The case against Goldman Sachs Group Inc. may turn on the meaning of the word “selected.”
The Securities and Exchange Commission must prove that the most profitable company in Wall Street history defrauded investors by failing to disclose that a hedge-fund firm betting against them played a role in creating what they bought. It must also counter Goldman Sachs’s assertion that an independent asset manager, which the SEC said rejected more than half of the securities initially proposed by Paulson & Co. for a collateralized debt obligation, signed off on the selections.
“The question is whether Paulson’s undisclosed role in portfolio selection was material,” said Larry Ribstein, a law professor at the University of Illinois in Champaign who has written about 140 articles and 10 books on topics including securities law and professional ethics. “There’s no clear and well-defined definition of what you have to disclose in this type of transaction.”
The SEC case signals the regulator could eventually target other banks over how much they told investors about at least $40 billion of CDOs that turned toxic as mortgage defaults soared to the highest level since the 1930s. Robert Khuzami, the SEC enforcement chief, said last week that the agency will aggressively pursue deals “that share similar profiles.”
Bank of America Corp.’s Merrill Lynch unit, Citigroup Inc. and UBS AG are among banks that underwrote CDOs involving two other hedge-fund firms that could have profited as homeowners stopped paying.
The CDO market is separate from the $2 trillion of mortgage-backed securities created from 2005 through 2007 out of risky subprime and Alt-A loans, and then often packaged into CDOs, including the more than $200 billion issued in 2007. The SEC hasn’t announced any suits over MBS disclosures by underwriters or issuers. This month, former Citigroup and Washington Mutual Inc. officials told government panels that their companies knew that their vetting of home loans they sold off was shoddy before the market crashed.
Clayton Holdings LLC, the largest provider of due diligence on mortgages that Wall Street banks bought to package into securities, has provided information to the SEC and state attorneys general in addition to New York’s Andrew Cuomo, who collected reports from it in 2007, Marc Rothenberg, a lawyer for the company in New York at Blank Rome LLP, said in January.
“Let’s see a full investigation of all the banks that made material misstatements and omissions in mortgage-securities issues during the lead-up to the crisis, because many of them did,” said Josh Rosner, managing director of New York-based advisory firm Graham Fisher & Co. “Hopefully this is the beginning of the SEC looking at dealer practices of putting their own returns ahead of their customers.”
The SEC, which filed its complaint against New York-based Goldman Sachs on April 16, is seeking to prove only that the CDO’s investors, including IKB Deutsche Industriebank AG and ABN Amro Bank NV, may have reasonably wanted more information than they got about Paulson’s involvement, said John Coffee, a securities law professor at Columbia University in New York.
The tactic reduces the case to whether there was “a false statement or a material omission that made statements materially misleading,” Coffee said. “That frees the SEC of the need to prove there was intent to defraud, which changes the balance considerably in favor of the SEC.”
Goldman Sachs, headed by Chief Executive Officer Lloyd Blankfein, said in a statement on April 16 that the SEC allegations were “unfounded” and that it plans to “vigorously contest them and defend the firm and its reputation.”
In a marketing document for the CDO, known as Abacus 2007- AC1, Goldman Sachs said it might have access to “non-publicly available information” about the collateral and, because of that, “this presentation may not contain all information that would be material to the evaluation of the merits and risks of purchasing the notes.” The flip book prepared for potential investors said the CDO would be linked to securities “selected” by asset manager ACA Management LLC.
Paulson’s Subprime Bets
It didn’t mention Paulson, the hedge-fund firm managed by John Paulson, 54, which became the world’s third-largest after betting against subprime mortgages and reaping about $1 billion on the Abacus deal.
The SEC complaint said that ACA rejected 68 of 123 positions Paulson initially suggested. After a back-and-forth between the asset manager and the hedge fund intermediated by Goldman Sachs resulted in ACA and Paulson agreeing on 90 securities, one ACA employee said in an e-mail to another that the portfolio “looks good to me,” according to the complaint.
Goldman Sachs wasn’t necessarily required to describe the selection process to sophisticated buyers of the CDO, said James Cox, a securities law professor at Duke University in Durham, North Carolina. Instead, he said, the bank may have crossed the line by telling investors half-truths -- touting the role of ACA, while omitting Paulson’s.
“If you’re creating a dangerous product, you can’t insulate yourself by bringing in an innocent party that dilutes the danger of that product, if you know it’s still dangerous,” Cox said.
The key to the SEC’s case will be to prove that investors may have balked if they knew that “a notorious bear” was on the other side of the trade and had a hand in designing the product, said Ribstein, the University of Illinois law professor. The SEC will need to show that the deal was designed to lose and that Goldman Sachs knowingly withheld information because it knew investors wouldn’t like it, he said.
“Once you start pulling on this thread, there’s potentially a lot of other people who might have done similar things,” said Thomas Adams, who worked in the CDO groups for two bond insurers and is now a partner at New York-based Paykin Krieg & Adams LLP. “These practices were relatively widespread.”
More than half a dozen of the world’s biggest banks underwrote CDOs involving hedge-fund firms with bets against mortgage bonds, including Citigroup, UBS, Bank of America, JPMorgan Chase & Co., Wells Fargo & Co.’s Wachovia Corp. unit, Deutsche Bank AG and Credit Agricole SA, according to data compiled by Bloomberg. The hedge funds, Evanston, Illinois-based Magnetar Capital LLC and Tricadia Capital Management LLC in New York, were involved in at least $42 billion of CDOs.
Magnetar helped create more than 20 mortgage-bond CDOs named after constellations by agreeing to buy the riskiest slices and paired the purchases with larger bets that pieces of those and other CDOs would fail. That reflected a view that if any low-rated subprime mortgage bonds defaulted, most would. The CDOs totaled at least $32 billion, according to Bloomberg data.
Many CDO managers “played along with” the interests of hedge funds when constructing their deals, said Jon Pickhardt, an attorney with Quinn Emanuel Urquhart Oliver & Hedges in New York.
His firm, which is representing Utrecht, Netherlands-based Rabobank in a suit against Merrill Lynch over a Magnetar CDO, said in an April 16 letter to the judge in that case that documents filed confidentially to the court show collateral manager NIR Capital Management LLC let Magnetar select assets.
Other plaintiffs in CDO suits have included M&T Bank Corp. and bond insurer MBIA Inc. Investors including the Plumbers’ Union Local No. 12 Pension Fund, City of Ann Arbor Employees’ Retirement System and the Federal Home Loan Banks of Pittsburgh, Seattle and San Francisco have sued banks including Bank of America, JPMorgan, Deutsche Bank, Credit Suisse Group AG and Nomura Holdings Inc. over disclosures on mortgage-backed securities.
Magnetar sometimes told CDO managers and banks that it wanted to bet against certain securities, said a person close to the company. The firm stopped short of insisting that the credit-default swaps used to make those bets be included in its CDOs, and they didn’t make up the majority of a CDO’s holdings, the person said.
While Magnetar avoided ordering managers to buy specific securities, it often pushed them to select ones with higher yields, according to a person who participated in some of the transactions and declined to be identified because the deals were private. The firm told banks and asset managers what its strategy was, the people said.
‘Conflicts of Interest’
Magnetar, in an e-mailed statement, said it didn’t select the assets going into its CDOs, that it didn’t have a particular view on the housing market and that both underwriters and collateral managers understood its strategy of betting against “particular tranches.”
Tricadia told investors in prospectuses for the almost $10 billion of CDOs for which it served as asset manager that it might or would bet against the collateral it selected. In April 2007, the firm took it one step further by disclosing in a 399- page prospectus that it took the opposite side of trades that the CDO entered into through UBS, the underwriter.
“General statements with respect to the possibility of conflicts of interest are not going to inoculate banks or asset managers or hedge funds,” said Pickhardt.
Tricadia, which also said it would buy some of the CDOs’ most junior slices, was created in April 2003 as an affiliate of Marnier Investment Group, a hedge-fund firm whose management included Lee Sachs, now a counselor to Treasury Secretary Timothy F. Geithner. Tricadia co-founder Michael Barnes didn’t respond to messages seeking comment.
The CDO at the center of the SEC case is one of at least 23 Abacus deals created by Goldman Sachs, and one of the only ones for which the firm hired an outside asset manager, according to prospectuses. The others were managed by Goldman Sachs.
CDOs are investment vehicles that repackage pools of assets such as home-loan bonds, buyout loans and bank capital notes into a series of new securities with varying risks. The vehicles come in three varieties: synthetic, meaning filled with credit- default swaps instead of actual securities; cash, which are filled with actual bonds; and hybrids, with a mix of both of debt and default swaps, which are derivatives that offer payments if the securities they reference don’t perform as expected, in return for regular premiums.
The Abacus deals were synthetic CDOs tied to mostly subprime home loans and commercial mortgages. UBS, in a series called North Street from at least 2000 through at least 2005, and Deutsche Bank, through its Start program in at least 2005 and 2006, also issued synthetic CDOs tied to mortgages, according to Bloomberg data.
Goldman Sachs brought in an outside firm to manage the assets in Abacus 2007-AC1 to reassure investors about the portfolio’s quality as the market began to show signs of distress, according to the SEC complaint. One buyer, Dusseldorf, Germany-based IKB, was no longer purchasing CDOs without independent managers, the SEC said.
The CDO and other late 2006 and 2007 Abacus transactions were also unusual because other banks had stopped doing synthetic CDOs, since hybrid CDOs could be used to off-load risk in the same ways, according to the people.
Hybrid mortgage-bond CDOs boomed as banks sought to balance the bets against home-loan securities they were selling to hedge funds such as Paulson, Hayman Advisors LP in Dallas and Lahde Capital Management LLC in Santa Monica, California.
One hybrid CDO was ACA Aquarius 2006-1 Ltd., a $2 billion deal created in September 2006 with ACA as the manager. It was part of the series of CDOs involving Magnetar.
‘Further to Fall’
The SEC suit says that Goldman Sachs misled ACA into believing that Paulson planned to buy the CDO’s lowest-ranked slices, while in fact the bank knew that the fund planned bets against more senior pieces.
“It’s interesting that ACA knew Paulson was involved in the selection process and wasn’t sued for aiding and abetting,” Ribstein, the Illinois law professor said. “It seems to have been common knowledge that Paulson was betting against the market through credit-default swaps.”
In early March 2007, Paulson said in an investor letter that subprime-mortgage defaults would “skyrocket” and that, “while the bonds have fallen significantly, we think they have much further to fall,” according to a March 15, 2007, Bloomberg News story.
ACA completed the portfolio on Feb. 26, 2007, the SEC said. The deal closed on April 26, 2007, according to the complaint, which didn’t say whether ACA, which sold protection against the default of part of the CDO through a sister bond insurance unit that was the first debt guarantor to collapse, had any ability to change the make-up in March or April of that year.
“ACA as collateral manager had sole authority over the selection of all collateral in the CDO,” Paulson said in a statement on April 16, adding that the securities were rated AAA by Moody’s Investors Service and Standard & Poor’s.
Goldman Sachs Response
Goldman Sachs said in a statement the securities were “selected by an independent and experienced portfolio selection agent after a series of discussions, including with Paulson & Co., which were entirely typical of these types of transactions.”
Buyers of deals involving default swaps are foolish if they don’t realize someone had picked securities to bet against them, said David Castillo, a senior managing director at San Francisco-based broker Further Lane Securities, a trader of structured securities.
“In a synthetic transaction involving any asset, the participants know upfront that there is someone who believes the opposite side of the trade,” Castillo said. “It’s unreasonable to participate in this type of transaction and expect any other scenario.”
Still, what Goldman Sachs didn’t tell investors included the fact that Paulson was betting against the Abacus CDO’s senior pieces, the SEC said, meaning the firm only stood to profit if many of the securities it helped pick went bad and not just a few. In addition, the regular sales of synthetic and hybrid CDO notes to other CDOs and into $400 billion market for structured investment vehicles, or SIVs, such as Axon Financial Funding Ltd. that funded themselves with commercial paper means that not all debt buyers were aware they were taking the opposite side of some investor’s bets.
The involvement of default swaps in the Goldman Sachs case may make it harder for the SEC to win, said Todd Henderson, a law professor at the University of Chicago.
“One possible defense for Goldman is that the disclosure would have been irrelevant because everybody knew,” said Henderson. “They could argue that these weren’t widows and orphans investing in these products.”
Goldman Sachs said in its statement that IKB and ACA Capital Management, two investors in Abacus 2007-AC1 identified in the SEC complaint, were aware of the risk associated with the securities and were “among the most sophisticated mortgage investors in the world.”
IKB lost about $150 million and Edinburgh-based Royal Bank of Scotland Plc paid $841 million to Goldman Sachs to unwind its position after taking over ABN Amro, according to the SEC. The insurance provided by ACA to ABN Amro was worth little after the insurer collapsed.
“Materiality is a lot like a continuum,” said Jacob Frenkel, a former SEC lawyer now in private practice at Shulman Rogers Gandal Pordy & Ecker in Potomac, Maryland. “The amount of information that needs to be disclosed to institutional investors at the highest level, where they’re doing their own research and analysis, is less. Their criteria for the investment decisions tend to be far more sophisticated than the individual investor’s.”
Even on that continuum, Goldman Sachs has a lot of explaining to do, said Ribstein, the University of Illinois law professor.
“It looks like the SEC is hoping that the facial fishiness of the transaction is going to be enough here to sink Goldman Sachs” in this case, he said.
To contact the reporters on this story: Jody Shenn in New York at firstname.lastname@example.org; Joshua Gallu in Washington at email@example.com