| GOLDMAN SACHS GROUP INC/ Item 1A Risk Factors We face a variety of risks that are substantial and inherent in our businesses, including market, liquidity, credit, operational, legal and regulatory risks |
| The following are some of the more important factors that could affect our businesses |
| Our businesses may be adversely affected by conditions in the global financial markets and economic conditions generally |
| We have achieved record earnings per common share in each of our last two fiscal years, reflecting a favorable trading environment in FICC, an improvement in the trading environment for Equities and an increase in investment banking activity |
| An adverse change in these market conditions may adversely affect our results of operations |
| Our businesses are materially affected by conditions in the global financial markets and economic conditions generally and these conditions may change suddenly and dramatically |
| Unfavorable or uncertain economic and market conditions have adversely affected, and may in the future adversely affect, our business and profitability in many ways, including the following: • We have been operating in a low interest rate market for the past several years |
| Increasing or high interest rates and/or widening credit spreads, especially if such changes are rapid, may create a less favorable environment for certain of our businesses |
| • We have been committing increasing amounts of capital in many of our businesses and generally maintain large trading, specialist and investing positions |
| Market fluctuations and volatility may adversely affect the value of those positions, including, but not limited to, our interest rate and credit products, currency, commodity and equity positions and our merchant banking investments, or may reduce our willingness to enter into new transactions |
| From time to time, we have incurred significant trading losses in periods of market turbulence |
| Conversely, certain of our trading businesses depend on market volatility to provide trading and arbitrage opportunities, and decreases in volatility may reduce these opportunities and adversely affect the results of these businesses |
| • Industry-wide declines in the size and number of underwritings and mergers and acquisitions may have an adverse effect on our revenues and, because we may be unable to reduce expenses correspondingly, our profit margins |
| In particular, because a significant portion of our investment banking revenues are derived from our participation in large transactions, a decrease in the number of large transactions due to uncertain or unfavorable market conditions may adversely affect our investment banking business |
| • Pricing and other competitive pressures have continued, even as the volume and number of investment banking transactions have increased |
| In addition, the trend in the underwriting business toward multiple book runners and co-managers handling transactions, where previously there would have been a single book runner, may adversely affect our business and reduce our revenues |
| • Reductions in the level of the equity markets also tend to reduce the value of our clients’ portfolios, which in turn may reduce the fees we earn for managing assets |
| Even in the absence of uncertain or unfavorable economic or market conditions, investment performance by our asset management business below the performance of benchmarks or competitors could result in a decline in assets under management and in the incentive and management fees we receive |
| 19 _________________________________________________________________ [94]Table of Contents • Concentration of risk increases the potential for significant losses in our market-making, proprietary trading and investing, block trading, merchant banking, underwriting and lending businesses |
| This risk may increase to the extent we expand our proprietary trading and investing businesses or commit capital to facilitate customer-driven business |
| For example, large blocks of securities are increasingly being sold in block trades rather than on a marketed basis, which increases the risk that Goldman Sachs may be unable to resell the purchased securities at favorable prices and may incur significant losses as a result |
| Moreover, because of concentration of risk, we may suffer losses even when economic and market conditions are generally favorable for others in the industry |
| We also regularly enter into large transactions as part of our trading businesses |
| The number and size of such transactions may affect our results of operations in a given period |
| • The volume of transactions that we execute for our clients and as a specialist or market maker may decline, which would reduce the revenues we receive from commissions and spreads |
| In addition, competitive pressures and other industry factors, including the increasing use by our clients of low-cost electronic trading, could cause a reduction in commissions and spreads |
| In our specialist businesses, we are obligated by stock exchange rules to maintain an orderly market, including by purchasing shares in a declining market |
| This may result in trading losses and an increased need for liquidity |
| Weakness in global equity markets and the trading of securities in multiple markets and on multiple exchanges could adversely impact our trading businesses and impair the value of our goodwill and identifiable intangible assets |
| In addition, competitive pressures have been particularly intense in the context of block trades |
| We may incur losses as a result of ineffective risk management processes and strategies |
| We seek to monitor and control our risk exposure through a variety of separate but complementary financial, credit, operational, compliance and legal reporting systems |
| Our trading risk management process seeks to balance our ability to profit from trading positions with our exposure to potential losses |
| While we employ a broad and diversified set of risk monitoring and risk mitigation techniques, those techniques and the judgments that accompany their application cannot anticipate every economic and financial outcome or the specifics and timing of such outcomes |
| Thus, we may, in the course of our activities, incur losses |
| For a further discussion of our risk management policies and procedures, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Risk Management” in Part II, Item 7 of the Annual Report on Form 10-K Our liquidity may be adversely affected by an inability to access the debt capital markets or to sell assets |
| Liquidity is essential to our businesses |
| Our liquidity could be impaired by an inability to access secured and/or unsecured debt markets, an inability to sell assets or unforeseen outflows of cash or collateral |
| This situation may arise due to circumstances that we may be unable to control, such as a general market disruption or an operational problem that affects third parties or us |
| Further, our ability to sell assets may be impaired if other market participants are seeking to sell similar assets at the same time |
| A reduction in our credit ratings could adversely affect our liquidity and businesses in many ways |
| A reduction in our credit ratings could adversely affect our liquidity and competitive position, increase our borrowing costs, limit our access to the capital markets or trigger our obligations under certain bilateral provisions in some of our trading and collateralized financing contracts |
| Under these provisions, counterparties could be permitted to 20 _________________________________________________________________ [95]Table of Contents terminate contracts with Goldman Sachs or require us to post additional collateral |
| Termination of our trading and collateralized financing contracts could cause us to sustain losses and impair our liquidity by requiring us to find other sources of financing or to make significant cash payments or securities movements |
| An inability of The Goldman Sachs Group, Inc |
| to access funds from its subsidiaries could adversely affect its ability to meet its obligations |
| The Goldman Sachs Group, Inc |
| is a holding company and, therefore, depends on dividends, distributions and other payments from its subsidiaries to fund dividend payments and to fund all payments on its obligations, including debt obligations |
| Many of our subsidiaries, including GS&Co, are subject to laws that authorize regulatory bodies to block or reduce the flow of funds from those subsidiaries to The Goldman Sachs Group, Inc |
| Regulatory action of that kind could impede access to funds that The Goldman Sachs Group, Inc |
| needs to make payments on obligations, including debt obligations, or dividend payments |
| (or any other entity) holds equity interests in the firm’s regulated or unregulated subsidiaries, its rights as an equity holder to the assets of such subsidiaries are subject to the satisfaction of the claims of the creditors of such subsidiaries |
| Our businesses, profitability and liquidity may be adversely affected by a deterioration in the credit quality of, or defaults by, third parties who owe us money, securities or other assets |
| We are exposed to the risk that third parties that owe us money, securities or other assets will not perform their obligations |
| These parties may default on their obligations to us due to bankruptcy, lack of liquidity, operational failure or other reasons |
| We are also subject to the risk that our rights against third parties may not be enforceable in all circumstances |
| In addition, a deterioration in the credit quality of third parties whose securities or obligations we hold could result in losses and/or adversely affect our ability to rehypothecate or otherwise use those securities or obligations for liquidity purposes |
| The amount and duration of our credit exposures have been increasing over the past several years, as has the breadth of the entities to which we have credit exposures |
| The scope of our lending businesses has also been expanding and includes loans to small and mid-size businesses, which are not traditional Goldman Sachs clients |
| As a clearing member firm, we finance our client positions and we could be held responsible for the defaults or misconduct of our clients |
| In addition, we have experienced, due to competitive factors, pressure to extend and price credit at levels that may not always fully compensate us for the risks we take |
| In particular, corporate clients sometimes seek to require credit commitments from us in connection with investment banking and other assignments |
| Although we regularly review credit exposures to specific clients and counterparties and to specific industries, countries and regions that we believe may present credit concerns, default risk may arise from events or circumstances that are difficult to detect or foresee |
| In addition, concerns about, or a default by, one institution could lead to significant liquidity problems, losses or defaults by other institutions, which in turn could adversely affect Goldman Sachs |
| Mandatory physical settlement of derivative transactions may expose us to losses if we are unable to deliver the underlying security or obligation |
| Like many participants in the derivatives marketplace, we are party to a large number of derivative transactions, including credit derivatives, that require that we deliver to the counterparty the underlying security or obligation in order to receive payment |
| In a number of cases, we do not hold the underlying security or obligation and may have difficulty obtaining, or be unable to obtain, the underlying security or obligation through the physical settlement of other transactions |
| As a result, we are subject to the risk that we may not be able to obtain the security or obligation within the required contractual timeframe for delivery |
| This could cause us to forfeit the payments due to us under these contracts or result in settlement delays with the attendant credit and operational risk as 21 _________________________________________________________________ [96]Table of Contents well as increased costs to the firm |
| The derivatives industry is working on various proposals to address this issue |
| A failure of the industry to address this issue could result in an unwillingness of counterparties to enter into certain types of derivative transactions, which could negatively impact our businesses |
| Unconfirmed derivative transactions and unauthorized assignments of derivatives by counterparties may expose us to unexpected risk and potential losses |
| Derivative contracts and other transactions entered into with third parties are not always confirmed by the counterparties on a timely basis |
| While the transaction remains unconfirmed, we are subject to heightened credit and operational risk and in the event of a default may find it more difficult to enforce the contract |
| The growth in the derivatives industry, including credit derivatives and other swap transactions, has also exposed us and other industry participants to an increasing incidence of counterparties seeking to unilaterally assign transactions without required prior notice and consent |
| Although industry participants have taken steps to eliminate this practice and its effects on a going-forward basis, including through the adoption of the 2005 ISDA Novation Protocol, it is not yet clear how effective these efforts will be, and the steps that have been taken by the industry do not resolve the issue for derivative contracts that were previously entered into |
| Unauthorized assignments could introduce uncertainty as to the status of a transaction, impair our ability to evaluate credit risk and impede trade reconciliations, which could lead to a higher number of failed transactions and collateral call defaults |
| A failure in our operational systems or infrastructure, or those of third parties, could impair our liquidity, disrupt our businesses, damage our reputation and cause losses |
| Shortcomings or failures in our internal processes, people or systems could lead to impairment of our liquidity, financial loss, disruption of our businesses, liability to clients, regulatory intervention or reputational damage |
| For example, our businesses are highly dependent on our ability to process, on a daily basis, a large number of transactions across numerous and diverse markets in many currencies |
| The transactions we process have become increasingly complex and often must adhere to client-specific guidelines, as well as legal and regulatory standards |
| Our financial, accounting, data processing or other operating systems and facilities may fail to operate properly or become disabled as a result of events that are wholly or partially beyond our control, adversely affecting our ability to process these transactions |
| The inability of our systems to accommodate an increasing volume of transactions could also constrain our ability to expand our businesses |
| We also face the risk of operational failure or termination of any of the clearing agents, exchanges, clearing houses or other financial intermediaries we use to facilitate our securities transactions, and as our interconnectivity with our clients grows, we will increasingly face the risk of operational failure with respect to our clients’ systems |
| Any such failure or termination could adversely affect our ability to effect transactions, service our clients and manage our exposure to risk |
| Despite the contingency plans and facilities we have in place, our ability to conduct business may be adversely impacted by a disruption in the infrastructure that supports our businesses and the communities in which we are located |
| This may include a disruption involving electrical, communications, transportation or other services used by Goldman Sachs or third parties with which we conduct business |
| These disruptions may occur, for example, as a result of events that affect only the buildings of Goldman Sachs or such third parties, or as a result of events with a broader impact on the cities where those buildings are located |
| Nearly all of our employees in our primary locations, including New York, London, Frankfurt, Hong Kong and Tokyo, work in close proximity to one another, in one or more buildings |
| If a disruption occurs in one location and our employees in that location are unable to occupy our offices or communicate with or travel to other locations, our ability to service and interact with our clients may suffer and we may not be able to successfully implement contingency plans that depend on communication or travel |
| 22 _________________________________________________________________ [97]Table of Contents Our operations rely on the secure processing, storage and transmission of confidential and other information in our computer systems and networks |
| Although we take protective measures and endeavor to modify them as circumstances warrant, our computer systems, software and networks may be vulnerable to unauthorized access, computer viruses or other malicious code and other events that could have a security impact |
| If one or more of such events occur, this potentially could jeopardize our or our clients’ or counterparties’ confidential and other information processed and stored in, and transmitted through, our computer systems and networks, or otherwise cause interruptions or malfunctions in our, our clients’, our counterparties’ or third parties’ operations, which could result in significant losses or reputational damage |
| We may be required to expend significant additional resources to modify our protective measures or to investigate and remediate vulnerabilities or other exposures, and we may be subject to litigation and financial losses that are either not insured against or not fully covered through any insurance maintained by us |
| Conflicts of interest are increasing and a failure to appropriately deal with conflicts of interest could adversely affect our businesses |
| Our reputation is one of our most important assets |
| As we have expanded the scope of our businesses and our client base, we increasingly have to address potential conflicts of interest, including those relating to our proprietary activities |
| For example, conflicts may arise between our position as a financial advisor in a merger transaction and a principal investment we hold in one of the parties to the transaction |
| In addition, hedge funds and private equity funds are an increasingly important portion of our client base, and also compete with us in a number of our businesses |
| We have extensive procedures and controls that are designed to address conflicts of interest |
| However, appropriately dealing with conflicts of interest is complex and difficult and our reputation could be damaged if we fail, or appear to fail, to deal appropriately with conflicts of interest |
| In addition, the SEC and other federal and state regulators have increased their scrutiny of potential conflicts of interest |
| For example, in June 2005, the NASD filed with the SEC proposed rules that would require certain disclosures to be contained in fairness opinions, and would mandate specific procedures to be followed by member firms in connection with issuing these opinions |
| While we have policies and procedures in place that are intended to ensure that any potential conflicts of interest are appropriately addressed, it is possible that potential or perceived conflicts could give rise to litigation or enforcement actions |
| It is possible that the regulatory scrutiny of, and litigation in connection with, conflicts of interest will make our clients less willing to enter into transactions in which such a conflict may occur, and will adversely affect our businesses |
| Our businesses and those of our clients are subject to extensive and pervasive regulation around the world |
| Goldman Sachs, as a participant in the financial services industry, is subject to extensive regulation in jurisdictions around the world |
| We face the risk of significant intervention by regulatory authorities in all jurisdictions in which we conduct our businesses |
| Among other things, we could be fined, prohibited from engaging in some of our business activities or subject to limitations or conditions on our business activities |
| New laws or regulations or changes in enforcement of existing laws or regulations applicable to our business or those of our clients may also adversely affect our businesses |
| For example, the SEC has adopted rules requiring the registration of certain hedge funds advisers under the Investment Advisers Act of 1940, and the SEC or other regulators may seek to further regulate hedge funds in the future |
| It is possible that these or other future regulatory developments rules may have a significant impact on our trading, prime brokerage and other business relationships with hedge funds, or on the growth of our prime brokerage and securities lending businesses |
| In addition, under the European Union’s Transparency Directive (Directive 2004/109/EC), which is due to be implemented by member states by January 2007, issuers of securities admitted to listing on regulated markets in the European Union may, depending upon the manner of implementation, be required to provide 23 _________________________________________________________________ [98]Table of Contents expanded ongoing financial disclosure, which could have an adverse impact on our ability or the ability of certain of our non-European Union-based clients to maintain the listing of these securities or to conduct securities offerings in Europe |
| Furthermore, the SEC’s Regulation NMS, which was adopted in 2005 and is expected to become effective in 2006, introduces significant changes to the regulation of trading on securities exchanges and marketplaces |
| While it is too early to predict the impact that Regulation NMS will have, it could result in the imposition of additional compliance costs on our trading businesses and alter the competitive environment in which these businesses function |
| Many of our businesses are operating in an uncertain and difficult regulatory environment |
| Firms in the financial services industry have been operating in a difficult regulatory environment |
| The industry has experienced increased scrutiny from a variety of regulators, both within and outside the United States |
| Penalties and fines sought by regulatory authorities have increased substantially over the last several years |
| This environment has led some of our clients to be less willing to engage in transactions that may carry a risk of increased scrutiny by regulators |
| In addition, while the firm always strives to fully comply with all legal and regulatory requirements, this regulatory and enforcement environment has created uncertainty with respect to a number of transactions that had historically been entered into by financial services firms, including our firm, and that were generally believed to be permissible and appropriate |
| This environment has led us and our competitors to modify transaction structures and, in some cases, to limit or cease our execution of some types of transactions |
| Substantial legal liability or significant regulatory action against Goldman Sachs could have material adverse financial effects or cause significant reputational harm to Goldman Sachs, which in turn could seriously harm our business prospects |
| We face significant legal risks in our businesses, and the volume of claims and amount of damages and penalties claimed in litigation and regulatory proceedings against financial institutions remain high |
| The interaction between our equity research analysts and investment banking businesses has been subject to new requirements and litigation |
| As discussed under “Business — Regulation” in Part I, Item 1 of the Annual Report on Form 10-K, the research areas of investment banks have been and remain the subject of regulatory scrutiny that has led to restrictions on the interaction between equity research analysts and investment banking personnel at securities firms |
| has agreed to a global settlement to resolve investigations into equity research analysts’ alleged conflicts of interest pursuant to which GS&Co |
| has been subject to certain restrictions and undertakings |
| Certain of these requirements and restrictions have imposed additional costs and limitations on the conduct of our businesses |
| Litigation and regulatory scrutiny of complex, structured financial transactions remain high |
| Regulators, both within and outside the United States, continue to scrutinize complex, structured finance transactions and have brought enforcement actions against a number of financial institutions in connection with such transactions |
| In some of the enforcement actions, clients of the financial institutions allegedly engaged in accounting, disclosure or other violations of the securities laws, and the financial institutions allegedly facilitated these improprieties by entering into transactions with the clients |
| We seek to create innovative solutions to address our clients’ needs, and we have entered into, and continue to enter into, structured transactions with clients |
| While we have policies and procedures in place that are intended to ensure that the structured transactions we enter into are appropriately reviewed and comply with applicable laws and regulations, it is possible that certain of these transactions could give rise to litigation or enforcement actions |
| It is possible that the regulatory scrutiny of, and litigation in connection with, structured finance transactions will make our clients less willing to enter into these transactions, and will adversely affect our business in this area |
| 24 _________________________________________________________________ [99]Table of Contents We are subject to regulatory inquiries and investigations into market timing, late trading and other activities involving mutual funds |
| In recent years, there have been industry-wide and other investigations by federal and state authorities concerning market timing, late trading and other activities involving mutual funds and investment advisers |
| Federal and state authorities have made informational requests regarding trading practices broadly across all of the major fund companies and broker-dealers |
| Goldman Sachs has received requests for information and has been fully cooperating with those authorities |
| While we believe that we have in place reasonable measures to detect and deter disruptive and abusive trading practices and comply with applicable legal and regulatory requirements, we cannot predict the course that these inquiries and areas of focus may take or the impact that any new laws or regulations governing mutual funds may have on our businesses |
| Our specialist business is subject to a global settlement and civil actions |
| Regulators have also been conducting investigations into certain trading practices of specialist firms, including our specialist unit |
| In March 2004, certain NYSE specialist firms, including our specialist unit, agreed to a global settlement with the SEC and NYSE to resolve charges that the firms violated certain federal securities laws and NYSE rules in connection with their activities as NYSE specialists during the years 1999 through 2003 |
| The global settlement involves, among others, restitution and penalties, a censure, cease and desist order and certain undertakings with respect to our specialist unit’s systems and procedures |
| The settlement did not resolve the related civil actions discussed under “Legal Proceedings — Specialist |