Saturday, April 22, 2006

Goldman Sachs and the Failure of Trust

Today the Financial Times reported that Rupert Murdoch's British Sky Broadcasting had dropped Goldman Sachs as its corporate broker in favour of Merrill Lynch. BSkyB and Goldman had been together for at least 12 years, when Goldman assisted in the stock market flotation of Murdoch's company. This relationship was cemented by John Thornton, former president of Goldman's joining the board of News Corporation, the BSkyB holding corporation.

What has gone wrong? In part, it can be traced to the statements of Hank Paulson, chairman and CEO of Goldman, warning his private equity buy-out executives not to get involved in hostile bids, especially ones (he didn't explicitly say) that fail. Since May 2004 Goldman has been participated in six failed UK bids, including, Marks & Spencer, Mitchells & Butler, BAA, and ITV. It was the criticism Goldman's behaviour by Roger Carr, M&B's chairman, which sparked Paulson's edict. Carr, who sits on the boards of several major companies, said that Goldman would lose the trust of clients if it played both sides of the fence too aggressively.

Goldman states as its first business principle: "Our clients' interests always come first. Our experience shows that if we serve our clients well, our own success will follow." It's difficult for clients to understand that principle when they may be on the receiving end of an hostile bid.

This goes back to the 1980s when vulture funds became active in bankruptcy buying distressed debt and using it to get good returns in workouts. Since the banks were actively involved in workouts they resisted the vulture funds, until they began setting up their own in-house vulture funds. So a bank could find itself sitting on both sides of the table.

With the growth of private equity funds this corporate schizophrenia has worsened. Although there are the "traditional" private equity funds like KKR, Texas Pacific, and Blackstone--freestanding funds--the banks have joined in. Interestingly, Apax and Blackstone, Goldman's partners in the failed ITV bid decried Goldman's "muscular" stance towards the bid. The returns on private equity investments are enormous. And Goldman admits that the returns on its advisory business were only a small part of its revenues. So, Goldman truly does sit on the "horns of a dilemma".

All professional services--and I include banking, law, accounting, consulting--depend on the creation and maintenance of trust. This type of relationship can exist as an arms length type but whether it gives rise to further business is questionable. Trust creates the potential for long term relationships. Trust is at the heart of fiduciary relationships.

The corollary of this is the way professional service firms create and sustain themselves. Many, such as law firms, accounting firms, are partnerships, ventures where sharing profits and losses is collectively valued. Bound in with the trust elements of the intra-firm relationships is the maintenance of reputation. A collective enterprise helps promote reputation and similarly if a partner deviates, the partnership is seen to act together to deal with the situation.

It's too easy these days to lose reputation. Mike Milken did it for Drexel Burnham: it vanished after the junk bond scandal. Enron did it for Andersen: also gone. If the SEC had indicted KPMG, the agreed opinion was that it would have been death on indictment: only just saved.

Of course it doesn't need scandal. Clifford Chance managed to upset a large number of clients when it announced that it would prioritize them according to size and global reach. Global clients would be in Rank #1; regional clients (eg, EU) would be in Rank #2; and national clients in Rank #3. Unsurprisingly, given the insensitive nature of the classification, a number of national and regional clients decided to change law firms. In the paper I gave at the Indiana Symposium on the Globalization of the Legal Profession recently, I argued that in promoting the cause of economic globalization, law firms helped by creating private systems of governance (private ordering), a process that depended on their good offices, their reputation, the trust they can engender. If their own organization fails in this, they can no longer command respect elsewhere.


ChinaLawBlog said...

Every firm (big or small) does this, be it formally or informally. They must. All firms, at least to a certain extent, categorize based on payment, type of work (i.e. interesting or not), core work or not, and even client likability. As the owner of a small international law firm I am often asked by potential clients why they should go with my firm rather than "Big Firm A." I reply by saying that Big Firm A is a great firm and everything we can do they can do, and more. BUT, what they are seeking we can do and, unlike Big Firm A, we really want their business and will treat them as an important client. I even go so far as to ask them how much attention they will get when Microsoft or Exxon calls Big Firm A and then tell them that they will be our Microsoft. Gets 'em nearly every time.

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