April 17, 2010
The Goldman Case: Gambling and Who Selects the Cards in the Deck
Posted by Erik Gerding

As I posted yesterday, the legal case against Goldman boils down to disclosure, particularly to this question:

“Did Goldman have to disclose to investors in the ABACUS CDO that the Paulson hedge fund, who was shorting the CDO, was involved in selecting the collateral?”

Listening to the radio last night, I heard a number of commentators talk about how investors should have known that there were investors – including Paulson -- out there that would buy credit default swaps and bet against their CDO investments. When you gamble, you should assume someone will bet against you. The question in this case is whether you should be told that that this gambler betting against you selected the cards in the deck.

Would a reasonable investor want to know who picked the cards in the deck?

My guess is that a reasonable investor would indeed want to know that Paulson was involved in selecting the deck. What’s the support for this beyond the SEC’s Complaint? Look at the “flipbook” for the transaction provided to investors by Goldman (posted on the NY Times). It goes on at length of why ACA is a good collateral manager for the CDO. On p. 27, it includes a bullet point “Alignment of Economic Interest.” The SEC complaint zooms in on this little nugget (see Complaint Para. 38). (Note to law students: bullet points in “powerpoint” style are not only bad devices to communicate ideas, they have some itty bitty securities law problems when used to market securities. If you can’t formulate something in a complete sentence, try again.) Nowhere does the flipbook mention that the Paulson hedge fund was involved in selecting the collateral for the CDO.

Hurdles for the SEC

Does this mean the SEC has a slam dunk case? No; they have plenty of other legal hurdles. [More after the break]

For starters, even though Paulson’s role in selecting the deck wasn’t disclosed to investors, the deck itself likely was. In other words, investors probably were told of the assets put into the CDO (I can’t say for sure, since I have not seen the prospectus given to investors, but would be shocked if it didn’t disclose in some detail the “reference assets”). This disclosure might lessen the importance of disclosing Paulson’s role in selecting the assets.

ACA’s role

A large chunk of the SEC Complaint focuses on the fact that ACA was duped into thinking that Paulson had invested in the CDO and was not betting against it. This section of the complaint highlights that the SEC needs to downplay the ACA’s ultimate responsibility for the collateral. The SEC’s argument goes like this:

1. ACA did not know Paulson was betting against the CDO. It thought Paulson was investing in the CDO.

2. If ACA had known that Paulson was betting against the CDO, it would not have acted as collateral manager (largely because its reputation would suffer because it would be seen as picking cards that would hurt the CDO investors).

3. If ACA had not acted as collateral manager, investors (like the German bank IKB) would not have bought the securities.

Goldman will likely try to saw away at each of the links in this chain. I am assuming that the SEC is not making these statements out of thin air, but has the cooperation of ACA and IKB. How well will these allies do in depositions? Did ACA really not know (or should it have known) that Paulson was not investing in, but betting against the CDO? Other commentators have noted that Paulson was becoming famous on Wall Street for betting against mortgage backed securities. The assertion that ACA didn’t know of Paulson’s bet may be a weak spot in the SEC case.

Causation and damages after Freefall

In a 10b-5 case, my Business Associations 2 students can tell you that the SEC still has to prove various other elements beyond whether the disclosure was materially misleading. Causation and damages might prove particularly tricky. The SEC focuses in the complaint on the number of the ABACUS CDO bonds that were downgraded. Downgrades don’t give us a sense of monetary damages. True – the complaint later mentions that the IKB lost most of its $150 million investment.

This looks a little grim for GS, but one big question is about “the baseline.” In other words, “shouldn’t we subtract market-wide losses from damages?” As the SEC Complaint notes, the ABACUS CDOs lost in value in the midst of market-wide losses in asset-backed securities tied to mortgages. Analyzing elements like causation and damages is extremely tricky during market-wide crashes. But not impossible – (see Lev & de Villiers, Stock Price Crashes and 10b-5 Damages: A Legal, Economic, and Policy Analysis, 47 Stan. L. Rev. 7 (1994) for an one, older treatment of this question.) Analyzing causation and damages would be greatly complicated if the market for a given class of security is frozen – with very few buyers.

What should investors be charged with knowing about the risk?

Many commentators asked whether the investors in the ABACUS should have known that the securities they were buying were extremely risky. Again, lots of mortgage-backed securities plummeted in value. This case is noteworthy for how late the ABACUS deal closed – April 2007, when the subprime real estate, mortgage-backed security, and ABS markets were already wobbling hard. That was pretty late in the game of musical chairs to be starting another dance.

Goldman will likely use this particular argument – investors should have known the general risks in these securities -- in multiple doctrinal places in the litigation – not just causation and damages.

Usha’s post reminded me of the 2003 opinion by Lewis Pollack in In re Merrill Lynch, in which Judge Pollack (known as a securities law expert) dismissed claims against Merrill Lynch, Henry Blodgett and others in one of the internet stock analyst cases because the collapse of the internet bubble was an intervening cause of the plaintiff’s losses. [My name is Erik. I’ve been addicted to studying bubbles and financial regulation for 8 years.]

Pollack’s particular ruling may not apply to this case, but it underscores that courts are not always sympathetic to investors investing in risky securities during boom times. The countervailing position is that issuers, underwriters, and others should bear responsibility for hidden practices that made the securities more risky. Claiming that a bubble occurred doesn’t necessarily mean that investors should bear losses because they were Tulipmaniacs; issuers and bankers often play a big role in blowing up a bubble.

Facts not overly general normative assertions should govern. Nevertheless, it is hard to escape normative judgments in the messy allocation of losses between investors and market players in the aftermath of a boom and crash. It is far easier to ask who is the “cheapest cost avoider” than to come up with a value-neutral answer. Answers usually have much to do with gut reactions and where you fall on an ideological spectrum.

A close look at the "investors"

Enough generalities, let’s go back to the Complaint – particularly the discussion of the Investors. IKB seems like a solid witness for the SEC. ACA, as mentioned above, less so. The Complaint details not only ACA’s role as collateral manager, but its parent, ACA Capital, as an investor that lost money. But ACA Capital is not your usual investor that lost money. It lost money when it issued a financial guaranty to some of the ABACUS investors. Essentially, ACA Capital wrote an “insurance policy” and would not have done so had it known that Paulson was betting against not investing in the CDO. But how did they not know? The timing in paragraph 62 of the complaint is odd. ACA Capital issued the guaranty in May 2007 – a month after the CDO closed. They didn’t have access to the list of investors in the CDO? They didn’t check that Paulson & Co wasn’t included? Did some firewall between the collateral manager ACA and the parent prevent them from putting two and two together? Did ACA Capital think Paulson invested in the CDO?

ABN Amro is also listed as an “investor,” because they entered into a series of credit default swaps under which they basically guaranteed ACA Capital’s guaranty. I buy a little more that ABN Amro had no reason to know of Paulson’s involvement.

Paragraph 66 is interesting too. What it looks like is that when Goldman sold the credit default swaps to Paulson (in which Paulson was betting against the CDO), Goldman hedged itself with the credit default swaps with ABN. Goldman sold the swaps to Paulson, but may not have taken any risk itself. According to the Complaint, ABN’s payment on the swaps mostly went to Paulson. Framing IKB as an “investor” is straight forward. ABN is not: it will be interesting to see how 10b-5 and 17(a) antifraud protections apply in this case when the “investor” is an OTC derivative counterparty, not a purchaser of the securities. (For example, 10b5 claims must involve the "purchase or sale" of securities).

Bigger picture questions

This last point raises some bigger picture issues for legal scholars. Securities law and the SEC has come a long way from the image of protecting mom & pop investors from sharp practices. As financial markets have been institutionalized and institutional investors have assumed a larger role (see Langevoort), how will the SEC’s role change? How should it?

You can make a strong case that protecting institutional investors benefits not only their beneficiaries (like pensioners), but also the small fry retail investors. But protecting institutional investors does not always translate into protecting mom & pop. Moreover, when you are protecting “big kids” in the playground, when do we let them fight for themselves and make their own mistakes?

The outcome of this case will also have much to say about the viability of Goldman’s business model (and the model of other conglomerates) to have their fingers in many different pots – and to play many different angles in the same transaction. But if the potential for conflicts of interest is a chief concern, let’s not think of litigation as anything other than a very poor substitute for regulation.

On another note, I often relish finding ways in which market players could get caught up in conflicting arguments. Here is one to watch for: many Wall Street executives have claimed “we could not have foreseen this.” Will this come back to haunt them in litigation when the lawyers claim that investors should have been on notice about risky securities? These mixed messages may create more political than legal problems. But then again, many commentators, like Larry Ribstein, have contended that the Goldman suit may be more about firing a salvo in the financial regulatory war – and putting Wall Street on the defensive as regulatory reform heats up -- than just the facts of this case.

The Question you’ll get asked at a party: Why didn’t the SEC go after Paulson & Co.?

The short answer is that – maybe it could have, but that would have made the case much harder to win. This case is about disclosure and Paulson didn’t say anything to the CDO investors and didn’t owe them any fiduciary duty to disclose. Perhaps the SEC could have brought a 10b-5 claim against Paulson on a “scheme” theory, but they may not have the evidence to do so. The Complaint doesn’t say Paulson intended to deceive the ABACUS investors. The hedge fund would likely take the position - “We were looking for an investment, so were the CDO investors. We didn’t create a “scheme” to defraud anyone and it was Goldman or the issuer’s job to disclose to investors.”

Perhaps the hedge fund employees were also smarter in what they put in e-mails than the 31 year old Goldman employee defendant. The SEC may also want to enlist Paulson in the case. Here is something else that may sound semi-smart to say at the party:

“Goldman may have more pressure to settle given that they have more of a reputational stake to lose with clients in their various businesses, they are much more heavily regulated than Paulson, and they may be even more regulated if financial reform gets any traction.”

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