Source: https://blogger.uncleleosden.com/2010/04/
Timestamp: 2019-04-24 00:42:13+00:00

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SEC v. Goldman Sachs: Are the Shareholders Now Speaking Up?
Today brought us news that federal prosecutors in Manhattan are sniffing Goldman over. Those would be pooches no one wants to get close to, because they bite with criminal charges. No investment bank has ever--repeat, ever--survived criminal charges.
It's also reported that Goldman is thinking hard about settling the recently filed SEC case. That would seem a striking change of heart, considering Goldman's jut jawed defiance at Congressional hearings on Tuesday. But there's a logical explanation for the apparent change of course--the shareholders are rumbling.
We mean the outside shareholders. They don't participate in the employee bonus pool, and receive their profits from share appreciation and dividends. They would take a longer term view of the firm--almost like the partners who owned Goldman before it went public in 1999. As with all investment banks, Goldman's reputation is its principal asset. That's been a depreciating asset in recent weeks, and the stock price has dropped a corresponding 15% or so.
Berkshire Hathaway may be Goldman's largest shareholder, having infused $5 billion in the fall of 2008 as a vote of confidence in the U.S. financial system. Berkshire Hathaway got about 7.6% of Goldman's beneficial ownership, according to Goldman's most recent proxy statement. Large mutual funds and money management firms are also major shareholders. Many of these institutional shareholders can't easily ditch GS stock, because they might hold it as part of an index fund or a basket of stocks needed for an investment strategy. Or else they might hold so much GS stock that they can't dump it all quickly without rippling the market big time. So they're stuck with this puppy, and every downward tick in its price probably ticks them off ever more.
Shareholders have been instrumental in fostering settlement in big government cases. In the late 1980s, the SEC and the U.S. Attorney's office in Manhattan squared off with Drexel Burnham Lambert Incorporated, the leading junk bond firm of its day. The SEC sued Drexel (and its junk bond star, Michael Milken) in September 1988, while a criminal investigation by the U.S. Attorney's Office in Manhattan moved forward. The prospect of indictment loomed for Drexel, and its largest shareholders, including a Belgian financial firm called Groupe Bruxelle Lambert, pressured Drexel's management into settling.
Some 23 years ago, Berkshire Hathaway acquired about 12% of Salomon Inc., another investment bank. Four years later, in 1991, a scandal over U.S. Treasury auction bidding blew up at Salomon. Warren Buffett, Berkshire Hathaway's CEO, became Salomon's Chairman, and steered the firm toward settlement with the U.S. government.
Goldman's large shareholders will likely avoid public comment. But surely they're thinking hard about how to save their investments. In just a couple of weeks, Goldman's legal problems have mushroomed to include not only the SEC lawsuit, but shareholder suits, investigations by foreign regulators, potential lawsuits by customers and now the possibility of criminal charges. A quick settlement with the SEC could reduce the incentive for the U.S. Attorney's office to press ahead. It might also staunch the flow of evidentiary revelations that bursts forth in tabloid fashion just about every day now (was the love life of a Goldman employee ever before so interesting?). While institutional shareholders in America generally maintain a lizard-like impassivity when it comes to corporate governance, a legal crisis that threatens a firm's viability is just the circumstance to inspire them to damage control. The recent past teaches that investment banks can't withstand the tsunami of bad publicity that seems to be engulfing Goldman. There's scarcely a chance that Warren Buffett will comment publicly about Goldman's situation. But you can bet dollars to doughnuts that he and other large GS shareholders aren't holding their peace behind the scenes.
They must have felt better after Tuesday's hearing, the Senators who got to ventilate their Kabuki outrage and the Goldman witnesses their defiant self-rationalizations. But in the end, Goldman lost ground.
In essence, Goldman argues that it served as an intermediary between long and short investors in ABACUS 2007-AC1, the first synthetic CDO ever to achieve tabloid fame, perhaps eclipsing, however momentarily, Kate Gosselin. Goldman claims it made extensive disclosure to sophisticated investors on both the long and short sides, and let these grownups decide for themselves if they wanted to invest. They should have to bear the risks that they voluntarily undertook, contends Goldman, perhaps overlooking the fact that it didn't bear any of the risks it voluntarily undertook in connection with AIG because the U.S. taxpayer (i.e., you) bailed out AIG, and therefore Goldman.
Synthetic CDOs are, on paper, pure bets. They don't actually hold any underlying investments and the payments investors make for them do not finance the building of factories or the development of advancements in computer memory chips. There is no intrinsic difference between a synthetic CDO and a sports bet. Both are wagers and nothing more.
But ABACUS 2007-AC1 wasn't analogous to an ordinary sports bet. It was like betting with someone who got to pick the lineups for the competing teams; in other words, someone who rigged the game. If you didn't know that--and it became indisputable from yesterday's hearing that IKB, one of the long investors in ABACUS 2007-AC1, didn't know about John Paulson & Co.'s role in choosing the collateral--you could get hosed. Which is exactly what happened to the long investors in ABACUS 2007-AC1.
So Goldman's explanation doesn't work. It wasn't just an intermediary between sophisticated investors that made informed bets on a fully disclosed investment. It was a promoter of a rigged bet that didn't disclose to everyone the playing field had been tilted.
Whether Goldman is legally liable remains for the courts to decide. However, it failed at the principal challenge it faced in yesterday's hearing, which was to diffuse the public controversy over the SEC's case. It had no appealing story for why Horatio Alger would want to grow up to be a synthetic CDO salesman. Goldman's witnesses offered only carefully crafted testimony that brought to mind some politician's line about the absence of controlling legal precedent or another politician's quibbling over the meaning of "is." Goldman couldn't bring even a scintilla of contrition to bear, apparently rejecting the notion that a little humility would come across better than polite arrogance. One thing that was loud and clear is that Goldman's management intends to litigate this case until Hell freezes over. But the SEC seems to have ended up with slightly improved litigation prospects, even though it didn't participate in the hearing. So it won't back down any sooner than Goldman. A long struggle in the courts bears greater risk for Goldman than it does the SEC. Goldman needs to be careful with the trade it just got into.
If you've ever wondered what it would have been like on the Titanic, take a look at the Euro bloc. Today's drop by the Dow Jones Industrial Average of 213 points only mildly foreshadows what could happen. Greece, as we all know, is in deep yogurt. But Portugal and Spain are also sliding into the vat. Current estimates of the bailouts needed by these three countries total around 500 billion Euros. (That would be around $650 billion.) The IMF might be able to cough up around 200 billion Euros. The other 300 just ain't happening. A large part would have to come from Germany, and the Germans are already struggling with the idea of contributing around 12 billion Euros to Greece's bailout. With the most recent developments, the German public might well conclude that even a small bailout for Greece would begin Germany's slide down the slippery slope, and clamor to depart the EU.
Neither the Federal Reserve nor any other part of the U.S. government can do much. Americans are fed up with bailing out each other; they won't stand for bailing out people overseas. To make things worse, Goldman Sachs appears to have played a significant role in certain aspects of Europe's sovereign debt problem. While its exposure to the sovereign debt mess remains unclear (no doubt GS has plenty of hedges in place), anything that might look like another bailout of Goldman, after AIG's nationalization, would be beyond the pale.
The European Union doesn't have a true governance structure. That's why it got into trouble and that's why it can't work its way out of trouble. Ten years ago, Argentina linked its currency to the dollar and got into a debt crisis not unlike Greece's current predicament. It had to delink from the dollar, and today is in decent shape. The Euro bloc will almost surely lose members--either the debtor nations that need the bailouts, or the wealthy nations that would be expected to fund the bailouts, will leave. The Euro may eventually be good only for buying its automotive counterpart, the Edsel.
The Paleolithic quality of the derivatives markets takes us back to earlier times, when the courts and the SEC struggled to establish the basic ground rules of the securities markets. Although American lawyers, unlike their English brethren, tend to fixate over the most recent judicial decisions, it is can be instructive to go back to a time when the stock markets were more rudimentary, bearing interesting resemblances to today's derivatives markets.
In 1972, when french fries were still cooked in lard and tasted much better than they do today, the U.S. Supreme Court handed down its decision in Affiliated Ute Citizens v. United States, 406 U.S. (128). This case involved a company, Ute Distribution Corp., which was created to distribute certain assets of the Ute Native American tribe to its mixed-blood members. The original mixed blood shareholders were permitted to sell their stock, although sales involved a somewhat laborious over-the-counter process by the transfer agent, a bank called First Security Bank. Two employees at a branch office of the bank saw a profit opportunity and devised a scheme to buy stock from original shareholders at lower prices and resell it to non-Utes at higher prices. The result was a two-tiered market, in which stock sales by Utes were in the range of $300 to $700 per share, while transactions between white buyers and sellers were in the $500 to $700 range. The two bank employees, who themselves purchased some of the selling Utes's shares, did not disclose to the Ute sellers the existence of the higher priced white market. When some of the selling Utes found out, they sued the bank and its employees (and also the United States, arguing it had some responsibility to restrain the Utes from selling their shares; but the Court ruled in favor of the U.S.).
The Court decided that the bank and its two employees were liable under the SEC's antifraud rule, 10b-5, for failure to disclose the existence of the two-tiered market the two employees had created. The two employees had actively encouraged non-Utes to buy, and received commissions and other compensation for sales to non-Utes. The Court held them and the bank liable even though the two employees made no affirmative representations or recommendations to selling Utes. The bank employees were deemed responsible because they had "facilitate[d] the mixed-bloods' sales to those seeking to profit in the non-Indian market the defendants had developed and encouraged and with which they were fully familiar." 406 U.S. at 153.
In the Affiliated Ute case, the bank and its two employees were not formal underwriters or broker-dealers. But they informally structured transactions so that selling Utes were unknowingly at a disadvantage. That, in the view of the Court, made the defendants liable for failure to disclose as required by the antifraud requirements of Rule 10b-5. The Court's imposition of Rule 10b-5 liability on the bank and its employees for their actual conduct, and not their contractual status (as transfer agent), is in keeping with the rule's purpose as a catch-all provision to guard against the inventiveness and creativity of fraudsters.
While there are differences of fact between Affiliated Ute and the SEC's case against Goldman Sachs, the basic principle of Affiliated Ute is problematic for Goldman. It created ABACUS 2007-AC1, in a way that some evidence indicates was slanted to favor the short side because of the substantial role in selecting the collateral played by John Paulson & Co., the short seller that commissioned Goldman to created this synthetic CDO. Even though Goldman evidently did not recommend buying to the investors on the long side, the Court in Affiliated Ute did not require affirmative recommendation or representation before applying liability. Following the Court's reasoning, Goldman, as a key participant in creating the CDO, should have disclosed to long investors the information indicating that ABACUS 2007-AC1 could be rigged in favor of the short investor.
The derivatives market, circa 2007, was an opaque, informal, heavily negotiated market. Even sophisticated investors didn't have much in the way of objective reference points to measure potential investments. Specific information is always more important than sophistication. Lots of sophisticated people ripped off by Bernie Madoff wouldn't have invested if he had, as required by law, disclosed what he was really up to. The Great Recession began as a result of idiocy in the derivatives markets and we taxpayers, workers, homeowners and citizens are still struggling to recover. All of us have a stake in the integrity, fairness and soundness of the derivatives markets.
Did Goldman Sachs Really Lose $90 Million from the CDO It Constructed for Paulson?
Goldman Sachs claims it lost $90 million from holding a piece of the synthetic CDO that it constructed for John Paulson & Co., a transaction now famous as the subject of the SEC's recent enforcement action against Goldman. Can we take this claim of a $90 million loss at face value? Goldman has persistently asserted it was well-hedged against AIG risk, and didn't need the billions it garnered when the U.S. Treasury bailed out AIG's creditors for 100 cents on the dollar. One wonders why Goldman, if it were a good corporate citizen dedicated to doing God's work, didn't decline the money it didn't need, especially when so many middle class taxpayers are badly stretched. But on Wall Street, money talks and good deeds walk. It's fine if John F. Kennedy declined his presidential salary because of his family's wealth, but Wall Street isn't in Camelot.
Considering how well Goldman supposedly was hedged against AIG risk, it's hard to imagine it wasn't hedged against the decline in the mortgage markets. After all, e-mails quoted in the SEC's charges make clear that Goldman expected that decline. And Goldman evidently greatly reduced its overall exposure to real estate and mortgages even before and while it put together ABACUS 2007-AC1. From a risk management standpoint, one would expect that when Goldman unexpectedly got saddled with a piece of the ABACUS deal, it would have hedged itself. Certainly, it wouldn't have knowingly carved out a piece of its risk profile and left its interest in ABACUS 2007-AC1 naked long. So did Goldman really lose $90 million? Its accounting and risk management records might make for interesting reading in this regard.
If Goldman was in fact hedged against its ABACUS exposure, or was able to take advantage of general hedging in the mortgage and real estate sector to offset its ABACUS losses, then its claim of a $90 million loss could be false or misleading. Ordinarily, $90 million, more than lunch money to most people, ain't squat sit to Goldman Sachs. But Goldman's vaunted reputation is on the line. Claiming this $90 million loss as an indication of its innocence, if there really isn't such a loss, just might step over the line. The SEC has sanctioned a public company for making a misstatement in connection with its defense of an investigation. See SEC Press Release No. 2004-67 (May 17, 2004)(captioned, "Lucent Settles SEC Enforcement Action Charging the Company with $1.1 Billion Accounting Fraud"). Given how Goldman's stock has gyrated with the back and forth among news stories about the case, a misstatement by Goldman about the strength of its defenses could conceivably step over the line and itself be potential grist for the SEC's enforcement mill.
Back to hedging. A fun question might be to ask what Goldman, as a market maker, did with the RMBSs that related to ABACUS 2007-AC1. Goldman, like other large banks active in the mortgage business, might have made markets in those RMBSs. The SEC complaint alleges (and essentially all news sources agree) that the RMBSs underlying ABACUS 2007-AC1 dropped in value very quickly after the deal was done, hammering the long side of the deal. If Goldman was a market maker in some or all of these RMBSs and dropped its quotes muy pronto, one would have to wonder why it was so unafraid of imposing losses on its own holdings in the ABACUS deal. The answer could well be that it was well-hedged on ABACUS and dropped its bids because it didn't want to buy doggy RMBSs from someone else trying to hit its bids.
Although the derivatives markets were, and still are, murky on the best of days, records of Goldman's quotes may exist in documentation maintained by institutional investors who were seeking market valuations for accounting purposes. Big compilers of market data like Bloomberg and Reuters may also have relevant information. Of course, Goldman should have records of its own quotes. But independent verification would be de rigueur, now that the parties are dancing in federal court. The discovery process (i.e., the process in litigation of collecting and exchanging evidence) in SEC v. Goldman is likely to begin presently. Perhaps the SEC's litigation team will find some interesting stuff.
The SEC's fraud case against Goldman Sachs, and Goldman's defense, reflect competing views of the way federal regulation of the financial markets should work. While we have no inside information about how either party plans to argue its side of the case, the information that's already public indicates the lay of the land. Goldman contends that it gave "extensive" disclosure to "sophisticated" investors and they should thereafter be held responsible for themselves. The SEC's argument is Goldman's defense doesn't address the way investments are sold in the real world and that, in reality, Goldman misled investors.
A central theme of the securities laws is disclosure--public companies, broker-dealers, mutual funds and a variety of other players are required to make disclosures prescribed by SEC rules. These disclosures can sometimes be extensive, and Goldman claims to have made extensive disclosures to its customers. The interests in the synthetic CDO in question (ABACUS 2007-AC1) were privately sold and it's unclear what disclosures were actually made. But Goldman claims that the investors pretty much knew what mortgage-backed securities the CDO would be based on and that an independent agent, ACA, selected those MBSs. It contends that the investors were sophisticated and able to decide for themselves how risky these investments were.
The SEC's case is that, however much Goldman may have spoken in its disclosures, it didn't speak the complete truth. Part of the SEC's version of the truth would be that John Paulson & Co. had a large role in the selection of the collateral, that Goldman slyly cultivated a contrary impression in the minds of investors, and that investors knowing the reality of Paulson's involvement would have been reluctant to buy the long side of the transaction.
The SEC's case appears to hark back to the 1930s, 40s, 50s and 60s, a foundational period of time in which the broad contours of the securities laws were shaped. This was a time when knowledge of investments and the financial markets was much more tightly held than is the case today. There was no Internet, no electronic trading systems and no electronic reporting of securities transactions (except the legendary but not terribly informative ticker tape, which was simply a very long telegram). Many stocks and bonds were traded by telephone, or in face-to-face transactions at bank counters (hence the term, "over-the-counter"). Investors relied heavily on financial professionals to deal fairly and squarely with them, because they had few, if any, other sources of information. When you think it about, it's similar to today's derivatives market.
It is axiomatic that the more opaque a market is, the easier it is to sell snake oil. The snake oil business was vibrant in the financial markets of the 1930s, with investors snake bit early and often. The SEC developed a doctrine of law called the "shingle theory." This theory postulates that when a broker-dealer hangs out its shingle to do business, it impliedly represents that it will deal fairly with its customers. An early decision affirming this theory is Charles Hughes & Co. v. SEC, 139 F.2d 434 (2d Cir. 1943), in which a broker-dealer was deemed to have violated the law by overcharging customers (by as much as 40% over market prices). The shingle theory has primarily focused on the pricing of securities, and limits the so-called "markup" a broker-dealer may charge a client. A more recent decision in this vein is SEC v. First Jersey Securities, Inc., 101 F.3d 1450 (2d Cir. 1996). In other words, the shingle theory isn't just a disclosure theory; it has substantive effect, limiting the pricing latitude of broker-dealers in the over-the-counter market. Although the SEC's case against Goldman isn't about prices, the shingle theory's premise--that a broker-dealer has a duty of fair dealing--provides support for the SEC's position that in an opaque market like the CDO market, Goldman isn't a mere intermediary, but has an obligation of fair dealing.
Another foundational case is United States v. Simon, 425 F.2d 796 (2d Cir. 1969). The president of a company called Continental Vending Machine Corporation borrowed a lot of the company's money in order to play the go-go stock market of the 1960s. He did not reveal to shareholders his use of the company's funds as a personal piggy bank, instead routing the funds through a corporation he controlled so that Continental's records did not show he was the true recipient of the money. The stock market of the 60s was every bit as volatile as today's stock markets, and the president's personal investments belly flopped. He had no other means to repay the loans and Continental was left insolvent. The way the president siphoned off the money allowed the company, under the accounting rules prevailing at the time, to present its financial condition as solid. Defendant Simon, an accountant who audited Continental's financial statements, knew of the president's hidden loans but didn't reveal them when he certified Continental's financial statements. Even though the company's financials complied with the applicable accounting rules, the court nevertheless held Simon criminally liable for his silence. It observed that " . . . it simply cannot be true that an accountant is under no duty to disclose what he knows when he has reason to believe that, to a material extent, a corporation is being operated not to carry out its business in the interest of all the stockholders but for the private benefit of its president." It described Simon's certification of Continental's financials as a "snare and a delusion." Thus, Simon, the auditor, was held to be a crook because he didn't disclose how the president had secretly ruined the company, even though the company had followed the accounting rules. In plain English, complying with the stated rules isn't enough when there's a larger truth that remains undisclosed.
Of course, there are differences between the roles of auditors and broker-dealers. But both serve as gatekeepers to the securities markets. Without auditors willing to certify their financial statements, companies could not go public. Without a broker-dealer willing to put together ABACUS 2007-AC1, John Paulson wouldn't have had an opportunity to take the short side of its collateral pool. He paid Goldman $15 million to put the deal together and played a large de facto role in choosing the collateral. Goldman evidently thought that the selection of the collateral had to appear objective to investors--the SEC complaint alleges that Goldman was very particular that ACA was necessary as the collateral manager to make the deal appear on the up and up. ACA wanted to know what Paulson's role was, and, according to the SEC, Goldman slyly implied that Paulson would take an equity position on the long side of the deal instead of revealing that Paulson was looking for a shorting opportunity. In essence, the SEC alleges that Goldman tricked ACA into acting as the collateral agent.
U.S. v. Simon indicates that even if Goldman made extensive disclosures to the investors, the fact that it did not reveal the larger picture of Paulson's role might have been improper. The SEC's allegations that Goldman made affirmative statements that misled ACA or investors would, if true, only compound Goldman's litigation risks, since they imply Goldman intentionally painted a false picture.
As to intentions, the SEC has an advantage. It charged Goldman and Fabrice Tourre with violations of Section 17(a) of the Securities Act of 1933, as well as violations of the SEC's all-purpose, utility infielder antifraud rule, 10b-5. To prove a violation of Rule 10b-5, the SEC must establish that Goldman and Tourre acted with scienter, a legal term for bad intent. The need to prove bad intent can sometimes be a challenge, depending on the facts of the case (although there seem to be colorful e-mails in the SEC's possession that will give it a shot at proving scienter in this case). Section 17(a) violations, however, can sometimes be established without the SEC having to prove any bad intent. See Aaron v. SEC, 446 U.S. 680 (1980). Even if the SEC cannot prove that Goldman and Tourre had bad intent, they may still found liable for securities fraud.
There is a thread in the SEC's Complaint indicating that Goldman itself believed that the mortgage market was, at the time it marketed ABACUS 2007-AC1, likely to tank. The facts here don't seem as extreme as those in the SEC's 2003 case against various underwriters for selling stocks that the brokers themselves thought were lousy investments. See the SEC's press release on April 28, 2003 (http://www.sec.gov/news/press/2003-54.htm). Goldman apparently didn't formally recommended ABACUS 2007-AC1. But if it is true that Goldman was negative on the mortgage market while selling the deal to long side investors, that would only add to the aura of cynical sleaze.
The case appears to be the SEC's effort to deal with the reality of the derivatives markets. These markets, circa 2007 when ABACUS 2007-AC1 was constructed and marketed, were understood in depth by only a small circle of cognoscenti, and perhaps not even all of them. The SEC alleges that Tourre in one e-mail referred [in translation] to " . . . standing in the middle of all these complex, highly leveraged, exotic trades he [i.e., Tourre] created without necessarily understanding all of the implications of those monstruosities [sic]!!!" (As an aside, Tourre could have legal liability if he marketed investments he didn't understand because brokers are supposed to understand the products they peddle to clients.) Most investors in this market likely relied, to varying degrees, on the perceived interests and reputations for integrity of the parties in the picture. However skillful and knowledgeable money managers and corporate treasurers may be, the fact is that detailed information about the esoterica of the derivatives market would not have necessarily been available to them, if only because they might not have even known what questions to ask. Thus, they would have been interested in the identities and roles of relevant players.
Remember, Bear Stearns and Lehman were sophisticated but they failed. Merrill Lynch and WaMu were sophisticated but they had to be sold in distressed circumstances. AIG was sophisticated, but it blew itself up. Even Fannie Mae and Freddie Mac were pretty sophisticated, but they are now wards of the state. Sophistication is no substitute for specific information. Lots of very intelligent people buy a stock because Warren Buffett bought the stock. Few would short it. And those decisions would be made without a whole lot of reference to the stock's "objective" merits. If you were a derivatives investor and learned that John Paulson was a de facto short side co-venturer with Goldman in ABACUS 2007-AC1, you might well have accidentally dropped the phone if Fab Tourre tried to pitch you the long side of the deal. Certainly, there are some people who wish they had.

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