Goldman Sachs’ and Lehman Brothers’ Contractual Clauses

NB: We do not resell your papers. Upon ordering, we do an original paper exclusively for you.

NB: All your data is kept safe from the public.

Table of Contents

Introduction
Analysis of the Contracts
Understanding the Cases
Policies in the Case
The Case Taken to Australian Court
Comparing the Cases
Conclusion and Recommendation
References

Introduction

When two or more parties enter into a deal that requires the signing of a contract, some basic factors must be met by both. Blinder (2013, p. 59) defines a contract as a “legally binding agreement between two or more parties that has legal obligation.” As seen in this definition, once parties enter into a contract, they must abide by the set agreement as expected of them by the law. However, the contract must meet the five basic elements to be considered legally binding. In a modern highly competitive business environment where firms are keen on identifying weaknesses of other parties and taking full advantage of them, it is common to find cases where contracts are not based on utmost good faith. Some parties enter into contracts with fraud in mind.

These fraudulent firms often aim at finding means of gaining more than the other parties in a contract. If it is proven that one party intentionally came up with measures to benefit more from a contract at the expense of the other party, then the aggrieved party may seek legal means of addressing the problem. However, Weatherall (2013) says that in most cases the deception is often done in such a smart way that it becomes almost impossible to detect that one party acted in bad faith.

Such was the case in the scandals about Goldman Sachs and Lehman Brothers. Scholars and financial experts have been interested in determining how Goldman Sachs was able to come out of the 2008 economic recession a stronger firm while Lehman Brothers were forced out of the market. The two firms had a different business contract that led to litigation because of taking advantage of the investors and business partners. The outcome of these business contracts was a massive loss of investors’ money that led to a series of court cases. In this paper, the researcher seeks to investigate these two cases.

Analysis of the Contracts

General Contract Elements

The United States Securities and Exchange Commission vs Goldman Sachs, April 16, 2010

Goldman Sachs had made great success trading in subprime mortgages before the 2008 global financial crisis. It enjoyed the high profitability of this product but was fully aware of the risks associated with it. In the 2005/2006 financial year, the management at Goldman Sachs realized that the market forces were changing. The chief executive officer at Goldman Sachs was duly advised that the economic trends strongly indicated that there might be a financial crisis in the global market, especially in the United States, Canada, and Europe. Given the anticipated financial meltdown, the top management at Goldman Sachs knew that the subprime mortgages that it had been offering to its clients posed a serious risk. It realized that most of the customers given such mortgages are the middle-class people who wholly rely on salaries from their employers to finance their mortgages. Given that these mortgages had no collaterals customers had to pay for them directly for this company to get profits.

When the top management at Goldman Sachs realized the risk that it faced with its current subprime mortgages, it looked for an easy way out without causing a steer in the market. It planned for a solution that would help in overcome this challenge without raising attention in the market. As such, the company created a multi-billion dollar deal that targeted non-suspecting investors. In this deal, it is alleged that “structured and marketed a synthetic collateralized debt obligation (CDO) that hinged on the performance of subprime residential mortgage-backed securities,” (Weatherall, 2013, p. 78). It meant that Goldman Sachs transferred all the responsibility for future losses associated with the subprime mortgages to the unsuspecting clients through the stock market.

The collateralized debt obligation (CDO) was a smart but unscrupulous move by the top management unit at Goldman Sachs to overcome the risks posed by subprime mortgages at the expense of other companies. The main issue that experts have raised is that there was no full disclosure in this deal. At the time of signing the deal, the executives at Goldman Sachs had made a bet that the subprime mortgage market would collapse with the coming financial crisis. On one hand, the top managers of Goldman Sachs knew that the risk would occur and had made bets to that effect. On the other hand, the firm entered into a contract with another firm, arguing that this was a good business deal because the risks were not likely to occur.

The top managers at Goldman Sachs stood to benefit in two main ways in case the risk occurred. Given that their interest was in seeing Goldman Sachs successful despite the expected economic woes, they were not committed to the deal and their primary objective was to push the financial burden of the expected loss to another company. As such, the deal that they were offering to the other party in the contract was a loss, not an opportunity that could bring either a loss or a profit. The betting made by people related to the firm about the sure collapse of the subprime mortgages was another element of the bad faith in which Goldman Sachs was entering the deal. The interest of the top executives of this firm was, therefore, to see the collapse of the subprime mortgages. Such a failure would lead to direct financial benefits for the executives who made the bet (Firoozye & Ariff, 2016). The Securities and Exchange Commission held that Goldman Sachs violated some regulations and basic principles of a contract.

Wingecarribee Shire Council vs. Lehman Brothers, Sep 23, 2012

Lehman Brothers was the fourth largest investment bank in the United States months before its collapse. As a financial institution that heavily relied on subprime mortgages to make its profits, the management realized that it had to act very quickly and effectively to secure its future in the market. The management realized that it needed to win the confidence of the investors to avoid a sharp drop in its market shares as it struggled to overcome the challenges in the market. In an attempt to attract new investors in Australia, () says that Lehman Brothers “had misdescribed very complex and high-risk financial products to councils and charities around Australia as ‘safer than the four major Australian banks’ when they were not.” It deliberately lied to the investors and sold them very complex synthetic collateralized obligations without fully informing them about the deal. It is alleged that Lehman Brothers only focused on the benefits of the deal, and failed to inform the investors about the threat associated with the CDOs.

In the meantime, the top executives of this firm and their close association who knew the actual challenges that the firm was facing went ahead and sold their shares as the firm continued to face more financial difficulties. The deal between Lehman Brothers and council members who were the investors was designed to transfer the risks associated with the CDOs to the new Australian investors. Bernanke (2013) argues that if the truth about the products offered by Lehman Brothers Wingecarribee Shire Council were revealed at the right time, corrective measures would have been adopted to avoid the massive financial loss that these clients experienced. Investors’ money would not have been lost to the tune that was witnessed because of the deception by those who were trusted by new investors. The Federal Court of Australia heard that this firm deliberately took advantage of investors’ limited knowledge about CDOs to expose them to serious financial risks without their knowledge.

Understanding the Cases

Elements of the Contract Concerning the Case

The case about Goldman Sachs subprime mortgage deals has attracted the attention of many financial analysts and scholars who have been investigating how this firm was able to use deception to overcome the financial crisis at the expense of another firm. In any normal contact, there are specific elements that must be clearly defined. The first element in any contract is the offer. In this contract, Goldman Sachs was offering collateralized debt obligations in the securities exchange market. In this case, Goldman Sachs did not reveal several factors concerning this deal. It meant that investors were not fully aware of the risks this deal would expose them to, and as such several firms went ahead and accepted the deal that Goldman Sachs was offering. Most of these clients never made any due consideration because they trusted products offered in the securities exchange. As such, Goldman Sachs and numerous other investors entered into a mutually binding deal with clear obligations to each of the parties. However, the executives at Goldman Sachs knew that important facts about the deal were never revealed to the other parties. It meant the contract was designed to specifically favor one party at the expense of the other parties.

In the case of Lehman Brothers, the contract was between Lehman Brothers and Wingecarribee Shire Council in Australia. According to (), Lehman Brothers Australia Ltd was a trusted company not only in Australia but also in the United States and at the global level. When it offered collateralized debt obligations (CDOs) in the securities market, many investors, including Wingecarribee Shire Council in Australia trusted the product. The Council gave their acceptance without making due investigation about the risks associated with the product. These investors only relied on the profitability of the CDOs and believed that Lehman Brothers had revealed all the risks associated with the product. As such, the investors, through Wingecarribee Shire Council, entered into a binding contract with Lehman Brothers in a deal where a lot of important facts were hidden from them. The complexity of synthetic collateralized debt obligations (CDOs) made it easy for Lehman Brothers to hide the truth about the risks involved to the investors ().

Products Under the Case and Laws Governing Them

In the case of Goldman Sachs, the product involved was synthetic collateralized debt obligations (CDOs). The investors bought this product believing that they are not exposed to any major risks based on the information that the executives at Goldman Sachs offered them. In exchange, Goldman Sachs offered financial incentives in terms of premiums as the law requires. The law governing contracts demands that both parties must be committed to full disclosure of important information regarding a contract. In this particular case, Goldman Sachs was expected to give full disclosure of the magnitude of the risk and the likelihood of its occurrence. The information is critical in determining the cost of synthetic collateralized debt obligations (CDOs). It would also determine whether or not investors in the securities market would have accepted or rejected the offer.

In the case of Lehman Brothers, the product that was offered was also the synthetic collateralized debt obligations (CDOs). Lehman Brothers Australia Ltd was interested in expanding its Australian market. However, the top management in Australia knew the challenges that this company was facing and the need to increase its revenues. As such, it came up with very complex CDOs and explained its profitability to the investors. Wingecarribee Shire Council was convinced that the product offered by Lehman Brothers was profitable. The risks associated with this product were expertly concealed by the top managers at Lehman Brothers in a way that it was almost impossible for them to detect. This act of non-disclosure was against the laws that regulate trading in the securities exchange within the country. It unfairly leaves investors exposed to risks they never even knew existed. Sure enough, the investors got exposed to the risks in this deal of Lehman Brothers.

The Logic Behind the Contract

When entering into a contract, it is important to understand the logic behind it. As Johnson and Kwak (2010) say, in any contract, both parties must have financial justification for why they are entering into it. In the contract between Goldman Sachs and investors in the securities market, each firm had the specific financial justification that made them believe it was worth signing the contract. For Goldman Sachs, the management unit was aware that the firm was facing a serious financial challenge because of the collapsing subprime mortgage market. Given that this firm had expended huge amounts of unsecured loans to its clients, there was a need to find a way of protecting itself from the expected loss. From this deal, Goldman Sachs was getting security from the expected loss.

It had known that the risk of failing to repay the loan was real. Through this contract, it would transfer the huge financial losses to another firm. On their part, the investors in the securities market saw a business opportunity that was granted to it by Goldman Sachs. It was an opportunity to invest in the collateralized debt obligation. Insurance companies often get their profits when they offer security against risks that do not occur. From this deal, it is expected to benefit from offering security that is expected not to occur. The management of this company was not aware that the risk against which it was offering security was bound to occur. As such, the logic behind which this firm entered into a contract with Goldman Sachs was to earn profits.

In the case of Lehman Brothers, there was a logic that made the top management of Lehman Brothers convinced that it was prudent to hide the truth about collateralized debt obligation risks. To the management of this firm, the logic of making this decision was to create time so that it could address the financial problems that were affecting the company. The management feared that when the investors knew about the events taking place at this firm, they would act in fear and sell their shares. By dumping the shares of this company in the securities market, the firm may find it difficult in overcoming the current challenges. As such, the firm wanted to specifically focus on the problem of the increasing risks posed by the subprime mortgages.

Santoro and Strauss (2013) say that the fear of the top managers of Lehman Brothers was justified. Dealing with the problem of falling market prices of the company shares and the risk posed by the subprime mortgages concurrently was going to be a big challenge. The approach they used was wrong, but the intention was noble because they thought they could restore normalcy within a short while. On their part, the investors saw a perfect opportunity to invest in the collateralized debt obligation of a reputable company. At the time of investing, they did not know that there were specific risks that were attached to the CDOs. Their logic was that they would make a good profit in investing in this firm. Being the fourth largest investment firm in the United States and one of the largest financial institutions in the global market, the investors were convinced that they will get value for their investment.

Issues that Occurred in the Cases

The two cases clearly show how mistakes made by those at the top may have serious financial implications for a firm they manage and other people who have a financial relationship with the firm. At Goldman Sachs, there was a fraud committed by the top managers by entering into a contract without making a full disclosure about the risks involved. It was also fraudulent of the management to bet on the failure of the subprime mortgages that it was seeking insurance against through the contract. It was as though it had the intention of ensuring that the risk would occur. For the case of Lehman Brothers, there was a conspiracy among the top managers to hide the truth about the firm’s financial problems. This decision proved very costly not only to the firm but also to the shareholders who had invested in the company.

Facts that Helped in the Development of the Issue

The case about Goldman Sachs was purely based on business on the part of the investors. Goldman Sachs had proposed a business deal to it and the firm was interested in the business deal because it was not aware of the associated risks. However, Goldman Sachs intended to find security against the risk of the volatile subprime mortgage market. These are the facts that pushed the two firms into having a business deal. In the case of Lehman Brothers, it was purely based on a conspiracy of the top management about needed time to address the problem it was facing with its subprime mortgages. The top management of this firm was convinced that the management was capable of addressing this problem in time to restore financial sanity at the firm.

Weaknesses in the Contractual Clauses

The contracts signed between Goldman Sachs and investors at the securities exchange had several weaknesses. The main weakness is that before signing the contract, the investors failed to demand full disclosure of information such as the level of certainty of the risk occurring. It assumed that it was a normal risk. The two parties also failed to agree on a penalty that either of the parties would face in case any failed to meet the end of the bargain or in case either of the party failed to provide important information to the other party. In the case of Lehman Brothers and Wingecarribee Shire Council, the main weakness is that the top executives at Lehman Brothers made a deliberate attempt to hide the risks associated with its products. Wingecarribee Shire Council also failed to conduct thorough investigations to understand the products they were purchasing. They purely relied on trust and believed that the executives at Lehman Brothers would not hide important facts about the product. The management of Lehman Brothers had to bear the blame for the collapse of this giant investment company.

Policies in the Case

There are policies and regulations that firms are expected to follow when engaging in any business deal. In the case of Goldman Sachs, it was entering into a deal that involved getting an insurance cover by selling its collateralized debt obligations. There are regulations that both the insurer and the insured must observe as defined in policy insurance. Gatti (2013, p. 45) defines policy in insurance as “a contract, generally a standard form contract, between the insurer and the insured, known as the policyholder, which determines the claims which the insurer is legally required to pay.” It is often determined by the value of the insured item which then subsequently determines the number of premiums that the policyholder should pay. In the case of Lehman Brothers, the policy regarding collateralized debt obligations require the seller to provide truthful information about the financial position of their client (Ramirez, 2013). The auditor should not only be loyal to the client but also members of the public.

Policies Regarding CDO

Collateralized Debt Obligations (CDOs) has evolved from what it was originally and currently, it also includes mortgages. As McLean and Nocera (2010) say, the most important policy regarding CDO is that it must always be asset-backed security. Because of the high risks involved, the insurer must get security before issuing the loan in the form of an asset. The asset must be easy to liquidate in case it becomes necessary. According to Ramirez (2013), CDOs were initially developed for the corporate debt market, but it quickly gained popularity in the mortgage market. This product is currently very popular in the mortgage market, but it is often guided by very strict policies because of the complexities associated with it. The strict policies, especially on the issue of disclosure, are developed because of the need to protect vulnerable investors from unscrupulous business people who may try to take advantage of the complexities of CDOs to steal from them.

The Logic Behind Early Settlement of the Case

When a lawsuit was filed against Goldman Sachs in Washington, D.C., the firm opted to make an early settlement instead of letting the case drag in the courts. It settled on USD 15 million in the class action suit for its deliberate decision to hide important details from the investors. In Australia, Lehman Brothers Australia Ltd was also taken to court by Wingecarribee Shire Council for failure to make full disclosure when the two firms entered into a contract. The company also opted to make an early settlement. In both cases, the logic behind early settlement was to protect the firm reputation in the market and to reduce the cost associated with prolonged court cases.

The Case Taken to Australian Court

Wingecarribee Shire Council came to realized that Lehman Brothers acted in bad faith when the two entities entered into a legally binding contract. Wingecarribee Shire Council realized that indeed there were several facts that Lehman Brothers Australia ltd hid from it when making the contract. As Levin and Coburn (2011) say, contracts are often based on utmost good faith. Both parties are expected to provide as much information as possible about the deal. It is illegal and unethical for a firm to deliberately hide fundamental facts about a contract to the other parties of the contract. As such, Lehman Brothers acted in bad faith, leading to the litigation against it by Wingecarribee Shire Council. In the case, Wingecarribee Shire Council claimed that it lost significant value of its investment from the deal. In the suit, Wingecarribee Shire Council was demanding for the value of its investment lost in the deal and a fine for the damages resulting from the deal.

The Judgment

The case against Lehman Brothers Australia Limited was tried in Australia. The firm reached a settlement of USD 500 million for its actions that demonstrated a lack of good faith when signing the contract. It was held that its failure to make full disclosure to the other party before signing the contract led to the financial losses of the firm.

How It Affected the Two Parties

The judgment had an impact on the two parties in different ways. For Wingecarribee Shire Council that had made losses because of the deceptive contract that it had signed with Lehman Brothers, the outcome of the case was a relief because it was compensated for the financial losses it suffered. For Lehman Brothers Australia Ltd that was responsible for the deception, the fine affected its finances.

Basis of the Judgment

The judgment was based on the fact that at the time when these two companies entered into the contract, one of the parties (Lehman Brothers) failed to provide an important detailed about the risk against which it was seeking insurance. As such, it acted against the law. The ruling was based on the fact that Lehman Brothers knew the risk was certainly going to occur but failed to warn Wingecarribee Shire Council.

How It Went with the Rules and Policies of the Regulators

The outcome of the case was in line with the policies and rules of the regulators. It was a warning to other companies that the need for full disclosure of all the relevant information relating to a contract must be made as demanded by law. Any manipulation of facts in favor of one firm can lead to legal action, as was the case with Lehman Brothers.

Comparing the Cases

The two cases discussed above have some factors that make them similar. However, the most striking factor is that they both involved parties hiding important facts.

The Case That Was Handled Better

The case about Lehman Brothers that was handled in Australia was handled in a better manner than that of Goldman Sachs. In Goldman Sachs’ case, many investors went without getting back their money after the fall of the firm. Lehman Brothers were able to face the law in Australia.

Ethical Issues in Both Cases

Both cases present ethical concerns that are worth taking note of because of the implications they had. The two cases clearly emphasize the need for full closure of relevant information to the investors and business partners, especially when entering into a business deal.

Conclusion and Recommendation

The two cases about Goldman Sachs and Lehman Brothers indicate that business ethics is very important. When a firm fails to embrace ethics, then it may affect its sustainability in the market. Lehman Brothers failed to make it through partly because of a lack of ethics and it was forced out of the market. For Goldman Sachs, its reputation was affected although it survived. The following recommendations should be taken when a firm is entering into any binding business contract.

Both parties must commit to making full disclosure of all the relevant information in a given contract.
There should be a clause that clearly defines consequences for each party that fails to make the relevant disclosure.
The government should come up with new policies that spell out punishments for firms that fail to make relevant disclosure.

References

Bernanke, B. (2013). The Federal Reserve and the financial crisis. Princeton, NJ: Princeton University Press.

Blinder, A. S. (2013). After the music stopped: The financial crisis, the response, and the work ahead. New York, NY: Penguin Press.

Firoozye, N. B., & Ariff, F. (2016). Managing uncertainty, mitigating risk: Tackling the unknown in financial risk assessment and decision making. Basingstoke, UK: Palgrave Macmillan.

Gatti, S. (2013). Project finance in theory and practice: Designing, structuring, and financing private and public projects. Amsterdam, Netherlands: Academic Press.

Johnson, S., & Kwak, J. (2010). 13 bankers: The Wall Street takeover and the next financial meltdown. New York, NY: Pantheon Books.

Levin, C., & Coburn, T. A. (2011). Wall Street and the financial crisis: Anatomy of a financial collapse. New York, NY: Cosimo Reports.

McLean, B., & Nocera, J. (2010). All the devils are here: The hidden history of the financial crisis. New York, NY: Portfolio/Penguin.

Ramirez, J. (2013). Accounting for derivatives: Advanced hedging under IFRS. Hoboken, N.J: Wiley.

Santoro, M. A., & Strauss, R. J. (2013). Wall Street values: Business ethics and the global financial crisis. Cambridge, UK: Cambridge University Press.

Weatherall, J. O. (2013). The physics of Wall Street: A brief history of predicting the unpredictable. Boston, MA: Houghton Mifflin Harcourt.

Click Here To Order Now!