Shorting the SEC’s case against Goldman Sachs
— 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.