10-K 1 y16720e10vk.htm FORM 10-K FORM 10-K
Table of Contents

 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549


FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934


     
For the fiscal year ended November 25, 2005   Commission File Number: 001-14965

The Goldman Sachs Group, Inc.
(Exact name of registrant as specified in its charter)

     
Delaware   13-4019460
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. employer
identification no.)
     
85 Broad Street
New York, N.Y.
 
10004
(Address of principal executive offices)   (Zip Code)

(212) 902-1000
(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:
     
Title of each class: Name of each exchange on which registered:
 
   
Common stock, par value $.01 per share, and attached Shareholder Protection Rights
  New York Stock Exchange
 
   
Depositary Shares, Each Representing 1/1,000th Interest in a Share of Floating Rate Non-Cumulative Preferred Stock, Series A
  New York Stock Exchange
 
   
Depositary Shares, Each Representing 1/1,000th Interest in a Share of 6.20% Non-Cumulative Preferred Stock, Series B
  New York Stock Exchange
 
   
Depositary Shares, Each Representing 1/1,000th Interest in a Share of Floating Rate Non-Cumulative Preferred Stock, Series C
  New York Stock Exchange
 
   
Medium-Term Notes, Series B, 0.25% Exchangeable Notes due 2007; Index-Linked Notes due 2013; Index-Linked Notes due April 2013; Index-Linked Notes due May 2013; Index-Linked Notes due July 2010; and Index-Linked Notes due 2011
  American Stock Exchange
 
   
Medium-Term Notes, Series B, 7.35% Notes due 2009; 7.80% Notes due 2010; Floating Rate Notes due 2006; and Floating Rate Notes due 2008
  New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes   x     No   o
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.     Yes   o     No   x
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.     Yes   x     No   o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of the Annual Report on Form 10-K or any amendment to the Annual Report on Form 10-K.     x
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer    x          Accelerated filer   o          Non-accelerated filer   o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).     Yes   o     No   x
As of May 27, 2005 the aggregate market value of the common stock of the registrant held by non-affiliates of the registrant was approximately $42.5 billion.
As of January 30, 2006 there were 436,004,478 shares of the registrant’s common stock outstanding.
Documents incorporated by reference: Portions of The Goldman Sachs Group, Inc.’s Proxy Statement for its 2006 Annual Meeting of Shareholders to be held on March 31, 2006 are incorporated by reference in the Annual Report on Form 10-K in response to Part III, Items 10, 11, 12, 13 and 14.
 
 

 


 

THE GOLDMAN SACHS GROUP, INC.

ANNUAL REPORT ON FORM 10-K FOR THE FISCAL YEAR ENDED NOVEMBER 25, 2005
INDEX
             
        Page
Form 10-K Item Number:   No.
             
PART I
    1  
Item 1.       1  
        1  
        2  
        3  
        4  
        12  
        12  
        13  
        13  
        13  
        15  
Item 1A.       19  
Item 1B.       29  
Item 2.       29  
Item 3.       30  
Item 4.       41  
        42  
             
PART II
    44  
Item 5.       44  
Item 6.       45  
Item 7.       46  
Item 7A.       97  
Item 8.       98  
Item 9.       153  
Item 9A.       153  
Item 9B.       153  
             
PART III
    154  
Item 10.       154  
Item 11.       154  
Item 12.       154  
Item 13.       155  
Item 14.       155  
             
PART IV
    156  
Item 15.       156  
        F-1  
SIGNATURES
    II-1  
POWER OF ATTORNEY
    II-2  
 
 
 EX-3.1: RESTATED CERTIFICATE OF INCORPORATION OF THE GOLDMAN SACHS GROUP, INC.
 EX-10.30: FORM OF 2005 RSU AWARD AGREEMENT FOR PMD DISCOUNT STOCK PROGRAM
 EX-10.31: FORM OF 2005 RSU AWARD AGREEMENT FOR PMD DISCOUNT STOCK PROGRAM
 EX-10.32: GROUP INC. NON-QUALIFIED DEFERRED COMPENSATION PLAN FOR US PMDS
 EX-10.34: GROUP INC. NON-QUALIFIED DEFERRED COMPENSATION PLAN FOR UK PMDS
 EX-10.41: DESCRIPTION OF NON-EMPLOYEE DIRECTOR COMPENSATION
 EX-10.42: DESCRIPTION OF CERTAIN BENEFITS FOR PARTICIPATING MANAGING DIRECTORS
 EX-10.43: FORM OF ONE-TIME RSU AWARD AGREEMENT
 EX-10.45: GENERAL GUARANTEE AGREEMENT, DATED JANUARY 30, 2006
 EX-12.1: STATEMENT RE: COMPUTATION OF RATIOS OF EARNINGS TO FIXED CHARGES
 EX-21.1: LIST OF SIGNIFICANT SUBSIDIARIES OF THE GOLDMAN SACHS GROUP, INC.
 EX-23.1: CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 EX-31.1: RULE 13A-14(A) CERTIFICATIONS
 EX-32.1: SECTION 1350 CERTIFICATIONS
 EX-99.1: REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

 


Table of Contents

PART I

Item 1.    Business

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. As of November 25, 2005, we operated offices in over 20 countries and approximately 38% of our 22,425 employees were based outside the United States.

Goldman Sachs is the successor to a commercial paper business founded in 1869 by Marcus Goldman. On May 7, 1999, we converted from a partnership to a corporation and completed an initial public offering of our common stock.

Our activities are divided into three segments: (i) Investment Banking, (ii) Trading and Principal Investments and (iii) Asset Management and Securities Services.

All references to 2005, 2004 and 2003 refer to our fiscal years ended, or the dates, as the context requires, November 25, 2005, November 26, 2004 and November 28, 2003, respectively.

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. References herein to the Annual Report on Form 10-K are to our Annual Report on Form 10-K for the fiscal year ended November 25, 2005.

Financial information concerning our business segments and geographic regions for each of 2005, 2004 and 2003 is set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and the consolidated financial statements and the notes thereto, which are in Part II, Items 7, 7A and 8 of the Annual Report on Form 10-K.

Our Internet address is www.gs.com and the investor relations section of our web site is located at www.gs.com/our_firm/investor_relations/. We make available free of charge, on or through the investor relations section of our web site, annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as well as proxy statements, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the U.S. Securities and Exchange Commission (SEC). Also posted on our web site, and available in print upon request of any shareholder to our Investor Relations Department, are our certificate of incorporation and by-laws, charters for our Audit Committee, Compensation Committee and Corporate Governance and Nominating Committee, our Policy Regarding Director Independence Determinations, our Policy on Reporting of Concerns Regarding Accounting and Other Matters, our Corporate Governance Guidelines and our Code of Business Conduct and Ethics governing our directors, officers and employees. Within the time period required by the SEC and the New York Stock Exchange (NYSE), we will post on our web site any amendment to the Code of Business Conduct and Ethics and any waiver applicable to any executive officer, director or senior financial officer (as defined in the Code). In addition, our web site includes information concerning purchases and sales of our equity securities by our executive officers and directors, as well as disclosure relating to certain non-GAAP financial measures (as defined in the SEC’s Regulation G) that we may make public orally, telephonically, by webcast, by broadcast or by similar means from time to time.

Our Investor Relations Department can be contacted at The Goldman Sachs Group, Inc., 85 Broad Street, 17th Floor, New York, New York 10004, Attn: Investor Relations, telephone: 212-902-0300, e-mail: gs-investor-relations@gs.com.

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Cautionary Statement Pursuant to the Private Securities Litigation Reform Act of 1995

We have included or incorporated by reference in the Annual Report on Form 10-K, and from time to time our management may make, statements that may constitute “forward-looking statements” within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. 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 our control. These statements include statements other than historical information or statements of current condition and may relate to our future plans and objectives and results, among other things, and may also include our belief regarding the effect of various legal proceedings, as set forth under “Legal Proceedings” in Part I, Item 3 of the Annual Report on Form 10-K, as well as statements about the objectives and effectiveness of our liquidity policies, statements about trends in our businesses and statements about our investment banking transaction backlog, in Part II, Item 7 of the Annual Report on Form 10-K. 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 the forward-looking statements include, among others, those discussed below and under “Risk Factors” in Part I, Item 1A of the Annual Report on Form 10-K and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of the Annual Report on Form 10-K.

In the case of statements about our investment banking transaction backlog, 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, outbreak of hostilities, 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.

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Segment Operating Results
(in millions)

                             
Year Ended November
2005 2004 2003
   
 
                       
Investment Banking  
Net revenues
  $ 3,671     $ 3,374     $ 2,711  
 
Operating expenses
    3,258       2,973       2,504  
 
 
                 
 
Pre-tax earnings
  $ 413     $ 401     $ 207  
 
 
                 
   
 
                       
Trading and Principal Investments  
Net revenues
  $ 16,362     $ 13,327     $ 10,443  
 
Operating expenses
    10,144       8,287       6,938  
 
 
                 
 
Pre-tax earnings
  $ 6,218     $ 5,040     $ 3,505  
   
 
                 
   
 
                       
Asset Management and Securities Services  
Net revenues
  $ 4,749     $ 3,849     $ 2,858  
 
Operating expenses
    3,070       2,430       1,890  
 
 
                 
 
Pre-tax earnings
  $ 1,679     $ 1,419     $ 968  
   
 
                 
   
 
                       
Total  
Net revenues
  $ 24,782     $ 20,550     $ 16,012  
 
Operating expenses (1)
    16,509       13,874       11,567  
 
 
                 
 
Pre-tax earnings
  $ 8,273     $ 6,676     $ 4,445  
   
 
                 
 
(1)   Includes the following expenses that have not been allocated to our segments: (i) the amortization of employee initial public offering awards, net of forfeitures, of $19 million and $80 million for the years ended November 2004 and November 2003, respectively; (ii) net provisions for a number of litigation and regulatory proceedings of $37 million, $103 million and $155 million for the years ended November 2005, November 2004 and November 2003, respectively; and (iii) $62 million in connection with the establishment of our joint venture in China for the year ended November 2004.

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Business Segments

These segments consist of various products and activities that are set forth in the following chart:

               
               
  Business Segment/Component     Primary Products and Activities
 
               
 
 
           
 
Investment Banking:
           
 
 
           
 
Financial Advisory
      Mergers and acquisitions advisory services  
 
 
      Financial restructuring advisory services  
 
 
           
 
Underwriting
      Equity and debt underwriting  
 
 
           
           
 
 
           
 
Trading and Principal Investments:
           
 
 
           
 
Fixed Income, Currency and Commodities
      Commodities and commodity derivatives, including our power generation activities  
 
 
      Credit products, including the trading of and investing in credit derivatives, investment-grade corporate securities, high-yield securities, bank loans, municipal securities, emerging market debt and other distressed debt, and equity securities  
 
 
      Currencies and currency derivatives  
 
 
      Interest rate products, including interest rate derivatives, global government securities and money market instruments, including our matched book  
 
 
      Mortgage-backed securities and loans and other asset-backed securities  
 
 
           
 
Equities
      Equity securities and derivatives  
 
 
      Securities, futures and options clearing services  
 
 
      Specialist and market-making activities in equity securities and options  
 
 
           
 
Principal Investments
      Principal investments in connection with merchant banking activities  
 
 
      Investment in the convertible preferred stock of Sumitomo Mitsui Financial Group, Inc.  
 
 
           
           
 
 
           
 
Asset Management and Securities Services:
           
 
 
           
 
Asset Management
      Asset management, advisory services and investment products for all major asset classes, including money markets, fixed income, currencies, equities and alternative investments (including hedge funds, private equity funds and real estate funds), for institutional and high-net-worth clients, as well as retail clients through third-party channels  
 
 
      Management of merchant banking funds  
 
 
           
 
Securities Services
      Prime brokerage  
 
 
      Financing services  
 
 
      Securities lending  
           

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Investment Banking

Investment Banking represented 15% of 2005 net revenues. We provide a broad range of investment banking services to a diverse group of corporations, financial institutions, governments and individuals and seek to develop and maintain long-term relationships with these clients as their lead investment bank.

Our current structure, which is organized by regional, industry and product groups, seeks to combine client-focused investment bankers with execution and industry expertise. We continually assess and adapt our organization to meet the demands of our clients in each geographic region. Through our commitment to teamwork, we believe that we provide services in an integrated fashion for the benefit of our clients.

Our goal is to make available to our clients the entire resources of the firm in a seamless fashion, with investment banking serving as “front of the house.” To accomplish this objective, we focus on coordination among our equity and debt underwriting businesses and our corporate risk and liability management businesses. This coordination is intended to assist our investment banking clients in managing their asset and liability exposures.

Our Investment Banking segment is divided into two components: Financial Advisory and Underwriting.

Financial Advisory

Financial Advisory includes advisory assignments with respect to mergers and acquisitions, divestitures, corporate defense activities, restructurings and spin-offs. Our mergers and acquisitions capabilities are evidenced by our significant share of assignments in large, complex transactions for which we provide multiple services, including “one-stop” acquisition financing and cross-border structuring expertise, as well as services in other areas of the firm, such as interest rate and currency hedging.

Underwriting

Underwriting includes public offerings and private placements of a wide range of securities and other financial instruments, including common and preferred stock, convertible and exchangeable securities, investment-grade debt, high-yield debt, sovereign and emerging market debt, municipal debt, bank loans, asset-backed securities and real estate-related securities, such as mortgage-backed securities and the securities of real estate investment trusts.

Equity Underwriting. Equity underwriting has been a long-term core strength of Goldman Sachs. As with mergers and acquisitions, we have been particularly successful in winning mandates for large, complex transactions. We believe our leadership in worldwide initial public offerings and worldwide public common stock offerings reflects our expertise in complex transactions, prior experience and distribution capabilities.

Debt Underwriting. We engage in the underwriting and origination of various types of debt instruments, including investment-grade debt securities, high-yield debt securities, bank and bridge loans and emerging market debt securities, which instruments may be issued by, among others, corporate, sovereign and agency issuers. In addition, we underwrite and originate structured securities, which include mortgage-backed and other asset-backed securities and collateralized debt obligations.

Trading and Principal Investments

Trading and Principal Investments represented 66% of 2005 net revenues. Trading and Principal Investments facilitates client transactions with a diverse group of corporations, financial institutions, governments and individuals and takes proprietary positions through market making in,

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trading of and investing in fixed income and equity products, currencies, commodities and derivatives on such products. In addition, we engage in specialist and market-making activities on equities and options exchanges and we clear client transactions on major stock, options and futures exchanges worldwide. In connection with our merchant banking and other investing activities, we make principal investments directly and through funds that we raise and manage.

To meet the needs of our clients, Trading and Principal Investments is diversified across a wide range of products. We believe our willingness and ability to take risk to facilitate client transactions distinguishes us from many of our competitors and substantially enhances our client relationships.

Our Trading and Principal Investments segment is divided into three components: Fixed Income, Currency and Commodities, Equities and Principal Investments.

Fixed Income, Currency and Commodities and Equities

Fixed Income, Currency and Commodities (FICC) and Equities are large and diversified operations through which we engage in a variety of customer-driven and proprietary trading and investing activities.

In their customer-driven businesses, FICC and Equities strive to deliver high-quality service by offering broad market-making and market knowledge to our clients on a global basis. In addition, we use our expertise to take positions in markets, by committing capital and taking risk, to facilitate client transactions and to provide liquidity. Our willingness to make markets, commit capital and take risk in a broad range of fixed income, currency, commodity and equity products and their derivatives is crucial to our client relationships and to support our underwriting business by providing secondary market liquidity.

A core activity in FICC and Equities is market making in a broad array of securities and products. For example, we are a primary dealer in many of the largest government bond markets around the world, including the United States, Japan and the United Kingdom. We are a member of the major futures exchanges, and also have interbank dealer status in the currency markets in New York, London, Tokyo and Hong Kong.

We generate trading net revenues from our customer-driven businesses in three ways.

    First, in large, highly liquid markets, we undertake a high volume of transactions for modest spreads and fees.
 
    Second, by capitalizing on our strong relationships and capital position, we undertake transactions in less liquid markets where spreads and fees are generally larger.
 
    Finally, we structure and execute transactions that address complex client needs.

We continue to increase coordination among our FICC and Equities businesses as we respond to what we believe is client demand for more coordinated services and for cross-market knowledge and expertise.

In our proprietary activities in both FICC and Equities, we assume a variety of risks and devote resources to identify, analyze and benefit from these exposures. We capitalize on our analytical models to analyze information and make informed trading judgments and we seek to benefit from perceived disparities in the value of assets in the trading markets and from macroeconomic and issuer-specific trends.

Through Allmerica Financial Life Insurance and Annuity Company, an insurance subsidiary that we acquired in December 2005, we now manage interests in variable annuity and variable life insurance contracts. We also plan to participate opportunistically in both the life and annuity and property reinsurance businesses.

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FICC

Our FICC business makes markets in and trades interest rate and credit products, mortgage-backed securities and loans and other asset-backed securities, currencies and commodities, structures and enters into a wide variety of derivative transactions, and engages in proprietary trading and investing. FICC has five principal businesses: commodities; credit products; currencies; interest rate products, including money market instruments; and mortgage-backed securities and loans and other asset-backed securities.

Commodities. We make markets in, and trade for our clients and our own account, a wide variety of commodities and commodity derivatives, including oil and oil products, metals, natural gas and electricity and forest products. We are also a member of or have relationships with major commodities exchanges worldwide.

As part of our commodities business, we have acquired interests in electric power generation facilities. As of January 1, 2006, we owned interests in 20 power generation facilities located in the United States and one power generation facility located outside the United States. Of these facilities, eight are fueled by natural gas, eight by coal, four by waste coal and one by fuel oil. We acquired interests in the first of these facilities in 2003. Since that time, we have acquired and disposed of interests in other power generation facilities.

Credit Products. We offer our clients, and trade for our own account, a broad array of credit and credit linked products, including credit derivatives, investment-grade corporate securities, high-yield securities, bank loans (origination and trading), municipal securities, emerging market debt and other distressed debt. We also trade credit products for the benefit of our clients. For example, we enter, as principal, into complex structured transactions designed to meet client needs and also provide credit through bridge and other loan facilities.

Our credit products business includes making long-term and short-term investments for our own account (often investing together with our merchant banking funds) in a broad array of asset classes (including distressed debt) globally. We opportunistically invest in assets across an entity’s capital structure, including in equity, senior loans, debt securities and preferred stock.

Currencies. We act as a dealer in foreign exchange and trade for our clients and ourselves in most currencies on exchanges and in cash and derivative markets globally.

Interest Rate Products. We trade and make markets in a variety of interest rate products, including interest rate swaps, options and other derivatives and government bonds, as well as money market instruments, such as commercial paper, treasury bills, repurchase agreements and other highly liquid securities and instruments. This business includes our matched book, which consists of short-term collateralized financing transactions.

Mortgage Business. We make markets in, and trade for our clients and ourselves, mortgage-related securities and loan products and other asset-backed securities, and we securitize loan portfolios backed by real estate and other assets.

Equities

We make markets in, trade and act as a specialist for equities and equity-related products, structure and enter into equity derivative transactions and engage in proprietary trading. We generate commissions from executing and clearing client transactions on major stock, options and futures exchanges worldwide through our Equities customer franchise and clearing activities.

Equities includes three principal businesses: our customer franchise business, principal strategies and specialist activities.

Customer Franchise Business. Our customer franchise business includes primarily customer-driven activities in the shares, convertible securities and equity derivatives markets.

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These activities also include clearing client transactions on major stock, options and futures exchanges worldwide, as well as our options specialist and market-making businesses.

We trade equity securities and equity-related products, including convertible securities, options, futures and over-the-counter (OTC) derivative instruments, on a global basis as an agent, as a market maker or otherwise as a principal. As a principal, we facilitate client transactions, often by committing capital and taking risk, to provide liquidity to clients with large blocks of stocks or options. For example, we are active in the execution of large block trades. We also execute transactions as agent and offer clients direct electronic access to trading markets.

We are a member of most of the world’s major stock, options and futures exchanges and marketplaces, including those located in New York, Chicago, London, Paris, Frankfurt, Tokyo and Hong Kong.

In the options and futures markets, we structure, distribute and execute derivatives on market indices, industry groups and individual company stocks to facilitate client transactions and our proprietary activities. We develop strategies and render advice with respect to portfolio hedging and restructuring and asset allocation transactions. We also create specially tailored instruments to enable sophisticated investors to undertake hedging strategies and to establish or liquidate investment positions. We are one of the leading participants in the trading and development of equity derivative instruments. We are an active participant in the trading of futures and options on most of the major exchanges in the United States, Europe and Asia. In options, we are a specialist and market maker on the International Securities Exchange and a market maker on the Boston Options Exchange and the Philadelphia Stock Exchange.

Principal Strategies. Our principal strategies business includes a multi-strategy proprietary investment business that invests and trades for the firm’s own account. Principal strategies trades and invests the firm’s capital across global markets employing strategies that are primarily focused on public markets. Most strategies involve fundamental equities and relative value trading (which involves trading strategies to take advantage of perceived discrepancies in the relative value of financial instruments, including equity, equity-related and debt instruments). Other strategies involve event-driven investments (which focus on event-oriented special situations such as corporate restructurings, bankruptcies, recapitalizations, mergers and acquisitions and legal and regulatory events) as well as convertible bond trading, various types of volatility trading and principal finance (which includes private structured investments in public or private companies).

Specialist Activities. Our specialist activities business includes our stock and exchange-traded funds (ETF) specialist and market-making businesses. We engage in specialist and market-making activities on equities exchanges. In the United States, we are one of the leading stock specialists on the NYSE. For ETFs, we are a specialist on the NYSE and a specialist and market maker on the American Stock Exchange.

Principal Investments

Principal Investments primarily represents net revenues from our corporate and real estate merchant banking investments. To date, these net revenues have been from three primary sources: returns on corporate and real estate investments, our investment in the convertible preferred stock of Sumitomo Mitsui Financial Group, Inc. (SMFG) and overrides. In January 2006, the firm entered into a definitive agreement to invest $2.58 billion in the Industrial and Commercial Bank of China Limited, with investment funds managed by the firm assuming a substantial portion of the firm’s economic interest. The transactions are expected to close by May 2006, subject to receipt of regulatory approvals and other closing conditions.

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Returns on Corporate and Real Estate Investments. In connection with our merchant banking activities, we invest by making principal investments directly and through funds that we raise and manage. As of November 2005, the aggregate carrying value of our principal investments held directly or through our merchant banking funds, excluding our investment in the convertible preferred stock of SMFG, was approximately $2.47 billion, comprised of corporate principal investments with an aggregate carrying value of approximately $1.72 billion and real estate investments with an aggregate carrying value of approximately $745 million. In addition, as of November 2005, we had outstanding equity capital commitments of up to $3.54 billion.

SMFG. Principal Investments also includes our investment in the convertible preferred stock of SMFG, which we
acquired on February 7, 2003. This preferred stock is generally nontransferable, but is freely convertible into SMFG common stock. Restrictions on our ability to hedge or sell one-third of the common stock underlying our investment in SMFG lapsed in February 2005. As of November 2005, we were fully hedged with respect to these unrestricted shares. Under our initial agreement with SMFG, restrictions on our ability to hedge or sell the remaining shares of common stock underlying our investment in SMFG lapse in equal installments on February 7, 2006 and February 7, 2007. In connection with a public offering by SMFG of its common stock, we have separately agreed with SMFG that the restrictions that were to lapse on February 7, 2006 will instead lapse on March 9, 2006. As of November 2005, the carrying value of our investment in the SMFG preferred stock was approximately $4.06 billion.

Overrides. Principal Investments also includes net revenues from the increased share of the income and gains derived from our merchant banking funds when the return on a fund’s investments exceeds certain threshold returns (typically referred to as an “override”).

Asset Management and Securities Services

Asset Management and Securities Services represented 19% of 2005 net revenues. Our Asset Management business provides investment advisory and financial planning services and offers investment products to a diverse group of institutions and individuals worldwide and primarily generates revenues in the form of management and incentive fees. Securities Services provides prime brokerage services, financing services and securities lending services to mutual funds, pension funds, hedge funds, foundations and high-net-worth individuals worldwide, and generates revenues primarily in the form of interest rate spreads or fees.

Asset Management

We offer a broad array of investment strategies, advice and planning. We provide asset management services and offer investment products across all major asset classes: money markets, fixed income, currencies, equities and alternative investments (which primarily includes private equity funds, hedge funds, real estate funds, certain currency and asset allocation strategies and other assets allocated to external investment managers). Through our subsidiary, The Ayco Company, L.P. (Ayco), we also provide fee-based financial counseling in the United States.

Assets under management (AUM) typically generate fees as a percentage of asset value. In certain circumstances, we are also entitled to receive asset management incentive fees based on a percentage of a fund’s return or when the return on assets under management exceeds specified benchmark returns or other performance targets. Incentive fees are recognized when the performance period ends and they are no longer subject to adjustment. We have numerous incentive fee arrangements, many of which have annual performance periods that end on December 31 and are not subject to adjustment thereafter. For that reason, incentive fees are seasonally weighted each year to our first fiscal quarter. Depending on the level of net revenues in our first fiscal quarter of 2006, these incentive fees may be material to the results of operations in that quarter.

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AUM includes our mutual funds, alternative investment funds and separately managed accounts for institutional and individual investors. Alternative investments include our merchant banking funds, which generate revenues as described below under “Management of Merchant Banking Funds.” AUM excludes assets in brokerage accounts, which generate commissions, mark-ups and spreads that are included in our Trading and Principal Investments segment. Increasingly, many of our individual clients’ brokerage accounts pay fees based on the assets in their accounts rather than commissions on transactional activity in the accounts.

The amount of AUM is set forth in the graph below. In the following graph, as well as in the following tables, substantially all assets under management are valued as of November 30.

Assets Under Management
(in billions)

ASSETS UNDER MANAGEMENT CHART


The following table sets forth AUM by asset class:

Assets Under Management by Asset Class
(in billions)

                         
As of November 30
2005 2004 2003
 
                       
Asset Class
                       
 
                       
Money markets
  $ 101     $ 90     $ 89  
Fixed income and currency
    159       139       115  
Equity  (1)
    158       126       98  
Alternative investments  (2)
    114       97       71  
 
                 
Total
  $ 532     $ 452     $ 373  
 
                 
 
(1)   Includes both our fundamental equity and our quantitative equity strategies.
 
(2)   Primarily includes private equity funds, hedge funds, real estate funds, certain currency and asset allocation strategies and other assets allocated to external investment managers.


Clients. Our clients are institutions and individuals, including both high-net-worth and retail investors. We access institutional and high-net-worth clients through both direct and third-party channels and retail clients through third-party channels. Our institutional clients include pension

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funds, governmental organizations, corporations, insurance companies, foundations and endowments. In third-party distribution channels, we distribute our mutual funds and separately managed accounts through brokerage firms, banks, insurance companies and other financial intermediaries. Our clients are located worldwide.

The table below sets forth the amount of AUM by distribution channel and client category:

Assets Under Management by Distribution Channel (1)
(in billions)

                             
As of November 30
2005 2004 2003
   
 
                       
Distribution Channel
                       
   
 
                       
 
Directly Distributed
                       
   
— Institutional
  $ 226     $ 183     $ 142  
   
— High-net-worth individuals
    148       130       115  
 
Third-Party Distributed
                       
   
— Institutional, high-net-worth and retail
    158       139       116  
   
 
                 
Total
  $ 532     $ 452     $ 373  
   
 
                 
 
(1)   The primary investment vehicles for these assets under management are separately managed accounts and commingled vehicles, such as mutual funds and private investment funds.


Management of Merchant Banking Funds. Goldman Sachs sponsors numerous corporate and real estate private investment funds. Our strategy with respect to these funds generally is to invest opportunistically to build a portfolio of investments that is diversified by industry, product type, geographic region and transaction structure and type. Our corporate investment funds pursue, on a global basis, long-term investments in equity and debt securities in privately negotiated transactions, leveraged buyouts, acquisitions and investments in funds managed by external parties. Our real estate investment funds invest in real estate operating companies, debt and equity interests in real estate assets, and other real estate-related investments. Our clients in private investment funds include pension plans, endowments, charitable institutions and high-net-worth individuals.

Since inception, we have raised $52.53 billion of committed equity capital in these funds, of which $37.23 billion relates to our corporate funds and $15.30 billion relates to our real estate funds. As of November 2005, $37.30 billion of the committed equity capital was funded and the amount of AUM remaining in these funds after distributions was $28.85 billion.

Merchant banking activities generate three primary revenue streams. First, we receive a management fee that is generally a percentage of a fund’s committed capital, invested capital, total gross acquisition cost or asset value. These annual management fees are included in our Asset Management net revenues. Second, Goldman Sachs, as a substantial investor in some of these funds, is allocated its proportionate share of the funds’ unrealized appreciation or depreciation arising from changes in fair value as well as gains and losses upon realization. Third, after a fund has achieved a minimum return for fund investors, we receive an increased share of the fund’s income and gains that is a percentage of the income and gains from the fund’s investments. The second and third of these revenue streams are included in net revenues of the Principal Investments component of our Trading and Principal Investments segment.

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Securities Services

Securities Services provides prime brokerage services, financing services and securities lending services to mutual funds, pension funds, hedge funds, foundations and high-net-worth individuals worldwide.

Prime brokerage services. We offer prime brokerage services to our clients, allowing them the flexibility to trade with most brokers while maintaining a single source for financing and consolidated portfolio reports. Our prime brokerage business provides clearing and custody in 45 markets (with net revenues from clearing and custody included in our Trading and Principal Investments segment), consolidated multi-currency accounting and reporting and offshore fund administration.

Financing services. A central element of our prime brokerage business involves providing financing to our clients for their securities trading activities through margin and securities loans that are collateralized by securities, cash or other acceptable collateral.

Securities lending services. Securities lending services principally involve the borrowing and lending of securities to cover clients’ and Goldman Sachs’ short sales and otherwise to make deliveries into the market. In addition, we are an active participant in the broker-to-broker securities lending business and the third-party agency lending business.

Global Investment Research

Global Investment Research provides fundamental research on companies, industries, economies, currencies, commodities and macro strategy research on a worldwide basis.

Global Investment Research employs a team approach that as of November 28, 2005 provided research coverage of approximately 2,250 companies worldwide, over 50 national economies and 25 stock markets. This is accomplished by the following departments:

    The Equity Research Departments provide fundamental analysis, earnings forecasts and investment opinions for equity securities;
 
    The Credit Research Department provides fundamental analysis, forecasts and investment opinions as to investment-grade and high-yield corporate bonds and credit derivatives;
 
    The Economic Research Department formulates macroeconomic forecasts for economic activity, foreign exchange and interest rates;
 
    The Commodities Research Department provides research on the commodity markets; and
 
    The Strategy Research Department provides equity market forecasts, opinions on both asset and industry sector allocation, equity trading strategies and options research.

Further information regarding research at Goldman Sachs is provided below under “— Regulation — Regulations Applicable in and Outside the United States,” “Risk Factors” in Part I, Item 1A of the Annual Report on Form 10-K and “Legal Proceedings — Research Independence Matters” in Part I, Item 3 of the Annual Report on Form 10-K.

Technology

Goldman Sachs is committed to the ongoing development, maintenance and use of technology throughout the organization. Our technology initiatives can be broadly categorized into four efforts:

    Enhancing client service through increased connectivity and the provision of value-added, tailored products and services;

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    Improving our trading, execution and clearing capabilities;
 
    Risk management; and
 
    Overall efficiency, productivity and control.

We have tailored our services to our clients by providing them with electronic access to our products and services. In particular, we provide global electronic trading and information distribution capabilities covering many of our fixed income, currency, commodity, equity and mutual fund products around the world.

Electronic commerce and technology have changed and will continue to change the ways that securities and other financial products are traded, distributed and settled. This creates both opportunities and challenges for our businesses. We remain committed to being at the forefront of technological innovation in the global capital markets.

Business Continuity and Information Security

Business continuity and information security are high priorities for Goldman Sachs. Our Business Continuity Program has been developed to provide reasonable assurance of business continuity in the event of disruptions at the firm’s critical facilities and to comply with NYSE and National Association of Securities Dealers, Inc. (NASD) regulatory requirements. The key elements of the program are crisis management, business recovery, systems and data recovery, people recovery facilities and process improvement. In the area of information security, a framework of principles, policies and technology has been developed to protect the information assets of the firm and our clients. Safeguards are applied to maintain the confidentiality, integrity and availability of information resources.

Employees

Management believes that a major strength and principal reason for the success of Goldman Sachs is the quality and dedication of our people and the shared sense of being part of a team. We strive to maintain a work environment that fosters professionalism, excellence, diversity, cooperation among our employees worldwide and high standards of business ethics.

Instilling the Goldman Sachs culture in all employees is a continuous process, in which training plays an important part. All employees are offered the opportunity to participate in education and periodic seminars that we sponsor at various locations throughout the world. Another important part of instilling the Goldman Sachs culture is our employee review process. Employees are reviewed by supervisors, co-workers and employees they supervise in a 360-degree review process that is integral to our team approach.

As of November 2005, we had 22,425 employees (excluding 1,437 employees of Goldman Sachs’ property management and loan servicing subsidiaries, for whom the majority of the costs are reimbursed to Goldman Sachs by the investment funds for which these subsidiaries provide services, and 7,143 employees of certain consolidated entities that are held for investment purposes only). Consolidated entities held for investment purposes include entities that are held strictly for capital appreciation, have a defined exit strategy and are engaged in activities that are not closely related to our principal businesses.

Competition

The financial services industry — and all of our businesses — are intensely competitive, and we expect them to remain so. Our competitors are other brokers and dealers, investment banking firms, insurance companies, investment advisers, mutual funds, hedge funds, private equity funds, commercial banks and merchant banks. We compete with some of our competitors globally and with

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others on a regional, product or niche basis. Our competition is based on a number of factors, including transaction execution, our products and services, innovation, reputation and price.

We also face intense competition in attracting and retaining qualified employees. Our ability to continue to compete effectively in our businesses will depend upon our ability to attract new employees and retain and motivate our existing employees.

Over time, there has been substantial consolidation and convergence among companies in the financial services industry, due in part to U.S. federal legislation that has expanded the activities permissible for firms affiliated with a U.S. bank. In particular, a number of large commercial banks, insurance companies and other broad-based financial services firms have established or acquired broker-dealers or have merged with other financial institutions. Many of these firms have the ability to offer a wide range of products, from loans, deposit-taking and insurance to brokerage, asset management and investment banking services, which may enhance their competitive position. They also have the ability to support investment banking and securities products with commercial banking, insurance and other financial services revenues in an effort to gain market share, which has resulted in pricing pressure in certain of our businesses and could result in pricing pressure in other of our businesses.

Moreover, we have faced, and expect to continue to face, pressure to retain market share by committing capital to businesses or transactions on terms that offer returns that may not be commensurate with their risks. In particular, corporate clients increasingly seek such commitments (such as agreements to participate in their commercial paper backstop or other revolving loan facilities) from financial services firms in connection with investment banking and other assignments. To respond to this trend, we established the William Street entities, through which we have issued commitments to lend to counterparties, primarily investment-grade clients. With respect to these commitments, we have credit loss protection provided to us by SMFG, which is generally limited to 95% of the first loss we realize on approved loan commitments, subject to a maximum of $1.00 billion. In addition, subject to the satisfaction of certain conditions, upon our request, SMFG will provide protection for 70% of the second loss on such commitments, subject to a maximum of $1.13 billion. We also use other financial instruments to hedge certain William Street commitments not covered by SMFG. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of the Annual Report on Form 10-K and Note 6 to our consolidated financial statements in Part II, Item 8 of the Annual Report on Form 10-K for more information regarding the William Street entities and for a description of the credit loss protection provided by SMFG.

Increasingly, in connection with investment banking transactions, we are being called upon to provide capital commitments that do not meet the criteria established for the William Street entities. These commitments are issued through Goldman Sachs Credit Partners L.P. or our other subsidiaries.

The trend toward consolidation and convergence has significantly increased the capital base and geographic reach of some of our competitors. This trend has also hastened the globalization of the securities and other financial services markets. As a result, we have had to commit capital to support our international operations and to execute large global transactions. To take advantage of some of our most significant challenges and opportunities, we will have to compete successfully with financial institutions that are larger and better capitalized and that may have a stronger local presence and longer operating history outside the United States.

We have experienced intense price competition in some of our businesses in recent years. There has been considerable pressure in the pricing of block trades. Also, equity and debt underwriting discounts, as well as trading spreads, have been under pressure for a number of years and the ability to execute trades electronically, through the Internet and through other alternative trading systems, has increased the pressure on trading commissions. It appears that this trend toward electronic and other “low-touch,” low-commission trading will continue. We believe that we

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will continue to experience competitive pressures in these and other areas in the future as some of our competitors seek to obtain market share by reducing prices.

Regulation

Goldman Sachs, as a participant in the securities and commodity futures and options industries, is subject to extensive regulation in the United States and elsewhere. As a matter of public policy, regulatory bodies in the United States and the rest of the world are charged with safeguarding the integrity of the securities and other financial markets and with protecting the interests of clients participating in those markets. They are not, however, charged with protecting the interests of Goldman Sachs’ shareholders or creditors.

Broker-dealers, in particular, are subject to regulations that cover all aspects of the securities business, including sales methods, trade practices, use and safekeeping of clients’ funds and securities, capital structure, recordkeeping, the financing of clients’ purchases, and the conduct of directors, officers and employees. A number of our affiliates are regulated by investment advisory laws in and outside the United States. Additional legislation, changes in rules promulgated by self-regulatory organizations, or changes in the interpretation or enforcement of existing laws and rules, either in the United States or elsewhere, may directly affect the operations and profitability of Goldman Sachs.

Regulation in the United States

In the United States, the SEC is the federal agency responsible for the administration of the federal securities laws. The SEC has approved an application by Goldman, Sachs & Co. (GS&Co.), our principal broker-dealer in the United States, to calculate net capital requirements using the alternative method available to a broker-dealer that is part of a Consolidated Supervised Entity. As a condition to GS&Co.’s use of the alternative method, The Goldman Sachs Group, Inc. was required to consent to group-wide supervision and examination by the SEC and to report to the SEC consolidated computations of our capital adequacy on an ongoing basis. Consenting to regulation as a Consolidated Supervised Entity is among the measures we have taken to enable us to comply with the requirements of the European Financial Groups Directive described below under
“— Regulation Outside the United States.”

GS&Co. is registered as a broker-dealer and as an investment adviser with the SEC and as a broker-dealer in all 50 states and the District of Columbia. Self-regulatory organizations, such as the NYSE and NASD, adopt rules that apply to, and examine, broker-dealers such as GS&Co. In addition, state securities and other regulators also have regulatory or oversight authority over GS&Co. Similarly, our businesses are also subject to regulation by various non-U.S. governmental and regulatory bodies and self-regulatory authorities in virtually all countries where we have offices. Goldman Sachs Execution & Clearing, L.P. (GSEC) and two of its subsidiaries are registered U.S. broker-dealers and are regulated by the SEC and NYSE and GSEC is also regulated by the NASD. Goldman Sachs Financial Markets, L.P. is registered with the SEC as an OTC derivatives dealer and conducts certain OTC derivatives businesses.

The commodity futures and commodity options industry in the United States is subject to regulation under the Commodity Exchange Act, as amended. The Commodity Futures Trading Commission (CFTC) is the federal agency charged with the administration of the Commodity Exchange Act and the regulations thereunder. Several of Goldman Sachs’ subsidiaries, including GS&Co. and GSEC, are registered with the CFTC and act as futures commission merchants, commodity pool operators or commodity trading advisors and are subject to the Commodity Exchange Act and the regulations thereunder. The rules and regulations of various self-regulatory organizations, such as the Chicago Board of Trade, other futures exchanges and the National Futures Association, also govern the commodity futures and commodity options businesses of these entities.

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GS&Co. and GSEC are registered U.S. broker-dealers and futures commission merchants subject to Rule 15c3-1 of the SEC and Rule 1.17 of the CFTC, which specify minimum net capital levels for their registrants, and also require that a significant part of the registrants’ assets be kept in relatively liquid form. GS&Co. and GSEC have elected to compute their minimum capital requirements in accordance with the “Alternative Minimum Net Capital Requirement” as permitted under Rule 15c3-1. As of November 2005, GS&Co. and GSEC had net capital in excess of their minimum capital requirements. In addition to its alternative minimum net capital requirements, GS&Co. is also required to hold tentative net capital in excess of $1 billion and net capital in excess of $500 million in accordance with the market and credit risk standards of Appendix E of Rule 15c3-1. GS&Co. is required to notify the SEC in the event that its tentative net capital is less than $5 billion. As of November 2005, GS&Co. had tentative net capital and net capital in excess of both the minimum and the notification requirements. These net capital requirements may have the effect of prohibiting these entities from distributing or withdrawing capital and may require prior notice to the SEC for certain withdrawals of capital. See Note 15 to the consolidated financial statements in Part II, Item 8 of the Annual Report on Form 10-K.

Goldman Sachs has established three limited purpose trust companies with limited powers under state and federal law. They are not permitted to accept deposits or make loans and, as a result, are not considered to be banks for purposes of the Bank Holding Company Act, nor are they insured by the FDIC or subject to the Community Reinvestment Act. These entities and their regulators are: The Goldman Sachs Trust Company, N.A., a national bank with limited trust powers that is regulated by the Office of the Comptroller of the Currency and is a member bank of the Federal Reserve System; The Goldman Sachs Trust Company, a New York limited purpose trust company that is regulated by the New York State Banking Department; and The Goldman Sachs Trust Company of Delaware, a Delaware limited purpose trust company that is regulated by the Office of the Delaware State Bank Commissioner.

Goldman Sachs has established Goldman Sachs Bank USA (GS Bank), a Utah-chartered industrial bank, to extend credit and to take deposits, other than demand deposits. GS Bank is subject to regulation by the FDIC and the Utah Commissioner of Financial Institutions. Because it does not accept demand deposits, GS Bank is not considered to be a bank for purposes of the Bank Holding Company Act. The deposits maintained at GS Bank are insured by the FDIC to the extent provided by law and GS Bank is subject to the requirements of the Community Reinvestment Act.

J. Aron & Company is authorized by the Federal Energy Regulatory Commission (FERC) to sell wholesale physical power at market-based rates. As a FERC-authorized power marketer, J. Aron & Company is subject to regulation under the Federal Power Act and FERC regulations.

In addition, as a result of our interests in electric power generation facilities, we are subject to extensive and evolving energy, environmental and other governmental laws and regulations, as discussed under “Risk Factors — Our power generation interests subject us to the risks associated with owning power generation facilities” in Part I, Item 1A of the Annual Report on Form 10-K.

Our U.S. insurance subsidiaries are subject to state insurance regulation in the states in which they are domiciled and in the other states in which they are licensed.

The effort to combat money laundering and terrorist financing is a priority in governmental policy with respect to financial institutions. The USA PATRIOT Act of 2001 contains anti-money laundering and financial transparency laws and mandates the implementation of various new regulations applicable to broker-dealers and other financial services companies, including standards for verifying client identification at account opening, and obligations to monitor client transactions and report suspicious activities. Through these and other provisions, the USA PATRIOT Act of 2001 seeks to promote the identification of parties that may be involved in terrorism or money laundering. Anti-money laundering laws outside the United States contain some similar provisions. The obligation of financial institutions, including Goldman Sachs, to identify their clients, to watch for and report suspicious transactions, to respond to requests for information by regulatory authorities and law

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enforcement agencies, and to share information with other financial institutions, has required the implementation and maintenance of internal practices, procedures and controls that have increased, and may continue to increase, our costs, and
any failure with respect to our programs in this area could subject us to substantial liability and regulatory fines.

Regulation Outside the United States

Goldman Sachs is an active participant in the international fixed income and equity markets. Many of our principal subsidiaries that participate in these markets are subject to comprehensive regulations in the United States and elsewhere that include some form of capital adequacy rules and other customer protection rules. Goldman Sachs provides investment services in and from the United Kingdom under the regulation of the Financial Services Authority (FSA). Various Goldman Sachs entities are regulated by the banking and regulatory authorities of the other European countries in which Goldman Sachs operates, including, among others, the Federal Financial Supervisory Authority (BaFin) and the Bundesbank in Germany, the Autorité des Marchés Financiers and Banque de France in France, Banca d’Italia and the Commissione Nazionale per le Società e la Borsa (CONSOB) in Italy and the Swiss Federal Banking Commission. Goldman Sachs entities are also regulated by the European securities, derivatives and commodities exchanges of which they are members. The investment services that are subject to oversight by the FSA and other European regulators are regulated in accordance with European Union directives requiring, among other things, compliance with certain capital adequacy standards, customer protection requirements and conduct of business rules. These standards, requirements and rules are similarly implemented, under the same directives, throughout the European Union and are broadly comparable in scope and purpose to the regulatory capital and customer protection requirements imposed under the SEC and CFTC rules. Some European Union directives also permit local regulation in each jurisdiction, including those in which we operate, to be more restrictive than the requirements of such directives and these local requirements can result in certain competitive disadvantages to Goldman Sachs.

The European Union’s European Financial Groups Directive (Directive 2002/87/EC) introduced certain changes to the way financial conglomerates and other financial services organizations operating in Europe are regulated. As a result of these changes, activities that are conducted in otherwise unregulated entities are now subject to certain forms of regulation, including consolidated supervision and capital adequacy requirements. The measures we have taken to comply with the directive include becoming subject to the Consolidated Supervised Entity rules described above under “— Regulation in the United States.”

The European Union’s European Markets in Financial Instruments Directive (Directive 2004/39/EC) will affect several of our subsidiaries by imposing detailed pan-European requirements in areas such as internal organization (including conflict management), best execution, real-time disclosure of completed transactions in shares, quoting obligations for internalized client orders in shares, transaction reporting to regulators, client documentation and regulation of investment services related to commodity derivatives. The practical consequences of some of these changes on the European markets are still unclear. The European Parliament and the Council of the European Union are currently considering a new directive that would delay the implementation deadline from April 30, 2006 to November 1, 2007.

In addition, the Financial Services Agency, the Tokyo Stock Exchange, the Osaka Securities Exchange, The Tokyo International Financial Futures Exchange, the Japan Securities Dealers Association, the Tokyo Commodity Exchange and the Ministry of Economy, Trade and Industry in Japan, the Securities and Futures Commission in Hong Kong, the Monetary Authority of Singapore and the China Securities Regulatory Commission, among others, regulate various of our subsidiaries in Asia and also have capital standards and other requirements comparable to the rules of the SEC. Certain of our insurance subsidiaries are regulated by the Bermuda Registrar of Companies.

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Regulations Applicable in and Outside the United States

The U.S. and non-U.S. government agencies, regulatory bodies and self-regulatory organizations, as well as state securities commissions in the United States, are empowered to conduct administrative proceedings that can result in censure, fine, the issuance of cease and desist orders, or the suspension or expulsion of a broker-dealer or its directors, officers or employees. From time to time, our subsidiaries have been subject to investigations and proceedings, and sanctions have been imposed for infractions of various regulations relating to our activities, none of which has had a material adverse effect on us or our businesses.

Compliance with the capital adequacy and other regulatory requirements of U.S. and non-U.S. regulators could limit those operations of our subsidiaries that require the intensive use of capital, such as underwriting and trading activities, specialist activities and the financing of client account balances, and also could restrict our ability to withdraw capital from our regulated subsidiaries, which in turn could limit our ability to repay debt or to pay dividends on our preferred and common stock.

In 2004, the Basel Committee on Banking Supervision issued the Basel II capital standards, which are designed to
promote enhanced risk management practices among large, international financial services firms by aligning regulatory capital requirements more closely with the underlying risks faced by these firms. Under the currently proposed time schedule, Goldman Sachs International would become subject to the Basel II requirements on January 1, 2008. The Consolidated Supervised Entity rules described above under “— Regulation in the United States,” which provide for group-wide supervision, are consistent with Basel II. Complying with these new standards requires us to develop and apply new and advanced measurement techniques to determine our regulatory capital adequacy.

Our specialist businesses are subject to extensive regulation by a number of securities exchanges. The rules of these exchanges generally require our specialists to maintain orderly markets in the securities in which they are specialists. These requirements, in turn, may require us to commit significant amounts of capital to our specialist businesses.

Changes to the rules and regulations governing stock markets and the conduct of participants in those markets, including the NYSE, may impose additional costs on us, adversely affect our customer-driven or specialist businesses or impair the value of our goodwill and identifiable intangible assets relating to those businesses.

The research areas of investment banks have been and remain the subject of regulatory scrutiny. The SEC, NYSE and NASD have adopted rules imposing restrictions on the interaction between equity research analysts and investment banking personnel at member securities firms. Various non-U.S. jurisdictions have imposed both substantive and disclosure-based requirements with respect to research, and continue to consider additional regulation. In addition, we are a party to a settlement with certain federal and state securities regulators and self-regulatory organizations that imposes restrictions on the interaction between research and investment banking departments and requires us to fund the provision of independent research to our clients.

In connection with the research settlement, the firm has also subscribed to a voluntary initiative imposing restrictions on the allocation of shares in initial public offerings to executives and directors of public companies. The FSA in the United Kingdom has imposed requirements on the conduct of the allocation process in equity and fixed income securities offerings (including initial public offerings and secondary distributions). The SEC, NYSE and NASD have proposed rules that would further affect the manner in which securities are distributed and allocated in registered public offerings. We cannot fully predict the practical effect that these new and proposed requirements will have on our business, and the SEC, NYSE, NASD and non-U.S. regulators, such as the FSA, may adopt additional and more stringent rules with respect to offering procedures and the management of conflicts of interest in the future.

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Certain of our businesses are subject to compliance with regulations enacted by U.S. federal and state governments, the European Union or other jurisdictions and/or enacted by various regulatory organizations or exchanges relating to the privacy of client information, and any failure to comply with these regulations could expose us to liability and/or reputational damage.

Item 1A.    Risk Factors

We face a variety of risks that are substantial and inherent in our businesses, including market, liquidity, credit, operational, legal and regulatory risks. Our business, by its nature, does not produce predictable earnings. The following are some of the more important factors that could affect our businesses.

Our businesses may be adversely affected by conditions in the global financial markets and economic conditions generally.

We have achieved record earnings per common share in each of our last two fiscal years, reflecting a favorable trading environment in FICC, an improvement in the trading environment for Equities and an increase in investment banking activity. An adverse change in these market conditions may adversely affect our results of operations.

Our businesses are materially affected by conditions in the global financial markets and economic conditions generally and these conditions may change suddenly and dramatically. Unfavorable or uncertain economic and market conditions have adversely affected, and may in the future adversely affect, our business and profitability in many ways, including the following:

    We have been operating in a low interest rate market for the past several years. Increasing or high interest rates and/or widening credit spreads, especially if such changes are rapid, may create a less favorable environment for certain of our businesses.
 
    We have been committing increasing amounts of capital in many of our businesses and generally maintain large trading, specialist and investing positions. Market fluctuations and volatility may adversely affect the value of those positions, including, but not limited to, our interest rate and credit products, currency, commodity and equity positions and our merchant banking investments, or may reduce our willingness to enter into new transactions. From time to time, we have incurred significant trading losses in periods of market turbulence. Conversely, certain of our trading businesses depend on market volatility to provide trading and arbitrage opportunities, and decreases in volatility may reduce these opportunities and adversely affect the results of these businesses.
 
    Industry-wide declines in the size and number of underwritings and mergers and acquisitions may have an adverse effect on our revenues and, because we may be unable to reduce expenses correspondingly, our profit margins. In particular, because a significant portion of our investment banking revenues are derived from our participation in large transactions, a decrease in the number of large transactions due to uncertain or unfavorable market conditions may adversely affect our investment banking business.
 
    Pricing and other competitive pressures have continued, even as the volume and number of investment banking transactions have increased. In addition, the trend in the underwriting business toward multiple book runners and co-managers handling transactions, where previously there would have been a single book runner, may adversely affect our business and reduce our revenues.
 
    Reductions in the level of the equity markets also tend to reduce the value of our clients’ portfolios, which in turn may reduce the fees we earn for managing assets. Even in the absence of uncertain or unfavorable economic or market conditions, investment performance by our asset management business below the performance of benchmarks or competitors could result in a decline in assets under management and in the incentive and management fees we receive.

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    Concentration of risk increases the potential for significant losses in our market-making, proprietary trading and investing, block trading, merchant banking, underwriting and lending businesses. This risk may increase to the extent we expand our proprietary trading and investing businesses or commit capital to facilitate customer-driven business. For example, large blocks of securities are increasingly being sold in block trades rather than on a marketed basis, which increases the risk that Goldman Sachs may be unable to resell the purchased securities at favorable prices and may incur significant losses as a result. Moreover, because of concentration of risk, we may suffer losses even when economic and market conditions are generally favorable for others in the industry. We also regularly enter into large transactions as part of our trading businesses. The number and size of such transactions may affect our results of operations in a given period.
 
    The volume of transactions that we execute for our clients and as a specialist or market maker may decline, which would reduce the revenues we receive from commissions and spreads. In addition, competitive pressures and other industry factors, including the increasing use by our clients of low-cost electronic trading, could cause a reduction in commissions and spreads. In our specialist businesses, we are obligated by stock exchange rules to maintain an orderly market, including by purchasing shares in a declining market. This may result in trading losses and an increased need for liquidity. Weakness in global equity markets and the trading of securities in multiple markets and on multiple exchanges could adversely impact our trading businesses and impair the value of our goodwill and identifiable intangible assets. In addition, competitive pressures have been particularly intense in the context of block trades.

We may incur losses as a result of ineffective risk management processes and strategies.

We seek to monitor and control our risk exposure through a variety of separate but complementary financial, credit, operational, compliance and legal reporting systems. Our trading risk management process seeks to balance our ability to profit from trading positions with our exposure to potential losses. While we employ a broad and diversified set of risk monitoring and risk mitigation techniques, those techniques and the judgments that accompany their application cannot anticipate every economic and financial outcome or the specifics and timing of such outcomes. Thus, we may, in the course of our activities, incur losses.

For a further discussion of our risk management policies and procedures, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Risk Management” in Part II, Item 7 of the Annual Report on Form 10-K.

Our liquidity may be adversely affected by an inability to access the debt capital markets or to sell assets.

Liquidity is essential to our businesses. Our liquidity could be impaired by an inability to access secured and/or unsecured debt markets, an inability to sell assets or unforeseen outflows of cash or collateral. This situation may arise due to circumstances that we may be unable to control, such as a general market disruption or an operational problem that affects third parties or us. Further, our ability to sell assets may be impaired if other market participants are seeking to sell similar assets at the same time.

A reduction in our credit ratings could adversely affect our liquidity and businesses in many ways.

Our credit ratings are important to our liquidity. A reduction in our credit ratings could adversely affect our liquidity and competitive position, increase our borrowing costs, limit our access to the capital markets or trigger our obligations under certain bilateral provisions in some of our trading and collateralized financing contracts. Under these provisions, counterparties could be permitted to

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terminate contracts with Goldman Sachs or require us to post additional collateral. Termination of our trading and collateralized financing contracts could cause us to sustain losses and impair our liquidity by requiring us to find other sources of financing or to make significant cash payments or securities movements.

An inability of The Goldman Sachs Group, Inc. to access funds from its subsidiaries could adversely affect its ability to meet its obligations.

The Goldman Sachs Group, Inc. is a holding company and, therefore, depends on dividends, distributions and other payments from its subsidiaries to fund dividend payments and to fund all payments on its obligations, including debt obligations. Many of our subsidiaries, including GS&Co., are subject to laws that authorize regulatory bodies to block or reduce the flow of funds from those subsidiaries to The Goldman Sachs Group, Inc. Regulatory action of that kind could impede access to funds that The Goldman Sachs Group, Inc. needs to make payments on obligations, including debt obligations, or dividend payments. In addition, to the extent that The Goldman Sachs Group, Inc. (or any other entity) holds equity interests in the firm’s regulated or unregulated subsidiaries, its rights as an equity holder to the assets of such subsidiaries are subject to the satisfaction of the claims of the creditors of such subsidiaries.

Our businesses, profitability and liquidity may be adversely affected by a deterioration in the credit quality of, or defaults by, third parties who owe us money, securities or other assets.

We are exposed to the risk that third parties that owe us money, securities or other assets will not perform their obligations. These parties may default on their obligations to us due to bankruptcy, lack of liquidity, operational failure or other reasons. We are also subject to the risk that our rights against third parties may not be enforceable in all circumstances. In addition, a deterioration in the credit quality of third parties whose securities or obligations we hold could result in losses and/or adversely affect our ability to rehypothecate or otherwise use those securities or obligations for liquidity purposes. The amount and duration of our credit exposures have been increasing over the past several years, as has the breadth of the entities to which we have credit exposures. The scope of our lending businesses has also been expanding and includes loans to small and mid-size businesses, which are not traditional Goldman Sachs clients. As a clearing member firm, we finance our client positions and we could be held responsible for the defaults or misconduct of our clients. In addition, we have experienced, due to competitive factors, pressure to extend and price credit at levels that may not always fully compensate us for the risks we take. In particular, corporate clients sometimes seek to require credit commitments from us in connection with investment banking and other assignments. Although we regularly review credit exposures to specific clients and counterparties and to specific industries, countries and regions that we believe may present credit concerns, default risk may arise from events or circumstances that are difficult to detect or foresee. In addition, concerns about, or a default by, one institution could lead to significant liquidity problems, losses or defaults by other institutions, which in turn could adversely affect Goldman Sachs.

Mandatory physical settlement of derivative transactions may expose us to losses if we are unable to deliver the underlying security or obligation.

Like many participants in the derivatives marketplace, we are party to a large number of derivative transactions, including credit derivatives, that require that we deliver to the counterparty the underlying security or obligation in order to receive payment. In a number of cases, we do not hold the underlying security or obligation and may have difficulty obtaining, or be unable to obtain, the underlying security or obligation through the physical settlement of other transactions. As a result, we are subject to the risk that we may not be able to obtain the security or obligation within the required contractual timeframe for delivery. This could cause us to forfeit the payments due to us under these contracts or result in settlement delays with the attendant credit and operational risk as

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well as increased costs to the firm. The derivatives industry is working on various proposals to address this issue. A failure of the industry to address this issue could result in an unwillingness of counterparties to enter into certain types of derivative transactions, which could negatively impact our businesses.

Unconfirmed derivative transactions and unauthorized assignments of derivatives by counterparties may expose us to unexpected risk and potential losses.

Derivative contracts and other transactions entered into with third parties are not always confirmed by the counterparties on a timely basis. While the transaction remains unconfirmed, we are subject to heightened credit and operational risk and in the event of a default may find it more difficult to enforce the contract. The growth in the derivatives industry, including credit derivatives and other swap transactions, has also exposed us and other industry participants to an increasing incidence of counterparties seeking to unilaterally assign transactions without required prior notice and consent. Although industry participants have taken steps to eliminate this practice and its effects on a going-forward basis, including through the adoption of the 2005 ISDA Novation Protocol, it is not yet clear how effective these efforts will be, and the steps that have been taken by the industry do not resolve the issue for derivative contracts that were previously entered into. Unauthorized assignments could introduce uncertainty as to the status of a transaction, impair our ability to evaluate credit risk and impede trade reconciliations, which could lead to a higher number of failed transactions and collateral call defaults.

A failure in our operational systems or infrastructure, or those of third parties, could impair our liquidity, disrupt our businesses, damage our reputation and cause losses.

Shortcomings or failures in our internal processes, people or systems could lead to impairment of our liquidity, financial loss, disruption of our businesses, liability to clients, regulatory intervention or reputational damage. For example, our businesses are highly dependent on our ability to process, on a daily basis, a large number of transactions across numerous and diverse markets in many currencies. The transactions we process have become increasingly complex and often must adhere to client-specific guidelines, as well as legal and regulatory standards. Our financial, accounting, data processing or other operating systems and facilities may fail to operate properly or become disabled as a result of events that are wholly or partially beyond our control, adversely affecting our ability to process these transactions. The inability of our systems to accommodate an increasing volume of transactions could also constrain our ability to expand our businesses.

We also face the risk of operational failure or termination of any of the clearing agents, exchanges, clearing houses or other financial intermediaries we use to facilitate our securities transactions, and as our interconnectivity with our clients grows, we will increasingly face the risk of operational failure with respect to our clients’ systems. Any such failure or termination could adversely affect our ability to effect transactions, service our clients and manage our exposure to risk.

Despite the contingency plans and facilities we have in place, our ability to conduct business may be adversely impacted by a disruption in the infrastructure that supports our businesses and the communities in which we are located. This may include a disruption involving electrical, communications, transportation or other services used by Goldman Sachs or third parties with which we conduct business. These disruptions may occur, for example, as a result of events that affect only the buildings of Goldman Sachs or such third parties, or as a result of events with a broader impact on the cities where those buildings are located. Nearly all of our employees in our primary locations, including New York, London, Frankfurt, Hong Kong and Tokyo, work in close proximity to one another, in one or more buildings. If a disruption occurs in one location and our employees in that location are unable to occupy our offices or communicate with or travel to other locations, our ability to service and interact with our clients may suffer and we may not be able to successfully implement contingency plans that depend on communication or travel.

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Our operations rely on the secure processing, storage and transmission of confidential and other information in our computer systems and networks. Although we take protective measures and endeavor to modify them as circumstances warrant, our computer systems, software and networks may be vulnerable to unauthorized access, computer viruses or other malicious code and other events that could have a security impact. If one or more of such events occur, this potentially could jeopardize our or our clients’ or counterparties’ confidential and other information processed and stored in, and transmitted through, our computer systems and networks, or otherwise cause interruptions or malfunctions in our, our clients’, our counterparties’ or third parties’ operations, which could result in significant losses or reputational damage. We may be required to expend significant additional resources to modify our protective measures or to investigate and remediate vulnerabilities or other exposures, and we may be subject to litigation and financial losses that are either not insured against or not fully covered through any insurance maintained by us.

Conflicts of interest are increasing and a failure to appropriately deal with conflicts of interest could adversely affect our businesses.

Our reputation is one of our most important assets. As we have expanded the scope of our businesses and our client base, we increasingly have to address potential conflicts of interest, including those relating to our proprietary activities. For example, conflicts may arise between our position as a financial advisor in a merger transaction and a principal investment we hold in one of the parties to the transaction. In addition, hedge funds and private equity funds are an increasingly important portion of our client base, and also compete with us in a number of our businesses. We have extensive procedures and controls that are designed to address conflicts of interest. However, appropriately dealing with conflicts of interest is complex and difficult and our reputation could be damaged if we fail, or appear to fail, to deal appropriately with conflicts of interest.

In addition, the SEC and other federal and state regulators have increased their scrutiny of potential conflicts of interest. For example, in June 2005, the NASD filed with the SEC proposed rules that would require certain disclosures to be contained in fairness opinions, and would mandate specific procedures to be followed by member firms in connection with issuing these opinions. While we have policies and procedures in place that are intended to ensure that any potential conflicts of interest are appropriately addressed, it is possible that potential or perceived conflicts could give rise to litigation or enforcement actions. It is possible that the regulatory scrutiny of, and litigation in connection with, conflicts of interest will make our clients less willing to enter into transactions in which such a conflict may occur, and will adversely affect our businesses.

Our businesses and those of our clients are subject to extensive and pervasive regulation around the world.

Goldman Sachs, as a participant in the financial services industry, is subject to extensive regulation in jurisdictions around the world. We face the risk of significant intervention by regulatory authorities in all jurisdictions in which we conduct our businesses. Among other things, we could be fined, prohibited from engaging in some of our business activities or subject to limitations or conditions on our business activities.

New laws or regulations or changes in enforcement of existing laws or regulations applicable to our business or those of our clients may also adversely affect our businesses. For example, the SEC has adopted rules requiring the registration of certain hedge funds advisers under the Investment Advisers Act of 1940, and the SEC or other regulators may seek to further regulate hedge funds in the future. It is possible that these or other future regulatory developments rules may have a significant impact on our trading, prime brokerage and other business relationships with hedge funds, or on the growth of our prime brokerage and securities lending businesses. In addition, under the European Union’s Transparency Directive (Directive 2004/109/EC), which is due to be implemented by member states by January 2007, issuers of securities admitted to listing on regulated markets in the European Union may, depending upon the manner of implementation, be required to provide

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expanded ongoing financial disclosure, which could have an adverse impact on our ability or the ability of certain of our non-European Union-based clients to maintain the listing of these securities or to conduct securities offerings in Europe. Furthermore, the SEC’s Regulation NMS, which was adopted in 2005 and is expected to become effective in 2006, introduces significant changes to the regulation of trading on securities exchanges and marketplaces. While it is too early to predict the impact that Regulation NMS will have, it could result in the imposition of additional compliance costs on our trading businesses and alter the competitive environment in which these businesses function.

Many of our businesses are operating in an uncertain and difficult regulatory environment.

Firms in the financial services industry have been operating in a difficult regulatory environment. The industry has experienced increased scrutiny from a variety of regulators, both within and outside the United States. Penalties and fines sought by regulatory authorities have increased substantially over the last several years. This environment has led some of our clients to be less willing to engage in transactions that may carry a risk of increased scrutiny by regulators. In addition, while the firm always strives to fully comply with all legal and regulatory requirements, this regulatory and enforcement environment has created uncertainty with respect to a number of transactions that had historically been entered into by financial services firms, including our firm, and that were generally believed to be permissible and appropriate. This environment has led us and our competitors to modify transaction structures and, in some cases, to limit or cease our execution of some types of transactions.

Substantial legal liability or significant regulatory action against Goldman Sachs could have material adverse financial effects or cause significant reputational harm to Goldman Sachs, which in turn could seriously harm our business prospects.

We face significant legal risks in our businesses, and the volume of claims and amount of damages and penalties claimed in litigation and regulatory proceedings against financial institutions remain high.

The interaction between our equity research analysts and investment banking businesses has been subject to new requirements and litigation.

As discussed under “Business — Regulation” in Part I, Item 1 of the Annual Report on Form 10-K, the research areas of investment banks have been and remain the subject of regulatory scrutiny that has led to restrictions on the interaction between equity research analysts and investment banking personnel at securities firms. GS&Co. has agreed to a global settlement to resolve investigations into equity research analysts’ alleged conflicts of interest pursuant to which GS&Co. has been subject to certain restrictions and undertakings. Certain of these requirements and restrictions have imposed additional costs and limitations on the conduct of our businesses.

Litigation and regulatory scrutiny of complex, structured financial transactions remain high.

Regulators, both within and outside the United States, continue to scrutinize complex, structured finance transactions and have brought enforcement actions against a number of financial institutions in connection with such transactions. In some of the enforcement actions, clients of the financial institutions allegedly engaged in accounting, disclosure or other violations of the securities laws, and the financial institutions allegedly facilitated these improprieties by entering into transactions with the clients. We seek to create innovative solutions to address our clients’ needs, and we have entered into, and continue to enter into, structured transactions with clients. While we have policies and procedures in place that are intended to ensure that the structured transactions we enter into are appropriately reviewed and comply with applicable laws and regulations, it is possible that certain of these transactions could give rise to litigation or enforcement actions. It is possible that the regulatory scrutiny of, and litigation in connection with, structured finance transactions will make our clients less willing to enter into these transactions, and will adversely affect our business in this area.

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We are subject to regulatory inquiries and investigations into market timing, late trading and other activities involving mutual funds.

In recent years, there have been industry-wide and other investigations by federal and state authorities concerning market timing, late trading and other activities involving mutual funds and investment advisers. Federal and state authorities have made informational requests regarding trading practices broadly across all of the major fund companies and broker-dealers. Goldman Sachs has received requests for information and has been fully cooperating with those authorities. While we believe that we have in place reasonable measures to detect and deter disruptive and abusive trading practices and comply with applicable legal and regulatory requirements, we cannot predict the course that these inquiries and areas of focus may take or the impact that any new laws or regulations governing mutual funds may have on our businesses.

Our specialist business is subject to a global settlement and civil actions.

Regulators have also been conducting investigations into certain trading practices of specialist firms, including our specialist unit. In March 2004, certain NYSE specialist firms, including our specialist unit, agreed to a global settlement with the SEC and NYSE to resolve charges that the firms violated certain federal securities laws and NYSE rules in connection with their activities as NYSE specialists during the years 1999 through 2003. The global settlement involves, among others, restitution and penalties, a censure, cease and desist order and certain undertakings with respect to our specialist unit’s systems and procedures. The settlement did not resolve the related civil actions discussed under “Legal Proceedings — Specialist Matters” in Part I, Item 3 of the Annual Report on Form 10-K, or potential regulatory charges against individuals. As a result of this global settlement and any related developments, other investigations or any new laws or regulations governing specialists, our specialist businesses may be adversely affected and the value of our goodwill and identifiable intangible assets related to these businesses may be impaired.

Employee misconduct is difficult to detect and prevent and may have an adverse effect on our businesses.

There have been a number of highly publicized cases involving fraud or other misconduct by employees in the financial services industry in recent years, and we run the risk that employee misconduct could occur. It is not always possible to deter or prevent employee misconduct and the precautions we take to prevent and detect this activity may not be effective in all cases.

Corporate governance and public disclosure requirements may adversely affect our investment banking businesses.

Financial scandals in recent years have led to insecurity and uncertainty in the financial markets and contributed to declines in capital markets. In response to these scandals, the Sarbanes-Oxley Act of 2002 and the rules of the SEC, NYSE and NASDAQ have necessitated significant changes to corporate governance and public disclosure. These provisions generally apply to companies with securities listed on U.S. securities exchanges, and some provisions apply to non-U.S. issuers with securities traded on U.S. securities exchanges. To the extent that private companies, to avoid becoming subject to these requirements, decide to forgo initial public offerings, our equity underwriting business may be adversely affected and our ability to successfully exit some of our merchant banking investments may be adversely affected. Similarly, the imposition of those provisions on non-U.S. issuers has made these issuers less likely to list their securities in the United States or undertake merger or acquisition transactions that would result in their securities being listed in the United States. These measures may result in less activity by non-U.S. issuers in the United States and, as a result, the U.S. capital markets and our investment banking business may be adversely affected.

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The provisions of the Sarbanes-Oxley Act of 2002 and the NYSE and NASDAQ corporate governance rules have imposed significant compliance costs on public companies and have increased the cost of conducting many types of capital market transactions, including securities offerings and acquisition and disposition transactions. In particular, companies that are or are planning to be public are incurring significant expenses in complying with the SEC and accounting standards relating to internal control over financial reporting, and companies that disclose material weaknesses in such controls under the new standards may have some difficulty accessing the capital markets. These factors, in addition to adopted or proposed accounting and disclosure changes, may have an adverse effect on our investment banking business.

The financial services industry is highly competitive.

The financial services industry — and all of our businesses — are intensely competitive, and we expect them to remain so. We compete on the basis of a number of factors, including transaction execution, our products and services, innovation, reputation and price. We believe that we will continue to experience pricing pressures in the future as some of our competitors seek to increase market share by reducing prices. Over time, there has been substantial consolidation and convergence among companies in the financial services industry. U.S. federal legislation, which significantly expanded the activities permissible for firms affiliated with a U.S. bank, may accelerate this consolidation and further increase competition. This trend toward consolidation and convergence has significantly increased the capital base and geographic reach of our competitors. This trend has also hastened the globalization of the securities and other financial services markets. As a result, we have had to commit capital to support our international operations and to execute large global transactions.

The growth of electronic trading and the introduction of new technology may adversely affect our business and may increase competition.

Technology is fundamental to our business and our industry. The growth of electronic trading and the introduction of new technologies is changing our businesses and presenting us with new challenges. Securities, futures and options transactions are increasingly occurring electronically, both on our own systems and through other alternative trading systems, and it appears that the trend toward alternative trading systems will continue and probably accelerate. Some of these alternative trading systems compete with our trading businesses, including our specialist businesses, and we may experience continued competitive pressures in these and other areas. In addition, the increased use by our clients of low-cost electronic trading systems and direct electronic access to trading markets could cause a reduction in commissions and spreads.

Our businesses may be adversely affected if we are unable to hire and retain qualified employees.

Our performance is largely dependent on the talents and efforts of highly skilled individuals. Competition in the financial services industry for qualified employees is intense. In addition, competition with businesses outside the financial services industry, such as hedge funds, private equity funds and venture capital funds, for the most highly skilled individuals has been intense. Our continued ability to compete effectively in our businesses depends on our ability to attract new employees and to retain and motivate our existing employees. Changes in the business environment may cause us to move employees from one business to another or to reduce the number of employees in certain of our businesses; this may cause temporary disruptions as our employees adapt to new roles and may reduce our ability to take advantage of improvements in the business environment. In addition, current and future laws (including laws relating to immigration and outsourcing) may restrict our ability to move responsibilities or personnel from one jurisdiction to another. This may impact our ability to take advantage of business opportunities or potential efficiencies.

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We may be unable to fully integrate future acquisitions or joint ventures into our businesses and systems.

We expect to grow in part through acquisitions and joint ventures. We have undertaken joint ventures, including in Australia and China, and may enter into additional joint ventures from time to time. To the extent we make acquisitions or enter into combinations or joint ventures, we face numerous risks and uncertainties combining or integrating the relevant businesses and systems, including the need to combine accounting and data processing systems and management controls and to integrate relationships with clients and business partners. In the case of joint ventures, we are subject to additional risks and uncertainties in that we may be dependent upon, and subject to liability, losses or reputational damage relating to, systems, controls and personnel that are not under our control. In addition, conflicts or disagreements between us and our joint venture partners may negatively impact the benefits to be achieved by the joint venture.

Our power generation interests subject us to the risks associated with owning power generation facilities.

We own interests in electric power generation facilities. As a result of these interests and future investments that we may make in the power generation industry, we face numerous risks and uncertainties.

We are a relatively new entrant to the electric power generation industry. As a result, we have less expertise and experience in owning and managing power generation facilities than many of our competitors and we may not be successful in owning and managing our power generation facilities. In particular, in the future we may be unable to attract and retain qualified independent contractors and employees.

The operation of power generation facilities may be disrupted. The continued operation of power generation facilities involves many risks, including the breakdown or failure of power generation equipment, transmission lines or other equipment or processes, and performance below expected levels of output or efficiency. Although our power generation facilities contain various redundancies and backup mechanisms, a breakdown or failure may prevent the affected facilities from performing under applicable power sales agreements or otherwise operating as planned.

The power companies in which we own interests are parties to numerous agreements with third parties, including lenders, suppliers of raw materials, service providers and utilities, which impose significant obligations on the power companies. Some of these obligations may be difficult for the power companies to satisfy, depending, in some cases, on market conditions and other factors. For example, during 2004 we faced difficulties in obtaining and retaining adequate coal inventories at many power generation facilities due to supply constraints on coal and a rationing of services by railroads. Any failure by the power company to satisfy or obtain waivers of their obligations under any of these agreements could cause them to lose the benefits provided by the agreements, subject them to litigation, result in reputational harm or impair their operations or financial results. In addition, the operations or financial results of these power companies could be adversely affected by the failure of any of these third parties to perform their contractual obligations to the power companies.

We are subject to extensive and evolving energy, environmental and other governmental laws and regulations. In the past several years, intensified scrutiny of the energy market by federal, state and local authorities and the public has resulted in increased regulatory and legal proceedings involving energy companies, including those engaged in electric power generation. We may incur substantial costs in complying with current or future laws and regulations relating to power generation, and our overall businesses and reputation may be adversely affected by legal and regulatory proceedings arising out of our power generation business. In particular, our power generation activities are subject to extensive federal, state and local environmental laws and regulations relating to, among others, air quality, water quality, waste management, natural

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resources, site remediation and health and safety. Compliance with these environmental laws and regulations may require us to commit significant capital toward environmental monitoring, installation of pollution control equipment, payment of emission fees, and application for, and holding of, permits and licenses at our power generation facilities. In certain instances, compliance with these laws and regulations may require us to cease or curtail operations of one or more of the power generation facilities in which we have an ownership interest.

Our failure to comply with environmental laws or regulations or the associated requirements and provisions of the permits and licenses may result in the assessment of severe civil or criminal liabilities against us and the need to expend substantial additional capital for compliance or remediation. In particular, the Environmental Protection Agency recently issued the Clean Air Interstate Rule, which imposes additional controls over power generation facility emissions and requires significant reductions of emissions by 2010 (for Phase I) and 2015 (for Phase II). We are assessing the impact of this legislation, but it may require us to make significant capital expenditures on our power generation facilities. Other legislation, rules and requirements may be imposed on our power generation activities by the federal government or one or more states. Insurance covering some of these environmental risks with respect to our power generation facilities may not be available, and the proceeds from insurance recovery, if any, may not be adequate to cover our liabilities in a particular incident. As a result, our financial condition and results of operations may be adversely affected by an environmental or a health and safety problem at one of our facilities.

We are subject to the risk of unforeseen or catastrophic events, including terrorist attacks, natural disasters or other hostile or catastrophic events. We may not have insurance against these risks, and, in cases in which we do have insurance, the insurance proceeds may be inadequate to cover our losses.

In conducting our businesses around the world, we are subject to political, economic, legal, operational and other risks that are inherent in operating in many countries.

In conducting our businesses and maintaining and supporting our global operations, we are subject to risks of possible nationalization, expropriation, price controls, capital controls, exchange controls and other restrictive governmental actions, as well as the outbreak of hostilities. In many countries, the laws and regulations applicable to the securities and financial services industries are uncertain and evolving, and it may be difficult for us to determine the exact requirements of local laws in every market. Our inability to remain in compliance with local laws in a particular foreign market could have a significant and negative effect not only on our businesses in that market but also on our reputation generally. We are also subject to the enhanced risk that transactions we structure might not be legally enforceable in all cases.

The emergence of a pandemic or other widespread health emergency, or concerns over the possibility of such an emergency, could create economic and financial disruptions in emerging markets and other areas throughout the world, and could lead to operational difficulties (including travel limitations) that could impair our ability to manage our businesses around the world. In addition, unforeseen or catastrophic events, including health emergencies, terrorist attacks or natural disasters, could expose our insurance subsidiaries to significant losses.

Our businesses and operations are increasingly involved in emerging markets throughout the world, and we expect this trend to continue. In the last several years, various emerging market countries have experienced severe economic and financial disruptions, including significant devaluations of their currencies, capital and currency exchange controls, and low or negative growth rates in their economies. The possible effects of any of these conditions include an adverse impact on our businesses and increased volatility in financial markets generally.

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Item 1B.    Unresolved Staff Comments

There are no material unresolved written comments that were received from the SEC staff 180 days or more before the end of our fiscal year relating to our periodic or current reports under the Securities Exchange Act of 1934.

Item 2.    Properties

Our principal executive offices are located at 85 Broad Street, New York, New York, and comprise approximately 1 million rentable square feet of leased space, pursuant to a lease agreement expiring in June 2008 (with options to renew for up to 20 additional years). We also occupy over 680,000 rentable square feet at One New York Plaza under lease agreements expiring primarily in 2009 (with options to renew for up to five additional years), and we lease space at various other locations in the New York metropolitan area. In total, we lease approximately 4.0 million rentable square feet in the New York metropolitan area.

In September 2004, we completed the construction of a new office building at 30 Hudson Street in Jersey City, New Jersey. This building, which includes approximately 1.6 million gross square feet of office space, was constructed to complement our offices in lower Manhattan. The building is being occupied in phases.

In August 2005, we leased from Battery Park City Authority a parcel of land in lower Manhattan, pursuant to a ground lease. We currently intend to construct a 2.1 million gross-square-foot office building on the site that will serve as our world headquarters. Under the lease, Battery Park City Authority holds title to all improvements, including the office building, subject to Goldman Sachs’ right of exclusive possession and use for the 64-year duration of the lease.

Under the terms of the ground lease, we are required to make a lump-sum ground rent payment of $161 million by June 2007 and to make additional periodic payments during the term of the lease. We are obligated under the ground lease to construct the office building by 2011 (subject to extensions in the case of force majeure) in accordance with certain pre-approved design standards. Construction began on the building in November 2005, and we expect initial occupancy of the building by 2009. The building is projected to cost between $2.3 billion and $2.5 billion, including acquisition, development, fitout and furnishings, financing and other related costs.

We are receiving a number of benefits from the City and State of New York based on our agreement to construct our world headquarters in lower Manhattan. These benefits are subject to recoupment or recapture if we do not proceed in accordance with our agreements with the City and State of New York.

We have additional offices in the United States and elsewhere in the Americas. Together, these offices comprise approximately 2.1 million rentable square feet of leased space.

We also have offices in Europe, Asia and Africa. In Europe, we have offices that total approximately 2.0 million rentable square feet, which includes our office space in Frankfurt, approximately 55,000 rentable square feet of which we expect to exit by 2006. Our European headquarters is located in London at Peterborough Court, pursuant to a lease expiring in 2026. In total, we lease approximately 1.6 million rentable square feet in London through various leases, relating to various properties.

In Asia, we have offices that total approximately 900,000 rentable square feet. Our headquarters in this region are in Tokyo, at the Roppongi Hills Mori Tower, and in Hong Kong, at the Cheung Kong Center. In Tokyo, we currently lease approximately 290,000 rentable square feet through a lease that will expire in 2018. In Hong Kong, we currently lease approximately 220,000 rentable square feet under lease agreements, the majority of which will expire in fiscal 2012.

Our occupancy expenses include costs associated with office space held in excess of our current requirements. This excess space, the cost of which is charged to earnings as incurred, is

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being held for potential growth or to replace currently occupied space that we may exit in the future. We regularly evaluate our current and future space capacity in relation to current and projected staffing levels. We may incur exit costs in 2006 and thereafter to the extent we (i) reduce our space capacity or (ii) commit to, or occupy, new properties in the locations in which we operate and, consequently, dispose of existing space that had been held for potential growth. These exit costs may be material to our results of operations in a given period.

Item 3.    Legal Proceedings

We are involved in a number of judicial, regulatory and arbitration proceedings (including those described below) concerning matters arising in connection with the conduct of our businesses. We believe, based on currently available information, that the results of such proceedings, in the aggregate, will not have a material adverse effect on our financial condition, but might be material to our operating results for any particular period, depending, in part, upon the operating results for such period. Given the range of litigation and investigations presently under way, our litigation expenses can be expected to remain high.

IPO Process Matters

The Goldman Sachs Group, Inc. and Goldman, Sachs & Co. are among the numerous financial services companies that have been named as defendants in a variety of lawsuits alleging improprieties in the process by which those companies participated in the underwriting of public offerings in recent years.

Certain purported class actions have been brought in the U.S. District Court for the Southern District of New York, beginning on November 3, 1998, by purchasers of securities in public offerings as well as certain purported issuers of such offerings, that allege that the defendants have conspired to fix at 7% the discount that underwriting syndicates receive from issuers of shares in certain offerings in violation of federal antitrust laws. On March 15, 1999, the purchaser plaintiffs filed a consolidated amended complaint seeking treble damages as well as injunctive relief. The defendants moved to dismiss the consolidated amended complaint on April 29, 1999. On February 9, 2001, the federal district court granted with prejudice the defendants’ motion to dismiss the claims asserted by the purchasers of securities on the ground that they lacked antitrust standing. The plaintiffs in those actions appealed, and by a decision dated December 13, 2002, the U.S. Court of Appeals for the Second Circuit vacated the dismissal on the ground that the lower court had engaged in improper fact-finding on the motion and remanded for consideration of other potential bases for dismissal. On September 28, 2001, the defendants moved to dismiss the complaints filed by the issuer plaintiffs on statute of limitations grounds. On September 25, 2002, the federal district court denied the underwriter defendants’ motion to dismiss. On March 26, 2003, defendants moved to dismiss the claims asserted by both the issuers and the purchasers of securities on preemption grounds, but the motion was denied on June 27, 2003. On June 24, 2003, defendants filed a motion to dismiss the claims asserted by the purchasers of securities on standing grounds, and on February 24, 2004, the district court granted the motion to dismiss as to the purchasers’ damages claims. Plaintiffs in both actions moved for class certification on September 16, 2004 and for summary judgment on November 16, 2005.

Goldman, Sachs & Co. is one of numerous financial services firms that have been named as defendants in purported class actions filed beginning on March 9, 2001 in the U.S. District Court for the Southern District of New York by purchasers of securities in public offerings, who claim that the defendants engaged in a conspiracy to “tie” allocations in certain offerings to higher customer brokerage commission rates as well as purchase orders in the aftermarket, in violation of federal antitrust laws. The plaintiffs filed a consolidated amended complaint on January 2, 2002 seeking treble damages as well as injunctive relief. The defendants moved to dismiss the consolidated amended complaint on May 24, 2002, and the motion was granted by a decision dated November 3, 2003. Plaintiffs appealed, and by a decision dated September 28, 2005, the U.S. Court

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of Appeals for the Second Circuit reversed and remanded the action. Goldman, Sachs & Co. has also, together with other underwriters in certain offerings as well as the issuers and certain of their officers and directors, been named as a defendant in a number of related lawsuits alleging, among other things, that the prospectuses for the offerings violated the federal securities laws by failing to disclose the existence of the alleged “tying” arrangements. On July 1, 2002, the underwriter defendants moved to dismiss those complaints. By an opinion and order dated February 19, 2003, the federal district court denied the motion to dismiss in all material respects relating to the underwriter defendants. By a decision dated October 13, 2004, the federal district court generally granted plaintiffs’ motion for class certification in six “focus cases.” The underwriter defendants petitioned the U.S. Court of Appeals for the Second Circuit to review that certification decision on an interlocutory basis, and the appellate court agreed to review the decision by order dated June 30, 2005. On June 10, 2004, plaintiffs entered into a definitive settlement agreement with respect to their claims against the issuer defendants and the issuers’ present or former officers and directors named in the lawsuits. On June 14, 2004, those parties jointly moved for approval of the proposed settlement, and the district court granted preliminary approval by a decision dated February 15, 2005.

Goldman, Sachs & Co. has been named as a defendant in an action commenced on May 15, 2002 in New York Supreme Court, New York County, by an official committee of unsecured creditors on behalf of eToys, Inc., alleging that the firm intentionally underpriced eToys, Inc.’s initial public offering. The action seeks, among other things, consequential damages resulting from the alleged lower amount of offering proceeds. On August 1, 2002, Goldman, Sachs & Co. moved to dismiss the complaint. On May 2, 2003, the court granted Goldman, Sachs & Co.’s motion to dismiss as to five of the claims; plaintiff appealed from the dismissal of the five claims, and Goldman, Sachs & Co. appealed from the denial of its motion as to the remaining claim. By a decision dated May 20, 2004, the New York Appellate Division, First Department affirmed in part and reversed in part the lower court’s ruling on the firm’s motion to dismiss, permitting all claims to proceed except the claim for fraud, as to which the appellate court granted leave to replead. The Appellate Division granted leave to appeal, and by a decision dated June 7, 2005, the New York Court of Appeals affirmed in part and reversed in part the Appellate Division’s decision, dismissing claims for breach of contract, professional malpractice and unjust enrichment, but permitting claims for breach of fiduciary duty and fraud to continue. On remand to the lower court, Goldman, Sachs & Co. moved to dismiss the claims that survived the appeal or, in the alternative, for summary judgment.

The Goldman Sachs Group, Inc. and certain of its affiliates have, together with various underwriters in certain offerings, received subpoenas and requests for documents and information from various governmental agencies and self-regulatory organizations in connection with investigations relating to the public offering process. Goldman Sachs has cooperated with the investigations. On January 25, 2005, in connection with an investigation by the SEC of certain allocation practices employed by Goldman, Sachs & Co. and other firms, the SEC announced a settlement pursuant to which Goldman, Sachs & Co., without admitting or denying the allegations, (i) consented to the entry of an order permanently enjoining Goldman, Sachs & Co. from violating Rule 101 of Regulation M of the Securities Exchange Act of 1934, by inducing or attempting to induce customers receiving IPO allocations to buy additional shares in the aftermarket; and (ii) agreed to pay a penalty of $40 million. In connection with effectuation of the settlement, the SEC filed a civil action against Goldman, Sachs & Co. in the U.S. District Court for the Southern District of New York on January 25, 2005, and the district court entered a final judgment on February 7, 2005 approving the settlement and granting the permanent injunctive relief.

Stock Options Litigation

Hull Trading Co. L.L.C. and Spear, Leeds & Kellogg, L.P. (now known as Goldman Sachs Execution & Clearing, L.P.), affiliates of The Goldman Sachs Group, Inc., are among the numerous

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market makers in listed equity options that have been named as defendants, together with five national securities exchanges, in a purported class action brought in the U.S. District Court for the Southern District of New York on behalf of persons who purchased or sold listed equity options. The consolidated class action complaint, filed on October 4, 1999 (which consolidated certain previously pending actions and added Hull Trading Co. L.L.C. and other market makers as defendants), generally alleges that the defendants engaged in a conspiracy to preclude the multiple listing of certain equity options on the exchanges and seeks treble damages under the antitrust laws as well as injunctive relief. Certain of the parties, including Hull Trading Co. L.L.C. and Spear, Leeds & Kellogg, L.P., have entered into a stipulation of settlement, subject to court approval, which originally required Hull Trading Co. L.L.C. to pay an aggregate of $2.48 million and Spear, Leeds & Kellogg, L.P. an aggregate of $19.59 million. On February 14, 2001, the federal district court granted the motion of certain non-settling defendants for summary judgment. By a decision dated April 24, 2001, the district court ruled that in light of that order granting summary judgment, the court lacked jurisdiction to entertain the proposed settlement. Plaintiffs appealed, and by a decision dated January 9, 2003, the U.S. Court of Appeals for the Second Circuit affirmed the grant of summary judgment, but held that the decision did not divest the lower court of jurisdiction to entertain the proposed settlement, and remanded for further proceedings. By an Order dated March 17, 2003, the U.S. Court of Appeals denied plaintiffs’ motion for rehearing or rehearing en banc of the Court’s January 9, 2003 decision. On October 26, 2005, certain defendants, including Spear, Leeds & Kellogg, L.P. and Hull Trading Co. L.L.C., reached an agreement to modify and restate the original settlement agreement, reducing the overall settlement payments by certain market maker defendants by approximately 25% of the original amounts. The modified settlement remains subject to court approval.

Iridium Securities Litigation

Goldman, Sachs & Co. has been named as a defendant in two purported class action lawsuits commenced, beginning on May 26, 1999, in the U.S. District Court for the District of Columbia brought on behalf of purchasers of Class A common stock of Iridium World Communications, Ltd. in a January 1999 underwritten secondary offering of 7,500,000 shares of Class A common stock at a price of $33.50 per share, as well as in the secondary market. The defendants in the actions include Iridium, certain of its officers and directors, Motorola, Inc. (an investor in Iridium) and the lead underwriters in the offering, including Goldman, Sachs & Co. The complaints in both actions allege violations of the disclosure requirements of the federal securities laws and seek compensatory and/or rescissory damages. On May 13, 2002, plaintiffs filed a consolidated amended complaint alleging substantively identical claims as the original complaints. On July 15, 2002, the defendants moved to dismiss the consolidated amended complaint, and by a decision dated August 31, 2004, the motion was denied. On September 30, 2005, the underwriter defendants moved for summary judgment. On April 15, 2005, plaintiffs moved for class certification, and the district court granted the motion, certifying two subclasses, by a decision dated January 9, 2006. Goldman, Sachs & Co. underwrote 996,500 shares of common stock and Goldman Sachs International underwrote 320,625 shares of common stock for a total offering price of approximately $44 million.

On August 13, 1999, Iridium World Communications, Ltd. filed for protection under the U.S. bankruptcy laws.

World Online Litigation

Several lawsuits have been commenced in the Netherlands courts based on alleged misstatements and omissions relating to the initial public offering of World Online in March 2000. Goldman Sachs and ABN AMRO Rothschild served as joint global coordinators of the approximately 2.9 billion offering. Goldman Sachs International underwrote 20,268,846 shares and Goldman, Sachs & Co. underwrote 6,756,282 shares for a total offering price of approximately 1.16 billion.

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On September 11, 2000, several Dutch World Online shareholders as well as a Dutch entity purporting to represent the interests of certain World Online shareholders commenced a proceeding in Amsterdam District Court against “ABN AMRO Bank N.V., also acting under the name of ABN AMRO Rothschild,” alleging misrepresentations and omissions relating to the initial public offering of World Online. The lawsuit seeks, among other things, the return of the purchase price of the shares purchased by the plaintiffs or unspecified damages. By a decision dated May 7, 2003, the court held that the claims failed and dismissed the complaint. The plaintiffs appealed, and by a decision dated October 7, 2004, the Amsterdam Court of Appeal affirmed dismissal of the complaint.

In March 2001, a Dutch shareholders association initiated legal proceedings in Amsterdam District Court in connection with the World Online offering. Goldman Sachs International is named as a defendant in the writ served on its Dutch attorneys on March 14, 2001. The amount of damages sought is not specified in the writ. Goldman Sachs International filed its Statement of Defense on January 16, 2002 and a rejoinder on January 14, 2003. By a decision dated December 17, 2003, the court rejected the claims against Goldman Sachs International, but found World Online liable in an amount to be determined. On March 12, 2004, the Dutch shareholders association appealed from the dismissal of their claims against Goldman Sachs International.

Owens Corning Bondholder Litigation

Goldman, Sachs & Co. has been named as a defendant in a purported class action filed on April 27, 2001 in the U.S. District Court for the District of Massachusetts arising from a 1998 offering by Owens Corning of two series of its notes. The defendants include certain of Owens Corning’s officers and directors and the underwriters for the offering (including Goldman, Sachs & Co., which was the lead manager in the offering). The offering included a total of $550 million principal amount of notes, of which Goldman, Sachs & Co. underwrote $275 million.

The lawsuit, brought by certain institutional purchasers of the notes, alleges that the prospectus issued in connection with the offering was false and misleading in violation of the disclosure requirements of the federal securities laws. The plaintiffs are seeking, among other things, unspecified damages. The underwriter defendants moved to dismiss the complaint on November 14, 2001. By a decision dated August 26, 2002, the federal district court denied the underwriter defendants’ motion to dismiss, and by a decision dated March 9, 2004, granted plaintiffs’ motion for class certification. On November 4, 2005, the underwriter defendants reached an agreement in principle to settle all claims against them for an aggregate payment of $8.25 million, of which Goldman, Sachs & Co. will contribute approximately $2.5 million. The settlement remains subject to, among other things, documentation and court approval.

On October 5, 2000, Owens Corning filed for protection under the U.S. bankruptcy laws.

Research Independence Matters

The Goldman Sachs Group, Inc. and its affiliates, together with other financial services firms, have received requests for information from various governmental agencies and self-regulatory organizations in connection with their review of research independence issues. Goldman Sachs has cooperated with the requests.

On April 28, 2003, a final global settlement relating to investment research analysts’ alleged conflicts of interest and involving various of the leading securities firms operating in the United States, including Goldman, Sachs & Co., was announced. In that connection, without admitting or denying the allegations, findings or conclusions by various federal and state regulators, Goldman Sachs entered into consents, agreements and other definitive documentation with the SEC, the NYSE, the NASD and the Utah Division of Securities, to resolve their investigations of Goldman, Sachs & Co. relating to those matters. Pursuant to the final arrangements, Goldman, Sachs & Co.

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agreed, among other things, to (i) pay an aggregate of $25 million as penalties, (ii) pay an aggregate of $25 million as disgorgement of commissions and other monies, (iii) contribute an aggregate of $50 million over five years to provide independent third-party research to clients, (iv) contribute an aggregate of $10 million over five years for investor education, (v) adopt various additional policies, systems, procedures and other safeguards to ensure further the integrity of Goldman, Sachs & Co. investment research and (vi) be permanently restrained and enjoined from violating certain rules of the NYSE and the NASD relating to investment research activities. In connection with the global settlement, Goldman, Sachs & Co. and other firms also subscribed to a voluntary initiative imposing restrictions on the allocation of shares in initial public offerings to executives and directors of public companies. In connection with effectuation of the global settlement, in a civil action brought by the SEC in the U.S. District Court for the Southern District of New York against the settling firms, including Goldman, Sachs & Co., on October 31, 2003, the court entered a final judgment imposing the permanent restraint and injunction. In addition, Goldman, Sachs & Co. has entered into settlement stipulations with all 50 states and certain U.S. territories in connection with the global settlement. Current or future civil lawsuits implicating investment research analysts’ conflicts of interest were not settled as part of the global settlement. The global settlement also did not resolve potential charges involving individual employees, including supervisors.

Goldman, Sachs & Co. is one of several investment firms that have been named as defendants in substantively identical purported class actions filed in the U.S. District Court for the Southern District of New York alleging violations of the federal securities laws in connection with research coverage of certain issuers and seeking compensatory damages. In one such action, relating to coverage of RSL Communications, Inc. commenced on July 5, 2003, Goldman, Sachs & Co. moved to dismiss the complaint on January 13, 2004, and the motion was denied by a decision dated May 21, 2004. On November 9, 2004, plaintiffs moved for class certification, and the district court granted the motion by a decision dated August 15, 2005. Defendants petitioned the U.S. Court of Appeals for the Second Circuit to review that certification decision on an interlocutory basis and, by an order dated December 22, 2005, the appellate court denied the petition in part and otherwise held the petition in abeyance for consideration by the panel assigned to review the certification decision in the action described under “IPO Process Matters” above. Goldman, Sachs & Co. is also a defendant in several actions relating to research coverage of Exodus Communications, Inc. that commenced beginning in May 2003. The actions were consolidated, and on March 15, 2004, Goldman, Sachs & Co. moved to dismiss.

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. and its board of directors, which, as amended, alleges that the directors breached their fiduciary duties in connection with the firm’s research as well as the firm’s IPO allocations practices. An amended complaint was filed on March 3, 2004, which was further amended on June 14, 2005.

The Goldman Sachs Group, Inc., Goldman, Sachs & Co. and Henry M. Paulson, Jr. have been named as defendants in a purported class action filed originally on July 18, 2003 in the U.S. District Court for the District of Nevada on behalf of purchasers of The Goldman Sachs Group, Inc. stock from July 1, 1999 through May 7, 2002. The complaint alleges that defendants breached their fiduciary duties and violated the federal securities laws in connection with the firm’s research activities. The complaint
seeks, among other things, unspecified compensatory damages and/or rescission. The action was transferred on consent to the U.S. District Court for the Southern District of New York, defendants moved to dismiss the amended complaint on August 30, 2004, and the district court granted the motion with leave to amend by order dated February 17, 2005. Plaintiffs filed a second amended complaint on February 25, 2005, and defendants filed a motion to dismiss on March 24, 2005.

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Enron Litigation Matters

Goldman Sachs affiliates are defendants in certain actions arising relating to Enron Corp., which filed for protection under the U.S. bankruptcy laws on December 2, 2001.

Goldman, Sachs & Co. and co-managing underwriters have been named as defendants in certain purported securities class and individual actions commenced beginning on December 14, 2001 in the U.S. District Court for the Southern District of Texas and California Superior Court brought by purchasers of $222,500,000 of Exchangeable Notes of Enron Corp. in August 1999. The notes were mandatorily exchangeable in 2002 into shares of Enron Oil & Gas Company held by Enron Corp. or their cash equivalent. The complaints also name as defendants The Goldman Sachs Group, Inc. as well as certain past and present officers and directors of Enron Corp. and the company’s outside accounting firm. The complaints generally allege violations of the disclosure requirements of the federal securities laws and/or state law, and seek compensatory damages. Goldman, Sachs & Co. underwrote $111,250,000 principal amount of the notes. The Goldman Sachs Group, Inc. and Goldman, Sachs & Co. moved to dismiss the class action complaint in the Texas federal court on March 15, 2004, and by a decision dated December 5, 2005, the motion was granted as to The Goldman Sachs Group, Inc. but denied as to Goldman, Sachs & Co. Plaintiffs in various consolidated actions relating to Enron entered into a settlement with Banc of America Securities LLC on July 2, 2004 and with Citigroup, Inc. on June 10, 2005, including with respect to claims relating to the Exchangeable Notes offering, as to which affiliates of those settling defendants were two of the three underwriters (together with Goldman, Sachs & Co.). The settling parties have yet to announce what portion of the settlement will apply to the Exchangeable Notes offering.

Several funds which allegedly sustained investment losses of approximately $125 million in connection with secondary market purchases of the Exchangeable Notes as well as Zero Coupon Convertible Notes of Enron Corp. commenced an action in the U.S. District Court for the Southern District of New York on January 16, 2002. As amended, the lawsuit names as defendants the underwriters of the August 1999 offering, the company’s outside accounting firm, various former officers and directors of Enron Corp., as well as other financial services firms, and alleges violations of the disclosure requirements of the federal securities laws, fraud and misrepresentation. By an Order dated June 24, 2002, the Judicial Panel on Multidistrict Litigation entered an order transferring that action to the Texas federal district court for purposes of coordinated or consolidated pretrial proceedings with other matters relating to Enron Corp. On March 20, 2002, Goldman, Sachs & Co. moved to dismiss the complaint. By a decision dated December 10, 2003, the motion was granted in part and denied in part. Goldman, Sachs & Co. sought clarification and reconsideration of the decision, and on June 13, 2005, the federal district court granted Goldman, Sachs & Co.’s motion for reconsideration and provided for further briefing on Goldman, Sachs & Co.’s motion to dismiss.

The Goldman Sachs 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 Corp., 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 complaints seek unspecified compensatory damages. In July 2003, defendants removed the actions to the U.S. District Court for the District of Oregon, and the actions were transferred by the Judicial Panel on Multidistrict Litigation to the U.S. District Court for the Southern District of Texas for coordinated proceedings with other actions relating to Enron Corp. On February 25, 2004, The Goldman Sachs Group, Inc. and Goldman, Sachs & Co. moved to dismiss the action, and on August 5, 2004, the federal district court granted the motion to dismiss and denied plaintiffs’ motion to remand the actions to state court. On October 14, 2004, plaintiffs moved for reconsideration, and on November 10, 2004, the motion was denied.

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Goldman, Sachs & Co. is among numerous defendants in two substantively identical actions filed in the U.S. Bankruptcy Court for the Southern District of New York beginning in November 2003 seeking to recover as fraudulent transfers and/or preferences payments made by Enron Corp. in repurchasing its commercial paper shortly before its bankruptcy filing. Goldman, Sachs & Co., which had acted as a commercial paper dealer for Enron Corp., resold to Enron Corp. approximately $30 million of commercial paper as principal, and as an agent facilitated Enron Corp.’s repurchase of additional commercial paper from various customers who have also been named as defendants. Goldman, Sachs & Co. moved to dismiss the complaints on February 19, 2004, but the bankruptcy court denied the motion as well as similar motions by other defendants by a decision dated June 15, 2005. On August 1, 2005, various defendants including Goldman, Sachs & Co. petitioned to have the denial of their motion to dismiss reviewed by the U.S. District Court for the Southern District of New York.

Exodus Securities Litigation

By an amended complaint dated July 11, 2002, Goldman, Sachs & Co. and the other lead underwriters for the February 2001 offering of 13,000,000 shares of common stock and $575,000,000 of 51/4% convertible subordinated notes of Exodus Communications, Inc. were added as defendants in a purported class action pending in the U.S. District Court for the Northern District of California. The complaint, which also names as defendants certain officers and directors of Exodus Communications, Inc., alleges violations of the disclosure requirements of the federal securities laws and seeks compensatory damages. On October 23, 2002, the underwriter defendants moved to dismiss the complaint. By a decision dated August 19, 2003, the district court granted the defendants’ motion to dismiss with leave to replead, and the plaintiffs filed a third amended complaint on January 15, 2004. On March 12, 2004, the underwriter defendants moved to dismiss the third amended complaint, and by a decision dated August 5, 2005, the district court denied the motion. The underwriter defendants moved for reconsideration and clarification on August 30, 2005, but the motion was denied by an order dated September 12, 2005. Goldman, Sachs & Co. underwrote 5,200,000 shares of common stock for a total offering price of approximately $96,200,000, and $230,000,000 principal amount of the notes.

On September 26, 2001, Exodus Communications, Inc. filed for protection under the U.S. bankruptcy laws.

Montana Power Litigation

Goldman, Sachs & Co. and The Goldman Sachs Group, Inc. have been named as defendants in a purported class action commenced originally on October 1, 2001 in Montana District Court, Second Judicial District on behalf of former shareholders of Montana Power Company. The complaint generally alleges that Montana Power Company violated Montana law by failing to procure shareholder approval of certain corporate strategies and transactions, that the company’s board breached its fiduciary duties in pursuing those strategies and transactions, and that Goldman, Sachs & Co. aided and abetted the board’s breaches and rendered negligent advice in its role as financial advisor to the company. The complaint seeks, among other things, compensatory damages. In addition to Goldman, Sachs & Co. and The Goldman Sachs Group, Inc., the defendants include Montana Power Company, certain of its officers and directors, an outside law firm for the Montana Power Company, and certain companies that purchased assets from Montana Power Company and its affiliates. The Montana state court denied motions to dismiss by a decision dated August 1, 2002. On July 18, 2003, following the bankruptcies of certain defendants in the action, defendants removed the action to federal court, the U.S. District Court for the District of Montana, Butte Division.

On October 26, 2004, a creditors committee of Touch America Holdings, Inc. brought an action against Goldman, Sachs & Co., The Goldman Sachs Group, Inc., and a former outside law firm for Montana Power Company in Montana District Court, Second Judicial District. The complaint asserts that Touch America Holdings, Inc. is the successor to Montana Power Corporation and alleges

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substantially the same claims as in the purported class action. Defendants removed the action to federal court on November 19, 2004. On January 14, 2005, defendants moved to dismiss the complaint, but the motion was denied by a decision dated June 10, 2005.

WorldCom Bondholders Litigation

Goldman, Sachs & Co. and other underwriters of WorldCom, Inc. bonds have been named as defendants in certain purported securities class and individual actions commenced beginning on July 19, 2002 alleging that the offering materials issued in connection with certain securities offerings were false and misleading. Certain of the lawsuits (some of which were originally filed in various state courts and removed to federal court) have been transferred by order of the Judicial Panel on Multidistrict Litigation to the U.S. District Court for the Southern District of New York. Goldman, Sachs & Co. underwrote $75,000,000 principal amount out of a total principal amount of $5,000,000,000 of notes in a May 24, 2000 offering. Among the defendants in these actions in addition to the underwriters are certain of WorldCom, Inc.’s former officers and/or directors, and/or WorldCom, Inc.’s former outside accounting firm. Each of these actions seeks, among other things, compensatory damages. The district court denied the underwriter defendants’ motion to dismiss by a decision dated May 19, 2003 and granted plaintiffs’ motion for class certification by an order dated October 24, 2003. On August 20, 2004, the underwriter defendants moved for summary judgment and plaintiffs cross-moved for partial summary judgment as to liability. By a decision dated December 15, 2004, the district court granted in part and denied in part the motions. All defendants, including Goldman, Sachs & Co., have since entered into agreements to settle the class action claims, with Goldman, Sachs & Co. contributing approximately $12.5 million, and the settlement was approved by the district court by a decision dated September 21, 2005, but several class members have appealed from certain aspects of the approval. That settlement did not resolve claims brought by certain investors who opted out of the class. On June 22, October 27 and December 28, 2005, respectively, the underwriter defendants in certain of the remaining individual actions agreed to settle certain of these actions, and Goldman, Sachs & Co. contributed approximately $1.94 million toward those settlements.

On July 21, 2002, WorldCom, Inc. filed for protection under the U.S. bankruptcy laws.

Global Crossing and Asia Global Crossing Securities Litigation

Goldman, Sachs & Co. has been named as a defendant in a consolidated class action lawsuit in the U.S. District Court for the Southern District of New York relating to various securities offerings by Global Crossing, Ltd. and Asia Global Crossing Ltd. in which Goldman, Sachs & Co. acted as an underwriter. The claims had originally been asserted in separate actions, reflected in an amended complaint filed on January 28, 2003 as to Global Crossing, Ltd. and in a complaint filed on November 8, 2002 as to Asia Global Crossing Ltd., but the claims were consolidated into a single amended complaint on August 11, 2003, which was further amended on March 22, 2004 (including to drop The Goldman Sachs Group, Inc. as a defendant). The consolidated action includes claims relating to Global Crossing, Ltd.’s concurrent April 2000 offerings of 43 million shares of common stock at $33 per share and 4.6 million shares of 6 3/4% cumulative preferred stock at $250 per share, as well as Asia Global Crossing Ltd.’s October 2000 initial public offering of 68,500,000 shares of common stock at a price of $7 per share. Goldman, Sachs & Co. acted as a co-lead underwriter of both Global Crossing, Ltd. offerings, underwriting 12.9 million shares of common stock and 1,840,000 shares of convertible preferred stock for a total offering price of approximately $886 million. Goldman, Sachs & Co. underwrote 20,670,000 shares of common stock in the Asia Global Crossing Ltd. offering for a total offering price of approximately $145 million. The claims assert violations of the disclosure requirements of the federal securities laws as to such offerings and seek compensatory and/or rescissory damages. In addition to the lead and other underwriters in the offerings, the defendants as to such claims originally included certain officers and directors of

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Global Crossing, Ltd. and Asia Global Crossing Ltd. as well as the companies’ former outside auditors.

On April 21, 2003, the underwriter defendants as to the Global Crossing, Ltd. offerings moved to dismiss the claims relating to such offerings; the motion was denied in significant part by a decision dated December 18, 2003. On July 23, 2004, the underwriter defendants as to the Asia Global Crossing Ltd. offering moved to dismiss the claims relating to that offering. On March 1, 2005, plaintiffs entered into a definitive settlement agreement with Citigroup, Inc. and certain related parties, including as to claims asserted against such parties in respect of the various offerings in which Goldman, Sachs & Co. participated. The settlement, pursuant to which the Citigroup defendants have agreed to pay $75 million, does not resolve claims against the other members of the underwriting syndicates, including Goldman, Sachs & Co. The various officer and director defendants as well as the former auditors separately entered into settlement agreements.

Global Crossing, Ltd. filed for protection under the U.S. bankruptcy laws on January 28, 2002, and Asia Global Crossing Ltd. filed for such protection on November 17, 2002.

Adelphia Communications Fraudulent Conveyance Litigations

Goldman, Sachs & Co. is among numerous entities named as defendants in two adversary proceedings commenced in the U.S. Bankruptcy Court for the Southern District of New York, one on July 6, 2003 by a creditors committee, and the second on or about July 31, 2003 by an equity committee of Adelphia Communications, Inc. The nearly identical complaints seek, among other things, to recover, as fraudulent conveyances, payments made allegedly by Adelphia Communications, Inc. 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 Communications, Inc.

Specialist Matters

Spear, Leeds & Kellogg Specialists LLC (SLKS) and certain affiliates have received requests for information from various governmental agencies and self-regulatory organizations as part of an industry-wide investigation relating to activities of floor specialists in recent years. Goldman Sachs has cooperated with the requests.

On March 30, 2004, a final global settlement with the SEC and the NYSE was announced covering certain activities during the years 1999 through 2003 of certain specialist firms on the NYSE, including SLKS. Without admitting or denying the allegations, SLKS and the other specialist firms entered into settlements to resolve these SEC and NYSE investigations of the firms with respect to those activities. The SLKS settlement involves, among other things, (i) findings by the SEC and the NYSE that SLKS violated certain federal securities laws and NYSE rules, and in some cases failed to supervise certain individual specialists, in connection with trades that allegedly disadvantaged customer orders, (ii) a cease and desist order against SLKS, (iii) a censure of SLKS, (iv) SLKS’ agreement to pay an aggregate of $45.3 million in disgorgement and a penalty to be used to compensate customers, (v) certain undertakings with respect to SLKS’ systems and procedures, and (vi) SLKS’ retention of an independent consultant to review and evaluate certain of SLKS’ compliance systems, policies and procedures. Comparable findings were made and sanctions imposed in the settlements with other specialist firms. The settlement did not resolve the related private civil actions against SLKS and other firms or regulatory investigations involving individuals.

SLKS, Spear, Leeds & Kellogg, L.P. and The Goldman Sachs Group, Inc. are among numerous defendants named in purported class actions brought beginning in October 2003 on behalf of investors in the U.S. District Court for the Southern District of New York alleging violations

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of the federal securities laws and state common law in connection with NYSE floor specialist activities. The actions seek unspecified compensatory damages, restitution and disgorgement on behalf of purchasers and sellers of unspecified securities between October 17, 1998 and October 15, 2003. Plaintiffs filed a consolidated amended complaint on September 16, 2004, defendants moved to dismiss the amended complaint on November 16, 2004, and the motion was granted in part and denied in part by a decision dated December 13, 2005.

Treasury Matters

On September 4, 2003, the SEC announced that Goldman, Sachs & Co. had settled an administrative proceeding arising from certain trading in U.S. Treasury bonds over an approximately eight-minute period after Goldman, Sachs & Co. received an October 31, 2001 telephone call from a Washington, D.C.-based political consultant concerning a forthcoming Treasury refunding announcement. The administrative complaint alleged that Goldman, Sachs & Co. (i) violated Section 15(c)(1) and Rule 15c1-2 of the Securities Exchange Act of 1934 as a result of the trading and (ii) violated Section 15(f) of the Securities Exchange Act of 1934 by failing to maintain policies and procedures specifically addressed to the possible misuse of information obtained by consultants from confidential government sources. Without admitting or denying the allegations, Goldman, Sachs & Co. consented to the entry of an order that, among other things, (i) censured Goldman, Sachs & Co.; (ii) directed Goldman, Sachs & Co. to cease and desist from committing or causing any violations of Section 15(c)(1)(A) and (C) and 15(f) of, and Rule 15c1-2 under, the Securities Exchange Act of 1934; (iii) ordered Goldman, Sachs & Co. to pay disgorgement and prejudgment interest in the amount of $1,742,642, and a civil monetary penalty of $5 million; and (iv) directed Goldman, Sachs & Co. to conduct a review of its policies and procedures and adopt, implement and maintain policies and procedures consistent with the order and that review. Goldman, Sachs & Co. also undertook to pay $2,562,740 in disgorgement and interest relating to certain trading in U.S. Treasury bond futures during the same eight-minute period.

Goldman, Sachs & Co. has been named as a defendant in a purported class action filed on March 10, 2004 in the U.S. District Court for the Northern District of Illinois on behalf of holders of short positions in 30-year U.S. Treasury futures and options on the morning of October 31, 2001. The complaint alleges that the firm purchased 30-year bonds and futures prior to the Treasury’s refunding announcement that morning based on non-public information about that announcement, and that such purchases increased the costs of covering such short positions. The complaint also names as defendants the Washington, D.C.-based political consultant who allegedly was the source of the information, a former Goldman, Sachs & Co. economist who allegedly received the information, and another company and one of its employees who also allegedly received and traded on the information prior to its public announcement. The complaint alleges violations of the federal commodities and antitrust laws, as well as Illinois statutory and common law, and seeks, among other things, unspecified damages including treble damages under the antitrust laws. On June 28, 2004, Goldman, Sachs & Co. moved to dismiss the complaint, and by a decision dated March 28, 2005, the district court dismissed the antitrust and Illinois state law claims but permitted the federal commodities law claims to proceed.

Mutual Fund Matters

Goldman, Sachs & Co. and certain mutual fund affiliates have received subpoenas and requests for information from various governmental agencies and self-regulatory organizations including the SEC as part of the industry-wide investigation relating to the practices of mutual funds and their customers. Goldman, Sachs & Co. and its affiliates have cooperated with such requests.

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The Goldman Sachs Group, Inc., Goldman, Sachs & Co. and various asset management affiliates and employees have been named as defendants in several putative consolidated class and derivative actions commenced in the U.S. District Court for the Southern District of New York beginning in April 2004 by purported shareholders of certain Goldman Sachs mutual funds. The consolidated complaint also names as nominal defendants certain of the Goldman Sachs family of mutual funds. The cases are brought on behalf of all persons or entities that held shares in these mutual funds between April 2, 1999 and January 9, 2004, and allege violations of the Investment Company Act of 1940, the Investment Advisers Act of 1940 and common law breaches of fiduciary duty. The complaint alleges, among other things, that Goldman Sachs charged the mutual funds improper Rule 12b-1 fees, paid excessive brokerage commissions and made other undisclosed payments to brokers in exchange for selling shares of the mutual funds, and made untrue statements of material fact in registration statements and reports filed pursuant to the Investment Company Act. The complaint further alleges that the funds’ trustees, officers and directors breached their fiduciary duties by, among other things, failing to prevent such violations. The complaint seeks compensatory and punitive damages; rescission of the funds’ investment advisory agreements with Goldman Sachs and recovery of fees paid; an accounting of all fund-related fees, commissions and other payments; restitution of all unlawfully or discriminatorily-obtained fees and charges; and costs and expenses incurred in connection with these lawsuits. Defendants moved to dismiss the complaint on May 2, 2005, and the motion was granted by a Memorandum and Order dated January 13, 2006.

Refco Securities Litigation

Goldman, Sachs & Co. and the other lead underwriters for the August 2005 initial public offering of 26,500,000 shares of common stock of Refco Inc. are among the defendants in various putative class actions commenced beginning in October 2005 by Refco Inc. investors and derivative actions filed on behalf of Refco Inc. in response to certain publicly reported events that culminated in the October 17, 2005 filing by Refco Inc. and certain affiliates for protection under U.S. bankruptcy laws. The actions are pending in the U.S. District Court for the Southern District of New York. The putative class actions allege violations of the disclosure requirements of the federal securities laws and seek compensatory damages, while the derivative complaints allege that Refco Inc.’s board breached its fiduciary duties and that the underwriters aided and abetted that breach. In addition to the underwriters, the actions name as defendants Refco Inc. and certain of its affiliates, certain officers and directors of Refco Inc., Thomas H. Lee Partners, L.P. (which held a majority of Refco Inc.’s equity through certain funds it manages) and Grant Thornton (Refco Inc.’s outside auditor). Goldman, Sachs & Co. underwrote 5,639,200 shares of common stock at a price of $22 per share for a total offering price of approximately $124 million.

Goldman, Sachs & Co. and the other lead underwriters for Refco Inc.’s initial public offering are also among the defendants in a putative class action filed in January 2006 on behalf of customers that held securities custodied with certain Refco Inc. affiliates. The complaint alleges that the defendants violated federal securities laws by publishing financial statements of Refco Inc., including in the initial public offering prospectus, that were false and misleading and that misled such customers with respect to custodying their securities.

A purported shareholder derivative action was filed in the U.S. District Court for the Southern District of New York on November 2, 2005 on behalf of The Goldman Sachs Group, Inc. against certain of its officers and directors. The complaint alleges that the individual defendants breached their fiduciary duties by failing to ensure that adequate due diligence was conducted in connection with the Refco Inc. initial public offering. On October 17, 2005, Refco Inc. filed for protection under the U.S. bankruptcy laws.

Goldman, Sachs & Co. has, together with other underwriters of the Refco Inc. initial public offering, received requests for information from various governmental agencies and self-regulatory organizations. Goldman, Sachs & Co. is cooperating with those requests.

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Item 4.    Submission of Matters to a Vote of Security Holders

There were no matters submitted to a vote of security holders during the fourth quarter of our fiscal year ended November 25, 2005.

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EXECUTIVE OFFICERS OF THE GOLDMAN SACHS GROUP, INC.

Set forth below are the name, age, present title, principal occupation and certain biographical information for our executive officers as of February 1, 2006, all of whom have been appointed by and serve at the pleasure of our board of directors.

Henry M. Paulson, Jr., 59

Mr. Paulson has been our Chairman and Chief Executive Officer since May 1999, and a director since August 1998. He was Co-Chairman and Chief Executive Officer or Co-Chief Executive Officer of The Goldman Sachs Group, L.P., our predecessor, from June 1998 to May 1999, and served as Chief Operating Officer from December 1994 to June 1998. Mr. Paulson is not on the board of any public company other than Goldman Sachs. He is currently the Chairman of the Financial Services Forum. He is affiliated with certain non-profit organizations, including as a member of the Board of Directors of Catalyst. He also serves on the Advisory Board of the Tsinghua University School of Economics and Management. He is Chairman of the Board of Directors of The Nature Conservancy, Co-Chairman of the Asia/Pacific Council of The Nature Conservancy and Chairman Emeritus of The Peregrine Fund, Inc.

Lloyd C. Blankfein, 51

Mr. Blankfein has been our President and Chief Operating Officer since January 2004, and a director since April 2003. Prior to that, from April 2002 until January 2004, he was a Vice Chairman of Goldman Sachs, with management responsibility for the Fixed Income, Currency and Commodities Division (FICC) and the Equities Division. Prior to becoming a Vice Chairman, he had served as Co-Head of FICC since its formation in 1997. From 1994 to 1997, he headed or co-headed the Currency and Commodities Division. Mr. Blankfein is not on the board of any public company other than Goldman Sachs. He is affiliated with certain non-profit organizations, including as a member of the Harvard University Committee on University Resources, as a trustee of the New York Historical Society, as an overseer of the Weill Medical College of Cornell University, as a director of the Partnership for New York City and as a director of The Robin Hood Foundation.

Alan M. Cohen, 55

Mr. Cohen has been an Executive Vice President of Goldman Sachs and our Global Head of Compliance since February 2004. From 1991 until January 2004, he was a partner in the law firm of O’Melveny & Myers LLP. Mr. Cohen is also affiliated with the Chelsea Piers Scholarship Fund, a non-profit organization.

Edward C. Forst, 45

Mr. Forst has been an Executive Vice President of Goldman Sachs and our Chief Administrative Officer since February 2004. Prior to that, he was our Chief of Staff for FICC from November 2003 to February 2004 (after having served in that position earlier from July 2000 to March 2002), our Chief of Staff for the Equities Division from August 2003 to February 2004, and Co-Head of Global Credit Markets in FICC from March 2002 to August 2003. Prior to July 2000, Mr. Forst served as Co-Head of our Global Bank Debt business. Mr. Forst serves as Chairman of the Board of Directors of The Bond Market Association. He also serves as a trustee of the Woods Hole Oceanographic Institution, a non-profit organization, and as co-chairman of the Harvard University Committee on Student Excellence and Opportunity.

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Kevin W. Kennedy, 57

Mr. Kennedy has been our Executive Vice President — Human Capital Management since December 2001. From 1999 until 2001, he served as a member of the Executive Office. From 1994 to 1999, he served as Head of the Americas Group, in the Investment Banking Division, and, from 1988 to 1994, as Head of Corporate Finance. Mr. Kennedy is a life trustee and a former Chairman of the Board of Hamilton College, a Managing Director and Secretary and Treasurer of the Board of the Metropolitan Opera, a trustee of the New York Public Library, a member of the Board of Directors of the Wallace Foundation and an honorary trustee of the Chewonki Foundation.

Suzanne M. Nora Johnson, 48

Ms. Nora Johnson has been a Vice Chairman of Goldman Sachs since November 2004. She has served as chairman of the Global Markets Institute since April 2004 and has headed our Global Investment Research Division since February 2002. Ms. Nora Johnson served as head of our global healthcare business in the Investment Banking Division from 1994 to 2002. She also serves on the boards of The Goldman Sachs Foundation, the Carnegie Institution of Washington, the University of Southern California, RAND Health, Technoserve, Children Now and Women’s World Banking, and is a trustee of The Brookings Institution and The Council for Excellence in Government.

Gregory K. Palm, 57

Mr. Palm has been an Executive Vice President of Goldman Sachs since May 1999, and our General Counsel and Head or Co-Head of the Legal Department since May 1992.

Esta E. Stecher, 48

Ms. Stecher has been an Executive Vice President of Goldman Sachs and our General Counsel and Co-Head of the Legal Department since December 2000. From 1994 to 2000, she was Head of the firm’s Tax Department, over which she continues to have senior oversight responsibility. She is also a trustee of Columbia University and a member of the Board of Directors of the Securities Industry Association.

David A. Viniar, 50

Mr. Viniar has been an Executive Vice President of Goldman Sachs and our Chief Financial Officer since May 1999. He has been the Head of Operations, Technology and Finance Division since December 2002. He was Head of the Finance Division and Co-Head of Credit Risk Management and Advisory and Firmwide Risk from December 2001 to December 2002. Mr. Viniar was Co-Head of Operations, Finance and Resources from March 1999 to December 2001. He was Chief Financial Officer of The Goldman Sachs Group, L.P. from March 1999 to May 1999. From July 1998 until March 1999, he was Deputy Chief Financial Officer and from 1994 until July 1998, he was Head of Finance, with responsibility for Controllers and Treasury. From 1992 to 1994, he was Head of Treasury and prior to that was in the Structured Finance Department of Investment Banking. He also serves on the Board of Trustees of Union College.

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PART II

Item 5.    Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

The principal market on which our common stock is traded is the NYSE. Information relating to the high and low sales prices per share of our common stock, as reported by the Consolidated Tape Association, for each full quarterly period during fiscal 2004 and 2005 is set forth under the heading “Supplemental Financial Information — Common Stock Price Range” in Part II, Item 8 of the Annual Report on Form 10-K. As of January 30, 2006, there were 6,159 holders of record of our common stock.

During fiscal 2004 and 2005, dividends of $0.25 per share of common stock were declared on December 17, 2003, March 22, 2004, June 21, 2004, September 20, 2004, December 15, 2004, March 16, 2005, June 15, 2005 and September 19, 2005. The holders of our common stock share proportionately on a per share basis in all dividends and other distributions on common stock declared by our board of directors.

The declaration of dividends by Goldman Sachs is subject to the discretion of our board of directors. Our board of directors will take into account such matters as general business conditions, our financial results, capital requirements, contractual, legal and regulatory restrictions on the payment of dividends by us to our shareholders or by our subsidiaries to us, the effect on our debt ratings and such other factors as our board of directors may deem relevant. See “Business — Regulation” in Part I, Item 1 of the Annual Report on Form 10-K for a discussion of potential regulatory limitations on our receipt of funds from our regulated subsidiaries.

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The table below sets forth the information with respect to purchases made by or on behalf of The Goldman Sachs Group, Inc. or any “affiliated purchaser” (as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934), of our common stock during the fourth quarter of our fiscal year ended November 25, 2005.

                                 
Total Number of Maximum Number
Average Shares Purchased of Shares That May
Total Number Price as Part of Publicly Yet Be Purchased
of Shares Paid per Announced Plans Under the Plans or
Period Purchased (2) Share or Programs (3) Programs (3)
 
                       
 
                               
Month #1
                               
(August 27, 2005 to
September 30, 2005)
    4,745,300     $ 119.48       4,745,300       58,426,179  
 
                               
Month #2
                               
(October 1, 2005 to
October  28, 2005)
    13,184,100     $ 119.22       13,184,100       45,242,079  
 
                               
Month #3
                               
(October 29, 2005 to
November 25, 2005)
    2,528,700     $ 128.65       2,528,700       42,713,379  
 
                           
 
                               
Total (1)
    20,458,100     $ 120.45       20,458,100          
 
                           

  (1)   Goldman Sachs did not repurchase shares of its common stock as part of the repurchase program during a self-imposed “black-out” period from the last two weeks of the fiscal quarter through the date of the earnings release for the quarter.  
 
  (2)   No shares were purchased other than through our publicly announced repurchase program during the fourth quarter of our fiscal year ended November 25, 2005.  
 
  (3)   On March 21, 2000, we announced that our board of directors had approved a repurchase program, pursuant to which up to 15 million shares of our common stock may be repurchased. This repurchase program was increased by an aggregate of 160 million shares by resolutions of our board of directors adopted on June 18, 2001, March 18, 2002, November 20, 2002, January 30, 2004, January 25, 2005 and September 16, 2005. The repurchase program is intended to help maintain our total shareholders’ equity at appropriate levels and to substantially offset increases in share count over time resulting from employee equity-based compensation. The repurchase program has been effected primarily through regular open-market purchases, and is influenced by, among other factors, the level of our common shareholders’ equity, our overall capital position, employee equity awards granted and exercises of employee stock options, the prevailing market price of our common stock and general market conditions. The total remaining authorization under the repurchase program was 29,495,079 shares as of January 30, 2006. The repurchase program has no set expiration or termination date.  


Information relating to compensation plans under which equity securities of the Registrant are authorized for issuance is set forth in Part III, Item 12 of the Annual Report on Form 10-K.

Item 6.    Selected Financial Data

The Selected Financial Data table is set forth under Part II, Item 8 of the Annual Report on Form  10-K.

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Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

INDEX

         
Page
No.
 
       
    47  
 
       
    48  
 
       
    49  
 
       
    50  
 
       
    53  
    53  
    58  
 
       
    60  
 
       
    61  
    61  
    66  
    73  
 
       
    73  
 
       
    74  
    74  
    77  
    78  
    79  
 
       
    82  
 
       
    82  
    82  
    84  
    88  
    89  
    90  
    96  
 
       
    96  

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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:

    Investment Banking. We provide a broad range of investment banking services to a diverse group of corporations, financial institutions, governments and individuals.
 
    Trading and Principal Investments. We facilitate client transactions with a diverse group of corporations, financial institutions, governments and individuals and take proprietary positions through market making in, trading of and investing in fixed income and equity products, currencies, commodities and derivatives on such products. In addition, we engage in specialist and market-making activities on equities and options exchanges and we clear client transactions on major stock, options and futures exchanges worldwide. In connection with our merchant banking and other investing activities, we make principal investments directly and through funds that we raise and manage.
 
    Asset Management and Securities Services. We provide investment advisory and financial planning services and offer investment products across all major asset classes to a diverse group of institutions and individuals worldwide, and provide prime brokerage services, financing services and securities lending services to mutual funds, pension funds, hedge funds, foundations and high-net-worth individuals worldwide.

Unless specifically stated otherwise, all references to 2005, 2004 and 2003 refer to our fiscal years ended, or the dates, as the context requires, November 25, 2005, November 26, 2004 and November 28, 2003, respectively.

When we use the terms “Goldman Sachs,” “we,” “us” and “our,” we mean The Goldman Sachs Group, Inc. (Group Inc.), a Delaware corporation, and its consolidated subsidiaries. References herein to the Annual Report on Form 10-K are to our Annual Report on Form 10-K for the fiscal year ended November 25, 2005.

In this discussion, we have included statements that 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 beliefs regarding future events, many of which, by their nature, are inherently uncertain and beyond our control. These statements relate to our future plans and objectives, among other things. By identifying these statements for you in this manner, we are alerting you to the possibility that our actual results may differ, possibly materially, from the results indicated in these forward-looking statements. Important factors, among others, that could cause our results to differ, possibly materially, from those indicated in the forward-looking statements are discussed below under “— Certain Risk Factors That May Affect Our Business” as well as “Risk Factors” in Part I, Item 1A of the Annual Report on Form 10-K and “Cautionary Statement Pursuant to the Private Securities Litigation Reform Act of 1995” in Part I, Item 1 of the Annual Report on Form 10-K.

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Executive Overview

Our diluted earnings per common share were $11.21 for 2005, a 26% increase compared with 2004. Return on average tangible common shareholders’ equity was 27.6% (1) and return on average common shareholders’ equity was 21.8%. Our results in 2005 reflected strong growth in net revenues from Trading and Principal Investments and Asset Management and Securities Services as well as higher net revenues in Investment Banking. The increase in Trading and Principal Investments reflected significantly higher net revenues in Fixed Income, Currency and Commodities (FICC), as all major businesses performed well. During 2005, FICC operated in an environment generally characterized by strong customer-driven activity, tight, but volatile, credit spreads, higher energy prices and a flatter yield curve. Net revenues in Equities also improved significantly compared with the prior year, reflecting strong performance across the business. Equities operated in an environment characterized by generally higher equity prices, improved customer-driven activity and continued low levels of market volatility. Net revenues in our Principal Investments business also increased significantly, primarily reflecting a gain on our investment in the convertible preferred stock of Sumitomo Mitsui Financial Group, Inc. (SMFG) as well as gains from real estate principal investments. The strong net revenue growth in Asset Management and Securities Services primarily reflected higher assets under management and higher customer balances in Securities Services. The increase in Investment Banking net revenues was due to significantly higher net revenues in debt underwriting and improved results in Financial Advisory, primarily reflecting an increase in industry-wide corporate activity, partially offset by lower net revenues in equity underwriting. Our investment banking backlog at the end of 2005 was significantly higher than at the end of 2004. (2)

Our operating results for 2005 reflected generally favorable market conditions and strong customer-driven activity levels. We continued to see favorable trading and investing opportunities for our clients and ourselves, particularly during the second half of our fiscal year. Consequently, during the second half of 2005 we increased our market risk, particularly in equities and interest rate products, to capitalize on these opportunities. Net revenues in our Equities and FICC businesses surpassed previous peak levels. Our Investment Banking net revenues reflected our best performance in four years as corporate activity continued to recover, particularly in announced and completed mergers and acquisitions and debt underwriting, although competitive pressures remained. We also continued to focus on managing our capital base, with the goal of optimizing our returns while, at the same time, growing our businesses. During 2005, we repurchased 63.7 million shares of our stock at a cost of $7.11 billion. With respect to the regulatory environment, financial services firms continued to be under intense scrutiny, with the volume and amount of claims against financial institutions and other related costs remaining significant. Given the range of litigation and investigations presently under way, our litigation expenses can be expected to remain high.

Though our operating results were strong in 2005, our business, by its nature, does not produce predictable earnings. Our results in any given period can be materially affected by conditions in global financial markets and economic conditions generally. For a further discussion of these trends and other factors affecting our businesses, see “— Certain Risk Factors That May Affect Our Business” below as well as “Risk Factors” in Part I, Item 1A of the Annual Report on Form 10-K.

 

 

 
(1)   Return on average tangible common shareholders’ equity is computed by dividing net earnings applicable to common shareholders by average monthly tangible common shareholders’ equity. See ‘‘— Results of Operations — Financial Overview’’ below for further information regarding our calculation of return on average tangible common shareholders’ equity.
 
(2)   Our investment banking backlog represents an estimate of our future net revenues from investment banking transactions where we believe that future revenue realization is more likely than not.

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Business Environment

As an investment banking, securities and investment management firm, our businesses are materially affected by conditions in the financial markets and economic conditions generally, both in the United States and elsewhere around the world. A favorable business environment is generally characterized by low inflation, low or declining interest rates, and strong equity markets. Over the business cycle, these factors provide a positive climate for our investment banking activities, for many of our trading businesses and for wealth creation, which contributes to growth in our asset management business. Although short-term interest rates, particularly in the United States, continued to rise and the yield curve continued to flatten, economic conditions remained generally favorable during 2005, as global interest rates remained at historically low levels, core inflation was broadly contained, global equity prices generally rose and corporate activity continued to improve. For a further discussion of how market conditions can affect our businesses, see "— Certain Risk Factors That May Affect Our Business” below as well as “Risk Factors” in Part I, Item 1A of the Annual Report on Form 10-K. A further discussion of the business environment in 2005 is set forth below.

Global. After strong growth in 2004, the global economy remained solid in 2005, despite a brief period of weakness during our fiscal second quarter. Worldwide real gross domestic product growth for the calendar year, although lower than the prior year, was slightly above the average of the past 20 years. Energy prices rose significantly during the first nine months of our fiscal year, peaking at the beginning of our fourth quarter, but the sharp increase did not appear to have a significant impact on global growth. In addition, the U.S. economy performed well and the Japanese economy continued to grow at a moderate pace, particularly in the first half of the calendar year. The U.S. Federal Reserve continued to raise rates in 2005, increasing its federal funds rate target by a total of 200 basis points during our fiscal year. Despite the increase in U.S. short-term rates, fixed income markets generally performed well, as long-term bond yields remained generally low and corporate credit spreads remained generally tight. In the currency markets, the U.S. dollar strengthened against the major currencies, although it weakened against a number of emerging market currencies such as the Brazilian real, Mexican peso, Chinese yuan and Korean won. Global equity markets generally rose during the year, with significant increases in many markets around the world. Corporate activity continued to improve during the year. Although equity and equity-related volumes were essentially unchanged from 2004, debt underwriting volumes improved and industry-wide announced and completed mergers and acquisitions increased significantly.

United States. The U.S. economy grew at a strong pace during the year. Real gross domestic product rose by approximately 3.5% in the 2005 calendar year, driven principally by continued strength in the housing market and consumer spending. Despite hurricane-related disruptions, consumer spending reached its highest rate of growth during the third calendar quarter. After slowing modestly in the first quarter of 2005, the rate of inflation increased, particularly in the third quarter, as energy prices rose significantly. However, measures of core inflation remained broadly contained. In response to the improving environment and rising inflation, the U.S. Federal Reserve raised its federal funds rate target by 25 basis points in each of its meetings, bringing the rate to 4.00% by the end of our fiscal year. Despite the sharp rise in short-term interest rates, the 10-year U.S. Treasury note yield ended the year only 19 basis points higher. Although the U.S. dollar generally strengthened throughout the year, financial conditions remained generally supportive of economic activity. The Dow Jones Industrial Average, S&P 500 Index and NASDAQ Composite Index increased by 4%, 7% and 8%, respectively, during our fiscal year.

Europe. The pace of economic growth in Europe remained slow as real gross domestic product in the Eurozone economies grew by approximately 1.5% in the 2005 calendar year. Economic conditions in the Eurozone economies softened in the first half of the year as business sentiment deteriorated and energy prices rose. However, conditions improved modestly later in the year as continued strength in the global economy and the weakening of the euro supported higher growth in exports and investment spending. The European Central Bank left interest rates unchanged through our fiscal year. In the U.K., real gross domestic product growth appeared to slow

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sharply, declining to approximately 1.8% in the 2005 calendar year, reflecting softer growth in consumption and investment spending. The Bank of England reduced interest rates by 25 basis points and long-term bond yields in both the Eurozone and the U.K. ended the year lower. Despite the modest economic growth, the FTSE 100 Index increased by 16% and continental European equity markets also increased significantly during our fiscal year.

Asia. Japan’s economy grew at its strongest pace since 2000, with real gross domestic product growing by over 2% for the second consecutive calendar year. The recovery in domestic demand and private investment drove much of the improvement, while exports improved in the second half of the calendar year. The unemployment rate fell to 4.4% in 2005 from 4.7% in 2004. The Bank of Japan continued to provide substantial liquidity to the market and continued to hold short-term interest rates at zero percent through the year and long-term bond yields ended the year slightly lower. With short-term interest rates rising in the U.S., the yen weakened and financial conditions remained generally supportive of economic activity. The Nikkei 225 Index increased 36% during our fiscal year.

Elsewhere in Asia, China’s real gross domestic product growth remained robust, with growth particularly reliant on higher net exports, as demonstrated by China’s large current account surplus. China’s modest currency revaluation in July did not result in further significant exchange rate developments in the region. Growth in India remained very strong, which, together with China, supported growth throughout the region. Equity markets across the region generally rose, with markets in South Korea and India posting significant gains during our fiscal year.

Certain Risk Factors That May Affect Our Business

We face a variety of risks that are substantial and inherent in our businesses, including market, liquidity, credit, operational, legal and regulatory risks. For a discussion of how management seeks to manage some of these risks, see “— Risk Management” below. A summary of the more important factors that could affect our business follows below. For a further discussion of these and other important factors that could affect our business, see “Risk Factors” in Part I, Item 1A of the Annual Report on Form 10-K.

Market Conditions and Market Risk. Our businesses are materially affected by conditions in the global financial markets and economic conditions generally and these conditions may change suddenly and dramatically. Unfavorable or uncertain economic and market conditions have adversely affected, and may in the future adversely affect, our business and profitability in many ways, including the following:

    We have been operating in a low interest rate market for the past several years. Increasing or high interest rates and/or widening credit spreads, especially if such changes are rapid, may create a less favorable environment for certain of our businesses.
 
    We have been committing increasing amounts of capital in many of our businesses and generally maintain large trading, specialist and investing positions. Market fluctuations and volatility may adversely affect the value of those positions, including, but not limited to, our interest rate and credit products, currency, commodity and equity positions and our merchant banking investments, or may reduce our willingness to enter into new transactions. From time to time, we have incurred significant trading losses in periods of market turbulence. Conversely, certain of our trading businesses depend on market volatility to provide trading and arbitrage opportunities, and decreases in volatility may reduce these opportunities and adversely affect the results of these businesses.
 
    Industry-wide declines in the size and number of underwritings and mergers and acquisitions may have an adverse effect on our revenues and, because we may be unable to reduce expenses correspondingly, our profit margins. In particular, because a significant portion of our investment banking revenues are derived from our participation in large transactions, a

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      decrease in the number of large transactions due to uncertain or unfavorable market conditions may adversely affect our investment banking business.
 
    Pricing and other competitive pressures have continued, even as the volume and number of investment banking transactions have increased. In addition, the trend in the underwriting business toward multiple book runners and co-managers handling transactions, where previously there would have been a single book runner, may adversely affect our business and reduce our revenues.
 
    Reductions in the level of the equity markets also tend to reduce the value of our clients’ portfolios, which in turn may reduce the fees we earn for managing assets. Even in the absence of uncertain or unfavorable economic or market conditions, investment performance by our asset management business below the performance of benchmarks or competitors could result in a decline in assets under management and in the incentive and management fees we receive.
 
    Concentration of risk increases the potential for significant losses in our market-making, proprietary trading and investing, block trading, merchant banking, underwriting and lending businesses. This risk may increase to the extent we expand our proprietary trading and investing businesses or commit capital to facilitate customer-driven business. For example, large blocks of securities are increasingly being sold in block trades rather than on a marketed basis, which increases the risk that Goldman Sachs may be unable to resell the purchased securities at favorable prices and may incur significant losses as a result. Moreover, because of concentration of risk, we may suffer losses even when economic and market conditions are generally favorable for others in the industry. We also regularly enter into large transactions as part of our trading businesses. The number and size of such transactions may affect our results of operations in a given period.
 
    The volume of transactions that we execute for our clients and as a specialist or market maker may decline, which would reduce the revenues we receive from commissions and spreads. In addition, competitive pressures and other industry factors, including the increasing use by our clients of low-cost electronic trading, could cause a reduction in commissions and spreads. In our specialist businesses, we are obligated by stock exchange rules to maintain an orderly market, including by purchasing shares in a declining market. This may result in trading losses and an increased need for liquidity. Weakness in global equity markets and the trading of securities in multiple markets and on multiple exchanges could adversely impact our trading businesses and impair the value of our goodwill and identifiable intangible assets. In addition, competitive pressures have been particularly intense in the context of block trades. For a further discussion of our goodwill and identifiable intangible assets, see “— Critical Accounting Policies — Goodwill and Identifiable Intangible Assets” below.
 
    While we employ a broad and diversified set of risk monitoring and risk mitigation techniques, those techniques and the judgments that accompany their application cannot anticipate every economic and financial outcome or the specifics and timing of such outcomes. Thus, we may, in the course of our activities, incur losses.

Liquidity Risk. Liquidity is essential to our businesses. Our liquidity could be impaired by an inability to access secured and/or unsecured debt markets, an inability to access funds from our subsidiaries, an inability to sell assets or unforeseen outflows of cash or collateral. This situation may arise due to circumstances that we are unable to control, such as a general market disruption or an operational problem that affects third parties or us. Further, our ability to sell assets may be impaired if other market participants are seeking to sell similar assets at the same time.

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Our credit ratings are important to our liquidity. A reduction in our credit ratings could adversely affect our liquidity and competitive position, increase our borrowing costs, limit our access to the capital markets or trigger our obligations under certain bilateral provisions in some of our trading and collateralized financing contracts. Under these provisions, counterparties could be permitted to terminate contracts with Goldman Sachs or require us to post additional collateral. Termination of our trading and collateralized financing contracts could cause us to sustain losses and impair our liquidity by requiring us to find other sources of financing or to make significant cash payments or securities movements. For a discussion of the potential impact on Goldman Sachs of a reduction in our credit ratings, see “— Capital and Funding — Credit Ratings” below.

Credit Risk. We are exposed to the risk that third parties that owe us money, securities or other assets will not perform their obligations. These parties may default on their obligations to us due to bankruptcy, lack of liquidity, operational failure or other reasons. We are also subject to the risk that our rights against third parties may not be enforceable in all circumstances. In addition, a deterioration in the credit quality of third parties whose securities or obligations we hold could result in losses and/or adversely affect our ability to rehypothecate or otherwise use those securities or obligations for liquidity purposes. The amount and duration of our credit exposures have been increasing over the past several years, as has the breadth of the entities to which we have credit exposures. The scope of our lending businesses has also been expanding and includes loans to small and mid-size businesses, which are not traditional Goldman Sachs clients. As a clearing member firm, we finance our client positions and we could be held responsible for the defaults or misconduct of our clients. In addition, we have experienced, due to competitive factors, pressure to extend and price credit at levels that may not always fully compensate us for the risks we take. In particular, corporate clients sometimes seek to require credit commitments from us in connection with investment banking and other assignments. Although we regularly review credit exposures to specific clients and counterparties and to specific industries, countries and regions that we believe may present credit concerns, default risk may arise from events or circumstances that are difficult to detect or foresee. In addition, concerns about, or a default by, one institution could lead to significant liquidity problems, losses or defaults by other institutions, which in turn could adversely affect Goldman Sachs.

Operational Risk. Shortcomings or failures in our internal processes, people or systems, or external events could lead to impairment of our liquidity, financial loss, disruption of our businesses, liability to clients, regulatory intervention or reputational damage. For example, our businesses are highly dependent on our ability to process, on a daily basis, a large number of transactions across numerous and diverse markets in many currencies. The transactions we process have become increasingly complex and often must adhere to client-specific guidelines, as well as legal and regulatory standards. Despite the contingency plans and facilities we have in place, our ability to conduct business may be adversely impacted by a disruption in the infrastructure that supports our businesses and the communities in which we are located. This may include a disruption involving electrical, communications, transportation or other services used by Goldman Sachs or third parties with which we conduct business.

Legal and Regulatory Risk. We are subject to extensive and evolving regulation in jurisdictions around the world. Substantial legal liability or a significant regulatory action against Goldman Sachs could have material adverse financial effects or cause significant reputational harm to Goldman Sachs, which in turn could seriously harm our business prospects. Firms in the financial services industry have been operating in a difficult regulatory environment. We face significant legal risks in our businesses, and the volume of claims and amount of damages and penalties claimed in litigation and regulatory proceedings against financial institutions remain high. For a discussion of how we account for our legal and regulatory exposures, see
“— Use of Estimates” below.

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Critical Accounting Policies

Fair Value

The use of fair value to measure our financial instruments, with related unrealized gains and losses recognized immediately in our results of operations, is fundamental to our financial statements and is our most critical accounting policy. 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.

In determining fair value, we separate our financial instruments into three categories — cash (i.e., nonderivative) trading instruments, derivative contracts and principal investments, as set forth in the following table:

Financial Instruments by Category
(in millions)

                                 
As of November
2005 2004
Financial Financial
Financial Instruments Sold, Financial Instruments Sold,
Instruments But Not Yet Instruments But Not Yet
Owned, At Purchased, At Owned, At Purchased, At
Fair Value Fair Value Fair Value Fair Value
 
                               
Cash trading instruments
  $ 210,042     $ 89,735     $ 143,376     $ 68,096  
Derivative contracts
    58,532       57,829       62,495       64,001  
Principal investments
    6,526  (1)     1,507  (2)     4,654  (1)      —  
 
                       
Total
  $ 275,100     $ 149,071     $ 210,525     $ 132,097  
 
                       
 
(1)   Excludes assets for which Goldman Sachs is not at risk (e.g., assets related to consolidated employee-owned merchant banking funds) of $1.93 billion and $1.28 billion as of November 2005 and November 2004, respectively.
 
(2)   Represents an economic hedge on the unrestricted shares of common stock underlying our investment in the convertible preferred stock of SMFG. For a further discussion of our investment in SMFG, see “— Principal Investments” below.

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Cash Trading Instruments. The following table sets forth the valuation of our cash trading instruments by level of price transparency:

Cash Trading Instruments by Price Transparency
(in millions)

                                 
As of November
2005 2004
Financial Financial
Financial Instruments Sold, Financial Instruments Sold,
Instruments But Not Yet Instruments But Not Yet
Owned, At Purchased, At Owned, At Purchased, At
Fair Value Fair Value Fair Value Fair Value
 
                               
Quoted prices or alternative pricing sources with reasonable price transparency
  $ 198,233     $ 89,565     $ 130,908     $ 67,948  
Little or no price transparency
    11,809       170       12,468       148  
 
                       
Total
  $ 210,042     $ 89,735     $ 143,376     $ 68,096  
 
                       

 

Fair values of our cash trading instruments are generally obtained from quoted market prices in active markets, broker or dealer price quotations, or alternative pricing sources with reasonable levels of price transparency. The types of instruments valued in this manner include U.S. government and agency securities, other 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 trade infrequently and have little or no price transparency. Such instruments may include certain high-yield debt, corporate bank loans, mortgage whole loans and distressed debt. We value these instruments initially at cost and generally do not adjust valuations unless there is substantive evidence supporting a change in the value of the underlying instrument or valuation assumptions (such as similar market transactions, changes in financial ratios or changes in the credit ratings of the underlying companies). Where there is evidence supporting a change in the value, we use valuation methodologies such as the present value of known or estimated cash flows.

Cash trading instruments we own (long positions) are marked to bid prices and instruments we have sold but not yet purchased (short positions) are marked to offer prices. If liquidating a position is expected to affect its prevailing market price, our valuation is adjusted generally based on market evidence or predetermined policies. In certain circumstances, such as for highly illiquid positions, management’s estimates are used to determine this adjustment.

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Derivative Contracts. Derivative contracts consist of exchange-traded and over-the-counter (OTC) derivatives. The following table sets forth the fair value of our exchange-traded and OTC derivative assets and liabilities:

Derivative Assets and Liabilities
(in millions)

                                 
As of November
2005 2004
Assets Liabilities Assets Liabilities
 
                               
Exchange-traded derivatives
  $ 10,869     $ 9,083     $ 5,464     $ 5,905  
OTC derivatives
    47,663       48,746       57,031       58,096  
 
                       
Total
  $ 58,532  (1)   $ 57,829  (2)   $ 62,495  (1)   $ 64,001  (2)
 
                       
 
(1)   Net of cash received pursuant to credit support agreements of $22.61 billion and $18.65 billion as of November 2005 and November 2004, respectively.
 
(2)   Net of cash paid pursuant to credit support agreements of $16.10 billion and $5.45 billion as of November 2005 and November 2004, respectively.

 

Fair values of our exchange-traded derivatives are generally determined from quoted market prices. OTC derivatives are valued using valuation models. We use a variety of valuation models including the present value of known or estimated cash flows and option-pricing models. The valuation models that we use to derive the fair values of our OTC derivatives require inputs including contractual terms, market prices, yield curves, credit curves, measures of volatility, prepayment rates and correlations of such inputs. The selection of a model to value an OTC derivative depends upon the contractual terms of, and specific risks inherent in, the instrument as well as the availability of pricing information in the market. We generally use similar models to value similar instruments. Where possible, we verify the values produced by our pricing models to market transactions. For OTC derivatives that trade in liquid markets, such as generic forwards, swaps and options, model selection does not involve significant judgment because market prices are readily available. For OTC derivatives that trade in less liquid markets, model selection requires more judgment because such instruments tend to be more complex and pricing information is less available in these markets. Price transparency is inherently more limited for more complex structures because they often combine one or more product types, requiring additional inputs such as correlations and volatilities. As markets continue to develop and more pricing information becomes available, we continue to review and refine the models that we use.

At the inception of an OTC derivative contract (day one), we value the contract at the model value if we can verify all of the significant model inputs to observable market data and verify the model to market transactions. When appropriate, valuations are adjusted to reflect various factors such as liquidity, bid/offer spreads and credit considerations. These adjustments are generally based on market evidence or predetermined policies. In certain circumstances, such as for highly illiquid positions, management’s estimates are used to determine these adjustments.

Where we cannot verify all of the significant model inputs to observable market data and verify the model to market transactions, we value the contract at the transaction price at inception and, consequently, record no day one gain or loss in accordance with Emerging Issues Task Force (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.”

Following day one, we adjust the inputs to our valuation models only to the extent that changes in these inputs can be verified by similar market transactions, third-party pricing services and/or broker quotes, or can be derived from other substantive evidence such as empirical market data. In circumstances where we cannot verify the model to market transactions, it is possible that a different valuation model could produce a materially different estimate of fair value.

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The following tables set forth the fair values of our OTC derivative assets and liabilities by product and by remaining contractual maturity:

OTC Derivatives
(in millions)

                                                 
As of November 2005
Assets            
  0 - 6 6 - 12 1 - 5 5 - 10 10 Years  
Contract Type Months Months Years Years or Greater Total
 
                                   
 
                                               
Interest rates
  $ 1,898     $ 467     $ 4,634     $ 5,310     $ 5,221     $ 17,530  
Currencies
    5,825       1,031       1,843       919       1,046       10,664  
Commodities
    3,772       1,369       8,130       1,374       120       14,765  
Equities
    1,168       1,171       832       1,403       130       4,704  
 
                                   
Total
  $ 12,663     $ 4,038     $ 15,439     $ 9,006     $ 6,517     $ 47,663  
 
                                   
                                                 
Liabilities            
  0 - 6 6 - 12 1 - 5 5 - 10 10 Years  
Contract Type Months Months Years Years or Greater Total
 
                                   
 
                                               
Interest rates
  $ 1,956     $ 590     $ 5,327     $ 3,142     $ 4,970     $ 15,985  
Currencies
    6,295       575       3,978       436       924       12,208  
Commodities
    3,852       2,080       5,904       1,865       162       13,863  
Equities
    1,308       1,068       2,079       1,993       242       6,690  
 
                                   
Total
  $ 13,411     $ 4,313     $ 17,288     $ 7,436     $ 6,298     $ 48,746  
 
                                   
                                                 
As of November 2004
Assets            
  0 - 6 6 - 12 1 - 5 5 - 10 10 Years  
Contract Type Months Months Years Years or Greater Total
 
                                   
 
                                               
Interest rates
  $ 1,475     $ 451     $ 5,682     $ 4,250     $ 12,743     $ 24,601  
Currencies
    9,570       1,499       3,670       2,320       1,198       18,257  
Commodities
    2,943       1,164       5,581       1,108       160       10,956  
Equities
    1,311       813       457       634       2       3,217  
 
                                   
Total
  $ 15,299     $ 3,927     $ 15,390     $ 8,312     $ 14,103     $ 57,031  
 
                                   
                                                 
Liabilities            
  0 - 6 6 - 12 1 - 5 5 - 10 10 Years  
Contract Type Months Months Years Years or Greater Total
 
                                   
 
                                               
Interest rates
  $ 1,854     $ 789     $ 7,366     $ 7,136     $ 5,658     $ 22,803  
Currencies
    9,577       1,580       4,456       2,755       1,184       19,552  
Commodities
    3,791       1,425       4,522       814       107       10,659  
Equities
    1,409       1,304       1,114       1,084       171       5,082  
 
                                   
Total
  $ 16,631     $ 5,098     $ 17,458     $ 11,789     $ 7,120     $ 58,096  
 
                                   

 

We enter into certain OTC option transactions that provide us or our counterparties with the right to extend the maturity of the underlying contract. The fair value of these option contracts is not material to the aggregate fair value of our OTC derivative portfolio. In the tables above, for option contracts that require settlement by delivery of an underlying derivative instrument, the remaining contractual maturity is generally classified based upon the maturity date of the underlying derivative instrument. In those instances where the underlying instrument does not have a maturity date or either counterparty has the right to settle in cash, the remaining contractual maturity is generally based upon the option expiration date.

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Principal Investments. In valuing our corporate and real estate principal investments, we separate our portfolio into investments in private companies, investments in public companies (excluding our investment in the convertible preferred stock of SMFG) and our investment in SMFG.

The following table sets forth the carrying value of our principal investments portfolio:

Principal Investments
(in millions)

                                                 
As of November
2005 2004
Corporate Real Estate Total Corporate Real Estate Total
 
                                               
Private
  $ 1,538     $ 716     $ 2,254     $ 935     $ 769     $ 1,704  
Public
    185       29       214       343       51       394  
 
                                   
Subtotal (1)
    1,723       745       2,468       1,278       820       2,098  
SMFG convertible preferred
stock (2)
    4,058             4,058  (3)     2,556             2,556  
 
                                   
Total
  $ 5,781     $ 745     $ 6,526     $ 3,834     $ 820     $ 4,654  
 
                                   
 
(1)   Excludes assets for which Goldman Sachs is not at risk (e.g., assets related to consolidated employee-owned merchant banking funds) of $1.93 billion and $1.28 billion as of November 2005 and November 2004, respectively.
 
(2)   The fair value of our Japanese yen-denominated investment in the convertible preferred stock of SMFG includes the effect of foreign exchange revaluation. We hedge our economic exposure to exchange rate movements on our investment in SMFG by borrowing Japanese yen. Foreign exchange revaluation on the investment and the related borrowing are generally equal and offsetting. For example, if the Japanese yen appreciates against the U.S. dollar, the U.S. dollar carrying value of our SMFG investment will increase and the U.S. dollar carrying value of the related borrowing will also increase by an amount that is generally equal and offsetting.
 
(3)   Excludes an economic hedge on the unrestricted shares of common stock underlying our investment in the convertible preferred stock of SMFG. As of November 25, 2005, the fair value of this hedge was $1.51 billion and is reflected in “Financial instruments sold, but not yet purchased, at fair value” in the consolidated statements of financial condition. For a further discussion of the restrictions on our ability to hedge or sell the common stock underlying our investment in SMFG, see below.

 

Our private principal investments, by their nature, have little or 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, in the absence of third-party transactions, 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 result from initial public offerings or other corporate transactions, are valued using quoted market prices discounted based on predetermined written policies for nontransferability and illiquidity.

Our investment in the convertible preferred stock of SMFG is carried at fair value, which is derived from a model that incorporates SMFG’s common stock price and credit spreads, the impact of nontransferability and illiquidity, and the downside protection on the conversion strike price. The fair value of our investment is particularly sensitive to movements in the SMFG common stock price. As a result of transfer restrictions and the downside protection on the conversion strike price, the relationship between changes in the fair value of our investment and changes in SMFG’s common

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stock price is nonlinear. During our fiscal year, the fair value of our investment (excluding the economic hedge on the unrestricted shares of common stock underlying one-third of our investment) increased 85% (expressed in Japanese yen), primarily due to an increase in the SMFG common stock price and, to a lesser extent, the impact of passage of time in respect of the transfer restrictions on the underlying common stock.

Our investment in the convertible preferred stock of SMFG is generally nontransferable, but is freely convertible into SMFG common stock. Restrictions on our ability to hedge or sell one-third of the common stock underlying our investment in SMFG lapsed in February 2005. As of November 2005, we were fully hedged with respect to these unrestricted shares. Under our initial agreement with SMFG, restrictions on our ability to hedge or sell the remaining shares of common stock underlying our investment in SMFG lapse in equal installments on February 7, 2006 and February 7, 2007. In connection with a public offering by SMFG of its common stock, we have separately agreed with SMFG that the restrictions that were to lapse on February 7, 2006 will instead lapse on March 9, 2006. Effective February 1, 2006, the conversion price of our SMFG preferred stock into shares of SMFG common stock is ¥320,900. This price is subject to downward adjustment if the price of SMFG common stock at the time of conversion is less than the conversion price (subject to a floor of ¥105,800).

Controls Over Valuation of Financial Instruments. A control infrastructure, independent of the trading and investing functions, is fundamental to ensuring that our financial instruments are appropriately valued and that fair value measurements are reliable. This is particularly important in valuing instruments with lower levels of price transparency.

We employ an oversight structure that includes appropriate segregation of duties. Senior management, independent of the trading functions, is responsible for the oversight of control and valuation policies and for reporting the results of these policies to our Audit Committee. We seek to maintain the necessary resources to ensure that control functions are performed to the highest standards. We employ procedures for the approval of new transaction types and markets, price verification, review of daily profit and loss, and review of valuation models by personnel with appropriate technical knowledge of relevant products and markets. These procedures are performed by personnel independent of the revenue-producing units. For trading and principal investments with little or no price transparency, we employ, where possible, procedures that include comparisons with similar observable positions, analysis of actual to projected cash flows, comparisons with subsequent sales and discussions with senior business leaders. For a further discussion of how we manage the risks inherent in our trading and principal investing businesses, see
“— Risk Management” below.

Goodwill and Identifiable Intangible Assets

As a result of our acquisitions, principally SLK LLC (SLK) in fiscal 2000, The Ayco Company, L.P. (Ayco) in fiscal 2003, Cogentrix Energy, Inc. (Cogentrix) in fiscal 2004 and National Energy & Gas Transmission, Inc. (NEGT) in fiscal 2005, we have acquired goodwill and identifiable intangible assets. Goodwill is the cost of acquired companies in excess of the fair value of net assets, including identifiable intangible assets, at the acquisition date.

Goodwill. We test the goodwill in each of our operating segments for impairment at least annually in accordance with Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets,” by comparing the estimated fair value of each operating segment with its estimated net book value. We derive the fair value of each of our operating segments primarily based on price-earnings multiples. We derive the net book value of our operating segments by estimating the amount of shareholders’ equity required to support the assets of each operating segment. Our last annual impairment test was performed during our fiscal 2005 fourth quarter and no impairment was identified.

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The following table sets forth the carrying value of our goodwill by operating segment:

Goodwill by Operating Segment
(in millions)

                 
As of November
2005 2004
 
               
Investment Banking
               
Financial Advisory
  $     $  
Underwriting
    125       125  
 
               
Trading and Principal Investments
               
FICC
    91       135  
Equities (1)
    2,390       2,382  
Principal Investments
    1        
 
               
Asset Management and Securities Services
               
Asset Management (2)
    424       423  
Securities Services
    117       117  
 
           
Total
  $ 3,148     $ 3,182  
 
           
 
(1)   Primarily related to SLK.
 
(2)   Primarily related to Ayco.

 

Identifiable Intangible Assets. We amortize our identifiable intangible assets over their estimated useful lives in accordance with SFAS No. 142, and test for potential impairment whenever events or changes in circumstances suggest that an asset’s or asset group’s carrying value may not be fully recoverable in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” An impairment loss, calculated as the difference between the estimated fair value and the carrying value of an asset or asset group, is recognized if the sum of the estimated undiscounted cash flows relating to the asset or asset group is less than the corresponding carrying value.

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The following table sets forth the carrying value and range of remaining useful lives of our identifiable intangible assets by major asset class:

Identifiable Intangible Assets by Asset Class
($ in millions)

                     
As of November
2005 2004
Range of Remaining  
Carrying Useful Lives Carrying
Value (in years) Value
 
                   
Customer lists (1)
  $ 777      6 – 20   $ 828  
New York Stock Exchange (NYSE) specialist rights
    580     22 – 24     607  
Power contracts (2)
    481      2 – 31      
Exchange-traded fund (ETF) and option specialist rights
    111     22     121  
Other (3)
    106      2 – 9     133  
 
               
Total
  $ 2,055         $ 1,689  
 
               
 
(1)   Primarily includes our clearance and execution and NASDAQ customer lists related to SLK and financial counseling customer lists related to Ayco.
 
(2)   Primarily relates to above-market power contracts of consolidated power generation facilities related to Cogentrix and NEGT. We closed on our acquisition of NEGT and recorded purchase price allocation adjustments for NEGT and Cogentrix in fiscal 2005. Substantially all of these power contracts have been pledged as collateral to counterparties in connection with certain of our secured short-term and long-term borrowings.
 
(3)   Primarily includes technology-related assets related to SLK.

 

A prolonged period of weakness in global equity markets and the trading of securities in multiple markets and on multiple exchanges could adversely impact our businesses and impair the value of our goodwill and/or identifiable intangible assets. In addition, certain events could indicate a potential impairment of our identifiable intangible assets, including (i) changes in market structure that could adversely affect our specialist businesses, (ii) an adverse action or assessment by a regulator or (iii) a default event under a power contract or physical damage or other adverse events impacting the underlying power generation facilities.

Use of Estimates

The use of generally accepted accounting principles requires management to make certain estimates. In addition to the estimates we make in connection with fair value measurements and the accounting for goodwill and identifiable intangible assets, the use of estimates is also important in determining provisions for potential losses that may arise from litigation and regulatory proceedings and tax audits.

We estimate and provide for potential losses that may arise out of litigation and regulatory proceedings and tax audits to the extent that such losses are probable and can be estimated, in accordance with SFAS No. 5, “Accounting for Contingencies.” Significant judgment is required in making these estimates and our final liabilities may ultimately be materially different. Our total liability in respect of litigation and regulatory proceedings is determined on a case-by-case basis and represents an estimate of probable losses after considering, among other factors, the progress of each case or proceeding, our experience and the experience of others in similar cases or proceedings, and the opinions and views of legal counsel. Given the inherent difficulty of predicting the outcome of our litigation and regulatory matters, particularly in cases or proceedings in which

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substantial or indeterminate damages or fines are sought, we cannot estimate losses or ranges of losses for cases or proceedings where there is only a reasonable possibility that a loss may be incurred. See “Legal Proceedings” in Part I, Item 3 of the Annual Report on Form 10-K, for information on our judicial, regulatory and arbitration proceedings.

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. For a further discussion of the impact of economic and market conditions on our results of operations, see “— Business Environment” and “— Certain Risk Factors That May Affect Our Business” above, and “Risk Factors” in Part I, Item 1A of the Annual Report on Form 10-K.

Financial Overview

The following table sets forth an overview of our financial results:

Financial Overview
($ in millions, except per share amounts)

                         
Year Ended November
2005 2004 2003
 
                       
Net revenues
  $ 24,782     $ 20,550     $ 16,012  
Pre-tax earnings
    8,273       6,676       4,445  
Net earnings
    5,626       4,553       3,005  
Net earnings applicable to common shareholders
    5,609       4,553       3,005  
Diluted earnings per common share
    11.21       8.92       5.87  
Return on average common shareholders’ equity (1)
    21.8 %     19.8 %     15.0 %
Return on average tangible common shareholders’ equity (2)
    27.6 %     25.2 %     19.9 %
 
(1)   Return on average common shareholders’ equity is computed by dividing net earnings applicable to common shareholders by average monthly common shareholders’ equity.
 
(2)   Tangible common shareholders’ equity equals total shareholders’ equity less preferred stock and goodwill and identifiable intangible assets. We believe that return on average tangible common shareholders’ equity is a meaningful measure of performance because it excludes the portion of our common shareholders’ equity attributable to goodwill and identifiable intangible assets. As a result, this calculation measures corporate performance in a manner that treats underlying businesses consistently, whether they were acquired or developed internally. Return on average tangible common shareholders’ equity is computed by dividing net earnings applicable to common shareholders by average monthly tangible common shareholders’ equity. The following table sets forth the reconciliation of average total shareholders’ equity to average tangible common shareholders’ equity:
                         
Average for the
Year Ended November
2005 2004 2003
(in millions)
 
                       
Total shareholders’ equity
  $ 26,264     $ 22,975     $ 20,031  
Deduct: Preferred stock
    (538 )            
 
                 
Common shareholders’ equity
  $ 25,726     $ 22,975     $ 20,031  
Deduct: Goodwill and identifiable intangible assets
    (5,418 )     (4,918 )     (4,932 )
 
                 
Tangible common shareholders’ equity
  $ 20,308     $ 18,057     $ 15,099  
 
                 

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Net Revenues

2005 versus 2004. Our net revenues were $24.78 billion in 2005, an increase of 21% compared with 2004, reflecting strong growth in Trading and Principal Investments and Asset Management and Securities Services as well as higher net revenues in Investment Banking. The increase in Trading and Principal Investments reflected significantly higher net revenues in FICC, as all major businesses performed well. During 2005, FICC operated in an environment generally characterized by strong customer-driven activity, tight, but volatile, credit spreads, higher energy prices and a flatter yield curve. Net revenues in Equities also improved significantly compared with the prior year, reflecting strong performance across the business. Equities operated in an environment characterized by generally higher equity prices, improved customer-driven activity and continued low levels of market volatility. Net revenues in our Principal Investments business also increased significantly, primarily reflecting a gain on our investment in the convertible preferred stock of SMFG as well as gains from real estate principal investments. The strong net revenue growth in Asset Management and Securities Services primarily reflected higher assets under management and higher customer balances in Securities Services. The increase in Investment Banking net revenues was due to significantly higher net revenues in debt underwriting and improved results in Financial Advisory, primarily reflecting an increase in industry-wide corporate activity, partially offset by lower net revenues in equity underwriting.

2004 versus 2003. Our net revenues were $20.55 billion in 2004, an increase of 28% compared with 2003, reflecting strong growth in Trading and Principal Investments, Asset Management and Securities Services, and Investment Banking. The increase in Trading and Principal Investments reflected significantly higher net revenues in FICC, as all major businesses and regions performed well in a generally favorable environment. Net revenues in our Principal Investments business also increased significantly, due to an unrealized gain on our investment in the convertible preferred stock of SMFG, as well as gains from other corporate principal investments. In addition, Equities net revenues improved, primarily reflecting higher customer-driven activity and favorable market conditions early in 2004. Equities operated in a less favorable environment after our first fiscal quarter of 2004, as volatility levels continued to decline and markets generally lacked direction before moving higher in the last several weeks of our fiscal year. Asset Management and Securities Services generated strong revenue growth, primarily reflecting higher assets under management, increased incentive fees and significantly higher customer balances in Securities Services. In Investment Banking, net revenues also increased, highlighted by strong growth in both our Financial Advisory and equity underwriting businesses, primarily reflecting an increase in industry-wide corporate activity.

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Operating Expenses

Our operating expenses are primarily influenced by compensation, headcount and levels of business activity. A substantial portion of our compensation expense represents discretionary bonuses, with our overall compensation and benefits expenses generally targeted at 50% (plus or minus a few percentage points) of consolidated net revenues. In addition to the level of net revenues, our compensation expense in any given year is influenced by, among other factors, prevailing labor markets, business mix and the structure of our equity-based compensation programs.

The following table sets forth our operating expenses and number of employees:

Operating Expenses and Employees
($ in millions)

                         
Year Ended November
2005 2004 2003
 
                       
Compensation and benefits (1) (2) (3)
  $ 11,688     $ 9,652     $ 7,515  
 
                       
Brokerage, clearing and exchange fees
    1,109       952       829  
Market development
    378       374       264  
Communications and technology
    490       461       478  
Depreciation and amortization
    501       499       562  
Amortization of identifiable intangible assets
    124       125       319  
Occupancy
    728       646       722  
Professional fees
    475       338       253  
Other expenses
    1,016       827       625  
 
                 
Total non-compensation expenses
    4,821       4,222       4,052  
 
                 
Total operating expenses
  $ 16,509     $ 13,874     $ 11,567  
 
                 
 
                       
Employees at year end (2) (3)
    22,425       20,722       19,476  
 
(1)   Includes the amortization of employee initial public offering and acquisition awards of $19 million, $61 million and $122 million for the years ended November 2005, November 2004 and November 2003, respectively.
 
(2)   Excludes 1,437, 1,206 and 1,228 employees as of November 2005, November 2004 and November 2003, respectively, of Goldman Sachs’ consolidated property management and loan servicing subsidiaries. Compensation and benefits includes $182 million, $164 million and $134 million for the years ended November 2005, November 2004 and November 2003, respectively, attributable to these subsidiaries, the majority of which is reimbursed to Goldman Sachs by the investment funds for which these subsidiaries manage properties and perform loan servicing. Such reimbursements are recorded in net revenues.
 
(3)   Excludes 7,143, 293 and 279 employees as of November 2005, November 2004 and November 2003, respectively, of consolidated entities held for investment purposes. Compensation and benefits includes $128 million, $11 million and $3 million for the years ended November 2005, November 2004 and November 2003, respectively, attributable to these consolidated entities. Consolidated entities held for investment purposes includes entities that are held strictly for capital appreciation, have a defined exit strategy and are engaged in activities that are not closely related to our principal businesses.

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The following table sets forth non-compensation expenses of consolidated entities held for investment purposes and our remaining non-compensation expenses by line item:

Non-Compensation Expenses
(in millions)

                         
Year Ended November
2005 2004 2003
 
                       
Non-compensation expenses of consolidated investments (1)
  $ 265     $ 21     $ 7  
 
                       
Non-compensation expenses excluding consolidated investments
                       
Brokerage, clearing and exchange fees
    1,109       952       829  
Market development
    361       374       264  
Communications and technology
    487       461       478  
Depreciation and amortization
    467       499       562  
Amortization of identifiable intangible assets
    124       125       319  
Occupancy
    674       646       722  
Professional fees
    468       338       253  
Other expenses
    866       806       618  
 
                 
Subtotal
    4,556       4,201       4,045  
 
                 
 
                       
Total non-compensation expenses, as reported
  $ 4,821     $ 4,222     $ 4,052  
 
                 
 
(1)   Consolidated entities held for investment purposes includes entities that are held strictly for capital appreciation, have a defined exit strategy and are engaged in activities that are not closely related to our principal businesses. For example, these investments include consolidated entities that hold real estate assets such as golf courses and hotels in Asia, but exclude investments in entities that primarily hold financial assets. We believe that it is meaningful to review non-compensation expenses excluding expenses related to these consolidated entities in order to evaluate trends in non-compensation expenses related to our principal business activities. Revenues related to such entities are included in “Trading and principal investments” in the consolidated statements of earnings.
 
   
 

2005 versus 2004. Operating expenses were $16.51 billion for 2005, 19% above 2004. Compensation and benefits expenses of $11.69 billion increased 21% compared with 2004, resulting from higher discretionary compensation, reflecting higher net revenues, and increased levels of employment. The ratio of compensation and benefits to net revenues for 2005 was 47.2% compared with 46.7% (2) for 2004. Employment levels increased 8% compared with November 2004.

Non-compensation expenses of $4.82 billion for 2005 increased 14% compared with 2004. Excluding non-compensation expenses related to consolidated entities held for investment purposes, non-compensation expenses were 8% higher than 2004, primarily due to higher brokerage, clearing and exchange fees, reflecting higher transaction volumes in FICC and Equities, increased professional fees, reflecting higher legal and consulting fees, and higher other expenses, primarily reflecting increased levels of business activity and higher charitable contributions.

Non-compensation expenses in 2005 included $37 million of net provisions for litigation and regulatory proceedings (included in other expenses) and $36 million of real estate costs associated with the relocation of office space (included in occupancy). Non-compensation expenses in 2004 included $103 million of net provisions for litigation and regulatory proceedings, $62 million in connection with the establishment of our joint venture in China (included in market development) and $41 million of real estate exit costs associated with reductions in our office space (included in occupancy and depreciation and amortization).

 
(2)   For the year ended November 2004, including the amortization of employee initial public offering and acquisition awards of $61 million, the ratio of compensation and benefits to net revenues was 47.0%.

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2004 versus 2003. Operating expenses were $13.87 billion for 2004, 20% above 2003. Compensation and benefits expenses of $9.65 billion increased 28% compared with 2003, due to higher discretionary compensation, reflecting higher net revenues, and increased employment levels. The ratio of compensation and benefits to net revenues for 2004 was 46.7% compared with 46.2% for 2003. (1) Employment levels increased 6% compared with November 2003.

Non-compensation expenses of $4.22 billion for 2004 increased 4% compared with 2003. Other expenses included net provisions for litigation and regulatory proceedings of $103 million for 2004 compared with $159 million for 2003. Excluding these provisions, other expenses increased $258 million, primarily due to the acquisition of consolidated investments, increased levels of business activity and higher charitable contributions. Brokerage, clearing and exchange fees increased, reflecting higher transaction volumes in certain of our businesses, and market development expenses were higher, primarily reflecting $62 million in connection with the establishment of our joint venture in China, as well as higher levels of business activity. In addition, professional fees were higher, primarily due to higher legal and consulting fees. These increases were partially offset by decreased amortization of identifiable intangible assets (2003 included impairment charges of $188 million, primarily in respect of option specialist rights) as well as lower occupancy and depreciation and amortization expenses. Total exit costs associated with reductions in our global office space (included in occupancy and depreciation and amortization) were $41 million for 2004 compared with $153 million for 2003.

Provision for Taxes

The effective income tax rate for 2005 was 32.0% compared with 31.8% for 2004. Excluding the impact of audit settlements in 2005, the effective income tax rate for 2005 would have been 33.3%. (2) Excluding the impact of audit settlements, the increase in the effective income tax rate for 2005 compared with 2004 was primarily due to a lower benefit from tax credits in 2005. The effective income tax rate for 2004 was 31.8%, down from 32.4% for 2003. The decrease in the effective income tax rate for 2004 as compared with 2003 reflected lower state and local taxes and the effect of audit settlements.

Our effective income tax rate can vary from period to period depending on, among other factors, the geographic and business mix of our earnings, the level of our tax credits and the effect of tax audits. Certain of these and other factors, including our history of pre-tax earnings, are taken into account in assessing our ability to realize our net deferred tax assets. See Note 14 to the consolidated financial statements in Part II, Item 8 of the Annual Report on Form 10-K for further information regarding our provision for taxes.

 
 
(1)   For the years ended November 2004 and November 2003, including the amortization of employee initial public offering and acquisition awards of $61 million and $122 million, respectively, the ratio of compensation and benefits to net revenues was 47.0% and 46.9%, respectively.
 
(2)   The effective income tax rate excluding the impact of audit settlements is calculated by dividing the provision for taxes, adjusted to exclude the impact of audit settlements, by pre-tax earnings. The impact of audit settlements decreased the effective income tax rate by 1.3% for 2005. We believe that the effective income tax rate excluding the impact of audit settlements provides a meaningful basis for period-to-period comparisons of our effective income tax rates.

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Segment Operating Results

The following table sets forth the net revenues, operating expenses and pre-tax earnings of our segments:

Segment Operating Results
(in millions)

                             
Year Ended November
2005 2004 2003
   
 
                       
Investment Banking  
Net revenues
  $ 3,671     $ 3,374     $ 2,711  
 
Operating expenses
    3,258       2,973       2,504  
 
 
                 
 
Pre-tax earnings
  $ 413     $ 401     $ 207  
   
 
                 
   
 
                       
Trading and Principal Investments  
Net revenues
  $ 16,362     $ 13,327     $ 10,443  
 
Operating expenses
    10,144       8,287       6,938  
 
 
                 
 
Pre-tax earnings
  $ 6,218     $ 5,040     $ 3,505  
   
 
                 
   
 
                       
Asset Management and Securities Services  
Net revenues
  $ 4,749     $ 3,849     $ 2,858  
 
Operating expenses
    3,070       2,430       1,890  
 
 
                 
 
Pre-tax earnings
  $ 1,679     $ 1,419     $ 968  
   
 
                 
   
 
                       
Total  
Net revenues
  $ 24,782     $ 20,550     $ 16,012  
 
Operating expenses (1)
    16,509       13,874       11,567  
 
 
                 
 
Pre-tax earnings
  $ 8,273     $ 6,676     $ 4,445  
   
 
                 
 
(1)   Includes the following expenses that have not been allocated to our segments: (i) the amortization of employee initial public offering awards, net of forfeitures, of $19 million and $80 million for the years ended November 2004 and November 2003, respectively; (ii) net provisions for a number of litigation and regulatory proceedings of $37 million, $103 million and $155 million for the years ended November 2005, November 2004 and November 2003, respectively; and (iii) $62 million in connection with the establishment of our joint venture in China for the year ended November 2004.
 
   
 

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. See Note 16 to the consolidated financial statements in Part II, Item 8 of the Annual Report on Form 10-K for further information regarding our segments.

The cost drivers of Goldman Sachs taken as a whole — compensation, headcount and levels of business activity — are broadly similar in each of our business segments. Compensation expenses within our segments reflect, among other factors, the overall performance of Goldman Sachs as well as the performance of individual business units. Consequently, pre-tax margins in one segment of our business may be significantly affected by the performance of our other business segments. A discussion of segment operating results follows.

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Investment Banking

Our Investment Banking segment is divided into two components:

    Financial Advisory. Financial Advisory includes advisory assignments with respect to mergers and acquisitions, divestitures, corporate defense activities, restructurings and spin-offs.
 
    Underwriting. Underwriting includes public offerings and private placements of equity, equity-related and debt instruments.

The following table sets forth the operating results of our Investment Banking segment:

Investment Banking Operating Results
(in millions)

                         
Year Ended November
2005 2004 2003
 
                       
Financial Advisory
  $ 1,905     $ 1,737     $ 1,202  
Equity underwriting
    704       819       678  
Debt underwriting
    1,062       818       831  
 
                 
Total Underwriting
    1,766       1,637       1,509  
 
                 
Total net revenues
    3,671       3,374       2,711  
Operating expenses
    3,258       2,973       2,504  
 
                 
Pre-tax earnings
  $ 413     $ 401     $ 207  
 
                 

 

The following table sets forth our financial advisory and underwriting transaction volumes:

Goldman Sachs Global Investment Banking Volumes (1)
(in billions)

                         
Year Ended November
2005 2004 2003
 
                       
Announced mergers and acquisitions
  $ 865     $ 403     $ 414  
Completed mergers and acquisitions
    599       502       355  
Equity and equity-related offerings (2)
    47       52       40  
Debt offerings (3)
    260       236       250  
 
(1)   Source: Thomson Financial. Announced and completed mergers and acquisitions volumes are based on full credit to each of the advisors in a transaction. Equity and equity-related offerings and debt offerings are based on full credit for single book managers and equal credit for joint book managers. Transaction volumes may not be indicative of net revenues in a given period.
 
(2)   Includes public common stock offerings and convertible offerings.
 
(3)   Includes non-convertible preferred stock, mortgage-backed securities, asset-backed securities and taxable municipal debt. Includes publicly registered and Rule 144A issues.

 

2005 versus 2004. Net revenues in Investment Banking of $3.67 billion for 2005 increased 9% compared with 2004. Net revenues in Financial Advisory of $1.91 billion increased 10% compared with 2004, primarily reflecting an increase in industry-wide completed mergers and acquisitions. Net revenues in our Underwriting business of $1.77 billion increased 8% compared with 2004, reflecting higher net revenues in debt underwriting, primarily due to an increase in leveraged finance and mortgage activity, partially offset by lower net revenues in equity underwriting. Our investment banking backlog at the end of 2005 was significantly higher than at the end of 2004. (4)

 
(4)   Our investment banking backlog represents an estimate of our future net revenues from investment banking transactions where we believe that future revenue realization is more likely than not.

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Operating expenses of $3.26 billion for 2005 increased 10% compared with 2004, primarily due to increased compensation and benefits expenses resulting from higher levels of discretionary compensation and increased amortization expense related to prior year equity awards. In addition, other expenses increased principally due to higher levels of business activity, and professional fees were higher driven by increased legal and consulting fees. Pre-tax earnings of $413 million in 2005 increased 3% compared with 2004.

2004 versus 2003. Net revenues in Investment Banking of $3.37 billion for 2004 increased 24% compared with 2003. Net revenues in Financial Advisory of $1.74 billion increased 45% compared with 2003, primarily reflecting a significant increase in industry-wide completed mergers and acquisitions. Net revenues in our Underwriting business of $1.64 billion increased 8% compared with 2003, reflecting a significant increase in industry-wide public common stock offerings and industry-wide initial public offerings. The increase in Investment Banking net revenues primarily reflects higher levels of activity in the industrial and consumer sectors. Our investment banking backlog at the end of 2004 was higher than at the end of 2003. (1)

Operating expenses of $2.97 billion for 2004 increased 19% compared with 2003, primarily due to increased compensation and benefits expenses resulting from higher discretionary compensation and increased levels of employment. These increases were partially offset by lower occupancy expenses, primarily reflecting lower exit costs associated with reductions in our global office space, and reduced amortization of identifiable intangible assets, as 2003 included impairment charges in respect of certain distribution rights. Depreciation and amortization expenses were also lower. Pre-tax earnings of $401 million in 2004 increased 94% compared with 2003.

Trading and Principal Investments

Our Trading and Principal Investments segment is divided into three components:

    FICC. We make markets in and trade interest rate and credit products, mortgage-backed securities and loans, currencies, and commodities, structure and enter into a wide variety of derivative transactions and engage in proprietary trading and investing.
 
    Equities. We make markets in, trade and act as a specialist for equities and equity-related products, structure and enter into equity derivative transactions and engage in proprietary trading. We also execute and clear client transactions on major stock, options and futures exchanges worldwide.
 
    Principal Investments. We generate net revenues from our corporate and real estate merchant banking investments, including the increased share of the income and gains derived from our merchant banking funds when the return on a fund’s investments exceeds certain threshold returns (merchant banking overrides), as well as gains or losses related to our investment in the convertible preferred stock of SMFG.

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 generated from our merchant banking funds. These management fees are included in the net revenues of the Asset Management and Securities Services segment.

 
 
(1)   Our investment banking backlog represents an estimate of our future net revenues from investment banking transactions where we believe that future revenue realization is more likely than not.

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The following table sets forth the operating results of our Trading and Principal Investments segment:

Trading and Principal Investments Operating Results
(in millions)

                         
Year Ended November
2005 2004 2003
 
                       
FICC
  $ 8,484     $ 7,322     $ 5,596  
 
Equities trading
    2,675       1,969       1,738  
Equities commissions
    2,975       2,704       2,543  
 
                 
Total Equities
    5,650       4,673       4,281  
 
SMFG
    1,475       771       293  
Gross gains
    767       855       593  
Gross losses
    (198 )     (399 )     (437 )
 
                 
Net other corporate and real estate investments
    569       456       156  
Overrides
    184       105       117  
 
                 
Total Principal Investments
    2,228       1,332       566  
 
                 
Total net revenues
    16,362       13,327       10,443  
Operating expenses
    10,144       8,287       6,938  
 
                 
Pre-tax earnings
  $ 6,218     $ 5,040     $ 3,505  
 
                 

 

2005 versus 2004. Net revenues in Trading and Principal Investments of $16.36 billion for 2005 increased 23% compared with 2004. Net revenues in FICC of $8.48 billion increased 16% compared with 2004, primarily reflecting significantly higher net revenues in credit products (which includes distressed investing) and, to a lesser extent, interest rate products and currencies. Net revenues in commodities and mortgages were strong, but essentially unchanged compared with 2004. During 2005, FICC operated in an environment generally characterized by strong customer-driven activity, tight, but volatile, credit spreads, higher energy prices and a flatter yield curve. Net revenues in Equities of $5.65 billion increased 21% compared with 2004, reflecting significantly higher net revenues in our customer franchise and principal strategies businesses. The increase in our customer franchise businesses reflected improved results in derivatives and shares, particularly in Europe and Asia, as well as in convertibles. In addition, results in principal strategies reflected strength across all regions. During 2005, Equities operated in an environment characterized by generally higher equity prices, improved customer-driven activity and continued low levels of market volatility. Principal Investments recorded net revenues of $2.23 billion, due to a $1.48 billion gain related to our investment in the convertible preferred stock of SMFG and $753 million in gains and overrides from other corporate and, to a lesser extent, real estate principal investments.

Operating expenses of $10.14 billion for 2005 increased 22% compared with 2004, primarily due to increased compensation and benefits expenses, reflecting higher discretionary compensation and increased levels of employment and, to a lesser extent, higher non-compensation expenses related to consolidated entities held for investment purposes. Excluding non-compensation expenses related to consolidated entities held for investment purposes, the increase in non-compensation expenses was primarily attributable to higher brokerage, clearing and exchange fees, principally due to increased transaction volumes in FICC and Equities, and higher professional fees, due to increased legal and consulting fees. Pre-tax earnings of $6.22 billion in 2005 increased 23% compared with 2004.

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2004 versus 2003. Net revenues in Trading and Principal Investments of $13.33 billion for 2004 increased 28% compared with 2003. Net revenues in FICC of $7.32 billion increased 31% compared with 2003, primarily due to significantly higher net revenues in credit products and commodities, as well as improved performances in currencies and mortgages. In addition, net revenues in interest rate products were strong, but were lower compared with 2003. During 2004, FICC operated in an environment generally characterized by strong customer-driven activity, rising energy prices, narrow corporate credit spreads and low, although rising, interest rates. The yield curve remained steep in 2004, but flattened in the second half of the year. Net revenues in Equities of $4.67 billion increased 9% compared with 2003, reflecting higher net revenues in our customer franchise business, primarily due to increased activity in shares and derivatives. In addition, net revenues were higher in our principal strategies business. During 2004, Equities operated in an environment characterized by improved customer-driven activity, particularly early in the year, and generally higher equity prices. However, volatility levels continued to decline during 2004. Principal Investments recorded net revenues of $1.33 billion, primarily due to an unrealized gain related to our investment in the convertible preferred stock of SMFG of $771 million, as well as gains and overrides from other corporate principal investments.

Operating expenses of $8.29 billion for 2004 increased 19% compared with 2003, primarily due to increased compensation and benefits expenses resulting from higher discretionary compensation and increased levels of employment. Other expenses also increased, principally due to the acquisition of consolidated investments and increased levels of business activity. In addition, brokerage, clearing and exchange fees were higher, reflecting higher transaction volumes in certain of our businesses, professional fees increased, primarily due to higher consulting and legal fees, and market development expenses increased, primarily due to higher levels of business activity. These increases were partially offset by lower amortization of identifiable intangible assets, as 2003 included impairment charges in respect of option specialist rights. In addition, occupancy expenses decreased, primarily reflecting lower exit costs associated with reductions in our global office space, and depreciation and amortization expenses were lower. Pre-tax earnings of $5.04 billion in 2004 increased 44% compared with 2003.

Asset Management and Securities Services

Our Asset Management and Securities Services segment is divided into two components:

    Asset Management. Asset Management provides investment advisory and financial planning services and offers investment products across all major asset classes to a diverse group of institutions and individuals worldwide and primarily generates revenues in the form of management and incentive fees.
 
    Securities Services. Securities Services provides prime brokerage services, financing services and securities lending services to mutual funds, pension funds, hedge funds, foundations and high-net-worth individuals worldwide, and generates revenues primarily in the form of interest rate spreads or fees.

Assets under management typically generate fees as a percentage of asset value. In certain circumstances, we are also entitled to receive asset management incentive fees based on a percentage of a fund’s return or when the return on assets under management exceeds specified benchmark returns or other performance targets. Incentive fees are recognized when the performance period ends and they are no longer subject to adjustment. We have numerous incentive fee arrangements, many of which have annual performance periods that end on December 31 and are not subject to adjustment thereafter. For that reason, incentive fees are seasonally weighted each year to our first fiscal quarter. Depending on the level of net revenues in our first fiscal quarter of 2006, these incentive fees may be material to the results of operations in that quarter.

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The following table sets forth the operating results of our Asset Management and Securities Services segment:

Asset Management and Securities Services Operating Results
(in millions)

                         
Year Ended November
2005 2004 2003
 
                       
Asset Management
  $ 2,956     $ 2,553     $ 1,853  
Securities Services
    1,793       1,296       1,005  
 
                 
Total net revenues
    4,749       3,849       2,858  
Operating expenses
    3,070       2,430       1,890  
 
                 
Pre-tax earnings
  $ 1,679     $ 1,419     $ 968  
 
                 

 

Assets under management include our mutual funds, alternative investment funds and separately managed accounts for institutional and individual investors. 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
(in billions)

                         
As of November 30
2005 2004 2003
 
                       
Money markets
  $ 101     $ 90     $ 89  
Fixed income and currency
    159       139       115  
Equity (1)
    158       126       98  
Alternative investments (2)
    114       97       71  
 
                 
Total
  $ 532     $ 452     $ 373  
 
                 
 
(1)   Includes both our fundamental equity and quantitative equity strategies.
 
(2)   Primarily includes private equity funds, hedge funds, real estate funds, certain currency and asset allocation strategies and other assets allocated to external investment managers.

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The following table sets forth a summary of the changes in our assets under management:

Changes in Assets Under Management
(in billions)

                         
Year Ended November 30
2005 2004 2003 (1)
 
                       
Balance, beginning of year
  $ 452     $ 373     $ 348  
 
                       
Net asset inflows/(outflows)
                       
Money markets
    11       1       (19 )
Fixed income and currency
    18       14       10  
Equity
    20       13       (1 )
Alternative investments
    14       24       6  
 
                 
Total net asset inflows/(outflows)
    63       52       (4 )
 
                       
Net market appreciation/(depreciation)
    17       27       29  
 
                 
Balance, end of year
  $ 532     $ 452     $ 373  
 
                 
 
(1)   Includes $4 billion in non-money market assets from our acquisition of Ayco and $16 billion in non-money market net asset outflows resulting from British Coal Pension Schemes’ planned program of diversification among its asset managers.

 

2005 versus 2004. Net revenues in Asset Management and Securities Services of $4.75 billion for 2005 increased 23% compared with 2004. Asset Management net revenues of $2.96 billion increased 16% compared with 2004, primarily due to higher management fees, driven by growth in assets under management. During 2005, assets under management increased 18% to $532 billion, reflecting net asset inflows of $63 billion across all asset classes as well as market appreciation of $17 billion, primarily in equity assets. Securities Services net revenues of $1.79 billion for 2005 increased 38% compared with 2004, primarily reflecting significantly higher global customer balances in securities lending and margin lending.

Operating expenses of $3.07 billion for 2005 increased 26% compared with 2004, primarily due to increased compensation and benefits expenses resulting from higher discretionary compensation and increased levels of employment. Other expenses also increased and professional fees were higher, principally due to increased consulting and legal fees. Pre-tax earnings of $1.68 billion increased 18% compared with 2004.

2004 versus 2003. Net revenues in Asset Management and Securities Services of $3.85 billion for 2004 increased 35% compared with 2003. Asset Management net revenues of $2.55 billion increased 38% compared with 2003, primarily due to higher assets under management, significantly higher incentive fees and a full year contribution from Ayco. During 2004, assets under management increased 21% to $452 billion, reflecting net asset inflows of $52 billion across all asset classes, as well as market appreciation of $27 billion, primarily in equity and fixed income assets. Securities Services net revenues of $1.30 billion increased 29% compared with 2003, primarily due to significantly higher customer balances in securities lending and margin lending.

Operating expenses of $2.43 billion for 2004 increased 29% compared with 2003, primarily due to increased compensation and benefits expenses resulting from higher discretionary compensation and increased levels of employment. In addition, other expenses increased, principally due to higher levels of business activity, including increased Asset Management distribution costs. Professional fees were also higher, primarily reflecting increased legal and consulting fees. These increases were partially offset by lower depreciation and amortization and occupancy expenses, primarily reflecting lower exit costs associated with reductions in our global office space. Pre-tax earnings of $1.42 billion increased 47% compared with 2003.

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Geographic Data

For a summary of the net revenues and pre-tax earnings of Goldman Sachs by geographic region, see Note 16 to the consolidated financial statements in Part II, Item 8 of the Annual Report on Form 10-K.

Off-Balance-Sheet Arrangements

We have various types of off-balance-sheet arrangements that we enter into in the ordinary course of business. Our involvement in these arrangements can take many different forms, including purchasing or retaining residual and other interests in mortgage-backed and other asset-backed securitization vehicles; holding senior and subordinated debt, interests in limited and general partnerships, and preferred and common stock in other nonconsolidated vehicles; entering into interest rate, foreign currency, equity, commodity and credit derivatives; entering into operating leases; and providing guarantees, indemnifications, loan commitments, letters of credit, representations and warranties.

We enter into these arrangements for a variety of business purposes, primarily related to the securitization of commercial and residential mortgages, home equity and auto loans, government and corporate bonds, and other types of financial assets. Other reasons for entering into these arrangements include underwriting client securitization transactions; providing secondary market liquidity; making investments in performing and nonperforming debt, equity, real estate and other assets; providing investors with credit-linked and asset-repackaged notes; and receiving or providing letters of credit to satisfy margin requirements and to facilitate the clearance and settlement process.

Variable interest entities (VIEs) and qualifying special-purpose entities (QSPEs) are critical to the functioning of several significant investor markets, including the mortgage-backed and other asset-backed securities markets, since they provide market liquidity to financial assets by offering investors access to specific cash flows and risks created through the securitization process. Our financial interests in, and derivative transactions with, such nonconsolidated entities are accounted for at fair value, in the same manner as our other financial instruments, except in cases where we exert significant influence over an entity and apply the equity method of accounting.

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The following table sets forth where a discussion of these and other off-balance-sheet arrangements may be found in Part II, Items 7 and 8 of the Annual Report on Form 10-K:

     
Type of Off-Balance-Sheet Arrangement Disclosure in Annual Report on Form 10-K
 
 
   
Retained interests or contingent interests in assets transferred by us to nonconsolidated entities
  See Note 3 to the consolidated financial statements in Part II, Item 8 of the Annual Report on Form 10-K.
 
   
Other obligations, including contingent obligations, arising out of variable interests we have in nonconsolidated entities
  See Note 3 to the consolidated financial statements in Part II, Item 8 of the Annual Report on Form 10-K.
 
   
Derivative contracts
  See “—  Critical Accounting Policies” above and
“—  Risk Management” below and Note 3 to the consolidated financial statements in Part II, Item 8 of the Annual Report on Form 10-K.
 
   
Guarantees
  See Note 6 to the consolidated financial statements in Part II, Item 8 of the Annual Report on Form 10-K.
 
   
Leases, letters of credit, and loans and other commitments
  See “—  Capital and Funding” below and Note 6 to the consolidated financial statements in Part II, Item 8 of the Annual Report on Form 10-K.
 

In addition, see Note 2 to the consolidated financial statements in Part II, Item 8 of the Annual Report on Form 10-K for a discussion of our consolidation policies.

Capital and Funding

Capital

The amount of capital we hold is principally determined by regulatory capital requirements, rating agency guidelines, subsidiary capital requirements and our overall risk profile, which is largely driven by the size and composition of our trading and investing positions. Goldman Sachs’ total capital (total shareholders’ equity and long-term borrowings) increased 21% to $128.01 billion as of November 2005 compared with $105.78 billion as of November 2004. See “— Risk Management — Liquidity Risk — Cash Flows” below for a discussion of how we deployed capital raised as part of our financing activities.

The increase in total capital resulted primarily from an increase in long-term borrowings to $100.01 billion as of November 2005 from $80.70 billion as of November 2004. The weighted average maturity of our long-term borrowings as of November 2005 was approximately seven 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. See Note 5 to the consolidated financial statements in Part II, Item 8 of the Annual Report on Form 10-K for further information regarding our long-term borrowings.

Over the past several years, our ratio of long-term borrowings to total shareholders’ equity has been increasing. The growth in our long-term borrowings has been driven primarily by (i) our ability to replace a portion of our short-term borrowings with long-term borrowings and pre-fund near-term refinancing requirements, in light of the favorable debt financing environment, and (ii) the need to increase total capital in response to growth in our trading and investing businesses.

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Total shareholders’ equity increased by 12% to $28.00 billion (common equity of $26.25 billion and preferred stock of $1.75 billion) as of November 2005 from $25.08 billion as of November 2004. During 2005, Goldman Sachs issued 70,000 shares of preferred stock in three series as set forth in the following table:

Preferred Stock by Series

                                     
Shares Shares Earliest Redemption Value
Series Description Date Issued Issued Authorized Redemption Date (in millions)
   
 
                               
A  
Perpetual Floating Rate
  April 25, 2005     30,000       50,000     April 25, 2010   $ 750  
   
Non-Cumulative
                               
   
 
                               
B  
Perpetual 6.20%
  October 31,  2005     32,000       50,000     October 31,  2010     800  
   
Non-Cumulative
                               
   
 
                               
C  
Perpetual Floating Rate
  October 31,  2005     8,000       25,000     October 31,  2010     200  
   
Non-Cumulative
                               
   
 
                         
   
 
        70,000       125,000         $ 1,750  
   
 
                         

 

Each share of preferred stock has a par value of $0.01, has a liquidation preference of $25,000, is represented by
1,000 depositary shares and is redeemable at our option at a redemption price equal to $25,000 plus declared and unpaid dividends. Our ability to declare or pay dividends on, or purchase, redeem or otherwise acquire, our common stock is subject to certain restrictions in the event we fail to pay or set aside full dividends on our preferred stock for the latest completed dividend period. All preferred stock also has a preference over our common stock upon liquidation.

Our stock repurchase program is intended to help maintain our total shareholders’ equity at appropriate levels and to substantially offset increases in share count over time resulting from employee equity-based compensation. The repurchase program has been effected primarily through regular open-market purchases and is influenced by, among other factors, the level of our common shareholders’ equity, our overall capital position, employee equity awards granted and exercises of employee stock options, the prevailing market price of our common stock and general market conditions.

During 2005, we repurchased 63.7 million shares of our common stock at a total cost of $7.11 billion, and during 2004, we repurchased 18.7 million shares of our common stock at a total cost of $1.81 billion. The average price paid per share for repurchased shares was $111.57 and $96.29 for the years ended November 2005 and November 2004, respectively. The increase in the level of repurchases in 2005 compared with 2004 primarily reflects our decision to manage the growth of our common shareholders’ equity. In addition, to satisfy minimum statutory employee tax withholding requirements related to the delivery of shares underlying restricted stock units, we cancelled 1.6 million restricted stock units at a total cost of $163 million in 2005 and we cancelled 9.1 million restricted stock units at a total cost of $870 million in 2004. As of November 2005, we were authorized to repurchase up to 42.7 million additional shares of stock pursuant to our repurchase program. For additional information on our repurchase program, see “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” in Part II, Item 5 of the Annual Report on Form 10-K.

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The following table sets forth information on our assets, shareholders’ equity, leverage ratios and book value per common share:

                 
As of November
2005 2004
($ in millions, except per
share amounts)
 
               
Total assets
  $ 706,804     $ 531,379  
Adjusted assets (1)
    466,019       347,082  
Total shareholders’ equity
    28,002       25,079  
Tangible equity capital (2)
    25,549       22,958  
Leverage ratio (3)
    25.2x       21.2x  
Adjusted leverage ratio (4)
    18.2x       15.1x  
Debt to equity ratio (5)
    3.6x       3.2x  
 
               
Common shareholders’ equity
    26,252       25,079  
Tangible common shareholders’ equity (6)
    21,049       20,208  
 
               
Book value per common share (7)
  $ 57.02     $ 50.77  
Tangible book value per common share (8)
    45.72       40.91  
 
(1)   Adjusted assets excludes (i) low-risk collateralized assets generally associated with our matched book and securities lending businesses (which we calculate by adding our securities purchased under agreements to resell and securities borrowed, and then subtracting our nonderivative short positions), (ii) cash and securities we segregate for regulatory and other purposes and (iii) goodwill and identifiable intangible assets. The following table sets forth a reconciliation of total assets to adjusted assets:
                     
As of November
2005 2004
(in millions)
   
 
               
Total assets
  $ 706,804     $ 531,379  
   
 
               
Deduct:  
Securities purchased under agreements to resell
    (83,619 )     (44,257 )
   
 
               
   
Securities borrowed
    (191,800 )     (155,086 )
   
 
               
Add:  
Financial instruments sold, but not yet purchased, at fair value
    149,071       132,097  
   
 
               
   
Less derivative liabilities
    (57,829 )     (64,001 )
   
 
           
   
Subtotal
    91,242       68,096  
   
 
               
Deduct:  
Cash and securities segregated for regulatory and other purposes
    (51,405 )     (48,179 )
   
 
               
   
Goodwill and identifiable intangible assets
    (5,203 )     (4,871 )
   
 
           
Adjusted assets
  $ 466,019     $ 347,082  
   
 
           
(2)   Tangible equity capital equals total shareholders’ equity and junior subordinated debt issued to a trust less goodwill and identifiable intangible assets. We consider junior subordinated debt issued to a trust to be a component of our tangible equity capital base due to the inherent characteristics of these securities, including the long-term nature of the securities, our ability to defer coupon interest for up to ten consecutive semiannual periods and the subordinated nature of the obligations in our capital structure. The following table sets forth the reconciliation of total shareholders’ equity to tangible equity capital:
                     
As of November
2005 2004
(in millions)
   
 
               
Total shareholders’ equity
  $ 28,002     $ 25,079  
   
 
               
Add:  
Junior subordinated debt issued to a trust
    2,750       2,750  
   
 
               
Deduct:  
Goodwill and identifiable intangible assets
    (5,203 )     (4,871 )
   
 
           
Tangible equity capital
  $ 25,549     $ 22,958  
   
 
           

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(3)   Leverage ratio equals total assets divided by total shareholders’ equity.
 
(4)   Adjusted leverage ratio equals adjusted assets divided by tangible equity capital. We believe that the adjusted leverage ratio is a more meaningful measure of our capital adequacy than the leverage ratio because it excludes certain low-risk collateralized assets that are generally supported with little or no capital and reflects the tangible equity capital deployed in our businesses.
 
(5)   Debt to equity ratio equals long-term borrowings divided by total shareholders’ equity.
 
(6)   Tangible common shareholders’ equity equals total shareholders’ equity less preferred stock and goodwill and identifiable intangible assets. The following table sets forth a reconciliation of total shareholders’ equity to tangible common shareholders’ equity:
                     
As of November
2005 2004
(in millions)
   
 
               
Total shareholders’ equity
  $ 28,002     $ 25,079  
   
 
               
Deduct:  
Preferred stock
    (1,750 )      
   
 
           
Common shareholders’ equity
  $ 26,252     $ 25,079  
   
 
               
Deduct:  
Goodwill and identifiable intangible assets
    (5,203 )     (4,871 )
   
 
           
Tangible common shareholders’ equity
  $ 21,049     $ 20,208  
   
 
           
(7)   Book value per common share is based on common shares outstanding, including restricted stock units granted to employees with no future service requirements, of 460.4 million and 494.0 million as of November 2005 and November 2004, respectively.
 
(8)   Tangible book value per common share is computed by dividing tangible common shareholders’ equity by the number of common shares outstanding, including restricted stock units granted to employees with no future service requirements.

 

Short-Term Borrowings

Goldman Sachs obtains secured and unsecured short-term borrowings primarily through the issuance of promissory notes, commercial paper and bank loans. Short-term borrowings also include the portion of long-term borrowings maturing within one year of our financial statement date and certain long-term borrowings that are redeemable within one year of our financial statement date at the option of the holder.

The following table sets forth our short-term borrowings by product:

Short-Term Borrowings
(in millions)

                 
As of November
2005 2004
 
               
Promissory notes
  $ 17,339     $ 19,513  
Commercial paper
    5,154       4,355  
Bank loans and other
    15,975       13,474  
Current portion of long-term borrowings
    16,751       17,617  
 
           
Total
  $ 55,219     $ 54,959  
 
           

 

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 (short-term unsecured debt that is nontransferable and in which Goldman Sachs does not make a market) and commercial paper have no obligation to purchase new instruments when the outstanding instruments mature.

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The following table sets forth our secured and unsecured short-term borrowings:

                 
As of November
2005 2004
(in millions)
 
               
Secured short-term borrowings
  $ 7,972     $ 8,558  
Unsecured short-term borrowings
    47,247       46,401  
 
           
Total short-term borrowings
  $ 55,219     $ 54,959  
 
           

 

A large portion of our secured short-term borrowings are similar in nature to our other collateralized financing sources such as securities sold under agreements to repurchase. These secured short-term borrowings provide Goldman Sachs with a more stable source of liquidity than unsecured short-term borrowings, as they are less sensitive to changes in our credit ratings due to underlying collateral. Our unsecured short-term borrowings include extendible debt if the earliest maturity occurs within one year of our financial statement date. Extendible debt is debt that allows the holder the right to extend the maturity date at predetermined periods during the contractual life of the instrument. These borrowings can be, and in the past generally have been, extended. See “— Risk Management — Liquidity Risk” below for a discussion of the principal liquidity policies we have in place to manage the liquidity risk associated with our short-term borrowings. For a discussion of factors that could impair our ability to access the capital markets, see “— Certain Risk Factors That May Affect Our Business” above. See Note 4 to the consolidated financial statements in Part II, Item 8 of the Annual Report on Form 10-K for further information regarding our short-term borrowings.

Credit Ratings

We rely upon the short-term and long-term debt capital markets to fund a significant portion of our 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 OTC derivatives. We believe our credit ratings are primarily based on the credit rating agencies’ assessment of our liquidity, market, credit and operational risk management practices, the level and variability of our earnings, our capital base, our franchise, reputation and management, our corporate governance and the external operating environment. See “— Certain Risk Factors That May Affect Our Business” above for a discussion of the risks associated with a reduction in our credit ratings.

The following table sets forth our unsecured credit ratings as of November 2005:

             
Short-Term Debt Long-Term Debt Preferred Stock
 
           
Dominion Bond Rating Service Limited (1)
  R-1 (middle)   A (high)   N/A
Fitch, Inc.  
  F1+   AA-   A+
Moody’s Investors Service
  P-1   Aa3   A2
Standard & Poor’s (2)
  A-1   A+   A-
 
(1)   On November 22, 2005, Dominion Bond Rating Service Limited placed Goldman Sachs’ long-term debt issuer rating “under review with positive implications.”
 
(2)   On October 11, 2005, Standard & Poor’s affirmed Goldman Sachs’ long-term debt rating and revised its outlook from “stable” to “positive.”

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As of November 2005, collateral or termination payments pursuant to bilateral agreements with certain counterparties of approximately $384 million would have been required in the event of a one-level reduction in our long-term credit ratings. In evaluating our liquidity requirements, we consider additional collateral or termination payments that would be required in the event of further reductions in our long-term credit ratings, as well as collateral that has not been called by counterparties, but is available to them. For a further discussion of our excess liquidity policies, see “— Risk Management — Liquidity Risk — Excess Liquidity — Maintenance of a Pool of Highly Liquid Securities” below.

Contractual Obligations and Contingent Commitments

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 November 2005:

Contractual Obligations
(in millions)

                                         
2007- 2009- 2011-  
2006 2008 2010 Thereafter Total
 
                                       
Long-term borrowings by contract
maturity (1) (2)
  $     $ 23,613     $ 26,444     $ 49,950     $ 100,007  
Minimum rental payments
    399       875       594       2,134       4,002  
 
(1)   Long-term borrowings maturing within one year of our financial statement date and certain long-term borrowings that are redeemable within one year of our financial statement date at the option of the holder are included as short-term borrowings in the consolidated statements of financial condition.
 
(2)   Long-term borrowings repayable at the option of Goldman Sachs are reflected at their contractual maturity dates. Certain long-term borrowings that are redeemable prior to maturity at the option of the holder are reflected at the dates such options become exercisable.

 

As of November 2005, our long-term borrowings were $100.01 billion and consisted principally of senior borrowings with maturities extending to 2035. These long-term borrowings consisted of $15.67 billion in secured long-term borrowings and $84.34 billion in unsecured long-term borrowings. As of November 2005, long-term borrowings included nonrecourse debt of $13.63 billion, consisting of $5.11 billion issued by William Street Funding Corporation (a wholly owned subsidiary of Group Inc. formed to raise funding to support loan commitments to investment-grade clients made by another wholly owned William Street entity), and $8.52 billion issued by other consolidated entities, of which $1.33 billion was related to our power generation facilities. Nonrecourse debt is debt that only the issuing subsidiary or, if applicable, a subsidiary guaranteeing the debt is obligated to repay. See Note 5 to the consolidated financial statements in Part II, Item 8 of the Annual Report on Form 10-K for further information regarding our long-term borrowings.

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The following table sets forth our quarterly long-term borrowings maturity profile through fiscal 2011:

Long-Term Borrowings Maturity Profile
($ in millions)

LONG-TERM BORROWINGS MATURITY PROFILE CHART

 
(1)   Our long-term borrowings include extendible debt if the earliest maturity is one year or greater from our financial statement date. Extendible debt is categorized in the maturity profile at the earliest possible maturity date even though the debt can be, and in the past generally has been, extended.

 

As of November 2005, our future minimum rental payments, net of minimum sublease rentals, under noncancelable leases were $4.00 billion. These lease commitments, principally for office space, expire on various dates through 2069. Certain agreements are subject to periodic escalation provisions for increases in real estate taxes and other charges.

During our third fiscal quarter of 2005, we announced plans for a new world headquarters in New York City, with initial occupancy scheduled for 2009, at an expected cost of $2.3 billion to $2.5 billion. Goldman Sachs will partially finance the project with tax-exempt Liberty Bonds. As of November 2005, we borrowed approximately $1.4 billion through the issuance of Liberty Bonds and may borrow up to an additional $250 million through the issuance of additional Liberty Bonds before 2010. As of November 2005, we had outstanding construction-related commitments of $47 million in connection with this project. Included in our future minimum rental payments under noncancelable lease agreements is $309 million related to a 64-year ground lease for the land on which our world headquarters will be constructed, of which $161 million is a lump-sum payment due by June 2007. See Note 6 to the consolidated financial statements in Part II, Item 8 of the Annual Report on Form 10-K for further information regarding our leases.

Our occupancy expenses include costs associated with office space held in excess of our current requirements. This excess space, the cost of which is charged to earnings as incurred, is being held for potential growth or to replace currently occupied space that we may exit in the future. We regularly evaluate our current and future space capacity in relation to current and projected staffing levels. We may incur exit costs in 2006 and thereafter to the extent we (i) reduce our space capacity or (ii) commit to, or occupy, new properties in the locations in which we operate and, consequently, dispose of existing space that had been held for potential growth. These exit costs may be material to our results of operations in a given period.

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The following table sets forth our contingent commitments as of November 2005:

Contingent Commitments
(in millions)

                                         
Commitment Amount by Period of Expiration
2007- 2009- 2011-  
2006 2008 2010 Thereafter Total
 
                                       
Commitments to extend credit
                                       
William Street program
  $ 1,811     $ 1,788     $ 9,385     $ 1,521     $ 14,505  
Other commercial lending:
                                       
Investment-grade
    9,592       5,893       1,008       1,099       17,592  
Non-investment-grade
    1,783       1,361       3,569       11,823       18,536  
Warehouse financing
    7,614       2,746       10       119       10,489  
 
                             
Total commitments to extend credit
    20,800       11,788       13,972       14,562       61,122  
Commitments under letters of credit issued by banks to counterparties
    9,205       17       12             9,234  
Other commercial commitments (1)
    1,069       324       3,127       238       4,758  
 
                             
Total
  $ 31,074     $ 12,129     $ 17,111     $ 14,800     $ 75,114  
 
                             
 
(1)   Includes our corporate and real estate investment fund commitments, construction-related commitments and other purchase commitments.

 

Our commitments to extend credit are agreements to lend to counterparties that have fixed termination dates and are contingent on the satisfaction of all conditions to borrowing set forth in the contract. In connection with our lending activities, we had outstanding commitments of $61.12 billion as of November 2005 compared with $27.72 billion as of November 2004. The increase primarily related to our commercial lending activities outside the William Street credit extension program, and such commitments were generally extended in connection with contingent acquisition financing and other types of corporate lending. Since these commitments may expire unused, the total commitment amount does not necessarily reflect the actual future cash flow requirements. We may reduce our credit risk on these commitments by syndicating all or substantial portions of commitments to other investors. In addition, commitments that are extended for contingent acquisition financing are often short-term in nature, as borrowers often replace them with other funding sources. With respect to the William Street credit extension program, substantially all of the commitments extended are to investment-grade corporate borrowers. With respect to these commitments, we have credit loss protection provided to us by SMFG, which is generally limited to 95% of the first loss we realize on approved loan commitments, subject to a maximum of $1.00 billion. In addition, subject to the satisfaction of certain conditions, upon our request, SMFG will provide protection for 70% of the second loss on such commitments, subject to a maximum of $1.13 billion. We also use other financial instruments to hedge certain William Street commitments not covered by SMFG.

As of November 2005, we had commitments to enter into forward secured financing transactions, including certain repurchase and resale agreements and secured borrowing and lending arrangements, of $49.93 billion.

See Note 6 to the consolidated financial statements in Part II, Item 8 of the Annual Report on Form 10-K for further information regarding our commitments, contingencies and guarantees.

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Regulation

During our second fiscal quarter of 2005, Goldman Sachs became regulated by the U.S. Securities and Exchange Commission (SEC) as a Consolidated Supervised Entity (CSE). As such, Goldman Sachs is subject to group-wide supervision and examination by the SEC and is subject to minimum capital requirements on a consolidated basis. As of November 2005, Goldman Sachs was in compliance with the CSE capital requirements.

The European Union’s European Financial Groups Directive (Directive 2002/87/EC) introduced certain changes to the way financial conglomerates and other financial services organizations operating in Europe are regulated. As a result of these changes, activities that are conducted in otherwise unregulated entities are now subject to certain forms of regulation, including consolidated supervision and capital adequacy requirements. The measures we have taken to comply with the directive include becoming regulated as a CSE.

In addition, many of our principal subsidiaries are subject to separate regulation in the United States and/or elsewhere. Goldman, Sachs & Co. and Goldman Sachs Execution & Clearing, L.P. are registered U.S. broker-dealers and futures commissions merchants, and their primary regulators include the SEC, the Commodity Futures Trading Commission, the Chicago Board of Trade, the NYSE, the National Association of Securities Dealers, Inc. and the National Futures Association. Goldman Sachs International, a regulated U.K. broker-dealer, is subject to regulation primarily by the Financial Services Authority. Goldman Sachs (Japan) Ltd., a regulated broker-dealer based in Tokyo, is subject to regulation by the Financial Services Agency, the Tokyo Stock Exchange, the Osaka Securities Exchange, The Tokyo International Financial Futures Exchange, the Japan Securities Dealers Association, the Tokyo Commodity Exchange, and the Ministry of Economy, Trade and Industry. Several other subsidiaries of Goldman Sachs are regulated by securities, investment advisory, banking, and other regulators and authorities around the world, such as the Federal Financial Supervisory Authority (BaFin) and the Bundesbank in Germany, the Autorité des Marchés Financiers and Banque de France in France, Banca d’Italia and the Commissione Nazionale per le Società e la Borsa (CONSOB) in Italy, the Swiss Federal Banking Commission, the Securities and Futures Commission in Hong Kong, the Monetary Authority of Singapore and the China Securities Regulatory Commission. See Note 15 to the consolidated financial statements in Part II, Item 8 of the Annual Report on Form 10-K for further information regarding our regulated subsidiaries. For a discussion of our potential inability to access funds from our regulated entities, see “— Risk Management — Liquidity Risk — Intercompany Funding” below.

Risk Management

Management believes that effective risk management is of primary importance to the success of Goldman Sachs. Accordingly, we have a comprehensive risk management process to monitor, evaluate and manage the principal risks we assume in conducting our activities. These risks include market, credit, liquidity, operational, legal and reputational exposures.

Risk Management Structure

We seek to monitor and control our risk exposure through a variety of separate but complementary financial, credit, operational, compliance and legal reporting systems. In addition, a number of committees are responsible for monitoring risk exposures and for general oversight of our risk management process. These committees, whose responsibilities are described below, meet regularly and consist of senior members of both our revenue-producing units and departments that are independent of our revenue-producing units.

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Segregation of duties and management oversight are fundamental elements of our risk management process. In addition to the committees described below, functions that are independent of the revenue-producing units, such as Compliance, Finance, Legal, Management Controls (Internal Audit) and Operations, perform risk management functions, which include monitoring, analyzing and evaluating risk.

Management Committee. All risk control functions ultimately report to our Management Committee. Through both direct and delegated authority, the Management Committee approves all of our operating activities, trading risk parameters and customer review guidelines.

Risk Committees. The Firmwide Risk Committee reviews the activities of existing businesses, approves new businesses and products, approves firmwide and divisional market risk limits, reviews business unit market risk limits, approves market risk limits for selected sovereign markets and business units, approves sovereign credit risk limits and credit risk limits by ratings group, and reviews scenario analyses based on abnormal or “catastrophic” market movements.

The Divisional Risk Committee sets market risk limits for our trading activities subject to overall firmwide risk limits, based on a number of measures, including Value-at-Risk (VaR), stress tests and scenario analyses. Several other committees oversee various risk, valuation, operational, credit and business practice issues related to our asset management business.

Business unit risk limits are established by the various risk committees and may be further allocated by the business unit managers to individual trading desks. Trading desk managers have the first line of responsibility for managing risk within prescribed limits. These managers have in-depth knowledge of the primary sources of risk in their respective markets and the instruments available to hedge their exposures.

Market risk limits are monitored by the Finance Division and are reviewed regularly by the appropriate risk committee. Limit violations are reported to the appropriate risk committee and business unit managers and addressed, as necessary. Credit risk limits are also monitored by the Finance Division and reviewed by the appropriate risk committee.

Business Practices Committee. The Business Practices Committee assists senior management in its oversight of compliance, legal and operational risks and related reputational concerns, such as potential conflicts of interest. The Business Practices Committee also reviews the firm’s business practices, policies, and procedures for consistency with our business principles. The Business Practices Committee reviews these areas and makes recommendations for improvements as necessary to mitigate potential risks and assist in achieving adherence to our business principles.

Capital Committee. The Capital Committee reviews and approves transactions involving commitments of our capital. Such capital commitments include extensions of credit, alternative liquidity commitments, certain bond underwritings, certain distressed debt and principal finance activities, and certain equity-linked structured products. The Capital Committee is also responsible for ensuring that business and reputational standards for capital commitments are maintained on a global basis.

Commitments Committee. The Commitments Committee reviews and approves underwriting and distribution activities, primarily with respect to offerings of equity and equity-related securities, and sets and maintains policies and procedures designed to ensure that legal, reputational, regulatory and business standards are maintained in conjunction with these activities. In addition to reviewing specific transactions, the Commitments Committee periodically conducts strategic reviews of industry sectors and products and establishes policies in connection with transaction practices.

Credit Policy Committee. The Credit Policy Committee establishes and reviews broad credit policies and parameters that are implemented by the Credit Department.

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Finance Committee. The Finance Committee establishes and ensures compliance with our liquidity policies, approves balance sheet limits and has oversight responsibility for liquidity risk, the size and composition of our balance sheet and capital base, and our credit ratings. The Finance Committee regularly reviews our balance sheet, funding position and capitalization and makes adjustments in light of current events, risks and exposures.

New Products Committee. The New Products Committee, under the oversight of the Firmwide Risk Committee, is responsible for reviewing and approving new products and businesses globally.

Operational Risk Committee. The Operational Risk Committee provides oversight of the ongoing development and implementation of our operational risk policies, framework and methodologies, and monitors the effectiveness of operational risk management.

Structured Products Committee. The Structured Products Committee reviews and approves structured product transactions entered into with our clients that raise legal, regulatory, tax or accounting issues or present reputational risk to Goldman Sachs.

Market Risk

The potential for changes in the market value of our trading and investing positions is referred to as market risk. Such positions result from market-making, specialist, proprietary trading and investing, and underwriting activities.

Categories of market risk include exposures to interest rates, equity prices, currency rates and commodity prices. A description of each market risk category is set forth below:

    Interest rate risks primarily result from exposures to changes in the level, slope and curvature of the yield curve, the volatility of interest rates, mortgage prepayment speeds and credit spreads.
 
    Equity price risks result from exposures to changes in prices and volatilities of individual equities, equity baskets and equity indices.
 
    Currency rate risks result from exposures to changes in spot prices, forward prices and volatilities of currency rates.
 
    Commodity price risks result from exposures to changes in spot prices, forward prices and volatilities of commodities, such as electricity, natural gas, crude oil, petroleum products, and precious and base metals.

We seek to manage these risks by diversifying exposures, controlling position sizes and establishing hedges in related securities or derivatives. For example, we may hedge a portfolio of common stocks by taking an offsetting position in a related equity-index futures contract. The ability to manage an exposure may, however, be limited by adverse changes in the liquidity of the security or the related hedge instrument and in the correlation of price movements between the security and related hedge instrument.

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In addition to applying business judgment, senior management uses a number of quantitative tools to manage our exposure to market risk. These tools include:

    risk limits based on a summary measure of market risk exposure referred to as VaR, which are updated and monitored on a daily basis;
 
    scenario analyses, stress tests and other analytical tools that measure the potential effects on our net revenues of various market events, including, but not limited to, a large widening of credit spreads, a substantial decline in equity markets and significant moves in selected sovereign markets; and
 
    inventory position limits for selected business units.

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 1 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 VaR. Thus, shortfalls from expected trading net revenues on a single trading day greater than the reported VaR would be anticipated to occur, on average, about once a month. Shortfalls on a single day can exceed reported VaR by significant amounts. Shortfalls can also accumulate over a longer time horizon such as a number of consecutive trading days.

The VaR numbers below are shown separately for interest rate, equity, currency and commodity products, as well as for our overall trading positions. The VaR numbers in each risk category 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 standard 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. Changes in VaR between reporting periods are generally due to changes in levels of exposure, volatilities and/or correlations among asset classes.

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The following tables set forth the daily VaR:

Average Daily VaR (1)
(in millions)

                         
Year Ended November
Risk Categories 2005 2004 2003
 
                       
Interest rates
  $ 37     $ 36     $ 38  
Equity prices
    34       32       27  
Currency rates
    17       20       18  
Commodity prices
    26       20       18  
Diversification effect (2)
    (44 )     (41 )     (43 )
 
                 
Total
  $ 70     $ 67     $ 58  
 
                 
 
(1)   During the second quarter of 2004, we began to exclude from our calculation other debt portfolios that cannot be properly measured in VaR. The effect of excluding these portfolios was not material to prior periods and, accordingly, such periods have not been adjusted. For a further discussion of the market risk associated with these portfolios, see “— Other Debt Portfolios” below.
 
(2)   Equals the difference between total VaR and the sum of the VaRs for the four risk categories. This effect arises because the four market risk categories are not perfectly correlated.

 

Our average daily VaR increased to $70 million in 2005 from $67 million in 2004. The increase was primarily due to higher levels of exposure to commodity prices, equity prices and interest rates, partially offset by reduced exposures to currency rates, as well as reduced volatilities, particularly in interest rate and equity assets.

Our average daily VaR increased to $67 million in 2004 from $58 million in 2003, primarily due to higher levels of exposure to equity prices, currency rates and commodity prices, partially offset by reduced exposures to interest rates, as well as reduced volatilities, particularly in interest rate and equity assets.

Daily VaR
(in millions)

                                 
Year Ended
As of November November 2005
Risk Categories 2005 2004 High Low
 
                               
Interest rates
  $ 45     $ 28     $ 53     $ 26  
Equity prices
    54       25       62       21  
Currency rates
    10       18       31       9  
Commodity prices
    18       35       37       16  
Diversification effect (1)
    (44 )     (40 )                
 
                           
Total
  $ 83     $ 66     $ 91     $ 51  
 
                           
 
(1)   Equals the difference between total VaR and the sum of the VaRs for the four risk categories. This effect arises because the four market risk categories are not perfectly correlated.

 

Our daily VaR increased to $83 million as of November 2005 from $66 million as of November 2004. The increase was primarily due to higher levels of exposure to equity prices and interest rates, partially offset by reduced exposures to commodity prices and currency rates, as well as reduced volatilities in equity, currency and commodity assets.

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The following chart presents our daily VaR during 2005:

Daily VaR
($ in millions)

DAILY VAR CHART

 

     Trading Net Revenues Distribution

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 of our daily trading net revenues for substantially all inventory positions included in VaR for the year ended November 2005:

Daily Trading Net Revenues
($ in millions)

DAILY TRADING NET REVENUES CHART

Daily Trading Net Revenues

 

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 2005.

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     Other Debt Portfolios

The market risk associated with portfolios in our credit products business that cannot be properly measured in VaR (primarily due to inadequate historical data on the underlying assets in the aggregate) is measured based on a potential 10% decline in the asset value of such portfolios. The market values of the underlying positions are sensitive to changes in a number of factors, including discount rates and the projected timing and amount of future cash flows. As of November 2005, the potential impact of a 10% decline in the asset value of these portfolios was $669 million compared with $416 million as of November 2004. The increase in 2005 is primarily due to new investments in the Americas and Asia.

     Nontrading Risk

SMFG. The market risk of our investment in the convertible preferred stock of SMFG, net of the economic hedge on the unrestricted shares of common stock underlying a portion of our investment, 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 November 2005, the sensitivity of our investment to a 10% decline in the SMFG common stock price was $262 million compared with $236 million as of November 2004. The change is primarily due to an increase in the SMFG common stock price and, to a lesser extent, the impact of the passage of time in respect of the transfer restrictions on the underlying common stock, partially offset by the effect of hedging the unrestricted shares of common stock underlying our investment. 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 nonlinear.

Other Principal Investments. 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 November 2005, the sensitivity of our nontrading portfolio (excluding our investment in the convertible preferred stock of SMFG) to a 10% equity market decline was $181 million compared with $118 million as of November 2004, primarily reflecting new private investments.

Credit Risk

Credit risk represents the loss that we would incur if a counterparty or an issuer of securities or other instruments we hold fails to perform under its contractual obligations to us, or upon a deterioration in the credit quality of third parties whose securities or obligations we hold. To reduce our credit exposures, we seek to enter into netting agreements with counterparties that permit us to offset receivables and payables with such counterparties. In addition, we attempt to further reduce credit risk with certain counterparties by (i) entering into agreements that enable us to obtain collateral from a counterparty or to terminate or reset the terms of transactions after specified time periods or upon the occurrence of credit-related events, (ii) seeking third-party guarantees of the counterparty’s obligations, and/or (iii) using credit derivatives and other structures and techniques.

For most businesses, counterparty credit limits are established by the Credit Department, which is independent of the revenue-producing departments, based on guidelines set by the Firmwide Risk Committee and the Credit Policy Committee. For most products, we measure and limit credit exposures by reference to both current and potential exposure. We typically measure potential exposure based on projected worst-case market movements over the life of a transaction within a 95% confidence interval. For collateralized transactions, we also evaluate potential exposure over a shorter collection period, and give effect to the value of collateral received. We further seek to measure credit exposure through the use of scenario analyses, stress tests and other quantitative

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tools. Our global credit management systems monitor current and potential credit exposure to individual counterparties and on an aggregate basis to counterparties and their affiliates. These systems also provide management, including the Firmwide Risk and Credit Policy Committees, with information regarding overall credit risk by product, industry sector, country and region.

As of both November 2005 and November 2004, we held U.S. government and federal agency obligations that represented 7% and 5% of our total assets, respectively. In addition, most of our securities purchased under agreements to resell are collateralized by U.S. government, federal agency and other sovereign obligations. As of November 2005 and November 2004, we did not have credit exposure to any other counterparty that exceeded 5% of our total assets. However, over the past several years, the amount and duration of our credit exposures have been increasing, due to, among other factors, the growth of our lending and OTC derivative activities. A further discussion of our derivative activities follows below.

Derivatives

Derivative contracts are 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.

Substantially all of our derivative transactions are entered into for trading purposes, to facilitate client transactions, to take proprietary positions or as a means of risk management. In addition to derivative transactions entered into for trading purposes, we enter into derivative contracts to hedge our net investment in non-U.S. operations and to manage the interest rate and currency exposure on our long-term borrowings and certain short-term borrowings.

Derivatives are used in many of our businesses, and we believe that the associated market risk can only be understood relative to all of the underlying assets or risks being hedged, or as part of a broader trading strategy. Accordingly, the market risk of derivative positions is managed together with our nonderivative positions.

Fair values of our derivative contracts are reflected net of cash paid or received pursuant to credit support agreements and are reported on a net-by-counterparty basis in our consolidated statements of financial condition when 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.

The following table sets forth the distribution, by credit rating, of substantially all of our exposure with respect to OTC derivatives as of November 2005, 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
($ in millions)

                                 
Exposure Percentage of
Collateral Net of Total Exposure
Credit Rating Equivalent Exposure  (1) Held Collateral Net of Collateral
 
                     
AAA/Aaa
  $ 4,332     $ 222     $ 4,110       12 %
AA/Aa2
    9,721       1,801       7,920       22  
A/A2
    13,166       3,332       9,834       28  
BBB/Baa2
    10,209       2,809       7,400       21  
BB/Ba2 or lower
    8,859       3,330       5,529       15  
Unrated
    1,376       582       794       2  
 
                         
Total
  $ 47,663     $ 12,076     $ 35,587       100 %
 
                         
 
(1)   Net of cash received pursuant to credit support agreements of $22.61 billion.

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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
(in millions)

                                                 
0  -  6 6  -  12 1  -  5 5  -  10 10 Years  
Credit Rating Equivalent Months Months Years Years or Greater Total (1)
 
                                   
AAA/Aaa
  $ 858     $ 367     $ 1,053     $ 1,074     $ 758     $ 4,110  
AA/Aa2
    1,897       596       1,954       2,228       1,245       7,920  
A/A2
    3,049       1,009       2,542       1,841       1,393       9,834  
BBB/Baa2
    2,151       621       2,700       409       1,519       7,400  
BB/Ba2 or lower
    1,558       352       2,850       508       261       5,529  
Unrated
    293       124       193       168       16       794  
 
                                   
Total
  $ 9,806     $ 3,069     $ 11,292     $ 6,228     $ 5,192     $ 35,587  
 
                                   
                                                 
0  -  6 6  -  12 1  -  5 5  -  10 10 Years  
Contract Type Months Months Years Years or Greater Total  (1)
 
                                   
Interest rates
  $ 1,591     $ 346     $ 3,212     $ 4,237     $ 3,946     $ 13,332  
Currencies
    4,395       609       1,506       739       1,022       8,271  
Commodities
    3,381       1,240       6,082       711       116       11,530  
Equities
    439       874       492       541       108       2,454  
 
                                   
Total
  $ 9,806     $ 3,069     $ 11,292     $ 6,228     $ 5,192     $ 35,587  
 
                                   
 
(1)   Where we have obtained collateral from a counterparty under a master trading agreement that covers multiple products and transactions, we have allocated the collateral ratably based on exposure before giving effect to such collateral.

 

Derivative transactions may also involve legal risks including the risk that they are not authorized or appropriate for a counterparty, that documentation has not been properly executed or that executed agreements may not be enforceable against the counterparty. We attempt to minimize these risks by obtaining advice of counsel on the enforceability of agreements as well as on the authority of a counterparty to effect the derivative transaction. In addition, certain derivative transactions involve the risk that we may have difficulty obtaining, or be unable to obtain, the underlying security or obligation in order to satisfy any physical settlement requirement or that the derivative may have been assigned to a different counterparty without our knowledge or consent.

Liquidity Risk

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 resulting from adverse circumstances. 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 even under adverse circumstances.

Management has implemented a number of policies according to the following liquidity risk management framework:

    Excess Liquidity — maintain substantial excess liquidity to meet a broad range of potential cash outflows in a stressed environment including financing obligations.
 
    Asset-Liability Management — ensure we fund our assets with appropriate financing.
 
    Intercompany Funding — maintain parent company liquidity and manage the distribution of liquidity across the group structure.
 
    Crisis Planning — ensure all funding and liquidity management is based on stress-scenario planning and feeds into our liquidity crisis plan.

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     Excess Liquidity

Maintenance of a Pool of Highly Liquid Securities. Our most important liquidity policy is to pre-fund what we estimate will be our likely cash needs during a liquidity crisis and hold such excess liquidity in the form of unencumbered, highly liquid securities that may be sold or pledged to provide same-day liquidity. This “Global Core Excess” 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. We believe that this pool of excess liquidity provides us with a resilient source of funds and gives us significant flexibility in managing through a difficult funding environment. Our Global Core Excess reflects the following principles:

    The first days or weeks of a liquidity crisis are the most critical to a company’s survival.
 
    Focus must be maintained on all potential cash and collateral outflows, not just disruptions to financing flows. Goldman Sachs’ businesses are diverse, and its cash needs are driven by many factors, including market movements, collateral requirements and client commitments, all of which can change dramatically in a difficult funding environment.
 
    During a liquidity crisis, credit-sensitive funding, including unsecured debt and some types of secured financing agreements, may be unavailable and the terms or availability of other types of secured financing may change.
 
    As a result of our policy to pre-fund liquidity that we estimate may be needed in a crisis, we hold more unencumbered securities and larger unsecured debt balances than our businesses would otherwise require. We believe that our liquidity is stronger with greater balances of highly liquid unencumbered securities, even though it increases our unsecured liabilities.

The following table sets forth the average loan value (the estimated amount of cash that would be advanced by counterparties against these securities) of our Global Core Excess:

                   
Year Ended November
2005 2004
(in millions)
 
                 
 
U.S. dollar-denominated
  $ 35,310     $ 33,858  
 
Non-U.S. dollar-denominated
    11,029       8,135  
 
 
           
 
Total Global Core Excess
  $ 46,339     $ 41,993  
 
 
           

 

The U.S. dollar-denominated excess is comprised of only unencumbered U.S. government and agency securities and highly liquid mortgage securities, all of which are Federal Reserve repo-eligible, as well as overnight cash deposits. Our non-U.S. dollar-denominated excess is comprised of only unencumbered French, German, United Kingdom and Japanese government bonds and euro, British pound and Japanese yen overnight cash deposits. We strictly limit our Global Core Excess to this narrowly defined list of securities and cash that we believe are highly liquid, even in a difficult funding environment.

The majority of our Global Core Excess is structured such that it is available to meet the liquidity requirements of our parent company, Group Inc., and all of its subsidiaries. The remainder is held in our principal non-U.S. operating entities, primarily to better match the currency and timing requirements for those entities’ potential liquidity obligations.

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The size of our Global Core Excess is determined by an internal liquidity model together with a qualitative assessment of the condition of the financial markets and of Goldman Sachs. Our liquidity model identifies and estimates cash and collateral outflows over a short-term horizon in a liquidity crisis, including, but not limited to:

    upcoming maturities of unsecured debt and letters of credit;
 
    potential buybacks of a portion of our outstanding negotiable unsecured debt;
 
    adverse changes in the terms or availability of secured funding;
 
    derivatives and other margin and collateral outflows, including those due to market moves or increased requirements;
 
    additional collateral that could be called in the event of a downgrade in our credit ratings;
 
    draws on our unfunded commitments not supported by William Street Funding Corporation (1); and
 
    upcoming cash outflows, such as tax and other large payments.

Other Unencumbered Assets. In addition to our Global Core Excess described above, we have a significant amount of other unencumbered securities as a result of our business activities. These assets, which are located in the United States, Europe and Asia, include other government bonds, high-grade money market securities, corporate bonds and marginable equities. We do not include these securities in our Global Core Excess.

We maintain Global Core Excess and other unencumbered assets in an amount that, if pledged or sold, would provide the funds necessary to replace at least 110% of our unsecured obligations that are scheduled to mature (or where holders have the option to redeem) within the next 12 months. This implies that we could fund our positions on a secured basis for one year in the event we were unable to issue new unsecured debt or liquidate assets. We assume conservative loan values that are based on stress-scenario borrowing capacity and we regularly review these assumptions asset-by-asset. The estimated aggregate loan value of our Global Core Excess and our other unencumbered assets averaged $125.36 billion in 2005 and $100.51 billion in 2004.

     Asset-Liability Management

Asset Quality and Balance Sheet Composition. We seek to maintain a highly liquid balance sheet and substantially all of our inventory is marked-to-market daily. We utilize aged inventory limits for certain financial instruments as a disincentive to our businesses to hold inventory over longer periods of time. We believe that these limits provide a complementary mechanism for ensuring appropriate balance sheet liquidity in addition to our standard position limits. In addition, we periodically reduce the size of certain parts of our balance sheet to comply with period end limits set by management. Because of these periodic reductions and certain other factors including seasonal activity, market conventions and periodic market opportunities in certain of our businesses that result in larger positions during the middle of our reporting periods, our balance sheet fluctuates between financial statement dates and is lower at fiscal period end than would be observed on an average basis. Over the last six quarters, our total assets and adjusted assets at quarter end have been, on average, 9% and 11% 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 liquidity position because they are generally in highly liquid assets that are typically financed on a secured basis.

 

 
(1)   The Global Core Excess excludes liquid assets held separately to support the William Street credit extension program.

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Certain financial instruments may be more difficult to fund on a secured basis during times of market stress and, accordingly, we generally hold higher levels of capital for these assets than more liquid types of financial instruments. The table below sets forth our aggregate holdings in these categories of financial instruments:

                 
As of November
2005 2004
(in millions)
 
               
Mortgage whole loans and collateralized debt obligations  (1)
  $ 31,459     $ 18,346  
Bank loans (2)
    13,843       8,900  
High-yield securities
    8,822       6,057  
Emerging market debt securities
    1,789       1,653  
SMFG convertible preferred stock
    4,058       2,556  
Other corporate principal investments (3)
    1,723       1,278  
Real estate principal investments (3)
    745       820  
 
(1)   Includes certain mortgage-backed interests held in QSPEs. See Note 3 to the consolidated financial statements in Part II, Item 8 of the Annual Report on Form 10-K for further information regarding our securitization activities.
 
(2)   Includes funded commitments and inventory held in connection with our origination and secondary trading activities.
 
(3)   Excludes assets for which Goldman Sachs is not at risk (e.g., assets related to consolidated employee-owned merchant banking funds) of $1.93 billion and $1.28 billion as of November 2005 and November 2004, respectively.

 

A large portion of these assets are funded on a secured basis through secured funding markets or nonrecourse financing. We focus on demonstrating a consistent ability to fund these assets on a secured basis for extended periods of time to reduce refinancing risk and to help ensure that these assets have an established amount of loan value in order that they can be funded in periods of market stress.

See Note 3 to the consolidated financial statements in Part II, Item 8 of the Annual Report on Form 10-K for further information regarding the financial instruments we hold.

Appropriate Financing of Asset Base. We seek to manage the maturity profile of our funding base 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 generally do not rely on immediate sales of assets (other than our Global Core Excess) to maintain liquidity in a distressed environment. However, we recognize that orderly asset sales may be prudent and necessary in a persistent liquidity crisis.

In order to avoid reliance on asset sales, our goal is to ensure that we have sufficient total capital (long-term borrowings plus total shareholders’ equity) to fund our balance sheet for at least one year. We seek to maintain total capital in excess of the aggregate of the following long-term financing requirements:

    the portion of financial instruments owned that we believe could not be funded on a secured basis in periods of market stress, assuming conservative loan values;
 
    goodwill and identifiable intangible assets, property, leasehold improvements and equipment, and other illiquid assets;
 
    derivative and other margin and collateral requirements;
 
    anticipated draws on our unfunded loan commitments; and
 
    capital or other forms of financing in our regulated subsidiaries that is in excess of their long-term financing requirements. See “— Intercompany Funding” below for a further discussion of how we fund our subsidiaries.

Our total capital of $128.01 billion and $105.78 billion as of November 2005 and November 2004, respectively, exceeded the aggregate of these requirements.

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Conservative Liability Structure. We structure our liabilities conservatively to reduce refinancing risk as well as the risk that we may redeem or repurchase certain of our borrowings prior to their contractual maturity. For example, we may repurchase Goldman Sachs’ commercial paper through the ordinary course of business as a market maker. As such, we emphasize the use of promissory notes (in which Goldman Sachs does not make a market) over commercial paper in order to improve the stability of our short-term unsecured financing base. We have also created internal guidelines regarding the principal amount of debt maturing on any one day or during any single week or year and have average maturity targets for our unsecured debt programs.

We seek to maintain broad and diversified funding sources globally for both secured and unsecured funding. We have imposed various internal guidelines, including the amount of our commercial paper that can be owned and letters of credit that can be issued by any single investor or group of investors. We benefit from distributing our debt issuances through our own sales force to a large, diverse global creditor base and we believe that our relationships with our creditors are critical to our liquidity.

We access funding in a variety of markets in the United States, Europe and Asia. We issue debt through syndicated U.S. registered offerings, U.S. registered and 144A medium-term note programs, offshore medium-term note offerings and other bond offerings, U.S. and non-U.S. commercial paper and promissory note issuances, and other methods. We make extensive use of the repurchase agreement and securities lending markets and arrange for letters of credit to be issued on our behalf.

Additionally, unsecured debt issued by Group Inc. does not contain provisions that would, based solely upon an adverse change in our credit ratings, financial ratios, earnings, cash flows or our stock price, trigger a requirement for an early payment, collateral support, change in terms, acceleration of maturity or the creation of an additional financial obligation.

     Intercompany Funding

Subsidiary Funding Policies. Substantially all of our unsecured funding is raised by our parent company, Group Inc. The parent company then lends the necessary funds to its subsidiaries, some of which are regulated, to meet their asset financing and capital requirements. In addition, the parent company provides its regulated subsidiaries with the necessary capital to meet their regulatory requirements. The benefits of this approach to subsidiary funding include enhanced control and greater flexibility to meet the funding requirements of our subsidiaries.

Our intercompany funding policies are predicated on an assumption that, unless legally provided for, funds or securities are not freely available from a subsidiary to its parent company or other subsidiaries. In particular, many of our subsidiaries are subject to laws that authorize regulatory bodies to block or limit the flow of funds from those subsidiaries to Group Inc. Regulatory action of that kind could impede access to funds that Group Inc. needs to make payments on obligations, including debt obligations. As such, we assume that capital or other financing provided to our regulated subsidiaries is not available to our parent company or other subsidiaries. In addition, we assume that the Global Core Excess held in our principal non-U.S. operating entities will not be available to our parent company or other subsidiaries and therefore is available only to meet the potential liquidity requirements of those entities.

We also manage our intercompany exposure by requiring senior and subordinated intercompany loans to have maturities equal to or shorter than the maturities of the aggregate borrowings of the parent company. This policy ensures that the subsidiaries’ obligations to the parent company will generally mature in advance of the parent company’s third-party borrowings. In addition, many of our subsidiaries and affiliates pledge collateral at loan value to the parent company to cover their intercompany borrowings (other than subordinated debt) in order to mitigate parent company liquidity risk.

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Equity investments in subsidiaries are generally funded with parent company equity capital. As of November 2005, Group Inc.’s equity investment in subsidiaries was $25.26 billion compared with its total shareholders’ equity of $28.00 billion.

Group Inc. has provided substantial amounts of equity and subordinated indebtedness, directly or indirectly, to its regulated subsidiaries; for example, as of November 2005, Group Inc. had $17.04 billion of such equity and subordinated indebtedness invested in Goldman, Sachs & Co., its principal U.S. registered broker-dealer; $16.06 billion invested in Goldman Sachs International, a regulated U.K. broker-dealer; $2.41 billion invested in Goldman Sachs Execution & Clearing, L.P., a U.S. registered broker-dealer; and $1.98 billion invested in Goldman Sachs (Japan) Ltd., a regulated broker-dealer based in Tokyo. Group Inc. also had $44.52 billion of unsubordinated loans to these entities as of November 2005, as well as significant amounts of capital invested in and loans to its other regulated subsidiaries.

Subsidiary Foreign Exchange Policies. Our capital invested in non-U.S. subsidiaries is generally exposed to foreign exchange risk, substantially all of which is hedged. In addition, we generally hedge the nontrading exposure to foreign exchange risk that arises from transactions denominated in currencies other than the transacting entity’s functional currency.

     Crisis Planning

In order to be prepared for a liquidity event, or a period of market stress, we base our liquidity risk management framework and our resulting funding and liquidity policies on conservative stress-scenario planning.

In addition, we maintain a liquidity crisis plan that specifies an approach for analyzing and responding to a liquidity-threatening event. The plan provides the framework to estimate the likely impact of a liquidity event on Goldman Sachs based on some of the risks identified above and outlines which and to what extent liquidity maintenance activities should be implemented based on the severity of the event. It also lists the crisis management team and internal and external parties to be contacted to ensure effective distribution of information.

     Cash Flows

As a global financial institution, our cash flows are complex and interrelated and bear little relation to our net earnings and net assets and, consequently, we believe that traditional cash flow analysis is less meaningful in evaluating our liquidity position than the excess liquidity and asset-liability management policies described above. Cash flow analysis may, however, be helpful in highlighting certain macro trends and strategic initiatives in our business.

Year Ended November 2005. Our cash and cash equivalents increased by $5.90 billion to $10.26 billion at the end of 2005. We raised $19.37 billion in net cash from financing activities, primarily in long-term debt, in light of the favorable debt financing environment, partially offset by common stock repurchases. We used net cash of $13.48 billion in our operating and investing activities, primarily to capitalize on trading and investing opportunities for ourselves and our clients.

Year Ended November 2004. Our cash and cash equivalents decreased by $2.72 billion to $4.37 billion at the end of 2004. We raised $31.75 billion in net cash from financing activities, primarily in long-term debt, in light of the favorable debt financing environment. We used net cash of $34.47 billion in our operating and investing activities, primarily to capitalize on trading and investing opportunities for ourselves and our clients, to meet additional collateral requirements at securities exchanges and clearing organizations and to provide additional funding support for our William Street loan commitments program.

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Year Ended November 2003. Our cash and cash equivalents increased by $2.27 billion to $7.09 billion at the end of 2003. We raised $20.58 billion in net cash from financing activities, primarily in long-term debt. We used net cash of $18.32 billion in our operating and investing activities primarily to capitalize on opportunities in our trading and principal investing businesses, including the purchase of investments that could be difficult to fund in periods of market stress. We also increased our Global Core Excess, provided funding support for our William Street loan commitments program, invested in the convertible preferred stock of SMFG and financed the acquisition of East Coast Power L.L.C.

Operational Risk

Operational risk relates to the risk of loss arising from shortcomings or failures in internal processes, people or systems, and from external events. Operational risk can arise from many factors ranging from routine processing errors to potentially costly incidents arising, for example, from major systems failures. Operational risk may also cause reputational harm. Thus, efforts to identify, manage and mitigate operational risk must be equally sensitive to the risk of reputational damage as well as the risk of financial loss.

We manage operational risk through the application of long-standing, but continuously evolving, firmwide control standards: the training, supervision and development of our people; the active participation and commitment of senior management in a continuous process of identifying and mitigating key operational risks across the firm; and a framework of strong and independent control departments that monitor operational risk on a daily basis. Together, these elements form a strong firmwide control culture that serves as the foundation of our efforts to minimize events that create operational risk and the damage they can cause.

The Operational Risk Department, an independent risk management function, is responsible for developing and implementing a standardized framework to identify, measure, monitor and manage operational risk across the firm. This framework, which evolves with the changing needs of our businesses and regulatory guidance, takes into account internal and external operational risk events, business environment and internal control factors, the ongoing analysis of business-specific risk metrics and the use of scenario analysis. While individual business units have direct responsibility for the control and mitigation of operational risk, this framework provides a consistent methodology for identifying and monitoring operational risk factors at the business unit and firmwide level.

Recent Accounting Developments

In December 2004, the Financial Accounting Standards Board (FASB) issued a revision to SFAS No. 123, “Accounting for Stock-Based Compensation,” SFAS No. 123-R, “Share-Based Payment.” SFAS No. 123-R establishes standards of accounting for transactions in which an entity exchanges its equity instruments for goods and services. SFAS No. 123-R focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. Two key differences between SFAS No. 123 and SFAS No. 123-R relate to attribution of compensation costs to reporting periods and accounting for award forfeitures. SFAS No. 123-R generally requires the immediate expensing of equity-based awards granted to retirement-eligible employees. However, awards granted subject to a substantive non-compete agreement are generally expensed over the non-compete period. SFAS No. 123-R also requires expected forfeitures to be included in determining stock-based employee compensation expense. See Note 2 to the consolidated financial statements in Part II, Item 8 of the Annual Report on Form 10-K, “Significant Accounting Policies — Stock-Based Compensation” for a discussion of how we currently account for equity-based awards granted to retirement-eligible employees and forfeitures. We will adopt SFAS No. 123-R in the first quarter of fiscal 2006. Management is currently evaluating the effect of adoption of SFAS No. 123-R on our results of operations with respect to awards granted to retirement-eligible employees that are subject to a non-compete agreement.

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The following table sets forth the pro forma net earnings that would have been reported for each year if equity-based awards granted to retirement-eligible employees had been expensed over the non-compete period and if expected forfeitures had been accrued as required by SFAS No. 123-R:

                             
Year Ended November
2005 2004 2003
(in millions)
   
 
                       
Net earnings applicable to common shareholders, as reported   $ 5,609     $ 4,553     $ 3,005  
   
 
                       
Add:   Stock-based employee compensation expense, net of related tax effects, included in reported net earnings     1,133       790       458  
   
 
                       
Deduct:   Stock-based employee compensation expense, net of related tax effects, determined under SFAS No. 123-R     (1,106 )     (802 )     (503 )
   
 
                 
Pro forma net earnings applicable to common shareholders   $ 5,636     $ 4,541     $ 2,960  
   
 
                 

 

In June 2005, the EITF reached consensus on Issue No. 04-5, “Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights,” which requires general partners (or managing members in the case of limited liability companies) to consolidate their partnerships or to provide limited partners with rights to remove the general partner or to terminate the partnership. Goldman Sachs, as the general partner of numerous merchant banking and asset management partnerships, is required to adopt the provisions of EITF 04-5 (i) immediately for partnerships formed or modified after June 29, 2005 and (ii) in the first quarter of fiscal 2007 for partnerships formed on or before June 29, 2005 that have not been modified. We generally expect to provide limited partners in these funds with rights to remove Goldman Sachs or rights to terminate the partnerships and, therefore, do not expect that EITF 04-5 will have a material effect on our financial condition, results of operations or cash flows.

Item 7A.    Quantitative and Qualitative Disclosures About Market Risk

Quantitative and qualitative disclosure about market risk is set forth under “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Risk Management” in Part II, Item 7 of the Annual Report on Form 10-K.

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Item 8.    Financial Statements and Supplementary Data

INDEX

         
Page
No.
 
       
    99  
 
       
    100  
 
       
       
    102  
    103  
    104  
    105  
    106  
 
       
       
    107  
    107  
    117  
    124  
    124  
    126  
    131  
    133  
    133  
    135  
    135  
    140  
    143  
    143  
    145  
    146  
    149  
 
       
       
    150  
    151  
    152  
 
       
       
    100  
    F-2  
    F-2  
    F-3  
    F-4  
    F-5  

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Management’s Report on Internal Control over
Financial Reporting

Management of The Goldman Sachs Group, Inc., together with its consolidated subsidiaries (the firm), is responsible for establishing and maintaining adequate internal control over financial reporting. The firm’s internal control over financial reporting is a process designed under the supervision of the firm’s principal executive and principal financial officers to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the firm’s financial statements for external reporting purposes in accordance with U.S. generally accepted accounting principles.

As of the end of the firm’s 2005 fiscal year, management conducted an assessment of the effectiveness of the firm’s internal control over financial reporting based on the framework established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this assessment, management has determined that the firm’s internal control over financial reporting as of November 25, 2005 was effective.

Our internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets; provide reasonable assurances that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures are being made only in accordance with authorizations of management and the directors of the firm; and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the firm’s assets that could have a material effect on our financial statements.

Management’s assessment of the effectiveness of the firm’s internal control over financial reporting as of November 25, 2005 has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report appearing on pages 100 and 101, which expresses unqualified opinions on management’s assessment and on the effectiveness of the firm’s internal control over financial reporting as of November 25, 2005.

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Report of Independent Registered Public Accounting Firm

To the Board of Directors and the Shareholders of
The Goldman Sachs Group, Inc.:

We have completed integrated audits of The Goldman Sachs Group, Inc.’s 2005 and 2004 consolidated financial statements and of its internal control over financial reporting as of November 25, 2005 and an audit of its 2003 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions on The Goldman Sachs Group, Inc.’s 2005, 2004, and 2003 consolidated financial statements and on its internal control over financial reporting as of November 25, 2005, based on our audits, are presented below.

Consolidated financial statements and financial statement schedule

In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of The Goldman Sachs Group, Inc. and its subsidiaries (the Company) at November 25, 2005 and November 26, 2004, and the results of its operations and its cash flows for each of the three fiscal years in the period ended November 25, 2005 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the accompanying index presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

Internal control over financial reporting

Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control over Financial Reporting appearing on page 99, that the Company maintained effective internal control over financial reporting as of November 25, 2005 based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of November 25, 2005, based on criteria established in Internal Control — Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

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A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

/s/    PricewaterhouseCoopers LLP

New York, New York
February 3, 2006

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THE GOLDMAN SACHS GROUP, INC. and SUBSIDIARIES

CONSOLIDATED STATEMENTS OF EARNINGS
                         
Year Ended November
2005 2004 2003
(in millions, except per
share amounts)
 
                       
Revenues
                       
Investment banking
  $ 3,599     $ 3,286     $ 2,400  
Trading and principal investments
    15,452       11,984       8,555  
Asset management and securities services
    3,090       2,655       1,917  
Interest income
    21,250       11,914       10,751  
 
                 
Total revenues
    43,391       29,839       23,623  
Interest expense
    18,153       8,888       7,600  
Cost of power generation
    456       401       11  
 
                 
Revenues, net of interest expense and cost of power generation
    24,782       20,550       16,012  
 
                       
Operating expenses
                       
Compensation and benefits
    11,688       9,652       7,515  
Brokerage, clearing and exchange fees
    1,109       952       829  
Market development
    378       374       264  
Communications and technology
    490       461       478  
Depreciation and amortization
    501       499       562  
Amortization of identifiable intangible assets
    124       125       319  
Occupancy
    728       646       722  
Professional fees
    475       338       253  
Other expenses
    1,016       827       625  
 
                 
Total non-compensation expenses
    4,821       4,222       4,052  
 
                 
Total operating expenses
    16,509       13,874       11,567  
 
                 
Pre-tax earnings
    8,273       6,676       4,445  
Provision for taxes
    2,647       2,123       1,440  
 
                 
Net earnings
    5,626       4,553       3,005  
Preferred stock dividend
    17              
 
                 
Net earnings applicable to common shareholders
  $ 5,609     $ 4,553     $ 3,005  
 
                 
 
                       
Earnings per common share
                       
Basic
  $ 11.73     $ 9.30     $ 6.15  
Diluted
    11.21       8.92       5.87  
 
                       
Average common shares outstanding
                       
Basic
    478.1       489.5       488.4  
Diluted
    500.2       510.5       511.9  

The accompanying notes are an integral part of these consolidated financial statements.

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CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
                 
As of November
2005 2004
(in millions, except share
and per share amounts)
 
               
Assets
               
Cash and cash equivalents
  $ 10,261     $ 4,365  
Cash and securities segregated for regulatory and other purposes
    51,405       48,179  
Receivables from brokers, dealers and clearing organizations
    15,150       14,458  
Receivables from customers and counterparties
    60,231       38,087  
Securities borrowed
    191,800       155,086  
Securities purchased under agreements to resell
    83,619       44,257  
 
               
Financial instruments owned, at fair value
    238,043       183,880  
Financial instruments owned and pledged as collateral, at fair value
    38,983       27,924  
 
           
Total financial instruments owned, at fair value
    277,026       211,804  
 
               
Other assets
    17,312       15,143  
 
           
Total assets
  $ 706,804     $ 531,379  
 
           
 
               
Liabilities and shareholders’ equity
               
Secured short-term borrowings
  $ 7,972     $ 8,558  
Unsecured short-term borrowings
    47,247       46,401  
 
           
Total short-term borrowings, including the current portion of long-term borrowings
    55,219       54,959  
 
               
Payables to brokers, dealers and clearing organizations
    10,014       8,000  
Payables to customers and counterparties
    178,304       153,221  
Securities loaned
    23,331       19,394  
Securities sold under agreements to repurchase
    149,026       47,573  
Financial instruments sold, but not yet purchased, at fair value
    149,071       132,097  
Other liabilities and accrued expenses
    13,830       10,360  
 
               
Secured long-term borrowings
    15,669       12,087  
Unsecured long-term borrowings
    84,338       68,609  
 
           
Total long-term borrowings
    100,007       80,696  
 
           
Total liabilities
    678,802       506,300  
 
               
Commitments, contingencies and guarantees
               
 
               
Shareholders’ equity
               
Preferred stock, par value $0.01 per share; 150,000,000 shares authorized, 70,000 shares issued and outstanding as of November 2005 with liquidation preference of $25,000 per share
    1,750        
Common stock, par value $0.01 per share; 4,000,000,000 shares authorized, 573,970,935 and 554,063,234 shares issued as of November 2005 and November 2004, respectively, and 437,170,695 and 480,959,660 shares outstanding as of November 2005 and November 2004, respectively
    6       6  
Restricted stock units and employee stock options
    3,415       2,013  
Nonvoting common stock, par value $0.01 per share; 200,000,000 shares authorized, no shares issued and outstanding
           
Additional paid-in capital
    17,159       15,501  
Retained earnings
    19,085       13,970  
Unearned compensation
          (117 )
Accumulated other comprehensive income
          11  
Common stock held in treasury, at cost, par value $0.01  per share; 136,800,240 and 73,103,574 shares as of November 2005 and November 2004, respectively
    (13,413 )     (6,305 )
 
           
Total shareholders’ equity
    28,002       25,079  
 
           
Total liabilities and shareholders’ equity
  $ 706,804     $ 531,379  
 
           

The accompanying notes are an integral part of these consolidated financial statements.

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CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
                         
Year Ended November
2005 2004 2003
(in millions, except per
share amounts)
 
               
Preferred stock
                       
Balance, beginning of year
  $     $     $  
Issued
    1,750              
 
                 
Balance, end of year
    1,750              
 
               
Common stock, par value $0.01 per share
                       
Balance, beginning of year
    6       5       5  
Issued
          1        
 
                 
Balance, end of year
    6       6       5  
 
               
Restricted stock units and employee stock options
                       
Balance, beginning of year
    2,013       2,984       3,517  
Issued
    1,871       1,050       339  
Delivered
    (423 )     (1,948 )     (714 )
Forfeited
    (37 )     (62 )     (156 )
Options exercised
    (9 )     (11 )     (2 )
 
                 
Balance, end of year
    3,415       2,013       2,984  
 
               
Additional paid-in capital
                       
Balance, beginning of year
    15,501       13,562       12,750  
Issuance of common stock
    1,417       1,609       709  
Preferred stock issuance costs
    (31 )            
Excess net tax benefit related to delivery of stock-based awards
    272       330       103  
 
                 
Balance, end of year
    17,159       15,501       13,562  
 
               
Retained earnings
                       
Balance, beginning of year
    13,970       9,914       7,259  
Net earnings
    5,626       4,553       3,005  
Dividends declared on common stock
    (494 )     (497 )     (350 )
Dividends declared on preferred stock
    (17 )            
 
                 
Balance, end of year
    19,085       13,970       9,914  
 
               
Unearned compensation
                       
Balance, beginning of year
    (117 )     (339 )     (845 )
Restricted stock units granted
                (6 )
Restricted stock units forfeited
          11       48  
Amortization of restricted stock units
    117       211       464  
 
                 
Balance, end of year
          (117 )     (339 )
 
               
Accumulated other comprehensive income/(loss)
                       
Balance, beginning of year
    11       6       (122 )
Currency translation adjustment, net of tax
    (27 )     5       128  
Minimum pension liability adjustment, net of tax
    (11 )            
Net gains on cash flow hedges, net of tax
    9              
Net unrealized holdings gain, net of tax
    18              
 
                 
Balance, end of year
          11       6  
 
               
Common stock held in treasury, at cost
                       
Balance, beginning of year
    (6,305 )     (4,500 )     (3,561 )
Repurchased
    (7,108 )     (1,805 )     (939 )
 
                 
Balance, end of year
    (13,413 )     (6,305 )     (4,500 )
 
                 
 
               
Total shareholders’ equity
  $ 28,002     $ 25,079     $ 21,632  
 
                 

The accompanying notes are an integral part of these consolidated financial statements.

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CONSOLIDATED STATEMENTS OF CASH FLOWS
                         
Year Ended November
2005 2004 2003
(in millions)
 
               
Cash flows from operating activities
                       
Net earnings
  $ 5,626     $ 4,553     $ 3,005  
Noncash items included in net earnings
                       
Depreciation and amortization
    689       720       826  
Amortization of identifiable intangible assets
    165       125       319  
Deferred income taxes
    (450 )     1,040       93  
Stock-based compensation
    1,756       1,224       711  
Changes in operating assets and liabilities
                       
Cash and securities segregated for regulatory and other purposes
    (3,226 )     (18,437 )     (9,311 )
Net receivables from brokers, dealers and clearing organizations
    1,322       (776 )     (1,797 )
Net payables to customers and counterparties
    2,953       36,669       7,826  
Securities borrowed, net of securities loaned
    (32,777 )     (24,102 )     (10,249 )
Securities sold under agreements to repurchase, net of securities purchased under agreements to resell
    62,269       (12,912 )     2,081  
Financial instruments owned, at fair value
    (66,899 )     (52,366 )     (30,264 )
Financial instruments sold, but not yet purchased, at fair value
    16,974       29,429       19,227  
Other, net
    (815 )     1,442       794  
 
                 
Net cash used for operating activities
    (12,413 )     (33,391 )     (16,739 )
 
               
Cash flows from investing activities
                       
Purchase of property, leasehold improvements and equipment
    (1,421 )     (829 )     (856 )
Proceeds from sales of property, leasehold improvements and equipment
    639              
Business acquisitions, net of cash acquired
    (556 )     (255 )     (721 )
Proceeds from sales of investments
    274              
 
                 
Net cash used for investing activities
    (1,064 )     (1,084 )     (1,577 )
 
               
Cash flows from financing activities
                       
Short-term borrowings, net
    2,233       3,901       729  
Issuance of long-term borrowings
    43,177       39,283       28,238  
Repayment of long-term borrowings, including the current portion of long-term borrowings
    (22,340 )     (10,198 )     (7,471 )
Derivative contracts with a financing element, net
    1,060       548       231  
Common stock repurchased
    (7,108 )     (1,805 )     (939 )
Dividends paid on common and preferred stock
    (511 )     (497 )     (350 )
Proceeds from issuance of preferred stock, net of issuance costs
    1,719              
Proceeds from issuance of common stock
    1,143       521       143  
 
                 
Net cash provided by financing activities
    19,373       31,753       20,581  
 
               
Net increase/(decrease) in cash and cash equivalents
    5,896       (2,722 )     2,265  
 
               
Cash and cash equivalents, beginning of year
    4,365       7,087       4,822  
 
                 
Cash and cash equivalents, end of year
  $ 10,261     $ 4,365     $ 7,087  
 
                 
 
SUPPLEMENTAL DISCLOSURES:
 
Cash payments for interest, net of capitalized interest, were $17.49 billion, $8.55 billion and $7.21 billion for the years ended November 2005, November 2004 and November 2003, respectively.
 
Cash payments for income taxes, net of refunds, were $2.47 billion, $1.02 billion and $846 million for the years ended November 2005, November 2004 and November 2003, respectively.
 
Noncash activities:
 
The firm assumed $1.15 billion and $1.63 billion of debt in connection with business acquisitions for the years ended November 2005 and November 2004, respectively.
 
The value of common stock issued in connection with business acquisitions was $165 million for the year ended November 2003.

The accompanying notes are an integral part of these consolidated financial statements.

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CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
                         
Year Ended November
2005 2004 2003
(in millions)
 
               
Net earnings
  $ 5,626     $ 4,553     $ 3,005  
Currency translation adjustment, net of tax
    (27 )     5       128  
Minimum pension liability adjustment, net of tax
    (11 )            
Net gains on cash flow hedges, net of tax
    9              
Net unrealized holding gains, net of tax
    18              
 
                 
Comprehensive income
  $ 5,615     $ 4,558     $ 3,133  
 
                 

The accompanying notes are an integral part of these consolidated financial statements.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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:

    Investment Banking. The firm provides a broad range of investment banking services to a diverse group of corporations, financial institutions, governments and individuals.
 
    Trading and Principal Investments. The firm facilitates client transactions with a diverse group of corporations, financial institutions, governments and individuals and takes proprietary positions through market making in, trading of and investing in fixed income and equity products, currencies, commodities and derivatives on such products. In addition, the firm engages in specialist and market-making activities on equities and options exchanges and clears client transactions on major stock, options and futures exchanges worldwide. In connection with the firm’s merchant banking and other investing activities, the firm makes principal investments directly and through funds that the firm raises and manages.
 
    Asset Management and Securities Services. The firm provides investment advisory and financial planning services and offers investment products across all major asset classes to a diverse group of institutions and individuals worldwide, and provides prime brokerage services, financing services and securities lending services to mutual funds, pension funds, hedge funds, foundations and high-net-worth individuals worldwide.

Note 2.    Significant Accounting Policies

     Basis of Presentation

These consolidated financial statements have been prepared in accordance with generally accepted accounting principles that require management to make certain estimates and assumptions. The most important of these estimates and assumptions relate to fair value measurements, the accounting for goodwill and identifiable intangible assets and the provision for potential losses that may arise from litigation and regulatory proceedings and tax audits. Although these and other estimates and assumptions are based on the best available information, actual results could be materially different from these estimates.

These 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 firm determines whether it has a controlling financial interest in an entity by first evaluating whether the entity is a voting interest entity, a variable interest entity (VIE) or a qualifying special-purpose entity (QSPE) under generally accepted accounting principles.

    Voting Interest Entities. Voting interest entities are entities in which (i) the total equity investment at risk is sufficient to enable the entity to finance its activities independently and (ii) the equity holders have the obligation to absorb losses, the right to receive residual returns and the right to make decisions about the entity’s activities. Voting interest entities are consolidated in accordance with Accounting Research Bulletin (ARB) No. 51, “Consolidated Financial Statements,” as amended. ARB No. 51 states that the usual

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condition for a controlling financial interest in an entity is ownership of a majority voting interest. Accordingly, the firm consolidates voting interest entities in which it has a majority voting interest.

    Variable Interest Entities. VIEs are entities that lack one or more of the characteristics of a voting interest entity. A controlling financial interest in a VIE is present when an enterprise has a variable interest, or a combination of variable interests, that will absorb a majority of the VIE’s expected losses, receive a majority of the VIE’s expected residual returns, or both. The enterprise with a controlling financial interest, known as the primary beneficiary, consolidates the VIE. In accordance with Financial Accounting Standards Board (FASB) Interpretation (FIN) No. 46-R, “Consolidation of Variable Interest Entities,” the firm consolidates all VIEs of which it is the primary beneficiary.

The firm determines whether it is the primary beneficiary of a VIE by first performing a qualitative analysis of the VIE that includes a review of, among other factors, its capital structure, contractual terms, which interests create or absorb variability, related party relationships and the design of the VIE. Where qualitative analysis is not conclusive, the firm performs a quantitative analysis. For purposes of allocating a VIE’s expected losses and expected residual returns to its variable interest holders, the firm utilizes the “top down” method. Under that method, the firm calculates its share of the VIE’s expected losses and expected residual returns using the specific cash flows that would be allocated to it, based on contractual arrangements and/or the firm’s position in the capital structure of the VIE, under various probability-weighted scenarios.

    QSPEs. QSPEs are passive entities that are commonly used in mortgage and other securitization transactions. Statement of Financial Accounting Standards (SFAS) No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” sets forth the criteria an entity must satisfy to be a QSPE. These criteria include the types of assets a QSPE may hold, limits on asset sales, the use of derivatives and financial guarantees, and the level of discretion a servicer may exercise in attempting to collect receivables. These criteria may require management to make judgments about complex matters, including whether a derivative is considered passive and the degree of discretion a servicer may exercise. In accordance with SFAS No. 140 and FIN No. 46-R, the firm does not consolidate QSPEs.
 
    Equity-Method Investments. 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 interest of 20% to 50%) and has an investment in common stock or in-substance common stock, the firm accounts for its investment in accordance with the equity method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock.”
 
    Other. If the firm does not consolidate an entity or apply the equity method of accounting, the firm accounts for its investment at fair value. The firm also has formed numerous nonconsolidated investment funds with third-party investors that are typically organized as limited partnerships. The firm acts as general partner for these funds and does not hold a majority of the economic interests in any fund. For funds established on or before June 29, 2005 in which the firm holds more than a minor interest and for funds established or modified after June 29, 2005, the firm has provided the third-party investors with rights to terminate the funds (see “— Recent Accounting Developments” below). These fund investments are included in “Financial instruments owned, at fair value” in the consolidated statements of financial condition.

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Unless otherwise stated herein, all references to November 2005, November 2004 and November 2003 refer to the firm’s fiscal years ended, or the dates, as the context requires, November 25, 2005, November 26, 2004 and November 28, 2003, respectively. Certain reclassifications have been made to previously reported amounts to conform to the current presentation.

     Revenue Recognition

Investment Banking. Underwriting revenues and fees from mergers and acquisitions and other financial advisory assignments are recognized in the consolidated statements of earnings 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 financial advisory transactions are recorded as non-compensation expenses, net of client reimbursements.

Financial Instruments. “Total financial instruments owned, at fair value” and “Financial instruments sold, but not yet purchased, at fair value” are reflected in the consolidated statements of financial condition on a trade-date basis and consist of financial instruments carried at fair value or amounts that approximate fair value, with related unrealized gains or losses recognized in the consolidated statements of earnings. 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.

In determining fair value, the firm separates its financial instruments into three categories — cash (i.e., nonderivative) trading instruments, derivative contracts and principal investments.

    Cash Trading Instruments. Fair values of the firm’s cash trading instruments are generally obtained from quoted market prices in active markets, broker or dealer price quotations, or alternative pricing sources with reasonable levels of price transparency. The types of instruments valued in this manner include U.S. government and agency securities, other 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 trade infrequently and have little or no price transparency. Such instruments may include certain high-yield debt, corporate bank loans, mortgage whole loans and distressed debt. The firm values these instruments initially at cost and generally does not adjust valuations unless there is substantive evidence supporting a change in the value of the underlying instrument or valuation assumptions (such as similar market transactions, changes in financial ratios or changes in the credit ratings of the underlying companies). Where there is evidence supporting a change in the value, the firm uses valuation methodologies such as the present value of known or estimated cash flows.

Cash trading instruments owned by the firm (long positions) are marked to bid prices and instruments sold but not yet purchased (short positions) are marked to offer prices. If liquidating a position is expected to affect its prevailing market price, the valuation is adjusted generally based on market evidence or predetermined policies. In certain circumstances, such as for highly illiquid positions, management’s estimates are used to determine this adjustment.

    Derivative Contracts. Fair values of the firm’s derivative contracts consist of exchange-traded and over-the-counter (OTC) derivatives and are reflected net of cash that the firm has paid and received (for example, option premiums or cash paid or received pursuant to credit support agreements). Fair values of the firm’s exchange-traded derivatives are generally

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determined from quoted market prices. OTC derivatives are valued using valuation models. The firm uses a variety of valuation models including the present value of known or estimated cash flows and option-pricing models. The valuation models used to derive the fair values of the firm’s OTC derivatives require inputs including contractual terms, market prices, yield curves, credit curves, measures of volatility, prepayment rates and correlations of such inputs. The selection of a model to value an OTC derivative depends upon the contractual terms of, and specific risks inherent in, the instrument as well as the availability of pricing information in the market. The firm generally uses similar models to value similar instruments. Where possible, the firm verifies the values produced by its pricing models to market transactions. For OTC derivatives that trade in liquid markets, such as generic forwards, swaps and options, model selection does not involve significant judgment because market prices are readily available. For OTC derivatives that trade in less liquid markets, model selection requires more judgment because such instruments tend to be more complex and pricing information is less available in these markets. Price transparency is inherently more limited for more complex structures because they often combine one or more product types, requiring additional inputs such as correlations and volatilities. As markets continue to develop and more pricing information becomes available, the firm continues to review and refine the models it uses.

At the inception of an OTC derivative contract (day one), the firm values the contract at the model value if the firm can verify all of the significant model inputs to observable market data and verify the model to market transactions. When appropriate, valuations are adjusted to reflect various factors such as liquidity, bid/offer spreads and credit considerations. These adjustments are generally based on market evidence or predetermined policies. In certain circumstances, such as for highly illiquid positions, management’s estimates are used to determine these adjustments.

Where the firm cannot verify all of the significant model inputs to observable market data and verify the model to market transactions, the firm values the contract at the transaction price at inception and, consequently, records no day one gain or loss in accordance with Emerging Issues Task Force (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.”

Following day one, the firm adjusts the inputs to its valuation models only to the extent that changes in these inputs can be verified by similar market transactions, third-party pricing services and/or broker quotes, or can be derived from other substantive evidence such as empirical market data. In circumstances where the firm cannot verify the model to market transactions, it is possible that a different valuation model could produce a materially different estimate of fair value.

    Principal Investments. In valuing corporate and real estate principal investments, the firm’s portfolio is separated into investments in private companies, investments in public companies (excluding the firm’s investment in the convertible preferred stock of Sumitomo Mitsui Financial Group, Inc. (SMFG)) and the firm’s investment in SMFG.

The firm’s private principal investments, by their nature, have little or 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, in the absence of third-party transactions, if it is determined that the expected realizable value of the investment is less than the carrying value. In reaching that determination, many factors are considered 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

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models, expected exit timing and strategy, and any specific rights or terms associated with the investment, such as conversion features and liquidation preferences.

The firm’s public principal investments, which tend to be large, concentrated holdings that result from initial public offerings or other corporate transactions, are valued using quoted market prices discounted based on predetermined written policies for nontransferability and illiquidity.

The firm’s investment in the convertible preferred stock of SMFG is carried at fair value, which is derived from a model that incorporates SMFG’s common stock price and credit spreads, the impact of nontransferability and illiquidity, and the downside protection on the conversion strike price. The firm’s investment in the convertible preferred stock of SMFG is generally nontransferable, but is freely convertible into SMFG common stock. Restrictions on the firm’s ability to hedge or sell one-third of the common stock underlying its investment in SMFG lapsed in February 2005. As of November 2005, the firm was fully hedged with respect to these unrestricted shares. Under the firm’s initial agreement with SMFG, restrictions on the firm’s ability to hedge or sell the remaining shares of common stock underlying its investment in SMFG lapse in equal installments on February 7, 2006 and February 7, 2007. In connection with a public offering by SMFG of its common stock, the firm has separately agreed with SMFG that the restrictions that were to lapse on February 7, 2006 will instead lapse on March 9, 2006. Effective February 1, 2006, the conversion price of the firm’s SMFG preferred stock into shares of SMFG common stock is ¥320,900. This price is subject to downward adjustment if the price of SMFG common stock at the time of conversion is less than the conversion price (subject to a floor of ¥105,800).

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 as sales, any related gains or losses are recognized in net revenues. Transfers that are not accounted for as sales are accounted for as collateralized financing arrangements, with the related interest expense recognized in net revenues over the lives of the transactions.

Collateralized Financing Arrangements. Collateralized financing arrangements consist of repurchase agreements and securities borrowed and loaned. Interest income or expense on repurchase agreements and securities borrowed and loaned is recognized in net revenues over the life of the transaction.

    Resale and Repurchase Agreements. 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 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,” or FIN No. 39, “Offsetting of Amounts Related to Certain Contracts,” are satisfied. The firm receives securities purchased under agreements to resell, makes delivery of securities sold under agreements to repurchase, monitors the market value of these securities on a daily basis and delivers or obtains additional collateral as appropriate.
 
    Securities Borrowed and Loaned. Securities borrowed and loaned are recorded based on the amount of cash collateral advanced or received. These transactions are generally collateralized by cash, securities or letters of credit. The firm receives securities borrowed,

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      makes delivery of securities loaned, monitors the market value of securities borrowed and loaned, and delivers or obtains additional collateral as appropriate.

Power Generation. Power generation revenues associated with the firm’s consolidated power generation facilities are included in “Trading and principal investments” in the consolidated statements of earnings when power is delivered. “Cost of power generation” in the consolidated statement of earnings includes all of the direct costs of these facilities (e.g., fuel, operations and maintenance), as well as the depreciation and amortization associated with the facility and related contractual assets.

The following table sets forth the power generation revenues and costs directly associated with the firm’s consolidated power generation facilities:

                         
Year Ended November
2005 2004 2003 (2)
(in millions)
 
Revenues (1)
  $ 496     $ 488     $ 15  
Cost of power generation
    456       401       11  
 
(1)   Excludes revenues from nonconsolidated power generation facilities, accounted for in accordance with the equity method of accounting, as well as revenues associated with the firm’s power trading activities.
 
(2)   The firm acquired its first consolidated power generation facility in October 2003.

Commissions. Commission revenues from executing and clearing client transactions on stock, options and futures markets worldwide are recognized in “Trading and principal investments” in the consolidated statements of earnings on a trade date basis.

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 of override previously distributed to the firm to be returned to the funds. Accordingly, overrides are recognized in the consolidated statements of earnings only when all material contingencies have been resolved. Overrides are included in “Trading and principal investments” in the consolidated statements of earnings.

Asset Management. Management fees are recognized over the period that the related service is provided based upon average net asset values. In certain circumstances, the firm is also entitled to receive asset management incentive fees based on a percentage of a fund’s return or when the return on assets under management exceeds specified benchmark returns or other performance targets. Incentive fees are generally based on investment performance over a 12-month period and are subject to adjustment prior to the end of the measurement period. Accordingly, incentive fees are recognized in the 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 consolidated statements of earnings.

     Stock-Based Compensation

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, “Accounting for Stock-Based Compensation,” 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. No unearned

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compensation is included in “Shareholders’ equity” for such stock options and restricted stock units granted. Rather, such stock options and restricted stock units are included in “Shareholders’ equity” under SFAS No. 123 when services required from employees in exchange for the awards are rendered and expensed.

Compensation expense resulting from stock options and restricted stock units granted for the year ended November 29, 2002 and prior years is accounted for under the intrinsic-value-based method prescribed by APB Opinion No. 25, “Accounting for Stock Issued to Employees,” as permitted by SFAS No. 123. Therefore, no compensation expense is recognized for unmodified stock options issued for years prior to fiscal 2003 that had no intrinsic value on the date of grant. Compensation expense for restricted stock units issued for the years prior to fiscal 2003 was, and continues to be, recognized over the relevant service periods using amortization schedules based on the applicable vesting provisions.

Employees who meet the retirement criteria are subject to a non-compete agreement from the date of retirement through the date that shares underlying the awards are delivered. Equity awards granted to employees who have satisfied the retirement eligibility criteria are expensed over the stated service period for the award. In the event a retirement-eligible employee retires, any unamortized grant date value is immediately expensed. A reduction to compensation expense is recorded upon forfeiture related to employees who meet the retirement criteria and violate their non-compete agreements.

The firm pays cash dividend equivalents on outstanding restricted stock units. Dividend equivalents paid on restricted stock units accounted for under SFAS No. 123 are charged to retained earnings when paid. Dividend equivalents paid on restricted stock units that are later forfeited by employees are reclassified to compensation expense from retained earnings. Dividend equivalents paid on restricted stock units granted for the year ended November 29, 2002 and prior years, accounted for under APB Opinion No. 25, are charged to compensation expense.

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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 29, 2002 and all prior years, net earnings would have decreased, resulting in pro forma net earnings and earnings per common share (EPS) as set forth below:

                             
Year Ended November
2005 2004 2003
(in millions, except per share amounts)
 
                           
Net earnings applicable to common shareholders, as reported
  $ 5,609     $ 4,553     $ 3,005  
Add:  
Stock-based employee compensation expense, net of related tax effects, included in reported net earnings
    1,133       790       458  
Deduct:  
Stock-based employee compensation expense, net of related tax effects, determined under the fair value method for all awards
    (1,178 )     (947 )     (782 )
 
                     
Pro forma net earnings applicable to common shareholders
  $ 5,564     $ 4,396     $ 2,681  
 
                     
EPS, as reported
                       
Basic
      $ 11.73     $ 9.30     $ 6.15  
Diluted
        11.21       8.92       5.87  
Pro forma EPS
                       
Basic
      $ 11.64     $ 8.98     $ 5.49  
Diluted
        11.12       8.61       5.24  

Goodwill

Goodwill is the cost of acquired companies in excess of the fair value of identifiable net assets at acquisition date. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill is tested at least annually for impairment. An impairment loss is triggered if the estimated fair value of an operating segment is less than its estimated net book value. Such loss is calculated as the difference between the estimated fair value of goodwill and its carrying value.

Identifiable Intangible Assets

Identifiable intangible assets, which consist primarily of customer lists, above-market power contracts and specialist rights, are amortized over their estimated useful lives. Identifiable intangible assets are tested for potential impairment whenever events or changes in circumstances suggest that an asset’s or asset group’s carrying value may not be fully recoverable in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” An impairment loss, calculated as the difference between the estimated fair value and the carrying value of an asset or asset group, is recognized if the sum of the estimated undiscounted cash flows relating to the asset or asset group is less than the corresponding carrying value.

Property, Leasehold Improvements and Equipment

Property, leasehold improvements and equipment, net of accumulated depreciation and amortization, are included in “Other assets” in the consolidated statements of financial condition.

Property and equipment placed in service prior to December 1, 2001 are depreciated under the accelerated cost recovery method. Property and equipment placed in service on or after December 1, 2001 are depreciated on a straight-line basis over the useful life of the asset.

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Leasehold improvements for which the useful life of the improvement is shorter than the term of the lease are amortized under the accelerated cost recovery method if placed in service prior to December 1, 2001. All other leasehold improvements are amortized on a straight-line basis over the useful life of the improvement or the term of the lease, whichever is shorter. Certain costs of software developed or obtained for internal use are amortized on a straight-line basis over the useful life of the software.

Property, leasehold improvements and equipment are tested for potential impairment whenever events or changes in circumstances suggest that an asset’s or asset group’s carrying value may not be fully recoverable in accordance with SFAS No. 144. An impairment loss, calculated as the difference between the estimated fair value and the carrying value of an asset or asset group, is recognized if the sum of the expected undiscounted cash flows relating to the asset or asset group is less than the corresponding carrying value.

The firm’s operating leases include space held in excess of current needs. Rent expense relating to space held for growth is included in “Occupancy” in the consolidated statements of earnings. In accordance with SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” the firm records a liability, based on the remaining lease rentals reduced by any potential or existing sublease rentals, for leases where the firm has ceased using the space and management has concluded that the firm will not derive any future economic benefits. Costs to terminate a lease before the end of its term are recognized and measured at fair value upon termination.

Foreign Currency Translation

Assets and liabilities denominated in non-U.S. currencies are translated at rates of exchange prevailing on the date of the consolidated statement of financial condition, and revenues and expenses are translated at average rates of exchange for the fiscal year. Gains 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 and taxes, on the consolidated statements of comprehensive income. The firm seeks to reduce its net investment exposure to fluctuations in foreign exchange rates through the use of foreign currency forward contracts and foreign currency-denominated debt. For foreign currency forward contracts, 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 consolidated statements of comprehensive income. For foreign currency-denominated debt, hedge effectiveness is assessed based on changes in spot rates. Foreign currency remeasurement gains or losses on transactions in nonfunctional currencies are included in the consolidated statements of earnings.

Income Taxes

Deferred tax assets and liabilities are recognized for temporary differences between the financial reporting and tax bases of the firm’s assets and liabilities. Valuation allowances are established to reduce deferred tax assets to the amount that more likely than not will be realized. The firm’s tax assets and liabilities are presented as a component of “Other assets” and “Other liabilities and accrued expenses,” respectively, in the consolidated statements of financial condition. Tax provisions are computed in accordance with SFAS No. 109, “Accounting for Income Taxes.” Contingent liabilities related to income taxes are recorded when the criteria for loss recognition under SFAS No. 5, “Accounting for Contingencies,” as amended, have been met.

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Earnings Per Common Share

Basic EPS is calculated by dividing net earnings applicable to common shareholders by the weighted average number of common shares outstanding. Common shares outstanding includes common 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.

Cash and Cash Equivalents

The firm defines cash equivalents as highly liquid overnight deposits held in the ordinary course of business.

Recent Accounting Developments

In December 2004, the FASB issued a revision to SFAS No. 123, SFAS No. 123-R, “Share-Based Payment.” SFAS No. 123-R establishes standards of accounting for transactions in which an entity exchanges its equity instruments for goods and services. SFAS No. 123-R focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. Two key differences between SFAS No. 123 and SFAS No. 123-R relate to attribution of compensation costs to reporting periods and accounting for award forfeitures. SFAS No. 123-R generally requires the immediate expensing of equity-based awards granted to retirement-eligible employees. However, awards granted subject to a substantive non-compete agreement are generally expensed over the non-compete period. SFAS No. 123-R also requires expected forfeitures to be included in determining stock-based employee compensation expense (see “— Stock-Based Compensation” above for a discussion of how the firm currently accounts for equity-based awards granted to retirement-eligible employees and forfeitures). The firm will adopt SFAS No. 123-R in the first quarter of fiscal 2006. Management is currently evaluating the effect of adoption of SFAS No. 123-R on the firm’s results of operations with respect to awards granted to retirement-eligible employees that are subject to a non-compete agreement.

The following table sets forth the pro forma net earnings that would have been reported for each year if equity-based awards granted to retirement-eligible employees had been expensed over the non-compete period and if expected forfeitures had been accrued as required by SFAS No. 123-R:

                             
Year Ended November
2005 2004 2003
(in millions)
   
 
                       
Net earnings applicable to common shareholders, as reported
  $ 5,609     $ 4,553     $ 3,005  
Add:  
Stock-based employee compensation expense, net of related tax effects, included in reported net earnings
    1,133       790       458  
Deduct:  
Stock-based employee compensation expense, net of related tax effects, determined under SFAS No.  123-R
    (1,106 )     (802 )     (503 )
   
 
                 
Pro forma net earnings applicable to common shareholders
  $ 5,636     $ 4,541     $ 2,960  
   
 
                 

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In June 2005, the EITF reached consensus on Issue No. 04-5, “Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights,” which requires general partners (or managing members in the case of limited liability companies) to consolidate their partnerships or to provide limited partners with rights to remove the general partner or to terminate the partnership. The firm, as the general partner of numerous merchant banking and asset management partnerships, is required to adopt the provisions of EITF 04-5 (i) immediately for partnerships formed or modified after June 29, 2005 and (ii) in the first quarter of fiscal 2007 for partnerships formed on or before June 29, 2005 that have not been modified. The firm generally expects to provide limited partners in these funds with rights to remove the firm or rights to terminate the partnerships and, therefore, does not expect that EITF 04-5 will 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, at fair value, including those pledged as collateral, and financial instruments sold, but not yet purchased, at fair value:

                                 
As of November
2005 2004
Assets Liabilities Assets Liabilities
(in millions)
 
                               
Commercial paper, certificates of deposit, time deposits and other money market instruments
  $ 14,609  (1)   $     $ 7,386  (1)   $  
U.S. government, federal agency and sovereign obligations
    68,688       51,458       46,777       40,866  
Corporate and other debt obligations
                               
Mortgage whole loans and collateralized debt obligations
    31,459       223       18,346       671  
Investment-grade corporate bonds
    12,415       4,232       11,783       5,163  
Bank loans
    13,843       288       8,900       428  
High-yield securities
    8,822       2,072       6,057       1,725  
Preferred stock
    7,315       71       4,792       109  
Other
    877       278       885       248  
 
                       
 
    74,731       7,164       50,763       8,344  
Equities and convertible debentures
    56,656       32,565       42,263       18,766  
State, municipal and provincial obligations
    2,524             1,308        
Derivative contracts
    58,532  (2)     57,829  (3)     62,495  (2)     64,001  (3)
Physical commodities
    1,286       55       812       120  
 
                       
Total
  $ 277,026     $ 149,071     $ 211,804     $ 132,097  
 
                       
 
(1)   Includes $6.12 billion and $5.84 billion, as of November 2005 and November 2004, respectively, of money market instruments held by William Street Funding Corporation to support the William Street credit extension program.
 
(2)   Net of cash received pursuant to credit support agreements of $22.61 billion and $18.65 billion as of November 2005 and November 2004, respectively.
 
(3)   Net of cash paid pursuant to credit support agreements of $16.10 billion and $5.45 billion as of November 2005 and November 2004, respectively.

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Credit Concentrations

Credit concentrations may arise from trading, underwriting and securities borrowing activities and may be impacted by changes in economic, industry or political factors. As of November 2005 and November 2004, the firm held U.S. government and federal agency obligations that represented 7% and 5% of the firm’s total assets, respectively. In addition, most of the firm’s securities purchased under agreements to resell are collateralized by U.S. government, federal agency and other sovereign obligations. As of November 2005 and November 2004, the firm did not have credit exposure to any other counterparty that exceeded 5% of the firm’s total assets.

Derivative Activities

Derivative contracts are 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. 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, currencies or indices.

Certain cash instruments, such as mortgage-backed securities, interest-only and principal-only obligations, and indexed debt instruments, are not considered derivatives even though their values or contractually required cash flows are derived from the price of some other security or index. However, certain commodity-related contracts are included in the firm’s derivatives disclosure, as these contracts may be settled in cash or are readily convertible into cash.

Substantially all of the firm’s derivative transactions are entered into for trading purposes, to facilitate client transactions, to take proprietary positions or 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 trading purposes are generally included in “Trading and principal investments” in the consolidated statements of earnings.

In addition to derivative transactions entered into for trading purposes, the firm enters into derivative contracts to hedge its net investment in non-U.S. operations (see Note 2 for further information regarding the firm’s policy on foreign currency translation) and to manage the interest rate and currency exposure on its long-term borrowings and certain short-term borrowings. To manage exposure on its borrowings, the firm uses derivatives to effectively convert a substantial portion of its long-term borrowings into U.S. dollar-based floating rate obligations. The firm applies fair value hedge accounting to derivative contracts that hedge the benchmark interest rate (i.e., London Interbank Offered Rate (LIBOR)) on its fixed rate long-term borrowings. The firm also applies cash flow hedge accounting to derivative contracts that hedge changes in interest rates associated with floating rate long-term borrowings related to its power generation facilities.

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Fair values of the firm’s derivative contracts are reflected net of cash paid or received pursuant to credit support agreements and are reported on a net-by-counterparty basis in the firm’s 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:

                                 
As of November
2005 2004
Assets Liabilities Assets Liabilities
(in millions)
 
                               
Forward settlement contracts
  $ 13,921     $ 15,345     $ 13,137     $ 14,578  
Swap agreements
    25,865       22,001       34,727       30,836  
Option contracts
    18,746       20,483       14,631       18,587  
 
                       
Total
  $ 58,532     $ 57,829     $ 62,495     $ 64,001  
 
                       

Securitization Activities

The firm securitizes commercial and residential mortgages, home equity and auto 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. Net revenues related to these underwriting activities are recognized in connection with the sales of the underlying beneficial interests to investors.

The firm may retain interests in securitized financial assets. Retained interests are accounted for at fair value and included in “Total financial instruments owned, at fair value” in the consolidated statements of financial condition.

During the years ended November 2005 and November 2004, the firm securitized $92.00 billion and $62.93 billion, respectively, of financial assets, including $65.18 billion and $47.46 billion, respectively, of residential mortgage-backed securities. Cash flows received on retained interests were approximately $908 million and $984 million for the years ended November 2005 and November 2004, respectively.

As of November 2005 and November 2004, the firm held $6.07 billion and $4.33 billion of retained interests, respectively, including $5.62 billion and $4.11 billion, respectively, held in QSPEs. The fair value of retained interests valued using quoted market prices in active markets was $1.34 billion and $949 million as of November 2005 and November 2004, respectively.

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The following table sets forth the weighted average key economic assumptions used in measuring retained interests for which fair value is based on alternative pricing 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:

                                 
As of November 2005 As of November 2004
Type of Retained Interests Type of Retained Interests
Mortgage-