Sunday, April 18, 2010

SEC v. Goldman Sachs: Betting the Ranch

The New York Times reports that the SEC didn't give Goldman Sachs a chance to discuss settlement before filing its fraud case on Friday (4/16/10). The SEC had notified Goldman last year that it might face charges, the Times reports, but Goldman didn't find out about Friday's lawsuit until after it was filed.

The SEC's normal procedure is to discuss settling before filing an enforcement action. Those discussions usually lead to settlement. Why would this time have been different? We don't have any inside information from either side. But here's our guess.

It's likely there were settlement talks of an informal nature before the case was filed. The notice last year that the SEC might bring charges was probably a so-called Wells notice, which gives persons that the SEC staff is thinking ought to be subjects of an enforcement action an opportunity to present their views before the Commissioners make a final decision. It almost always happens that the SEC staff and the potential defendants informally discuss the possibility of settlement at the Wells stage. There could have been an exchange of views between the SEC staff and Goldman in which Goldman indicated it would settle for a nonfraud charge if no individual Goldman employees were sued and if it didn't have to pay a painfully large amount of money. The SEC staff, however, may have made it clear that it would not recommend to the Commissioners any settlement that didn't include fraud charges, while reserving the right to pursue individuals (as the Commission in fact did on Friday). The Commissioners would have been informed, one way or another, of any settlement positions offered by Goldman. But if they agreed that the evidence required a fraud charge, they may well have authorized the staff to file the case promptly instead of engaging in fruitless attempts to persuade Goldman to accept fraud charges that Goldman had already rejected.

One indication that Goldman wasn't caught terribly off guard is the fact that, within hours after the lawsuit was filed, it began issuing public denials of certain factual assertions made by the SEC. Making those public denials is risky from a litigation standpoint, because those statements could be used as evidence against Goldman in the future. Many defense lawyers would recommend against such detailed denials except perhaps in court pleadings. That Goldman could pump out these factual assertions so quickly after supposedly being surprised by a lawsuit indicates that it probably was prepared for a battle, even if it didn't know the exact time of the opening bombardment.

The SEC did gain an advantage by filing without formal settlement talks. It was able to write the charging document (called the complaint) the way it thought was appropriate. Complaints filed in settled cases are meticulously negotiated by defense lawyers who try to make the charges appear as milquetoasty apologies by the SEC for having the temerity to disturb the tranquility of the defendants. This time, the complaint unequivocally charged the defendants with fraud.

The SEC's assertiveness tilts the playing field against Goldman in a number of ways. The principal victims in this case were European banks. European governments are making noise about investigating Goldman and recovering from it the losses their banks sustained. Investors on the losing end of other Goldman derivatives transactions are no doubt reviewing their files and reliving their losses in an effort to ascertain if they, too, can recover. Class action lawsuits by Goldman shareholders may be filed, as its stock has taken a beating. The SEC is probably investigating other deals that may be connected to Goldman, and further enforcement actions would be in the works. State regulators whose municipalities took losses in Goldman deals may become emboldened. In this vein, the case against Goldman may be the first since the Before Spitzer era that the SEC has upstaged the Attorney General of New York. It's not beyond the realm of possibility that the NY AG's office will be looking to run with the new big dog in the neighborhood.

On the regulatory reform front, this case strengthens arguments for major change in the derivatives markets. Even if Goldman and other Wall Street banks continue their furious lobbying offensive in Washington, they have probably lost some traction in Washington, and also in Europe, where the impetus for change was already great. It's one thing to argue that honest businesses shouldn't be burdened by costly and unnecessary rules. It's another to be an accused fraudster saying more regulation would be bad. The dynamics of regulatory reform are shifting.

Worst of all for Goldman, the U.S. Department of Justice may come under pressure to act. A criminal charge would be the worst possible development for Goldman. Financial firms never--repeat, never--survive federal criminal charges. Think of E.F. Hutton and Drexel Burnham Lambert. Younger readers may not recognize those firms because they were major investment banks that were criminally charged years ago and didn't survive. A civil fraud charge, such as the SEC filed, can fairly readily be crafted into criminal charges if the evidence is strong enough.

It's doubtful that DOJ has enough for criminal charges at the moment (or else it would have acted, too). But the individual defendant, Fabrice Tourre, will surely come under pressure to settle and become a cooperating witness for the government. The fact that he now lives in the UK and a British bank (Royal Bank of Scotland) wound up holding close to a billion dollars of the losses in this case, may prompt the British government to start clearing its throat in Mr. Tourre's direction. If Tourre does settle and cooperate, he perhaps could provide the government with details it doesn't yet have and point the finger up the chain of command. Tourre need not testify in the SEC's case because of his Fifth Amendment right against self-incrimination. But in a civil lawsuit such as the SEC's, a defendant's assertion of the Fifth can be used as evidence against him (yes, seriously, the courts have said so; the privilege against self-incrimination protects a defendant only in criminal prosecutions). So Tourre may hurt himself in the SEC case if he takes Five. But if he talks, he will have to answer tough questions about some e-mails and other documents that don't exactly cover him with glory. He might be damned if he does and damned if he doesn't. Defendants in that situation sometimes cut deals with the government.

This is a must-win case for the SEC. After years of horrendously bad publicity for a proud agency with a renowned heritage, the Commission marks a turning point by filing this case--but only if it wins or gets a good settlement. As much as it ever has, the SEC is betting the ranch. But it's done that before and prevailed. The SEC case against Michael Milken and Drexel Burnham Lambert in the 1980s was comparable. Drexel was perhaps the most powerful investment bank of the day and Milken was unequivocally its most powerful employee. Milken and Drexel fought tooth and nail, employing an army of defense lawyers that may have outnumbered the government's team by a ratio of 10 to 1. Most of the government lawyers were in their late 20s or early 30s. But they cared--tremendously--and the government (SEC and DOJ) carried the day, primarily by building a strong body of evidence. Both Drexel and Milken eventually settled, agreeing to criminal and civil charges. Don't sell the SEC short just because 18 months ago it was in the ICU. The staff working on this case are not the SEC's Madoff team, and Goldman's management and lawyers could be in for a surprise if they're banking on the presumed incompetence of their adversaries.

Goldman, too, is betting the ranch. We presume that at some point in its dialogue with the SEC staff it rejected the possibility of settling to fraud charges. Now, that position, assuming it is Goldman's position, is being put to the test. The only thing worse than agreeing to a fraud charge is being found liable for fraud after a trial. Goldman's only good outcome would be to go to trial and win. Perhaps it will. But will its management want to risk going to trial? If Goldman loses, the floodgates will opened for plaintiffs lawyers, state regulators and attorneys general, European regulators, and perhaps other claimants. And even if Goldman litigates this case for years, what about Goldman's other derivatives deals that went sour? They'll all now be assiduously scrutinized by armies of potential claimants. Fighting the SEC could be tantamount to manning the Maginot Line, while swarms of other claimants outflank Goldman from the left and the right.

Corporations generally don't like to litigate with federal regulators because the risks of losing usually outweigh the gains from winning. And the SEC, as painful as a loss could be in this case, has less to lose than Goldman. Goldman's top executives were once traders, where everything they did involved a deal. In a deal, you give up something to get something else. No doubt they will think about a deal. The terms for settlement are likely to be unpalatable at best. But what will Goldman's alternative be? Years of litigation and the accompanying uncertainty while competitors try to woo away its clients? Losses totaling many millions, and perhaps even billions in the end? A downside of doing leveraged deals is that if they become legal problems, the leverage works against you.

One thing to watch for is Goldman's earnings announcement on Tuesday, April 20, 2010. What will it say about the SEC case? What impact will the SEC case have on Goldman's litigation reserves? It's possible Goldman will delay its earnings announcement while it sorts out the fallout from the lawsuit. But these questions will remain whenever Goldman speaks.

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