Goldman Sachs and the sophisticated investor: Who’s duping whom?

By Alison Frankel
October 22, 2012

By all accounts, neither Michael Lewis nor Frank Serpico should be concerned about competition from Greg Smith, the erstwhile Goldman Sachs vice president whose supposed tell-all, “Why I Left Goldman Sachs,” was published Monday. I’ve only read the first chapter excerpt that’s been floating around the Internet since last week, but Smith clearly lacks Lewis’s humor and narrative verve, and reviewers who read advance copies of the entire book have said there’s not much substance to his assertions about Goldman’s culture. I suspect that Smith will have a short shelf life as a Wall Street chronicler and whistle-blower.

But in an interview Sunday night with Anderson Cooper on “60 Minutes,” Smith caught my attention when he echoed an accusation that’s become a meme of financial crisis litigation: Goldman abused the trust of unsuspecting clients when it offloaded its exposure to mortgage-backed securities via complex financial instruments. “These are very complicated derivative securities which (it) takes a PhD in physics or in engineering to understand,” Smith told Cooper, according to a transcript. “There are pension funds and mutual funds that represent people’s 401(k)s and retirement savings that are trading the most complex instruments out there without fully understanding them,” he said. “Getting an unsophisticated client was the golden prize. The quickest way to make money on Wall Street is to take the most sophisticated product and try to sell it to the least sophisticated client.”

In the law, as you know, an investor’s sophistication is not an incidental question. Courts expect that so-called sophisticated investors engage in their own due diligence and don’t rely entirely on what sellers tell them. Sophisticated investors have a higher bar for claims of fraud and negligent misrepresentation than ordinary people who buy and sell securities. So, as a matter of law, were the Goldman clients that bought the toxic CDOs Smith mentioned really unsophisticated? Or just less sophisticated than Goldman Sachs?

Different judges have answered that question quite differently in litigation over Goldman’s subprime-stuffed CDOs. U.S. District Judge William Pauley of Manhattan, in a ruling affirmed by the 2nd Circuit Court of Appealslast May, said that Landesbank Baden-Wuerttemberg couldn’t show that it justifiably relied on Goldman when it decided to invest in the $2 billion Davis Square CDO because the German regional bank had the expertise to evaluate the CDO’s risks. But the other state and federal judges who have ruled in Goldman CDO cases have agreed with Smith’s assessment of Goldman’s alleged dupes. The latest of these decisions came Friday, when New York State Supreme Court Justice Shirley Kornreichrefused to dismiss fraud and negligent misrepresentation claims against Goldman by a defunct Cayman Islands hedge fund.

The fund, Basic Yield Alpha Fund (Master), said Goldman misrepresented the underlying assets and its own position in the notorious Timberwolf CDO, which defaulted within weeks of BYAFM’s investment. Kornreich referenced Goldman Sachs’s alleged campaign to purge subprime mortgage exposure, calling the assertions “big picture” fraud and citing U.S. District Judge Victor Marrero’sruling last March in another hedge fund’s very similar case against Goldman, this one involving the allegedly rigged-to-fail Hudson CDOs. Kornreich’s colleague in state court in Manhattan, Justice Barbara Kapnick, has also described Goldman’s allegedly fraudulent offloading of subprime exposure in a decision last April that permitted the bond insurer ACA to proceed with claims that it was misled into backing yet another infamous Goldman CDO, Abacus. All three rulings suggest that, however sophisticated Goldman’s counterparties were, the bank withheld crucial information that would have informed their decisions.

Goldman has refused to concede that point. In fact, in two of the cases, the bank has revived “sophisticated investor” arguments in counterclaims against its alleged dupes. I told you in May about Goldman’s allegations about the Hudson investor, a fund founded by a former Salomon asset-backed trader that marketed its expertise in mortgage-related CDOs. Last week, the bank’s lawyers at Sullivan & Cromwell filed a new brief in the ACA case, asserting that if the insurer is telling the truth about relying on Goldman Sachs emails describing the selection of the securities underlying the Abacus CDO, then ACA breached its own representations about the deal in the Abacus offering circular. The bond insurer, Goldman asserts, can’t have it both ways: It can’t tell CDO investors one thing about its due diligence but say another in court. The bank hasn’t yet filed counterclaims in the BYAFM case, in which it is represented by Boies, Schiller & Flexner, but it’s a good bet we’ll see allegations that the hedge fund was an experienced CDO investor with a record of battling Goldman Sachs margin calls.

None of the CDO counterparties suing Goldman quite fits the role of victim in the scenario Smith sketched for Cooper in Sunday’s “60 Minutes” interview, in which, according to Smith, the bank allegedly sought out “philanthropies or endowments or teachers’ retirement pension funds in Alabama or Virginia or Oregon” as buyers of its incomprehensible-to-mere-mortals derivatives. Frankly, Smith’s scenario sounds a lot like the allegations against Morgan Stanley in the Cheyne and Rhinebridge CDO cases. (And Goldman has denied any allegation that it put the bank’s interest before those of its clients.)

But right now, as you can see from the different outcomes Goldman has had in essentially parallel cases, the line that defines fraudulent and perfectly legal interactions between CDO sponsors and investors is blurrier than it should be. As the Goldman CDO cases move forward, they’re going to provide important focus.

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