Inside the SEC's Legal Case Against Goldman Sachs

Goldman Sachs (GS) has been accused in the media of playing both sides of a transaction for its own benefit, such as structuring and selling junk securities and then buying insurance on them from AIG (AIG)and helping create an index that allowed people to bet against debt that Goldman helped Greece issue.

Now, the Securities and Exchange Commission is accusing Goldman of doing something similar with respect to a collateralized debt obligation (CDO) it packaged and sold. What got the SEC involved isn't the double-sided play, however, so much as the fact that Goldman didn't tell buyers of the soon-to-be-worthless CDO about that play.

As laid out by the SEC, the sale of the CDO appears to be textbook securities fraud. If the SEC's allegations are true -- and Goldman hasn't really had a chance to respond beyond a blanket denial -- Goldman's best defense may be to claim that the vice president, Fabrice Tourre, overseeing the deal essentially went rogue, and kept Goldman in the dark about it. Alternatively, Goldman could deny the SEC's core fraud narrative by pointing to the involvement of an independent company in structuring the transaction. However, if the SEC can back up its claims, such a defense is unlikely to be convincing.

The Two Key Elements

The SEC charged Goldman and Tourre with two counts of securities fraud, one under section 17a of the 1933 Act and one under section 10(b) and rule 10b-5 of the 1934 Act. Although the two charges are similar, in this situation the burden in proving the 10b-5 violation is slightly harder. To win in both then, the SEC must show that Goldman and Tourre (a) made a material misstatement or omission (b) indicating an intent to deceive or defraud (c) in connection with the purchase or sale of a security.

Since all of the conduct at issue involves the sale of a security created and sold by Tourre and Goldman, the two key elements are whether Goldman/Tourre made material misstatements or omissions, and whether they had sufficient intent -- SEC must prove at least recklessness -- to deceive or defraud. So let's look at what the SEC alleges.

The commission alleges that Goldman/Tourre didn't tell investors material information, specifically that the CDO it was selling had been deliberately constructed out of residential mortgages backed securities (RMBS) likely to experience "credit events" (i.e., become worthless or virtually so) at the request of, and with the active participation of, a Goldman client named Paulson & Co. That is, Goldman/Tourre allegedly didn't tell purchasers of the CDO it marketed that the CDO was designed to lose value.

Chinks in Goldman's Defense

What could Goldman say in return? Perhaps that Paulson and Goldman weren't alone in structuring the CDO. Goldman hired ACA Management LLC (ACA) to evaluate the RMBS securities put into the CDO. Why would ACA allow the CDO to be structured out of RMBS that were likely to experience credit events?

The problem with this defense is that the SEC alleges, and has at least email to support it, that Goldman/Tourre deceived ACA into thinking that Paulson's interests were aligned with the potential CDO investors rather than diametrically opposed to them. ACA apparently believed that Paulson was investing a significant amount of money in the riskiest slice of the CDO, something that couldn't have been further from the truth.

Why does the SEC claim the RMBS were chosen precisely because they were likely to lose value?

• First, the SEC says Paulson approached Goldman specifically to create a way for Paulson to bet against RMBS, meaning Paulson was looking to make money on RMBS that lost value.

• Second, according to the SEC, Paulson invested in credit default swaps (CDSs, a form of credit insurance) on the CDO it helped Goldman issue, positioning itself to make money if the mortgage securities underlying the CDO defaulted -- those same securities that Paulson helped select.

• Third, within six months of the deal closing, 83% of the underlying securities had been downgraded, and less than a year later, 99% had.

• Fourth, the complaint includes email supporting this narrative. In all, the CDO buyers lost about $1 billion, and Paulson made about $1 billion. Goldman made $15 million.

What does it mean for omitted information to be material? In 1988's Basic Inc. v. Levinson, the U.S. Supreme Court explained: "an omitted fact is material if there is a substantial likelihood that its disclosure would have been considered significant by a reasonable investor." If the SEC really can prove that Goldman/Tourre structured the CDO so that the CDO would lose value, benefiting Paulson & Co. -- even going so far as to allow Paulson to participate in structuring the CDO so that outcome could be virtually assured -- and if the SEC can show that Goldman/Tourre failed to disclose that information to investors, it's hard to imagine a more material omission.

The SEC has to show that Goldman/Tourre intended to deceive, or at least were reckless about deceiving, investors by failing to disclose the material information. Common sense suggests the mere fact that no one would likely buy a CDO if they knew that it had been deliberately designed to lose value might be enough to prove that the failure to disclose the information was a deliberate effort to deceive investors. However, the SEC alleges more than that.

A Very Deliberate Effort to Misrepresent?

The SEC claims that to make the CDO attractive to the market, Goldman/Tourre brought in ACA and deceived ACA about Paulson's interests in order to persuade ACA to put its name on the securities. Those actions, if true, suggest a very deliberate effort to misrepresent the process for selecting the underlying securities, and thus the potential value of the CDO being sold.

Goldman will undoubtedly deny the charges vigorously and perhaps will file a motion to dismiss. Assuming the judge allows the case to go forward, it will enter a discovery phase. Depending on how that phase goes, Goldman may settle with the SEC. Whether the U.S. Department of Justice will get involved is an open question. It could bring criminal charges on the same allegations if it wished, although the burden of proof for a criminal case is much higher.

It's also not clear if this will be the only such case the SEC brings. Maybe I'm too cynical, but I find it unlikely that the alleged Goldman/Tourre-Paulson alliance was unique among deals or firms.