The Great Debate

Shorting the SEC’s case against Goldman Sachs

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.

Embrace reality, not fight speculation

Stock up on canned goods, the authorities appear to be opening a new front in the War Against Speculation; this time taking aim at the people who might profit from Greece and its European partners’ woes.

Just days after the U.S. Securities and Exchange Commission voted new limits on short selling, Germany is investigating the credit default swap trading of speculators to try to prevent them from profiting from any bailout of Greece.

“It would be bad if it were to emerge after a rescue that the money had gone into the pockets of speculators,” a source with knowledge of the efforts told Reuters.

Investor confidence not too helpful

Once again someone in charge — Mary Schapiro of the U.S. Securities and Exchange Commission this time –  is going on about how they are making changes in order to “preserve investor confidence.”

As if this were in some way a good thing.

I would feel a whole lot better if instead the SEC were talking about making investors more sceptical.

The SEC on Wednesday moved by a 3-2 vote to place additional limits on short selling of stocks, the practice of betting on a decline in a given stock by borrowing shares, selling them and contracting to buy them back later at what the seller hopes will be a lower price.

from Rolfe Winkler:

Rakoff throws down the gauntlet

Judge Rakoff has rejected the settlement deal between the SEC and Bank of America. He clearly wasn't happy with it to begin with, and subsequent briefs from the two parties did nothing to allay his concerns. At the end of the day, he hated the idea that B of A shareholders, on whose behalf the SEC actually brought the case, would end up paying the fine for executives' wrongdoing.

So what's the next step? According to the Reuters story, "Rakoff directed the parties to prepare for a possible trial that would begin no later than February 1, 2010."

That doesn't mean there will be a trial. The parties could come back with a settlement more to Rakoff's liking.

from Commentaries:

Obama loves hedge funds

Matthew GoldsteinThe big winner in the Obama administration's financial regulatory reform package is the beaten-up hedge fund industry.

Hedge funds get a particularly "light touch'' when it comes to government oversight in the Obama plan. Essentially, the administration is calling for a reinstatment of a Securities and Exchange Commisison rules that requires managers to register with the agency as investment advisors.  The rule was overturned by the federal courts, but many large hedge funds remained registered with the SEC--even though they weren't required to do so.

The registration requirement would give the SEC the authority to conduct periodic inspections and require hedge funds to report information on trading positions. But the information reported by the hedge fund would remain confidential and not shared with the general public.

First 100 Days: Prioritize and take a hands-on approach

ram-charan-photo– Ram Charan is the author several book, including “Leadership in the Era of Economic Uncertainty: The New Rules for Getting the Right Things Done in Difficult Times.” A noted expert on business strategy, Charan has coached CEOs and helped companies like GE, Bank of America, Verizon, KLM, and Thomson shape and implement their strategic direction. The opinions expressed are his own. –

The first 100 days demand that President Barack Obama sort out his priorities and choose the ones that will help solve many others. With many constituencies and direct reports clamoring for his time and attention, he cannot attend to them all.  He has to decide which of the many complex and urgent issues that have accumulated must be resolved first.

The new president will inevitably be pushed to spend a huge amount of time on foreign policy.  But I suggest that the president’s top priority should be to get the nation out of this economic and psychological funk.  He has selected some very capable people who will help sort out the economic mess. He made a brilliant move to have Paul Volcker in the White House.

Why did the SEC fail to spot the Madoff case?

mark_williams– Mark T. Williams, a finance professor at the Boston University School of Management, is a risk-management expert and former Federal Reserve Bank examiner. The views expressed are his own. –

With Congress now probing the Bernard Madoff case, some claim the SEC missed the risk because of under staffing. Even if that’s an issue, one SEC enforcement officer using basic risk-management skills, asking probing questions, searching for clear answers, and exercising timely follow up could have helped in detecting this fraud before it grew to such a staggering size.

The central flaw at the SEC is that its current oversight approach is not sufficiently risk focused. Moreover, any changes in approach have tended to be in response to a specific event instead of incorporating an overall risk-based approach across all areas under their regulatory purview.