The SEC accuses Goldman Sachs of fraud

Goldman charged with fraud

The SEC announced Friday that it is charging the investment firm Goldman Sachs and one of the professionals in its bond area with fraud in connection with the creation and sale of a collateralized debt obligation (CDO) where the ultimate backing was a collection of  sub-prime mortgages.

The details

As I read it, the SEC complaint contends that in this particular issue the odds were stacked against investors in the CDO, because:

1.  the hedge fund Paulson & Co. did an extensive study of sub-prime mortgages early in 2007, identifying over a hundred mortgage-backed securities that its analysis concluded would most likely face financial difficulties.

2.  Paulson approached Goldman with the list and paid it $15 million for help in creating a CDO whose performance would be tied to most or all of the securities.  Paulson also intended to effectively sell this CDO short.

3.  Goldman got ACA Management, a firm experienced in managing credit risk with residential mortgage-backed securities, to act as the official selection agent for the securities linked to the CDO.  Goldman served as a middleman between Paulson and ACA in negotiations over the mortgage securities that would underlie the CDO to make sure they were satisfactory to both.  Goldman also knew that ACA had the mistaken belief that Paulson wanted the CDO to succeed, rather than fail, assuming Paulson would buy part/all of the riskiest tranche, but did not correct that misapprehension.

4.  Neither the offering document nor any of the CDO marketing materials contain any mention of Paulson’s role in selecting the sub-prime mortgages underling the CDO or of Paulson’s economic interest in seeing the mortgages fail.

As Paragraph 3 of the complain puts it:

“3. In sum, GS&Co arranged a transaction at Paulson’s request in which Paulson heavily influenced the selection of the portfolio to suit its economic interests, but failed to disclose to investors, as part of the description of the portfolio selection process contained in the marketing materials used to promote the transaction, Paulson’s role in the portfolio selection process or its adverse economic interests.”

In short order, virtually all the underlying mortgage-backed securities were downgraded.  Investors lost $1 billion.  By shorting tranches of the CDO, Paulson gained $1 billion.

Goldman’s response

The company has denied the charges, calling them “completely unfounded in law and fact.”

In addition, Goldman issued a press release after the close on Friday, in which it said (with some added interpretation from me):

a.  no matter what “help” it received from Paulson, ultimately ACA agreed to the CDO structure and put its name on the dotted line as Selection Agent

b.  Goldman never told ACA that Paulson was going to be a long investor in the transaction.  Further, as a middleman its duty is to protect the identities of both sides of any trade.  (I read this as a very narrow statement; as saying that, yes, Goldman may have known what ACA thought–and may not have put any obstacles in ACA’s way in going down that road–but it never said “Paulson” and “long investor” in the same sentence.  The SEC, in contrast, seems to be saying that the offense is in the failure to set ACA straight about Paulson’s role.)

c.  The investors, ACA and German bank IKB, are sophisticated professionals with a lot of experience with sub-prime.  They had all the materials they needed to analyze the relevant mortgage-backed securities themselves.  They made an independent (though horribly incorrect) judgment about the quality of the deal.

Besides, there’s always a guy on the other side of the transaction.  ACA and IKB knew that.  His identity and intentions aren’t relevant.

d.  Goldman itself lost over $90 million on this deal (no details on what this means; in particular, does this figure include any offsetting hedges?).

What the SEC is not saying (as I see it)

The SEC is not complaining that Goldman is

–acting as an agent In almost every trading situation, both buyer and seller think they know more than the other side.  Neither is obligated to educate the other, either before or after the fact.  When I bought AAPL at $13, I didn’t have to tell the seller I thought the iPod would transform the company.  He didn’t have to tell me what an idiot I was to take off his hands shares in a firm that was doubtless headed for Chapter 11.  No one wants the broker who acts as a middleman to put his two cents in, either.   Knowing more than the other guy isn’t acting against the other’s interests in the sense the SEC is talking about.

–providing liquidity Sometimes, when no “natural” counterparty can be found, a big client will ask a broker to facilitate the trade by either buying the securities itself or shorting them to the client.   The trade may, or may not, turn out to be a good idea.  In the latter case, and depending on how he trades out of the position (long or short) he has taken on, the broker may make a lot of money.  This isn’t acting against a client’s interests in the way the SEC means, either.

–trading against a client In some markets outside the US, it is the custom, when a broker provides research support that has a material influence on the client’s buy or sell decision, to transact through that broker.  The thought is that this will encourage the broker to provide more investment ideas, as well as to ensure the flow of maintenance research on this particular one.

The US custom is the opposite—to sever the connection completely between trading and research, so that brokers will have as little clue as possible about a firm’s intentions.  If the client’s traders are skillful enough, even if brokers wanted to act against its interests, they would have only a vague idea of what they are.

(Note that a trading issue came up last year when someone (my money is on analysts who thought the practice is unethical) leaked information about its trading “huddles” to the press.  These were weekly meetings that generated short-term trading recommendations that sometimes went against Goldman’s “official” recommendations and were only made known to a select group of big clients.  Goldman pointed to fine print in the Disclaimer section of its publications that said it might do this.)

What the SEC is saying

If I understand the Goldman statements, it’s saying it was acting in this private placement as a marketer/trader/middleman.  The SEC, I think, is maintaining that Goldman was an originator/underwriter of the security and therefore must comply to the higher standard of full and complete disclosure of all material facts.

The fact that Goldman knew Paulson was trying to put as many holes as it could into the bottom of the boat is presumably material.

my thoughts (so far)

1.  I’m not a lawyer.  I have no idea how this will play out in court.  It would be interesting, however, to see a list of Goldman’s clients by revenue generated.  My guess is that Paulson is on the first page or two and ACA and IKB are afterthoughts.

2. Given all the high-profile financial crisis-related cases where the SEC has declined to prosecute and settled instead, in part judging that it didn’t have enough evidence to prevail in court, it may consider this case a slam-dunk.  Or it’s under enormous pressure to do something and it’s just Goldman’s bad luck to be in the firing line.

3. Any good marketer tries to take a purely commercial relationship with his customers and turn it into one of friendship and trust.  For the best companies, they actually mean what they say.

For Goldman, the pitch has been something like–we’re very smart and have good ideas; you have assets and a distribution network; let’s team up to generate great investment performance and we’ll grow rich together.  The SEC account of this incident reads more like a chapter out of Liar’s Poker, where the broker’s intent was more to suck the client dry and toss him on the junk pile.

The real damage to Goldman is reputational, not the lawsuit.

4.  Goldman’s response so far is to say it has broken no laws.  I think a better tack would be to say (assuming the SEC complaint is more or less factually accurate)–yes, what we did was legally correct.  But it doesn’t live up to our high ethical standards.  It’s an isolated incident by rogue employees.  We’re going to punish those involved and make restitution.

Of course, this is a problem if the SEC has a dozen more similar cases lined up or witnesses who will testify that this deal was approved at the highest levels.  It’s also a problem if the SEC won’t allow Goldman to settle, or if Goldman is completely blameless.  According to Bloomberg, talks had already been going on for nine months about the case before the SEC made its lawsuit announcement last week.

Also, reporters are already beginning to ask how “political” the SEC decision is in this matter.  Is the desire to prosecute this case and right now based solely on its merits?  or is it a response, perhaps the first of a series, to the deep dissatisfaction of many Americans with the apparent lack of interest by Washington in investigating those who caused the financial crisis?  We’ll know better if further SEC complaints are filed against other financial companies in the coming weeks.

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