How the Government Could Build a Criminal Case Against Goldman Sachs

How could the U.S. Attorney's Office in Manhattan put together a criminal case against Goldman Sachs? The financial news channels and websites are full of skeptical commentary. But federal prosecutors in Manhattan are too busy and professional to pursue probably impossible cases. There must be something or some things they find tantalizing. We have no inside information about what the government may have or know. But one can look at the evidence that's already public, and see ways prosecutors might put a case together.

Fraud is the foundation. The SEC's fraud charge provides a ready foundation for criminal charges. A criminal charge of securities fraud has the same elements (i.e., points that must be proven) as a civil charge of securities fraud. The only difference is the criminal prosecutors must prove their case beyond a reasonable doubt, whereas the SEC needs only to prove its case by a preponderance of the evidence. An apt analogy is some Lexus models are simply fancier versions of certain Toyota models. In that vein, a criminal securities fraud charge is simply a civil securities fraud charge with a stronger body of evidence. Prosecutors can take the evidence accumulated by the SEC and build on it. That's easier than starting from scratch.

Goldman's public statements and testimony may have evidentiary value. Although the testimony and statements made publicly by Goldman were stiff with self-serving defiance, they didn't contradict one of the principal charges in the SEC's complaint: that the German bank, IKB, didn't know about short seller John Paulson & Co.'s role in selecting the collateral for ABACUS 2007-AC1, the derivative that will live in infamy. Goldman has also admitted that it unsuccessfully tried to sell the interest in ABACUS 2007-AC1 from which it wound up losing $90 million. Thus, from the get go, it didn't believe in the value of this investment. Prosecutors benefit from knowing of these weaknesses in Goldman's story.

Complexity isn't a defense. Much is made by defense-centric commentators that the government will have a lot of problems with the complexities of synthetic CDOs and the derivatives business in general. While these products are complex in many respects, let's remember a very basic fact: they are designed to increase or decrease in value. Indeed, being two-sided bets, they are designed to increase in value for one side of the contract while decreasing in value for the other side. A simple way for prosecutors to cut through the complexity is to explain to the judge and jury why the contracts go up in value or down in value. In the case of the subprime mortgages that underlie ABACUS 2007-AC1, a rise in default rates would be the simple, understandable causal factor that would trigger losses for the long side and gains for the short side. And the fact that the short side investor was involved in choosing the collateral for ABACUS 2007-AC1 is an even simpler fact. You don't need graduate level mathematics to understand that such an investor would have tried to stack the deck in its favor.

E-mails may provide a short cut through the complexity. The Goldman executive who called one derivatives transaction a "sh*tty deal" did prosecutors a good turn. So did Fabrice Tourre, when he wrote that the "CDO biz" was dead and that he might end up the last man standing after a bunch of derivatives deals collapsed. These real time acknowledgments of the ugliness of the deals can be used to undermine after the fact explanations offered by Goldman's witnesses.

Complexity for the goose is complexity for the gander. If prosecutors can cut through the complexity of derivatives deals and establish what lawyers call a prima facie case (i.e., they meet the minimum burden of proof), the defense will be hampered by the same complexity. The sheer abstractness of a synthetic CDO and the fact that it doesn't finance a real business or commercial transaction or investment will leave the judge or jury without much reason to conclude that the transaction is a good and socially desirable thing. Gut level, albeit unstated feelings like this can matter in a criminal prosecution.

Guaranteed losses produce guaranteed ugliness. As Goldman has copiously explained to any and all that would listen, synthetic CDOs necessarily have a winner and a loser. That's factually true, but it also facilitates criminal prosecution. Federal prosecutors don't pursue white collar crime unless it produces large, actual losses. CDOs like ABACUS 2007-AC1 produce truckloads of actual losses. The fact that they produce big gains doesn't make much difference, because those gains won't offset the losses if a crime has been committed. Large two-sided financial bets almost by definition make federal prosecution easier.

The amorality of it all. While the government has the burden of proof, juries and perhaps even judges sometimes subconsciously look to the defense for an innocuous alternative that explains the defendants' conduct. The need for an alternative becomes explicit if Goldman's personnel choose to testify in defense of the firm or in their own defense. This is where Goldman's public explanations are notably unsatisfying. Goldman depicts itself as a we-aim-to-please, would-you-like-fries-with-that intermediary accommodating the investment goals of sophisticated long and short customers that knew or should have known what they were doing. None of this explains why a talented or gifted 11-year old kid busy with school, soccer and piano lessons would want to grow up to be a synthetic CDO salesperson, not unless the only value we wish to instill in our children is greed. The amorality of Goldman's explanations offers judges and juries no sense of satisfaction from an acquittal. That, however subtly, makes it harder for them to acquit.

Cooperating witness(es). The key to many white collar criminal prosecutions is the cooperating witness. A human being who testifies under oath to the rapaciousness and venality of the defendants adds life to documentary evidence like e-mails and memoranda. The only publicly known potential cooperating witness, Fabrice Tourre, took careful aim at his feet before emptying a full clip. By publicly proclaiming his innocence, he would be hard pressed to change his story later. He's reportedly on a voluntary indefinite paid leave but Goldman has de-registered him with the British authorities, making it impossible for him to work in the U.K., where he now lives. Goldman also chose to release a few of his embarrassing e-mails, but no e-mails of other personnel. So Tourre has seemingly been isolated, while locking himself into a position where he would have a difficult time turning on Goldman. Maybe Tourre, being French, subscribes to romantic notions of one for all and all for one. He needs to listen closely because the rumble in the background could be the approaching bus under which he might be tossed.

Because of Tourre's proximity to the clothes line on which he could be hung out to dry, his recollection may change. Rehabilitating him as a cooperating witness isn't impossible. If he changes his story, and his subsequent story is supported by documents and other evidence, he might still have significant value to the government. Acknowledged liars have been effective cooperating witnesses. The SEC and U.S. Attorney's Office in Manhattan used an admitted liar, Dennis Levine, who operated an insider trading scheme from his vantage point as a New York investment banker, and who lied under oath about it to the SEC, to nail Ivan Boesky, the king of risk arbitrageurs. Boesky, who lied to the government, investors and even in a book, was used by the SEC and the U.S. Attorney's Office to bring down junk bond king Michael Milken and the firm where he worked, Drexel Burnham Lambert Incorporated. So Tourre potentially remains in play, even if he's damaged his value to the government.

A more chilling possibility for Goldman is that the government may have one or more other cooperating witnesses that Goldman doesn't know about. These could be former employees, or current or former employees of customers or counterparties. There are lots of people who know about Goldman's activities, and chances are good that some of them aren't angels. If federal prosecutors learn of bad behavior by a Wall Streeter--like having an account at UBS that wasn't exactly declared to the IRS, naughtiness in the Galleon insider trading case, or buccaneering with Bernie Madoff--they could use highly persuasive means to urge the said Streeter to reveal all he or she might just happen to know about potentially bad behavior by Goldman Sachs (or other firms or folks). This, apparently, is how the feds built their case against Galleon, and it might be how they're trying to build a case against Goldman. As we noted earlier, there is something motivating the federal prosecutors in Manhattan to look at Goldman; they wouldn't just go on a fishing expedition.

Whatever the Feds have, it could be worse than what we've already seen. News services have reported that the federal prosecutors are looking at a wider body of evidence than the materials underlying the SEC's case. That will give them more information to work with, and they might eventually build a stronger case than the SEC's.

Having said all that, a criminal prosecution remains distinctly difficult and it wouldn't be surprising if the U.S. Attorney's Office declines to press charges. Such a decision wouldn't legally weaken the SEC's case--the SEC's case would be as strong as it is now, or stronger if additional evidence emerges from discovery. And if the criminal authorities elect not to proceed, the SEC gets all the glory if it wins.