UNITED STATES
FORM 10-Q
For the quarterly period ended May 30, 2003
or
For the transition period to
Commission File Number: 001-14965
The Goldman Sachs Group, Inc.
(212) 902-1000
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. x Yes o No
Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). x Yes o No
APPLICABLE ONLY TO CORPORATE ISSUERS
As of July 3, 2003 there were 474,059,420 shares of the registrant’s common stock outstanding.
TABLE OF CONTENTS
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PART I: FINANCIAL INFORMATION
Item 1: Financial Statements (Unaudited)
THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES
The accompanying notes are an integral part of these condensed consolidated financial statements.
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Cash payments for interest approximated the related expense for each of the fiscal periods presented.
Cash payments of income taxes, net of refunds, were $488 million and $789 million during the six months ended May 2003 and May 2002, respectively.
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Note 1. Description of Business
The Goldman Sachs Group, Inc. (Group Inc.), a Delaware corporation, together with its consolidated subsidiaries (collectively, the firm), is a leading global investment banking, securities and investment management firm that provides a wide range of services worldwide to a substantial and diversified client base that includes corporations, financial institutions, governments and high-net-worth individuals.
The firm’s activities are divided into three segments:
Note 2. Significant Accounting Policies
Basis of Presentation
These condensed consolidated financial statements include the accounts of Group Inc. and all other entities in which the firm has a controlling financial interest. All material intercompany transactions and balances have been eliminated.
The usual condition for a controlling financial interest in an entity is ownership of a majority of the voting interest. Accordingly, the firm consolidates entities in which it has all, or a majority of, the voting interest. A controlling financial interest can also exist in entities whose activities are predetermined or significantly limited, or whose independent equity investors do not hold an equity investment with substantive risks and rewards. These types of entities were commonly referred to as special-purpose entities (SPEs) prior to the issuance of Financial Accounting Standards Board (FASB) Interpretation (FIN) No. 46, “Consolidation of Variable Interest Entities,” and are now known as variable interest entities (VIEs).
The firm consolidates all SPEs it controls and those in which it holds a majority of the SPE’s substantive risks and rewards. The firm also consolidates all SPEs to which it has transferred assets unless independent investors have made a substantive majority equity investment in legal form or the transferred assets are financial instruments and the SPE is a qualifying SPE (QSPE) as defined in Statement of Financial Accounting Standards (SFAS) No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities.” The firm consolidates all VIEs created after January 31, 2003 where it is the primary beneficiary, generally defined as holding a majority of the expected losses or a majority of the expected residual returns. The firm’s financial interests in, and derivative transactions with, non-consolidated SPEs and VIEs are accounted for at fair value, in the same manner as other financial instruments. As of May 2003, the firm had no material additional financial commitments or guarantees in respect of these entities.
When the firm does not have a controlling financial interest in an entity but exerts significant influence over the entity’s operating and financial policies (generally defined as owning a voting
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
or economic interest of 20% to 50%), the firm accounts for its investment in accordance with the equity method of accounting as prescribed by Accounting Principles Board (APB) Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock.”
If the firm does not have a controlling financial interest in, or exert significant influence over, an entity the firm accounts for its investment at fair value.
The firm has also formed numerous non-consolidated private investment funds with third-party investors that are typically organized as limited partnerships. The firm acts as general partner and also holds limited partnership interests in the funds. The firm does not hold a majority of the residual interests in any of the funds. The firm’s investments in these funds are included in “Financial instruments owned, at fair value” in the condensed consolidated statements of financial condition. As of March 31, 2003 (the most recent investment fund reporting date), the funds’ total assets were approximately $12.91 billion.
The firm’s principal U.S. and international subsidiaries include Goldman, Sachs & Co. (GS&Co.), J. Aron & Company and Spear, Leeds & Kellogg, L.P. (SLK) in New York, Goldman Sachs International (GSI) in London and Goldman Sachs (Japan) Ltd. (GSJL) in Tokyo.
These condensed consolidated financial statements are unaudited and should be read in conjunction with the audited consolidated financial statements incorporated by reference in the Annual Report on Form 10-K of Group Inc. for the fiscal year ended November 29, 2002. The condensed consolidated financial information as of November 29, 2002 has been derived from audited consolidated financial statements not included herein. Certain reclassifications have been made to previously reported amounts to conform to the current presentation.
These condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles that require management to make estimates and assumptions regarding trading inventory valuations, the outcome of pending litigation and other matters that affect the consolidated financial statements and related disclosures. These estimates and assumptions are based on judgment and available information; consequently, actual results could be materially different from these estimates.
These unaudited condensed consolidated financial statements reflect all adjustments that are, in the opinion of management, necessary for a fair statement of the results for the interim periods presented. These adjustments are of a normal, recurring nature. Interim period operating results may not be indicative of the operating results for a full year.
Unless otherwise stated herein, all references to May 2003 and May 2002 refer to the firm’s fiscal period ended or the date, as the context requires, May 30, 2003 and May 31, 2002, respectively. All references to November 2002 refer to the firm’s fiscal year ended or the date, as the context requires, November 29, 2002.
Investment Banking.Underwriting revenues and fees from mergers and acquisitions and other corporate finance advisory assignments are recorded when the services related to the underlying transaction are completed under the terms of the engagement. Expenses associated with such transactions are deferred until the related revenue is recognized or the engagement is otherwise concluded. Underwriting revenues are presented net of related expenses. Expenses associated with advisory transactions are recorded as non-compensation expenses, net of client reimbursements.
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Repurchase Agreements and Collateralized Financing Arrangements. Securities purchased under agreements to resell and securities sold under agreements to repurchase, principally U.S. government, federal agency and investment-grade foreign sovereign obligations, represent short-term collateralized financing transactions and are carried in the condensed consolidated statements of financial condition at their contractual amounts plus accrued interest. These amounts are presented on a net-by-counterparty basis when the requirements of FIN No. 41, “Offsetting of Amounts Related to Certain Repurchase and Reverse Repurchase Agreements,” are satisfied. The firm takes possession of securities purchased under agreements to resell, monitors the market value of these securities on a daily basis and obtains additional collateral as appropriate.
Securities borrowed and loaned are recorded based on the amount of cash collateral advanced or received. These transactions are generally collateralized by either cash, securities or letters of credit. The firm takes possession of securities borrowed, monitors the market value of securities loaned and delivers or obtains additional collateral as appropriate. Income or expense on repurchase agreements and collateralized financing arrangements is recognized as interest over the life of the transaction.
Financial Instruments.Gains and losses on financial instruments are recorded on a trade-date basis in the condensed consolidated statements of earnings. The condensed consolidated statements of financial condition generally reflect purchases and sales of financial instruments on a trade-date basis.
“Financial instruments owned, at fair value” and “Financial instruments sold, but not yet purchased, at fair value” in the condensed consolidated statements of financial condition consist of financial instruments carried at fair value or amounts that approximate fair value, with related unrealized gains or losses recognized in the firm’s results of operations. The fair value of a financial instrument is the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale.
Quoted market prices in active markets are the best evidence of fair value, and the firm uses them when available. If quoted market prices in active markets are not available, management’s estimate of fair value is based on, if available, quoted prices or recent transactions in less active markets and/or prices of similar instruments.
If prices are not readily available either through quoted market prices in active markets or alternative pricing sources, or if liquidating a position is reasonably expected to affect market prices, fair value is based on valuation models or management’s estimate, using the best information available, of amounts that could be realized under current market conditions, assuming an orderly liquidation over a reasonable period of time. The firm’s valuation models consider, among other inputs, contractual and market prices, yield curves, credit, volatility factors, prepayment rates and/or correlations of the underlying positions.
The inputs used in the firm’s valuation models are based on quoted market prices in active markets, if available, or, if not, quoted market prices or recent transactions in less active markets, and prices of similar instruments. Where such information is not readily available, inputs are derived from other market data taking into account observable market movements that could reasonably be expected to affect the derived input. Different valuation models and assumptions could produce materially different estimates of fair value.
In general, transfers of financial assets are accounted for as sales under SFAS No. 140 when the firm has relinquished control over the transferred assets. For transfers accounted for
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as sales, any related gains or losses are recognized in net revenues. Transfers that are not accounted for as sales are accounted for as repurchase agreements and collateralized financing arrangements, with the related interest expense recognized in net revenues over the life of the transaction.
Principal investments are initially carried at cost as an approximation of fair value. The carrying value of such investments is adjusted when changes in the underlying fair values are readily determinable. For public investments, values are determined using quoted market prices discounted for restrictions on sale. For private investments, adjustments to carrying value are made if there are third-party transactions evidencing a change in value. Downward adjustments are also made if management determines that the expected realizable value of the investment is less than the carrying value. In reaching that determination, management considers many factors including, but not limited to, the operating cash flows and financial performance of the companies or properties relative to budgets or projections, trends within sectors and/or regions, underlying business models, expected exit timing and strategy, and any specific rights or terms associated with the investment, such as conversion features and liquidation preferences.
Principal Investments includes the firm’s investment in the convertible preferred stock of SMFG. The firm’s investment in SMFG is carried at fair value, which is derived from market data, such as SMFG’s common stock price and credit spreads, and which incorporates the impact of the transfer restrictions on the firm’s investment as well as downside protection on the conversion strike price.
Asset Management.Asset management fees are generally recognized over the period that the related service is provided based upon average net asset values. In certain circumstances, the firm is entitled to receive incentive fees when the return on assets under management exceeds certain benchmark returns or other performance targets. Incentive fees are generally based on investment performance over a twelve-month period and are not subject to adjustment once the measurement period ends. Accordingly, incentive fees are recognized in the condensed consolidated statements of earnings when the measurement period ends. Asset management fees and incentive fees are included in “Asset management and securities services” in the condensed consolidated statements of earnings.
Commissions. The firm generates commissions from executing and clearing client transactions on stock, options and futures markets worldwide. These commissions are recorded on a trade-date basis in “Asset management and securities services” in the condensed consolidated statements of earnings.
Merchant Banking Overrides.The firm is entitled to receive merchant banking overrides (i.e., an increased share of a fund’s income and gains) when the return on the funds’ investments exceeds certain threshold returns. Overrides are based on investment performance over the life of each merchant banking fund, and future investment underperformance may require amounts previously distributed to the firm to be returned to the funds. Accordingly, overrides are recognized in the condensed consolidated statements of earnings only when all material contingencies have been resolved. Overrides are included in “Asset management and securities services” in the condensed consolidated statements of earnings.
Basic earnings per share (EPS) is calculated by dividing net earnings by the weighted average number of common shares outstanding. Common shares outstanding includes common
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stock and restricted stock units for which no future service is required as a condition to the delivery of the underlying common stock. Diluted EPS includes the determinants of basic EPS and, in addition, reflects the dilutive effect of the common stock deliverable pursuant to stock options and to restricted stock units for which future service is required as a condition to the delivery of the underlying common stock.
Effective for fiscal 2003, the firm began to account for stock-based employee compensation in accordance with the fair-value method prescribed by SFAS No. 123, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” using the prospective adoption method. Under this method of adoption, compensation expense is recognized over the relevant service period based on the fair value of stock options and restricted stock units granted for fiscal 2003 and future years.
Stock-based employee compensation, including stock options, for the three and six months ended May 2002 was accounted for under the intrinsic value-based method as prescribed by APB Opinion No. 25, “Accounting for Stock Issued to Employees.” Therefore, no compensation expense was recognized for those stock options that had no intrinsic value on the date of grant.
If the firm were to recognize compensation expense over the relevant service period under the fair-value method of SFAS No. 123 with respect to stock options granted for the year ended November 2002 and all prior years, net earnings would have decreased, resulting in pro forma net earnings and EPS as presented below:
Assets and liabilities denominated in non-U.S. currencies are translated at rates of exchange prevailing on the date of the condensed consolidated statement of financial condition, and revenues and expenses are translated at average rates of exchange for the fiscal period. Gains
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or losses on translation of the financial statements of a non-U.S. operation, when the functional currency is other than the U.S. dollar, are included, net of hedges, in the condensed consolidated statements of comprehensive income. Hedge effectiveness is assessed based on changes in forward exchange rates; accordingly, forward points are reflected as a component of the currency translation adjustment in the condensed consolidated statements of comprehensive income. Foreign currency remeasurement gains or losses on transactions in non-functional currencies are included in the condensed consolidated statements of earnings.
In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” The statement specifies the accounting for certain employee termination benefits, contract termination costs and costs to consolidate facilities or relocate employees and is effective for exit and disposal activities initiated after December 31, 2002. Adoption of this statement did not have a material effect on the firm’s financial condition, results of operations or cash flows.
In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 amends and clarifies the accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. In addition, the statement clarifies when a contract is a derivative and when a derivative contains a financing component that warrants special reporting in the statement of cash flows. SFAS No. 149 is generally effective prospectively for contracts entered into or modified, and hedging relationships designated, after June 30, 2003. Management does not expect adoption to have a material effect on the firm’s financial condition, results of operations or cash flows.
In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity, and imposes certain additional disclosure requirements. The provisions of SFAS No. 150 are generally effective for financial instruments entered into or modified after May 31, 2003. The firm must apply the provisions of SFAS No. 150 to all financial instruments at the beginning of the firm’s fourth quarter of fiscal 2003. Management does not expect adoption to have a material effect on the firm’s financial condition, results of operations or cash flows.
In January 2003, the FASB issued FIN No. 46, “Consolidation of Variable Interest Entities.” FIN No. 46 requires a company to consolidate a VIE if the company has variable interests that give it a majority of the expected losses or a majority of the expected residual returns of the entity. Prior to FIN No. 46, VIEs were commonly referred to as SPEs. As required, the firm adopted FIN No. 46 for VIEs created after January 31, 2003. The firm must apply FIN No. 46 to VIEs created before February 1, 2003 as of the beginning of the fourth quarter of fiscal 2003. Management does not expect adoption to have a material effect on the firm’s financial condition, results of operations or cash flows.
In November 2002, the Emerging Issues Task Force (EITF) reached a consensus on EITF Issue No. 02-3, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities.” EITF Issue No. 02-3 precludes mark-to-market accounting for energy-trading contracts that are not derivatives pursuant to SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” The firm has adopted the provisions of EITF Issue No. 02-3 related to energy-trading
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contracts as of the beginning of the first quarter of fiscal 2003, and the effect of adoption was not material to the firm’s financial condition, results of operations or cash flows. EITF Issue No. 02-3 also communicates the FASB staff’s view that the transaction price for a derivative contract is the best information available with which to estimate fair value at the inception of a contract when the estimate is not based on other observable market data. The application of the FASB staff’s view did not have a material effect on the firm’s financial condition, results of operations or cash flows.
Note 3. Financial Instruments
Fair Value of Financial Instruments
The following table sets forth the firm’s financial instruments owned, including those pledged as collateral, at fair value and financial instruments sold, but not yet purchased, at fair value:
Derivative Activities
Derivative contracts are financial instruments, such as futures, forwards, swaps or option contracts, that derive their value from underlying assets, indices, reference rates or a combination of these factors. Derivatives may involve future commitments to purchase or sell financial instruments or commodities, or to exchange currency or interest payment streams. The amounts exchanged are based on the specific terms of the contract with reference to specified rates, securities, commodities or indices.
Derivative contracts exclude certain cash instruments, such as mortgage-backed securities, interest-only and principal-only obligations, and indexed debt instruments, that derive their values or contractually required cash flows from the price of some other security or index. The firm includes certain commodity-related contracts in its derivative disclosure, although not required to do so, as these contracts may be settled in cash or are readily convertible into cash.
Most of the firm’s derivative transactions are entered into for trading purposes. The firm uses derivatives in its trading activities to facilitate customer transactions, to take proprietary positions and as a means of risk management. Risk exposures are managed through diversification, by controlling position sizes and by establishing hedges in related securities or derivatives. For example, the firm may hedge a portfolio of common stock by taking an offsetting position in a related equity-index futures contract. Gains and losses on derivatives used for
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trading purposes are generally included in “Trading and principal investments” in the condensed consolidated statements of earnings.
The firm also enters into derivative contracts to manage the interest rate, currency and equity-linked exposure on its long-term borrowings. These derivatives generally include interest rate futures contracts, interest rate swap agreements, currency swap agreements and equity-linked contracts, which are primarily utilized to convert a substantial portion of the firm’s long-term debt into U.S. dollar-based floating rate obligations. Certain interest rate swap contracts are designated as fair-value hedges. The gains or losses associated with the ineffective portion of these fair-value hedges are included in “Trading and principal investments” in the condensed consolidated statements of earnings and were not material for the three and six months ended May 2003 and May 2002.
Derivative contracts are reported on a net-by-counterparty basis on the firm’s condensed consolidated statements of financial condition when management believes a legal right of setoff exists under an enforceable netting agreement. The fair value of derivative financial instruments, computed in accordance with the firm’s netting policy, is set forth below:
Securitization Activities
The firm securitizes commercial and residential mortgages and home equity loans, government and corporate bonds, and other types of financial assets. The firm acts as underwriter of the beneficial interests that are sold to investors. The firm derecognizes financial assets transferred in securitizations provided it has relinquished control over such assets. Transferred assets are accounted for at fair value prior to securitization. Underwriting net revenues are recognized in connection with the sales of the underlying beneficial interests to investors.
The firm may retain interests in securitized financial assets, which it generally attempts to sell as quickly as possible, subject to prevailing market conditions. Retained interests are accounted for at fair value and are included in “Total financial instruments owned, at fair value” in the condensed consolidated statements of financial condition.
During the six months ended May 2003 and May 2002, the firm securitized $59.80 billion and $74.80 billion, respectively, of financial assets, including $46.32 billion and $54.70 billion, respectively, of agency mortgage-backed securities. Cash flows received on retained interests and other securitization cash flows were approximately $457 million for the six months ended May 2003. As of May 2003, the firm held $5.53 billion of retained interests, including $2.24 billion of retained interests for which the fair value is based on quoted market prices in active markets.
The following table sets forth the weighted average key economic assumptions used in measuring the fair value of retained interests for which fair value is based on alternative pricing
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sources with reasonable, little or no price transparency and the sensitivity of those fair values to immediate adverse changes of 10% and 20% in those assumptions:
The preceding table does not give effect to the offsetting benefit of other financial instruments that are held to hedge risks inherent in these retained interests. Changes in fair value based on a 10% adverse variation in assumptions generally cannot be extrapolated because the relationship of the change in assumptions to the change in fair value is not usually linear. In addition, the impact of a change in a particular assumption is calculated independently of changes in any other assumption. In practice, simultaneous changes in assumptions might magnify or counteract the sensitivities disclosed above.
Variable Interest Entities (VIEs)
The firm, in the ordinary course of its business, utilizes VIEs such as trusts, limited partnerships and limited liability companies to securitize commercial and residential mortgages and home equity loans, government and corporate bonds, and other types of financial instruments. Prior to the issuance of FIN No. 46, VIEs were commonly referred to as SPEs. The firm holds variable interests in such entities in the form of senior and subordinated debt, preferred and common stock, interest rate, foreign currency and credit derivatives as well as residual interests in asset-backed securitization vehicles. The following table summarizes the firm’s maximum exposure to loss as a result of its significant variable interests in consolidated
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and non-consolidated VIEs, excluding QSPEs, in accordance with FIN No. 46, and the total assets of such VIEs:
Secured Borrowing and Lending Activities
The firm obtains secured short-term financing principally through the use of repurchase agreements and securities lending agreements to obtain securities for settlement, to finance inventory positions and to meet customers’ needs. In these transactions, the firm either provides or receives collateral, including U.S. government, federal agency, mortgage-backed, investment-grade foreign sovereign obligations and equity securities.
The firm receives collateral in connection with resale agreements, securities lending transactions, derivative transactions, customer margin loans and other secured lending activities. In many cases, the firm is permitted to sell or repledge securities held as collateral. These securities may be used to secure repurchase agreements, enter into securities lending or derivative transactions, or cover short positions. As of May 2003 and November 2002, the fair value of securities received as collateral by the firm that it was permitted to sell or repledge was $350.19 billion and $316.31 billion, respectively, of which the firm sold or repledged $305.50 billion and $272.49 billion, respectively.
The firm also pledges its own assets to collateralize repurchase agreements and other secured financings. As of May 2003 and November 2002, the carrying value of securities included in “Financial instruments owned, at fair value” that had been loaned or pledged to counterparties that did not have the right to sell or repledge was $47.24 billion and $34.66 billion, respectively.
Note 4. Short-Term Borrowings
The firm generally obtains unsecured short-term borrowings through issuance of promissory notes, commercial paper and bank loans. Short-term borrowings also include the portion of long-term borrowings maturing within one year. The carrying value of these short-term obligations approximates fair value due to their short-term nature.
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Short-term borrowings are set forth below:
Note 5. Earnings Per Share
The computations of basic and diluted EPS are set forth below:
Note 6. Shareholders’ Equity
The Board of Directors of Group Inc. increased the firm’s quarterly dividend to $0.25 per share from $0.12 per share paid in prior quarters. The dividend will be paid on August 28, 2003, to common shareholders of record on July 29, 2003.
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During the three and six months ended May 2003, the firm repurchased 3.7 million shares and 7.6 million shares of the firm’s common stock, respectively. The average price paid per share for repurchased shares was $74.02 and $71.34 for the three and six months ended May 2003, respectively. As of May 2003, the firm was authorized to repurchase up to 12.0 million additional shares of common stock pursuant to the firm’s common stock repurchase program.
Note 7. Commitments, Contingencies and Guarantees
The firm had commitments to enter into forward secured financing transactions, including certain repurchase and resale agreements and secured borrowing and lending arrangements, of $30.29 billion as of May 2003.
In connection with its lending activities, the firm had outstanding commitments of $10.97 billion as of May 2003. These commitments are agreements to lend to counterparties, have fixed termination dates and are contingent on all conditions to borrowing set forth in the contract having been met. Since these commitments may expire unused, the total commitment amount does not necessarily reflect the actual future cash flow requirements. As of May 2003, $1.18 billion of the firm’s outstanding commitments have been issued through the William Street credit extension program.(1) Substantially all of the credit risk associated with these commitments has been hedged through the credit loss protection provided by SMFG. The firm has also hedged the credit risk of certain non-William Street commitments using a variety of other financial instruments.
The firm provides letters of credit issued by various banks to counterparties in lieu of securities or cash to satisfy various collateral and margin deposit requirements. Letters of credit outstanding were $12.66 billion as of May 2003.
The firm acts as an investor in merchant banking transactions, which includes making long-term investments in equity and debt securities in privately negotiated transactions, corporate acquisitions and real estate transactions. In connection with these activities, the firm had commitments to invest up to $1.23 billion in corporate and real estate merchant banking investment funds as of May 2003.
The firm had construction-related commitments of $152 million and other purchase commitments of $118 million as of May 2003.
The firm has obligations under long-term noncancelable lease agreements, principally for office space, expiring on various dates through 2029. Certain agreements are subject to periodic
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escalation provisions for increases in real estate taxes and other items. Minimum rental payments, net of minimum sublease rentals, under noncancelable leases are set forth below:
The firm is involved in a number of judicial, regulatory and arbitration proceedings concerning matters arising in connection with the conduct of its businesses. Management believes, based on currently available information, that the results of such proceedings, in the aggregate, will not have an adverse effect on the firm’s financial condition, but may be material to the firm’s operating results for any particular period, depending, in part, upon the operating results for such period.
In November 2002, the FASB issued FIN No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN No. 45 specifies the disclosures to be made about obligations under certain issued guarantees and requires a liability to be recognized for the fair value of a guarantee obligation. The recognition and measurement provisions of the interpretation apply prospectively to guarantees issued or modified after December 31, 2002.
The firm enters into various derivative contracts that meet the definition of a guarantee under FIN No. 45. Such derivative contracts include credit default swaps, written equity and commodity put options, written currency contracts and interest rate caps, floors and swaptions. FIN No. 45 does not require disclosures about derivative contracts if such contracts may be cash settled and the firm has no basis to conclude it is probable that the counterparties held, at inception, the underlying instruments related to the derivative contracts. If these conditions have been met, the firm has not included such contracts in the table below.
The firm, in its capacity as an agency lender, occasionally indemnifies securities lending customers against losses incurred in the event that borrowers do not return securities and the collateral held is insufficient to cover the market value of the securities borrowed. In relation to certain asset sales and securitization transactions, the firm guarantees the collection of contractual cash flows. In connection with fund management activities, the firm may issue loan guarantees to secure financing and to obtain preferential investment terms. In addition, the firm provides letters of credit and other guarantees, on a limited basis, to enable clients to enhance their credit standing and complete transactions.
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The following table sets forth certain information about the firm’s derivative contracts that meet the definition of a guarantee and certain other guarantees as of May 2003:
In the normal course of its business, the firm indemnifies certain service providers, such as clearing and custody agents, trustees and administrators against specified potential losses in connection with their acting as an agent of, or providing services to, the firm or its affiliates. The firm also indemnifies some clients against potential losses incurred in the event specified third-party service providers, including subcustodians and third-party brokers, improperly execute transactions. In addition, the firm is a member of payment, clearing and settlement networks as well as securities exchanges around the world that may require the firm to meet the obligations of such networks and exchanges in the event of member defaults. In connection with its prime brokerage and clearing businesses, the firm may agree to clear and settle on behalf of its clients the transactions entered into by them with other brokerage firms. The firm’s obligations in respect of such transactions are secured by the assets in the client’s account as well as any proceeds received from the transactions cleared and settled by the firm on behalf of the client. The firm is unable to develop an estimate of the maximum payout under these guarantees and indemnifications. However, management believes that it is unlikely the firm will have to make material payments under these arrangements, and no liabilities related to these guarantees and indemnifications have been recognized in the condensed consolidated statement of financial condition as of May 2003.
The firm provides representations and warranties to counterparties in connection with a variety of commercial transactions and occasionally indemnifies them against potential losses caused by the breach of those representations and warranties. The firm may also provide indemnifications protecting against changes in or adverse application of certain U.S. tax laws in connection with ordinary-course transactions such as securities issuances, borrowings or derivatives. In addition, the firm may provide indemnifications to some counterparties to protect them in the event additional taxes are owed or payments are withheld, due either to a change in
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or an adverse application of certain non-U.S. tax laws. These indemnifications generally are standard contractual terms and are entered into in the normal course of business. Generally, there are no stated or notional amounts included in these indemnifications, and the contingencies triggering the obligation to indemnify are not expected to occur. The firm is unable to develop an estimate of the maximum payout under these guarantees. However, management believes that it is unlikely the firm will have to make material payments under these arrangements, and no liabilities related to these arrangements have been recognized in the condensed consolidated statement of financial condition as of May 2003.
Note 8. Regulated Subsidiaries
GS&Co. and SLK are registered U.S. broker-dealers and futures commission merchants subject to Rule 15c3-1 of the Securities and Exchange Commission and Rule 1.17 of the Commodity Futures Trading Commission, which specify uniform minimum net capital requirements, as defined, for their registrants. They have elected to compute their net capital in accordance with the “Alternative Net Capital Requirement” as permitted by Rule 15c3-1. As of May 2003, GS&Co. had regulatory net capital, as defined, of $3.40 billion, which exceeded the amount required by $2.59 billion. As of May 2003, SLK had regulatory net capital, as defined, of $1.13 billion, which exceeded the amount required by $1.07 billion.
GSI, a registered U.K. broker-dealer, is subject to the capital requirements of the Financial Services Authority, and GSJL, a Tokyo-based broker-dealer, is subject to the capital requirements of The Financial Services Agency. As of May 2003, GSI and GSJL were in compliance with their local capital adequacy requirements.
Certain other subsidiaries of the firm are also subject to capital adequacy requirements promulgated by authorities of the countries in which they operate. As of May 2003, these subsidiaries were in compliance with their local capital adequacy requirements.
Note 9. Business Segments
In reporting to management, the firm’s operating results are categorized into the following three segments: Investment Banking, Trading and Principal Investments and Asset Management and Securities Services.
In reporting segments, certain of the firm’s business lines have been aggregated where they have similar economic characteristics and are similar in each of the following areas: (i) the nature of the services they provide, (ii) their methods of distribution, (iii) the types of clients they serve and (iv) the regulatory environments in which they operate.
The cost structures of each of the firm’s segments are broadly similar to that of the firm taken as a whole in that they are primarily influenced by discretionary compensation, headcount and levels of business activity. The firm’s overall compensation and benefits expenses are generally targeted at 50% (plus or minus a few percentage points) of consolidated net revenues. A substantial portion of the firm’s compensation expense represents discretionary bonuses, which are determined at the end of the fiscal year. The segment allocation of these bonuses reflects, among other factors, the overall performance of the firm as well as the performance of individual business units. The timing and magnitude of changes in the firm’s bonus accruals can have a significant effect on segment operating results in a given period.
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Management believes that the following information provides a reasonable representation of each segment’s contribution to consolidated pre-tax earnings and total assets:
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Review Report of Independent Auditors
To the Directors and Shareholders of
We have reviewed the accompanying condensed consolidated statement of financial condition of The Goldman Sachs Group, Inc. and subsidiaries (the Company) at May 30, 2003, the related condensed consolidated statements of earnings for the three and six months ended May 30, 2003 and May 31, 2002, the condensed consolidated statement of changes in shareholders’ equity for the six months ended May 30, 2003, the condensed consolidated statements of cash flows for the six months ended May 30, 2003 and May 31, 2002, and the condensed consolidated statements of comprehensive income for the three and six months ended May 30, 2003 and May 31, 2002. These condensed consolidated financial statements are the responsibility of the Company’s management.
We conducted our review in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with auditing standards generally accepted in the United States of America, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our review, we are not aware of any material modifications that should be made to the accompanying condensed consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.
We previously audited in accordance with auditing standards generally accepted in the United States of America, the consolidated statement of financial condition of The Goldman Sachs Group, Inc. and subsidiaries at November 29, 2002, and the related consolidated statements of earnings, changes in shareholders’ equity, cash flows and comprehensive income for the year ended November 29, 2002 (not presented herein); in our report dated January 27, 2003, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated statement of financial condition as of November 29, 2002, and the condensed consolidated statement of changes in shareholders’ equity for the year ended November 29, 2002, is fairly stated, in all material respects, in relation to the consolidated financial statements from which it has been derived.
New York, New York
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Introduction
Goldman Sachs is a leading global investment banking, securities and investment management firm that provides a wide range of services worldwide to a substantial and diversified client base that includes corporations, financial institutions, governments and high-net-worth individuals.
Our activities are divided into three segments:
This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our Annual Report on Form 10-K for the fiscal year ended November 29, 2002.
Unless specifically stated otherwise, all references to May 2003, February 2003 and May 2002 refer to our fiscal periods ended, or the date, as the context requires, May 30, 2003, February 28, 2003 and May 31, 2002, respectively. All references to November 2002, unless specifically stated otherwise, refer to our fiscal year ended, or the date, as the context requires, November 29, 2002.
When we use the terms “Goldman Sachs,” “we,” “us” and “our,” we mean The Goldman Sachs Group, Inc., a Delaware corporation, and its consolidated subsidiaries.
Business Environment
The pace of global economic growth remained slow during our second fiscal quarter, with the early part of the quarter dominated by uncertainties over the conflict in Iraq. Corporate activity, as measured by industry-wide equity underwriting volumes and completed mergers and acquisitions, although higher than the first quarter, remained very low. Major world equity indices, however, recorded gains, and the fixed income markets continued to benefit from a favorable environment, characterized by narrowing credit spreads, a steep yield curve and declining interest rates (the 10-year U.S. Treasury note yield declined to 45-year lows). In addition, industry-wide debt origination activity and secondary fixed income trading volumes continued to be strong.
In the United States, the economy continued to grow at a modest pace. The labor market remained soft, consumer spending was modest and industrial activity was subdued, although there were some signs towards the end of our fiscal quarter of a stabilization in manufacturing activity. Against this background, the U.S. Federal Reserve left its federal funds rate target unchanged, but indicated that it would ease policy further if needed, and noted that it regarded a substantial fall in inflation as unwelcome. These indications contributed to a rapid decline in long-term bond yields during May. Despite the uncertain environment, expectations of an improvement in economic activity, combined with a significant new U.S. government stimulus package, contributed to increases in the Dow Jones Industrial Average and the Nasdaq Composite Index of 12% and 19%, respectively, during the fiscal quarter.
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Economic conditions in Europe remained very weak during the quarter. Weakness in industrial activity and a decline in business confidence led the European Central Bank to lower interest rates by 25 basis points in March. As in the United States, bond yields fell and despite the uncertain environment, European equity markets improved during the fiscal quarter. In Japan, economic growth remained subdued, reflecting a decline in consumer spending and export activity. In the rest of Asia, a number of economies (particularly Hong Kong and China) were adversely impacted by the spread of the SARS virus, which negatively impacted domestic spending and reduced tourism. Demand growth in China appeared to ease from first quarter levels but remained generally strong.
Results of Operations
The composition of our net revenues has varied over time as financial markets and the scope of our operations have changed. The composition of net revenues can also vary over the shorter term due to fluctuations in U.S. and global economic and market conditions. Over the last two years, we have been operating in a challenging economic and business environment. Industry-wide declines in the volume of equity underwritings and mergers and acquisitions have adversely affected the results of our Underwriting and Financial Advisory businesses, and, although market conditions improved somewhat in the second quarter of 2003, continued weakness in global equities markets has adversely affected the results of certain of our Trading and Principal Investments businesses. For a further discussion of the impact these market conditions may have on our results of operations and financial condition, see Item 1 “Business — Certain Factors That May Affect Our Business” in our Annual Report on Form 10-K for the fiscal year ended November 29, 2002.
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The following table sets forth a summary of our financial results:
Financial Overview
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The following table sets forth the net revenues, operating expenses and pre-tax earnings of our segments:
Operating Results by Segment
Net revenues in our segments include allocations of interest income and interest expense to specific securities, commodities and other positions in relation to the cash generated by, or funding requirements of, such underlying positions.
The cost structures of each of our segments are broadly similar to that of Goldman Sachs taken as a whole in that they are primarily influenced by discretionary compensation, headcount and levels of business activity. Our overall compensation and benefits expenses are generally targeted at 50% (plus or minus a few percentage points) of consolidated net revenues. A substantial portion of our compensation expense represents discretionary bonuses, which are determined at the end of our fiscal year. The segment allocation of these bonuses reflects, among other factors, the overall performance of Goldman Sachs as well as the performance of individual business units. The timing and magnitude of changes in our bonus accruals can have a significant effect on segment operating results in a given period.
Goldman Sachs provides a broad range of investment banking services to a diverse group of corporations, financial institutions, governments and individuals. The activities of our Investment Banking segment are divided into two categories:
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The following table sets forth the operating results of our Investment Banking segment:
Investment Banking Operating Results
Net revenues in Investment Banking decreased 14% to $659 million. Net revenues in Financial Advisory were $258 million compared to $428 million for the second quarter of 2002, primarily reflecting a decline in industry-wide completed mergers and acquisitions. Net revenues in our Underwriting business were $401 million compared to $334 million for the same 2002 period, reflecting higher net revenues from debt new issuance activity, partially offset by lower net revenues from equity underwriting. The reduction in Investment Banking net revenues compared to the same period last year was due to lower levels of activity across nearly all sectors. Our investment banking backlog increased during the quarter.(1)
Operating expenses decreased 21%, primarily due to decreased compensation and benefits expenses, reflecting both lower discretionary compensation and lower employment levels. Pre-tax earnings were $81 million compared to $29 million in 2002.
Net revenues in Investment Banking decreased 17% to $1.38 billion. Net revenues in Financial Advisory were $595 million compared to $885 million for the first half of 2002, primarily reflecting a decline in industry-wide completed mergers and acquisitions. Net revenues in our Underwriting business were $782 million compared to $770 million for the same 2002 period, reflecting higher debt new issuance activity, primarily in mortgage-backed securities, partially offset by lower net revenues from equity issuances. The reduction in Investment Banking net revenues was due to lower levels of activity across nearly all sectors.
Operating expenses decreased 17%, primarily due to reduced compensation and benefits expenses, reflecting both lower discretionary compensation and lower employment levels. This decrease was partially offset by higher occupancy expenses, reflecting exit costs associated with reductions in our global office space. Pre-tax earnings were $211 million compared to $246 million in 2002.
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Our Trading and Principal Investments business facilitates customer transactions with a diverse group of corporations, financial institutions, governments and individuals and takes proprietary positions through market making in, and trading of, fixed income and equity products, currencies, commodities, and swaps and other derivatives. In addition, we engage in floor-based and electronic market making as a specialist on U.S. equities and options exchanges. The activities of our Trading and Principal Investments segment are divided into three categories:
Substantially all of our inventory is marked-to-market daily and, therefore, its value and our net revenues are subject to fluctuations based on market movements. In addition, net revenues derived from our principal investments in privately held concerns and in real estate may fluctuate significantly depending on the revaluation or sale of these investments in any given period. 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.
Net revenues from Principal Investments do not include management fees and the increased share of the income and gains from our merchant banking funds (merchant banking overrides) to which we are entitled when the return on investments exceeds certain threshold returns to fund investors. These management fees and merchant banking overrides are included in the net revenues of the Asset Management and Securities Services segment.
The following table sets forth the operating results of our Trading and Principal Investments segment:
Trading and Principal Investments Operating Results
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Net revenues in Trading and Principal Investments increased 40% to $2.01 billion. FICC net revenues of $1.59 billion increased 39% compared to the same 2002 period, reflecting higher net revenues across nearly all businesses, particularly credit products, interest rate products, currencies and mortgages. FICC continued to operate in a favorable environment, characterized by tightening credit spreads, declining interest rates, a steep yield curve, volatile currency markets and strong customer demand. Net revenues in Equities were $446 million compared to $418 million for the second quarter of 2002, primarily reflecting higher levels of customer activity in equity derivatives, as well as higher net revenues in equity arbitrage, partially offset by lower net revenues in our European shares business. Principal Investments recorded negative net revenues of $28 million, primarily due to an unrealized loss of $113 million related to our convertible preferred stock investment in SMFG, partially offset by real estate disposition gains.
Operating expenses increased 16%, primarily due to increased compensation and benefits expenses, with higher discretionary compensation more than offsetting the impact of reduced employment levels, as well as higher occupancy expenses, reflecting exit costs associated with reductions in our global office space. These increases were partially offset by lower brokerage, clearing and exchange fees, professional services and other expenses, communications and technology expenses and market development costs, reflecting the impact of reduced employment levels and lower levels of activity. Pre-tax earnings were $725 million compared to $326 million in 2002.
Net revenues in Trading and Principal Investments increased 50% to $4.16 billion. FICC net revenues increased 47% to $3.47 billion, primarily reflecting higher net revenues in credit products, interest rate products and mortgages, partially offset by lower net revenues in currencies. During the first half of 2003, FICC operated in a favorable environment, characterized by tightening credit spreads, a steep yield curve, favorable financing rates and strong customer demand. Net revenues in Equities increased to $795 million from $523 million, primarily due to higher levels of customer activity in equity derivatives, the negative effect of a single block trade in the first quarter of 2002 and higher net revenues in equity arbitrage. Principal Investments recorded negative net revenues of $105 million, primarily due to an unrealized loss of $157 million related to our investment in SMFG, partially offset by real estate disposition gains.
Operating expenses increased 22%, primarily due to increased compensation and benefits expenses, with higher discretionary compensation more than offsetting the impact of reduced employment levels, as well as higher occupancy and depreciation and amortization expenses, reflecting exit costs associated with reductions in our global office space. These increases were partially offset by the effect of the transfer of our Nasdaq fee-based business to Commissions(1), as well as lower communications and technology expenses, brokerage, clearing and exchange fees and market development costs, reflecting the impact of reduced employment levels and lower levels of activity. Pre-tax earnings were $1.44 billion compared to $544 million in 2002.
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The components of our Asset Management and Securities Services segment are set forth below:
The following table sets forth the operating results of our Asset Management and Securities Services segment:
Asset Management and Securities Services Operating Results
Assets under management typically generate fees based on a percentage of their value and include our mutual funds, separate accounts managed for institutional and individual investors, our merchant banking funds and other alternative investment funds. Substantially all assets under management are valued as of calendar month end.
The following table sets forth our assets under management by asset class:
Assets Under Management by Asset Class
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The following table sets forth a summary of the changes in our assets under management:
Assets Under Management
Net revenues in Asset Management and Securities Services decreased 20% to $1.32 billion. Asset Management net revenues of $404 million decreased 9% compared to last year’s second quarter, primarily reflecting lower management and fund origination fees. During the quarter, assets under management were unchanged, reflecting net asset outflows of $18 billion, primarily in money market assets, offset by market appreciation, primarily in equity and fixed income assets. Securities Services net revenues were $279 million compared to $262 million for the same 2002 period, primarily reflecting higher customer balances in our securities lending and margin lending businesses and higher net revenues in our matched book business. Commissions were $635 million compared to $948 million for the same period last year, primarily reflecting lower equity commissions in our global shares businesses, reduced execution and clearing fees, as well as lower merchant banking overrides.
Operating expenses were essentially unchanged, with lower compensation and benefits expenses offset by increases in professional services and other expenses, as well as higher occupancy expenses, reflecting exit costs associated with reductions in our global office space. Pre-tax earnings were $254 million compared to $599 million in 2002.
Net revenues in Asset Management and Securities Services decreased 13% to $2.64 billion. Asset Management net revenues were $859 million compared to $866 million, primarily reflecting lower management and fund origination fees, partially offset by higher incentive income. During the first half of 2003, assets under management declined by $2 billion, reflecting net asset outflows of $14 billion, primarily in money market assets, partially offset by market appreciation of $12 billion, primarily in fixed income assets. Securities Services net revenues were $530 million compared to $469 million, primarily reflecting increased spreads in our matched book business and higher customer balances in our securities lending and margin lending businesses. Commissions were $1.25 billion compared to $1.69 billion for the same period last year, primarily reflecting lower equity commissions in our global shares businesses, reduced execution and clearing fees, and lower merchant banking overrides.
Operating expenses increased 8%, primarily due to lower compensation and benefits expenses, more than offset by the effect of the transfer of our Nasdaq fee-based business to Commissions and higher occupancy and depreciation and amortization expenses, reflecting exit costs associated with reductions in our global office space, as well as higher professional services and other expenses. Pre-tax earnings were $567 million compared to $1.11 billion in 2002.
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Operating Expenses
The following table sets forth our operating expenses and number of employees:
Operating Expenses and Employees
Operating expenses were $2.95 billion, essentially unchanged from last year’s second quarter. Compensation and benefits of $1.99 billion increased 3% compared to the same period last year, commensurate with higher net revenue levels. The ratio of compensation and benefits to net revenues was 50% for the quarter, consistent with the same prior year period. Employment levels at the end of May 2003 were 18,421, a decrease of 13% from May 2002.
Non-compensation-related expenses of $921 million decreased 2% compared to the same period last year, primarily reflecting lower market development costs, brokerage, clearing and exchange fees, and communications and technology expenses, reflecting the impact of reduced employment levels and lower levels of activity. These decreases were partially offset by higher occupancy costs, reflecting exit costs of $36 million associated with reductions in our global office space.
Operating expenses were $6.12 billion for the six months ended May 2003, a 7% increase from the same prior year period. Compensation and benefits expenses increased 10% to $4.09 billion, commensurate with higher net revenue levels. The ratio of compensation and benefits to net revenues was 50% for the six months ended May 2003, consistent with the same prior year period.
Non-compensation-related expenses were $1.95 billion, 10% above the same prior year period. These increases were primarily due to higher professional services and other expenses, reflecting a provision of $100 million for a number of litigation and regulatory proceedings, as well as higher occupancy and depreciation and amortization expenses, reflecting exit costs of $133 million associated with reductions in our global office space. These increases were partially offset by lower communications and technology expenses, market development costs and brokerage, clearing and exchange fees, reflecting the impact of reduced employment levels and lower levels of activity.
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The provision for taxes for the quarter and six months ended May 2003 was $343 million and $699 million, respectively. The effective income tax rate was 34% for the first half of 2003, down from 35% for both the first quarter of 2003 and fiscal year 2002. The lower effective income tax rate reflects an increase in tax credits and a change in our geographic earnings mix.
Cash Flows
Our cash flows are primarily related to operating and financing activities undertaken in connection with our trading and market-making businesses.
Six Months Ended May 2003.Cash and cash equivalents increased by $2.39 billion to $7.21 billion as of May 2003. Cash of $13.16 billion was used for operating activities, primarily reflecting an increase in financial instruments owned, partially offset by an increase in financial instruments sold, but not yet purchased. Cash of $1.57 billion was used for investing activities, primarily reflecting our investment in the convertible preferred stock of SMFG. Financing activities provided cash of $17.12 billion, reflecting proceeds from the issuances of long-term and net short-term borrowings, partially offset by repayments of long-term borrowings (including the current portion of long-term borrowings) and common stock repurchases.
Six Months Ended May 2002.Cash and cash equivalents decreased by $607 million to $6.30 billion as of May 2002. Cash of $4.20 billion was used for operating activities. Cash of $360 million was used for investing activities, primarily for leasehold improvements and the purchase of telecommunications and technology-related equipment. Financing activities provided cash of $3.95 billion, reflecting proceeds from the issuances of long-term and net short-term borrowings, partially offset by repayments of long-term borrowings (including the current portion of long-term borrowings) and common stock repurchases.
Liquidity Risk Management
Liquidity is of critical importance to companies in the financial services sector. Most failures of financial institutions have occurred in large part due to insufficient liquidity. Accordingly, Goldman Sachs has in place a comprehensive set of liquidity and funding policies that are intended to maintain significant flexibility to address both firm-specific and broader industry or market liquidity events. Our principal objective is to be able to fund Goldman Sachs and to enable our core businesses to continue to generate revenue and provide services to our clients, even under adverse circumstances.
Our liquidity policies are focused on the maintenance of excess liquidity and conservative asset-liability management. For a description of our liquidity policies and our oversight of liquidity, see our Annual Report on Form 10-K for the fiscal year ended November 2002. Some of our principal liquidity policies are summarized below.
Maintenance of a Pool of Highly Liquid Securities. Our most important liquidity policy is to maintain excess liquidity in the form of unencumbered, highly liquid securities. This liquidity is intended to allow us to meet immediate obligations without needing to sell other assets or depend on additional funding from credit-sensitive markets.
Our primary liquidity cushion consists of cash and unencumbered U.S. government and agency securities and highly liquid mortgage securities that may be sold or pledged to provide same-day liquidity. This pool of highly liquid assets averaged $33.89 billion during the second quarter of 2003 and $30.06 billion during 2002. We also maintain smaller pools of unencumbered
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Other Unencumbered Assets.In addition to the liquidity cushion described above, we maintain a significant amount of other unencumbered securities in the United States, Europe and Asia, including other government bonds, high-grade money market securities, corporate bonds and marginable equities.
Maintenance of Liquidity Ratio.Our policy is to maintain total unencumbered assets, including our liquidity cushion and other unencumbered assets described above, in an amount that, if pledged or sold, is intended to provide the funds necessary to replace at least 100% of unsecured obligations that are scheduled to mature (or where holders have the option to redeem) within the coming year. This “liquidity ratio” of unencumbered assets at loan value divided by short-term unsecured liabilities is intended to ensure that we could fund our positions on a secured basis in the event we were unable to replace our unsecured debt maturing within one year. In calculating this ratio, we assume conservative loan values (the estimated amount of cash that would be advanced by counterparties against securities we own) that are based on stress-scenario borrowing capacity. The estimated loan value of the aggregate of our liquidity cushion and the other unencumbered assets averaged $74.20 billion during the second quarter of 2003 and $68.55 billion during 2002.
Committed Bank Facilities.While we assume committed or advised bank facilities will be unavailable in the event of a liquidity crisis, Goldman Sachs maintains over $1 billion in undrawn bank facilities as an additional liquidity resource.
Maintenance of a Highly Liquid Balance Sheet.Goldman Sachs seeks to maintain a highly liquid balance sheet. Many of our assets are readily funded in the repurchase agreement and securities lending markets, which generally have proven to be a consistent source of funding, even in periods of market stress. Substantially all of our inventory is marked-to-market daily.
Our balance sheet fluctuates significantly between financial statement dates and is lower at quarter end than would be observed on an average basis. We require our businesses to reduce balance sheet usage on a quarterly basis to demonstrate compliance with limits set by management, thereby providing a disincentive to committing our capital over longer periods of time. These balance sheet reductions are generally achieved during the last several weeks of each fiscal quarter through ordinary-course, open-market transactions in the most liquid portions of our balance sheet, principally U.S. government and agency securities, securities of foreign sovereigns, and mortgage and money market instruments, as well as through the roll-off of repurchase agreements and certain collateralized financing arrangements. Accordingly, over the last six quarters, our total assets and adjusted assets at quarter end have been, on average, 17% lower and 14% lower, respectively, than amounts that would have been observed, based on a weekly average, over that period. These differences, however, have not resulted in material changes to our credit risk, market risk or excess liquidity position because they are generally in highly liquid assets that are typically financed on a secured basis.
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Funding of Assets With Longer Term Liabilities. While Goldman Sachs’ liquidity policies generally do not rely on sales of assets (other than the liquidity cushions) to maintain liquidity in a distressed environment, we recognize that orderly asset sales may be prudent, and could be necessary, in a persistent liquidity crisis. As a result, we seek to manage the composition of our asset base and the maturity profile of our funding such that we should be able to liquidate our assets prior to our liabilities coming due, even in times of prolonged or severe liquidity stress.
We seek to maintain total capital (long-term borrowings plus shareholders’ equity) substantially in excess of our less liquid assets. Our total capital of $71.31 billion and $57.71 billion as of May 2003 and November 2002, respectively, exceeded the assets that we believe may be more difficult to fund or sell, particularly during times of market stress. Such assets include, but are not limited to, bank loans, high-yield debt securities, emerging market debt securities and principal investments.
As of May 2003 and November 2002, we held $5.55 billion and $2.97 billion, respectively, in bank loans, $3.52 billion and $1.94 billion, respectively, in high-yield debt securities and $0.70 billion and $0.76 billion, respectively, in emerging market debt securities. As of May 2003 and November 2002, the aggregate carrying value of our principal investments held directly or through our merchant banking funds was $3.09 billion and $1.78 billion, respectively. These carrying values were comprised of corporate principal investments with an aggregate carrying value of $1.17 billion and $1.04 billion, respectively, real estate investments with an aggregate carrying value of $0.81 billion and $0.74 billion, respectively, and our investment in SMFG convertible preferred stock with a carrying value as of May 2003 of $1.11 billion. In addition, we held other financial assets such as certain mortgage whole loans, certain mortgage-backed securities and other distressed assets that could be less liquid, particularly during times of market stress.
In addition, we had illiquid non-financial assets of $13.39 billion and $12.30 billion as of May 2003 and November 2002, respectively. These assets, which are reported as “Other assets” in the condensed consolidated statements of financial condition, include goodwill and identifiable intangible assets, property, plant and equipment, deferred tax assets, prepaid assets and our equity method investments.
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Capital and Funding
Capital
Our capital requirements are determined by factors such as subsidiary regulatory requirements, rating agency guidelines, our capital policies regarding asset composition, leverage and risk of loss, business opportunities, and capital availability and cost. Goldman Sachs’ total capital increased 24% to $71.31 billion as of May 2003 compared with $57.71 billion as of November 2002.
The increase in total capital resulted primarily from an increase in long-term borrowings to $51.27 billion as of May 2003 from $38.71 billion as of November 2002. The weighted average maturity of our long-term borrowings as of May 2003 was approximately 6 years. We swap a substantial portion of our long-term borrowings into U.S. dollar obligations with short-term floating interest rates in order to minimize our exposure to interest rates and foreign exchange movements.
Shareholders’ equity increased by 5% to $20.04 billion as of May 2003 from $19.00 billion as of November 2002. During the three months and the six months ended May 2003, we repurchased 3.7 million shares and 7.6 million shares of our common stock, respectively. The average price paid per share for repurchased shares was $74.02 and $71.34 for the second quarter of 2003 and for the first half of 2003, respectively. As of May 2003, we were authorized to repurchase up to 12.0 million additional shares of common stock pursuant to our common stock repurchase program. The principal purpose of our stock repurchase program is to substantially offset the dilutive effect of employee equity-based compensation. The repurchase program has been effected through regular open-market purchases, the sizes of which have been and will be influenced by, among other factors, prevailing prices and market conditions.
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The following table sets forth information on our assets, shareholders’ equity, leverage ratios and book value per share:
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Goldman Sachs generally obtains unsecured short-term borrowings through issuance of promissory notes, commercial paper and bank loans. Short-term borrowings also include the portion of long-term borrowings maturing within one year.
The following table sets forth our short-term borrowings:
Short-Term Borrowings
Our liquidity depends to an important degree on our ability to refinance these borrowings on a continuous basis. Investors who hold our outstanding promissory notes and commercial paper have no obligation to purchase new instruments when the outstanding instruments mature. As part of our overall liquidity policies, we maintain unencumbered assets in an amount that, if pledged or sold, would provide the funds necessary to replace unsecured obligations that are scheduled to mature (or where holders have the option to redeem) within the coming year.
Goldman Sachs relies upon the short-term and long-term debt capital markets to fund a significant portion of its day-to-day operations. The cost and availability of debt financing is influenced by our credit ratings. Credit ratings are important when we are competing in certain markets and when we seek to engage in longer term transactions, including over-the-counter (OTC) derivatives. We believe our credit ratings are determined primarily based on the credit rating agencies’ assessment of the external operating environment, our liquidity, market and credit risk management practices, the level and variability of our earnings, our franchise, reputation and management and our capital base. An adverse change in any of these factors could result in a reduction in our credit ratings which, in turn, could increase our borrowing costs and limit our access to the capital markets or require us to post additional collateral and permit counterparties to terminate transactions, pursuant to our obligations under bilateral provisions in certain of our trading and collateralized financing contracts. This could reduce our earnings and adversely affect our liquidity.
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As of May 2003, additional collateral that would have been callable in the event of a one level reduction in our long-term credit ratings, pursuant to bilateral agreements with certain counterparties, was not material.
The following table sets forth our credit ratings as of May 2003:
Goldman Sachs has contractual obligations to make future payments under long-term debt and long-term noncancelable lease agreements and has contingent commitments under a variety of commercial arrangements.
The following table sets forth our contractual obligations as of May 2003:
Contractual Obligations
As of May 2003, our long-term borrowings were $51.27 billion. Substantially all of our long-term borrowings were unsecured and consisted principally of senior borrowings with maturities extending to 2033.
As of May 2003, our minimum rental payments, net of minimum sublease rentals, under noncancelable leases were $3.97 billion. These lease payments, principally for office space, expire on various dates through 2029. Certain agreements are subject to periodic escalation provisions for increases in real estate taxes and other items.
Our occupancy expenses include costs associated with office space held in excess of our current requirements, primarily due to the impact of the levels of current business activity on our previously anticipated growth in headcount. This excess space is being held for potential future growth. We continually review our space requirements and may, from time to time, reduce capacity through the use of sublease contracts or early termination agreements. We may incur costs in connection with such reductions in our global office space. Where we have unoccupied space that we may occupy in the future, we will continue to charge the underlying operating costs to earnings as incurred.
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The following table sets forth our contingent commitments as of May 2003:
Contingent Commitments
As of May 2003, we had commitments to enter into forward secured financing transactions, including certain repurchase and resale agreements and secured borrowing and lending arrangements, of $30.29 billion.
In connection with our lending activities, we had outstanding commitments of $10.97 billion as of May 2003. These commitments are agreements to lend to counterparties, have fixed termination dates and are contingent on all conditions to borrowing set forth in the contract having been met. Since these commitments may expire unused, the total commitment amount does not necessarily reflect the actual future cash flow requirements. As of May 2003, $1.18 billion of our outstanding commitments have been issued through the William Street credit extension program. Substantially all of the credit risk associated with these commitments have been hedged through the credit loss protection provided by SMFG. We have also hedged the credit risk of certain non-William Street commitments using a variety of other financial instruments.
Critical Accounting Policies
“Financial instruments owned, at fair value” and “Financial instruments sold, but not yet purchased, at fair value” in the condensed consolidated statements of financial condition are carried at fair value or amounts that approximate fair value, with related unrealized gains or losses recognized in our results of operations. The determination of fair value is fundamental to our statements of financial condition and earnings and, in certain circumstances, it requires management to make complex judgments.
The fair value of a financial instrument is the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale.
Quoted market prices in active markets are the best evidence of fair value and we use them when available. Such prices provide the best price transparency and we typically obtain them through electronic quotations or published prices. If quoted market prices in active markets are not available, our estimate of fair value is based on, if available, quoted prices or recent
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If prices are not readily available either through quoted market prices in active markets or alternative pricing sources, or if liquidating a position is reasonably expected to affect market prices, fair value is based on valuation models or management’s estimate, using the best information available, of amounts that could be realized under current market conditions, assuming an orderly liquidation over a reasonable period of time. Our valuation models consider, among other inputs, contractual and market prices, yield curves, credit, volatility factors, prepayment rates and/or correlations of the underlying positions. Examples of valuation models we use include the present value of estimated cash flows, option-pricing models, matrix pricing, option-adjusted spread models and fundamental analysis. The inputs to and the design of our valuation models incorporate assumptions that we believe other market participants would use in their estimates of fair values. However, different valuation models and assumptions could produce materially different estimates of fair value.
In determining fair value, we separate our financial instruments into three categories — cash trading instruments (i.e., nonderivative trading instruments), derivative contracts and principal investments, as set forth in the following table as of May 2003:
Financial Instruments by Category
The fair values of cash trading instruments are generally obtained from quoted market prices in active markets, broker or dealer price quotations, or alternative pricing sources with a reasonable level of price transparency. The types of instruments valued in this manner include U.S. government and agency securities, sovereign government obligations, liquid mortgage products, investment-grade corporate bonds, listed equities, money market securities, state, municipal and provincial obligations, and physical commodities. Certain cash trading instruments have little or no price transparency, including certain high-yield debt, corporate bank loans, whole loan mortgages and distressed debt.
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The following table sets forth the valuation of our cash trading instruments by level of price transparency as of May 2003:
Cash Trading Instruments by Price Transparency
We generally do not adjust the valuation assumptions for cash trading instruments with little or no price transparency unless there is substantial evidence supporting a change in value (for example, comparable third-party transactions) or if management determines that expected realizable value is less than carrying value.
Derivative contracts consist of exchange-traded and OTC derivatives. The fair values of our exchange-traded derivatives are generally determined from quoted market prices. OTC derivatives are valued using valuation models.
The following table sets forth our exchange-traded and OTC derivative assets and liabilities as of May 2003:
Derivative Assets and Liabilities
The fair values of our derivative assets and liabilities include cash we have paid and received (for example, option premiums) and will change significantly from period to period based on, among other factors, changes in our trading positions and market movements.
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The following tables set forth the fair values of our OTC derivative assets and liabilities as of May 2003 by product and by remaining contractual maturity:
OTC Derivatives
Price transparency for OTC derivative model inputs varies depending on, among other factors, product type, maturity and the complexity of the contract. In general, there is significant price transparency for simple interest rate contracts. Price transparency for currency contracts varies by the underlying currencies, with the currencies of the leading industrialized nations having the most price transparency. Price transparency for commodity contracts varies by type of underlying commodity. Price transparency for equity contracts varies by market, with the equity markets of the leading industrialized nations having the most price transparency. For more complex structures, price transparency is inherently more limited because they often combine one or more product types, requiring additional inputs such as correlations and volatilities.
The inputs used in our valuation models are based on quoted market prices in active markets, if available, or, if not, quoted market prices or recent transactions in less active markets and/or prices of similar instruments. Where such data is not readily available, inputs are derived from other market data, taking into account observable market movements that could reasonably be expected to affect the derived input.
In valuing our corporate and real estate principal investments, we separate our portfolio into three categories — public securities, private securities and our investment in the convertible
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Principal Investments
Our private principal investments, by their nature, have little to no price transparency. Such investments are initially carried at cost as an approximation of fair value. Adjustments to carrying value are made if there are third-party transactions evidencing a change in value. Downward adjustments are also made if we determine that the expected realizable value of the investment is less than the carrying value. In reaching that determination, we consider many factors including, but not limited to, the operating cash flows and financial performance of the companies or properties relative to budgets or projections, trends within sectors and/or regions, underlying business models, expected exit timing and strategy, and any specific rights or terms associated with the investment, such as conversion features and liquidation preferences.
Our public principal investments, which tend to be large, concentrated holdings that resulted from initial public offerings or other corporate transactions, are valued using quoted market prices discounted for restrictions on sale.
Our investment in SMFG convertible preferred stock is carried at fair value, which is derived from market data, such as SMFG’s common stock price and credit spreads, and which incorporates the impact of transfer restrictions on our investment as well as downside protection on the conversion strike price. The fair value of our investment is particularly sensitive to movements in the SMFG common stock price. During the second quarter, the fair value of our investment declined 10%, primarily due to a 28% fall in the SMFG common stock price. The effect of changes in the SMFG common stock price on the fair value of our investment is non-linear due to, among other factors, our downside protection on the conversion strike price.
Proper controls, independent of the trading and principal investing functions, are fundamental to ensuring that financial instruments are appropriately valued and the resulting fair value measurements are reliable, particularly where certain levels of price discovery may require additional analysis. These controls include independent review of valuation models and price verification by personnel with technical knowledge of relevant markets and products.
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Recent Accounting Developments
In April 2003, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 amends and clarifies the accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. In addition, the statement clarifies when a contract is a derivative and when a derivative contains a financing component that warrants special reporting in the statement of cash flows. SFAS No. 149 is generally effective prospectively for contracts entered into or modified, and hedging relationships designated, after June 30, 2003. We do not expect adoption to have a material effect on our financial condition, results of operations or cash flows.
In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity, and imposes certain additional disclosure requirements. The provisions of SFAS No. 150 are generally effective for financial instruments entered into or modified after May 31, 2003. We must apply the provisions of SFAS No. 150 to all financial instruments at the beginning of our fourth quarter of fiscal 2003. We do not expect adoption to have a material effect on our financial condition, results of operations or cash flows.
In January 2003, the FASB issued FASB Interpretation (FIN) No. 46, “Consolidation of Variable Interest Entities.” FIN No. 46 requires a company to consolidate a variable interest entity (VIE) if the company has variable interests that give it a majority of the expected losses or a majority of the expected residual returns of the entity. Prior to FIN No. 46, VIEs were commonly referred to as special-purpose entities (SPEs). As required, we adopted FIN No. 46 for VIEs created after January 31, 2003. We must apply FIN No. 46 to VIEs created before February 1, 2003 as of the beginning of the fourth quarter of fiscal 2003. We do not expect adoption to have a material effect on our financial condition, results of operations or cash flows.
In November 2002, the Emerging Issues Task Force (EITF) reached a consensus on EITF Issue No. 02-3, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities.” EITF Issue No. 02-3 precludes mark-to-market accounting for energy-trading contracts that are not derivatives pursuant to SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” We have adopted the provisions of EITF Issue No. 02-3 related to energy-trading contracts as of the beginning of the first quarter of fiscal 2003, and the effect of adoption was not material to our financial condition, results of operations or cash flows. EITF Issue No. 02-3 also communicates the FASB staff’s view that the transaction price for a derivative contract is the best information available with which to estimate fair value at the inception of a contract when the estimate is not based on other observable market data. The application of the FASB staff’s view did not have a material effect on our financial condition, results of operations or cash flows.
For a description of our risk management policies and procedures, see Part II, Item 7A “Quantitative and Qualitative Disclosures About Market Risk” in our Annual Report on Form 10-K for the fiscal year ended November 29, 2002 and the information incorporated by reference therein.
VaR. VaR is the potential loss in value of Goldman Sachs’ trading positions due to adverse market movements over a defined time horizon with a specified confidence level.
For the VaR numbers reported below, a one-day time horizon and a 95% confidence level were used. This means that there is a one in 20 chance that daily trading net revenues will fall below the expected daily trading net revenues by an amount at least as large as the reported
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The VaR numbers below are shown separately for interest rate, equity, currency and commodity products, as well as for our overall trading positions. These VaR numbers include the underlying product positions and related hedges that may include positions in other product areas. For example, the hedge of a foreign exchange forward may include an interest rate futures position, and the hedge of a long corporate bond position may include a short position in the related equity.
The modeling of the risk characteristics of our trading positions involves a number of assumptions and approximations. While management believes that these assumptions and approximations are reasonable, there is no uniform industry methodology for estimating VaR, and different assumptions and/or approximations could produce materially different VaR estimates.
We use historical data to estimate our VaR and, to better reflect current asset volatilities, we generally weight historical data to give greater importance to more recent observations. Given its reliance on historical data, VaR is most effective in estimating risk exposures in markets in which there are no sudden fundamental changes or shifts in market conditions. An inherent limitation of VaR is that the distribution of past changes in market risk factors may not produce accurate predictions of future market risk. Different VaR methodologies and distributional assumptions could produce a materially different VaR. Moreover, VaR calculated for a one-day time horizon does not fully capture the market risk of positions that cannot be liquidated or offset with hedges within one day.
The following table sets forth the daily VaR for substantially all of our trading positions:
Daily VaR
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The following chart presents the daily VaR for substantially all of our trading positions during the last four quarters:
Substantially all of our inventory positions are marked-to-market on a daily basis and changes are recorded in net revenues. The following chart sets forth the frequency distribution for substantially all of our daily trading net revenues for the quarter ended May 2003.
Daily Trading Net Revenues
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As part of our overall risk control process, daily trading net revenues are compared with VaR calculated as of the end of the prior business day. Trading losses incurred on a single day did not exceed our 95% one-day VaR during the quarter ended May 2003.
The market risk for financial instruments in our nontrading portfolio, including our merchant banking investments but excluding our investment in the convertible preferred stock of SMFG, is measured using a sensitivity analysis that estimates the potential reduction in our net revenues associated with a 10% decline in equity markets. This sensitivity analysis is based on certain assumptions regarding the relationship between changes in stock price indices and changes in the fair value of the individual financial instruments in our nontrading portfolio. Different assumptions could produce materially different risk estimates. As of May 2003, the sensitivity of our nontrading portfolio (excluding our investment in the convertible preferred stock of SMFG) to a 10% equity market decline was $90 million compared to $86 million as of February 2003.
The market risk for our investment in the convertible preferred stock of SMFG is measured using a sensitivity analysis that estimates the potential reduction in our net revenues associated with a 10% decline in the SMFG common stock price. As of May 2003, the sensitivity of our investment to a 10% decline in the SMFG common stock price was $53 million compared to $42 million as of February 2003. This sensitivity should not be extrapolated to other movements in the SMFG common stock price, as the relationship between the fair value of our investment and the SMFG common stock price is non-linear.
Derivative contracts are financial instruments, such as futures, forwards, swaps or option contracts, that derive their value from underlying assets, indices, reference rates or a combination of these factors. Derivative instruments may be privately negotiated contracts, which are often referred to as OTC derivatives, or they may be listed and traded on an exchange.
Most of our derivative transactions are entered into for trading purposes. We use derivatives in our trading activities to facilitate customer transactions, to take proprietary positions and as a means of risk management. We also enter into derivative contracts to manage the interest rate and currency exposure on our long-term borrowings.
Derivatives are used in many of our businesses, and we believe that the associated market risk can only be understood relative to the underlying assets or risks being hedged, or as part of a broader trading strategy. Accordingly, the market risk of derivative positions is managed with all of our other nonderivative risk.
Derivative contracts are reported on a net-by-counterparty basis on our condensed consolidated statements of financial condition where management believes a legal right of setoff exists under an enforceable netting agreement. For an OTC derivative, our credit exposure is directly with our counterparty and continues until the maturity or termination of such contract.
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The following table sets forth the distribution, by credit rating, of substantially all of our exposure with respect to OTC derivatives as of May 2003, after taking into consideration the effect of netting agreements. The categories shown reflect our internally determined public rating agency equivalents.
Over-the-Counter Derivative Credit Exposure
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The following tables set forth our OTC derivative credit exposure, net of collateral, by remaining contractual maturity:
Exposure Net of Collateral
Within the 90-day period prior to the filing of this report, an evaluation was carried out under the supervision and with the participation of Goldman Sachs’ management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-14(c) under the Securities Exchange Act of 1934). Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the design and operation of these disclosure controls and procedures were effective. No significant changes were made in our internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.
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PART II: OTHER INFORMATION
Item 1: Legal Proceedings
The following supplements and amends our discussion set forth under Item 3 “Legal Proceedings” in our Annual Report on Form 10-K for the fiscal year ended November 29, 2002, as updated by our Quarterly Report on Form 10-Q for the quarter ended February 28, 2003 and our Current Report on Form 8-K dated April 28, 2003.
IPO Process Matters
In the lawsuit alleging a conspiracy to discourage or restrict the resale of securities, the plaintiffs have filed a petition for review by the U.S. Supreme Court of the ruling by the U.S. Court of Appeals for the Second Circuit affirming dismissal of the complaint.
In the lawsuit alleging a conspiracy to fix at 7% the discount that underwriting syndicates receive from issuers of shares in certain offerings, on June 27, 2003, the federal district court denied defendants’ motion to dismiss the claims asserted by both the issuers and the purchasers of securities on preemption grounds.
In the lawsuits alleging that the prospectuses for certain offerings violated the federal securities laws by failing to disclose the existence of alleged arrangements to “tie” allocations to higher customer brokerage commission rates as well as purchase orders in the aftermarket, plaintiffs announced on June 25, 2003 that they had entered into a Memorandum of Understanding regarding a proposed settlement of their claims against the issuer defendants and the issuers’ present or former officers and directors named in the lawsuits.
In the purported shareholder derivative actions in the U.S. District Court for the Northern District of California alleging underpricing of certain offerings, plaintiffs determined to discontinue their appeals from the granting of judgment on the pleadings, and the appeals were dismissed by Order entered on June 19, 2002. In the underpricing action in New York state court, on May 2, 2003, the court granted Goldman, Sachs & Co.’s motion to dismiss as to five of the claims; plaintiff has appealed from the dismissal of the five claims, and Goldman, Sachs & Co. has appealed from the denial of its motion as to the remaining claim.
Rockefeller Center Properties, Inc. Litigation
In the state proceeding, all but one of the plaintiffs have voluntarily discontinued their actions.
Laidlaw Bondholders Litigation
On June 23, 2003, Laidlaw, Inc. emerged from bankruptcy, the last condition to consummation of the settlement.
World Online Litigation
In the lawsuit against “ABN AMRO Bank N.V., also acting under the name of ABN AMRO Rothschild,” by a decision dated May 7, 2003, the court held that the claims failed and dismissed the complaint.
Research Independence Matters
In connection with the global settlement involving the leading securities firms operating in the United States, on April 28, 2003, Goldman, Sachs & Co. announced that it had entered into stipulations and consents with the SEC, the NYSE, the NASD and the Utah Division of Securities to effectuate the settlement. The settlement with those regulators and the Utah Division of
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On June 23, 2003, the West Virginia Attorney General filed an action against all of the settling securities firms in West Virginia Circuit Court, Marshall County, alleging violations of the West Virginia Consumer Credit and Protection Act in connection with their research activities and seeking monetary penalties.
On April 9, 2003, plaintiffs in the lawsuit relating to research coverage of Covad Communications filed an amended complaint. On May 8, 2003, defendants moved to dismiss the amended complaint, and the motion was granted by a decision dated June 30, 2003.
On June 5, 2003, plaintiffs in the lawsuit relating to research coverage of Allied Riser Communications Corp. filed an amended complaint.
Goldman, Sachs & Co. and one of its former research analysts have been named as defendants in purported class actions filed in the U.S. District Court for the Southern District of New York beginning on May 16, 2003 alleging violations of the federal securities laws in connection with research coverage of Exodus Communications, Inc. Goldman, Sachs & Co. and the other firms which are party to the global settlement described above have been named as defendants in a purported class action filed in the U.S. District Court for the District of Colorado on May 15, 2003 alleging violations of the federal securities laws in connection with their research coverage of unidentified stocks. One of the defendants has filed a motion with the Judicial Panel on Multi-District Litigation to transfer the action to the U.S. District Court for the Southern District of New York.
A purported shareholder derivative action was filed in New York Supreme Court, New York County on June 13, 2003 against The Goldman Sachs Group, Inc. (Group Inc.) and its board of directors alleging that the directors breached their fiduciary duties in connection with the firm’s research activities.
Exodus Securities Litigation
Goldman, Sachs & Co. was named as a defendant in an additional purported class action filed in the U.S. District Court for the Southern District of New York on June 11, 2003 alleging violation of the federal securities laws in connection with the February 2001 public offering of Exodus Communications, Inc. common shares.
Montana Power Shareholders Litigation
By a decision dated May 23, 2003, the federal court remanded the action to the state court. On June 20, 2003, defendants moved to disqualify the state court judge.
Global Crossing Securities Litigation
On April 21, 2003, defendants moved to dismiss the consolidated amended complaint.
Portland General Shareholders Litigation
Group Inc. and Goldman, Sachs & Co. have been named as defendants in two substantively identical purported class actions filed on June 5, 2003 in Oregon Circuit Court, Multnomah County, on behalf of former shareholders of Portland General Corporation. The complaints generally allege that defendants breached their fiduciary duties in connection with Portland General’s 1997 merger with Enron Corporation, in respect of which Goldman, Sachs & Co. acted as financial advisor to Portland General. The defendants also include Arthur Andersen, LLP, Andersen-U.S., and certain former officers and directors of Portland General. The complaint
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Adelphia Communications Fraudulent Conveyance Litigation
Goldman, Sachs & Co. is among numerous entities named as defendants in an adversary proceeding commenced in the U.S. Bankruptcy Court for the Southern District of New York on July 6, 2003 by a creditors’ committee of Adelphia Communications, Inc. The complaint seeks, among other things, to recover, as fraudulent conveyances, payments made by Adelphia and its affiliates to certain brokerage firms, including approximately $62.9 million allegedly paid to Goldman, Sachs & Co., in respect of margin calls made in the ordinary course of business on accounts owned by members of the family that formerly controlled Adelphia.
Item 5: Other Information
Cautionary Statement Pursuant to The Private Securities
We have included in this Form 10-Q filing, and from time to time our management may make, statements which may constitute “forward-looking statements” within the meaning of the safe harbor provisions of The Private Securities Litigation Reform Act of 1995. These forward-looking statements are not historical facts but instead represent only our belief regarding future events, many of which, by their nature, are inherently uncertain and outside of our control. It is possible that our actual results may differ, possibly materially, from the anticipated results indicated in these forward-looking statements. Important factors that could cause actual results to differ from those in our specific forward-looking statements include, but are not limited to, those discussed in our Form 10-K for our fiscal year ended November 29, 2002, under Item 1 “Business — Certain Factors That May Affect Our Business.”
Statements about our investment banking transaction backlog also may constitute forward-looking statements. Such statements are subject to the risk that the terms of these transactions may be modified or that they may not be completed at all; therefore, the net revenues that we expect to earn from these transactions may differ, possibly materially, from those currently expected. Important factors that could result in a modification of the terms of a transaction or a transaction not being completed include, in the case of underwriting transactions, a decline in general economic conditions, volatility in the securities markets generally or an adverse development with respect to the issuer of the securities and, in the case of financial advisory transactions, a decline in the securities markets, an adverse development with respect to a party to the transaction or a failure to obtain a required regulatory approval. Other important factors that could adversely affect our investment banking transactions are contained in our Form 10-K for our fiscal year ended November 29, 2002, under Item 1 “Business — Certain Factors That May Affect Our Business.”
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Item 6: Exhibits and Reports on Form 8-K
(a) Exhibits:
(b) Reports on Form 8-K:
On March 20, 2003, Group Inc. filed a Current Report on Form 8-K reporting its net earnings for its fiscal first quarter ended February 28, 2003.
On April 16, 2003, Group Inc. filed a Current Report on Form 8-K reporting its agreement to acquire El Paso Corporation’s interests in East Coast Power L.L.C.
On April 28, 2003, Group Inc. filed a Current Report on Form 8-K reporting the final global settlement of certain investigations into the investment research department of its U.S. broker-dealer subsidiary Goldman, Sachs & Co.
On June 25, 2003, Group Inc. filed a Current Report on Form 8-K reporting its net earnings for its fiscal second quarter ended May 30, 2003.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Date: July 11, 2003
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CERTIFICATIONS
I, Henry M. Paulson, Jr., certify that:
1. I have reviewed this quarterly report on Form 10-Q of The Goldman Sachs Group, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):
6. The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
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I, David A. Viniar, certify that:
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