Opinion

The Great Debate

Shorting the SEC’s case against Goldman Sachs

By Charles K. Whitehead
April 23, 2010

CharlesWhitehead — Charles K. Whitehead is an Associate Professor of Law at Cornell Law School.  He practiced in the United States, Europe, and Asia as outside counsel and general counsel of several multinational financial institutions, including as an associate in a law firm representing Goldman, Sachs & Co.  The opinions expressed are his own —

The civil action brought by the SEC against Goldman, Sachs & Co. has placed it squarely in the cross-hairs of those who argue, in the debate over new financial regulation, that Wall Street needs a new moral compass.  But it’s important, I think, to separate our frustration with Wall Street from the strength of the SEC’s case.  The case for reform is relatively easy to make.  After all, who needs smoke when we have just put out the fire?  The case against Goldman Sachs, I argue, is not nearly as convincing.  And, while there is – and, no doubt, will continue to be – a he-said, she-said quality to some important facts, it may be useful to consider the core case the SEC has brought.

The SEC’s charge, if proved, is fairly straightforward:  Goldman Sachs defrauded investors in notes whose value was based on a portfolio of assets selected by a hedge fund, Paulson & Co., first, by failing to disclose Paulson’s involvement in the selection process, and second, knowing that Paulson had placed bets on the portfolio declining in value.  To prevail, the SEC must show a substantial likelihood that the failure to disclose Paulson’s involvement and its short position was significant to a reasonable investor, considered within the total mix of information available at the time the purchase was made.  That may be difficult to do in light of what was being sold.

The notes here were issued in a structured transaction known as a synthetic collateralized debt obligation (CDO).  In a typical CDO, the proceeds are used to purchase a portfolio of assets whose value, whether up or down, determines the value of the notes.  Not so in a synthetic deal.  The notes continue to be tied to a portfolio of assets.  But, instead of buying them, the issuer enters into a credit derivative with someone else (ultimately Paulson in this case) in order to replicate the credit quality of that same portfolio.  If the portfolio does well, Paulson pays a premium to the CDO issuer that it uses to pay interest on the notes.  If it tanks (as in this case), the CDO issuer must pay Paulson an amount that reflects the write-down in value.

What this means is that every investor in a synthetic CDO – and, certainly, the sophisticated investors in the Goldman Sachs deal – knows there is someone else taking the opposite bet on the portfolio they invested in.   In fact, very often these deals are driven, not by the note investors, but by the short-seller, who is looking to the synthetic CDO as one means to bet against a portfolio of assets.

Was the fact it was Paulson material to investors?  Others have argued that Paulson was not nearly as well known in early 2007, when the notes were sold, as the fund is today.  More troubling, however, is the suggestion that – regardless of how well known – Goldman Sachs was obligated to disclose Paulson’s short position to the note investors.

It’s not uncommon for clients to have opposite views about the same asset.  It happens daily.  If, instead of sponsoring a synthetic CDO, Paulson decided to sell the identical assets to Goldman Sachs, and Goldman Sachs then sold the portfolio to the note investors, would Goldman Sachs be obligated to disclose that Paulson was the seller?  No – in fact, doing so would be a breach of confidentiality under the SEC’s own rules.  But that is a key element of the fraud alleged to have occurred here.

The SEC claims that Paulson helped identify the assets included in the CDO portfolio, and its role was masked by using ACA Capital Management as portfolio selection agent.  In essence, they argue that Goldman Sachs tapped ACA to cover Paulson’s tracks and may have even duped ACA into thinking that Paulson was an investor in (and not against) the portfolio.  It’s unclear, however, how involved Paulson really was.  The SEC’s complaint notes that ACA rejected over half the initial assets that Paulson hoped to include.  So long as the final decision rested with ACA, which appears to have been the case, Goldman Sachs has a strong argument that Paulson’s involvement was, at best, secondary.  And, in that case, disclosing that role becomes significantly less meaningful.

It’s also important to note what the SEC has not alleged:  They are not claiming that Paulson picked the portfolio, that ACA did not use its own judgment to decide what to include, or that what was included was not fully disclosed to the note investors.  That final point is particularly note­worthy – the note purchasers were seasoned parti­ci­pants in the CDO market and, with a list of the portfolio’s assets in hand, could (and, one would hope, did) make their own assessment of the quality of those assets, independent of Paulson or ACA.

On the heels of an eighteen-month investigation, all of this begs the question of why the SEC decided to bring this case at this time.  By all accounts, the SEC leapfrogged over its normal settlement process to file a lawsuit that was approved by a 3-2 vote of the SEC’s Commissioners, divided along party lines.   Perhaps taking on Goldman Sachs is a signal of the SEC’s renewed commitment to oversee Wall Street.  In that light, the SEC is to be commended for its efforts.  Less obvious is whether this lawsuit was the right one, and at the right time, on which to bet the SEC’s continued credibility as an effective watchdog.

Comments
12 comments so far | RSS Comments RSS

Goldman’s CEO or should I say America’s CEO visited the white house and told BHO to back off or he will shut off the lights in the White House. Nothing will come of this. Any fine they have to pay is a write off. You can’t beat them.

Posted by sdchanman | Report as abusive
 

If I buy a car from an auto-shop and somebody working there makes a bet it will break down within a year. I sure would like to know about this information as the buyer of the car.

If my neighbour makes the same bet I would not worry much about it.

Your argument seems to be the following: Paulson was working as a janitor or filing clerk and not as a mechanic. Knowing how information spreads among staff etc in a company would YOU buy that car?

And here is the problem, or lack thereof….transparency
But just like the reason why the diamond industry did not let the majority of stones get laser tagged, same applies to the financial industry. With transparency you can’t sell turds and make a bundle…

Posted by pusle | Report as abusive
 

Excuse me professor. I have no legal status but I have questions. I think denigrating the SEC and their possible credibility without seeing the case sounds not too lawyer-like. 18 months to sift through 8 million pages sounds reasonable and the correct time to make the charge was once you felt you could make it stick…NOT because there was a correct time politically.

Talking about the highly complex product *cough* and instruments that make up the whole package and breaking it down as you did will be the Goldman’s Layers position, certainly. But it is all deflection from the simple truths which are all that must be proven, after all. Misleading clients and knowingly misrepresenting the product or Paulson, which it seems they did.

Do you have privy to the 8 million pages of documentation and the emails and perhaps even witness statements at this time? Are you aware of who they are calling for witnesses and what information they may have? have they subpoenaed the ex-employee who left shortly after the deal was made? What was her involvement and why is she no longer in the business? Do they have some industry insiders as witnesses? How do you know their position is weak then?

Are you saying that to save his skin, perhaps the VP will not squeal/break, even though he will for certain be thrown to the lions? (too bad this is not a criminal suit … but, maybe there are criminal charges, such as insider trading or kickbacks, which will be lessened if he talks. Isn’t that a deal lawyers can make?)

I would say the 2 charges go hand in hand, although you present them separately and try to weaken each by diffusing with explanations of the ‘highly complex product,’ which it is often labeled. Was the material misleading because Paulson was the one who provided the list to be selected from, yet was called something other then the firm name? Such as, an ‘independent third party?’ They were also named the ‘transaction sponsor’.

If Paulson’s firm was at times represented by those 2 monikers, was he also represented as Paulson, the firm going short? All three were one and the same, so I am sorry but I see that as misleading, and materially misleading.

Was there coercion/kickbacks on behalf of Goldman to parties/rating companies to give the AAA ratings for what they themselves knew to be highly volatile sub- prime mortgage packages? Were they not being traded this way because they were NOT AAA product, and so could not be sold and traded in the ‘normal’ fashion? The ones which were left in the portfolio were picked as they were on the brink of being defaulted on. Is that not misleading? How can a stacked deck not be considered materially misleading by those who stacked the deck? being Goldman knew who was stacking the deck he was materially responsible to tell.

Also, which of the 3 monikers was used by Paulson’s firm were used to say they were going short. Pellegrini’s testimony says he represented Paulson, but was this in writing or to a few people over a beer. Did Goldman misrepresent these 3 parties as separate entities?

The fact that Paulson has no Wells Notice as of yet, doesn’t mean there isn’t one forthcoming and he wasn’t complicit in these dealings. His 6 page letter to his shareholders repeats it was an arm’s length transaction, but was it? He is the one to come to Goldman’s and eventually rejected ACA’s additions the profile. So to that end, ACA did NOT have final say.

The presentation of the firms as ‘seasoned professionals’ has little to do with the case, as in the long run that is not what this case is about. Using that as a defense is pure deflection. The mafia can still be charged even if it dupes rubes who are seasoned professionals, correct?

I ask these questions without the knowledge of a lawyer, but with enough knowledge to know that THIS is similar to what a lawyer DOES need to know to make a case.
Although there are cute words being bandied about, the ordinary folk like myself use words more akin to bookie, swindling, rubes, etc.

Regardless of the outcome of this case and others, they can’t be seen as anything but a toxic, contrived mess, no matter how ‘professional’ the unscrupulous dealings were. Nice try though.

Posted by hsvkitty | Report as abusive
 

I was going to make a comment but what is the point really? The one with the most money wins. I give up. Lets start a new game and change the rules altogether. Lets call the new game REAL VALUE. Oh, and there is a limit as to how much one person/company can acquire.

Posted by ThePup | Report as abusive
 

Excuse me professor. I have no legal status but I have questions. I think denigrating the SEC and their credibility without seeing the case is not too lawyer-like. 18 months to sift through 8 million pages sounds reasonable and the correct time to make the charge was once you felt you could make it stick…NOT because there was a correct time politically.

Talking about the ‘highly complex product’ and instruments that make up the whole package and breaking it down as you did will be the Goldman’s Layers position, certainly. But it is all deflection from the simple truths which are all that must be proven, after all. Misleading clients and knowingly misrepresenting the product or Paulson, which it seems they did.

Do you have privy to the 8 million pages of documentation and the emails and perhaps even witness statements at this time? Are you aware of who they are calling for witnesses and what information they may have? have they subpoenaed the ex-employee who left shortly after the deal was made? What was her involvement and why is she no longer in the business? Do they have some industry insiders as witnesses? I have seen the How do you know their position is weak then?

Are you saying that to save his skin, perhaps the VP will not squeal, even though he will for certain be thrown to the lions? (too bad this is not a criminal suit … but, maybe there are criminal charges, such as insider trading or kickbacks, which will be lessened if he talks. Isn’t that a deal lawyers can make?)

Posted by hsvkitty | Report as abusive
 

I would also have to say the two charges go hand in hand, although you present them separately to weaken each by diffusing with explanations of the ‘highly complex product.’ (which the elite affectionately call it) Was the material misleading (fraud) because Paulson was the one who provided the list to be selected from, yet was called something other then the firm name? Such as, an ‘independent third party?’ They were also called the ‘transaction sponsor’.

If Paulson’s firm was at times represented by those 2 monikers, was he also represented as Paulson, the firm going short? All three were one and the same, so I am sorry but I call that misleading.

Was there coercion/kickbacks on behalf of Goldman to parties/rating companies to give the AAA ratings for what they themselves knew to be highly volatile sub- prime mortgage packages? Were they not being traded this way because they were NOT an AAA product, and so could not be sold and traded in the ‘normal’ fashion? The ones which were left in the portfolio were picked as they were on the brink of being defaulted on. Is that not misleading? How can a stacked deck not be considered materially misleading?

Also, which of the 3 monikers was used by Paulson’s firm were used to say they were going short. Pellegrini’s testimony says he represented Paulson, but was this in writing or to a few people over a beer. Did Goldman misrepresent these 3 parties as separate entities?

The fact that Paulson has no Wells Notice as of yet, doesn’t mean there isn’t one forthcoming and he wasn’t complicit in these dealings. His 6 page letter to his shareholders repeats it was an arm’s length transaction, but was it? He is the one to come to Goldman’s and rejected ACA’s additions the profile. So to that end, ACA did NOT have final say.

The presentation of the firms as ‘seasoned professionals’ has little to do with the case, as in the long run that is not what this case is about. Using that as a defense is pure deflection. The mafia can still be charged even if it dupes rubes who are seasoned professionals, correct?

I ask these questions without the knowledge of a lawyer, but with enough knowledge to know that THIS is similar to what a lawyer DOES need to know to make a case.
Although there are cute words being bandied about, the ordinary folk like myself use words more akin to bookie, swindling, rubes, etc.

Regardless of the outcome of this case and others, they can’t be seen as anything but a toxic, contrived mess, no matter how ‘professional’ the unethical dealings were. Nice try though.

Posted by hsvkitty | Report as abusive
 

I would say the 2 charges go hand in hand, although you present them separately and try to weaken each by diffusing with explanations of the ‘highly complex product.’ Was the material misleading (fraud) because Paulson was the one who provided the list to be selected from, yet was called something other then the firm name? Such as, an ‘independent third party’ or ‘transaction sponsor’.

If Paulson’s firm was at times represented by those 2 monikers, was he also represented as Paulson, the firm going short? All three were one and the same, so I am sorry but I call that misleading.

Was there coercion/kickbacks on behalf of Goldman to parties/rating companies to give the AAA ratings for what they themselves knew to be highly volatile sub- prime mortgage packages? Were they not being traded this way because they were NOT an AAA product, and so could not be sold and traded in the ‘normal’ fashion? The ones which were left in the portfolio were picked as they were on the brink of being defaulted on. Is that not misleading? How can a stacked deck not be considered materially misleading?

Also, which of the 3 monikers was used by Paulson’s firm were used to say they were going short. Pellegrini’s testimony says he represented Paulson, but was this in writing or to a few people over a beer. Did Goldman misrepresent these 3 parties as separate entities? Paulson is the one to come to Goldman’s and rejected ACA’s additions the profile. So to that end, ACA did NOT have final say.

The presentation of the firms as ‘seasoned professionals’ has little to do with the case, as in the long run that is not what this case is about. Using that as a defense is pure deflection. The mafia can still be charged even if it dupes rubes who are seasoned professionals, correct?

I ask these questions without the knowledge of a lawyer, but with enough knowledge to know that THIS is similar to what a lawyer DOES need to know to make a case.
Although there are cute words being bandied about, the ordinary folk like myself use words more akin to bookie, swindlers, rubes, etc.

Regardless of the outcome of this case, it can’t be seen as anything but a toxic, contrived mess, no matter how ‘professional’ the unethical dealings were.

Posted by hsvkitty | Report as abusive
 

Paulson was the one who provided the list to be selected from, yet was referred to as an ‘independent third party’ or ‘transaction sponsor’.

If Paulson’s firm was at times represented by those 2 monikers, was he also represented as Paulson, the firm going short? All three were one and the same, so I am sorry but I call that misleading.

Also, which of the 3 monikers was used by Paulson’s firm were used to say they were going short. Pellegrini’s testimony says he represented Paulson, but was this in writing or to a few people over a beer. Did Goldman misrepresent these 3 parties as separate entities? Paulson is the one to come to Goldman’s and rejected ACA’s additions the profile. So to that end, ACA seems to NOT have final say.

Was there misconduct on behalf of Goldman to parties/rating companies to give the AAA ratings for what they themselves knew to be highly volatile sub- prime mortgage packages? Were they not being traded this way because they were NOT an AAA product, and so could not be sold and traded in the ‘normal’ fashion? The ones which were left in the portfolio were picked as they were on the brink of being defaulted on. Is that not misleading? How can a stacked deck not be considered materially misleading?

Referring to the firms as ‘seasoned professionals’ has little to do with the case, as in the long run that is not what this case is about. Using that as a defense is pure deflection. The mafia can still be charged even if it dupes rubes who are seasoned professionals, correct?

Regardless of the outcome, it can’t be seen as anything but a toxic, contrived mess,no matter how ‘professional’ the unethical dealings were.

Posted by hsvkitty | Report as abusive
 

The part two of my post is not being allowed… this is a test

Posted by hsvkitty | Report as abusive
 

Professor — you obviously are aware that the sale of securities is governed by various SEC acts and laws, including 10-B5.

That rule states that seller of securities may not make material misrepresentations when pitching their products; i.e., Stocks cannot be sold like used cars.

The SEC complaint alleges that GS told potential buyers that a Paulson & Co., a major hedge fund, was long $200 million dollars worth of this product, when they were in fact short that much (if not more).

Its hard to see how that is not a 10-b5 violation…

There is more here:
http://www.ritholtz.com/blog/2010/04/10- things-you-dont-know-gs-case/

Posted by Ritholtz | Report as abusive
 

It’s a pleasant change to see a legal practitioner with a firm grasp of the financial particulars of a complex case, and better still to see them expressed with such clarity.

You are indeed correct to say that Goldman often acts as the middleman, or broker, in transactions where one party takes the opposite position to another. However, a CDO doesn’t quite work that way: the investors who buy into the upper tranches take a reduced return in the knowledge that they’ve offloaded the risks onto a class of speculators will take a higher return on the ‘equity’ tranche.

This risk transfer is a graded redistribution of common risks and common profits, not a trade of diametrically-opposed interests managed by an independent broker.

It’s accepted that outsiders will take short positions – bets, if you will – against some or all of the investments involved: but every time I but a share, I know that someone sold it, and that someone else is probably ‘shorting ‘ it right now.

Outsiders, fine. But insiders? Would I buy into a company if I knew the directors were taking bets on the price going down? Would I buy into a mutual fund, if I knew that the stocks were picked by someone who was actively shorting the very same constituents?

Would I have bought a tranche of a Goldman Sachs CDO, knowing that the constituents were selected by someone with an interest in seeing their value fall – or even in seeing the whole structure go down?

It’s not the same as knowing your broker found a seller for the share I bought, or a buyer for the CDS I sold, who will lose money on it if I gain and vice versa. That situation’s about brokering a deal between counterparties; this one’s about dealings with investors.

Goldman stand accused of failing to disclose that material decisions in the structure of an investment were made by a party who stood to gain from investors’ losses. That’s the SEC’s case: it may be difficult to prove, and sure as hell the investors have an interest in handing back their losses to Goldman – but the SEC believe they have enough to get it to court and that means there’s good documented evidence.

God forbid that they have hard evidence of Goldman representing Paulson as being ‘onside’, or as a coinvestor, when the opposite turns out to have been the case. Would you like to rule that out? Today’s testimony in the hearings was, shall we say, lacking in an unambiguous denial of that awful possibility; and I would’ve expected to hear something – anything – intended to lay such a suspicion conclusively to rest.

Posted by Nile_H | Report as abusive
 

Wow, I do apologize for the mess of comments here from myself. The test post was put up before all of the secondary postings, so that is just wrong! It seems that long postings are checked after short ones, which is ridiculous. Moderators should check in sequence.

Also, if you have moderation, why is it I report 2 to 3 spam messages for dating sites daily.

Posted by hsvkitty | Report as abusive
 

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