April 16, 2010
SEC v. Goldman: Why this case?
Posted by Erik Gerding

Earlier today, the SEC brought a 10b-5 and Section 17(a) claim against Goldman Sachs (and a GS employee) for its role in structuring and selling to investors a "synthetic" collateralized debt obligation (“CDO”). At first blush, this case looks to take on a practice of Goldman and other banks that has been widely criticized in the media – selling asset-backed securities (ABSs) to investors then using credit default swaps to profit should those securities default. Which has been likened to a doctor taking out a life insurance policy on a patient.

A closer examination of the facts asserted in the press release suggests that the SEC carefully chose a test case. An underwriter that sells ABSs has a stronger argument that buying credit default swaps (which would pay out should the ABSs default) is legitimate when the underwriter is holding on to some of those ABSs. The credit default swap then looks like a legitimate hedging of risk (and some believe that we want to encourage underwriters to hold part of an offering to retain some “skin in the game.”) In other words, the doctor is taking her own medicine, and the life insurance policy covers her own life.

But, based solely on the SEC’s allegations, that is not what happened here. The allegations are that a large hedge fund, Paulson & Co., pushed Goldman to sell a CDO to investors. The hedge fund allegedly (a) played a large behind-the-scenes role in helping Goldman structure and select the assets (collateral) that backed the CDO, and then (b) bought a number of credit default swaps that “shorted” the CDO. The SEC alleges that Goldman told neither investors nor the CDO’s collateral manager (akin to the investment manager for the CDO) of Paulson’s role in selecting assets or its short position – which would suggest a conflict of interest. It is hardly shocking that a securities law case boils down to disclosure.

A few other interesting tidbits from the SEC. The CDO involved is a “synthetic” one. Unlike many asset-backed securities transactions, in which the investment vehicle actually purchases cash producing assets (like mortgages, bonds or other ABSs), in a synthetic transaction, the investment vehicle enters into credit default swaps and other derivatives to mimic what it would be like actually to hold a real portfolio of cash-producing assets.  (Partnoy & Skeel have a good discussion of synthetic CDOs). 

Would this make a difference in litigation? Arguably no; it shouldn’t matter what the CDO actually invested in as long as “it” was accurately described. But a court may struggle with the synthetic nature of a CDO – either because of a suspicion that there is more room for abuse when there are derivatives coming in and derivatives coming out or because of a gut reaction that there is not a socially productive investment at stake. Non-synthetic ABSs theoretically perform the functions of spreading credit risk from borrowers (like homeowners taking out a mortgage), while funneling credit back to those borrowers. Synthetic ABSs look more like pure gambles.

It is important to note that all of the foregoing are from the SEC’s statements. Let’s see if the SEC’s version of the facts holds up. Everybody should get their day in court, even institutions Rolling Stone writers hate.

Correction and clarification: According to the SEC Complaint, the collateral manager, ACA, knew of Paulson's role in selecting assets for the CDO, but did not know Paulson & Co was betting against the CDO.  Rather, ACA was led to believe the hedge fund was investing in the CDO.

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