White Collar and Securities: U.S. Reportedly Opens Investigation of Goldman Sachs

Various news organizations are reporting today that the U.S. Attorney for the Southern District of New York has begun an investigation of Wall Street banking giant Goldman Sachs. The reports state that the investigation resulted from a Securities and Exchange Commission referral of possible criminal activity by the bank. The SEC brought a civil enforcement action against Goldman earlier in the month alleging securities fraud.

The prosecutors will most likely begin their investigation on the basis of facts generated by the SEC investigation. The government will begin by looking to see whether Goldman and its executives defrauded customers who invested in Goldman's CDO offering, ABACUS 2007-AC1. (See prior post for a discussion of the SEC complaint.) There are a number of fraud statutes available to federal prosecutors should they seek indictments. Those most commonly used by federal prosecutors in securities fraud cases are wire fraud, mail fraud, securities fraud, conspiracy, and money laundering.

The criminal investigation will focus more on the potential culpability of individuals rather than the Goldman corporate entity. Typically, federal prosecutors will seek to hold individuals responsible for any criminal wrongdoing rather than settle for corporate liability. In many cases a corporation will enter into a corporate integrity agreement with the government. Such an agreement will require compliance and internal education programs and a period of time in which the company must report regularly to the government. In return for the agreement the government forgoes prosecution of the business entity.

The criminal authorities have more difficult task than the SEC in prevailing in a law suit. For a criminal prosecution to be successful the government must convince the jury beyond a reasonable doubt, a much greater burden than the preponderance of the evidence burden that the SEC must meet in its civil enforcement action.

A potentially important factor to bear in mind is that the SEC did not name John A. Paulson or his hedge fund in its complaint against Goldman. In the press conference announcing the SEC action, the Commission's Director of Enforcement seemed to deflect questions about the charging of the hedge fund. Additionally, when Goldman executives testified before the Permanent Senate Subcommittee on Investigations, there was an absence of questioning about the role of the Paulson hedge fund in creating the CDO offering. One possible explanation for the absence of discussion about Paulson is that persons involved in the hedge fund may be cooperating with the government investigations.

If there are persons involved in the the deal cooperating with investigators, that fact could greatly facilitate the government's investigation and proof of wrongdoing. "Flipping" an insider to a criminal conspiracy is one of the best means of investigating and bringing a successful case against a criminal conspiracy.

For more about the reported federal criminal investigation of Goldman, please see The New York Times, "Goldman's Share Plunge on Inquiries and Downgrades," April 30, 2010, http://www.nytimes.com/2010/05/01/business/01goldman.html?ref=business.

Financial Reform: Goldman Sachs Executives Testify before Congress

On Tuesday of this week several Goldman Sachs executives testified before the Permanent Senate Subcommittee on Investigations. Among those spending the day testifying were CEO Lloyd Blankfein and Fabrice (The Fabulous Fab) Tourre, who was named along with Goldman by the SEC in its securities fraud suit. The hearing picked up where the SEC suit left off as the Committee's staff focused the senators' attention more on conflicts of interest in its conduct than the SEC's specific fraud allegations. While the coverage of the hearing focused on assertions from senators with corresponding denials from Goldman personnel concerning whether Goldman had conflicts of interest, a broad view of the hearing highlights the fact that the senators and executives were not even in agreement about underlying duties and definitions.

Black's Law Dictionary defines a "conflict of interest" as a "[t]erm used in connection with . . . fiduciaries and their relationship to matters of private interest or gain to them." Thus, the concept of a "fiduciary" or "fiduciary duty" provides the basis to analyze a conflict of interest. Black's defines "fiduciary duty" as "[a] duty to act for someone else's benefit, while subordinating one's personal interests to that of the other person. . . ."

It is clear that the subcommittee and its staff assumed that Goldman had a fiduciary duty to its clients and then violated that duty by developing and selling bad investment deals and then engaging in financial transactions involving these deals that were adverse to the interests of the clients. What is far less clear is whether Goldman's executives believe that they have a fiduciary duty to Goldman's customers. If they do believe such a duty exists, Goldman's definition of a "fiduciary duty" must be significantly different from the one offered by Black's and intuitively adopted by the subcommittee.

Ultimately, apart from the speeches and political posturing, which is a part of any high profile legislative hearing, Tuesday's hearing was probably very important for the public as Congress moves forward with financial reform. A fundamental question that the reform package will address is the duty that financial professionals owe to their clients. The resulting law will attempt to define the parameters of the duty by the limits that it imposes on the financial industry. The likelihood is that the legislation will state clearly that Wall Street has a clear duty of care owed to clients and customers that must prevail over the banking institutionss goals of realizing profits. The final rules could range from outright bans on certain activities to allowing the banking institutions to hold adverse positions, but with full disclosure to their clients.

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.