My view on SEC v. Goldman Sachs & Co. is that it will likely become a watershed event in the history of Wall Street regulation.  It's time that we pull back the curtain between us and the mighty Wizard of Oz -- so that we might see the old man pulling the bells, whistles, and levers.  It is also appropriate for us to stop pretending that laissez-faire regulation must tolerate financial products that are little more than roadside IEDs along the highway that is Wall Street. 

The larger question is are we now about regime change on Wall Street or merely crowd control?

Since the Securities and Exchange Commissions (SEC) announced its Goldman Sachs Complaint last Friday (Copy of the SEC Complaint and my initial comments at http://www.brokeandbroker.com/index.php?a=blog&id=372), I have given a number of interviews to the press concerning the case.  As I noted,

The SEC's case essentially accuses GS&Co of fabricating the financial equivalent of an Improvised Explosive Device (IED) which it then placed amidst investors with the expectation that the CDO would explode -- which it did.  Carried to its logical conclusion, the SEC's Complaint depicts the Defendants as financial suicide bombers on Wall Street. 

To the extent that the Complaint finally pulls back the curtain and lets the investing public see the shenanigans that truly go on behind the scenes, it is a welcome development. . . 

One note of caution, just as we need to be attentive to "Too Big to Fail," we also need to consider "Too Stupid to Remain in Business."  The SEC must be careful that in punishing GS&Co, if that be the intent and eventual outcome, that those supposedly sophisticated financial institutions who stupidly bought Abacus and the other exotic garbage then available for sale are not rewarded by the equivalent of an insurance policy.  There was far too much available market information when Abacus was being marketed to permit anyone who bought the CDO to suggest, now, that they were unaware of the negative analysis or growing chorus of naysayers.

http://www.brokeandbroker.com/index.php?a=blog&id=372

I have likely read, re-read, analyzed, and pondered the SEC's Complaint over a dozen times.  Clearly, I live a somewhat sad and boring existence.  Having digested the pleading, answered questions about it, and challenged my own assumptions, I find that my position on the case has evolved and better incorporates the nuances and legal realities.  In  my opinion, the SEC Complaint has uncovered and exposed unsavory Wall Street conduct.  On the other hand, I see much political theater in the SEC's 22-page pleading. As such, be prepared for a number of additional acts and scenes in this play. No!!! -- I am not defending Goldman and I am not defending the avarice that has been depicted in all its shameful vainglory in the Complaint.  What has too long passed as business-as-usual on Wall Street is tawdry and digusting. 

However, the larger task for this Blog entry is whether the SEC Complaint sets forth a compelling legal case.

There is a difference between having the right to do something and doing the right thing. Running afoul of the former is often illegal.  Running afoul of the latter is the stuff of morality, ethics, and philosophy -- but not necessarily lawsuits.  Frankly, I'm just not sure that from a legal perspective that the SEC's Complaint presents a compelling case that Goldman did something unlawful or in violation of industry rules and regulations.  How we ultimately respond to that conundrum (do we write new laws, rules and regulations?) may be our greatest challenge.

So, to my lawyer's eye, how does SEC v. Goldman play out?  First off, consider the very first paragraph of the Complaint:

The Commission brings this securities fraud action against Goldman, Sachs & Co. ("GS&Co") and a GS&Co employee, Fabrice Tourre ("Tourre"), for making materially misleading statements and omissions in connection with a synthetic collateralized debt obligation ("CDO") GS&Co structured and marketed to investors. This synthetic CDO, ABACUS 2007AC1, was tied to the performance of subprime residential mortgage-backed securities ("RMBS") and was structured and marketed by GS&Co in early 2007 when the United States housing market and related securities were beginning to show signs of distress. Synthetic CDOs like ABACUS 2007-AC1 contributed to the recent financial crisis by magnifying losses associated with the downturn in the United States housing market.

The highlighted portion of Paragraph 1 above is troubling for the SEC because it will likely form the foundation for an important component of Goldman's likely defense.  By the time the ABACUS synthetic CDO was being structured and marketed, the housing market and its deriviative securities were "beginning to show signs of distress."  As such, by 2007, investors who had yet to jump into real estate or its securities were on notice that the perceived optimism in that sector was waning.  The growing chorus of doomsday predictors and naysayers had started to fill the airwaves with their warnings.

Consequently, let's put things into an accurate perspective. By the time ABACUS was being packaged and offered, most financial institutions who would be buying this product (or fabricating it) were on notice that it could be a dicey bet.

What Did ACA Know and When?

In Paragraph 2 of the Complaint, the SEC alleges that

GS&Co marketing materials for ABACUS 2007-AC1 - including the term sheet, flip book and offering memorandum for the CDO - all represented that the reference portfolio of RMBS underlying the CDO was selected by ACA Management LLC ("ACA"), a third-party with experience analyzing credit risk in RMBS. . .

The gist -- the very guts -- of the SEC Complaint is that ACA was manipulated by Goldman, that John Paulson (and his hedge fund) picked the CDO reference portfolio, and that Goldman lied about Paulson's influence in the portofolio's selection.  However, all the marketing materials clearly disclosed that the reference portolio of residential mortgage backed securities (RMBS) was the child of ACA. The SEC Complaint implies that ACA is now backing away from those 2007 written representations.  According to the SEC's allegations, ACA apparently is pointing a finger at Paulson and Goldman -- that Paulson picked the reference portfolio, or did so in conjunction with Goldman, or that ACA was defrauded into selecting the RMBS.

Why weren't ACA's protestations contemporaneously forthcoming with the distribution of the marketing materials?  Either ACA had independently picked the portfolio and was comfortable with Goldman's marketing statements (which is perhaps why ACA doesn't seem to have protested about the marketing materials when they were first issued);  or ACA knew that it hadn't independently picked the portfolio and should have been immediately discomforted when it saw that its name was cited by Goldman.

I'm just not understanding (or getting) the SEC's point on this critical aspect of the case. ACA had an obligation to act as an independent agent in the selection of the reference portfolio. The Complaint stresses that ACA jealously guarded its reputation and integrity. Assuming that ACA read the marketing materials, I have to assume that ACA agreed with the representations that it had independently and professionally selected the component RMBS.  If the SEC is now asserting that Paulson picked the RMBS or that Goldman picked the RMBs, then why didn't ACA protest about the marketing representation when those statements were first published? 

Yes, yes -- I know -- the SEC's point is that ACA was manipulated into going along with the deal.  However, here's what is stated in the Complaint at Paragraph 2:

[A] large hedge fund, Paulson & Co. Inc. ("Paulson"), with economic interests directly adverse to investors in the ABACUS 2007-AC1 CDO, played a significant role in the portfolio selection process. After participating in the selection of the reference portfolio, Paulson effectively shorted the RMBS portfolio it helped select by entering into credit default swaps ("CDS") with GS&Co to buy protection on specific layers of the ABACUS 2007-AC1 capital structure. . .

Although the SEC states that Paulson "played a significant role" in the selection process, even those words grudgingly concede that there was a "selection process." Playing a role in a process is not the same as having the final, sole word. Moreover, the SEC Complaint does not assert that Paulson (the individual or the fund) called all the shots -- to the contrary, the allegation is that Paulson played a role, of which there were apparently a number of other actors in this play. As such, I infer that ACA had a role to play too.

The more critical question is whether ACA performed reasonable due diligence. Similarly, we must ask whether ACA selected the reference portfolio -- as was stated in the marketing materials. If Paulson made the reference portfolio decisions and somehow stacked the deck, then I go back to my earlier point: Why did ACA permit the distribution of marketing materials that stated that it had selected the reference portfolio?

The Bastard Children of Wall Street 

The SEC admits that the Paulson hedge fund had adverse interests to the likely investors in ABACUS -- and unless many of you forgot, Paulson's view of the subprime market was fairly well known in 2007.  Consider this statement in Paragraph 11 of the SEC's Complaint:

Beginning in 2006, Paulson created two funds, known as the Paulson Credit Opportunity Funds, which took a bearish view on subprime mortgage loans by buying protection through CDS on various debt securities. . .

Similarly, in Paragraph 17, the SEC admits that Paulson's employees held the following views as of January 2007:

"It is true that the market is not pricing the subprime RMBS wipeout scenario. In my opinion this situation is due to the fact that rating agencies, CDO managers and underwriters have all the incentives to keep the game going, while ‘real money' investors have neither the analytical tools nor the institutional framework to take action before the losses that one could anticipate based [on] the ‘news' available everywhere are actually realized."

In Paragraph 3 of the Complaint, the SEC preliminarily sums up its case:

In sum, GS&Co arranged a transaction at Paulson's request in which Paulson heavily influenced the selection of the portfolio to suit its economic interests, but failed to disclose to investors, as part of the description of the portfolio selection process contained in the marketing materials used to promote the transaction, Paulson's role in the portfolio selection process or its adverse economic interests.

You know, that's just not as powerful a case as the initial press commentary suggested.  Whatever Paulson's alleged role -- which the Complaint describes as a significant role or heavy influence -- a role is a role is a role. The ultimate challenge for the SEC is whether it can demonstrate that Goldman did something tortious or illegal as a result of Paulson's role.  Of course, there is that massive fly in the ointment.  In case you didn't notice, Paulson (the individual or the hedge fund) isn't named as a Defendant. If the SEC doesn't think that Paulson's role required naming him or the hedge fund as a Defendant, then apparently the SEC didn't conclude that Paulson did anything wrong. If Paulson didn't do anything wrong, then what was Goldman supposed to voluntarily disclose -- that Paulson was engaged in a legal undertaking? 

Moreover, is there anything illegal or improper about Goldman or any company considering a request to offer a securities product based upon the request or urging of a third party?  Absent more, the answer is "no," and, frankly, it's a fairly common occurrence.  Third parties often approach Wall Street investment bankers with proposals to make money. Present investment banking clients or desired ones wield much influence when pitching deals to Wall Street.  It's hard to even imagine a deal where the public isn't being sold something that may have many fathers -- of which none is disclosed.  Indeed, there are many bastard children of Wall Street. Did Goldman have a legal obligation to disclose Paulson's "role" in the portfolio selection process or the hedge fund's adverse economic interests?  Ahh...now we have the crux of this landmark case. 

Due Diligence Anyone?

In reading the SEC Complaint, I see the suggestion that Goldman "should have" volunteered information about Paulson's role (or that Goldman fraudulently covered up that role). On the other hand, did ACA or any purchasers directly contact Goldman and/or Paulson and ask whether Paulson had a role in selecting the portfolio components? Similarly, I see no inquiry as to whether Paulson was or would be adverse to ABACUS. Pointedly, in Paragraph 31 of the Complaint, the SEC states:

How could Paulson's opinions and predilections about subprime RMBS have been "unbeknownst" to ACA at the time?  If Paulson was not among the more likely shorters of the components of the portfolio, then who was -- and how will the SEC gloss over that issue?  Are we to believe that despite Paulson's reputation as a shorter of subprime, as a believer in the wipeout scenario, that his reputation and beliefs were not known to ACA?  Again, I ask, did ACA confront Paulson with such concerns? More pointedly, as a matter of law, did the Defendants have to discuss their awareness of Paulson's economic interests with ACA or with the purchasers of ABACUS? I would appreciate seeing some citations to law and case precedent from the SEC on those points. Again, such is the stuff of lawsuits.  It will be interesting to see what comes out in the wash.

Reluctant and Unlikely

However, the most damning weakness in the SEC's case is less artfully hidden by the regulator.  Consider Paragraph 45 of the Complaint:

Had ACA been aware that Paulson was taking a short position against the CDO, ACA would have been reluctant to allow Paulson to occupy an influential role in the selection of the reference portfolio because it would present serious reputational risk to ACA, which was in effect endorsing the reference portfolio. In fact, it is unlikely that ACA would have served as portfolio selection agent had it known that Paulson was taking a significant short position instead of a long equity stake in ABACUS 2007-AC1. . .

To the layperson's eye, the above statements may seem strong points for the SEC. I see the opposite. I see weakness.

Why is the SEC only willing to admit that if ACA had known that Paulson was adverse that it "would have been reluctant" to allow him the role that he had in the selection process? 

Let me reiterate that point.

In the SEC's Complaint, all that the regulator is able to state is that ACA would have been "reluctant" about Paulson's actual role if it had known he would short the CDO. Pointedly, ACA is still not saying that if it had actually confirmed Paulson's intention to short the CDO that it would have walked away from the deal.  Even at this late hour, the most that ACA seems prepared to testify to is that it would have been reluctant -- not that Paulson's shorting would have been a deal breaker.  The inference is that ACA may well have allowed Paulson to occupy an influential role in selecting the reference portfolio even if Paulson had confirmed that it would take a short position against the CDO! Further, ACA is only prepared to state that it would have been "unlikely" for the company to serve as portfolio selection agent if it had "known that Paulson was taking a significant short position . . ." In my book, "unlikely" is not an unequivocal "are you nuts, if we had known that Paulson was shorting we would never, ever, no-way have participated as the agent."  It will be interesting to see what ACA's executives ultimately testify to in court under rigorous cross-examination.

No Slam Dunk Case

As such, the SEC does not have a slam dunk case.  Further, given Goldman's deep pockets, one should expect a robust defense. 

I still wonder if SEC v. Goldman Sachs is just so much political theater.  In Act I, the SEC and Congress throw the rabble just a small slice of bloody, red meat. In Act II there is a multi-million dollar settlement, a cloud of harmless dust, and, after a few calendar pages are pulled off the pad, things pretty much get back to usual -- with some juicy campaign contributions down the road.

Forgive an old Wall Street veteran's cynicism.  After some three decades of sitting through these staged dramas, I've become a bit jaded.  Like I said at the beginning, is this about regime change or crowd control?

Silly season is now if full bloom among Wall Street's regulators.  As we all wait this morning with bated breath to hear the testimony of Goldman Sachs' executives before the Senate Permanent Subcommittee on Investigations, we learn that the industry's cops are still up to their old shenanigans.

Consider this absurd tidbit posted on the Securities and Exchange Commission's ("SEC's") website at http://sec.gov/news/studies/2010/oig-526-memo.pdf.

It seems that on April 22, 2010, SEC Inspector General (OIG) H. David Kotz sent a Memorandum to SEC Chair Mary Schapiro, with a copy to the SEC's Ethic Counsel William Lenox. The subject of that Memo was: Report of Investigation, Case No. 01G-526 Investigation of the SEC's Response to Concerns Regarding Robert Allen Stanford's Alleged Ponzi Scheme

Oh my, it seems that someone's feelings may have been hurt when the above Report of Investigation ("ROI") was released on Friday, April 16, 2010.  You can read the full ROI at http://www.sec.gov/news/studies/2010/oig-526.pdf  You missed this damning ROI?  Geez, wonder why.  Oh, yeah, I remember, the SEC just happened to choose that same day to coincidentally released the SEC v. Goldman Sachs et al. Complaint.  That lawsuit seems to have gotten a lot more press.  

For those of you who were unaware of the April 16th 159-page Stanford ROI, the OIG alleges that the SEC  knew that Allen Stanford was involved in a Ponzi scheme as far back as 1997.  Moreover, the OIG suggests that STanford's scheme was able to flourish because of questionable "institutional influences" within the SEC.   

The Play By Play

Section IV of the ROI states that the SEC had received a letter dated October 28, 2002 ("the Letter"), from, a citizen of Mexico [Ed: The letter writer's name has been redacted by the regulatory community and does not appear in the ROI or the Memo] who raised concerns about Robert Allen Stanford and his companies ("Stanford"), and its CDs in which her mother had invested. See ROI at 53. I have reprinted the relevant section below:

C. During the 2002 Examination, the FWDO Enforcement Staff

Received a Letter From the Daughter of an Elderly Stanford Investor

Concerned That the Stanford CDs Were Fraudulent

On December 5, 2002, Degenhardt received a letter dated October 28, 2002, from a citizen of Mexico who raised concerns about Stanford similar to those raised by the Examination staff. See October 28, 2002 Letter from to SEC Complaint Center, copying Harold Degenhardt (the "Letter"), attached as Exhibit 76. The Letter stated:

My mother is an old woman with more than 75 years of age

and she has all her money my father inherited to her for his

life work in CDs of Stanford Bank. This is the only money

my mother has, and it is necessary for my mother, my

sisters and me for living. My mother put it in the United

States because of the bad situation in Mexico and because

the most important thing is to look for security. …

I am an accountant by profession and work for a large bank

in Mexico. I know some banking regulations of my

country that are very different from practices in Stanford

Bank and for that reason I am very nervous. Please look at

this bank and investigate if everything is honest and

correct. There are many investors from Mexico in this

bank. My questions and doubts are listed here.

1. Stanford says the CDs have insurance. My mother

receives two statements of accounts. One from Stanford

bank in Antigua with the CDs and another one from

Stanford and Bear Stearns in New York. I know Bear

Stearns is a very good company, but the statement of Bear

Stearns only has cash that my mother uses to take out

checks. This cash is the interest that the CD pays.

Is the bank in Antigua truly covered by insurance of the United

States Government?

2. The CD has a higher than 9% interest and I know

other big banks like Citibank pay interest of 4%. Is this

possible and secure?

…

4. In December of 1999 the bank had a lot of

investments in foreign currencies and in stocks. In all the

world many stocks and foreign currencies came down in

2000. If a lot of money was in investments that came

down, how did the bank make money to pay the interest

and all of the very high expenses I imagine it has. …

5. The accounting company that makes the audit

(C.A.S. Hewlett & Co) is in Antigua and [no]body knows.

I saw the case of ENRON with bad accounting and I am

preoccupied with another case of fraud accounting. Why is

the auditor a company of Antigua that [no]body knows and

not a good United States accounting company?

I know some investors that lost money in a United States

company named InverWorld in San Antonio. Please

review very well Stanford to make sure that many investors

do not get cheated. These investors are simple people of

Mexico and maybe many other places and have their faith

in the United States financial system.

Okay, you might ask (go ahead, ask), what happened to the Letter after the SEC got it in December 2002? Hey, great question - thanks for asking! 

The SEC Punts to the TSSB

The OIG reported that it found evidence that without responding to or investigating the writer's concerns, the SEC staff decided to forward the Letter to the Texas State Securities Board ("TSSB") on December 10, 2002,  ROI at 56.  There is so much that I can think of saying -- would you mind if I just let it go at "pathetic?"

Incomplete Pass

The OIG also reported, based on interviews with TSSB Commissioner Denise Crawford, and with a TSSB employee whose name was redacted in the official report, that the TSSB had searched its files and found no record of receiving the letter. The OIG also reported Crawford's statement that she was confident that the TSSB had not received the letter from the SEC because the TSSB's internal tracking system for such correspondence would have evidenced its receipt. Id. Further, the OIG noted that Crawford and the unidentified TSSB employee all stated in interviews that they had never seen the letter. Id. at 56, n. 35.

Okay, so let me recap here. The SEC gets a letter warning about Stanford. The SEC doesn't communicate with the letter writer but sends the letter to the TSSB.  TSSB claims that it never got the letter. Ya got all of that?  Eight years roll by.

Late Hit

On April 16, 2010, TSSB's Crawford called the OIG and stated that while the information provided to OIG about the Letter was accurate at the time she and her staff were interviewed by OIG, a copy of the letter had subsequently been located in TSSB files.

Okay, let's look at the instant replay. The SEC gets a letter warning about Stanford. The SEC doesn't communicate with the letter writer but sends the letter to the TSSB.  TSSB claims that it never got the letter. Ya got all of that?  Eight years roll by. TSSB finds the letter in a file cabinet, where it should not have been filed. How it got there, no one knows.  Why it was there, no one knows. Oops.

Off-Setting Penalties

The new information does not change the OIG's finding that the SEC Staff had decided to forward the Letter to the TSSB without responding to or investigating the writer's concerns. It also does not change the OIG's finding that the decision to refer the matter to the TSSB was not revisited when, one week later, the SEC examination Staff referred the Stanford matter to the Division of Enforcement staff because of its concerns that Stanford was operating a Ponzi scheme. See ROI at 56-57.

However, in order for there to be a full and complete record of this matter, and, you know, in the spirit of fairplay and all, the OIG provided Chair Schapiro with this newly-discovered information.

Bill Singer's Comment: I dunno about you but, wow, I'm feeling much better about all of this.  I mean things are getting better among the ranks of Wall Street's cops.  They are at least uniform in their antics. Don't respond to complaints. Don't follow-up. Jealously guard your own regulatory turf. Dump the crap in a file cabinet. Lose the leads for nearly a decade.  Don't keep a document inventory worth jack. Deny that you have anything.  When you find it, blame some low level shnook.  Generate higher-profile, publicity hogging events when you're criticized.  Finally, make sure to prominently post the apology letters even though you aren't blameless.  Ah . . . progress!