Original Screenplay in Film

Jay Fernandez of The Hollywood Reporter asks, “Who’s to blame for the lack of original movie projects being submitted to film studios these days?” He points to vertical integration and a bottom-line reliance on pre-branded franchises, plus diminished film slates, producer deals, and writing jobs. Indeed, in early 2011, spec submissions were down by more than half.

Given the increased competition and the pressure of the studios, writers and agents “looking to maintain careers and commissions” have been “abandoning original screenplays to deliver template-fitting material.” As one lit agent said, “It’s the system that’s at fault, not the writer.” Of course, it could also be argued that studios have been going for known commodities, such as in multiple sequals, because the writers have run out of material. According to one studio head, writers “can’t get themselves up to write something original.”

I must admit I have looked at all the formulaic films and wondered whether narrative itself had been exhausted. The rigidity of a screenplay’s structure and format, for instance, must surely narrow the sort of narrative that can come through the pipeline.

For example, having an inciting event 10 to 12 pages in and a critical event about 10 pages from the end means that the narrative’s tension runs from 10-12 pages in until 10 pages from the end. Having a regularity akin to Joseph Campbell’s journey of the hero, a screenplay’s protagonist is bound to be seeking to restore equilibrium from 10-12 pages in until 10 pages from the end. Would it kill a narrative if the protagonist is seen in his or her new world for more than ten pages? Might the viewers enjoy seeing the protagonist in his or her original world for more than 10-12 pages? Furthermore, how might film narratives differ if the instigating event were to happen up front?

As tempting as it might be to loosen up the screenplay format (assuming it is arbitrary from the standpoint of what makes good narrative), it is worth asking whether original narratives are still possible even within the screenplay box. If they are possible, it is worth investigating how writers can come up with original plots. I suspect the answer lies in the writer becoming aware of the assumptions in his or her extant stories so as to be able to relax or change paradigms or frameworks so as to come up with novel narratives.

Also, a writer could do worse than study classic myth so as to get a deeper sense of basic themes that could be woven into new fabric for today. By this I do not mean that modern writers should simply pour old wine into new bottles; rather, the ancient ingredients—once known—can be interwoven in new ways to create new plot structures.  Simply engaging in thought-experiments in coming up with innovative short stories can be like weight-lifting for the writer interested in going out and playing in game of screenwriting.

Of course, context matters, and studios having allowed themselves to be more dependent on remakes and reinventions has translated into “creative stagnation,” according to Fernandez. Working within the confines of prefab projects, writers are given the house in order to decorate it. As one writer observed, “You can’t build your own house, and you can’t change the house.” That is hardly the sort of context in which the narratives that can generate real interest in cinema are likely to be purchased, let alone written.

As the field of writers narrows and the studios become increasingly risk-averse as the costs of producing a film increase, creativity must be reckoned as collateral damage.Yet even in this eye of the needle, even just those few writers who have gained entry can think outside the box and make alliances with the talent to lobby producers for relatively small-budget projects. More ideally, actors and even producers could use the social media and explore blogs in order to look beyond the usual suspects if only to get an inkling of the alternative stories out there in small electronic ponds called blogs (perhaps one all-too-imaginative writer will write a screenplay on the blog-pond monster that eats up the radiation in Japan and saves the day--the antithesis of Godzilla).

In short, there are indeed fruitful alternatives to deconstruction (e.g., the New Wave, Neo-Realism). We need not eclipse narrative, as if the human race has outlived story-telling. We need not give up on the possibility of rich, new stories that have not hitherto been thought and told.

Click to add a question or comment (or view comments) on original narrative in the film industry.


Jay A. Fernandez, “Crisis at the Movies: No New Ideas,” The Hollywood Reporter, May 20, 2011, pp. 8-9.

Tuesday, May 24, 2011

Lehman's Dick Fuld as the Antagonist in the film, "Too Big to Fail"

The reporter-author of Too Big to Fail, Andrew Ross Sorkin, expressed the following fear as his 600-plus-page book was being made into a movie: "I went into the process I think worried – as I imagine most writers would be – that it would be sexed up and hollywoodized in some other way." To be sure, putting the Dick Fuld (CEO of Lehman Brothers) character into any sort of sex scene would have been counterproductive at best.

As it was, the director of the tv-movie based on Sorkin’s book let the drama inherent in the historical events to lead the narrative. The only quibble I may have with the historical veracity has to do with Bart McDade replacing Joe Gregory as President of Lehman. According to Larry McDonald, a former distressed-bonds trader at Lehman, the replacement also relegated Fuld even as he remained as CEO only to quell the markets. Specifically, on June 11, 2008, “Fuld was effectively deposed,” according to McDonald, “by Bart McDade with the support of the executive committee” (McDonald, p. 297). In the movie, however, Fuld was still in charge even in September of that year, with McDade still bowing to him in front of the Koreans.

While it could be that Sorkin and McDonald have different sources of information on whether there was a coup within Lehman, the film’s director and screenwriter could have kept Fuld in charge to maintain the character as the principal antagonist. Even so, McDonald’s description of McDade confronting Fuld in Fuld’s office and the subsequent decision of Gregory in the conference room to take the stunned CFO, Erin Callan, down with him in front of the executive committee would have made excellent scenes in the movie.

The other change I would have made to the screenplay would give the viewers an improved insight into how the sub-prime crisis could have been allowed to get so bad. Specifically, the Fuld character could have had a flashback to Mike Gelband’s warning on June 7, 2005 in defiance of Fuld that Lehman should get out of the housing-related CDO market; the bank was then leveraged twenty-two times its net worth (McDonald, p. 136). Meeting with Gelband and other senior executives on the 31st floor on that day, Fuld and his allies insinuated that Gelband had some kind of attitude problem that needed to be changed “real fast” (McDonald, p. 138).  As a flashback, this scene would have shown the viewer Fuld’s recklessness in terms of risk (and leverage), and thus how the financial system could have been put in such peril by the “experts”. In fact, in the spring of 2007 Fuld decided to bully and belittle Gelband publically at the bank in order to get him to take on even more risk (McDonald, p. 235). This could have been fused into the “attitude problem” meeting, showing the viewer Fuld’s pathology, which goes beyond a bad temper.

Whether one points to Jim Cayne at Bear Stearns or Dick Fuld at Lehman, the role of pathology in the near-demise of Wall Street could uncover for us how recklessness could have gained such traction. In other words, HBO’s Too Big to Fail could have delved into Fuld’s character beyond having him drop some F-bombs. Speaking on Charlie Rose on the evening of the movie’s premiere, Sorkin marveled that it must be difficult for actors to convey their respective characters in just a few scenes. That is true; however, the director and screenwriter could have brought out Fuld’s pathology (beyond his anger) by a few well-chosen additional scenes. Sometimes what a character says, and to whom, can be more damning than how loud he or she says it. Concerning Fuld, the viewers could have been shaking their heads in utter disbelief rather than simply concluding that the guy is arrogant and has a temper.

Lawrence McDonald, Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers (New York: Three River Press, 2009).

Monday, May 23, 2011

Too Big to Fail: The Trillion Dollar Club

Banks with assets over $50 billion are considered “systemically important” according to the Dodd-Frank law of 2010. The act is geared to shoring up protection against systemic risk. The U.S. Goverment deems certain banks (and companies) systemically important if they are big enough to threaten the entire financial system should they fail. Such enterprises are subject to higher capital standards and stricter rules. Roughly three dozen banks in the U.S. had been classified as systemically important by mid-May 2011.

A major flaw in the law is its failure to sufficiently distinguish the banks having assets at just over $50 billion (the floor of systemically important) from the banks with assets over $1 trillion. For example, Bank of America ($2.28 trillion), J.P. Morgan Chase ($2.2 trillion), Citigroup ($1.95 trillion), and Wells Fargo ($1.24 trillion) can be clustered and distinguished from Huntington Bancshares ($52.95 billion), CIT Group ($50.85 billion), Zions Bancorp ($50.81 billion), and Marshall & Ilsley ($49.68 billion). If just one of the institutions in the over $1 trillion club fails, the financial system worldwide could be toast. In contrast, the system would be more likely to remain viable if just one of the banks with assets of around $50 billion were to fail.

Of the $50 billion club, Stephen Steinour, chair and CEO of Huntington, stresses, “We are not vital to the economic system of the U.S.” The chair and CEO of Bank of America could not make the same claim. However, Steinour is ignoring the possibility that Huntington could be a domino in a line of similar banks whose failures altogether could challenge the viability of the financial system; yet even this risk can and should be distinguished from the inherent systemic risk in just one of the banks in the $1 trillion plus club.  Furthermore, those big banks have grown even larger since before the financial crisis—meaning that their systemic risk is higher rather than lower after the crisis. At the end of 2010, the top ten banks in U.S. had 77% of the banking assets in the U.S.

In 2007, Bank of America had assets of $1.54 trillion; by 2011 that number had moved to $2.28 trillion. J.P. Morgan Chase had gone from $1.46 trillion to $2.20 trillion, and Wells Fargo went from $539 billion to $1.24 trillion. Citigroup bucks this trend, moving from $2.22 trillion down to $1.95 trillion. Generally speaking, this cluster of banks represents more rather than less systemic risk after the crisis of 2008.  Were one of these banks to founder, a government-arranged orderly liquidation as per the Dodd-Frank law might not be sufficient to keep credit markets from freezing up. The very existence of a bank with more than $1 trillion in assets should be questioned. Ironically, efforts to evade financial catastrophe in the fall of 2008 contributed to the increase in size. That is to say, staving off the crisis may have made another more likely in the future.

So especially after the scare in 2008, it is incumbant on us to question the sheer existence of the banks that have been allowed and in fact encouraged to get bigger. If a bank having more than $1 trillion in assets is deemed necessary for corporate capitalism to function in spite of such a bank's inherent systemic risk, one might ask how the system got along without them before they had grown so big. After all, it is not unheard of for a syndicate of banks to package financing on a mega-LBO (leveraged buy-out); one mega-bank is not necessary. Indeed, mega-LBOs themselves may result in unacceptable systemic risk. Finance itself, and particularly the increasing role of leverage, can also be subjected to question. 

Although distasteful from the vantage-point of the financial interests vested in the status quo, the trillion-dollar-plus club of banks could be treated differently than the banks of around $50 billion. Whereas the latter could be more strictly regulated, the former could be broken up not only in terms of management, but also in ownership (rather than the spin-offs having the same fractional owners, as was the case with Standard Oil after its “break-up”).  Considering that obviating financial collapse in 2008 included the byproduct of even larger banks, a second systemic-risk law delimiting a maximum size could complement existing anti-trust laws. Unfortunately, the Dodd-Frank law does not address this point, and is thus insufficient from the standpoint of obviating the systemic risk of firms being too big to fail.


Robin Sidel and Jean Eaglesham, “Vital? Not Us, Say Small Banks,” The Wall Street Journal, May 13, 2011, p. C1.

2007 Bank Assets, ForbesAdvice.com.

Goldman's Ethical Conflict of Interest: Obviated or Enabled?

According to U.S. Senator Carl Levin, Goldman Sachs “profited by taking advantage of its clients’ reasonable expection[s] that it would not sell products that it did not want to succeed and that there was no conflict of economic interest between the firm and the customers that it had pledged to serve.” (Cohen, p. 19). Not only was the bank secretly betting against housing-related securities while selling them to clients, in at least one case a client shorting such a security was allowed to have a hand in picking the bonds. What is perhaps most striking, however, is how little Goldman Sachs has had to pay for acting at the expense of some of its clients. One might predict on this basis that the unethical culture at the bank is ongoing.

Sen. Levin was referring in his statement to Timberwolf (ABACUS 2007-AC1), a security arranged by ACA Management and Paulson for Goldman. Paulson was to short the security, and thus had an economic incentive to have junk bonds put into the security so it would fail. Basis Yield Alpha Fund, which purchased some of the issue from Goldman, has claimed that Goldman, which in turn viewed Timberwolf as “a shitty deal” and “crap,” falsely represented said issue in claiming that it was designed for “positive performance.” (Cohen, p. 21).

To rebuff Sen. Levin’s charge, Blankfein retorted that the discounted price on a given security corresponds to the risk acceptable to the purchasers. However, in this particular case, the Fund’s managers further claimed that the Fund would not have bought the “shitty deal” had they known Goldman employees viewed it as “crap” (that the bank was secretly shorting it in proprietary trading would presumably have also made a different in the Fund’s decision to buy), even at the discounted price (Cohen, p. 21). In other words, the risk corresponding to discounted price was understated by Goldman. For the risk/price relation to work, the information given by the seller to the buyers must be accurate.

As part of its $550 million settlement with the SEC in July 2010, Goldman Sachs stated that it “acknowledges that the marketing material for the ABACUS 2007-AC1 transaction contained incomplete information. In particular, it was a mistake for the Goldman marketing materials to state that the reference portfolio was ‘selected by’ ACA Management LLC without disclosing the role of Paulson & Co. Inc. in the portfolio selection process and that Paulson’s economic interests were adverse to CDO investors.” (Cohen, p. 15). In other words, Goldman admitted that its marketing material on the security contained a conflict of interest wherein Paulson’s involvement, which was averse to the value of the security, was omitted in line with Goldman’s financial incentive to sell the security. To have obviated the conflict of interest would have meant less profit. Without a probable loss of much greater profit upon the discovery of the unethical exploitation of the conflict of interest, the financial calculus is unavoidably on the sordid side of the equation—and a business is an economic enterprise.

In effect, Goldman was invoking the caveat in its ethics code because the calculus had indicated, whether explicitly or implicitly, that more profit would in all probability be realized by doing so. The caveat states, “From time to time, the firm may waive certain provisions of this Code.” (Cohan, p. 18). The probability of being penalized and the amount of financial sanction would together have to be anticipated to be greater than the amount of profit expected from exploiting the conflict of interest for Goldman not to have opted out of its own ethics code. Given the propensity of the human mind to understate the likelihood of low probabilities, the amount of the penalty would have to be significantly greater than the profit that could be expected from exploiting the conflict of interest. In other words, because we tend to assume that low-probability though highly-expensive scenerios won't occur, the expense involved should be jacked up for managers of a company to be motivated to take sufficient account of such scenerios. In the case of Goldman's conflict of interest, government regulators have failed in this regard.

In spite of the unethical conflict of interest, Goldman Sachs’ settlement with the SEC in July 2010 amounted to just two weeks of profits for the bank—hardly even a slap on the wrist. To be sure, Goldman had slipped in the pecking order of top underwriters of stocks and bonds to eighth in the wake of the settlement. Even so, few if any clients left the bank in the wake of the settlement. Oklahoma’s Teachers Retirement System, for example, did not terminate its relationship with Goldman even though the system’s general director said he was disappointed in the bank’s admission of an omission in its marketing materials.

One might wonder if a firm such as Goldman, whose culture condones or looks the other way when ethical conflicts of interest are acted upon in an unethical direction, is eventually to be held accountable by the market if not by a servile government. It would be sad indeed, or at least enabling, were the market (if not the government) not to sufficiently penalize the bank for its unethical expediency.  For a business to act unethically with financial impunity is to enable the sordid conduct and its enabling culture to go on, unfettered.

In business terms, ethical obligation itself must be translated into financial terms, for ought itself does not compute in commercial calculation. Lest the ethicist get caught up in weighing particular probabilities and the present-value of penalties relative to the present-value of expected profits from exploiting a conflict of interest, regulation can obviate the structural conflicts of interest in the first place.  The Glass-Steagall Act of 1933, which was repealed in 1999, was an example of such regulation because it kept investment banks from being able to draw on depositors' savings and checking accounts to gamble. That the act was not put back on the books in the wake of the financial crisis of 2008 suggests that congressional and/or regulatory capture by the regulated may make regulating structural conflicts of interests away unlikely or practically impossible.

As an alternative, we might look for moral leadership from CEOs concerning institutional conflicts of interest. Even if they are not disabled, a moral leader does not exploit them for financial gain. Such leadership can be relevant, meaning that it can be in line with the business calculus. In particular, the financial value of a unsullied reputation can outweigh profits from exploiting a conflict of interest (less probability-adjusted penalties). In other words, moral leadership can dovetail with cost/benefit analysis if the time-line is extended sufficiently. As John Fullerton, a former banker at J.P. Morgan observed, "At its core, Wall Street's failure, and Goldman's, is a failure of moral leadership that no laws or regulations can ever fully address." (Cohan, p. 16).  Fullerton adds to this realistic assessment an implied pessimism regarding the likelihood of such leadership manifesting (even in sync with the business calculus) in suggesting that the SEC settlement "is the tipping point that provides society with an opportunity to fundamentally rethink the purpose of finance." (Ibid.). That is, the value of Wall Street itself can and perhaps should be reassessed relative to business system overall.

Click to add a question or comment on ethical conflicts of interest at Goldman Sachs.


Thomas Catan and Kara Scannell, “Convictions From Crisis Hard,” Wall Street Journal (July 17-18, 2010), B2

Susanne Craig and Randall Smithy, “For Goldman, Reputation Reclamation Project,” Wall Street Journal (July 17-18, 2010), B1-2.

William D. Cohan, Money and Power: How Goldman Sachs Came to Rule the World (NY: Doubleday, 2011).

See related essays:

"Business Ethics in the Business World: A Glimpse from Goldman Sachs"

"Institutional Conflicts of Interest"

Sunday, May 22, 2011

Business Ethics in the Business World: A Glimpse from Goldman Sachs

Goldman Sachs’ ethics code reads in part, “[We] expect our people to maintain high ethical standards in everything they do. . . . From time to time, the firm may waive certain provisions of this Code.” (Cohan, p. 18). The explicit conditionality is notable and significant. I contend that among other reasons, a negative impact on the bank’s financial position and/or profits is apt to trigger such a waiver not only at Goldman Sachs, but from the business standpoint more generally.

To be sure, when maintaining high ethical standards are in line with profitability, there is no pressure for the waiver of any provisions. In his office sometime in 2010, for instance, Lloyd Blankfein reflected, “Of course I feel a huge responsibility to address the assault on Goldman Sachs’ reputation.” (Cohan, pp. 10-11). This duty did not weigh heavily on the chairman and CEO, for the bank would profit from a recovered reputation. If only ethics were so easy and convenient.

In yet another scenario, the benefit to a firm (and its managers) in maintaining high ethical standards can be deliberately hidden under a subterfuge of ethical obligation to another party even as that obligation is actually shirked as the benefit to the firm (and its managers) is quietly realized. In a letter dated April 27, 2010, for instance, Blankfein wrote, “People are angry and understandably ask why their tax dollars have to support large financial institutions. That’s why we believe strongly that those institutions that are able to repay the public’s investment without adversely affecting their financial profile or curtailing their role and responsibilities in the capital markets are obligated to do so.” (Cohan, p. 9).  No mention is made here of the caps on executive pay for banks still holding TARP funds, or that the TARP money was supposed to be used to make loans (which the banks did not do). Blankfein’s personal economic interest was that his bonus not be caped. Also, paying back the TARP loan would improve Goldman’s reputation as a good “corporate citizen.”

Moreover, Blankfein’s letter proffers us a particular insight into business ethics from a business standpoint. In short, profit-seeking and financial position are not to be relegated or truncated by any obligation to the wider society. The point can be found where Blankfein stipulates that his bank’s obligation must be accomplished “without adversely affecting [the banks’] financial profile or curtailing their role and responsibilities in the capital markets are obligated to do so.” People outside of business typically do not understand that from a business standpoint, ethical obligation is not to be at the expense of a firm’s financial position or existing contracts. The fiduciary obligation to stockholders supersedes any obligations to society at large; hence, obligation contrary to a company’s financial interests does not compute in business terms. Society is thus too generous in what it typically presupposes in terms of business ethics within the business world.


William D. Cohan, Money and Power: How Goldman Sachs Came to Rule the World (NY: Doubleday, 2011).