The Securities and Exchange Commission’s civil fraud suit against Goldman Sachs that shook Wall Street stands in sharp contrast to the agency’s many blunders in failing to stop the $50 billion Ponzi scheme of Bernard Madoff.
The complaint filed against Goldman Friday contained a meticulous narrative of a highly complex deal, but also included the crowing e-mails of a young Goldman executive who allegedly allowed a hedge fund client to stack the package with risky home mortgages. The hedge fund, Paulson & Co., secretly reaped a $1 billion profit by betting against the deal at the expense of other investors, the suit said.
Even the agency’s news release announcing the Goldman suit was infused with “a condemnatory tone that we have not seen coming out of the SEC for almost a decade,” since the end of the Clinton administration, said James Cox, a Duke University law professor who specializes in securities.
“The release is very judgmental about the conduct, almost scolding … and those releases get done at the highest level,” he said.
The message: The SEC is back on the job.
By way of comparison, in the case of Madoff’s Ponzi scheme, the SEC failed to act on repeated tips that Madoff was cheating his investors.
Cox said that the Goldman case also represents a departure from what he called a “third-down punt” as it meekly settled a suit in February against Bank of America over disclosure issues surrounding its acquisition of ailing investment bank Merrill Lynch.
In the Bank of America case, a judge threw out the initial settlement as inadequate and later denounced the agency for “half-baked justice” in approving a $150 million settlement over BofA’s concealment of Merrill’s losses and pre-merger agreement to pay its executives huge bonuses.
The SEC brought its case against Goldman, Wall Street’s biggest player, just three months after its enforcement director, Robert Khuzami, appointed heads of five new investigative units. One of the units focuses on “structured products,” such as those in the Goldman deal and hundreds of others engineered by Wall Street from 2001-2007.
The unit’s chief, veteran agency attorney Kenneth Lench, has been hiring non-lawyer financial experts.
Ironically, the sagging economy has put the agency in a position to recruit the kind of talent that it will need to disentangle complex deals and hold the financial industry accountable for ruining the global economy, said Elizabeth Nowicki, a former lawyer in the SEC’s general counsel’s office who is a visiting law professor at Boston University.
Because of the decline in initial public offerings on Wall Street, some SEC divisions are underworked and available to help, she said. Meantime, “really competent qualified corporate lawyers have been laid off from the Wall Street firms, and the government has money to pay these lawyers.”
Cox said the case against Goldman shows that the agency “is capable of putting together a very strong team of investigators and enforcement personnel to put together these facts and unravel them.”
The agency also could be aided in the Goldman case by an appeals court ruling two years ago that that lays responsibility on companies to avoid communicating “half-truths” that might mislead investors, he said.
The suit accuses Goldman and Fabrice Tourre, one of its structured products vice presidents, of creating a synthetic deal for the purpose of letting Paulson & Co. bet on a sharp decline in the housing market. The investors didn’t buy any securities in the deal, known as ABACUS-07-AC1, but instead wagered on the performance of an agreed-upon bundle of risky subprime mortgages.
Tourre is accused of allowing Paulson to recommend scores of highly risky mortgages to an outside firm hired to manage the deal, ACA Management LLC, without telling ACA that Paulson would be betting on their default. During the negotiations over which securities to select, ACA at one point asked Goldman why Paulson had kicked out several loans initiated by Wells Fargo, a lender with stronger underwriting standards than the industry’s, the suit said. ACA itself became a victim of the scheme.
A German bank, IKB, and an ACA affiliate, ACA Capital Management, together invested more than $1 billion in the deal and lost nearly all of it, it said.
Goldman, which marketed numerous synthetic deals based on subprime mortgages, has denied the charges and vowed to “vigorously” fight them. It said that ACA had the final say on what securities were selected and it never told ACA that Paulson planned to bet that the securities would perform well.
The suit, however, says that ACA never knew that Paulson bet “short,” or against the securities.
Cox said that the suit is likely to trigger a spate of private lawsuits against Goldman and predicted that the company will try to resolve the matter by seeking “a global settlement in which Goldman Sachs will neither admit nor deny responsibility in all of these transactions.”
Goldman, he said, “can write a big check.”