By Una Galani
Breakingviews
Reuters

July 22, 2016

Malaysia’s sovereign fund scandal has exposed shortcomings in Goldman Sachs’ post-crisis overhaul of its business practices. Five years ago, the Wall Street firm led by Lloyd Blankfein went to great lengths to assure regulators, investors and clients that it was tightening up standards. But its dealings with the now disgraced 1Malaysia Development Berhad (1MDB) cast doubt on the depth of Goldman’s changes.

An attempt by the U.S. Department of Justice to seize assets bought with some of the $3.5 billion it says was stolen from 1MDB offer the clearest account yet of the bank’s deep relationship with the Malaysian fund. Though Goldman has not been accused of any wrongdoing, its name appears frequently in lawsuits that detail a complex web of fraudulent transactions over several years.

Back in 2009, Goldman helped set up the fund which counted Malaysian Prime Minister Najib Razak as its top advisor. An excerpt of an email suggests that, from the very start, Goldman executives were concerned about the issue of transparency at the new fund and its reliance on borrowed money. By the time the bank started raising money for 1MDB in earnest three years later, corrupt officials had already sucked around $1 billion from the fund, the legal documents show.

Nevertheless, between 2012 and 2013 Goldman helped 1MDB raise $6.5 billion by issuing three bonds. The Justice Department suggests that around 40 percent of that money was siphoned off, and indicates that $681 million ultimately found its way into Najib’s personal bank account, though the prime minister is not directly named.

Some of the rest of the funds taken from 1MDB ended up in a Bombardier jet, artwork by Monet, an interest in EMI Music Publishing, prime real estate in Beverly Hills, and the movie “The Wolf of Wall Street”.

The relationship with 1MDB was highly lucrative for Goldman. In total, the bank earned roughly $590 million in fees, commissions and expenses, according to the legal filings – far more than a bank would normally expect to earn on bond deals for a quasi-sovereign client. Goldman was able to charge more because it put its balance sheet at risk by buying the bonds from 1MDB before selling them on to other investors. One of the bond offerings was given the code name “Project Maximus”.

1MDB says that it has not been contacted by the Justice Department or any other foreign agency in relation to their investigations. Najib’s press secretary said in a statement that the law will be enforced without exception if any wrongdoing is proved.

For its part, Goldman says it had no visibility on whether the funds it raised for 1MDB were diverted for other purposes. The bank has previously stressed that its fees were commensurate with the risk it assumed and that it did proper due diligence on 1MDB.

Nonetheless, the transactions may yet drag Goldman into a criminal investigation. U.S. law enforcement officials are probing whether the bank failed to comply with the U.S. Bank Secrecy Act with regards to its fundraising for 1MDB, according to a person familiar with the situation. The Act requires financial institutions to report suspicious transactions to regulators.

Whatever the outcome of the ongoing investigations, however, Goldman’s reputation has already taken a savage beating. This was exactly the kind of mess it was trying to avoid by overhauling its standards following the financial crisis.

Around the time that the bank agreed in 2010 to pay $550 million to settle charges it improperly sold a product linked to subprime mortgages, chairman and Chief Executive Blankfein launched a global review to strengthen the firm’s practices and culture. The following year, Goldman published a 63-page document with 39 recommendations designed to ensure its bankers and traders paid as much attention to reputational risks as financial ones.

Goldman says Blankfein dedicated more time to reinforcing the message about personal accountability, client service and reputational risk management with employees than to any other initiative in 2011 and early 2012.

Moreover, a 28-page assessment of the reforms published by Goldman in 2013 claimed the bank’s approach to transactions was now “fundamentally different”. Committees that approve individual transactions were required to vet deals more vigorously and differentiate “from those we could have done, but should not do, to transactions that we both can and should do”.

It is impossible for outsiders to understand all that transpired inside Goldman while it was vetting the 1MDB deals. But plenty of warning signs were visible. The three most obvious were that a quasi-sovereign client wanted to raise a large amount of money at short notice, was willing to pay hefty fees, and directed the proceeds to a small Swiss private bank.

Goldman’s top bankers doubtless had a vigorous debate about the merits and structure of the various 1MDB bonds. The bank did propose cheaper ways for the sovereign fund to raise cash, according to a person familiar with the situation. On one occasion, it insisted that 1MDB went to rival banks to seek alternative pricing. Nevertheless, the transactions still went ahead.

The 1MDB saga does not invalidate Goldman’s efforts to reform the way it does business around the world. But the Malaysia mess does raise questions about the depth of these reforms – and serves as a reminder about how hard it is to change a bank’s culture.