By Zachary A. Goldfarb
Washington Post Staff Writer
Friday, May 7, 2010; A22
Investment banks such as Goldman Sachs and Morgan Stanley do not always need to act in their customers' best interests.
It is a startling statement: Why would anyone want to do business with a company that does not put the customer first?
It is also the law that allows companies to do this.
But whether it should be the law is the subject of debate on Capitol Hill as the Senate prepares to vote on legislation to overhaul financial regulation. It is also one of the key issues underpinning the recent controversy regarding Goldman's role in the financial crisis.
Key senators are trying to ensure that financial firms, when they are providing investment advice to clients, are doing what the firms truly think is in the best interests of those clients.
That is not the current standard. Firms must only ensure that what they sell clients is suitable to the investment strategy the clients have described.
Many financial firms oppose the change, saying that if they always had to work in the best interests of their clients, they would not be able to do much of what their clients want. For example, if a client approaches a firm wanting to conduct a transaction that the firm thinks is unwise, then the firm may have to refuse to conduct the transaction. In that way, the firm might be limiting the types of investments its clients can make.
The issue surfaced recently in the Goldman case. Goldman created financial securities that allowed its clients to bet that the housing market would continue to boom. Privately, Goldman was skeptical about the housing market and placed bets that it would fail.
In a highly publicized report, a Senate panel accused the firm of secretly acting against the interests of its clients, a charge the company denies. But whether Goldman did or did not, there is broad agreement that the firm's decision to privately bet against the market while helping some of its customers bet on it was legal.
"Current law does not impose any obligation on Goldman where it is buying and selling securities that says you can't short while you're selling to people," said John C. Coffee, a law professor at Columbia University.
The debate stems from the many hats that big financial companies wear. When a firm is operating as an investment adviser -- meaning clients are paying to get advice on where to invest their money -- it must meet a "fiduciary" standard. That means that the financial company must do what it thinks is in the best interests of its clients.
But Goldman, Morgan and other firms are not primarily engaged in dispensing advice. Much of the time, they are acting as a broker-dealer. A broker-dealer helps clients who already have an investment strategy carry out that strategy.
At its simplest, a broker-dealer helps an investor who has decided to buy shares in a company's stock locate shares to purchase.
At its more complex, a broker-dealer might, for example, structure a specialized product that would allow an investor to bet on the direction of interest rates or whether a company will go bankrupt.
The distinction holds true both for Main Street investors, who might be setting money aside for retirement, and for sophisticated financial entities such as pension or hedge funds.
Often, the line between broker-dealer and investment adviser can blur -- especially when dealing with more complex financial products or strategies. Studies published by the Securities and Exchange Commission show that many investors do not realize the difference.
On Thursday, SEC Chairman Mary Schapiro called for broker-dealers and investment advisers to meet the same standards.
"I believe that broker-dealers and investment advisers providing the same services, especially to retail investors, should meet that same high fiduciary standard," she said in a speech. "This is an issue that I hope will be addressed in regulatory reform legislation and one that is fully consonant with the principle of fairness that helped guide the development of the securities laws."
The regulatory overhaul bill that has already passed the House would require broker-dealers who serve the public to meet the higher fiduciary standard. But after originally including a similar provision, the Senate legislation no longer does after lobbying by the financial industry.
"Conflicts of interest played a significant role in the 2008 financial crisis," Specter said. "This is a common-sense amendment which seeks to close a gaping loophole in federal law where brokers and dealers can avoid putting their clients' interest first."
Elisse B. Walter, an SEC commissioner, rejected the view of broker-dealers that a fiduciary standard would curb what they can do.
"I do not think imposing a fiduciary duty across the board requires a broker-dealer to provide a continuing stream of advice. The question is: What services are you performing?" she said.