April 21, 2010
The Goldman Case: When is a misimpression materially misleading?
Posted by Erik Gerding

As I wrote before, one of the most important legal issues in the Goldman case is whether Goldman misled the collateral manager ACA into thinking that Paulson was investing in the CDO and not betting against it.

Why does it matter?  Because as "Goldman's defense documents" make clear, ACA and the CDO investors were sophisticated investors able to "negotiate forcefully at arm's length" with Paulson.

But to bargain at arm's length you need to know that is what you are doing.  In other words, you need to know if the party who is making requests to you ("I want this collateral - not that.") is on your side or not.  Paulson was either short or long.  He was either with ACA or against it.  (Even if Paulson was engaging in a funky investment strategy of going short some tranches and long others, ACA would still want to know that it had to bargain at arm's length).  If ACA thought Paulson was on its side, it would have had a much different attitude towards its requests on collateral than if it thought Paulson was betting against the CDO.  "Are you cherry picking and trying to give me bad assets?" vs. "are you sure "we" (our side) wants this?" 

Did Goldman mislead ACA into thinking Paulson was "long"?  The documents described in the complaint are painfully ambiguous.  Consider the following paragraph from the Complaint

On January 10, 2007, Tourre emailed ACA a "Transaction Summary" that .included a description of Paulson as the "Transaction Sponsor" and referenced a "Contemplated Capital Structure" with a "[0]% - [9]%: pre-committed first loss" as part of the . Paulson deal structure. The description of this [0]% - [9]% tranche at the bottom of the capital structure was consistent with the description of an equity tranche and ACA reasonably believed it to be a reference to the equity tranche. In fact, GS&Co never intended to market to anyone a "[0]% - [9]%" first loss equity tranche in this transaction.

Is that Goldman misleading ACA into thinking Paulson was investing into the CDO not betting against it? Does "pre-committed first lost" suggest that Paulson was investing in the CDO (ie "going long").  Read the paragraph again.  It doesn't exactly say Paulson would invest in the "pre-committed first loss."

Goldman employees could not have gotten too cute though without violating the securities laws. 

If they knew ACA was under the misimpression that Paulson was on the CDO investor side, Goldman couldn't just keep silent.  Why?  Because I think a pretty strong argument can be made that a reasonable CDO investor would find it material that when the Collateral Manager was acting on requests from Paulson on selecting collateral that it was under the mistaken impression that it was working with a CDO investor not an adverse party.  Failure to disclose this misimpression would then be an omission of a material fact.

My guess is a reasonable investor cares not only about the assets  that were selected but the process in picking those assets.  Would an investor want to know everything about the process?  No - but arguably it would want to know if its agent -- the collateral manager -- was under the mistaken impression that a party it was taking requests from was on the investor's side and  not playing for the opposite team. 

Proving that a Goldman employee "actually" knew there was any misimpression might be extremely difficult.  Here is where we need to return to the elements of a 10b-5 claim.  The SEC absolutely must prove Goldman had "scienter" or intent to mislead the CDO investors.  The Supreme Court has never ruled on the issue - but most federal courts -- including the 2nd Circuit find that scienter includes "recklessness."

How a court would apply the "reckless" standard will have to wait for another post.

Addendum:  For clarity, I changed the original sentence above:

 Because as "Goldman's defense documents" make clear, ACA and the CDO investors were sophisticated investors able to "negotiate forcefully at arm's length."

to read

 Because as "Goldman's defense documents" make clear, ACA and the CDO investors were sophisticated investors able to "negotiate forcefully at arm's length" with Paulson.

This clarification was prompted by a Jeff Lipshaw post responding to this one:


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