Lack of ethical awareness, inadequate capital market regulations, and misconduct among professionals contributed to various scandals in the banking sector during the Global Financial Crisis (GFC). Firms in the banking industry entered into contracts with investors to sell sophisticated financial instruments. Contractual clauses that were found in agreements dealing with Collateralized Debt Obligations (CDOs), London Interbank Offered Rate (Libor) and other associated benchmarks played a significant role in the scandals. They were misleading and deceptive to investors when entering into purchase contracts that involved complex financial instruments.
The regulatory authorities tried to resolve the issues that arose in the scandals by taking the perpetrators to court and introducing reforms into the bank’s standards and practices. They adopted the approach to ensure that providers of financial services stopped taking advantage of unsuspecting clients and put their interests first. The report focuses on two cases, namely Goldman Sach and Wingecarribee v Lehman Brothers Australia. The contracts in these cases are involved in the sale of Synthetic Collateralized Debt Obligations (SCDOs). It will identify the essential contractual elements in the cases, issues, impact, policies, and regulations. The report also analyses the judgments in the cases and their ethical issues.
Elements of Contracts
Legally binding contracts have six essential elements that contribute to the protection of the rights of parties who are part of an agreement.
Offer and Acceptance
Creation of a valid contract requires one party, known as an offeror to make a lawful offer. It also requires the other party to the contract, referred to as an offeree to make a legal acceptance of the offer.
Legal Capacity
The parties entering into a contractual agreement must have the competence to do so. A contract cannot be valid if one of the parties does not have the legal capacity. Persons who lack the ability to contract include minors, people of unsound mind and intoxicated persons.
Genuine Assent
The parties forming a contract must have free consent, implying that they must come to an agreement about a similar thing and in the same way. Contracts lack genuine consent if they are made under circumstances such as coercion, undue influence, fraud, misrepresentation, and mistake. Such contracts are not valid.
Lawful Consideration
Legally binding contracts must have consideration, which entail what the promisee and promisor exchange between them.
Lawful Object
The objective of creating a contract must be legal, implying that the contract’s design or intention has to be lawful. Unlawful objectives include those forbidden by the law, fraudulent and injurious to a party or their property. It also consists of objects that are against public policy or regarded as immoral by courts.
Formalities of the Law
A legally binding contract can be formed orally, except in circumstances where an agreement is required to be in writing or registered by the law.
Analysis of the Cases
Goldman Sachs Case
Contractual Elements
Analysis of the Goldman Sach case indicates that essential contractual elements were involved in the process of creating the contract. Parties with legal capacity to contract made an agreement, whereby Goldman Sach made an offer, and it was acceptance by their clients. Parties had intended to form a legal relationship, and each party gave up something of value (consideration) when making the agreement. The legal formalities were included in the contract that involved having a written agreement between the parties. The missing element in this contract was the lack of genuine accent and a legitimate objective. Goldman omitted some relevant facts and made materially misleading statements to their client when negotiating the contract. Therefore, Goldman Sach firm and its employee deceived the client through fraud and nondisclosure leading to the lack of genuine assent from one party and hindered the existence of lawful objective in the contract.
Product and the Laws Governing It
The product under the Goldman Sach case was an SCDO. In this contract, it was being referred to as Abacus 2007-ACI (Abacus) security. Securities Act of 1933 in the U.S. governs the SCDOs.
Logic Behind the Contracts
Investing the SCDOs required parties that would take both long and short positions. There must have been a party on both sides of the SCDOs. It was inevitable that some of the parties involved would gain while the other party lost and all those involved must have been aware of this fact. The parties to the contract were considered as highly sophisticated institutions that were capable of using their resources and expertise in performing due diligence and analyzing the portfolio.
Discussion of the Issues in the Case
The issue that transpired in the case was that a junior trader from Goldman Sach violated the securities law by failing to reveal the other party that was part of the transaction to the client. Fabrice Tourre, the bank’s junior trader, withheld material information to its clients that a hedge fund, Paulson & Company, had a role in the selection of underlying securities. He also misled the investors by making them believe that the hedge fund was investing in the Abacus security. However, it was a secret plot with the bank as it was making an opposite investment wager. An agency relationship can be identified in the contract, with the principle being the bank, its employee acting as an agent and the client was the third party. Based on the relationship, the employee acted on behalf of the bank, making it liable to the third party for the actions of its agent. It explains why fraud and misconduct charges were brought against Goldman Sach bank and its employee.
Facts That Helps in the Development of the Issue to Be Taken to the Court
The investors in the Goldman Sach case incurred financial losses. They attributed the losses to the misstatements and omissions that were made by the bank and its employee during the structuring and marketing of the SCDOs. The bank had an obligation to prioritize needs of its clients when entering into any transaction. However, it assumed that clients had enough knowledge to evaluate the transactions and make the right investment decisions. Therefore, the occurrence of this issue resulted in the violation of securities law, creating enough grounds for charging the responsible parties in court (O’Brien 4).
Weaknesses in the Contractual Clauses
The contractual clause in the case of Goldman Sach was the assumption that if the client entering into an agreement with the bank had the resources and expertise to review the agreement, the bank could not be held liable for any damage suffered. However, it failed to offer guidance when fraudulent and deceitful conducts were involved in the agreement.
Wingecarribee v Lehman Brothers Australia
Contractual Elements
In this case, the Lehman Brothers branch in Australia that acquired Grange Securities made a contractual arrangement with local councils in Australia. Some key contractual elements were met in this agreement. The Lehman Brothers made an offer that was accepted by the councils. All parties had the capacity to enter into a contract, and adhered to the formalities of the law in the agreement. Participating parties also had the intention to enter into a legal relationship through their commercial agreement. However, genuine assent was lacking in the agreement due to the misrepresentation and deceptive conduct presented by Lehman Brothers towards the councils. Legal objective was also absent because Lehman Brothers engaged in fraudulent activities in the agreement that were injurious to the councils’ financial goals.
Products in the Case and Laws Governing It
The products involved in this case were SDCOs. In order to determine credit risk involved in these securities, it was necessary to identify the reference or underlying assets that had been named in a swap. In Australia, the product is classified as a derivative and governed by the Corporations Act 2001.
Logic Behind the Contracts
Before entering into the contract, the councils were known for having a conservative strategy when seeking financial products for investments purposes. Recommendations that Grange made pushed the councils to invest in products that did not meet its traditional strategy. It was against their norm to invest in one of the most complex investments with high-risk fixed income. However, the sales person from Lehman Brothers used great effort to convince them that SCDOs were low-risk securities. There were no documentations provided to reveal the actual risk factors of the SCDOs.
These actions show that Grange had a deliberate intention of misleading the councils from the inception of the contract. The councils had relied on Grange’s sales persons as their financial advisers. Lehman Brothers relied on the financial services legislation in Australia that allowed categorization of investors as either sophisticated or unsophisticated. Based on the classification, the defendant failed to advise its clients in an appropriate manner about the risk profiles of the specialized financial instruments.
Discussion of the Issue That Occurred in the Case
The actions of Grange securities resulted in misleading and deceptive conduct. The financial services provider was also negligent in its actions. It breached contractual terms and fiduciary duty. Breach of fiduciary duty occurred because Lehman Brothers offered recommendations, sold the product as a principle of the councils, and invested in the securities on behalf of the councils as their agent. Therefore, they owed their clients a duty of care by ensuring that their advice could not result in harming their financial goals.
Facts That Helps in the Development of the Issue to Be Taken to the Court
First, as a parent company of Grange Securities, Lehman Brothers was to be held responsible for all the transactions that Grande securities had entered. Secondly, as a financial services provider, it was necessary for the Lehman brothers to act in the best interests of its clients. However, the firm had taken advantage of the fact that the councils trusted its expert advice and lacked adequate knowledge on the securities it offered. As risk-averse individuals, the council members could not have entered into a contract with Grange if they were fully aware of the risks involved.
They only entered into a contractual agreement based on the expert advice they obtained from Grange, which turned out to be deceptive. The history of councils’ previous transactions and relationship with Grange revealed that they lacked sophistication. The financial expertise held by financial advisers of SCDOs enables them to have a greater understanding of the subtleties of risk profiles that are not necessarily indicated in a rating. Members of the councils lack this kind of expertise. Therefore, Lehman Brothers were liable for misconduct and their clients were justified to take them to court.
Weaknesses in the Contractual Clauses
According to a contractual clause in the agreement, the firm was allowed to classify its clients as sophisticated or unsophisticated investors. They could then provide financial advice based on which category its customers belonged to during a transaction process. The weakness in the clause is that it allowed the financial services provider to engage in misconduct through misstatement or fraud if it considered the client as sophisticated.
How Policies Set for SCDOs Handled the Issues in the Cases
Policies and regulations used to govern contracts involving SCDOs products were not adequate and could not help in preventing the issues that occurred. The issue of inadequate policies was also observed in other scandals that happened during the GFC. For instance, investigations revealed that the process of setting the London Interbank Offered Rate (Libor) was corrupt. Some institutions including Barclays bank were found to falsify and manipulate the reference rate systematically. The objective of their actions was to mislead the public about their financial health.
Lack of personal responsibility and accountability among business leaders led to the manipulation of LIBOR and associated scandals. The existing accounting standards were not adequate since the issues that arose during the GFC were considered to comply with the rules, or they were legal. Lack of a properly functioning ethical framework that was based on purpose, value and purpose mainly contributed to harmful corporate cultures. The various codes of conduct found within corporations, the industry and at professional level were not capable of handling the arrogance, shortsightedness, and dissociation of ethical considerations from core business (O’Brien 6).
In the case of Goldman Sach, it had set its standards and practices that were to be used in designing, marketing and selling complex financial products. According to these standards, it was not necessary for the bank to disclose all information to their clients. The assumption was that all those involved in transactions dealing with SCDOs were highly sophisticated investors. Therefore, they had the capability of performing due diligence on their own before entering into a contract to purchase the Abacus security. According to the applied policies, the bank was also required to disclose all information regarding the SCDOs to the investors. However, the policies did not give the extent of disclosure since in the contract; the bank provided partial information about the investment.
In the case of Wingecarribee v Lehman Brothers Australia, the product involved was supposed to be offered according to the policies laid out by the contractual terms and the legislation governing the sale of derivatives in Australia. However, the contractual terms had a weakness since they did not help in preventing the occurrence of the issues. The contractual terms indicated that the client was entering into an agreement to purchase low-risk securities (O’Brien 8).
The defendant was found guilty of having breached the contract because it instead sold the client high-risk securities. Lehman Brothers also relied on the financial services legislation in Australia that provided for the separation of sophisticated and unsophisticated investors. According to this legislation, Lehman Brothers felt they had no obligation to disclose all information to the client. They considered the clients as sophisticated, thus, were in a position to make sound financial decisions when purchasing complex debt instruments. The weakness in this legislative policy was that it lacked a clear guideline on how complex securities were to be marketed and sold to investors.
Settlement of the Cases
The Logic Behind the Early Settlement of the Case Instead of Taking Them to the Court
The reason that led to the settling of the case outside the court was due to lack of appropriate legislations that could be used in bringing the responsible parties to account. For instance, in the U.S, in exception of the civil proceedings that were brought against Goldman Sach junior partner and the bank, other enforcement had not occurred. The issue of the statute of limitations in the U.S had contributed to the lack of criminal or civil prosecutions. Similarly, in the United Kingdom, there were no cases relating to the GFC were taken to court. The logic behind settling the cases outside the court was due to the justification that it was impossible to get a guilty verdict.
Australian Case
Judgment
The judgment in the Wingecarribee Shire Council V Lehman Brothers was that the defendant was guilty of breaching the fiduciary duty in “facilitating individual transactions for complex products to sophisticated clients without explaining the risks” (O’Brien 9). As a trusted advisor to the plaintiff, Grange had a role to disclose the material risks that were associated with the financial products. These risks made the products inherently unsuitable to their clients. Grange fiduciary duty required it to state precisely the amount of its profits that it expected from its transactions with the clients and the manner in which these gains were obtained. The judgment did not find the clients guilty of contributory negligence since they did not have a chance of doubting the advice provided by the defendant.
Effect of the Judgment to the Parties
The effect of the judgment on the Lehman Brothers was that it was liable to the Council members for failure to exercise the fiduciary duty. Even without written documents to evidence that Grange had an advisory mandate, the agreement had an advisory relationship. The court failed to consider the defendant as a mere seller because they applied the principle of caveat emptor, which they should not have done. Identifying that Grange had an advisory relationship helps to indicate that it had a fiduciary duty. As a mere seller, the defendant did not have any duty to explain or provide advice on the securities. However, since it provided guidance and explanations, it was essential for this advice to be accurate and full. The fiduciary relationship led to two duties that the defendant breached. First, Grange could not get any unauthorized benefit out the fiduciary relationship. Secondly, it was not acceptable for a conflicting position to exist between fiduciary’s interests, duties, and interests of clients.
Lehman Brothers were held liable for breaching the implied terms in the purchase contract. The court implied terms into the purchase contract. The terms promised that the SCDOs were characterized with features that Lehman Brothers claimed they had, such as being suitable investments for the councils that were traditionally risk-averse investors. The councils had not been provided with all information concerning the securities, implying that Lehman Brothers conduct did not have their fully informed consent. According to the judgment, it is hard to determine the value of the damage suffered by the councils due to the illiquidity of the SCDOs and its increased deterioration in the market.
The judgment was based on some issues. First, the defendant took advantage of its client’s naivety in financial matters when entering into the contract. The firm stood to gain from this deception at the detriment of their clients. The client was also unsophisticated in financial matters and the firm deliberately used this fact to mis-sell complex debt instruments.
Adherence of the Judgment to Rules and Policies of Regulators
The rules and policies provided by regulators in the financial market offer investors a protection mechanism that is based on their classification as either sophisticated or unsophisticated. Regulators require more information to be disclosed to unsophisticated clients when they are being offered complex financial products. The aim of the regulation is to ensure that clients without adequate financial expertise are protected from deceitful firms that have an advantage of the asymmetrical information.
On the other hand, regulators assume that professional or sophisticated clients are in a position to make informed financial decisions because they have the necessary resources and competencies. In the judgment, the court adhered to the regulators’ policies and rules. It established that the councils were unsophisticated clients. As a result, they needed to be provided with all information concerning the SDCOs before entering into the contract. The determination of the councils as unsophisticated clients was crucial to the development of the court’s judgment (O’Brien 10).
Comparison of the Two Cases
The case handled in a better way
In my opinion, a comparison of the cases indicates that Goldman Sach case was handled in a better way than Wingecarribee v Lehman Brothers Australia. Goldman case included one of its employees, Fabrice Tourre. The employee and the bank were held liable for deceiving its clients. The case established that an agency relationship existed in the contract. Thus, the agent had to be held liable for his actions. Actions of the agent were within the authority given by his principle. Therefore, the principle was also liable for the actions of his agent as provided for in an agency relationship. Security Exchange Commission, a regulator in the U.S, was involved in taking the bank and its employee to court.
Thus, the market regulator played an active role in ensuring that professional misconducts were addressed and perpetrators charged in court. The settlement agreement in the case involved payment of penalties and a requirement to reform the bank’s standards and practices. Such a settlement would help in making sure banks were introducing improved internal control procedures within their systems (O’Brien 15). Contrary, in the Australian case, none of the employees from the firm was held responsible for any of the deceitful actions brought against it. The market regulator, the Australia Securities, and Investment Commission were not involved during the judicial process. The judgment found the firm guilty of deceiving and misleading the client, negligence, breaching contractual terms and fiduciary duty. However, the damages to be compensated to the client were not stated in the judgment.
Ethical Issues in the Handling the Cases
Cases were not handled in an ethical way since various issues remained unsolved in the settlement agreements and judgments provided in courts. Goldman Sachs entered into a settlement agreement with Securities and Exchange Commission (SEC) to reform its standards and practices. However, it is not a guarantee that the revised standards will solve the existing ethical problems. Indications are that ethical obligations in the industry are only laid down, but they were not adhered to, and organizations do not become accountable. The new standards also show that the bank did not come up with an effective mechanism that would help in dealing with the fundamental issues within a functioning ethical framework. For instance, the newly developed report states that improved levels of disclosure and transparency by the bank are voluntary initiatives.
However, the fact of the matter is that such initiatives have been introduced by legislative changes and negotiations in regulatory settlements. The bank also remains confident that professional investors are capable of making investment decisions without any advice as they consider them to have the necessary background, risk profile, and experience. Nevertheless, the previous court proceedings of the bank’s junior trader had already recognized that investors do not necessarily make correct investment decisions based on their background in financial matters. New standards also introduced vetting procedures that would help in designing and identifying the purpose of specific instruments provided by the bank. The procedure would help in making sure that financial products offered were appropriate for the market and relevant risk factors related to the instruments can be disclosed and addressed in an adequate manner.
The issue with these procedures is that it is not necessarily important that products being offered are appropriate or useful in the society as long as the bank could get away with selling them to the market. Therefore, the settlement agreement that required the bank to come up with new standards and practices overlooked its previous lack of commitment to developing a comprehensive ethical framework. In the Australian case, the judgment did not address the lack of an ethical framework that can be used by corporations in the future when selling complex financial products to all kinds of investors. According to the judgment, unsophisticated clients were entitled to a higher level of integrity from the corporations, unlike the sophisticated clients. The judgment indicates that if the clients, in this case, were determined to be sophisticated Lehman Brothers were not liable for the misconduct, which is unethical.
Conclusion
Analysis of the cases in the report indicates that contractual clauses contained in agreements dealing with complex financial products such as SCDOs were misleading and deceptive to investors. The main problem that led to these deceptions was the assumption that investors had access to the necessary financial knowledge and competencies that could enable them to make proper decisions. The categorization of investors as sophisticated or unsophisticated clients played a significant role in misrepresentation and omissions that occurred in these cases.
The approach taken by regulators was also based on this classification of investors as well as whether perpetrators owed their clients an obligation of putting their interests first. Additionally, during the pre and post-GFC period, the banking sector appears to lack full commitment to introduce adequate internal control measures that can help to align its practices with what is required by regulators. Existing policies did not have a way of identifying institutional or systematic risks and limitations in the statute resulting in the lack of criminal charges. It is also questionable whether the initiatives of reforms being undertaken are in a position to address the root of the normative issue of systemic unethical conduct.
Work Cited
O’Brien, Justin. “Professional Obligation, Ethical Awareness and Capital Market Regulation: An Achievable Goal or Contradiction in Terms?” Centre for Law Markets and Regulation, UNSW Law, Working Paper, 2013, pp.1-20.