Since the SEC won a jury verdict against former Goldman Sachs VP Fabrice Tourre last week, the financial press has published semi-snarky commentary about how the SEC has lost more financial crisis cases than it has won. This game of statistics misses an essential point. Wall Streeters, corporate executives and directors, and their attorneys are cautious folk. You might not think so from some of the inexplicably risky things they occasionally do, but on the whole they are more concerned about downside risk than upside potential. (Even good hedge fund traders look first at how much they can lose before they focus on how much they might make.)
A high profile SEC win, like the Tourre case, makes the risk averse pause and reflect all the more so before taking the plunge. It's better to settle and hide behind your PR person who repeatedly declines to comment to press inquiries than to be photographed outside a federal courthouse wearing a nice suit and a gloomy expression. People will remember that expression for a long time. Tourre didn't have to do a perp walk, but there's nobody--absolutely nobody--on Wall Street, Main Street or anywhere else in the corporate world who wants to wear his suit.
When the SEC loses in court, the defendants have a day in the sunshine. But then their cases are largely forgotten. Major SEC victories are remembered. The SEC's cases against notorious insider trader Ivan Boesky and junk bond king Michael Milken still receive public mention, even after 25 or so years. Who remembers the cases the SEC lost in the 1980's?
In the plush conference rooms and offices where corporate lawyers and their clients under SEC investigation discuss the risks of settling versus litigating, you can be sure that the SEC victory in the Tourre case is getting a lot of attention. The SEC's losses are probably mentioned as well. But no good attorney wants to be caught making, or even implying, a promise s/he can't keep, and the story of Fabrice Tourre is likely being presented as a cautionary tale. People with a lot more to lose from an SEC victory than they have to win from an SEC loss may well see the merit of capping their downside risks.
Showing posts with label SEC v. Goldman Sachs. Show all posts
Showing posts with label SEC v. Goldman Sachs. Show all posts
Thursday, August 8, 2013
Thursday, August 1, 2013
SEC 1, Tourre 0, Goldman 0, Financial Press -1
Today's jury verdict finding Fabrice (the "Fabulous Fab") Tourre liable on six of the seven civil counts against him represents a major victory for the SEC. That's not simply because of the prominence of the case, which involved the sale of a controversial motgage-backed derivatives investment and is the highest profile SEC enforcement action to come out of the 2008 financial crisis. It's because the agency's very efficacy has been under attack for the better part of a decade. Widely viewed as ineffectual, the SEC has re-established its presence as a cop on the beat. While one victory doesn't win the war, a victory this big will make a lot of corporate and white collar defendants think harder about settling, even if the price involves admitting to making bad choices.
Fabrice Tourre rolled the dice and lost. Litigation is a gamble, and some bets turn out to be losers. Perhaps he chose to fight instead of settling up front because he was angry about being a lower level guy who was singled out as a named defendant. But anger doesn't equate to victory in court. Above all, what matters is the evidence. Tourre may have been his own worst enemy, seemingly adding insouciance as too much of a fillip to his e-mails. Most likely, his attorneys will soon make motions for this and that, and perhaps later file appeals. But now that the jury has spoken, Tourre faces an uphill battle.
Goldman Sachs wasn't a party to the case. But it reportedly financed Tourre's defense. And perhaps it has reasons beyond loyalty to a former employee. Goldman faces potential liability in private civil lawsuits involving charges similar to those in the SEC case. If Tourre had won, Goldman might have negotiated more favorable settlements in those cases. Now that he's lost, GS has shifted closer to the 8-ball. But that's all just a matter of money, of which GS has a fair pile. GS isn't going to be kicked out of the securities business, as Tourre might be, because GS already settled with the SEC, thereby capping its regulatory liability. Now that he's been held liable by a jury, Tourre not only faces SEC sanctions, but perhaps demands for payment from the plaintiffs' attorneys in those private civil lawsuits as well. Poor Fab. Not so fabulous any more.
The financial press ends up looking silly. Not one publication of any prominence, to this writer's knowledge, predicted the SEC's victory. Many expressed serious doubt about the SEC's case. The coverage during the trial was frequently skeptical of the SEC's evidence and efforts. It might be interesting to know why the press coverage was so imbalanced. Whatever the reason, the press was scooped by the SEC staff, which convinced the jury to announce the real story.
Fabrice Tourre rolled the dice and lost. Litigation is a gamble, and some bets turn out to be losers. Perhaps he chose to fight instead of settling up front because he was angry about being a lower level guy who was singled out as a named defendant. But anger doesn't equate to victory in court. Above all, what matters is the evidence. Tourre may have been his own worst enemy, seemingly adding insouciance as too much of a fillip to his e-mails. Most likely, his attorneys will soon make motions for this and that, and perhaps later file appeals. But now that the jury has spoken, Tourre faces an uphill battle.
Goldman Sachs wasn't a party to the case. But it reportedly financed Tourre's defense. And perhaps it has reasons beyond loyalty to a former employee. Goldman faces potential liability in private civil lawsuits involving charges similar to those in the SEC case. If Tourre had won, Goldman might have negotiated more favorable settlements in those cases. Now that he's lost, GS has shifted closer to the 8-ball. But that's all just a matter of money, of which GS has a fair pile. GS isn't going to be kicked out of the securities business, as Tourre might be, because GS already settled with the SEC, thereby capping its regulatory liability. Now that he's been held liable by a jury, Tourre not only faces SEC sanctions, but perhaps demands for payment from the plaintiffs' attorneys in those private civil lawsuits as well. Poor Fab. Not so fabulous any more.
The financial press ends up looking silly. Not one publication of any prominence, to this writer's knowledge, predicted the SEC's victory. Many expressed serious doubt about the SEC's case. The coverage during the trial was frequently skeptical of the SEC's evidence and efforts. It might be interesting to know why the press coverage was so imbalanced. Whatever the reason, the press was scooped by the SEC staff, which convinced the jury to announce the real story.
Thursday, July 15, 2010
SEC v. Goldman Sachs: Is Contrition a New Trend in SEC Enforcement?
Today's settlement between Goldman Sachs and the SEC contains a novel provision: contrition. In a court filing called the Consent, Goldman acknowledged "that the marketing materials for the ABACUS 2007-AC1 transaction contained incomplete information. In particular, it was a mistake for the Goldman marketing materials to state that the reference portfolio was 'selected by' ACA Management LLC without disclosing the role of Paulson & Co. Inc. in the selection process and that Paulson's economic interests were adverse to CDO investors. Goldman regrets that the marketing materials did not contain that disclosure."
For the last 40 years, the SEC's settlement policy has allowed defendants to resolve enforcement cases without admitting or denying the SEC's allegations. Highly refined thought processes can be required to figure out what it means to neither admit nor deny. It is not an admission of liability. Or even an acceptance of responsibility.
Goldman's settlement--which also includes the usual boilerplate about neither admitting nor denying--takes a small step away from the agnosticism of the old policy. Contrition is not an admission of legal liability or even an acceptance of responsibility. But the settlement papers indicate that Goldman was--and very possibly future defendants will be--expected by the SEC to express regret or something comparable. The public at large might well see this as an improvement over a defendant neither admitting nor denying. After all, even three year olds are taught to say sorry when they make a boo boo. And contrition is likely to make settlements more palatable to presiding judges, who have to sign off on settlement proposals. Balky judges have recently made the settlement process more challenging, and it's in the interests of both the SEC and defendants to persuade judges not to nix deals that have been meticulously negotiated.
Lawyers will have a field day with the ambiguity of Goldman's expression of contrition. It may help customers and shareholders suing Goldman--but to what degree will be the subject of judicial rulings. Goldman might choose to avoid too much judicial clarity, because there remains the risk that a judge could consider the statement of contrition to be probative of Goldman's legal liability. Settling with customers and other private litigants before judges rule allows Goldman to put off to another day the legal significance of contrition. One way or another, look for more Goldman settlements (i.e., the cost to Goldman here is probably not limited to $550 million).
Many readers may wonder what the big deal is with Goldman's statement of regret. It's this: the SEC made the most powerful firm on Wall Street accept a disadvantageous change to 40 years of SEC enforcement policy. We don't know yet how disadvantageous to Goldman the change will be. But the fact that the recently ineffectual SEC Enforcement Division could extract even a smidgen of contrition from a defendant that had the means to litigate until the end of time shows that the SEC has gotten its mojo back.
The larger features of the settlement--a $535 million civil penalty, the largest in SEC history, $15 million in disgorgement, a court injunction, and undertakings by Goldman to improve the way it conducts business--are in the range of what one might have expected. This deal gives both sides bragging rights. Goldman paid less than the $1 billion or so in damages that the SEC alleged was caused to its customers who invested in ABACUS 2007-AC1. The SEC got a record setting penalty and Goldman's commitment to change the way it does business. But, most significantly, the SEC's victory (and that's what this was, even though Goldman's stock is rising in afterhours trading) means that power is shifting from Wall Street to Washington.
For the last 40 years, the SEC's settlement policy has allowed defendants to resolve enforcement cases without admitting or denying the SEC's allegations. Highly refined thought processes can be required to figure out what it means to neither admit nor deny. It is not an admission of liability. Or even an acceptance of responsibility.
Goldman's settlement--which also includes the usual boilerplate about neither admitting nor denying--takes a small step away from the agnosticism of the old policy. Contrition is not an admission of legal liability or even an acceptance of responsibility. But the settlement papers indicate that Goldman was--and very possibly future defendants will be--expected by the SEC to express regret or something comparable. The public at large might well see this as an improvement over a defendant neither admitting nor denying. After all, even three year olds are taught to say sorry when they make a boo boo. And contrition is likely to make settlements more palatable to presiding judges, who have to sign off on settlement proposals. Balky judges have recently made the settlement process more challenging, and it's in the interests of both the SEC and defendants to persuade judges not to nix deals that have been meticulously negotiated.
Lawyers will have a field day with the ambiguity of Goldman's expression of contrition. It may help customers and shareholders suing Goldman--but to what degree will be the subject of judicial rulings. Goldman might choose to avoid too much judicial clarity, because there remains the risk that a judge could consider the statement of contrition to be probative of Goldman's legal liability. Settling with customers and other private litigants before judges rule allows Goldman to put off to another day the legal significance of contrition. One way or another, look for more Goldman settlements (i.e., the cost to Goldman here is probably not limited to $550 million).
Many readers may wonder what the big deal is with Goldman's statement of regret. It's this: the SEC made the most powerful firm on Wall Street accept a disadvantageous change to 40 years of SEC enforcement policy. We don't know yet how disadvantageous to Goldman the change will be. But the fact that the recently ineffectual SEC Enforcement Division could extract even a smidgen of contrition from a defendant that had the means to litigate until the end of time shows that the SEC has gotten its mojo back.
The larger features of the settlement--a $535 million civil penalty, the largest in SEC history, $15 million in disgorgement, a court injunction, and undertakings by Goldman to improve the way it conducts business--are in the range of what one might have expected. This deal gives both sides bragging rights. Goldman paid less than the $1 billion or so in damages that the SEC alleged was caused to its customers who invested in ABACUS 2007-AC1. The SEC got a record setting penalty and Goldman's commitment to change the way it does business. But, most significantly, the SEC's victory (and that's what this was, even though Goldman's stock is rising in afterhours trading) means that power is shifting from Wall Street to Washington.
Sunday, May 16, 2010
A Proposal for Reform: No More Managed Money in the Synthetic Derivatives Market
Synthetic derivatives are having their 15 minutes of fame. It began with the SEC's lawsuit against Goldman Sachs, which featured the world's best known synthetic CDO, ABACUS 2007-AC1. Goldman allegedly structured this deal in a way that favored the short side investor, John Paulson & Co., without telling the long side investors about Paulson's involvment in choosing the collateral. Now, the financial press reports that Morgan Stanley is under SEC investigation for creating synthetic CDOs called "Baldwin" and "ABSpoke" in a way that supposedly favored the short side, and then itself investing in the short side. If the reports about Morgan Stanley are true, its conduct would arguably be worse than Goldman's, which did not include a proprietary bet against its long side customers. Other major Wall Street banks are also reportedly under investigation for structuring similar transactions and then taking the short side.
Enough already. Synthetic CDOs are pure bets, like sports bets. Unlike "real" CDOs, which can be connected to substantive economic activity, synthetic CDOs have no socially redeeming value. Yet, they can cause billions of dollars of losses. One solution would be to ban them outright. However, investors might simply go to offshore markets, where transactions would be even less visible and regulated than they are now.
A better idea would be to protect the money we really care about: managed money. Institutions holding or investing money for others shouldn't be allowed to transact or invest in synthetic CDOs or other synthetic derivatives. That would include broker-dealers, mutual funds, pension funds, banks and credit unions, insurance companies, investment advisers, trust companies and other fiduciaries, financial advisers who manage funds for clients, and anyone else who holds or invests money for others. The prohibition would not only apply to direct transactions and investments in synthetic derivatives, but also indirect transactions and investments through parent corporations, subsidiaries or other affiliates or agents. We wouldn't allow money managers to book or invest in sports bets. Why let them bet or make book in synthetic derivatives, which are analytically indistinguishable from sports bets? One advantage of taking the managed money approach is that the prohibition would extend to offshore markets as well as the U.S. market.
An exception could be made for independent hedge funds and other independent entities that receive no government subsidies, bailouts, or benefits (like deposit insurance) and whose investors are limited to individuals meeting the definition of accredited investors (i.e., those with net worths of $1 million or more, or who make more than $200,000 a year ($300,000 for married couples)) and institutions that aren't themselves prohibited from transacting or investing in synthetic derivatives (remember, no indirect transacting or investing). That would amount to a rather small universe of gamblers, but the point is to protect managed money.
Of course, Wall Street would howl in protest over such a proposal, as the lost profits could seriously impact bonuses. Tant pis, as the French would put it. Whatever Goldman Sachs and other big banks might say about their conduct not being illegal, none of them have made a coherent case why synthetic derivatives are good or socially beneficial. Only the most money-obsessed parents would want their children to grow up to sell synthetic derivatives. Plenty of derivatives contracts have made the trek to Boot Hill (such as the once popular portfolio insurance). The synthetic derivative has had plenty of opportunity to demonstrate its value to society, and has failed abysmally. R.I.P.
Enough already. Synthetic CDOs are pure bets, like sports bets. Unlike "real" CDOs, which can be connected to substantive economic activity, synthetic CDOs have no socially redeeming value. Yet, they can cause billions of dollars of losses. One solution would be to ban them outright. However, investors might simply go to offshore markets, where transactions would be even less visible and regulated than they are now.
A better idea would be to protect the money we really care about: managed money. Institutions holding or investing money for others shouldn't be allowed to transact or invest in synthetic CDOs or other synthetic derivatives. That would include broker-dealers, mutual funds, pension funds, banks and credit unions, insurance companies, investment advisers, trust companies and other fiduciaries, financial advisers who manage funds for clients, and anyone else who holds or invests money for others. The prohibition would not only apply to direct transactions and investments in synthetic derivatives, but also indirect transactions and investments through parent corporations, subsidiaries or other affiliates or agents. We wouldn't allow money managers to book or invest in sports bets. Why let them bet or make book in synthetic derivatives, which are analytically indistinguishable from sports bets? One advantage of taking the managed money approach is that the prohibition would extend to offshore markets as well as the U.S. market.
An exception could be made for independent hedge funds and other independent entities that receive no government subsidies, bailouts, or benefits (like deposit insurance) and whose investors are limited to individuals meeting the definition of accredited investors (i.e., those with net worths of $1 million or more, or who make more than $200,000 a year ($300,000 for married couples)) and institutions that aren't themselves prohibited from transacting or investing in synthetic derivatives (remember, no indirect transacting or investing). That would amount to a rather small universe of gamblers, but the point is to protect managed money.
Of course, Wall Street would howl in protest over such a proposal, as the lost profits could seriously impact bonuses. Tant pis, as the French would put it. Whatever Goldman Sachs and other big banks might say about their conduct not being illegal, none of them have made a coherent case why synthetic derivatives are good or socially beneficial. Only the most money-obsessed parents would want their children to grow up to sell synthetic derivatives. Plenty of derivatives contracts have made the trek to Boot Hill (such as the once popular portfolio insurance). The synthetic derivative has had plenty of opportunity to demonstrate its value to society, and has failed abysmally. R.I.P.
Wednesday, May 12, 2010
Contours of an SEC Settlement with Goldman Sachs
Settlement talks between the SEC and Goldman Sachs are reportedly ongoing. The parties are supposedly far apart; but that wouldn't be surprising for the early go 'rounds. Both sides have strong incentives to settle and they're likely to make progress. It would be interesting to speculate what a settlement might look like. We have no inside information from either side. Experience tells us that the settlement will probably contain certain features.
Undertakings to Change Business Practices. Goldman will undertake to change the ways in which it handles derivatives transactions. It's already begun a review of business practices in this area, and will formalize that review in the SEC settlement. The settlement will outline in general terms the changes that SEC expects, and will probably require Goldman to hire an independent consultant to review the changes it proposes. The consultant will report to the SEC staff, which will have an opportunity to object to proposed changes. These undertakings may take months or over a year to finalize, but this element of the settlement will probably be one of the least controversial because both sides see the need for change.
Court Order Against Future Violations. Goldman will agree to an injunction or other court order that would be equivalent to an injunction, which will prohibit it from future violations of certain specified provisions of law. Injunctions are standard requirements for SEC settlements, and Goldman won't seriously argue against one. It will try to limit the scope of the injunction as much as possible, probably to subsections (2) and (3) of Section 17(a) of the Securities Acts of 1933. These particular subsections are viewed by aficionados of the securities laws as the least harsh among the SEC's antifraud weapons (because one can violate them without acting intentionally). The SEC staff will negotiate for a broader injunction, that would also cover the more well-known rule 10b-5, the most expansive antifraud provision in the SEC's arsenal. Where the parties will come out isn't entirely predictable, but the end result isn't likely to be a show-stopper, one way or the other, for the broader investing public.
Money. Goldman will pay out money, probably in the form of disgorgement (i.e., a return of the compensation and gains it received in connection with its allegedly illegal conduct) and civil monetary penalties.
The disgorgement in this case would be comparatively small. Goldman supposedly was paid by John Paulson & Co. $15 million for structuring the ABACUS 2007-AC1 deal. The SEC would expect that amount to be paid out as disgorgement. Goldman claims it suffered a $90 million loss investing in the deal, but the SEC is unlikely to agree that Goldman can offset this investment loss against its structuring fee, because allowing Goldman to offset an investment loss against unlawfully obtained earnings makes for poor public policy. (Think of it this way: if a bank robber steals $5,000 and then loses it in the stock market, should the bank robber be excused from reimbursing the bank $5,000?) Goldman probably won't argue hard about giving up the $15 million in compensation. After all, this is a firm that makes billions per quarter.
Civil monetary penalties are, in cases involving fraud charges, de rigueur from the SEC's standpoint. Goldman probably won't argue vigorously against paying any penalty, but will try to limit the amount. The penalty is determined by a statutory formula: for each fraud violation by a corporate defendant, the penalty is the greater of $650,000 or the defendant's gross pecuniary gain from the violation. Goldman's gross pecuniary gain would likely be the $15 million it received in fees for structuring the deal. The number of violations would be the subject of intense debate. Goldman would probably contend that it engaged in one violation (failure to disclose in connection with the deal), or else, two violations (failures to disclose to the two injured investors, ACA Capital Holdings and IKB). The SEC staff would likely assert that each act by Goldman that involved a failure to disclose was a separate violation. Under this point of view, each communication by Goldman or one of its employees that involved a failure to disclose would constitute a separate violation giving rise to a $650,000 penalty. The SEC staff would count not only communications with actual investors (ACA Capital Holdings and IKB) but also communications with potential investors, since attempted frauds are treated by the agency (and courts) as violations of law. The number of acts falling within the SEC staff's likely point of view is unclear. About a dozen are specified in the SEC's charging document (the Complaint), but it's probable that the Complaint doesn't itemize all acts that the SEC staff would regard as separate violations.
If the SEC staff can point to 100 violations, the penalty would be $65 million. If there are 200 violations, the penalty would be $130 million. Considering that the investors allegedly lost almost $1 billion, the SEC staff will be looking for as large a number as possible. Money collected in the form of civil penalties can be returned to injured investors, through a vehicle called a "fair fund." Perhaps the best case for the SEC would be a fair fund that would reimburse the investors for all of their losses. But it is unclear that the evidence would support a civil monetary penalty anywhere close to the amount of investor losses in this case.
As we write, the investors haven't actually sued Goldman. They might be having conversations with Goldman about reimbursement, but even that isn't certain. Goldman, from a tactical standpoint, would probably want to settle with the SEC for as little as possible, and then negotiate any demands of the investors down to a separate settlement of cents on the dollar. The SEC staff might consider the approach taken in an enforcement case almost 17 years ago against Prudential Securities, Inc. Prudential was accused of defrauding hundreds of thousands of investors in limited partnerships, and agreed in its settlement with the SEC to establish a court supervised claims resolution process. In this way, numerous investors were able to recover their losses even though the SEC didn't have the means to provide such relief through its standard legal tools. The SEC staff might seek Goldman's agreement to such a claims resolution process.
Money is probably one of the issues on which the SEC and Goldman are far apart. Only time will tell whether and how this gap can be bridged.
Fabrice Tourre. Goldman would certainly want the litigation to end with its settlement, in order to stanch the flow of negative publicity. That would require a disposition of the case as against Fabrice Tourre, the Goldman executive who is also a defendant. Press reports have not indicated that Tourre is participating in the settlement talks. The defendants would be unrealistic if they expect the SEC to simply drop Tourre from the case. The agency's allegations have made him the poster child for bad conduct in the derivatives market and the Commission would surely feel obliged to pursue him if he didn't settle. The SEC probably would want a settlement with Tourre to include, among other things, his being barred from the U.S. securities industry for at least a few years. Such a sanction would imperil Tourre's career in finance (in the U.S. and other countries, since no foreign securities regulator would want Tourre chatting up its country's citizens if he's barred in the U.S.). So Tourre would face substantial personal consequences from a settlement, and might well choose to fight. Goldman has many reputational reasons to extract itself from the case quickly, and may simply choose to live with the continuation of the case against Tourre.
Undertakings to Change Business Practices. Goldman will undertake to change the ways in which it handles derivatives transactions. It's already begun a review of business practices in this area, and will formalize that review in the SEC settlement. The settlement will outline in general terms the changes that SEC expects, and will probably require Goldman to hire an independent consultant to review the changes it proposes. The consultant will report to the SEC staff, which will have an opportunity to object to proposed changes. These undertakings may take months or over a year to finalize, but this element of the settlement will probably be one of the least controversial because both sides see the need for change.
Court Order Against Future Violations. Goldman will agree to an injunction or other court order that would be equivalent to an injunction, which will prohibit it from future violations of certain specified provisions of law. Injunctions are standard requirements for SEC settlements, and Goldman won't seriously argue against one. It will try to limit the scope of the injunction as much as possible, probably to subsections (2) and (3) of Section 17(a) of the Securities Acts of 1933. These particular subsections are viewed by aficionados of the securities laws as the least harsh among the SEC's antifraud weapons (because one can violate them without acting intentionally). The SEC staff will negotiate for a broader injunction, that would also cover the more well-known rule 10b-5, the most expansive antifraud provision in the SEC's arsenal. Where the parties will come out isn't entirely predictable, but the end result isn't likely to be a show-stopper, one way or the other, for the broader investing public.
Money. Goldman will pay out money, probably in the form of disgorgement (i.e., a return of the compensation and gains it received in connection with its allegedly illegal conduct) and civil monetary penalties.
The disgorgement in this case would be comparatively small. Goldman supposedly was paid by John Paulson & Co. $15 million for structuring the ABACUS 2007-AC1 deal. The SEC would expect that amount to be paid out as disgorgement. Goldman claims it suffered a $90 million loss investing in the deal, but the SEC is unlikely to agree that Goldman can offset this investment loss against its structuring fee, because allowing Goldman to offset an investment loss against unlawfully obtained earnings makes for poor public policy. (Think of it this way: if a bank robber steals $5,000 and then loses it in the stock market, should the bank robber be excused from reimbursing the bank $5,000?) Goldman probably won't argue hard about giving up the $15 million in compensation. After all, this is a firm that makes billions per quarter.
Civil monetary penalties are, in cases involving fraud charges, de rigueur from the SEC's standpoint. Goldman probably won't argue vigorously against paying any penalty, but will try to limit the amount. The penalty is determined by a statutory formula: for each fraud violation by a corporate defendant, the penalty is the greater of $650,000 or the defendant's gross pecuniary gain from the violation. Goldman's gross pecuniary gain would likely be the $15 million it received in fees for structuring the deal. The number of violations would be the subject of intense debate. Goldman would probably contend that it engaged in one violation (failure to disclose in connection with the deal), or else, two violations (failures to disclose to the two injured investors, ACA Capital Holdings and IKB). The SEC staff would likely assert that each act by Goldman that involved a failure to disclose was a separate violation. Under this point of view, each communication by Goldman or one of its employees that involved a failure to disclose would constitute a separate violation giving rise to a $650,000 penalty. The SEC staff would count not only communications with actual investors (ACA Capital Holdings and IKB) but also communications with potential investors, since attempted frauds are treated by the agency (and courts) as violations of law. The number of acts falling within the SEC staff's likely point of view is unclear. About a dozen are specified in the SEC's charging document (the Complaint), but it's probable that the Complaint doesn't itemize all acts that the SEC staff would regard as separate violations.
If the SEC staff can point to 100 violations, the penalty would be $65 million. If there are 200 violations, the penalty would be $130 million. Considering that the investors allegedly lost almost $1 billion, the SEC staff will be looking for as large a number as possible. Money collected in the form of civil penalties can be returned to injured investors, through a vehicle called a "fair fund." Perhaps the best case for the SEC would be a fair fund that would reimburse the investors for all of their losses. But it is unclear that the evidence would support a civil monetary penalty anywhere close to the amount of investor losses in this case.
As we write, the investors haven't actually sued Goldman. They might be having conversations with Goldman about reimbursement, but even that isn't certain. Goldman, from a tactical standpoint, would probably want to settle with the SEC for as little as possible, and then negotiate any demands of the investors down to a separate settlement of cents on the dollar. The SEC staff might consider the approach taken in an enforcement case almost 17 years ago against Prudential Securities, Inc. Prudential was accused of defrauding hundreds of thousands of investors in limited partnerships, and agreed in its settlement with the SEC to establish a court supervised claims resolution process. In this way, numerous investors were able to recover their losses even though the SEC didn't have the means to provide such relief through its standard legal tools. The SEC staff might seek Goldman's agreement to such a claims resolution process.
Money is probably one of the issues on which the SEC and Goldman are far apart. Only time will tell whether and how this gap can be bridged.
Fabrice Tourre. Goldman would certainly want the litigation to end with its settlement, in order to stanch the flow of negative publicity. That would require a disposition of the case as against Fabrice Tourre, the Goldman executive who is also a defendant. Press reports have not indicated that Tourre is participating in the settlement talks. The defendants would be unrealistic if they expect the SEC to simply drop Tourre from the case. The agency's allegations have made him the poster child for bad conduct in the derivatives market and the Commission would surely feel obliged to pursue him if he didn't settle. The SEC probably would want a settlement with Tourre to include, among other things, his being barred from the U.S. securities industry for at least a few years. Such a sanction would imperil Tourre's career in finance (in the U.S. and other countries, since no foreign securities regulator would want Tourre chatting up its country's citizens if he's barred in the U.S.). So Tourre would face substantial personal consequences from a settlement, and might well choose to fight. Goldman has many reputational reasons to extract itself from the case quickly, and may simply choose to live with the continuation of the case against Tourre.
Sunday, May 2, 2010
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.
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.
Thursday, April 29, 2010
SEC v. Goldman Sachs: Are the Shareholders Now Speaking Up?
Today brought us news that federal prosecutors in Manhattan are sniffing Goldman over. Those would be pooches no one wants to get close to, because they bite with criminal charges. No investment bank has ever--repeat, ever--survived criminal charges.
It's also reported that Goldman is thinking hard about settling the recently filed SEC case. That would seem a striking change of heart, considering Goldman's jut jawed defiance at Congressional hearings on Tuesday. But there's a logical explanation for the apparent change of course--the shareholders are rumbling.
We mean the outside shareholders. They don't participate in the employee bonus pool, and receive their profits from share appreciation and dividends. They would take a longer term view of the firm--almost like the partners who owned Goldman before it went public in 1999. As with all investment banks, Goldman's reputation is its principal asset. That's been a depreciating asset in recent weeks, and the stock price has dropped a corresponding 15% or so.
Berkshire Hathaway may be Goldman's largest shareholder, having infused $5 billion in the fall of 2008 as a vote of confidence in the U.S. financial system. Berkshire Hathaway got about 7.6% of Goldman's beneficial ownership, according to Goldman's most recent proxy statement. Large mutual funds and money management firms are also major shareholders. Many of these institutional shareholders can't easily ditch GS stock, because they might hold it as part of an index fund or a basket of stocks needed for an investment strategy. Or else they might hold so much GS stock that they can't dump it all quickly without rippling the market big time. So they're stuck with this puppy, and every downward tick in its price probably ticks them off ever more.
Shareholders have been instrumental in fostering settlement in big government cases. In the late 1980s, the SEC and the U.S. Attorney's office in Manhattan squared off with Drexel Burnham Lambert Incorporated, the leading junk bond firm of its day. The SEC sued Drexel (and its junk bond star, Michael Milken) in September 1988, while a criminal investigation by the U.S. Attorney's Office in Manhattan moved forward. The prospect of indictment loomed for Drexel, and its largest shareholders, including a Belgian financial firm called Groupe Bruxelle Lambert, pressured Drexel's management into settling.
Some 23 years ago, Berkshire Hathaway acquired about 12% of Salomon Inc., another investment bank. Four years later, in 1991, a scandal over U.S. Treasury auction bidding blew up at Salomon. Warren Buffett, Berkshire Hathaway's CEO, became Salomon's Chairman, and steered the firm toward settlement with the U.S. government.
Goldman's large shareholders will likely avoid public comment. But surely they're thinking hard about how to save their investments. In just a couple of weeks, Goldman's legal problems have mushroomed to include not only the SEC lawsuit, but shareholder suits, investigations by foreign regulators, potential lawsuits by customers and now the possibility of criminal charges. A quick settlement with the SEC could reduce the incentive for the U.S. Attorney's office to press ahead. It might also staunch the flow of evidentiary revelations that bursts forth in tabloid fashion just about every day now (was the love life of a Goldman employee ever before so interesting?). While institutional shareholders in America generally maintain a lizard-like impassivity when it comes to corporate governance, a legal crisis that threatens a firm's viability is just the circumstance to inspire them to damage control. The recent past teaches that investment banks can't withstand the tsunami of bad publicity that seems to be engulfing Goldman. There's scarcely a chance that Warren Buffett will comment publicly about Goldman's situation. But you can bet dollars to doughnuts that he and other large GS shareholders aren't holding their peace behind the scenes.
It's also reported that Goldman is thinking hard about settling the recently filed SEC case. That would seem a striking change of heart, considering Goldman's jut jawed defiance at Congressional hearings on Tuesday. But there's a logical explanation for the apparent change of course--the shareholders are rumbling.
We mean the outside shareholders. They don't participate in the employee bonus pool, and receive their profits from share appreciation and dividends. They would take a longer term view of the firm--almost like the partners who owned Goldman before it went public in 1999. As with all investment banks, Goldman's reputation is its principal asset. That's been a depreciating asset in recent weeks, and the stock price has dropped a corresponding 15% or so.
Berkshire Hathaway may be Goldman's largest shareholder, having infused $5 billion in the fall of 2008 as a vote of confidence in the U.S. financial system. Berkshire Hathaway got about 7.6% of Goldman's beneficial ownership, according to Goldman's most recent proxy statement. Large mutual funds and money management firms are also major shareholders. Many of these institutional shareholders can't easily ditch GS stock, because they might hold it as part of an index fund or a basket of stocks needed for an investment strategy. Or else they might hold so much GS stock that they can't dump it all quickly without rippling the market big time. So they're stuck with this puppy, and every downward tick in its price probably ticks them off ever more.
Shareholders have been instrumental in fostering settlement in big government cases. In the late 1980s, the SEC and the U.S. Attorney's office in Manhattan squared off with Drexel Burnham Lambert Incorporated, the leading junk bond firm of its day. The SEC sued Drexel (and its junk bond star, Michael Milken) in September 1988, while a criminal investigation by the U.S. Attorney's Office in Manhattan moved forward. The prospect of indictment loomed for Drexel, and its largest shareholders, including a Belgian financial firm called Groupe Bruxelle Lambert, pressured Drexel's management into settling.
Some 23 years ago, Berkshire Hathaway acquired about 12% of Salomon Inc., another investment bank. Four years later, in 1991, a scandal over U.S. Treasury auction bidding blew up at Salomon. Warren Buffett, Berkshire Hathaway's CEO, became Salomon's Chairman, and steered the firm toward settlement with the U.S. government.
Goldman's large shareholders will likely avoid public comment. But surely they're thinking hard about how to save their investments. In just a couple of weeks, Goldman's legal problems have mushroomed to include not only the SEC lawsuit, but shareholder suits, investigations by foreign regulators, potential lawsuits by customers and now the possibility of criminal charges. A quick settlement with the SEC could reduce the incentive for the U.S. Attorney's office to press ahead. It might also staunch the flow of evidentiary revelations that bursts forth in tabloid fashion just about every day now (was the love life of a Goldman employee ever before so interesting?). While institutional shareholders in America generally maintain a lizard-like impassivity when it comes to corporate governance, a legal crisis that threatens a firm's viability is just the circumstance to inspire them to damage control. The recent past teaches that investment banks can't withstand the tsunami of bad publicity that seems to be engulfing Goldman. There's scarcely a chance that Warren Buffett will comment publicly about Goldman's situation. But you can bet dollars to doughnuts that he and other large GS shareholders aren't holding their peace behind the scenes.
Why Goldman's Explanation Doesn't Work
They must have felt better after Tuesday's hearing, the Senators who got to ventilate their Kabuki outrage and the Goldman witnesses their defiant self-rationalizations. But in the end, Goldman lost ground.
In essence, Goldman argues that it served as an intermediary between long and short investors in ABACUS 2007-AC1, the first synthetic CDO ever to achieve tabloid fame, perhaps eclipsing, however momentarily, Kate Gosselin. Goldman claims it made extensive disclosure to sophisticated investors on both the long and short sides, and let these grownups decide for themselves if they wanted to invest. They should have to bear the risks that they voluntarily undertook, contends Goldman, perhaps overlooking the fact that it didn't bear any of the risks it voluntarily undertook in connection with AIG because the U.S. taxpayer (i.e., you) bailed out AIG, and therefore Goldman.
Synthetic CDOs are, on paper, pure bets. They don't actually hold any underlying investments and the payments investors make for them do not finance the building of factories or the development of advancements in computer memory chips. There is no intrinsic difference between a synthetic CDO and a sports bet. Both are wagers and nothing more.
But ABACUS 2007-AC1 wasn't analogous to an ordinary sports bet. It was like betting with someone who got to pick the lineups for the competing teams; in other words, someone who rigged the game. If you didn't know that--and it became indisputable from yesterday's hearing that IKB, one of the long investors in ABACUS 2007-AC1, didn't know about John Paulson & Co.'s role in choosing the collateral--you could get hosed. Which is exactly what happened to the long investors in ABACUS 2007-AC1.
So Goldman's explanation doesn't work. It wasn't just an intermediary between sophisticated investors that made informed bets on a fully disclosed investment. It was a promoter of a rigged bet that didn't disclose to everyone the playing field had been tilted.
Whether Goldman is legally liable remains for the courts to decide. However, it failed at the principal challenge it faced in yesterday's hearing, which was to diffuse the public controversy over the SEC's case. It had no appealing story for why Horatio Alger would want to grow up to be a synthetic CDO salesman. Goldman's witnesses offered only carefully crafted testimony that brought to mind some politician's line about the absence of controlling legal precedent or another politician's quibbling over the meaning of "is." Goldman couldn't bring even a scintilla of contrition to bear, apparently rejecting the notion that a little humility would come across better than polite arrogance. One thing that was loud and clear is that Goldman's management intends to litigate this case until Hell freezes over. But the SEC seems to have ended up with slightly improved litigation prospects, even though it didn't participate in the hearing. So it won't back down any sooner than Goldman. A long struggle in the courts bears greater risk for Goldman than it does the SEC. Goldman needs to be careful with the trade it just got into.
In essence, Goldman argues that it served as an intermediary between long and short investors in ABACUS 2007-AC1, the first synthetic CDO ever to achieve tabloid fame, perhaps eclipsing, however momentarily, Kate Gosselin. Goldman claims it made extensive disclosure to sophisticated investors on both the long and short sides, and let these grownups decide for themselves if they wanted to invest. They should have to bear the risks that they voluntarily undertook, contends Goldman, perhaps overlooking the fact that it didn't bear any of the risks it voluntarily undertook in connection with AIG because the U.S. taxpayer (i.e., you) bailed out AIG, and therefore Goldman.
Synthetic CDOs are, on paper, pure bets. They don't actually hold any underlying investments and the payments investors make for them do not finance the building of factories or the development of advancements in computer memory chips. There is no intrinsic difference between a synthetic CDO and a sports bet. Both are wagers and nothing more.
But ABACUS 2007-AC1 wasn't analogous to an ordinary sports bet. It was like betting with someone who got to pick the lineups for the competing teams; in other words, someone who rigged the game. If you didn't know that--and it became indisputable from yesterday's hearing that IKB, one of the long investors in ABACUS 2007-AC1, didn't know about John Paulson & Co.'s role in choosing the collateral--you could get hosed. Which is exactly what happened to the long investors in ABACUS 2007-AC1.
So Goldman's explanation doesn't work. It wasn't just an intermediary between sophisticated investors that made informed bets on a fully disclosed investment. It was a promoter of a rigged bet that didn't disclose to everyone the playing field had been tilted.
Whether Goldman is legally liable remains for the courts to decide. However, it failed at the principal challenge it faced in yesterday's hearing, which was to diffuse the public controversy over the SEC's case. It had no appealing story for why Horatio Alger would want to grow up to be a synthetic CDO salesman. Goldman's witnesses offered only carefully crafted testimony that brought to mind some politician's line about the absence of controlling legal precedent or another politician's quibbling over the meaning of "is." Goldman couldn't bring even a scintilla of contrition to bear, apparently rejecting the notion that a little humility would come across better than polite arrogance. One thing that was loud and clear is that Goldman's management intends to litigate this case until Hell freezes over. But the SEC seems to have ended up with slightly improved litigation prospects, even though it didn't participate in the hearing. So it won't back down any sooner than Goldman. A long struggle in the courts bears greater risk for Goldman than it does the SEC. Goldman needs to be careful with the trade it just got into.
Sunday, April 25, 2010
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.
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.
Thursday, April 22, 2010
Did Goldman Sachs Really Lose $90 Million from the CDO It Constructed for Paulson?
Goldman Sachs claims it lost $90 million from holding a piece of the synthetic CDO that it constructed for John Paulson & Co., a transaction now famous as the subject of the SEC's recent enforcement action against Goldman. Can we take this claim of a $90 million loss at face value? Goldman has persistently asserted it was well-hedged against AIG risk, and didn't need the billions it garnered when the U.S. Treasury bailed out AIG's creditors for 100 cents on the dollar. One wonders why Goldman, if it were a good corporate citizen dedicated to doing God's work, didn't decline the money it didn't need, especially when so many middle class taxpayers are badly stretched. But on Wall Street, money talks and good deeds walk. It's fine if John F. Kennedy declined his presidential salary because of his family's wealth, but Wall Street isn't in Camelot.
Considering how well Goldman supposedly was hedged against AIG risk, it's hard to imagine it wasn't hedged against the decline in the mortgage markets. After all, e-mails quoted in the SEC's charges make clear that Goldman expected that decline. And Goldman evidently greatly reduced its overall exposure to real estate and mortgages even before and while it put together ABACUS 2007-AC1. From a risk management standpoint, one would expect that when Goldman unexpectedly got saddled with a piece of the ABACUS deal, it would have hedged itself. Certainly, it wouldn't have knowingly carved out a piece of its risk profile and left its interest in ABACUS 2007-AC1 naked long. So did Goldman really lose $90 million? Its accounting and risk management records might make for interesting reading in this regard.
If Goldman was in fact hedged against its ABACUS exposure, or was able to take advantage of general hedging in the mortgage and real estate sector to offset its ABACUS losses, then its claim of a $90 million loss could be false or misleading. Ordinarily, $90 million, more than lunch money to most people, ain't squat sit to Goldman Sachs. But Goldman's vaunted reputation is on the line. Claiming this $90 million loss as an indication of its innocence, if there really isn't such a loss, just might step over the line. The SEC has sanctioned a public company for making a misstatement in connection with its defense of an investigation. See SEC Press Release No. 2004-67 (May 17, 2004)(captioned, "Lucent Settles SEC Enforcement Action Charging the Company with $1.1 Billion Accounting Fraud"). Given how Goldman's stock has gyrated with the back and forth among news stories about the case, a misstatement by Goldman about the strength of its defenses could conceivably step over the line and itself be potential grist for the SEC's enforcement mill.
Back to hedging. A fun question might be to ask what Goldman, as a market maker, did with the RMBSs that related to ABACUS 2007-AC1. Goldman, like other large banks active in the mortgage business, might have made markets in those RMBSs. The SEC complaint alleges (and essentially all news sources agree) that the RMBSs underlying ABACUS 2007-AC1 dropped in value very quickly after the deal was done, hammering the long side of the deal. If Goldman was a market maker in some or all of these RMBSs and dropped its quotes muy pronto, one would have to wonder why it was so unafraid of imposing losses on its own holdings in the ABACUS deal. The answer could well be that it was well-hedged on ABACUS and dropped its bids because it didn't want to buy doggy RMBSs from someone else trying to hit its bids.
Although the derivatives markets were, and still are, murky on the best of days, records of Goldman's quotes may exist in documentation maintained by institutional investors who were seeking market valuations for accounting purposes. Big compilers of market data like Bloomberg and Reuters may also have relevant information. Of course, Goldman should have records of its own quotes. But independent verification would be de rigueur, now that the parties are dancing in federal court. The discovery process (i.e., the process in litigation of collecting and exchanging evidence) in SEC v. Goldman is likely to begin presently. Perhaps the SEC's litigation team will find some interesting stuff.
Considering how well Goldman supposedly was hedged against AIG risk, it's hard to imagine it wasn't hedged against the decline in the mortgage markets. After all, e-mails quoted in the SEC's charges make clear that Goldman expected that decline. And Goldman evidently greatly reduced its overall exposure to real estate and mortgages even before and while it put together ABACUS 2007-AC1. From a risk management standpoint, one would expect that when Goldman unexpectedly got saddled with a piece of the ABACUS deal, it would have hedged itself. Certainly, it wouldn't have knowingly carved out a piece of its risk profile and left its interest in ABACUS 2007-AC1 naked long. So did Goldman really lose $90 million? Its accounting and risk management records might make for interesting reading in this regard.
If Goldman was in fact hedged against its ABACUS exposure, or was able to take advantage of general hedging in the mortgage and real estate sector to offset its ABACUS losses, then its claim of a $90 million loss could be false or misleading. Ordinarily, $90 million, more than lunch money to most people, ain't squat sit to Goldman Sachs. But Goldman's vaunted reputation is on the line. Claiming this $90 million loss as an indication of its innocence, if there really isn't such a loss, just might step over the line. The SEC has sanctioned a public company for making a misstatement in connection with its defense of an investigation. See SEC Press Release No. 2004-67 (May 17, 2004)(captioned, "Lucent Settles SEC Enforcement Action Charging the Company with $1.1 Billion Accounting Fraud"). Given how Goldman's stock has gyrated with the back and forth among news stories about the case, a misstatement by Goldman about the strength of its defenses could conceivably step over the line and itself be potential grist for the SEC's enforcement mill.
Back to hedging. A fun question might be to ask what Goldman, as a market maker, did with the RMBSs that related to ABACUS 2007-AC1. Goldman, like other large banks active in the mortgage business, might have made markets in those RMBSs. The SEC complaint alleges (and essentially all news sources agree) that the RMBSs underlying ABACUS 2007-AC1 dropped in value very quickly after the deal was done, hammering the long side of the deal. If Goldman was a market maker in some or all of these RMBSs and dropped its quotes muy pronto, one would have to wonder why it was so unafraid of imposing losses on its own holdings in the ABACUS deal. The answer could well be that it was well-hedged on ABACUS and dropped its bids because it didn't want to buy doggy RMBSs from someone else trying to hit its bids.
Although the derivatives markets were, and still are, murky on the best of days, records of Goldman's quotes may exist in documentation maintained by institutional investors who were seeking market valuations for accounting purposes. Big compilers of market data like Bloomberg and Reuters may also have relevant information. Of course, Goldman should have records of its own quotes. But independent verification would be de rigueur, now that the parties are dancing in federal court. The discovery process (i.e., the process in litigation of collecting and exchanging evidence) in SEC v. Goldman is likely to begin presently. Perhaps the SEC's litigation team will find some interesting stuff.
Tuesday, April 20, 2010
SEC v. Goldman Sachs: What the Case Is Really About
The SEC's fraud case against Goldman Sachs, and Goldman's defense, reflect competing views of the way federal regulation of the financial markets should work. While we have no inside information about how either party plans to argue its side of the case, the information that's already public indicates the lay of the land. Goldman contends that it gave "extensive" disclosure to "sophisticated" investors and they should thereafter be held responsible for themselves. The SEC's argument is Goldman's defense doesn't address the way investments are sold in the real world and that, in reality, Goldman misled investors.
A central theme of the securities laws is disclosure--public companies, broker-dealers, mutual funds and a variety of other players are required to make disclosures prescribed by SEC rules. These disclosures can sometimes be extensive, and Goldman claims to have made extensive disclosures to its customers. The interests in the synthetic CDO in question (ABACUS 2007-AC1) were privately sold and it's unclear what disclosures were actually made. But Goldman claims that the investors pretty much knew what mortgage-backed securities the CDO would be based on and that an independent agent, ACA, selected those MBSs. It contends that the investors were sophisticated and able to decide for themselves how risky these investments were.
The SEC's case is that, however much Goldman may have spoken in its disclosures, it didn't speak the complete truth. Part of the SEC's version of the truth would be that John Paulson & Co. had a large role in the selection of the collateral, that Goldman slyly cultivated a contrary impression in the minds of investors, and that investors knowing the reality of Paulson's involvement would have been reluctant to buy the long side of the transaction.
The SEC's case appears to hark back to the 1930s, 40s, 50s and 60s, a foundational period of time in which the broad contours of the securities laws were shaped. This was a time when knowledge of investments and the financial markets was much more tightly held than is the case today. There was no Internet, no electronic trading systems and no electronic reporting of securities transactions (except the legendary but not terribly informative ticker tape, which was simply a very long telegram). Many stocks and bonds were traded by telephone, or in face-to-face transactions at bank counters (hence the term, "over-the-counter"). Investors relied heavily on financial professionals to deal fairly and squarely with them, because they had few, if any, other sources of information. When you think it about, it's similar to today's derivatives market.
It is axiomatic that the more opaque a market is, the easier it is to sell snake oil. The snake oil business was vibrant in the financial markets of the 1930s, with investors snake bit early and often. The SEC developed a doctrine of law called the "shingle theory." This theory postulates that when a broker-dealer hangs out its shingle to do business, it impliedly represents that it will deal fairly with its customers. An early decision affirming this theory is Charles Hughes & Co. v. SEC, 139 F.2d 434 (2d Cir. 1943), in which a broker-dealer was deemed to have violated the law by overcharging customers (by as much as 40% over market prices). The shingle theory has primarily focused on the pricing of securities, and limits the so-called "markup" a broker-dealer may charge a client. A more recent decision in this vein is SEC v. First Jersey Securities, Inc., 101 F.3d 1450 (2d Cir. 1996). In other words, the shingle theory isn't just a disclosure theory; it has substantive effect, limiting the pricing latitude of broker-dealers in the over-the-counter market. Although the SEC's case against Goldman isn't about prices, the shingle theory's premise--that a broker-dealer has a duty of fair dealing--provides support for the SEC's position that in an opaque market like the CDO market, Goldman isn't a mere intermediary, but has an obligation of fair dealing.
Another foundational case is United States v. Simon, 425 F.2d 796 (2d Cir. 1969). The president of a company called Continental Vending Machine Corporation borrowed a lot of the company's money in order to play the go-go stock market of the 1960s. He did not reveal to shareholders his use of the company's funds as a personal piggy bank, instead routing the funds through a corporation he controlled so that Continental's records did not show he was the true recipient of the money. The stock market of the 60s was every bit as volatile as today's stock markets, and the president's personal investments belly flopped. He had no other means to repay the loans and Continental was left insolvent. The way the president siphoned off the money allowed the company, under the accounting rules prevailing at the time, to present its financial condition as solid. Defendant Simon, an accountant who audited Continental's financial statements, knew of the president's hidden loans but didn't reveal them when he certified Continental's financial statements. Even though the company's financials complied with the applicable accounting rules, the court nevertheless held Simon criminally liable for his silence. It observed that " . . . it simply cannot be true that an accountant is under no duty to disclose what he knows when he has reason to believe that, to a material extent, a corporation is being operated not to carry out its business in the interest of all the stockholders but for the private benefit of its president." It described Simon's certification of Continental's financials as a "snare and a delusion." Thus, Simon, the auditor, was held to be a crook because he didn't disclose how the president had secretly ruined the company, even though the company had followed the accounting rules. In plain English, complying with the stated rules isn't enough when there's a larger truth that remains undisclosed.
Of course, there are differences between the roles of auditors and broker-dealers. But both serve as gatekeepers to the securities markets. Without auditors willing to certify their financial statements, companies could not go public. Without a broker-dealer willing to put together ABACUS 2007-AC1, John Paulson wouldn't have had an opportunity to take the short side of its collateral pool. He paid Goldman $15 million to put the deal together and played a large de facto role in choosing the collateral. Goldman evidently thought that the selection of the collateral had to appear objective to investors--the SEC complaint alleges that Goldman was very particular that ACA was necessary as the collateral manager to make the deal appear on the up and up. ACA wanted to know what Paulson's role was, and, according to the SEC, Goldman slyly implied that Paulson would take an equity position on the long side of the deal instead of revealing that Paulson was looking for a shorting opportunity. In essence, the SEC alleges that Goldman tricked ACA into acting as the collateral agent.
U.S. v. Simon indicates that even if Goldman made extensive disclosures to the investors, the fact that it did not reveal the larger picture of Paulson's role might have been improper. The SEC's allegations that Goldman made affirmative statements that misled ACA or investors would, if true, only compound Goldman's litigation risks, since they imply Goldman intentionally painted a false picture.
As to intentions, the SEC has an advantage. It charged Goldman and Fabrice Tourre with violations of Section 17(a) of the Securities Act of 1933, as well as violations of the SEC's all-purpose, utility infielder antifraud rule, 10b-5. To prove a violation of Rule 10b-5, the SEC must establish that Goldman and Tourre acted with scienter, a legal term for bad intent. The need to prove bad intent can sometimes be a challenge, depending on the facts of the case (although there seem to be colorful e-mails in the SEC's possession that will give it a shot at proving scienter in this case). Section 17(a) violations, however, can sometimes be established without the SEC having to prove any bad intent. See Aaron v. SEC, 446 U.S. 680 (1980). Even if the SEC cannot prove that Goldman and Tourre had bad intent, they may still found liable for securities fraud.
There is a thread in the SEC's Complaint indicating that Goldman itself believed that the mortgage market was, at the time it marketed ABACUS 2007-AC1, likely to tank. The facts here don't seem as extreme as those in the SEC's 2003 case against various underwriters for selling stocks that the brokers themselves thought were lousy investments. See the SEC's press release on April 28, 2003 (http://www.sec.gov/news/press/2003-54.htm). Goldman apparently didn't formally recommended ABACUS 2007-AC1. But if it is true that Goldman was negative on the mortgage market while selling the deal to long side investors, that would only add to the aura of cynical sleaze.
The case appears to be the SEC's effort to deal with the reality of the derivatives markets. These markets, circa 2007 when ABACUS 2007-AC1 was constructed and marketed, were understood in depth by only a small circle of cognoscenti, and perhaps not even all of them. The SEC alleges that Tourre in one e-mail referred [in translation] to " . . . standing in the middle of all these complex, highly leveraged, exotic trades he [i.e., Tourre] created without necessarily understanding all of the implications of those monstruosities [sic]!!!" (As an aside, Tourre could have legal liability if he marketed investments he didn't understand because brokers are supposed to understand the products they peddle to clients.) Most investors in this market likely relied, to varying degrees, on the perceived interests and reputations for integrity of the parties in the picture. However skillful and knowledgeable money managers and corporate treasurers may be, the fact is that detailed information about the esoterica of the derivatives market would not have necessarily been available to them, if only because they might not have even known what questions to ask. Thus, they would have been interested in the identities and roles of relevant players.
Remember, Bear Stearns and Lehman were sophisticated but they failed. Merrill Lynch and WaMu were sophisticated but they had to be sold in distressed circumstances. AIG was sophisticated, but it blew itself up. Even Fannie Mae and Freddie Mac were pretty sophisticated, but they are now wards of the state. Sophistication is no substitute for specific information. Lots of very intelligent people buy a stock because Warren Buffett bought the stock. Few would short it. And those decisions would be made without a whole lot of reference to the stock's "objective" merits. If you were a derivatives investor and learned that John Paulson was a de facto short side co-venturer with Goldman in ABACUS 2007-AC1, you might well have accidentally dropped the phone if Fab Tourre tried to pitch you the long side of the deal. Certainly, there are some people who wish they had.
A central theme of the securities laws is disclosure--public companies, broker-dealers, mutual funds and a variety of other players are required to make disclosures prescribed by SEC rules. These disclosures can sometimes be extensive, and Goldman claims to have made extensive disclosures to its customers. The interests in the synthetic CDO in question (ABACUS 2007-AC1) were privately sold and it's unclear what disclosures were actually made. But Goldman claims that the investors pretty much knew what mortgage-backed securities the CDO would be based on and that an independent agent, ACA, selected those MBSs. It contends that the investors were sophisticated and able to decide for themselves how risky these investments were.
The SEC's case is that, however much Goldman may have spoken in its disclosures, it didn't speak the complete truth. Part of the SEC's version of the truth would be that John Paulson & Co. had a large role in the selection of the collateral, that Goldman slyly cultivated a contrary impression in the minds of investors, and that investors knowing the reality of Paulson's involvement would have been reluctant to buy the long side of the transaction.
The SEC's case appears to hark back to the 1930s, 40s, 50s and 60s, a foundational period of time in which the broad contours of the securities laws were shaped. This was a time when knowledge of investments and the financial markets was much more tightly held than is the case today. There was no Internet, no electronic trading systems and no electronic reporting of securities transactions (except the legendary but not terribly informative ticker tape, which was simply a very long telegram). Many stocks and bonds were traded by telephone, or in face-to-face transactions at bank counters (hence the term, "over-the-counter"). Investors relied heavily on financial professionals to deal fairly and squarely with them, because they had few, if any, other sources of information. When you think it about, it's similar to today's derivatives market.
It is axiomatic that the more opaque a market is, the easier it is to sell snake oil. The snake oil business was vibrant in the financial markets of the 1930s, with investors snake bit early and often. The SEC developed a doctrine of law called the "shingle theory." This theory postulates that when a broker-dealer hangs out its shingle to do business, it impliedly represents that it will deal fairly with its customers. An early decision affirming this theory is Charles Hughes & Co. v. SEC, 139 F.2d 434 (2d Cir. 1943), in which a broker-dealer was deemed to have violated the law by overcharging customers (by as much as 40% over market prices). The shingle theory has primarily focused on the pricing of securities, and limits the so-called "markup" a broker-dealer may charge a client. A more recent decision in this vein is SEC v. First Jersey Securities, Inc., 101 F.3d 1450 (2d Cir. 1996). In other words, the shingle theory isn't just a disclosure theory; it has substantive effect, limiting the pricing latitude of broker-dealers in the over-the-counter market. Although the SEC's case against Goldman isn't about prices, the shingle theory's premise--that a broker-dealer has a duty of fair dealing--provides support for the SEC's position that in an opaque market like the CDO market, Goldman isn't a mere intermediary, but has an obligation of fair dealing.
Another foundational case is United States v. Simon, 425 F.2d 796 (2d Cir. 1969). The president of a company called Continental Vending Machine Corporation borrowed a lot of the company's money in order to play the go-go stock market of the 1960s. He did not reveal to shareholders his use of the company's funds as a personal piggy bank, instead routing the funds through a corporation he controlled so that Continental's records did not show he was the true recipient of the money. The stock market of the 60s was every bit as volatile as today's stock markets, and the president's personal investments belly flopped. He had no other means to repay the loans and Continental was left insolvent. The way the president siphoned off the money allowed the company, under the accounting rules prevailing at the time, to present its financial condition as solid. Defendant Simon, an accountant who audited Continental's financial statements, knew of the president's hidden loans but didn't reveal them when he certified Continental's financial statements. Even though the company's financials complied with the applicable accounting rules, the court nevertheless held Simon criminally liable for his silence. It observed that " . . . it simply cannot be true that an accountant is under no duty to disclose what he knows when he has reason to believe that, to a material extent, a corporation is being operated not to carry out its business in the interest of all the stockholders but for the private benefit of its president." It described Simon's certification of Continental's financials as a "snare and a delusion." Thus, Simon, the auditor, was held to be a crook because he didn't disclose how the president had secretly ruined the company, even though the company had followed the accounting rules. In plain English, complying with the stated rules isn't enough when there's a larger truth that remains undisclosed.
Of course, there are differences between the roles of auditors and broker-dealers. But both serve as gatekeepers to the securities markets. Without auditors willing to certify their financial statements, companies could not go public. Without a broker-dealer willing to put together ABACUS 2007-AC1, John Paulson wouldn't have had an opportunity to take the short side of its collateral pool. He paid Goldman $15 million to put the deal together and played a large de facto role in choosing the collateral. Goldman evidently thought that the selection of the collateral had to appear objective to investors--the SEC complaint alleges that Goldman was very particular that ACA was necessary as the collateral manager to make the deal appear on the up and up. ACA wanted to know what Paulson's role was, and, according to the SEC, Goldman slyly implied that Paulson would take an equity position on the long side of the deal instead of revealing that Paulson was looking for a shorting opportunity. In essence, the SEC alleges that Goldman tricked ACA into acting as the collateral agent.
U.S. v. Simon indicates that even if Goldman made extensive disclosures to the investors, the fact that it did not reveal the larger picture of Paulson's role might have been improper. The SEC's allegations that Goldman made affirmative statements that misled ACA or investors would, if true, only compound Goldman's litigation risks, since they imply Goldman intentionally painted a false picture.
As to intentions, the SEC has an advantage. It charged Goldman and Fabrice Tourre with violations of Section 17(a) of the Securities Act of 1933, as well as violations of the SEC's all-purpose, utility infielder antifraud rule, 10b-5. To prove a violation of Rule 10b-5, the SEC must establish that Goldman and Tourre acted with scienter, a legal term for bad intent. The need to prove bad intent can sometimes be a challenge, depending on the facts of the case (although there seem to be colorful e-mails in the SEC's possession that will give it a shot at proving scienter in this case). Section 17(a) violations, however, can sometimes be established without the SEC having to prove any bad intent. See Aaron v. SEC, 446 U.S. 680 (1980). Even if the SEC cannot prove that Goldman and Tourre had bad intent, they may still found liable for securities fraud.
There is a thread in the SEC's Complaint indicating that Goldman itself believed that the mortgage market was, at the time it marketed ABACUS 2007-AC1, likely to tank. The facts here don't seem as extreme as those in the SEC's 2003 case against various underwriters for selling stocks that the brokers themselves thought were lousy investments. See the SEC's press release on April 28, 2003 (http://www.sec.gov/news/press/2003-54.htm). Goldman apparently didn't formally recommended ABACUS 2007-AC1. But if it is true that Goldman was negative on the mortgage market while selling the deal to long side investors, that would only add to the aura of cynical sleaze.
The case appears to be the SEC's effort to deal with the reality of the derivatives markets. These markets, circa 2007 when ABACUS 2007-AC1 was constructed and marketed, were understood in depth by only a small circle of cognoscenti, and perhaps not even all of them. The SEC alleges that Tourre in one e-mail referred [in translation] to " . . . standing in the middle of all these complex, highly leveraged, exotic trades he [i.e., Tourre] created without necessarily understanding all of the implications of those monstruosities [sic]!!!" (As an aside, Tourre could have legal liability if he marketed investments he didn't understand because brokers are supposed to understand the products they peddle to clients.) Most investors in this market likely relied, to varying degrees, on the perceived interests and reputations for integrity of the parties in the picture. However skillful and knowledgeable money managers and corporate treasurers may be, the fact is that detailed information about the esoterica of the derivatives market would not have necessarily been available to them, if only because they might not have even known what questions to ask. Thus, they would have been interested in the identities and roles of relevant players.
Remember, Bear Stearns and Lehman were sophisticated but they failed. Merrill Lynch and WaMu were sophisticated but they had to be sold in distressed circumstances. AIG was sophisticated, but it blew itself up. Even Fannie Mae and Freddie Mac were pretty sophisticated, but they are now wards of the state. Sophistication is no substitute for specific information. Lots of very intelligent people buy a stock because Warren Buffett bought the stock. Few would short it. And those decisions would be made without a whole lot of reference to the stock's "objective" merits. If you were a derivatives investor and learned that John Paulson was a de facto short side co-venturer with Goldman in ABACUS 2007-AC1, you might well have accidentally dropped the phone if Fab Tourre tried to pitch you the long side of the deal. Certainly, there are some people who wish they had.
Sunday, April 18, 2010
SEC v. Goldman Sachs: Betting the Ranch
The New York Times reports that the SEC didn't give Goldman Sachs a chance to discuss settlement before filing its fraud case on Friday (4/16/10). http://www.nytimes.com/2010/04/19/business/19sec.html?src=busln. The SEC had notified Goldman last year that it might face charges, the Times reports, but Goldman didn't find out about Friday's lawsuit until after it was filed.
The SEC's normal procedure is to discuss settling before filing an enforcement action. Those discussions usually lead to settlement. Why would this time have been different? We don't have any inside information from either side. But here's our guess.
It's likely there were settlement talks of an informal nature before the case was filed. The notice last year that the SEC might bring charges was probably a so-called Wells notice, which gives persons that the SEC staff is thinking ought to be subjects of an enforcement action an opportunity to present their views before the Commissioners make a final decision. It almost always happens that the SEC staff and the potential defendants informally discuss the possibility of settlement at the Wells stage. There could have been an exchange of views between the SEC staff and Goldman in which Goldman indicated it would settle for a nonfraud charge if no individual Goldman employees were sued and if it didn't have to pay a painfully large amount of money. The SEC staff, however, may have made it clear that it would not recommend to the Commissioners any settlement that didn't include fraud charges, while reserving the right to pursue individuals (as the Commission in fact did on Friday). The Commissioners would have been informed, one way or another, of any settlement positions offered by Goldman. But if they agreed that the evidence required a fraud charge, they may well have authorized the staff to file the case promptly instead of engaging in fruitless attempts to persuade Goldman to accept fraud charges that Goldman had already rejected.
One indication that Goldman wasn't caught terribly off guard is the fact that, within hours after the lawsuit was filed, it began issuing public denials of certain factual assertions made by the SEC. Making those public denials is risky from a litigation standpoint, because those statements could be used as evidence against Goldman in the future. Many defense lawyers would recommend against such detailed denials except perhaps in court pleadings. That Goldman could pump out these factual assertions so quickly after supposedly being surprised by a lawsuit indicates that it probably was prepared for a battle, even if it didn't know the exact time of the opening bombardment.
The SEC did gain an advantage by filing without formal settlement talks. It was able to write the charging document (called the complaint) the way it thought was appropriate. Complaints filed in settled cases are meticulously negotiated by defense lawyers who try to make the charges appear as milquetoasty apologies by the SEC for having the temerity to disturb the tranquility of the defendants. This time, the complaint unequivocally charged the defendants with fraud.
The SEC's assertiveness tilts the playing field against Goldman in a number of ways. The principal victims in this case were European banks. European governments are making noise about investigating Goldman and recovering from it the losses their banks sustained. Investors on the losing end of other Goldman derivatives transactions are no doubt reviewing their files and reliving their losses in an effort to ascertain if they, too, can recover. Class action lawsuits by Goldman shareholders may be filed, as its stock has taken a beating. The SEC is probably investigating other deals that may be connected to Goldman, and further enforcement actions would be in the works. State regulators whose municipalities took losses in Goldman deals may become emboldened. In this vein, the case against Goldman may be the first since the Before Spitzer era that the SEC has upstaged the Attorney General of New York. It's not beyond the realm of possibility that the NY AG's office will be looking to run with the new big dog in the neighborhood.
On the regulatory reform front, this case strengthens arguments for major change in the derivatives markets. Even if Goldman and other Wall Street banks continue their furious lobbying offensive in Washington, they have probably lost some traction in Washington, and also in Europe, where the impetus for change was already great. It's one thing to argue that honest businesses shouldn't be burdened by costly and unnecessary rules. It's another to be an accused fraudster saying more regulation would be bad. The dynamics of regulatory reform are shifting.
Worst of all for Goldman, the U.S. Department of Justice may come under pressure to act. A criminal charge would be the worst possible development for Goldman. Financial firms never--repeat, never--survive federal criminal charges. Think of E.F. Hutton and Drexel Burnham Lambert. Younger readers may not recognize those firms because they were major investment banks that were criminally charged years ago and didn't survive. A civil fraud charge, such as the SEC filed, can fairly readily be crafted into criminal charges if the evidence is strong enough.
It's doubtful that DOJ has enough for criminal charges at the moment (or else it would have acted, too). But the individual defendant, Fabrice Tourre, will surely come under pressure to settle and become a cooperating witness for the government. The fact that he now lives in the UK and a British bank (Royal Bank of Scotland) wound up holding close to a billion dollars of the losses in this case, may prompt the British government to start clearing its throat in Mr. Tourre's direction. If Tourre does settle and cooperate, he perhaps could provide the government with details it doesn't yet have and point the finger up the chain of command. Tourre need not testify in the SEC's case because of his Fifth Amendment right against self-incrimination. But in a civil lawsuit such as the SEC's, a defendant's assertion of the Fifth can be used as evidence against him (yes, seriously, the courts have said so; the privilege against self-incrimination protects a defendant only in criminal prosecutions). So Tourre may hurt himself in the SEC case if he takes Five. But if he talks, he will have to answer tough questions about some e-mails and other documents that don't exactly cover him with glory. He might be damned if he does and damned if he doesn't. Defendants in that situation sometimes cut deals with the government.
This is a must-win case for the SEC. After years of horrendously bad publicity for a proud agency with a renowned heritage, the Commission marks a turning point by filing this case--but only if it wins or gets a good settlement. As much as it ever has, the SEC is betting the ranch. But it's done that before and prevailed. The SEC case against Michael Milken and Drexel Burnham Lambert in the 1980s was comparable. Drexel was perhaps the most powerful investment bank of the day and Milken was unequivocally its most powerful employee. Milken and Drexel fought tooth and nail, employing an army of defense lawyers that may have outnumbered the government's team by a ratio of 10 to 1. Most of the government lawyers were in their late 20s or early 30s. But they cared--tremendously--and the government (SEC and DOJ) carried the day, primarily by building a strong body of evidence. Both Drexel and Milken eventually settled, agreeing to criminal and civil charges. Don't sell the SEC short just because 18 months ago it was in the ICU. The staff working on this case are not the SEC's Madoff team, and Goldman's management and lawyers could be in for a surprise if they're banking on the presumed incompetence of their adversaries.
Goldman, too, is betting the ranch. We presume that at some point in its dialogue with the SEC staff it rejected the possibility of settling to fraud charges. Now, that position, assuming it is Goldman's position, is being put to the test. The only thing worse than agreeing to a fraud charge is being found liable for fraud after a trial. Goldman's only good outcome would be to go to trial and win. Perhaps it will. But will its management want to risk going to trial? If Goldman loses, the floodgates will opened for plaintiffs lawyers, state regulators and attorneys general, European regulators, and perhaps other claimants. And even if Goldman litigates this case for years, what about Goldman's other derivatives deals that went sour? They'll all now be assiduously scrutinized by armies of potential claimants. Fighting the SEC could be tantamount to manning the Maginot Line, while swarms of other claimants outflank Goldman from the left and the right.
Corporations generally don't like to litigate with federal regulators because the risks of losing usually outweigh the gains from winning. And the SEC, as painful as a loss could be in this case, has less to lose than Goldman. Goldman's top executives were once traders, where everything they did involved a deal. In a deal, you give up something to get something else. No doubt they will think about a deal. The terms for settlement are likely to be unpalatable at best. But what will Goldman's alternative be? Years of litigation and the accompanying uncertainty while competitors try to woo away its clients? Losses totaling many millions, and perhaps even billions in the end? A downside of doing leveraged deals is that if they become legal problems, the leverage works against you.
One thing to watch for is Goldman's earnings announcement on Tuesday, April 20, 2010. What will it say about the SEC case? What impact will the SEC case have on Goldman's litigation reserves? It's possible Goldman will delay its earnings announcement while it sorts out the fallout from the lawsuit. But these questions will remain whenever Goldman speaks.
The SEC's normal procedure is to discuss settling before filing an enforcement action. Those discussions usually lead to settlement. Why would this time have been different? We don't have any inside information from either side. But here's our guess.
It's likely there were settlement talks of an informal nature before the case was filed. The notice last year that the SEC might bring charges was probably a so-called Wells notice, which gives persons that the SEC staff is thinking ought to be subjects of an enforcement action an opportunity to present their views before the Commissioners make a final decision. It almost always happens that the SEC staff and the potential defendants informally discuss the possibility of settlement at the Wells stage. There could have been an exchange of views between the SEC staff and Goldman in which Goldman indicated it would settle for a nonfraud charge if no individual Goldman employees were sued and if it didn't have to pay a painfully large amount of money. The SEC staff, however, may have made it clear that it would not recommend to the Commissioners any settlement that didn't include fraud charges, while reserving the right to pursue individuals (as the Commission in fact did on Friday). The Commissioners would have been informed, one way or another, of any settlement positions offered by Goldman. But if they agreed that the evidence required a fraud charge, they may well have authorized the staff to file the case promptly instead of engaging in fruitless attempts to persuade Goldman to accept fraud charges that Goldman had already rejected.
One indication that Goldman wasn't caught terribly off guard is the fact that, within hours after the lawsuit was filed, it began issuing public denials of certain factual assertions made by the SEC. Making those public denials is risky from a litigation standpoint, because those statements could be used as evidence against Goldman in the future. Many defense lawyers would recommend against such detailed denials except perhaps in court pleadings. That Goldman could pump out these factual assertions so quickly after supposedly being surprised by a lawsuit indicates that it probably was prepared for a battle, even if it didn't know the exact time of the opening bombardment.
The SEC did gain an advantage by filing without formal settlement talks. It was able to write the charging document (called the complaint) the way it thought was appropriate. Complaints filed in settled cases are meticulously negotiated by defense lawyers who try to make the charges appear as milquetoasty apologies by the SEC for having the temerity to disturb the tranquility of the defendants. This time, the complaint unequivocally charged the defendants with fraud.
The SEC's assertiveness tilts the playing field against Goldman in a number of ways. The principal victims in this case were European banks. European governments are making noise about investigating Goldman and recovering from it the losses their banks sustained. Investors on the losing end of other Goldman derivatives transactions are no doubt reviewing their files and reliving their losses in an effort to ascertain if they, too, can recover. Class action lawsuits by Goldman shareholders may be filed, as its stock has taken a beating. The SEC is probably investigating other deals that may be connected to Goldman, and further enforcement actions would be in the works. State regulators whose municipalities took losses in Goldman deals may become emboldened. In this vein, the case against Goldman may be the first since the Before Spitzer era that the SEC has upstaged the Attorney General of New York. It's not beyond the realm of possibility that the NY AG's office will be looking to run with the new big dog in the neighborhood.
On the regulatory reform front, this case strengthens arguments for major change in the derivatives markets. Even if Goldman and other Wall Street banks continue their furious lobbying offensive in Washington, they have probably lost some traction in Washington, and also in Europe, where the impetus for change was already great. It's one thing to argue that honest businesses shouldn't be burdened by costly and unnecessary rules. It's another to be an accused fraudster saying more regulation would be bad. The dynamics of regulatory reform are shifting.
Worst of all for Goldman, the U.S. Department of Justice may come under pressure to act. A criminal charge would be the worst possible development for Goldman. Financial firms never--repeat, never--survive federal criminal charges. Think of E.F. Hutton and Drexel Burnham Lambert. Younger readers may not recognize those firms because they were major investment banks that were criminally charged years ago and didn't survive. A civil fraud charge, such as the SEC filed, can fairly readily be crafted into criminal charges if the evidence is strong enough.
It's doubtful that DOJ has enough for criminal charges at the moment (or else it would have acted, too). But the individual defendant, Fabrice Tourre, will surely come under pressure to settle and become a cooperating witness for the government. The fact that he now lives in the UK and a British bank (Royal Bank of Scotland) wound up holding close to a billion dollars of the losses in this case, may prompt the British government to start clearing its throat in Mr. Tourre's direction. If Tourre does settle and cooperate, he perhaps could provide the government with details it doesn't yet have and point the finger up the chain of command. Tourre need not testify in the SEC's case because of his Fifth Amendment right against self-incrimination. But in a civil lawsuit such as the SEC's, a defendant's assertion of the Fifth can be used as evidence against him (yes, seriously, the courts have said so; the privilege against self-incrimination protects a defendant only in criminal prosecutions). So Tourre may hurt himself in the SEC case if he takes Five. But if he talks, he will have to answer tough questions about some e-mails and other documents that don't exactly cover him with glory. He might be damned if he does and damned if he doesn't. Defendants in that situation sometimes cut deals with the government.
This is a must-win case for the SEC. After years of horrendously bad publicity for a proud agency with a renowned heritage, the Commission marks a turning point by filing this case--but only if it wins or gets a good settlement. As much as it ever has, the SEC is betting the ranch. But it's done that before and prevailed. The SEC case against Michael Milken and Drexel Burnham Lambert in the 1980s was comparable. Drexel was perhaps the most powerful investment bank of the day and Milken was unequivocally its most powerful employee. Milken and Drexel fought tooth and nail, employing an army of defense lawyers that may have outnumbered the government's team by a ratio of 10 to 1. Most of the government lawyers were in their late 20s or early 30s. But they cared--tremendously--and the government (SEC and DOJ) carried the day, primarily by building a strong body of evidence. Both Drexel and Milken eventually settled, agreeing to criminal and civil charges. Don't sell the SEC short just because 18 months ago it was in the ICU. The staff working on this case are not the SEC's Madoff team, and Goldman's management and lawyers could be in for a surprise if they're banking on the presumed incompetence of their adversaries.
Goldman, too, is betting the ranch. We presume that at some point in its dialogue with the SEC staff it rejected the possibility of settling to fraud charges. Now, that position, assuming it is Goldman's position, is being put to the test. The only thing worse than agreeing to a fraud charge is being found liable for fraud after a trial. Goldman's only good outcome would be to go to trial and win. Perhaps it will. But will its management want to risk going to trial? If Goldman loses, the floodgates will opened for plaintiffs lawyers, state regulators and attorneys general, European regulators, and perhaps other claimants. And even if Goldman litigates this case for years, what about Goldman's other derivatives deals that went sour? They'll all now be assiduously scrutinized by armies of potential claimants. Fighting the SEC could be tantamount to manning the Maginot Line, while swarms of other claimants outflank Goldman from the left and the right.
Corporations generally don't like to litigate with federal regulators because the risks of losing usually outweigh the gains from winning. And the SEC, as painful as a loss could be in this case, has less to lose than Goldman. Goldman's top executives were once traders, where everything they did involved a deal. In a deal, you give up something to get something else. No doubt they will think about a deal. The terms for settlement are likely to be unpalatable at best. But what will Goldman's alternative be? Years of litigation and the accompanying uncertainty while competitors try to woo away its clients? Losses totaling many millions, and perhaps even billions in the end? A downside of doing leveraged deals is that if they become legal problems, the leverage works against you.
One thing to watch for is Goldman's earnings announcement on Tuesday, April 20, 2010. What will it say about the SEC case? What impact will the SEC case have on Goldman's litigation reserves? It's possible Goldman will delay its earnings announcement while it sorts out the fallout from the lawsuit. But these questions will remain whenever Goldman speaks.
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