Sunday, April 18, 2010

Are Fraud Allegations by the SEC the Final Nail in the Cross for Goldman?

Sources:
U.S. Securities and Exchange Commission press release: SEC Charges Goldman Sachs with Fraud in Structuring and Marketing of CDO Tied to Subprime Mortgages;
New York Times: For Goldman, a Bet’s Stakes Keep Growing;
Reuters: Germany, UK Demand Goldman Sachs Probe;
Reuters: SEC Finally Lights Fire Under Goldman Smoke;
Fox Business: SEC Charges Goldman Sachs with Fraud.

On Friday, April 16, the U.S. Securities and Exchange Commission (SEC) charged Goldman Sachs and Fabrice Tourre, the company’s vice president of mortgage operations, with defrauding its investors. The SEC is the federal agency in charge of regulating the U.S. securities market. Essentially, the SEC complaint, filed in the U.S. District Court for the Southern District of New York, alleges that in 2007 before the housing market collapse, Goldman Sachs, under the direction of Mr. Tourre, marketed and sold collateralized debt obligations (CDOs) to investors knowing that the company that had bundled the mortgages for the sale had a vested interest in seeing those mortgages fail.

A CDO is an investment security that is backed by a pool of assets, in this case, backed by subprime residential mortgage-backed securities (RMBS). This means that instead of being a simple asset, bought and sold in the market, CDOs are essentially an asset made up of promised money. The SEC’s complaint alleges that Goldman Sachs allowed Paulson & Co., a hedge fund, select the compilation of mortgages that comprised the CDO while that hedge fund had simultaneously bet on the failure of that CDO in the market, a process known in market terms as “short-selling.” The SEC claims that Paulson & Co. made $1 billion in the short sale of this particular CDO, and that they paid Goldman $15 million to structure the product. The fraud, according to the SEC, was in Goldman’s misrepresentations to its investor-clients that the RMBS portfolio underlying the CDO had been chosen by a well known expert in assessing RMBS credit risk, rather than Paulson & Co. Paulson has not been charged with regard to this matter.

Goldman made a statement on Friday indicating that the company would fight the “unfounded” charges. The complaint comes at a sticky time for Wall Street, as the Obama Administration has, in recent months, been pushing for broad financial reforms to the banking sector. Some say that a scandal like this will mount significant political pressure on those who are still opposed to reform of the financial sector.

If found guilty, Goldman could be required to forfeit all profits from the fraudulent transaction with Paulson, and could be subject to additional civil penalties. However, repercussions for Goldman could prove to be far more extensive. On Friday after the announcement of the SEC’s allegation, Goldman’s shares dropped 12.8 percent, resulting in a loss of around $12 billion in market value. There is also the possibility that, should Goldman be found guilty, hoards of investors who lost money in the financial crisis could be inspired to bring suit for similar damages. So far, the SECs allegations have encouraged special investigations to begin in both Germany and the UK.

Discussion Questions:
1. Is there any advantage to charging only one mid-level executive in such a large scandal if you are the SEC? Is a possible that this was a strategic move? Consider whether the allegations become easier to prove if the government can cut a deal with Mr. Tourre to testify as to his involvement.

2. According to the New York Times article, Goldman Sachs would usually settle a case such as this, but has chosen to defend itself vigorously at the outset. What are the advantages to settlement in such a case? What are the disadvantages? Consider the transaction costs associated with litigation and the high price of a guilty verdict for Goldman.

3. From the complaint, it sounds as though Paulson & Co.’s actions caused intentional harm to investors. Why do you think the SEC did not charge the hedge fund for its role in the events? Did Paulson have a duty to the investors?

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