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Goldman Sachs

In: Business and Management

Submitted By mschellhamer
Words 4309
Pages 18
Melisa Schellhamer, April 13, 2010
Melisa Schellhamer, April 13, 2010

SEC files a fraud case against Goldman Sachs, an industry leader, is now being investigated for unfair investing scandal.
SEC files a fraud case against Goldman Sachs, an industry leader, is now being investigated for unfair investing scandal.
Goldman Sach’s Case # 5
AC805 Advanced Management Accounting Control Systems
Goldman Sach’s Case # 5
AC805 Advanced Management Accounting Control Systems

The Goldman Sachs fraud case opened by the Securities and Exchange is one of the items that were highlighted by the down turn of the economy in the last few years. Goldman Sachs has vigorously denied any wrongdoing, but the case against them seems fairly tight if the information currently provided is accurate. At the center of all of this Fabrice Tourre. Tourre is an employee of Goldman Sachs that has been charged with fraud. The nature of the charge is that as an employee of Goldman Sachs he helped create a Collateralized Debt Obligation (CDO) that was not disclosed to potential investors. More damning than anything however that seized email correspondence is seems to point to the fact that he was fully aware of what he was doing.
How this all ties in is that a CDO is an investment vehicle whose performance is directly related to a set of assets. In regards to this case the CDO was a family of securities that were backed by subprime residential mortgages. As this is considered risky - especially when the figures are in the billions of dollars - a Credit Default Swap (CDS) was arranged with Paulson & Co. A CDS is an agreement between two - or more parties in some cases -in which one party purchases protection from another to ensure that their debt obligation will remain in good standing. Should the entity that purchased protection see their debt fall out of good standing they then pay the protection. In this case that meant Paulson & Co. made about a $1 billion dollar profit on the deal.
Having that happen is not in and of itself illegal or fraud, it is the reason that it happened which is and comes back to Fabrice Tourre and Paulson & Co. Paulson & Co. was allowed to help pick the mortgages that were going to be used to build the CDO. When they did this, the allegation is that they knew they were picking mortgages in which of which a fair portion would lose value. This ties into Fabrice Tourre because according the previously mentioned seized correspondence of his he knew the same and also knew that Paulson & Co. stood to profit if they did.
Having that knowledge, Tourre went on marketing the CDO without disclosing to the fact that Paulson & Co. had input into creating the CDO, but also withheld that they stood to profit if the CDO lost value causing protection to be paid. Now ACA Management LLC. Financial enters the picture. ACA was brought in by Goldman Sachs to act in the capacity of the portfolio selection agent. Where it gets murkier and much more incestuous is that ACA acting in their capacity then advised their parent company ACA Capital Holdings Inc. to sell credit protection on behalf of the CDO. The problem is that they were not told Paulson & Co. was actually betting on the CDO to lose value.
The reason Paulson & Co. would play the role they did is fairly simple, they get a big payout really fast by poisoning the CDO with subprime mortgages they feel have the best odds of failing. Tourre goes along with everything because it is his job to unload this package and as he himself said in reference to this at the time “The whole building is about to collapse anytime now.” If he expects to retain his job and likely very healthy bonuses it behooves him to make sure he does his end. The problem is that doing his end was not going to be easy, a falling market with CDO filled with the worst possible garbage was going to be hard to unload on anyone following the proper legal disclosure policies not to mention ethics.

So you may now wonder how this could have impacted you, me, or any regular person not moving in the world of billion dollar investments. The answer to that is that to some degree we all paid for this. The money to pay for protection had to come from somewhere. The money that was invested came from somewhere. That somewhere was for the most part banks and insurance companies that financed the deal not knowing they were about to become the victim of fraud.
When the banks, insurance companies, and other financial backers lost money on the deal, sometimes everything as was the case with IKB Deutsche Industriebank AG who lost a $150 million, that means that the people who had accounts in the banks or money tied into the insurance companies all lost money. These entities invest with the money that comes from regular people paying premiums and adding to their passbook accounts for instance. As these entities are still obligated to their customers they have to take a loss and find a way to make up for the lost money which often translates to lower interest rates and higher premiums.
Why is this quality, compensation, balanced scorecard and corporate governance issue? What factors contributed to the problem? Goldman Sachs issue is related to each of the following facets of a business, the quality, compensation, balanced scorecard, and corporate governance. Each item helps in the detection, reputation and operations of the organization. Quality is an item that is constantly a selling point of Goldman Sachs. The idea that fraud is capable of happening within the organization deters many investors from investing with them; Goldman’s name is often associated with quality. Compensation was obviously the driving point of creating the fraud. The need for money, greed and the expectations placed on executives within Goldman, to increase the bottom line of the organization in order to increase their own bottom line resulted in fraudulent white collar crimes. This reflects in the corporate governance of the organization as well. If top executives expect and look away from acts that are not “truthful” or “lawful” then the whole organization tends to reflect in their beliefs and values in generating profits. The balance scorecard is the tool to better evaluate several areas of the organization. This tool is used by executives to help monitor the success of all areas of the business, and is to entice them to perform at high levels. Recognizing some of the weaknesses and vagueness of management approaches, the balanced scorecard provides a clear prescription as to what companies should measure in order to 'balance' the financial perspective. The balanced scorecard is a management system that will enable Goldman the ability to clarify their vision and strategy and translate them into action. It provides feedback around both the internal business processes and external outcomes in order to continuously improve strategic performance and results.
Why and how should the management accountant be involved?
Management accountants represent a natural “survival of the fittest” as individuals and organizations work hard to identify new and unique measures that help professional’s better plan control, and evaluates unique situations within the organization. The main focus of management accountants is to improve the organizations’ performance and profitability by providing relevant information for decision-making. Managerial accounting information is intended to serve the specific needs of management. Management accountants will help business managers with specialized reports, budgets, product costing data and other details to help them with business planning, controlling, and decision making. The role of the management accountant is one of the most important roles in the company; they apply their professional knowledge and skill in the preparation and presentation of financial and other decision oriented information in such a way as to assist management in the formulation of policies and in the planning and control of the operation of organization. Their role is crucial in the deciding rather to use a different strategy or procedure- because they are one of the few individuals that work in all areas of the organization. They provide a full picture view of the company to each part of management. A management accountant is instrumental in developing strategies that will produce the optimal level of output and create the best scenario to achieve a profitable organization. The management accountant also helps develop compensation packages.
How costs might be allocated differently to better evaluate the success of the strategy.
Activity-based costing (ABC) offers a way to analyze costs that is different from traditional methods. People often say that ABC is a better way to do product costing. But, in fact, it is a huge mistake to think that ABC is either better or worse than traditional costing. Traditional costing is premised on accounting concepts that were designed to satisfy the needs of external and regulatory financial reporting, based on an ancient set of assumptions. By contrast, ABC is a practical method designed to provide management with meaningful information with which to make better decisions.
ABC costing is an alternative to the traditional way of accounting. Traditionally it is believed that high volume customers are profitable customers, a loyal customer is also profitable one, and profits will follow a happy customer. Studies on customer profitability have unveiled that this is not necessarily true. ABC is a costing model that identifies the cost pools, or activity centers, in an organization and assigns costs to products and services based on the number of events or transactions involved in the process of providing a product or service. As a result, ABC can support managers to see how to maximize shareholder value and improve corporate performance.
Advantages of implementing the activity based costing system at Goldman Sachs include: more accurate costing products/services, customers, distribution channels, better understanding of overhead, easier to understand for everyone, utilizes unit cost rather than just total cost, facilitates benchmarking, and supports performance management and scorecards.
What corporate governance changes might be needed?
Great companies have to distinguish between what is legal and what is right. The definition of corporate governance that is most generally used: the set of processes, customs, policies, laws, and institutions affecting the way a corporation is directed, administered or controlled. Corporate governance also includes the relationships among the many stakeholders involved and the goals for which the corporation is governed. The principal stakeholders are the shareholders, management, and the board of directors. Other stakeholders include employees, customers, creditors, suppliers, regulators, and the community at large. Corporate governance is a multi-faceted subject. An important theme of corporate governance is to ensure the accountability of certain individuals in an organization through mechanisms that try to reduce or eliminate the principal-agent problem. Key elements of good corporate governance principles include honesty, trust and integrity, openness, performance orientation, responsibility and accountability, mutual respect, and commitment to the organization. When compensation arrangements are flawed, it is common to look for agency conflicts between insiders and shareholders as the source of the problem and to corporate governance reforms as the solution. Some of the incentives for excessive risk-taking may be undesirable from the perspective of shareholders.
Goldman is defending against the SEC complaint in the court of public opinion by saying that the synthetic CDO was a transaction between sophisticated parties (“consenting adults,”) that everyone knew there would be a long and short side of the transaction, that it did not mislead the long side of the transaction, which had every incentive to understand the CDOs packaged in the instrument. But, the underlying question is whether a synthetic CDO transaction, which is unrelated to the “real economy,” just a bet between well-heeled parties that creates significant economic risk — is “right.” There is a strong view that these transactions are not right. Goldman needs to defend not only its actions in the particular case but also take a position on whether such transactions are appropriate and under what conditions.
But, for most regulators and for the public, this answer of “it was legal” in the past and should be in the future is inadequate. Their justification appears to be to allow financial institutions to make outsized profits. Major financial players need to address the “what is right” question with a more complete assessment of the interests at stake and a more compromised position. But Goldman’s problem, as it faces an energized pounding from Congressional and SEC investigators, is being credible on that critical distinction for regulators, customers and the public: What it did in the past may have been “legal” under past standards and consistent with industry practice but a different standard of “what is right” should apply in the future.
How might the balanced scorecard be used to evaluate the company’s strategies and what measures could be used?
Goldman Sachs could use the balance scorecard to better evaluate several areas of the organization. It will also give them a better way to communicate the organization their goals, the objectives, and where they are at meeting those objectives. The balanced scorecard provides a daily snap shot of where the business stands, not only financially, but also other areas that management has deemed to be important to be monitored. The balanced scorecard views the organization from four perspectives, and to develop metrics, collect data and analyze it relative to each of these perspectives:
1. The Learning & Growth Perspective
This perspective includes employee training and corporate cultural attitudes related to both individual and corporate self-improvement. In a knowledge-worker organization, people -- the only repository of knowledge -- are the main resource. In the current climate of rapid technological change, it is becoming necessary for knowledge workers to be in a continuous learning mode. Metrics can be put into place to guide managers in focusing training funds where they can help the most. In any case, learning and growth constitute the essential foundation for success of any knowledge-worker organization.
2. The Business Process Perspective
This perspective refers to internal business processes. Metrics based on this perspective allow the managers to know how well their business is running, and whether its products and services conform to customer requirements (the mission). These metrics have to be carefully designed by those who know these processes most intimately; with the unique missions these are not something that can be developed by outside consultants. This is one area that many companies forget, or tend to overlook because if a business is functioning, many tend to overlook that it could be operating more efficiently or better.
3. The Customer Perspective
Recent management philosophy has shown an increasing realization of the importance of customer focus and customer satisfaction in any business. These are leading indicators: if customers are not satisfied, they will eventually find other suppliers that will meet their needs. Poor performance from this perspective is thus a leading indicator of future decline, even though the current financial picture may look good.
In developing metrics for satisfaction, customers should be analyzed in terms of kinds of customers and the kinds of processes for which we are providing a product or service to those customer groups.
4. The Financial Perspective
Timely and accurate funding data will always be a priority, and managers will do whatever necessary to provide it. In fact, often there is more than enough handling and processing of financial data. With the implementation of a corporate database, it is hoped that more of the processing can be centralized and automated. But the point is that the current emphasis on financials leads to the "unbalanced" situation with regard to other perspectives. There is perhaps a need to include additional financial-related data, such as risk assessment and cost-benefit data, in this category.
How could this fraud have been prevented? Develop a strategy for Goldman Sachs to improve its quality, preventing problems like this, and research how other financial services companies have benefited from that strategy and improved their quality. How do other financial services companies deal with these issues?
Evaluate, research, prioritize, implement, and reevaluate- seen through these steps, fraud prevention is like any other program an institution may launch. However, this program is not optional, unless possible staggering losses are of no concern. Success in weighing risk against the opportunity for prospective customers is a balancing act. While tough economic times increase the pressure on both sides, bankers must not only increase revenues and minimize expenses, but also effectively block fraud and criminal abuse of the U.S. banking system. Adding to the pressure is Section 326 of the USA PATRIOT Act, which requires banks to know their customers like never before. The legislation's identity, verification provisions outline identification standards and terrorist-screening measures, requiring banks to identify people who pose a risk to the system and the country. As daunting as establishing a fraud prevention program sounds, it is five basic steps: evaluate, research, prioritize, implement, and, most importantly, reevaluate.
1. Evaluate - assess where a new solution or process needs to be applied, it's necessary first to identify gaps in the existing process and where fraud losses are being experienced Having the best technology in the world is useless if associates do not follow procedures or are not trained in how to use them correctly. It is very important to document the initial metrics and processes at the outset so they can be used later as a benchmark during the reevaluation stage. Once the status of the bank's existing fraud program has been established and the weak points identified, the next course of action is to find the best accessible technology and/or methodology to solve the problem.
2. Research - so much information and similar marketing language used by vendors, research is often considered the hardest part, but it is a wise investment of time. Fraud-prevention solutions are moving toward sophisticated model-based decisioning that uses analytics and data mining to understand how the various elements relate. Models can make sense out of mountains of complex data and apply what is known about the past to predict the future, at least in the sense of repeat fraud offenders.
3. Prioritize - once all the research has been gathered and the options narrowed down, it is time to prioritize which initiatives should be addressed first. In the case of fraud programs, the squeaky wheel may not need the oil first. Common sense prevails in setting priorities--the obvious choices are those that can be fixed easily and will have the greatest overall impact.
4. Implementation -During this adjustment period, the institution can fine-tune the parameters of the risk solutions to catch any unexpected instances and evaluate how effective the training programs and new processes are. Training on prevention techniques for managers and back-office staff, as well as designating a centralized fraud manager, has helped many banks make their programs more effective
5. Reevaluation - The worst thing an institution can do after implementing a new fraud program is nothing. Once in place, a fraud prevention program requires periodic examination to ensure it is functioning at the intended levels. Reevaluate the solution or process to determine if it is effective by comparing it with the original benchmark metrics. Once determined effective, plan to reevaluate it periodically to make sure it is on track. At the very least, this should be done every six to 12 months. Changes in fraud or the market do not change the solution or process, and if they are not in sync, the result can be real losses. Conversely, by maintaining the standards of the initial fraud program, the bank will realize savings not only from return on the IT investment but also from loss prevention.
Many financial institutions have fraud prevention in place that will help deter from fraudulent activities, and guidelines that state expectations. It also expresses the morals and values the institution possesses to help employees and other executives understand the importance on an honest investment. Also, many financial institutions hire outside audit firms to help in fraud prevention programs. An organization must realize however that most fraudulent activity is identified within the organization and not from outside firms that provide services to detect fraud. So the most important step is to have a fraud program that educates employees within the organization on how to detect fraudulent activity.
How could evaluating managers by short-term profits be a dysfunctional measure that contributed to the problem? How should the CEO and other top management be evaluated in the future?
Evaluating managers by short-term profits could be very dysfunctional measure for Goldman Sachs, or any organization. It has been studied that managers tend to manipulate earnings to increase the earnings per share for shareholders, but reduce the amount they spend for research and development and capital spending. The reduction in spending in these two areas reduces the likelihood that the company will continue to thrive and grow in the industry, and perform at level it is a custom to. Reducing the discretionary developmental outlays will contribute to higher short term earnings, but could adversely affect future corporate earnings. These incentives also cause management to concentrate on short-term results and adopt policies that may discourage growth and the acceptance of risk.
Executive compensation is a governance mechanism that seeks to align the interests of managers and owners through salaries, bonuses, and long-term incentive compensation, such as a stock awards and options. Long term incentive plans have become a critical part of compensation packages in the US. The use of longer-term pay theoretically helps firms cope with or avoid potential agency problems by linking managerial wealth to the wealth of common shareholders.
Develop a compensation plan and a corporate code of conduct that could address some of the problems in the case.
One major factor that has induced excessive risk-taking is that firms ‘standard pay arrangements reward executives for short-term gains even when these gains are subsequently reversed with this problem becoming widely recognized. Many organizations have tried to tie compensation to long-term performance, ways to enforce this includes: Executives shouldn’t be allowed to cash out options and shares for a fixed number of years after vesting and bonuses should not be cashed right away, but placed in a company account for several years and adjusted downward if it turns out that the reasons for the bonus no longer hold up.
Compensation arrangements tied executives’ interests to the value of common shares in financial firms or even to the value of options on such shares, executives not exposed to the potential negative consequences that large losses could have for preferred shareholders, bondholders, and the government as a guarantor of deposits and executives incentivized to give insufficient weight to risks of large losses. Executive’s payoffs could be tied not to the long-term value of financial firms’ common shares but to the long-term value of a broader basket of securities, including at least preferred shares and bonds.
Regulation of pay can nicely complement the traditional regulation of financial firms. At a minimum, when assessing risks posed by any given financial firm, regulators should take into account the incentives produced by the firm’s pay arrangements --when arrangements encourage risk-taking, regulators should monitor the firm more closely and should consider raising its capital requirements. Regulating the compensation of financial executives should be a critical instrument in the toolkit of financial regulators. It would help ensure that financial firms and the economy don’t suffer in the future from the excessive risk-taking that has contributed to bringing about the current financial crisis.
Conclusion
For Goldman, size and power led straight to arrogance, which ultimately tripped up the investment bank. As the most influential and imperious financial-services firm, Goldman assumed it had the brainpower and political wherewithal to exercise its assumed right to make money in any way it deemed appropriate. And that's how Goldman came to ignore one of the most basic rules on Wall Street: Beware of any conflict of interest. Sheer arrogance blinded Goldman from understanding how damaging it was to be seen working against its clients' interests. Collateralized debt obligation deal in which the Securities and Exchange Commission charged Goldman with securities fraud, the storied bank is accused of playing both sides of the transaction, without making that disclosure to investors. The SEC says Goldman was pitting itself against the very investors who thought the firm was helping them make money. Instead, they lost $1 billion, and Goldman struck gold. This is turn causing many questions being asked by Goldman’s investors, and depleting the value of the Goldman name.

References
1. Cimilluca, Dana. “Goldman Sach’s Bonus-Busting” Wall Street Journal – Eastern Edition, 11/20/2007, Vol. 250 Issue 120, pC3.
2. “Goldman Cuts Trust Bank View” American Banker, 9/29/2009 Col 174 Issue 176 p 6.
3. Balanced Scorecard website, http://www.balancedscorecard.org
4. Taub, Stephen. “SEC vs. Goldman Simple Doesn’t mean Slam Dunk” Institutional Investor, May 2010, Vol. 44 Issue 4, p10.
5. Naich, Steve. “In This Issue: Appearance vs. reality.” Canadian Business. 5/10/2010, Vol 83 Issue 7 p 5.
6. Rouse, Robert. “Damaging Revelations and the Goldman Sachs Saga” Journal of Corporate Accounting & Finance: Sept/Oct 2010, Vol. 21 Issue 6, p93-94.
7. Gomez-Mejia, Luis; Wiseman, Robert. “Aligning the CEO’s Incentive Plan with Criteria That Drive Organizational Performance”, Compensation & Benefits Review May/June 2010, p190-196
8. Bushong, J. Gregory; Talbott, John C.; Cornell, David W. “Instructional Case—Activity-based Costing Incorporating both Activity and Product Costing” Accounting Education, Dec2008, Vol. 17 Issue 4, p385-403

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