Dissecting the Goldman Sachs Fraud Lawsuit

Remember hearing about all those mortgage fraud cases about five years ago?  They seemed to have died down for a while, but lately things indicate that we’re not completely in the clear.  Last April one of Wall Street’s most prominent investment and securities firm, Goldman Sachs, was charged with fraud for a transaction involving securities based on subprime mortgages.  The Securities and Exchange Commission (SEC) brought civil fraud charges against Goldman in what may turn out to be one of the biggest cases in securities law.

The Goldman case is massive and several other suits have already been filed, so what follows is an attempt to dissect the case and provide some background updates as to what in the financial world is going on here.

The Initial Suit: What Happened Exactly?

The SEC investigation all began with a single transaction in 2007 orchestrated by Goldman involving the sale of a “synthetic CDO” product called “Abacus 2007-AC1” to Goldman investors.  It’s complicated, but a synthetic CDO, or collaterized debt obligation, is a type of financial instrument that is not backed by loans but rather on a portfolio of credit swaps based on subprime residential mortgages.

Allegedly, Goldman had informed its investors that the subprime mortgage securities which the CDO’s were based upon were chosen by a third-party firm called ACA.

However, the SEC alleges that it was not ACA who selected the securities, but rather John Paulson, head of the Paulson & Co., a New York based hedge fund.  Then in a different transaction, Paulson allegedly put up large amounts of funds and bet that the securities would decline in value.

As the securities did indeed become unprofitable, the investors, namely ABN Amro, and IKB Deutsche Industriebank, collectively lost up to $1 billion during the mortgage crisis.  Meanwhile Paulson’s firm raked in profits of up to $1 billion.  The SEC alleges that Goldman assisted Paulson in betting against the securities, and is holding Goldman responsible for omitting details and making misrepresentations regarding the Abacus product.  In particular they are citing Goldman Vice President Fabrice Tourre as responsible for structuring the deal.

So basically, what happened here is somewhat similar to entering in a lame horse at a racetrack, and then being able to bet that the horse will come in last place.  This is known as “shorting a CDO”, or basing investments on knowledge that certain securities will fail.

Goldman reports that they have lost $90 million on the deal, and its stocks have fallen by 13% after word of the SEC investigation hit the streets.  Paulson has not been charged, because unlike Goldman, Paulson does not have a duty to disclose any adverse conflicts of interests to investors.  Goldman has officially responded by saying that the SEC allegations are “completely unfounded in law and fact”.

Several Shareholder Suits Follow

A few weeks after the SEC announced its investigation, a slew of shareholder suits were filed against Goldman Sachs as disgruntled shareholders learned of the investigation.  At least six shareholder suits have reportedly been filed, alleging such claims as corporate waste, breach of fiduciary duty, corporate waste, and mismanagement in relation to its dealings with the subprime mortgage securities.

Shareholders are seeking compensation from Goldman in the form of restitution, unspecified money damages, and declaratory relief.  There is also talk of requesting the government to institute further corporate reform measures.  A class action suit has also been filed on behalf of shareholders, claiming that Goldman failed to disclose an SEC investigation prior to the SEC lawsuit.  At least two derivative lawsuits have also been filed on behalf of Goldman Sachs itself.

To make matters worse, Goldman is trying to balance all of this along with other suits leftover from previous years.  For example, the company may also be under scrutiny by various government agencies in connection with its financial dealings with Greece.  And Goldman is also currently dealing charges by 15 California cities for supposedly rigging municipal investment contracts.  Not a good year for Goldman Sachs.

Goldman’s Projected Defense Strategy

Goldman’s proposed defense strategy has been playfully coined the “Big Boy” defense.  Basically Goldman attorneys will be arguing that the investors (ABN and IKB) who lost the $1 billion on the Paulson transactions were “big boys”- major investment players who were knowledgeable on investment matters and had the resources to conduct inquiries into their investments.

This essentially is the legal theory known as “caveat emptor”- or “buyer beware”.  Goldman is attempting to shift the risk of loss onto its investors, but critics of the strategy are wary for two reasons.  One is that synthetic CDO’s such as the Abacus product are fairly new and don’t really have a solid legal framework as to disclosure requirements.  Second, even if Goldman did in theory make proper disclosures, synthetic CDO’s can be so complicated that even experienced investment companies might not be able to fully analyze the risk involved with them.

Recent Developments- From Civil to Criminal Charges

Once again Goldman stocks experienced a drop as criminal investigations into the Abacus deal began.  Just a few weeks after civil claim was filed, the SEC officially referred the investigation to New York prosecutors from the Southern District.  This may be even more damaging to the company than any monetary losses they might incur, as a criminal charge would create problems for Goldman’s business reputation.

A review by the Justice Department for criminal sanctions involves a higher standard of proof, however.  In the SEC civil claim, the inquiry is whether the acts were committed at all.  In a criminal claim, federal prosecutors will have to show that Goldman Sachs acted with criminal intent to defraud investors.  They must also be able to prove their case beyond a reasonable doubt, which is particularly difficult in such cases.  The criminal inquiries began after 62 members of the House of Representatives requested an investigation.

There has also been talk of a settlement between the SEC and Goldman.  Experts speculate that Goldman may have to fork out more than the $1 billion that was covered in the deal.  If this happens, then this case will be the largest securities settlement in history and will officially eclipse the $800 million that American International Group (AIG) settled for in 2006.  Also, if Goldman vice president Tourre is involved in a settlement, he may end up paying fines and possibly face criminal sanctions himself.  Goldman has recently severed connections with Tourre, though.

Again, monetary payments are probably not what Goldman is worried about, and a settlement might be in their best interests to help them avoid a criminal reputation.

Conclusion

If the SEC and shareholders prevail, they will be entitled to disgorge profits and gains that Goldman reaped from the Abacus deal.  Other penalties may also lie in the future as other lawsuits continue to be brought.  What we are witnessing is one of the major moments in Wall Street history, and the case is indicative of the lingering effects of the recent mortgage crisis.  If they happen to break any records for highest settlement payment, let’s hope this is the last one.