By: Simon Wilson
A clever bank meets an unsophisticated customer with a huge pile of cash. The customer and the cash part company. Did the bank do anything wrong?
A High Court judge in London has cleared Goldman Sachs of tricking Libya’s state investment fund into making vast leveraged investments in 2007-2008 that it didn’t properly understand – investments that were wiped out in the banking crisis. The dispute centred on Goldman’s dealings with the Libyan Investment Authority (LIA), a body set up at Muammar Gaddafi’s instigation to invest some of the country’s oil wealth as it was reintegrated into the global economy in the 1990s.
Goldman was one of the first big banks to spot the opportunity presented by Libya’s $35bn fund. It got close to the client, sent key staff to work alongside the nascent investment fund in Tripoli, lavished hospitality on the Libyans – and persuaded the LIA (in late 2007) to invest $1.2bn in nine equity derivatives trades, mostly in supposedly “undervalued” banking stocks, such as Citigroup. The trouble is, when the crash came and sent bank shares reeling, the Libyans lost everything.
Understandably quite upset then?
Anyone would be furious at losing $1.2bn, especially when the bankers who sold you the investment made $200m in revenues on the deal. The issue at stake, however, is whether Goldman did anything wrong, and the court has ruled very clearly that it did not. This is not the first instance of mis-selling claims – relating to trades that went badly wrong during the financial crisis – being thrown out by the courts. In March, a London court ruled in favour of Santander in a case brought by three Portuguese firms. They had bought interest-rate swaps that snowballed into losses of several times the underlying debt.
Libya, however, tried an unusual legal argument usually only applicable in cases of nefarious youths tricking elderly relatives out of their loot: that Goldman Sachs’s bankers had used “undue influence” to trick the newbie Libyans into “unconscionable” trades its investment managers didn’t understand.
Why did they argue that?
The Libyans’ case was that the LIA’s financial expertise was so negligible that its managers hadn’t even grasped they were not buying shares in Citigroup (and so on), but were in fact buying a derivative trade amounting to a leveraged bet that banking stocks would rise. Technically, they entered into a “cash-forward purchase agreement for Citigroup shares with downside protection in the form of a put option at the same price as the forward”, which amounts to roughly the same as a “cash-settled call option”.
Clearly, if you are a newcomer to investing you might well not fully understand exactly what you are getting into with such an instrument. And the court heard plenty of evidence that some of the Libyan managers were indeed derivatives novices. But the idea that a multi-billion-dollar sovereign-wealth fund didn’t grasp the difference between owning an equity and doing a derivatives deal? The court wasn’t buying it.
Why does all this matter?
A good deal of the interest in the case has been generated by the details of some of the alleged hospitality lavished by Goldman bankers, and in particular by the key salesman driving the deal, Youssef Kabbaj. According to Bloomberg Businessweek, the sweeteners arranged by Kabbaj ranged from the salacious (prostitutes in Dubai) to the bizarre (multiple copies of Michael Lewis’s Liar’s Poker, the tale of a bond salesman screwing over his clients). Kabbaj, a wealthy Moroccan educated in Paris and at MIT, has since left Goldman, and strongly denies any wrongdoing (see below).
More prosaically, and more importantly, the LIA case is significant because it raises moral as well as legal questions – and because if Goldman had lost, it would have set an astonishing precedent.
Leading to more claims?
Indeed. Libya’s claim was that one party to a transaction can have so much power over the other that the contract between them is invalid. If the court had ruled in Libya’s favour, it would have opened banks everywhere to lawsuits from clients claiming they were bamboozled.
In essence, says Matt Levine of Bloomberg (himself a former Goldman securities trader), the case boils down to the question: if you are a clever bank, and you come across a fairly unsophisticated customer with a gigantic pile of money, and you get them to make some big trades (which they may not fully understand) and the trades work out badly – have you done a bad thing? “There is a long tradition, in the financial industry and the law, of thinking that it’s just fine. It’s unseemly, sure” – but not wrong.
Or is it? Following the financial crisis, argues Levine, it is no longer entirely satisfactory to say that “customers dealing with banks should look out for themselves, and that banks have no responsibility for protecting customers from themselves. But, in the UK at least, it is still the law.”
The salesman behind the deal
Born into a wealthy family in Rabat, Morocco, Youssef Kabbaj attended the elite Lycée Louis-le-Grand in Paris before studying engineering at MIT. He was hired by Goldman after a stint at a Moroccan bank, according to Bloomberg. Goldman initially offered him a job as one of its “quants” – the maths whizzes behind algorithmic trading strategies. But he “insisted on a role in sales, convinced he could climb the ladder faster by being close to clients”.
The only available post was covering Africa, a backwater that generated next to no revenue at the time (2006), so Kabbaj cold-called the nascent Libyan Investment Authority. Two years later, the Libyan deal had earned him a $9m bonus, though he ultimately only received $4.5m.