Wednesday, May 12, 2010

Contours of an SEC Settlement with Goldman Sachs

Settlement talks between the SEC and Goldman Sachs are reportedly ongoing. The parties are supposedly far apart; but that wouldn't be surprising for the early go 'rounds. Both sides have strong incentives to settle and they're likely to make progress. It would be interesting to speculate what a settlement might look like. We have no inside information from either side. Experience tells us that the settlement will probably contain certain features.

Undertakings to Change Business Practices. Goldman will undertake to change the ways in which it handles derivatives transactions. It's already begun a review of business practices in this area, and will formalize that review in the SEC settlement. The settlement will outline in general terms the changes that SEC expects, and will probably require Goldman to hire an independent consultant to review the changes it proposes. The consultant will report to the SEC staff, which will have an opportunity to object to proposed changes. These undertakings may take months or over a year to finalize, but this element of the settlement will probably be one of the least controversial because both sides see the need for change.

Court Order Against Future Violations. Goldman will agree to an injunction or other court order that would be equivalent to an injunction, which will prohibit it from future violations of certain specified provisions of law. Injunctions are standard requirements for SEC settlements, and Goldman won't seriously argue against one. It will try to limit the scope of the injunction as much as possible, probably to subsections (2) and (3) of Section 17(a) of the Securities Acts of 1933. These particular subsections are viewed by aficionados of the securities laws as the least harsh among the SEC's antifraud weapons (because one can violate them without acting intentionally). The SEC staff will negotiate for a broader injunction, that would also cover the more well-known rule 10b-5, the most expansive antifraud provision in the SEC's arsenal. Where the parties will come out isn't entirely predictable, but the end result isn't likely to be a show-stopper, one way or the other, for the broader investing public.

Money. Goldman will pay out money, probably in the form of disgorgement (i.e., a return of the compensation and gains it received in connection with its allegedly illegal conduct) and civil monetary penalties.

The disgorgement in this case would be comparatively small. Goldman supposedly was paid by John Paulson & Co. $15 million for structuring the ABACUS 2007-AC1 deal. The SEC would expect that amount to be paid out as disgorgement. Goldman claims it suffered a $90 million loss investing in the deal, but the SEC is unlikely to agree that Goldman can offset this investment loss against its structuring fee, because allowing Goldman to offset an investment loss against unlawfully obtained earnings makes for poor public policy. (Think of it this way: if a bank robber steals $5,000 and then loses it in the stock market, should the bank robber be excused from reimbursing the bank $5,000?) Goldman probably won't argue hard about giving up the $15 million in compensation. After all, this is a firm that makes billions per quarter.

Civil monetary penalties are, in cases involving fraud charges, de rigueur from the SEC's standpoint. Goldman probably won't argue vigorously against paying any penalty, but will try to limit the amount. The penalty is determined by a statutory formula: for each fraud violation by a corporate defendant, the penalty is the greater of $650,000 or the defendant's gross pecuniary gain from the violation. Goldman's gross pecuniary gain would likely be the $15 million it received in fees for structuring the deal. The number of violations would be the subject of intense debate. Goldman would probably contend that it engaged in one violation (failure to disclose in connection with the deal), or else, two violations (failures to disclose to the two injured investors, ACA Capital Holdings and IKB). The SEC staff would likely assert that each act by Goldman that involved a failure to disclose was a separate violation. Under this point of view, each communication by Goldman or one of its employees that involved a failure to disclose would constitute a separate violation giving rise to a $650,000 penalty. The SEC staff would count not only communications with actual investors (ACA Capital Holdings and IKB) but also communications with potential investors, since attempted frauds are treated by the agency (and courts) as violations of law. The number of acts falling within the SEC staff's likely point of view is unclear. About a dozen are specified in the SEC's charging document (the Complaint), but it's probable that the Complaint doesn't itemize all acts that the SEC staff would regard as separate violations.

If the SEC staff can point to 100 violations, the penalty would be $65 million. If there are 200 violations, the penalty would be $130 million. Considering that the investors allegedly lost almost $1 billion, the SEC staff will be looking for as large a number as possible. Money collected in the form of civil penalties can be returned to injured investors, through a vehicle called a "fair fund." Perhaps the best case for the SEC would be a fair fund that would reimburse the investors for all of their losses. But it is unclear that the evidence would support a civil monetary penalty anywhere close to the amount of investor losses in this case.

As we write, the investors haven't actually sued Goldman. They might be having conversations with Goldman about reimbursement, but even that isn't certain. Goldman, from a tactical standpoint, would probably want to settle with the SEC for as little as possible, and then negotiate any demands of the investors down to a separate settlement of cents on the dollar. The SEC staff might consider the approach taken in an enforcement case almost 17 years ago against Prudential Securities, Inc. Prudential was accused of defrauding hundreds of thousands of investors in limited partnerships, and agreed in its settlement with the SEC to establish a court supervised claims resolution process. In this way, numerous investors were able to recover their losses even though the SEC didn't have the means to provide such relief through its standard legal tools. The SEC staff might seek Goldman's agreement to such a claims resolution process.

Money is probably one of the issues on which the SEC and Goldman are far apart. Only time will tell whether and how this gap can be bridged.

Fabrice Tourre. Goldman would certainly want the litigation to end with its settlement, in order to stanch the flow of negative publicity. That would require a disposition of the case as against Fabrice Tourre, the Goldman executive who is also a defendant. Press reports have not indicated that Tourre is participating in the settlement talks. The defendants would be unrealistic if they expect the SEC to simply drop Tourre from the case. The agency's allegations have made him the poster child for bad conduct in the derivatives market and the Commission would surely feel obliged to pursue him if he didn't settle. The SEC probably would want a settlement with Tourre to include, among other things, his being barred from the U.S. securities industry for at least a few years. Such a sanction would imperil Tourre's career in finance (in the U.S. and other countries, since no foreign securities regulator would want Tourre chatting up its country's citizens if he's barred in the U.S.). So Tourre would face substantial personal consequences from a settlement, and might well choose to fight. Goldman has many reputational reasons to extract itself from the case quickly, and may simply choose to live with the continuation of the case against Tourre.

No comments: