Another Chink in the Wall: SEC Grants Self-Dealing Exemption to Goldman Funds

If you hired an adviser to make investment decisions for you, would you want him to buy securities for you out of his own account?

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Probably not. You couldn't always be sure you had gotten the best possible price. And you also wouldn't know whether the advisor recommend a security because it was a good investment or because he wanted to unload it from his account.

That's why more than 60 years ago, Congress prohibited mutual fund managers from selling securities to or buying securities from their funds. Nowadays, however, the Securities and Exchange Commission isn't so sure.

Last week, the SEC granted Goldman Sachs (GS Quote) an exemption from self-dealing prohibitions so that it could trade securities with the funds it advises.

Several months ago, I wrote that the securities industry was threatening to take its case to Congress if the SEC did not loosen restrictions on self-dealing. That threat gained credence recently when the House Financial Services Committee put mutual fund self-dealing rules on its legislative agenda.

The Goldman Sachs exemption signals the SEC may already be cutting deals to fend off legislation.

A Priceless Exemption

Goldman Sachs advises a number of money market funds, such as the Tax-Free Money Market fund, Tax-Exempt Diversified Portfolio and Tax-Exempt California Portfolio, that invest in short-term, tax-exempt securities issued by municipalities.

Goldman Sachs also is a municipal securities dealer. It trades billions of dollars in municipal securities with its customers, and profits by selling the securities at a markup and buying them at a markdown.

Goldman Sachs wants to trade municipal securities with its own funds. It argues that it has such a stranglehold on the short-term tax-free municipal securities market that its funds are at a disadvantage because they cannot compete. Although Goldman Sachs doesn't view this alleged disadvantage as significant enough to disclose in the funds prospectuses, it does believe that it is important enough to warrant an exemption.

The rules are designed to prevent firms from selling securities at inflated values to their funds (or buying from the funds at unreasonable discounts), and from using their funds as dumping grounds for excess inventory.

On a handful of occasions, the SEC has permitted firms to trade with their own funds when the transactions were limited to securities that trade in liquid, easily priced markets.

But the short-term, tax-exempt municipal securities market is characterized by illiquidity and price uncertainty, creating ideal conditions for fund managers to take advantage of their funds without leaving a trail.

Are Self-Dealing Rules Made To Be Broken?

Goldman Sachs openly admits in SEC filings that the overall liquidity of the municipal securities market has been declining, and that prices are uncertain. Prices are determined through "an elaborate telephone communication network to match buyers with sellers," concedes Goldman Sachs, "which generally precludes being able to obtain a single market price for a given price at any given time."

Shareholders of Heartland's (HRSDX Quote)Short-Duration High Yield Municipal and (HRHYX Quote)High Yield Municipal funds suffered the uncertainty of municipal securities pricing when their funds' values fell 70% and 44%, respectively, in a single day. (For more on the Heartland debacle, see my columns of Dec. 1, 2000, and Dec. 6, 2000.)

How will the funds know if they are receiving a fair price from Goldman Sachs the securities dealer? Why, they'll ask Goldman Sachs the fund manager, of course.

What's more disconcerting is how the fairness of the Goldman Sachs price is tested. Goldman Sachs fund managers will ask two fellow members of the exclusive club of tax-exempt municipal bond dealers at other firms -- there are only eight including Goldman Sachs -- for hypothetical prices for securities that are not the same but similar to the securities Goldman is trading with its funds.

At best, the "price test" will provide only a ballpark estimate of the true value of securities Goldman Sachs sells to its funds, which will still leave plenty of room for self-dealing. At worst, the price test may be a contrived exercise designed to paper the file for SEC examiners and cover up systematically disadvantageous deals for Goldman funds.

Even when the funds pay a fair price, there is nothing to prevent Goldman Sachs from dumping unwanted securities or excess inventory into its funds.

It is possible that Goldman Sachs will always act in the best interests of the funds -- we will never know. If there is cheating, it will occur at the imperceptible margins that will be difficult to identify, much less prove in court.

That's why Congress chose a prophylactic approach -- an outright ban on trades between funds and their affiliates -- that avoids the difficult problem of evaluating fairness by avoiding conflicts of interest altogether.

One Degree of Separation

Goldman Sachs objects to insinuations that its fund managers may be inclined to help out their dealer colleagues.

As if to guarantee the independence of its fund managers, it promises the managers and dealers will "maintain offices physically separate" from each other. But if memory serves, Michael Milken's relationship with Ivan Boesky was hardly inhibited by their not sharing an office suite.

In fact, Goldman Sachs regulatory filings paint a picture of liberal interaction between the managers and the firms' dealers. Municipal securities deals are done by phone, which means that Goldman Sachs dealers and fund managers will regularly be negotiating terms on a one-on-one basis.

In addition, Goldman Sachs filings reveal that fund managers also meet with "potential clients and may provide client services" outside their fund duties, and may "be solicited from time to time by various dealers, including Goldman Sachs," about how to structure new debt instruments.

Still, Goldman Sachs asserts that "information barriers" will separate fund managers from dealers. But it may take more than "information barriers" to separate Goldman Sachs fund managers from their share of Goldman Sachs' trading profits. While the managers' compensation is not based directly on how much their funds trade with Goldman Sachs, the firm's filings show that the fund managers' compensation "may be affected" by the dealers' trading profits.

Past as Prologue

Congress in 1940 prohibited self-dealing between funds and their managers largely in response to abusive practices engaged in by none other than Goldman Sachs.

In the 1920s, Goldman Sachs, Lehman Brothers (LEH Quote) and other investment banks organized mutual funds to provide a market for stocks the bankers brought to market. The abuses that arose from this practice were the subject of years of investigations in the 1930s.

In the course of the investigations, a senior Goldman Sachs partner testified before the then-fledgling SEC, "I don't think there is any doubt about it, when you form an investment company and sponsor it, you get income from stock exchange business and income from relationships created." Some things never change.