Securities: Analysis of SEC Suit against Goldman Sachs

Last week the U.S. Securities and Exchange Commission shocked Wall Street by bringing an enforcement action against Goldman Sachs, the world's premier investment banking firm. In the suit, brought in federal district court in Manhattan, the SEC charged the banking firm with securities fraud in connection with the marketing of a derivative, specifically a synthetic collateralized debt obligation ("CDO"). The complaint alleges a fraud of $1 billion.

The theory of the SEC's complaint is rather simple and straight forward. The Commission alleges that Goldman Sachs put together a CDO at the request of a hedge fund, Paulson & Co., Inc. ("Paulson"). Moreover, the SEC contends that Paulson picked the subprime residential mortgage-backed securities upon which the CDO was based. The complaint then alleges that Goldman Sachs was aware of the facts that Paulson had selected mortgage-backed securities for inclusion in the CDO that it believed would default and that Paulson had taken a short position or one adverse to the investors in the CDO. Finally, the complaint alleges that Goldman's failure to so advise its customers was a material omission resulting in liability for fraud.

The SEC succinctly sums its theory in paragraph three of the complaint: ". . . GS&Co [Goldman Sachs] 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."

In 2007 Goldman Sachs offered to its clients ABACUS 2007-AC1, the synthetic CDO. The performance of ABACUS 2007-AC1 was tied to an underlying group of subprime residential mortgage-backed securities. Paulson, the hedge fund, selected the underlying mortgage-backed securities upon which the CDO would rest. The complaint alleges that Paulson selected underlying mortgage-backed securities that would underperform, referring to the likelihood of those securities experiencing "credit events in the near future." In short, the SEC alleges that Paulson's selection process included nothing but bad investments. Then, Paulson engaged in credit default swaps involving the underlying securities, much like buying insurance against the failure of those underlying securities. The government contends that with knowledge of Paulson's actions, Goldman offered ABACUS 2007-AC1 to its clients without informing them that Paulson picked losers for inclusion and was taking a position adverse to those investing in the offering it had created.

The SEC claims that Goldman represented to its clients that ACA Management, LLC ("ACA"), a well respected, third-party entity with experience analyzing the risks of subprime mortgage-backed securities had selected the securities underlying the CDO. The government further argues that Goldman brought ACA into the deal to essentially hide Paulson's involvement. It alleges Paulson presented the underlying securities to ACA that Paulson wanted included without revealing to Paulson the reason for inclusion, specifically, the weakness of the securities and the fact that Paulson would make adverse investments. Moreover, the SEC alleges that Paulson objected to the inclusion of any strong underlying assets.

The complaint alleges that Paulson paid Goldman approximately $15 million for the structuring and marketing of ABACUS 2007-AC1. The deal closed on April 26, 2007. By October 24, 2007, credit rating agencies had downgraded 83% of the subprime mortgage-backed securities in the ABACUS 2007-AC1 portfolio and the remaining 17% were on negative watch. By January 29, 2008, these agencies had downgraded 99% of the portfolio. Finally, the SEC alleges that investors in ABACUS 2007-AC1 lost over $1 billion while Paulson's adverse positions result in its profit of approximately $1 billion.

The complaint accuses Goldman Sachs of violating Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Exchange Act Rule 10b-5. The Commission is seeking injunctive relief, disgorgement of profits, prejudgment interest, and civil penalties.

The case will probably revolve around two factual issues. First, did Goldman Sachs make adequate disclosure to investors in ABACUS 2007-AC1? If the court finds that disclosure was adequate, then by definition there was no omission of communication of material information to the investors. Second, if Goldman Sachs omitted to make disclosure of the Paulson facts, did the investors nevertheless have this information? If the investors were fully apprised from a different source, there could be a defense argument that the omission was not material.