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Goldman doth protest too much, we think, in the statement it issued on Sunday on the SECâ??s complaint against it and its trader Fabrice Tourre. We note that Goldman is already on its third rebuttal since Friday.
Itâ??s no more cogent than the previous one, or the first (a one-liner from Lucas Van Praag: â??The SEC's charges are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation.â?)
The third, most recent statement is also available in full in the Long Room.
First, letâ??s make Goldmanâ??s position absolutely clear. As the statement contends:
We believe the SECâ??s allegations to be completely unfounded both in law and fact, and will vigorously contest this action.
"? The core of the SEC's case is based on the view that one of our employees misled these two professional investors by failing to disclose the role of another market participant in the transaction, namely Paulson & Co., and that the employee thereby orchestrated the creation of materially defective offering materials for which the firm bears responsibility.
"? Goldman Sachs would never condone one of its employees misleading anyone, certainly not investors, counterparties or clients. We take our responsibilities as a financial intermediary very seriously and believe that integrity is at the heart of everything that we do.
"? Were there ever to emerge credible evidence that such behavior indeed occurred here, we would be the first to condemn it and to take all appropriate actions.
"? This particular transaction has been the subject of SEC examination and review for over eighteen months. Based on all that we have learned, we believe that the firmâ??s actions were entirely appropriate, and will take all steps necessary to defend the firm and its reputation by making the true facts known.
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Interesting enough, but weâ??re more interested in what the bank calls â??critical points missing from the SECâ??s complaintâ??. Weâ??ll take each point in turn, as presented by Goldman.
o Goldman Sachs Lost Money on the Transaction. The firm lost more than $90 million arising from this transaction. Our fee was $15 million. We certainly did not wish to structure an investment that was designed to lose money.
Not wishing to do something is different from going ahead and doing it all the same, however â?? or allowing John Paulson to do it. Neither is losing money on a transaction greatly relevant to its legality, as Kid Dynamite has noted on this point.
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o Objective Disclosure Was Provided. The transaction at issue involved a static portfolio of securities, and was marketed solely to sophisticated financial institutions. IKB, a large German Bank and leading CDO market participant and ACA Capital Management, the two investors, were provided extensive information about those securities and knew the associated risks. Among the most sophisticated mortgage investors in the world, they understood that a synthetic CDO transaction requires a short interest for every corresponding long position.
â??Objective disclosureâ?? and â??extensive informationâ?? are not quite complete disclosure of Mr Paulsonâ??s involvement, which Goldman has elided here.
The transaction at issue involved a static portfolio of securities chosen by Mr Paulson. Was this â??choosing powerâ?? made clear to investors when they came to select securities themselves? Should it have been? These are the key points, not addressed here, and they seriously affect the sophisticated investor defence.
This defence has emerged as a key point in the commentary on the filing so far. The defence includes the good argument that the ACA should have carried out its own due diligence on the securities contained in the CDO in question, prior to selecting them.
For example, perhaps ACA would have invested the same way in any case, or perhaps it should have known better. Maybe even â??no one in fact considered Paulsonâ??s role importantâ??, according to Goldmanâ??s pre-charge rebuttal to the SEC in September 2009. (That rebuttal was seen by the WSJ)
The argument depends a great deal on whether Paulsonâ??s selection of bonds was a material fact, liable or likely to alter ACAâ??s investment.
However, the definition of materiality would appear to remain fairly open to litigation on a case by case basis.
After all, the definition of a â??material factâ?? in SEC Rule 10b-5 has been interpreted by the US Supreme Court thus:
an omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.
As the Courtâ??s argument continued in TSC Industries, Inc. v. Northway, Inc., this test would not however require proof that ACA would have acted differently:
It does not require proof of a substantial likelihood that disclosure of the omitted fact would have caused the reasonable investor to change his vote, but contemplates a showing of a substantial likelihood that, under all the circumstances, the omitted fact would have assumed actual significance in the reasonable shareholderâ??s deliberations.
Erik Gerding at The Conglomerate business law blog presents one other ambiguous aspect of the SECâ??s filing:
The messiness comes if Goldman didn't exactly say that Paulson was investing in the CDO, but didn't exactly say the hedge fund was shorting it either. In fact, paragraphs 44-51 of the Complaint, which talk about ACA being misled by Goldman into believing Paulson would be an equity investor, don't contain any evidence of direct statements by Goldman to this effect. Rather, it looks like ACA believed that Paulson would invest in the transaction and the Goldman employee may have been aware of this. So the question was did Goldman's statements, actions or silence rise to the level of misleading ACA?
So, can a failure to correct an incorrect belief constitute omission of a material fact?
Weâ??re not exactly qualified to answer. Either way, itâ??s difficult to assert in advance of any actual hearings that no material fact could have impeded ACAâ??s exercise of due diligence in its mortgage investments.
Indeed, the legal standard here creates a grey area that it would appear only further litigation will solve â?? which leaves things on a tenterhook.
As FT Alphaville reader â??Jakâ?? commented on a previous FT Alphaville post on Goldman and the SEC filing, no other issue could be as important to the future of structured finance:
The SEC case, almost surprisingly given the so far disappointingly low level of the debate about reforming the financial system, does finally go to the heart of the matter. Finance operates on the assumption that buyers and sellers have symmetric access to information about third parties, whose underlying value determines the price of a security. The importance of this point is acknowledged also in the now infamous Paulson-Goldman Sachs CDO by the employment (as far as we know today mainly for marketing purposes) of a â??neutralâ? intermediary such as ACA. Minimising instances of asymmetric information (a practice akin to Insider trading) is crucial for re-establishing trust in the financial system and for healing the rift betwen Wall Street and Main Street.
Rebut that, Goldman.
Now, Letâ??s mop up the remaining points.
o Goldman Sachs Never Represented to ACA That Paulson Was Going To Be A Long Investor. The SEC's complaint in part accuses the firm of potential fraud because it didn't disclose to one party of the transaction the identity of the party on the other side. As normal business practice, market makers do not disclose the identities of a buyer to a seller and vice versa. Goldman Sachs never represented to ACA that Paulson was to be a long investor.
There appears to be a direct clash between the two sides on this point, which our fisking is hardly qualified to adjudicate.
However, suffice to note it is risky for Goldman to argue that it never represented to ACA that Paulson was a long investor, if this is later shown not to be true in court.
Conversely, of course, the SEC might be about to land itself in the greatest courtroom embarrassment in its history, if it hasnâ??t got its facts straight on this point.
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o ACA, the Largest Investor, Selected and Approved the Portfolio. The portfolio of mortgage backed securities was selected by an independent and experienced portfolio selection agent after a series of discussions, including with IKB and Paulson & Co. ACA had an obligation and, as by far the largest investor, every incentive to select appropriate securities.
ACA selected and approved the portfolio â?? and so did Paulson, without ACAâ??s prior approval, according to the SEC filing. If ACA did have an obligation to select appropriate securities, well, Paulsonâ??s involvement may have impeded this obligation.
In short, then, very little of Goldmanâ??s case is obvious either way, in advance of the actual litigation to which the bank has now committed itself. This places risk on the outcome of the case, especially in the area of deciding what counts as sufficient sophistication for an investor.
The SECâ??s charges may not promise the trial of a century, but as far as the future of structured finance is concerned, it comes pretty close.
Related links: Goldman v. SEC: It's All About Materiality â?? WSJ Law Blog On Goldman and disclosure"? - Footnoted
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