Tuesday, April 20, 2010

SEC v. Goldman Sachs: Read the Complaint

The big financial news the past few days has been the civil securities fraud suit filed by the Securities and Exchange Commission against Goldman Sachs in the United States District Court for the Southern District of New York.

The heart of a securities fraud suit is the claim that there was a "material" misstatement of fact or a "material" omission of fact. I have no opinion whether Goldman Sachs is liable, but I do think the press has made a simple situation appear to be oh-so-complicated.

The background is simple. In 2007 a hedge fund Paulson & Co. Inc. wanted to make a bet that the subprime residential mortgage market would collapse. It put together a portfolio of subprime residential mortgage market securities it believed would lose value and it asked Goldman Sachs to, in effect, find investors who would bet that the value of the securities would rise. The bet would be made by using a "synthetic collateralized debt obligation" (CDO)--the sophisticated financial instrument touted in the press.

The SEC claims that in marketing the bet Goldman Sachs did not disclose that Paulson was deeply involved in selecting the securities in the portfolio, and that Goldman took steps to conceal Paulson's involvement by having it appear that an impartial third party had independently selected the securities for the bet. The value of the portfolio did fall. Paulson made about $1 billion while those on the other side of the bet lost that amount.

Paulson's economic interests were, of course, adverse to those who would bet that the value of the securities would rise. In the SEC's view Goldman is guilty of a material omission of fact because it did not disclose to those betting the securities would rise that the portfolio was selected with the deep participation of the party who would bet that the value of the portfolio would decline. Whether Goldman was required to make this disclosure, and whether this failure to disclose is a material omission, will doubtless be the cause of multiple court filings by the SEC and Goldman's attorneys.

It has already been the source of endless press comment by academics and securities attorneys. But all the discussion regarding whether disclosure of the identity of the party on the other side of this "sophisticated" bet was required, has, in my opinion, obscured the SEC's second claim: Goldman affirmatively misled the parties by misstating Paulson's role in the transaction to suggest that Paulson had an economic interest in seeing the portfolio value rise.

Thus, for all the trumpeting in the press about an impenetrable, sophisticated transaction, in the end it boils down to a claim of a garden variety fraud: Goldman misstated the true nature of Paulson's involvement, thereby misleading those who bet the value of the securities would rise. Paragraphs 44 through 51 of the SEC complaint are, in my opinion, the practical heart of the matter. The complaint can be found here.

Goldman will undoubtedly deny it misled anyone. But it is one thing to argue to a jury that a party had no obligation to disclose certain information. It is an altogether different matter to acknowledge that one did say something, but it was not misleading. Juries understand the difference, and if the case goes to trial the outcome will turn on whether a jury believes Goldman affirmatively misled those who lost the bet.

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