SEC v. Goldman Sachs: In-depth Analysis by Bill Singer
My view on SEC v. Goldman Sachs & Co. is that it will likely become a watershed event in the history of Wall Street regulation. It's time that we pull back the curtain between us and the mighty Wizard of Oz -- so that we might see the old man pulling the bells, whistles, and levers. It is also appropriate for us to stop pretending that laissez-faire regulation must tolerate financial products that are little more than roadside IEDs along the highway that is Wall Street.
The larger question is are we now about regime change on Wall Street or merely crowd control?
Since the Securities and Exchange Commissions (SEC) announced its Goldman Sachs Complaint last Friday (Copy of the SEC Complaint and my initial comments at http://www.brokeandbroker.com/index.php?a=blog&id=372), I have given a number of interviews to the press concerning the case. As I noted,
The SEC's case essentially accuses GS&Co of fabricating the financial equivalent of an Improvised Explosive Device (IED) which it then placed amidst investors with the expectation that the CDO would explode -- which it did. Carried to its logical conclusion, the SEC's Complaint depicts the Defendants as financial suicide bombers on Wall Street.
To the extent that the Complaint finally pulls back the curtain and lets the investing public see the shenanigans that truly go on behind the scenes, it is a welcome development. . .
One note of caution, just as we need to be attentive to "Too Big to Fail," we also need to consider "Too Stupid to Remain in Business." The SEC must be careful that in punishing GS&Co, if that be the intent and eventual outcome, that those supposedly sophisticated financial institutions who stupidly bought Abacus and the other exotic garbage then available for sale are not rewarded by the equivalent of an insurance policy. There was far too much available market information when Abacus was being marketed to permit anyone who bought the CDO to suggest, now, that they were unaware of the negative analysis or growing chorus of naysayers.
I have likely read, re-read, analyzed, and pondered the SEC's Complaint over a dozen times. Clearly, I live a somewhat sad and boring existence. Having digested the pleading, answered questions about it, and challenged my own assumptions, I find that my position on the case has evolved and better incorporates the nuances and legal realities. In my opinion, the SEC Complaint has uncovered and exposed unsavory Wall Street conduct. On the other hand, I see much political theater in the SEC's 22-page pleading. As such, be prepared for a number of additional acts and scenes in this play. No!!! -- I am not defending Goldman and I am not defending the avarice that has been depicted in all its shameful vainglory in the Complaint. What has too long passed as business-as-usual on Wall Street is tawdry and digusting.
However, the larger task for this Blog entry is whether the SEC Complaint sets forth a compelling legal case.
By 2007, the Red Flags Were Waving
There is a difference between having the right to do something and doing the right thing. Running afoul of the former is often illegal. Running afoul of the latter is the stuff of morality, ethics, and philosophy -- but not necessarily lawsuits. Frankly, I'm just not sure that from a legal perspective that the SEC's Complaint presents a compelling case that Goldman did something unlawful or in violation of industry rules and regulations. How we ultimately respond to that conundrum (do we write new laws, rules and regulations?) may be our greatest challenge.
So, to my lawyer's eye, how does SEC v. Goldman play out? First off, consider the very first paragraph of the Complaint:
The Commission brings this securities fraud action against Goldman, Sachs & Co. ("GS&Co") and a GS&Co employee, Fabrice Tourre ("Tourre"), for making materially misleading statements and omissions in connection with a synthetic collateralized debt obligation ("CDO") GS&Co structured and marketed to investors. This synthetic CDO, ABACUS 2007AC1, was tied to the performance of subprime residential mortgage-backed securities ("RMBS") and was structured and marketed by GS&Co in early 2007 when the United States housing market and related securities were beginning to show signs of distress. Synthetic CDOs like ABACUS 2007-AC1 contributed to the recent financial crisis by magnifying losses associated with the downturn in the United States housing market.
The highlighted portion of Paragraph 1 above is troubling for the SEC because it will likely form the foundation for an important component of Goldman's likely defense. By the time the ABACUS synthetic CDO was being structured and marketed, the housing market and its deriviative securities were "beginning to show signs of distress." As such, by 2007, investors who had yet to jump into real estate or its securities were on notice that the perceived optimism in that sector was waning. The growing chorus of doomsday predictors and naysayers had started to fill the airwaves with their warnings.
Consequently, let's put things into an accurate perspective. By the time ABACUS was being packaged and offered, most financial institutions who would be buying this product (or fabricating it) were on notice that it could be a dicey bet.
What Did ACA Know and When?
In Paragraph 2 of the Complaint, the SEC alleges that
GS&Co marketing materials for ABACUS 2007-AC1 – including the term sheet, flip book and offering memorandum for the CDO – all represented that the reference portfolio of RMBS underlying the CDO was selected by ACA Management LLC ("ACA"), a third-party with experience analyzing credit risk in RMBS. . .
The gist -- the very guts -- of the SEC Complaint is that ACA was manipulated by Goldman, that John Paulson (and his hedge fund) picked the CDO reference portfolio, and that Goldman lied about Paulson's influence in the portofolio's selection. However, all the marketing materials clearly disclosed that the reference portolio of residential mortgage backed securities (RMBS) was the child of ACA. The SEC Complaint implies that ACA is now backing away from those 2007 written representations. According to the SEC's allegations, ACA apparently is pointing a finger at Paulson and Goldman -- that Paulson picked the reference portfolio, or did so in conjunction with Goldman, or that ACA was defrauded into selecting the RMBS.
Why weren't ACA's protestations contemporaneously forthcoming with the distribution of the marketing materials? Either ACA had independently picked the portfolio and was comfortable with Goldman's marketing statements (which is perhaps why ACA doesn't seem to have protested about the marketing materials when they were first issued); or ACA knew that it hadn't independently picked the portfolio and should have been immediately discomforted when it saw that its name was cited by Goldman.
I'm just not understanding (or getting) the SEC's point on this critical aspect of the case. ACA had an obligation to act as an independent agent in the selection of the reference portfolio. The Complaint stresses that ACA jealously guarded its reputation and integrity. Assuming that ACA read the marketing materials, I have to assume that ACA agreed with the representations that it had independently and professionally selected the component RMBS. If the SEC is now asserting that Paulson picked the RMBS or that Goldman picked the RMBs, then why didn't ACA protest about the marketing representation when those statements were first published?
Yes, yes -- I know -- the SEC's point is that ACA was manipulated into going along with the deal. However, here's what is stated in the Complaint at Paragraph 2:
[A] large hedge fund, Paulson & Co. Inc. ("Paulson"), with economic interests directly adverse to investors in the ABACUS 2007-AC1 CDO, played a significant role in the portfolio selection process. After participating in the selection of the reference portfolio, Paulson effectively shorted the RMBS portfolio it helped select by entering into credit default swaps ("CDS") with GS&Co to buy protection on specific layers of the ABACUS 2007-AC1 capital structure. . .
Although the SEC states that Paulson "played a significant role" in the selection process, even those words grudgingly concede that there was a "selection process." Playing a role in a process is not the same as having the final, sole word. Moreover, the SEC Complaint does not assert that Paulson (the individual or the fund) called all the shots -- to the contrary, the allegation is that Paulson played a role, of which there were apparently a number of other actors in this play. As such, I infer that ACA had a role to play too.
The more critical question is whether ACA performed reasonable due diligence. Similarly, we must ask whether ACA selected the reference portfolio -- as was stated in the marketing materials. If Paulson made the reference portfolio decisions and somehow stacked the deck, then I go back to my earlier point: Why did ACA permit the distribution of marketing materials that stated that it had selected the reference portfolio?
The Bastard Children of Wall Street
The SEC admits that the Paulson hedge fund had adverse interests to the likely investors in ABACUS -- and unless many of you forgot, Paulson's view of the subprime market was fairly well known in 2007. Consider this statement in Paragraph 11 of the SEC's Complaint:
Beginning in 2006, Paulson created two funds, known as the Paulson Credit Opportunity Funds, which took a bearish view on subprime mortgage loans by buying protection through CDS on various debt securities. . .
Similarly, in Paragraph 17, the SEC admits that Paulson's employees held the following views as of January 2007:
"It is true that the market is not pricing the subprime RMBS wipeout scenario. In my opinion this situation is due to the fact that rating agencies, CDO managers and underwriters have all the incentives to keep the game going, while ‘real money’ investors have neither the analytical tools nor the institutional framework to take action before the losses that one could anticipate based [on] the ‘news’ available everywhere are actually realized."
In Paragraph 3 of the Complaint, the SEC preliminarily sums up its case:
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.
You know, that's just not as powerful a case as the initial press commentary suggested. Whatever Paulson's alleged role -- which the Complaint describes as a significant role or heavy influence -- a role is a role is a role. The ultimate challenge for the SEC is whether it can demonstrate that Goldman did something tortious or illegal as a result of Paulson's role. Of course, there is that massive fly in the ointment. In case you didn't notice, Paulson (the individual or the hedge fund) isn't named as a Defendant. If the SEC doesn't think that Paulson's role required naming him or the hedge fund as a Defendant, then apparently the SEC didn't conclude that Paulson did anything wrong. If Paulson didn't do anything wrong, then what was Goldman supposed to voluntarily disclose -- that Paulson was engaged in a legal undertaking?
Moreover, is there anything illegal or improper about Goldman or any company considering a request to offer a securities product based upon the request or urging of a third party? Absent more, the answer is "no," and, frankly, it's a fairly common occurrence. Third parties often approach Wall Street investment bankers with proposals to make money. Present investment banking clients or desired ones wield much influence when pitching deals to Wall Street. It's hard to even imagine a deal where the public isn't being sold something that may have many fathers -- of which none is disclosed. Indeed, there are many bastard children of Wall Street. Did Goldman have a legal obligation to disclose Paulson's "role" in the portfolio selection process or the hedge fund's adverse economic interests? Ahh...now we have the crux of this landmark case.
Due Diligence Anyone?
In reading the SEC Complaint, I see the suggestion that Goldman "should have" volunteered information about Paulson's role (or that Goldman fraudulently covered up that role). On the other hand, did ACA or any purchasers directly contact Goldman and/or Paulson and ask whether Paulson had a role in selecting the portfolio components? Similarly, I see no inquiry as to whether Paulson was or would be adverse to ABACUS. Pointedly, in Paragraph 31 of the Complaint, the SEC states:
On January 27, 2007, ACA met with a Paulson representative in Jackson Hole, Wyoming, and they discussed the proposed transaction and reference portfolio. The next day, on January 28, 2007, ACA summarized the meeting in an email to Tourre. Tourre responded via email later that day, "this is confirming my initial impression that [Paulson] wanted to proceed with you subject to agreement on portfolio and compensation structure."
A lot of folks just didn't seem to catch that event. On January 27, 2007, ACA met with a Paulson representative -- and by that time, Paulson's distrust of the integrity of the subprime market was well known among Wall Street financial professionals. Don't forget that by the time of the meeting, Paulson is known as contemplating a subprime wipeout scenario. Did ACA confront Paulson with any concerns about the hedge fund's role in structuring ABACUS? Did ACA feel any discomfort about Paulson wanting to proceed with it "subject to agreement on portfolio . . ?" Why was it Goldman's obligation to provide ACA with information about Paulson when ACA was meeting with Paulson and could have (and should have) asked those same questions as part of its due diligence?
Perhaps the SEC anticipates my concerns because in Paragraph 32 of the Complaint, the regulator states:
Unbeknownst to ACA at the time, Paulson intended to effectively short the RMBS portfolio it helped select by entering into CDS with GS&Co to buy protection on specific layers of the synthetic CDO’s capital structure. Tourre and GS&Co, of course, were fully aware that Paulson’s economic interests with respect to the quality of the reference portfolio were directly adverse to CDO investors.
I just don't know if I'm buying the SEC's understandably self-serving conclusion.
How could Paulson's opinions and predilections about subprime RMBS have been "unbeknownst" to ACA at the time? If Paulson was not among the more likely shorters of the components of the portfolio, then who was -- and how will the SEC gloss over that issue? Are we to believe that despite Paulson's reputation as a shorter of subprime, as a believer in the wipeout scenario were not known to ACA? Again, I ask, did ACA confront Paulson with such concerns? More pointedly, as a matter of law, did the Defendants have to discuss their awareness of Paulson's economic interests with ACA or with the purchasers of ABACUS? I would appreciate seeing some citations to law and case precedent from the SEC on those points. Again, such is the stuff of lawsuits. It will be interesting to see what comes out in the wash.
Reluctant and Unlikely
However, the most damning weakness in the SEC's case is less artfully hidden by the regulator. Consider Paragraph 45 of the Complaint:
Had ACA been aware that Paulson was taking a short position against the CDO, ACA would have been reluctant to allow Paulson to occupy an influential role in the selection of the reference portfolio because it would present serious reputational risk to ACA, which was in effect endorsing the reference portfolio. In fact, it is unlikely that ACA would have served as portfolio selection agent had it known that Paulson was taking a significant short position instead of a long equity stake in ABACUS 2007-AC1. . .
To the layperson's eye, the above statements may seem strong points for the SEC. I see the opposite. I see weakness.
Why is the SEC only willing to admit that if ACA had known that Paulson was adverse that it "would have been reluctant" to allow him the role that he had in the selection process?
Let me reiterate that point.
In the SEC's Complaint, all that the regulator is able to state is that ACA would have been "reluctant" about Paulson's actual role if it had known he would short the CDO. Pointedly, ACA is still not saying that if it had actually confirmed Paulson's intention to short the CDO that it would have walked away from the deal. Even at this late hour, the most that ACA seems prepared to testify to is that it would have been reluctant -- not that Paulson's shorting would have been a deal breaker. The inference is that ACA may well have allowed Paulson to occupy an influential role in selecting the reference portfolio even if Paulson had confirmed that it would take a short position against the CDO! Further, ACA is only prepared to state that it would have been "unlikely" for the company to serve as portfolio selection agent if it had "known that Paulson was taking a significant short position . . ." In my book, "unlikely" is not an unequivocal "are you nuts, if we had known that Paulson was shorting we would never, ever, no-way have participated as the agent." It will be interesting to see what ACA's executives ultimately testify to in court under rigorous cross-examination.
No Slam Dunk Case
As such, the SEC does not have a slam dunk case. Further, given Goldman's deep pockets, one should expect a robust defense.
I still wonder if SEC v. Goldman Sachs is just so much political theater. In Act I, the SEC and Congress throw the rabble just a small slice of bloody, red meat. In Act II there is a multi-million dollar settlement, a cloud of harmless dust, and, after a few calendar pages are pulled off the pad, things pretty much get back to usual -- with some juicy campaign contributions down the road.
Forgive an old Wall Street veteran's cynicism. After some three decades of sitting through these staged dramas, I've become a bit jaded. Like I said at the beginning, is this about regime change or crowd control?
==========================================RRBDLaw.com: New FINRA Cases Analyzed by Bill Singer
Regulatory lawyer Bill Singer has analyzed and posted the latest crop of FINRA disciplinary cases.If you want to steal a half a million bucks from a bank, just write "At the Customer's Request" on a deposit slip. Think I'm kidding? CLICK HERE.
These bank cases are getting annoying -- I mean, c'mon now, it can't be that easy to steal money -- can it? Read about one enterprising employee who embezzled $1,452,158, and then enjoy a hilarious Woody Allen clip. CLICK HERE How about the broker how sold $2.5 million of promissory notes to individuals, for which he received commissions of approximately $157,000. His investors ultimately lost more than $2.2 million of the $2.5 million that they had invested. CLICK HERE You heard about the Merrill Lynch caper that seems straight out of a Marx Brothers' movie? Ya got yer disappearing facsimile machine. Ya got yer lawyer who's not a lawyer but has a business card that says he is. Ya got some odd shenanigans involving the Office of General Counsel. CLICK HERE What's up with Equity-Indexed Annuties (EIA)? Looks like FINRA is cracking down. Read these cases for guidance. CLICK HERE
I read your posts and half of the time i dont know what the h%ll you are talking about.
I think I'm going to stop reading them. too frustrating.
I guess i'm too stupid to understand.
(PS: You remind of of how lawyers write.
Most of the time I dont understand them either.
Oh thats right...you are a lawyer)
Would you please comment on Goldman's testimony before congress. They seemed to be trying to make an argument that in the SEC case, they were acting as a market maker as opposed to a placement agent or underwriter. As such a market maker has no obligation to disclose, but a placement agent or underwriter does. And what about the disclosure document...? I haven't seen a copy, but I wonder if they did make it clear what all the risks were. And what is the legal basis that the clients were sophiticated and should have been able to assess the risk without Goldman being more explicit. Is that their defense? Even if a client is considered sophiticated, does the law allow a broker to take that for granted or make assuptions. Do the rules still require that proper disclosure occur regardless. If so, perhaps the SEC does have a case. I would welcome your further comment.
I've been in this business a long time. I can't understand how GS can make a reasonable argument that they were acting as a market maker--this is plain arrogance. Anyone who has spent any time in this business should realize this is a stretch.
One other question---that is about fiduciary responsibilty. I was struck that they had a panel of managing directors, and only one said that they have a responsibilty to act in a fiduciary capacity--to put the clients' interests before their owns interests. Personally, the lack of an acknowledment that fiduciary responsibilty should always be adherred to is troubling. I think I wouldn't have any clients left if I didn't act in a fiduciary capacity all the time even though the law doesn't require me to do so. I realize that the rules are different as applied to a broker vs a RIA. What is your take on this--will this be part of financial reform? How difficult do you think the environment will become?
I agree. I've been in this business a long time---trust and reputation are everything. If the public sees the nonsense that goes on behind closed doors, they'd be disgusted. Even if the nonsense is perfectly legal, I suspect all the stuff the gov could bring out at trial would be enough to make even the most loyal client question why they do business with them.
I disagree. I think if this goes the distance, Goldman will not be as squeaky clean as we would like to think but, they will not be found guilty of anything. I beleive that a long drawnout trial, will again expose the governement and it's regulators for the inept fools they are. Unfortunately for us (the people in thios business) it will appear that "Wall Street" again is the bad guy. That's how it will appear to the uneducated. Which, by the way, is how the current administration wants it to play out.