SEC v. Goldman Sachs: Back to First Legal Principles

The Paleolithic quality of the derivatives markets takes us back to earlier times, when the courts and the SEC struggled to establish the basic ground rules of the securities markets. Although American lawyers, unlike their English brethren, tend to fixate over the most recent judicial decisions, it is can be instructive to go back to a time when the stock markets were more rudimentary, bearing interesting resemblances to today's derivatives markets.

In 1972, when french fries were still cooked in lard and tasted much better than they do today, the U.S. Supreme Court handed down its decision in Affiliated Ute Citizens v. United States, 406 U.S. (128). This case involved a company, Ute Distribution Corp., which was created to distribute certain assets of the Ute Native American tribe to its mixed-blood members. The original mixed blood shareholders were permitted to sell their stock, although sales involved a somewhat laborious over-the-counter process by the transfer agent, a bank called First Security Bank. Two employees at a branch office of the bank saw a profit opportunity and devised a scheme to buy stock from original shareholders at lower prices and resell it to non-Utes at higher prices. The result was a two-tiered market, in which stock sales by Utes were in the range of $300 to $700 per share, while transactions between white buyers and sellers were in the $500 to $700 range. The two bank employees, who themselves purchased some of the selling Utes's shares, did not disclose to the Ute sellers the existence of the higher priced white market. When some of the selling Utes found out, they sued the bank and its employees (and also the United States, arguing it had some responsibility to restrain the Utes from selling their shares; but the Court ruled in favor of the U.S.).

The Court decided that the bank and its two employees were liable under the SEC's antifraud rule, 10b-5, for failure to disclose the existence of the two-tiered market the two employees had created. The two employees had actively encouraged non-Utes to buy, and received commissions and other compensation for sales to non-Utes. The Court held them and the bank liable even though the two employees made no affirmative representations or recommendations to selling Utes. The bank employees were deemed responsible because they had "facilitate[d] the mixed-bloods' sales to those seeking to profit in the non-Indian market the defendants had developed and encouraged and with which they were fully familiar." 406 U.S. at 153.

In the Affiliated Ute case, the bank and its two employees were not formal underwriters or broker-dealers. But they informally structured transactions so that selling Utes were unknowingly at a disadvantage. That, in the view of the Court, made the defendants liable for failure to disclose as required by the antifraud requirements of Rule 10b-5. The Court's imposition of Rule 10b-5 liability on the bank and its employees for their actual conduct, and not their contractual status (as transfer agent), is in keeping with the rule's purpose as a catch-all provision to guard against the inventiveness and creativity of fraudsters.

While there are differences of fact between Affiliated Ute and the SEC's case against Goldman Sachs, the basic principle of Affiliated Ute is problematic for Goldman. It created ABACUS 2007-AC1, in a way that some evidence indicates was slanted to favor the short side because of the substantial role in selecting the collateral played by John Paulson & Co., the short seller that commissioned Goldman to created this synthetic CDO. Even though Goldman evidently did not recommend buying to the investors on the long side, the Court in Affiliated Ute did not require affirmative recommendation or representation before applying liability. Following the Court's reasoning, Goldman, as a key participant in creating the CDO, should have disclosed to long investors the information indicating that ABACUS 2007-AC1 could be rigged in favor of the short investor.

The derivatives market, circa 2007, was an opaque, informal, heavily negotiated market. Even sophisticated investors didn't have much in the way of objective reference points to measure potential investments. Specific information is always more important than sophistication. Lots of sophisticated people ripped off by Bernie Madoff wouldn't have invested if he had, as required by law, disclosed what he was really up to. The Great Recession began as a result of idiocy in the derivatives markets and we taxpayers, workers, homeowners and citizens are still struggling to recover. All of us have a stake in the integrity, fairness and soundness of the derivatives markets.