The Conference Board Governance Center Blog


Goldman Sachs Suit May be Start of Derivative Reform

If you are a director on a public company that relies on the derivatives market (i.e. credit default swaps, collateralized debt obligations, synthetic CDOs) to manage risk or a financial services company that is a player in that market, your world is about to change drastically.

It probably is not too surprising that on the same day the SEC charged Goldman Sachs in a civil suit for fraud in structuring and marketing a synthetic CDO tied to subprime mortgages, the head of the Senate Agriculture Committee, which oversees futures trading, proposed regulation of the derivatives market. My point is that just as the Obama Administration didn’t give up on health care reform it will do the same with financial regulatory reform. It seems that whatever financial reform is finally passed, regulation of the derivatives market will be included.

As you all know, the Dodd financial regulatory reform bill, due to hit the Senate floor in the next couple of weeks, also calls for derivative transactions to go through a clearinghouse and be traded on an exchange while the SEC and the Commodities and Futures Trading Commission would oversee them. [Read my March 15 blog post.]

Boards and the management they oversee are best served to make sure they know their company’s exposure to the myriad derivatives that are still out there. (At last count, the market was said to be from $300 trillion-to-$600 trillion.) Then, you should determine what regulation and the institution of an exchange could mean to the value of those securities. And, as Goldman is now learning, as a board you need to disclose as much as you can to your investors.

For those who don’t know about the Goldman Sachs case, James McRitchie of the Corporate Governance Network put it succinctly in his blog Monday:

“The SEC sued Goldman Sachs alleging that the bank created and sold ‘synthetic’ collateralized debt obligations, CDOs linked to subprime mortgages without disclosing to buyers that hedge fund Paulson & Co. helped pick the underlying securities and bet against the vehicle. Goldman is strongly disputing the SEC’s allegations.”

Lincoln’s bill would require derivatives to be subject to clearing and trading requirements, real-time reporting of trades and ensures that all loopholes are closed.

“The clearing and trading of financial transactions lowers risks and makes the entire financial system safer. My bill will bring 100 percent transparency to an unregulated $600 trillion market, expose these markets to the light of day and keep this money back on Main Street where it belongs,” Lincoln said.

U.S. Treasury Secretary Tim Geithner testified before the House of Representatives Financial Services Committee Tuesday about the need to regulate the “shadow” banking system.

He said: “The derivatives market, operating largely in the dark without oversight, grew to enormous scale, with firms able to write hundreds of billions of dollars in commitments without the capital needed to back them up … with financial reform we will bring the derivatives markets out of the dark.   We will establish transparency so that regulators can more effectively monitor risks of all significant derivatives players and financial institutions.”

So what do these developments mean for public boards? According to many corporate governance experts, quite a lot. In addition to McRitchie’s comments on his blog, Eleanor Bloxham, CEO of the Value Alliance and Corporate Governance Alliance, pointed out in her blog the need for proper disclosure to investors, especially in the case of Goldman Sachs.

Bloxham, in her first post to The Bloxham Voice, points out that Goldman Sachs’ board should have been cognizant of the fact the firm was under a 2003 settlement agreement with the SEC over charges stemming from the research/investment banking conflict of interest problems with several firms in the late 1990s.  According to that agreement, Goldman was supposed to “implement structural reforms and provide enhanced disclosure to investors.”

About the Goldman board’s responsibility, she writes:

What was the level of supervision in the most recent example? This is a question the Goldman Sachs board will need to address.”

While I am still awaiting the law firm client memos on this issue, here are some links to some good analysis on the issue the story broke last Friday:

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