How important is IKB’s sophistication?

By Felix Salmon
April 23, 2010
John Carney has a defense of Goldman Sachs up at the Daily Beast, based on the not-novel-at-all idea that the investors in the Abacus deal were sophisticated.

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John Carney has a defense of Goldman Sachs up at the Daily Beast, based on the not-novel-at-all idea that the investors in the Abacus deal were sophisticated.

A document exclusively obtained by the Daily Beast demonstrates (view them here) that just a few months before it invested in the derivatives at the center of the SEC’s case, the German bank was touting its prowess as a sophisticated investor in those derivatives.

But no one is asserting that IKB, or any other party to this transaction, wasn’t sophisticated. The word never appears in the SEC’s complaint against Goldman, for instance, and I have yet to see a Goldman critic latch onto the idea that IKB was some kind of naive widow or orphan, who was bamboozled by all these CDOs and CDSs and whatnot.

On the other hand, Goldman itself loves hammering home the idea that the investors in the deal were sophisticated. Its first big public statement on the deal uses the word twice, its second uses the word three times, and its two letters to the SEC use the word no fewer than twenty-three times between them.

Here, for example, is a chunk of the first letter:


The problem with all of this banging away about IKB’s sophistication is that it looks very much like protesting far too much. The SEC doesn’t need to show that IKB was unsophisticated, it just needs to show that Goldman didn’t make the disclosures required by the law.

Carney, a lawyer by training, tries to explain why he thinks this is such a big issue, but he’s far from convincing:

The sophistication of IKB will be an important issue in the Goldman case. In general, the securities laws of the United States assume that sophisticated investors can fend for themselves. That’s exactly why hedge funds—which only accept money from so-called “accredited investors”—are largely free from regulation. The focus of our securities laws is the protection of ordinary investors and market integrity.

I’m sure that a class on the history of US securities laws would be fascinated by their treatment “in general” of sophisticated investors, and by their overall focus in terms of investor protection. But the point at question here is whether Goldman failed to make necessary disclosures, simple as that. To be sure, the level of disclosure necessary changes according to the sophistication of the investor in question, and qualified institutional investors in the 144a market are much more sophisticated than ordinary individual investors. But the level of disclosure never goes away entirely, and in fact the statute in question is drawn very broadly:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,

in connection with the purchase or sale of any security.

There’s nothing there about “any unsophisticated person”: if Goldman’s omission of Paulson’s role in its statements made what it was saying misleading, or if it was deceitful, then that’s it, case closed. IKB may or may not have been a sophisticated investor, but I don’t think that status matters nearly as much as Goldman and Carney think and/or hope that it does.


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Lots of rubes think they’re sophisticated. IKB’s self-description in this regard isn’t useful, I wouldn’t think.

Posted by spistol | Report as abusive

The point is that Goldman’s argument (and I think it’s one that has had some sway in previous fraud cases) is that because IKB was supposedly sophisticated (and by rights it should have been, given the size of its CDO portfolio), it could evaluate the underlying collateral on its own merits. Therefore it didn’t need (so goes the argument) to rely on the brand name of ACA, or indeed any knowledge about what some hedge fund might think about the reference assets. Basically, the argument is that the omission of Paulson’s role isn’t material, becasue it wouldn’t be material to a sophisticated investor like IKB.

Posted by GingerYellow | Report as abusive

Here’s a thought-experiment. Suppose Paulson had approached IKB directly with an offer: “I’ll bet you that this set of mortgages will fail. If you win, you get $7 million from a third party, if I win, you pay me $800 million.” Do you think that IKB would have taken the bet?

Posted by MattF | Report as abusive

Excellent post. Goldman’s position is not strong, especially considering that a trial would be before a judge or jury making a subjective call as to whether there was deception.

Posted by DanHess | Report as abusive

The question of whether Goldman’s marketing amounted to fraud is indeed a question of fact and law: was the fact that Paulson was deeply involved in the selection of the securities in the portfolio and intended to short same “material” and, therefore, was the omission of this fact “misleading.” The sophistication or not of the investors does not enter into the determination of this fact, and therefore the judgment of fraud will not depend on it.

Goldman is screwed.

Posted by EpicureanDeal | Report as abusive

Stated another way, the arguable fact that your alleged victims were sophisticated is no defense against an allegation of fraud. Sophisticated people and institutions get defrauded all the time. That doesn’t make fraud legal.

Posted by EpicureanDeal | Report as abusive

In fact, the easiest people to defraud are the ones who think they are sophisticated, but are not.

I’ve had some dealings with German banks in similar circumstances, and they were mostly smart, but incredibly naive and dependent on the good intentions of the person committing the alleged deception.

Posted by RobNYNY1957 | Report as abusive

Ginger’s point is part of why the SEC bothered to include the accusation that Goldman misled ACA.

Attempting to hide a fact is essentially an admission that it is material. (I’d imagine the other possibility is that it allows IKG to claim that the facts are material because of the asymmetrical information involved with a CDO. Since its so easy to make a crappy security look fine even to a sophisticated investor, they relied on having a neutral CDO picker.)

Posted by AnonymousChef | Report as abusive

I think the weakest part of Goldman’s “sophisticated investor” defense is that the buyer *ASKED* for an independent party to select the mortgages and they did not get it. They were made to believe that’s what they had. They were asking for independent help in the selection and were betrayed.

They were a foreign company and surely did not know the intricacies of American geography as well as an American. When Goldman provided assurances that the securities were selected by an independent third party
they lied on a point of “material fact”. The supposed independence of the third party was “material” because the buyer requested assurances and in doing so demonstrated that it was material for them.

Posted by DanHess | Report as abusive

Hey, Goldman, stop listening to your lawyers and start doing your own legal analysis. You ought to be an expert on misaligned interests! Your lawyers’ interests are not aligned with yours, and they win by riding this gigantic gravy train to the bitter end.

Posted by DanHess | Report as abusive

As with the Credit Ratings Agencies, it appears to a casual unsophisticated observer such as myself that Reputation was used and sacrificed over and over in this crisis. Where does that fit in to theories or models of why businesses can be expected to act in their own best interests? It means such a view is subjective and determined by things like the amount of money to be gained, perception of regulators, etc.

Posted by DonthelibertDem | Report as abusive

My knowledge of securities regulations isn’t huge, but my recollection of the purpose of the whole 144A qualified institutional buyer was not to permit a lesser degree of disclosure to the buyer, but to permit a lesser degree of public disclosure (prospectus, periodic reports, etc). Sophisticated investors are not presumed to be able to live without material information, just to be able to get it from places apart from EDGAR.

Posted by gringcorp | Report as abusive

” In general, the securities laws of the United States assume that sophisticated investors can fend for themselves. That’s exactly why hedge funds—which only accept money from so-called “accredited investors”—are largely free from regulation.”

Note the sleight-of-hand from “sophisticated” to “accredited.”

Carney should know/knows better than to believe the claim he’s making. The “prudent man” standard–even after it was distended beyond recognition, creating the incentive for all that deregulation and the inevitable fall (see Gresham’s Law) of the Investment Banks–is not applied to hedge funds and their like because the standard for “accredited investor” is that they DO NOT NEED TO BE PRUDENT.

Accredited = has a lot of money. Sophisticated = knows investments and the markets. There is an overlap–see, e.g., Buffett, Warren–but a lawyer who tries to argue that people who have more than $1MM in assets excluding their primary residence are by definition “sophisticated” would be laughed out of John Carney’s brother’s court.

Posted by klhoughton | Report as abusive

The key part of the statute as it pertains to this case is this: “It shall be unlawful…to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.” This applies equally to sophisticated and unsophisticated investors. If Goldman had simply presented the portfolio to investors without any statement as to how it was selected and said, “Do you want to invest in this?”, it would have been fine. The problem was they selectively disclosed some information (“selected by ACA”) and withheld other information (“with the involvement of a short-seller”).

Posted by o_nate | Report as abusive


Oh my God, STFU about securities law issues. You’re in so far over your head that you probably don’t even know how badly you’re embarrassing yourself.


Every Securities Lawyer on Earth

Posted by jhedges | Report as abusive

Excellent point. Odd that a lawyer would be so indifferent to the text of the law (that was an effort at humor). However, I should point out that the fact that IKB claimed to be sophisticated doesn’t mean that they are, in fact, sophisticated. What does Carney expect them to tell the public “We’re clueless. We sure hope Goldman Sachs doesn’t want to take advantage of us. Hope so too and invest your money with us.” ?

I mean marks tend to think that they are sophisticated. A bank which knew it was clueless would have bought Treasuries.

Posted by robertwaldmann | Report as abusive

JHedges –

Do enlighten us. What other laws apply than the one Felix cited?

Posted by DanHess | Report as abusive

This reminds me of all of the Wall Street types who chastised the rest of the unwashed masses for daring, in our unsophisticated way, to question why this whole system melted down requiring a few hundred spare billion dollars from the federal treasury. After all, if you don’t have technical information regarding AT5-XQ*2! Structured Asset Ladder Reflux Capacitor Credit Field Obligation Funds, you shouldn’t get all cranky when the currency catches on fire and requires your taxes, right?

We need to come to terms with the fact that most parts of our society, upon which we interdepend, require specialized knowledge not shared by the masses. Fully 99.97% of us will never become doctors, but if a bunch of MDs run around spreading the plague, you shouldn’t need to be able to cite the differential diagnosis for pleuritic chest pain in order to make a complaint.

Perhaps we need a law that says if you can’t explain a financial instrument in under twelve words (“We’re buying coffee futures because people are drinking lotsa coffee.”) it is declared fraudulent. We would lose CDOs but maybe retain the housing sector.

An unsophisticated point of view, I admit.

Posted by ericgarland | Report as abusive

I’m not all that sophisticated, but what’s the big deal for Goldman Sachs? With 13 billion in profits, a fine of a few million is just a cost of doing business. In fact, the most they’ll have to pay is less than the compensation package of one of its big cheeses.

Posted by sethchan | Report as abusive

@ericgarland, I agree with your unsophisticated point of view!

Posted by iflydaplanes | Report as abusive

Somehow I think that the level of sophistication of the investors is relevant to the case, and Goldman is right to point it out (but maybe not 23 times).

The case boils down to whether or not Goldman disclosed the relevant material facts. The most pertinet fact being that Paulson sponsored the CDO and was actually shorting the entire structure.

An unsophisticated investor likely would not have realized (or even understood) that the sponsor of the CDO could be net short (or perhaps even that there was a sponsor separate from Goldman). Goldman’s defence is that a sophisticated investor must know that in a synthetic CDO, for every long, there must be short. Given that the sophisticated investor knows this, then it is not material that Paulson is that short.

I don’t know how the courts will rule on this issue, but it is important that IKB implicitly knew that there was a short position on the CDO. It obviates the need for Goldman to disclose it.

Mind you, the crux of the case isn’t that it wasn’t disclosed that Paulson was short, it’s that it (potentially) wasn’t disclosed that Paulson played a role in selecting the refence basket while being short.

Posted by Kosta0101 | Report as abusive

Remember the OJ trial? He may have been acquitted, but his reputation was destroyed by all the publicity about his life. I think Goldman would be wise to salvage their reputation by saying Fabric was a rogue trader, that there may be other rogues in their midst, and they are going to clean house.

If Nixon had fired Haldeman and Erlichman, and cut his losses, he would have gone down as one of the better presidents in the 20th century.

But Goldman will not do the sensible thing. Hubris trumps humility. And their stock will slowly drift down, and customers will drift away. Somebody is going to look at their market cap of 84 billion, and say almost all of that is blue sky, in other words, their reputation.

Posted by randymiller | Report as abusive

One more point, do you notice all the AAA and AA and A ratings on every traunch above equity? I would think that Goldman putting that in their literature indicates that they gave credence to those ratings, when they knew the indexed CDO’s were BBB trash.

Tell me why that is not deceptive, “All the security lawyers on earth”. The lawyers for Goldman are trying to find some slippery loopholes here, which will end up making Goldman look bad, and the lawyers look sleazy.

How do these guys feel about their kids friends reading about this in the Times? Are their kids going to be proud of them? I may not have made 68 million dollars in a year, but at least I can look my kids in the eyes. Which is worth a whole lot more to most people.

Posted by randymiller | Report as abusive

Sophisticated Goldman’s biggest challenge will be finding a judge whose retirement fund they haven’t already rogered.

Posted by HBC | Report as abusive

So if the Mob dupes someone sophisticated, then it is no longer doing anything wrong? Silly rubes then! (what a terrible argument but you gotta know that the lawyers will milk it)

*Withholding material information and misleading is not allowed, so while there were rubes, Goldman should still be charged with fraud. Rule 10b-5 applies.

*Referring to Paulson as the transaction sponsor rather then the one who picked the bonds, or the one who will be going short.

*saying an independent party picked the assortment of bond trash to select from.

*Calling it a hands off trade, then bet short on it, and insure it,knowing it was junkier then the usual junk in such ‘sophisticated’ transactions.

*Coercing Moody to upgrade AAA while admitting it was junk.

*This deal was created by someone who likes things to blow up, specifically designed to blow up and with that insider knowledge, Goldman sold it others. Who knows what the insurance actually netted of if they did switcheroos as well.

Posted by hsvkitty | Report as abusive

Getting in on a deal with Goldman-Sachs is like sitting at a poker table:

If you can’t spot the obvious patsy within the first 5 minutes then YOU ARE THE PATSY!

Posted by libarbarian | Report as abusive