Tuesday, April 20, 2010

SEC v. Goldman Sachs: What the Case Is Really About

The SEC's fraud case against Goldman Sachs, and Goldman's defense, reflect competing views of the way federal regulation of the financial markets should work. While we have no inside information about how either party plans to argue its side of the case, the information that's already public indicates the lay of the land. Goldman contends that it gave "extensive" disclosure to "sophisticated" investors and they should thereafter be held responsible for themselves. The SEC's argument is Goldman's defense doesn't address the way investments are sold in the real world and that, in reality, Goldman misled investors.

A central theme of the securities laws is disclosure--public companies, broker-dealers, mutual funds and a variety of other players are required to make disclosures prescribed by SEC rules. These disclosures can sometimes be extensive, and Goldman claims to have made extensive disclosures to its customers. The interests in the synthetic CDO in question (ABACUS 2007-AC1) were privately sold and it's unclear what disclosures were actually made. But Goldman claims that the investors pretty much knew what mortgage-backed securities the CDO would be based on and that an independent agent, ACA, selected those MBSs. It contends that the investors were sophisticated and able to decide for themselves how risky these investments were.

The SEC's case is that, however much Goldman may have spoken in its disclosures, it didn't speak the complete truth. Part of the SEC's version of the truth would be that John Paulson & Co. had a large role in the selection of the collateral, that Goldman slyly cultivated a contrary impression in the minds of investors, and that investors knowing the reality of Paulson's involvement would have been reluctant to buy the long side of the transaction.

The SEC's case appears to hark back to the 1930s, 40s, 50s and 60s, a foundational period of time in which the broad contours of the securities laws were shaped. This was a time when knowledge of investments and the financial markets was much more tightly held than is the case today. There was no Internet, no electronic trading systems and no electronic reporting of securities transactions (except the legendary but not terribly informative ticker tape, which was simply a very long telegram). Many stocks and bonds were traded by telephone, or in face-to-face transactions at bank counters (hence the term, "over-the-counter"). Investors relied heavily on financial professionals to deal fairly and squarely with them, because they had few, if any, other sources of information. When you think it about, it's similar to today's derivatives market.

It is axiomatic that the more opaque a market is, the easier it is to sell snake oil. The snake oil business was vibrant in the financial markets of the 1930s, with investors snake bit early and often. The SEC developed a doctrine of law called the "shingle theory." This theory postulates that when a broker-dealer hangs out its shingle to do business, it impliedly represents that it will deal fairly with its customers. An early decision affirming this theory is Charles Hughes & Co. v. SEC, 139 F.2d 434 (2d Cir. 1943), in which a broker-dealer was deemed to have violated the law by overcharging customers (by as much as 40% over market prices). The shingle theory has primarily focused on the pricing of securities, and limits the so-called "markup" a broker-dealer may charge a client. A more recent decision in this vein is SEC v. First Jersey Securities, Inc., 101 F.3d 1450 (2d Cir. 1996). In other words, the shingle theory isn't just a disclosure theory; it has substantive effect, limiting the pricing latitude of broker-dealers in the over-the-counter market. Although the SEC's case against Goldman isn't about prices, the shingle theory's premise--that a broker-dealer has a duty of fair dealing--provides support for the SEC's position that in an opaque market like the CDO market, Goldman isn't a mere intermediary, but has an obligation of fair dealing.

Another foundational case is United States v. Simon, 425 F.2d 796 (2d Cir. 1969). The president of a company called Continental Vending Machine Corporation borrowed a lot of the company's money in order to play the go-go stock market of the 1960s. He did not reveal to shareholders his use of the company's funds as a personal piggy bank, instead routing the funds through a corporation he controlled so that Continental's records did not show he was the true recipient of the money. The stock market of the 60s was every bit as volatile as today's stock markets, and the president's personal investments belly flopped. He had no other means to repay the loans and Continental was left insolvent. The way the president siphoned off the money allowed the company, under the accounting rules prevailing at the time, to present its financial condition as solid. Defendant Simon, an accountant who audited Continental's financial statements, knew of the president's hidden loans but didn't reveal them when he certified Continental's financial statements. Even though the company's financials complied with the applicable accounting rules, the court nevertheless held Simon criminally liable for his silence. It observed that " . . . it simply cannot be true that an accountant is under no duty to disclose what he knows when he has reason to believe that, to a material extent, a corporation is being operated not to carry out its business in the interest of all the stockholders but for the private benefit of its president." It described Simon's certification of Continental's financials as a "snare and a delusion." Thus, Simon, the auditor, was held to be a crook because he didn't disclose how the president had secretly ruined the company, even though the company had followed the accounting rules. In plain English, complying with the stated rules isn't enough when there's a larger truth that remains undisclosed.

Of course, there are differences between the roles of auditors and broker-dealers. But both serve as gatekeepers to the securities markets. Without auditors willing to certify their financial statements, companies could not go public. Without a broker-dealer willing to put together ABACUS 2007-AC1, John Paulson wouldn't have had an opportunity to take the short side of its collateral pool. He paid Goldman $15 million to put the deal together and played a large de facto role in choosing the collateral. Goldman evidently thought that the selection of the collateral had to appear objective to investors--the SEC complaint alleges that Goldman was very particular that ACA was necessary as the collateral manager to make the deal appear on the up and up. ACA wanted to know what Paulson's role was, and, according to the SEC, Goldman slyly implied that Paulson would take an equity position on the long side of the deal instead of revealing that Paulson was looking for a shorting opportunity. In essence, the SEC alleges that Goldman tricked ACA into acting as the collateral agent.

U.S. v. Simon indicates that even if Goldman made extensive disclosures to the investors, the fact that it did not reveal the larger picture of Paulson's role might have been improper. The SEC's allegations that Goldman made affirmative statements that misled ACA or investors would, if true, only compound Goldman's litigation risks, since they imply Goldman intentionally painted a false picture.

As to intentions, the SEC has an advantage. It charged Goldman and Fabrice Tourre with violations of Section 17(a) of the Securities Act of 1933, as well as violations of the SEC's all-purpose, utility infielder antifraud rule, 10b-5. To prove a violation of Rule 10b-5, the SEC must establish that Goldman and Tourre acted with scienter, a legal term for bad intent. The need to prove bad intent can sometimes be a challenge, depending on the facts of the case (although there seem to be colorful e-mails in the SEC's possession that will give it a shot at proving scienter in this case). Section 17(a) violations, however, can sometimes be established without the SEC having to prove any bad intent. See Aaron v. SEC, 446 U.S. 680 (1980). Even if the SEC cannot prove that Goldman and Tourre had bad intent, they may still found liable for securities fraud.

There is a thread in the SEC's Complaint indicating that Goldman itself believed that the mortgage market was, at the time it marketed ABACUS 2007-AC1, likely to tank. The facts here don't seem as extreme as those in the SEC's 2003 case against various underwriters for selling stocks that the brokers themselves thought were lousy investments. See the SEC's press release on April 28, 2003 (http://www.sec.gov/news/press/2003-54.htm). Goldman apparently didn't formally recommended ABACUS 2007-AC1. But if it is true that Goldman was negative on the mortgage market while selling the deal to long side investors, that would only add to the aura of cynical sleaze.

The case appears to be the SEC's effort to deal with the reality of the derivatives markets. These markets, circa 2007 when ABACUS 2007-AC1 was constructed and marketed, were understood in depth by only a small circle of cognoscenti, and perhaps not even all of them. The SEC alleges that Tourre in one e-mail referred [in translation] to " . . . standing in the middle of all these complex, highly leveraged, exotic trades he [i.e., Tourre] created without necessarily understanding all of the implications of those monstruosities [sic]!!!" (As an aside, Tourre could have legal liability if he marketed investments he didn't understand because brokers are supposed to understand the products they peddle to clients.) Most investors in this market likely relied, to varying degrees, on the perceived interests and reputations for integrity of the parties in the picture. However skillful and knowledgeable money managers and corporate treasurers may be, the fact is that detailed information about the esoterica of the derivatives market would not have necessarily been available to them, if only because they might not have even known what questions to ask. Thus, they would have been interested in the identities and roles of relevant players.

Remember, Bear Stearns and Lehman were sophisticated but they failed. Merrill Lynch and WaMu were sophisticated but they had to be sold in distressed circumstances. AIG was sophisticated, but it blew itself up. Even Fannie Mae and Freddie Mac were pretty sophisticated, but they are now wards of the state. Sophistication is no substitute for specific information. Lots of very intelligent people buy a stock because Warren Buffett bought the stock. Few would short it. And those decisions would be made without a whole lot of reference to the stock's "objective" merits. If you were a derivatives investor and learned that John Paulson was a de facto short side co-venturer with Goldman in ABACUS 2007-AC1, you might well have accidentally dropped the phone if Fab Tourre tried to pitch you the long side of the deal. Certainly, there are some people who wish they had.

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