I've been pondering the SEC complaint against Goldman Sachs. As the SEC litigation release explains, the complaint alleges that "one of the world's largest hedge funds, Paulson & Co., paid Goldman Sachs to structure a transaction in which Paulson & Co. could take short positions against mortgage securities chosen by Paulson & Co. based on a belief that the securities would experience credit events."
The SEC alleges that one of the world's largest hedge funds, Paulson & Co., paid Goldman Sachs to structure a transaction in which Paulson & Co. could take short positions against mortgage securities chosen by Paulson & Co. based on a belief that the securities would experience credit events.
According to the SEC's complaint, filed in U.S. District Court for the Southern District of New York, the marketing materials for the CDO known as ABACUS 2007-AC1 (ABACUS) all represented that the RMBS portfolio underlying the CDO was selected by ACA Management LLC (ACA), a third party with expertise in analyzing credit risk in RMBS. The SEC alleges that undisclosed in the marketing materials and unbeknownst to investors, the Paulson & Co. hedge fund, which was poised to benefit if the RMBS defaulted, played a significant role in selecting which RMBS should make up the portfolio.
The SEC's complaint alleges that after participating in the portfolio selection, Paulson & Co. effectively shorted the RMBS portfolio it helped select by entering into credit default swaps (CDS) with Goldman Sachs to buy protection on specific layers of the ABACUS capital structure. Given that financial short interest, Paulson & Co. had an economic incentive to select RMBS that it expected to experience credit events in the near future. Goldman Sachs did not disclose Paulson & Co.'s short position or its role in the collateral selection process in the term sheet, flip book, offering memorandum, or other marketing materials provided to investors.
If the SEC can prove those basic facts -- and that may be a very big IF -- this strikes me as pretty basic stuff. The fact that somebody who was going to take a short position against a security helped choose the instruments making up that security may involve high tech finance, but it's horse and buggy whip fraud. Goldman Sachs was on both sides of the deal, making money from both sides, and that's material information.
There is one red flag, however. SEC Commissioners Kathleen Casey and Troy Paredes reportedly voted against bringing the suit. Some partisans of the left will try to make political hay out of the fact that the Commission split on party lines. But I've interacted with Paredes many times over the years. He's not a blatantly partisan guy. He's one of the smartest and most knowledgeable securities law academics I know. Among other things, not everybody gets asked to take over maintenance of Louis Loss' famous multi-volume sec reg treatise. I respect his judgment and opinion. If he voted no, I'm inclined to think that he had good reason to do so. So I'm going to withhold judgment for now.
Let's take a spin around the blogosphere for more coverage:
Erik Gerding and I seem to be on the same page:
Someone asked me “so did Goldman deceive ACA and investors?” I don’t know. Am I being coy or hiding the ball? No, I think that fraud cases like any litigation should revolve around the facts, not deductive logic and theory. And we are just starting to get facts.
Saying investors should have known these were risky securities and declaring “bubble” after the fact, doesn’t speak to whether there was fraud in this particular case. Just as noting that Goldman had many potential conflicts from playing every angle of a transaction doesn’t mean that there was deception.
Assuming the facts as claimed by the SEC, however, I agree with Larry Cuningham that this looks like a simple case:
Despite a complex context and heated rhetoric on all sides, the core of the SEC’s complaint against Goldman Sachs is simple: Goldman sold to investors a bet based on a list of securities it said would be hand-picked by an independent expert when the list was allegedly picked in part by a Goldman client with interests diametrically opposed to the investors. The only successful defense to this allegation is that the independent expert did in fact hand-pick the list and neither Goldman nor its other clients played a role in it.
Picking the list is vital and related disclosures or non-disclosures material within the meaning of federal securities laws. If investors are told a list is chosen by an independent party, they are told that the bet will be a fair game—knowing, of course, that other investors will have different views and either refuse to buy the same device or even take short positions against it. But if investors are told that a list will be chosen by someone who will make money only if its value declines, rational investors will eschew such a game as rigged, not fair.
The Deal Journal has links to Goldman's Wells Submissions.
First, it is a myth to think that sophisticated investors can operate without some layer of regulatory protection, whether substantive or disclosure oriented. Mere knowledge of the reference securities is not enough. ABN-Amro and IKB may be sophisticated but they do not have the same depth or expertise as Paulson in assessing risk.
Second, disclosure is not enough, at least in some cases. Even had Paulson's identity been revealed in connection with the selection of the reference securities, sophisticated investors still would have been left at a serious disadvantage. They would know that Paulson would have an incentive to make sure the portfolio included the securities with the greatest risk of failure (and providing the short with the greatest likelihood of positive return).
But this is not enough. Investors would need to either be told far more about the portfolio (the precise criteria used to selection the reference securities, the precise role played by Paulson, given that ACA had some input and perhaps veto over the selected securities) or would need to duplicate Paulson's analysis. The former is difficult; the latter is inefficient and wasteful.
Third, these types of circumstances create a possible conflict of interest. The creator of the synthetic CDO has one set of clients that wants to make money from going long and another that wants to make money from going short. In these types of circumstances, there is always the risk that the transaction will be skewed in favor of one side or the other. As a result, disclosure will not be enough.
I agree that disclosure of conflicts of interest is almost always desirable. I agree that the fact that these were sophisticated investors doesn't mean they aren't entitled to protection. See Securities and Exchange Commission v. Texas Gulf Sulphur Co., 401 F.2d 833, 849 (2d Cir. 1968) ("The speculators and chartists of Wall and Bay Streets are also ‘reasonable’ investors entitled to the same legal protection afforded conservative traders.").
But I disagree with the proposition that investors -- especially sophisticated ones -- are entitled to the benefit of Paulson's research and analysis. See Texas Gulf Sulphur, 401 F.2d at 848 ("Nor is an insider obligated to confer upon outside investors the benefit of his superior financial or other expert analysis by disclosing his educated guesses or predictions.").
I also disagree with the proposition that disclosure is not enough. The securities laws have always been a rotten egg statute. You can sell somebody a rotten egg, so long as you tell them the material facts about the egg's condition. Cheryl L. Wade, The Integration of Securities Offerings: A Proposed Formulation that Fosters the Policies of Securities Regulation, 25 Loy. U. Chi. L.J. 199, 202 n.11 (1994) (referring specifically to the Securities Act of 1933 in stating that, under the federal securities laws, “if the investor purchases the ‘rotten eggs' on an informed basis, [the securities laws] provides no relief”).
David Zarig claims that:
Sophisticated investors comprised every party to the transaction, for one thing. The fraud seems to be the failure to disclose that John Paulson picked the assets for the investment vehicle - but someone had to, and anyone purchasing the assets knew someone was betting against them.
As noted above, I don't find the sophisticated investor argument dispositive of anything. And I'm puzzled by the claim that anoyone purchasing the CDOs would have known that "someone was betting against them." As far as I know, there's nothing inherent in the structure of CDOs that somebody will be buying credit default swaps against them. I stand corrected. See the comments of DK and steven below. Erik Gerding emailed the observation that "Goldman is completely right on one point -- the CDO investors had to know there was a party betting against them. The reason is because this was a synthetic CDO. Instead of purchasing "real" assets with a cash stream (like mortgage-backed securities), the investment vehicle entered into credit derivatives that would pay out as if they were bonds. Someone had to be the counterparty to those credit derivatives.
Last but not least, let's see what Larry Ribstein thinks:
... the case is more about the SEC struggling to be relevant to the financial crisis than about securities fraud. ...One would like to believe that the SEC is an independent agency that not only doesn't talk to the White House or Congress, but also doesn't read the political tea leaves. Of course, one would also like to believe in unicorns.
... the SEC was under pressure to come up with something. The timing of this complaint continues to be suspicious. ...
... the SEC, under pressure to come up with something on the eve of Congress's final push toward financial regulation comes with a case that the complaint makes clear is much more about the creation of systemic risk than about securities fraud.
This reflects, in part, the new Wall Street, more than three quarters of a century after the securities laws were enacted. Financial regulation is now much more about sophisticated market intermediaries than about individual investors who need somebody to ensure they have the truth about securities.
But I still think sunlight is the best disinfectant and electric light the best policeman even when one is dealing with "sophisticated market intermediaries."
