In an earlier post, I wrote that the crux of the issue in the Goldman case, was whether Goldman had to disclose the Paulson hedge fund's role in selecting collateral for the CDO. Let me refine that now. Goldman will argue that ACA, the collateral manager in the ABACUS CDO, bore ultimate responsibility for picking the collateral. This is why one key battle will ultimately be whether Goldman deceived ACA.

Here’s a quick explanation:

In my last post, I argued that an insightful paper supports that investors in CDOs may not fully protect themselves against lemons even if the collateral for the CDO is fully disclosed. The structuring of the CDO may allow the sponsor to hide “lemons.”

So what do investors do? One solution is to rely on the reputation of the collateral manager – a party that acts as a kind of investment manager and selects collateral for the CDO.  To reassure investors, the collateral manager is independent from the underwriter or the originator/issuer of the bonds, loans, and other collateral that are being fed into the CDO box. Of course, the collateral manager could collude with the parties sponsoring and structuring the deal to hide “lemons,” but would lose its reputation for integrity (and could incur legal liability).

This is why the issue of whether Goldman deceived ACA is so critical. If ACA was told that it should pick certain assets, it would want to know whether the person making the request had an adverse interest to investors. To switch metaphors: ACA was helping a bunch of investors (including, ultimately one of its affiliates) place bets on horses. The SEC is alleging that Goldman told ACA “The investors you are working for want you to pick Horses A, B, and C” when it was actually another gambler who asked ACA to place those bets because he was betting for those horses to lose. The SEC is equating deceiving ACA with deceiving all the CDO investors.

Here is my own bet – if the SEC can show Goldman misrepresented Paulson’s role to ACA, it wins (even with all the other hurdles I mentioned previously). Here is what leads me place this bet: the Goldman press release responding to the SEC Complaint asserts that Goldman never represented to ACA that Paulson was investing in the CDO.

The messiness comes if Goldman didn’t exactly say that Paulson was investing in the CDO, but didn’t exactly say the hedge fund was shorting it either. In fact, paragraphs 44-51 of the Complaint, which talk about ACA being misled by Goldman into believing Paulson would be an equity investor, don’t contain any evidence of direct statements by Goldman to this effect. Rather, it looks like ACA believed that Paulson would invest in the transaction and the Goldman employee may have been aware of this. So the question was did Goldman’s statements, actions or silence rise to the level of misleading ACA?

Now if ACA knew or should have known that Paulson was on the other side of the transaction, is the SEC case sunk? It would be severely wounded, but maybe not dead – arguably other reasonable investors would still have wanted to know of Paulson’s role in selecting the collateral and its adverse interest. A Goldman argument that ACA’s interest and skill in protecting investors obviated the need for disclosure to other investors of Paulson’s role is by no means ironclad. Even if ACA was not being deceived, reasonable investors might want to know if it was selecting collateral on its own or negotiating with an adverse party. But that would be a less earth-shaking disclosure problem.

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