Why SEC Has Strong Case Against Goldman, Part 2

Includes: DB, GS, MCO
by: Suna Reyent, CFA

<< Return to Part 1

The “But They Were Big Boys” Defense

This is the defense that Goldman, while acting as a broker-dealer, did not act in a fiduciary capacity in this deal, a fact that sophisticated investors are well aware of. Touché. But fraud is still fraud regardless of who the victim is. In other words, the laws that Goldman is charged with violating apply to qualified institutional buyers under Rule 144A as well.
The senate grilled Goldman executives on having made money at the expense of clients. This is bound to provoke outrage in the constituency, although betting against clients in and of itself does not a legal case make. But it does assist in establishing the bigger picture that shows purposeful actions on the part of the firm to push the aforementioned CDO deal onto the customers in an inappropriate and misleading fashion.
Besides, it does not hurt to spice up the case with insider details on how Goldman made money via selling “cats and dogs” to sophisticated clients. Not to mention that the deceived “big boys” may have been taking care of individual savings and retirement accounts of ordinary folk.
The “But The CDO Would Have Performed Poorly Even Without Paulson’s Involvement” Defense
So, that’s why the firm was so anxious to dump the “cats and dogs” remaining in its inventory, right? And that’s why the firm was trying so hard to find a counterparty to sell its remaining investment in the Abacus CDO as soon as the deal was completed.
Whether a certain misrepresentation or fraud changes the final outcome of a deal or situation does not excuse the fact that a material misrepresentation as well as fraud has been committed.
This is intellectually equivalent to saying that a person you poisoned died because of an earthquake so what you did to them prior to their death is not punishable by law.
The “But Others Were Doing What We Were Doing” Defense
Normally I would contain my sarcasm, but really, how solid is it to try to explain away material misrepresentation and fraud by saying that there were others out there who did what Goldman did as well? Since when did pointing fingers to others become a legitimate defense?
But did others do exactly what Goldman did?
There were plenty of other CDO deals done on the street. In fact, SEC and Goldman seem to have engaged in at least one conversation regarding which deal on the street included what kind of disclosure throughout the 18 months of this investigation.
Deutsche Bank (NYSE:DB) sold similar CDOs without notifying customers who was on the other side of the trade, and Paulson was taking short bets on these deals as well. Here is how Deutsche Bank’s head of communications argued that its deals were different from Goldman’s Abacus deal:

What distinguishes Deutsche Bank's CDO transactions is that both long and short investors were given the opportunity to select the specific collateral to which they were seeking exposure and mutually agreed on the CDO portfolio. No third-party collateral manager was utilized for these deals, which eliminated the potential for deception with respect to the role of such a manager.

So there was no (mis)representation to the long investors that an independent collateral manager had exclusively designed and approved the portfolio.
In fact, Deutsch Bank’s CDO transactions were overseen by the very Robert Khuzami who is the current head of SEC enforcement today.
The “But We Didn’t Know Fabrice Was Devious” Defense
Goldman has not been able to distance itself from Mr. Tourre by saying it was not aware of his actions and does not approve of what he has done, since doing so now would indicate serious failures of supervision on the part of the firm for at least 18 months that SEC was known to be investigating this issue.
An internal investigation must have been conducted during this period. Indeed, Goldman Sachs’ defense letters now made public reveal that the firm knew about all of the charges SEC alleges that Mr. Tourre as well as the firm have committed. The firm was also notified of the email that Mr. Tourre sent to Ms. Schwartz (ACA representative), which misrepresented Paulson’s involvement in the CDO deal as a long investor.
In the first response letter to SEC’s Wells notice, Goldman’s defense team has categorically denied that this employee had engaged in any “negligent, reckless, or intentional” misrepresentation (Page 33). A sudden reversal from that position when slapped with a lawsuit would look disingenuous at best, if not devious.
Also, distancing itself from Mr. Tourre would not extricate the firm from its own material omission of Paulson’s involvement in the offering memorandum, sales pitches as well as marketing materials, even if these documents were prepared by Mr. Tourre himself. These documents belong to Goldman Sachs and are considered firm’s property, hence they go through supervisors as well as legal department before being sent out to the clientele.
Yet, the aforementioned email of Mr. Tourre to ACA clearly states that Paulson planned to invest in the equity tranche of the Abacus CDO (SEC Complaint No: 47), which indicates a very serious intention to mislead. Goldman defense flat out rejects that this email constitutes any claim for Paulson to invest in the equity tranche.
I was actually offended that Goldman lawyers rejected the significance of Mr. Tourre’s email as well its misleading nature in their 49-page response to the SEC.
Perhaps there is not a direct sentence in English that spells it out for a four year-old, but Paulson’s “sponsorship” described in the “contemplated capital structure” with a “[0]% - [9]%: pre-committed first loss” is reasonably clear for a financial analyst to conclude that Paulson was investing in the equity tranche. If I were reading that email, I would have had the same impression that the ACA representative (a senior managing director who had 22 years of experience in the asset-backed securities business in firms like Merrill Lynch and New York Life) had.
Goldman defense instead tries to explain away the word “sponsor” by saying that in a deal, “sponsor” could refer to either long or short, depending on who initiated the CDO inquiry in the first place. But the way the email is written, any reasonable financial analyst would put the phrases “Paulson’s Sponsorship” and “contemplated capital structure” with a “[0]% - [9]%: pre-committed first loss” together to mean that Paulson was investing in the equity tranche.
Paulson could have indicated an interest in acquiring a spread position in the CDO by going long a smaller equity and short a much larger portion of the debt “space”. In fact, Goldman defense seems to refer to such a possibility via mentioning hedge fund Magnetar’s trades and Ms. Schwartz’s participation in those deals. If it were true, revealing Paulson’s long interest in the equity while hiding a much bigger short interest in the debt would indicate an even more devious method of conning ACA.
But in the end, no equity tranche was created.
In addition, Mr. Tourre is not the only person who has failed to correct the impression that ACA got of Paulson’s participation in the deal. One salesperson has failed to correct ACA Management’s email indicating the impression that Paulson was investing (long) in the structure (SEC Complaint No: 48). Goldman Sachs defense has alleged that the Wharton grad with experience in firms like Lehman Brothers and Merrill Lynch might not have understood the significance of statements like “equity investor”.
I’m of the opinion that even if one of Paulson’s employees later went out of his way to disabuse ACA of the notion that Paulson & Co. intended to go long, that still does not relieve Goldman employees and the firm itself from having given the wrong impression to ACA Management regarding Paulson’s intentions. Regardless, written Goldman material officially misrepresented the deal to IKB and ABN Amro.
The flip book of Abacus CDO indicates that the first loss tranche (equity trance) is empty, with N/A written over it. ACA must have seen this information. But nothing has been produced by Goldman defense thus far to show any solid effort (or a later email that clearly corrects Mr. Tourre’s earlier “mistake” and gives an explanation of Paulson’s participation in the “space”) on the part of the broker-dealer to disabuse ACA Management of the impression that Paulson was a long investor. I find this very troubling. This will be a very contentious point in court, especially when witnesses are called to the stand.
When trying to argue that this email and what took place thereafter did not constitute any “inference of scienter”, Goldman Sachs states the following: (Page 33)

If Ms. Schwartz inferred that Paulson was an equity investor from Mr. Tourre’s email, that at most indicates that a misunderstanding occurred. It does not indicate that Goldman Sachs negligently (let alone recklessly or intentionally) led ACA to believe this was the case, particularly in light of the amorphous language from which Ms. Schwartz apparently drew her inference.

This is equivalent to holding a glass of jar in front of your shop counter and a sign close-by that states “church donation”, and then claiming that the sign was actually meant for the boxes nearby that the church had for the clothing drive. And if good Samaritans put the jar and the sign together to come up with the idea that the jar also belonged to the church, well, too bad …They should have done their due diligence by asking the minister nearby…
But wait…The defense continues:

Indeed, there is no indication that a reasonable professional under the circumstances presented here would have expected Ms. Schwartz to construe the term “sponsor” to mean that Paulson necessarily was an equity investor.

So, there is no indication that a reasonable shop owner would have believed that the good Samaritans mistook the jar as belonging to the church, as opposed figuring out that the jar in fact belonged to the shop owner himself.

I am of the opinion that while trying to argue itself out of the charges of scienter, Goldman Sachs may have crossed the line of scienter itself. Which is most likely why the SEC did not make any mention of it in their September 15, 2009 meeting thereafter.
In a follow-up 20-page defense letter sent to the SEC after the September 15 meeting, the defense writes the following: (Page 15)

While the September 15 meeting included a robust discussion of materiality, the issue of scienter was never raised. Although we are therefore hopeful that our Wells submission was sufficient to dispel any continuing consideration of charges requiring scienter, out of an abundance of caution we comment briefly as to this issue as well.

I am guessing that the issue of scienter was never raised in this meeting not because the SEC did not think it was important. It was not raised so as not to tip Goldman defense of the entire and complete – how shall I put it – idiocracy (or shall I say arrogance) that made it possible to come up with such an inexcusable and unbelievable justification while defending such a material misrepresentation.

I cannot think of a worst way of trying to argue one’s way out of such a big issue, even if it is truly a big misunderstanding. I think the appropriate thing for the firm would have been to look for any tangible records of a later email or phone conversation that clearly and unequivocally attempted to correct this “error” that Mr. Tourre made.
If such a record cannot be found and ACA representatives won’t talk to you about this “misunderstanding” because they are possibly cooperating with the SEC in the ongoing investigation, then the best course would have been to admit that a mistake had been made and look for ways to make amends.
Goldman has carefully stated that it would never “condone one of its employees misleading anyone, certainly not investors, counterparties or clients”. I am getting the hint that the firm appears to be prepping itself towards a one-employee-did-it sort of defense:

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.

SEC’s case is not based upon this view. In fact, it is based upon using a much broader set of evidence to establish intent, and utilizing Goldman’s lack of compliance to the aforementioned laws in this specific deal to argue material misrepresentation and fraud charges both for the employee and the firm.

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.

So even in the light of the SEC complaint that very clearly manifests various efforts to mislead ACA as well as other investors, the firm still does not see “credible evidence” that any such behavior occurred.
Of course, via this statement the firm concurrently tries to hedge its bets by saying that if things start looking worse, it reserves the right to go on the offensive against Mr. Tourre to exonerate itself.
The most important thing to me is that the general counsel cannot keep it together when asked about Paulson’s involvement in the portfolio selection process in a routine conference call. And that is the crux of the matter.
My opinion is that it is quite straightforward to argue that both Goldman Sachs and Fabrice Tourre violated Section 17(a) of the Securities Act of 1933. Goldman defense letter to the SEC stresses that threshold for proving a violation of the Section 10(b) of Securities Exchange Act of 1934 and Rule 10b-5 is higher and requires more proof in terms of “intent.” The SEC complaint, as far as I can tell, has not made this distinction.
Proving “intent” appears to be easier as far as Mr. Tourre is concerned, if only because it was he who structured and marketed the CDO and engaged in conversations with investors.
In my opinion, arguing for intentionally deceptive practices on the part of the firm, given other evidence and emails during the time period the firm was working on the Abacus deal as well as others, should not be difficult at all.
Disclosure: No positions