Ever since Goldman Sachs agreed to pay $550 million to resolve claims by the Securities and Exchange Commission that it deceived investors in the Abacus collateralized debt obligation, there’s been a giant question mark hovering over the hedge fund Paulson & Co. Paulson worked with Goldman Sachs to select the CDO’s reference portfolio of mortgage-backed securities, then reaped the profits from a short position when the instrument failed. The implication was that Paulson picked securities that doomed Abacus, but the SEC never brought a case against the hedge fund. And when the bond insurer ACA Financial Guaranty, which was nominally the portfolio selection agent on the CDO, sued in 2011 to recover the $30 million it lost (plus punitive damages), it named only Goldman as a defendant.
But on Wednesday, New York State Supreme Court Justice Barbara Kapnick of Manhattan ruled from the bench that ACA can file an amended complaint – and this one names Paulson & Co and the Paulson Credit Opportunities fund as defendants. The 49-page suit, which was attached as an exhibit to ACA’s motion to file, adds layers of detail to what was previously known about Paulson’s involvement with the Abacus CDO, based on discovery not only from ACA’s suit but also from the SEC’s ongoing case against former Goldman vice president Fabrice Tourre. There aren’t huge surprises in the new evidence, but the disclosure of a side agreement between Goldman and Paulson and of a phone conversation in which Goldman assures ACA that Paulson has a long position appear to bolster ACA’s assertion that it was the dupe of a secret deal between the investment bank and the hedge fund.
“This is a very significant event,” said ACA counsel Marc Kasowitz of Kasowitz, Benson, Torres & Friedman. “It’s the first time Paulson has been fronted for having a share of the responsibility in Abacus.”
According to the new complaint, Paulson talked about shorting MBS-referenced CDOs with three banks besides Goldman: Bear Stearns, Morgan Stanley and Deutsche Bank. Bear and Morgan Stanley both balked; ACA alleges that the Morgan Stanley deal fell through after the collateral manager, Trust Company of the West, expressed concern about the arrangement. Deutsche Bank, however, supposedly had Paulson interview potential collateral managers for a 2007 CDO. According to the complaint, emails show that the hedge fund agreed both to “play the role” of an equity investor when the fund met with candidates and to “stick to the script.”
Those allegations are tantalizing, but they’re really not central to ACA’s case. More significant for the purposes of establishing liability to ACA are the insurer’s new allegations about behind-the-scenes negotiations between Paulson and Goldman. According to the complaint, Paulson was concerned that if Goldman Sachs, as the initial protection buyer of the credit default swap piece of Abacus, defaulted on the CDS, then the hedge fund wouldn’t be able to reap the benefit of its short, which was structured as a separate CDS with Goldman. Paulson wanted the Abacus deal to permit the fund to step into Goldman’s place as initial protection buyer in the event of default. But according to the complaint, Goldman was worried that if the indenture documents specified Paulson as a replacement counterparty, the hedge fund’s overall role in Abacus would have to be disclosed. So instead, ACA asserts, the indenture documents gave Goldman the right to appoint a successor – and an undisclosed side agreement between Goldman and Paulson, executed in April 2007, said that Paulson would be that successor (if the fund wanted to be). The complaint also alleges that Goldman was so eager to serve Paulson, which paid the bank $15 million to put the Abacus deal together, that it agreed to take on an additional $100 million of risk on the CDO so the hedge fund could take a bigger short position.