The fraud charges filled by the SEC against Goldman Sachs could be a pivotal moment in financial industry as the United States continues its painful recovery from the financial crisis. According to some experts this case signals that the regulators could eventually target other banks over how much they told investors about at least $40billion of collateralized debt obligations (CDO) that share similar profiles.
The allegations of the case can be summarized as follows: In early 2007, Paulson & Co. hedge fund manager John Paulson believed the U.S. housing market was in a bubble, and wanted to short the entire sector. Lacking any easy way to do this, he worked with Fabrice Tourre, a London based senior vice president at Goldman Sachs, to draw up a list of mortgage-backed securities that were certain to default.
Tourre then shared that list of securities with a mortgage analysis company named ACA Management, and persuaded ACA into using that list to draw up collateralized debt obligations Goldman Sachs could sell to investors, CDOs whose value would depend on homeowners continuing to make their mortgage payments.
Tourre neglected to tell ACA or investors that Paulson had pre-selected those securities on the assumption that the homeowners funding them would not continue to make their payments. Paulson, meanwhile, also purchased credit default swaps on those CDOs, betting that they would default. When they did, the investors lost $1 billion. Paulson profited $1 billion. Goldman acted as the middleman for this transaction and collected $15 million in fees.
These are all issues related to disclosure. Had Tourre disclosed Paulson’s role in this scheme, neither ACA nor any intelligent investor would have purchased the CDOs Goldman was selling. But Goldman had large and lucrative market for these securities, so it omitted material facts about the nature of CDOs in order to sell them. This is the underlying misconduct the SEC alleges.
The SEC accuses Goldman of violating three specific securities laws: Section 17(a) of the Securities Act, Section 10(b) of the Securities Exchange Act and Exchange Act Rule 10b-5. All three essentially forbid anyone from using fraud or deceit, including the omission of material facts, to profit from a securities sale.
The question is whether Paulson’s undisclosed role in portfolio selection was material. In other words, would a reasonable investor want to know this information before investing in this security? However, there is no clear and well-defined definition of what material information is and what you have to disclose in this type of transaction.
Goldman argues that the facts about Paulson weren’t material. That hedge-fund manager Paulson was nearly unknown when the securities were sold in early 2007, and participants were unlikely to have cared about his role. Goldman also said in its response that its clients got the material information needed, including the types of mortgages going into the securities. Finally, it argues that the investors in the CDOs were sophisticated enough to know that for every buyer of a CDO, somebody else out there is shorting that position (which is how these deals work).
How do legal experts respond to this case? They seem to be split on the issue. Some securities lawyers said the SEC’s 22-page complaint offered strong evidence that Goldman should have disclosed information about Paulson. Other lawyers not involved in the case said those buying the securities were sophisticated institutional investors presumably able to size up a product’s worth and should be judged by a different disclosure standard.
This legal battle is just about to unfold. Most likely, U.S. District Judge Barbara Jones, who was assigned the case won’t dismiss the SEC complaint because materiality is what’s at issue.
If the SEC’s case survives a dismissal motion, the case would probably proceed to discovery, when the agency may seek additional testimony or information from the firm. That process could provide incentive for private lawsuits, additional allegations from regulators, or media attention that would further damage Goldman’s reputation. After that, Goldman’s risk will mount and its negotiating position will weaken.
Finally, politicians rushed to tie the Goldman case to finance reform. Lloyd Blankfein and other Goldman executives are scheduled to testify at a Senate hearing next week along with Fabrice Tourre. The Permanent Subcommittee on Investigations will explore investment banks’ role in the financial crisis at the April 27 hearing.
The future of Goldman Sachs still uncertain, but it certainly will shape the future of the financial industry in the United States.
