How the SEC cracks down on unethical behavior

By Felix Salmon
April 20, 2010
Emanuel Derman has a fantastic two-line blog entry on the SEC/Goldman affair, which I can't really help but quote in full:

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Emanuel Derman has a fantastic two-line blog entry on the SEC/Goldman affair, which I can’t really help but quote in full:

The architects of the bailout have been trying to cure insolvency by treating it as illiquidity.

The SEC may be trying to cure unethical behavior by treating it as illegality.

This is also known as “how people behave when the only tool they have is a hammer”. Central banks can inject liquidity much more easily than finance ministries can spend money. And the lawyered-up SEC, if it finds a deal it considers odious, will go to great lengths to find a way in which that deal is illegal. Once they’ve done that, Goldman’s lawyers at Sullivan & Cromwell will go to equally great lengths and start quoting City of Monroe Employees Ret. System v. Bridgestone Corp, along with lots of other prior cases, in support of their argument.

I don’t doubt for a minute that Goldman’s behavior was more unethical than it was illegal. Goldmanites never stop talking about how they always put clients first, but because the U.S. has a rules-based rather than a principles-based regulatory system, that’s not an explicit regulatory requirement. One thing that the SEC has already done, in filing its complaint and making it public, is reveal that at least one banker — “Fab” Fabrice Tourre — does not fit that conception at all. Rather than treat every client with the utmost respect and transparency, he favored the sponsor of the Abacus deal, John Paulson, who was paying Goldman $15 million to put it together. And he blithely talked about a 0-9% equity tranche in emails to ACA, when no such tranche even existed.

Here’s the cunning thing about the SEC filing: they could settle with Goldman for $1 tomorrow, and Goldman’s reputation would still be tarnished for years to come. Here’s Allan Sloan:

I don’t much care about the legality of what Goldman allegedly did, because something doesn’t have to be illegal to be wrong. And almost everything about the Abacus 2007-AC1 “synthetic collateralized debt obligation” deal was wrong…

The SEC case seems more than a little weak legally, but tars Goldman as amoral at best, immoral at worst. It will take years for Goldman to erase the stain to its reputation, if it ever does.

If I were a betting man, I’d put money on Goldman prevailing in court, should the SEC charges go to trial. But in the court of public opinion, Goldman has already lost. And given the current state of things, that’s the court that matters.

This helps to explain why Goldman leads off its public self-defense by characterizing this deal as “a single transaction in the face of an extensive record”; general counsel Greg Palm said something very similar on the conference call today. Everybody at Goldman is hyper-aware of the degree to which a single mistake can ruin a bank’s reputation, and also of the degree to which that reputation is singlehandedly responsible for bringing enormous amounts of money into the bank. If you’re a journalist, no matter how good you are, you get better if you start working for the NYT or WSJ: your calls are returned that much more quickly, you’re that much more likely to be chosen as the outlet for leaks, and so on.

Similarly, if you’re a banker, you get better on your first day working for Goldman Sachs. Your calls get returned, you get better access to clients, and so on and so forth. The revelations in the SEC’s suit will hurt Goldman’s revenues, and Goldman wants to signal to the markets that they’re not at all typical of how it normally does business — while at the same time maintaining that they’re not even well-grounded in the first place.

It also helps explain why the SEC didn’t give Goldman the opportunity to settle the charges. The real damage to Goldman has already been done, and is much greater than any fine it might end up having to pay the SEC. (Which won’t be large, given that the firm lost money on the trade.) It’s an interesting case of the SEC using its rules-based structure to impose damages on firms who violate a hypothetical principles-based regime. It’s not what the SEC is necessarily meant to do, but that doesn’t mean it isn’t extremely effective.


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