— 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.