Research Research remains a critically important part of the Goldman Sachs franchise. We believe that a strong, differentiated research effort that is firmly aligned with the interests of our investing clients will be an important part of our Equities business for many years to come. Of course, 2003 began with the brokerage industry's global settlement with various regulators on equities research-related matters. As we have said before, in hindsight we and others could have done a better job. However, we had already begun implementing changes in our research business long before the final settlement, and we have been working diligently to comply in every respect with the new ground rules. We will continue to shape our research so that the qualities our clients value most—industry expertise, independent thinking and timely insights—are at the forefront of our proposition to investors. SLK Specialist Our SLK stock specialist business, as well as the other specialists on the New York Stock Exchange (NYSE), have been, and continue to be, the subject of an intense regulatory review and enforcement action. Much attention has focused on the conduct of specialists within the existing NYSE rules, as well as potential changes to the rules governing the role of specialists. The role of the specialist and the rules of the NYSE should be evaluated against the proper objective—the development of the best market structure for all participants. In our view, the market structure of the future can take any number of forms, but the goal should be to produce a system that is fair to all investors and one where liquidity is maximized and investors can prioritize price, speed and cost of execution. We have in the past stated that we are not wedded to any particular market structure. Goldman Sachs is active and successful in markets around the world, many of which make greater use of electronic interfaces than the NYSE. In fact, we have invested in a number of electronic trading platforms. We believe, however, that the specialist performs a valuable role in maintaining an orderly market, particularly during times of market stress or when there are imbalances or dislocations with regard to a single stock. This system has helped to maintain the NYSE as the leading equities exchange in the world. We also believe investors are best served by large liquidity pools and greater use of electronic structures. By centralizing, rather than fragmenting, liquidity, investors will achieve the best possible outcomes. At this point, we are unable to predict the outcome of the regulatory review or the impact of potential reforms. We can assure you, however, that we will continue to cooperate fully with the regulators and to assist them in every way we can to develop the best equities market possible. Whatever changes are adopted, we feel confident in our ability to compete successfully across our equities franchise, which remains an industry leader. Risk Management It is often reported in the media that we have increased our trading risk in recent years to offset the decline in investment banking activity levels. In fact, the same shocks and trends in the economy that have led to the sharp declines in investment banking have also created significant trading opportunities for our clients and for Goldman Sachs. We believe our willingness to take significant trading risk for appropriate reward is one of the distinguishing features of our firm and gives us a competitive advantage. We benefit in the marketplace because our clients—many of whom are among the world's largest and most sophisticated institutions—value our ability to tailor solutions and our willingness to commit our capital to meet their needs. Given the significant levels of risk we run in our business, we consider risk management to be one of our most vital functions. Risk management begins at the top of the firm with the establishment of risk limits for major business units and the involvement of our most senior people in critical decisions. In setting limits, there is no magic formula. But we do size our risk in proportion to our capital base and our overall earnings power. Since we went public in 1999, our shareholders' equity has grown more than threefold, to $21.63 billion as of November 2003. One principal tool we use to measure market risk is Value at Risk (VaR), a statistical measure of the potential loss in value of our trading positions due to adverse market movements over a defined time horizon with a specified confidence level. We use a one-day horizon and a 95% level of confidence. This means that, about once a month, our actual daily trading revenues should be less than our expected daily trading revenues by an amount at least as large as our VaR. In 2003, our average daily VaR was $58 million. As important as it is to understand what VaR is telling you, it is important to understand what it is not telling you. VaR in no way captures a “worst case” scenario. Shortfalls on a single day can exceed reported VaR by a large amount. In addition, shortfalls can accumulate over a longer period, such as a number of consecutive trading days. As a predictor of trading results, VaR historically has worked relatively well in stable markets and less well in very volatile and illiquid markets. Recognizing this fact, we also perform various scenario analyses, asking “What if?” about any number of possible events. These scenarios are used to establish limits and to attempt to keep our risk manageable. No one likes trading losses, but they are a feature of our business. In fact, it is our willingness to tolerate such occasional, sizeable losses that enables us to earn attractive returns over time. And, even when our trading businesses are performing well, results can be uneven. 3 / 6 3 / 6 © Copyright 2007, The Goldman Sachs Group, Inc. All rights reserved.