Goldman’s Caveat Emptor Defense Mirrors UBS, Merrill

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Goldman Sachs Group Inc.'s new headquarters
Goldman Sachs Group Inc.'s new headquarters building, center, stands at 200 West Street in New York, on April 19, 2010. Photographer: JB Reed/Bloomberg

Goldman Sachs Group Inc. has signaled it will fight a U.S. lawsuit over subprime mortgage instruments the same way Bank of America Corp.’s Merrill Lynch unit and UBS AG have challenged similar claims -- by invoking the concept of caveat emptor: Latin for buyer beware.

The strategy may work. By insisting that purchasers of collateralized debt obligations knew what they were getting into, Goldman Sachs is following a well-traveled path. Both Merrill and UBS won dismissal of similar claims that they misrepresented the risks of such assets by saying the buyers were sophisticated enough to know better.

The Securities and Exchange Commission accused Goldman Sachs of creating and selling the CDOs without disclosing that hedge fund Paulson & Co. helped pick the underlying securities and bet against the instrument. Goldman Sachs denied any wrongdoing, saying that it provided “extensive disclosure” to customers about the risks.

Goldman Sachs, whose mantra is clients’ interests always come first, has said “these are sophisticated investors who knew what they were buying,” said David Irwin, a former federal prosecutor in private practice in Towson, Maryland. The bank is arguing that the average buyer of this product isn’t some “credit union that didn’t know what it was doing,” he said.

Faltering Housing Market

In early 2007, as the U.S. housing market began to falter, Goldman Sachs created and sold the CDO vehicle, known as Abacus, linking it to bundles of subprime mortgages whose value would rise or fall depending on whether homeowners paid them off.

Billionaire John Paulson’s firm earned $1 billion on the CDOs and wasn’t accused of wrongdoing by the SEC.

The SEC alleged in its April 16 complaint that, had Goldman Sachs customers known Paulson helped choose the securities that formed the basis of the CDO, and that Paulson was betting against them, they might not have bought any. The regulator’s case in Manhattan federal court may hinge on that issue, said lawyer Mark Zauderer of New York’s Flemming Zulack Williamson Zauderer LLC, who isn’t involved in the case.

Even if a jury finds the customer would have bought the Goldman Sachs product with knowledge of Paulson’s role, the panel may still find in favor of the SEC if it decides those facts were intentionally hidden, Zauderer said.

‘Sophisticated Investors’

“Goldman certainly can and will argue that the sophisticated investors were perfectly capable of evaluating the quality of securities, regardless of what Paulson’s intentions were in betting against them,” said Zauderer, who helped defend former New York Stock Exchange Chairman Richard Grasso. Grasso successfully challenged a 2004 compensation lawsuit by then New York Attorney General Eliot Spitzer.

“Whether they did sufficient due diligence or reasonably relied upon what was presented to them” will be an issue, Zauderer said of the CDO’s buyers.

Goldman Sachs lawyer Richard Klapper of New York-based Sullivan & Cromwell LLP didn’t return a call seeking comment. Goldman Sachs said yesterday that the U.S. case hinges on the actions of an employee it placed on paid leave this week.

Fabrice Tourre, the 31-year-old Goldman Sachs executive director who was accused of misleading investors about the mortgage-linked investment in 2007, will also be de-registered from the Financial Services Authority, a spokeswoman at the firm in London said yesterday.

‘Factual Dispute’

“It’s all going to be a factual dispute about what he remembers and what the other folks remember on the other side,” Greg Palm, Goldman Sachs’s co-general counsel, said in a call with reporters yesterday, without naming Tourre. “If we had evidence that someone here was trying to mislead someone, that’s not something we’d condone at all and we’d be the first one to take action.”

The professional savvy of investors who buy such financial vehicles was cited by a New York state judge as grounds for dismissal earlier this month of fraud claims brought against two Merrill units.

In that 2009 suit, Armonk, New York-based bond insurer MBIA Inc. and its LaCrosse Financial Products LLC unit claimed that Merrill had a “deliberate strategy to offload” billions of dollars of “deteriorating” subprime mortgages from July 2006 to March 2007, as homeowner defaults began to soar. Merrill rejected the allegations and denied any wrongdoing.

MBIA Lawsuit

New York State Supreme Court Justice Bernard Fried in Manhattan dismissed five of six claims brought by MBIA over protection sold against mortgage-debt defaults. Fried, who allowed a breach-of-contract claim to continue, said the credit-default swaps were the product of “intensive negotiations among the parties, whose sophistication and business acumen and experience cannot be overstated.”

“MBIA and LaCrosse specifically stated that they were able to evaluate the validity of the CDOs, and were specifically warned that the transaction was appropriate only for sophisticated investors capable of analyzing the risks, including the risk related to the type of collateral involved in the transaction,” the judge wrote in his opinion. MBIA has said it will appeal.

UBS used that argument to fight a lawsuit by Hamburg-based HSH Nordbank AG seeking to recover at least $275 million in losses on a portfolio linked to the U.S. subprime-mortgage market.

Claims of Trickery

HSH alleged that the Zurich-based bank was able to trick it into making the investment because in 2001, when they were negotiating the deal, HSH was “a regional German bank with little familiarity with international structured finance,” according to its complaint.

UBS lawyer Barry Sher called that claim “the babes in the woods defense” during a May 2008 hearing in the case. Sher said HSH had done its own credit-linked note transaction a year before entering the contract with UBS, which denied the allegations.

New York State Supreme Court Justice Richard Lowe in Manhattan dismissed most of HSH’s claims, including fraud, in


HSH amended its complaint, saying new documents obtained during discovery showed UBS had an “undisclosed economic motivation” and intended the transaction to be “other than a vehicle for HSH’s gain.”

“UBS claimed that the transaction was ‘tailored to meet’ HSH’s needs when it was actually structured to enrich UBS at HSH’s expense,” according to a ruling by Lowe last October. He said HSH could proceed with its restated fraud claim as well as claims for breach of contract and breach of the implied covenant of good faith.

‘Naïve Investor’

Lowe said he still wasn’t convinced that HSH could sue for negligent misrepresentation and dismissed that claim.

“HSH’s reworded claim that it was but a naïve investor in the hands of the more experienced UBS in a world of complex investment rings as unconvincing now as it was in the original complaint,” Lowe said.

Both sides are appealing Lowe’s decision.

“There are substantial parallels between SEC v. Goldman Sachs and HSH’s case against UBS,” Michael McNicholas, legal counsel at HSH, said today in an e-mailed statement. UBS and Goldman Sachs exploited flaws in the ratings system to make high-risk investments appear to be investment grade, he said.

“Both cases are based on strong evidence that the arranging bank concealed material facts regarding the adverse selection of the portfolio and misrepresented the alignment of investor’s interests,” McNicholas said. “However, unlike the Goldman case where Paulson’s adverse economic interest was concealed, in our case UBS fraudulently concealed its own adverse economic interests to profit at HSH’s expense.”

HSH’s Specifications

Doug Morris, a UBS spokesman, said today in an e-mail that the transaction was structured according to HSH’s specifications.

“HSH was a professional and knowledgeable German bank,” Morris said. “We executed all of our contractual obligations.”

In a third case, JPMorgan Chase & Co.’s attempt to fend off billionaire Len Blavatnik’s suit blaming his losses on the bank’s risky mortgage bets led to a mixed court ruling.

Blavatnik, founder of Access Industries Group, accused the second-largest U.S. bank of stuffing its portfolio with too much subprime-mortgage risk.

In December, New York State Supreme Court Justice Melvin L. Schweitzer, also in Manhattan, threw out Blavatnik’s claims of negligence and breach of fiduciary duty. The judge refused to dismiss accusations against the New York-based bank of breach of contract and negligent misrepresentation.

‘Passive Investor

“Plaintiff was a passive investor that looked to the expertise and advice of defendants in structuring an investment strategy,” Schweitzer wrote. “Since plaintiff properly has alleged its reliance on these misrepresentations, there is a strong presumption that its reliance was reasonable given the investment management relationship between the parties.”

JPMorgan had argued Blavatnik couldn’t state a claim merely by pointing to losses.

“Whether defendants acted with ‘negligence or willful misconduct’ cannot be assessed by asking what investment decisions a reasonable investment adviser would have made under normal market conditions,” the bank’s lawyers said in court papers. “The relevant question is what a reasonable investment adviser would have done in the face of this historic financial crisis.”

Mary Sedarat, a spokeswoman for JPMorgan, declined to comment.

Goldman Arguments

If Goldman Sachs made a significant misrepresentation to customers looking to buy the instrument at issue in the SEC lawsuit, it can’t argue that experienced investors should have known what they were getting into, Zauderer said.

Goldman Sachs said in a statement responding to the SEC lawsuit that it provided full disclosure about the offering and that its portfolio was marketed solely to sophisticated financial institutions.

The investment bank also argued that the SEC complaint failed to mention that it lost more than $90 million from the transaction, as compared with the $15 million in fees it got.

Goldman Sachs said that IKB Deutsche Industriebank AG and ACA Management LLC, two investors in the Abacus product that were 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.”

Merrill has mounted a similar, sophisticated investor-defense to a suit brought by Netherlands-based Cooperatieve Centrale Raiffeisen-Boerenleenbank BA, known as Rabobank.

Rabobank’s Loss

As in the Goldman Sachs case, Utrecht-based Rabobank claimed Merrill omitted important information in advising on a CDO tied to subprime mortgages. In that case, also presided over by Judge Fried, the alleged omission was Merrill’s relationship with another client betting against the investment, which resulted in a loss of $45 million.

Merrill countered in court papers that Rabobank was aware of the risks, which were disclosed in the transaction documents. The bank should have been responsible for conducting its own due diligence, and shouldn’t have relied on Merrill, the bank said in a court filing last year seeking to dismiss the case.

Attorneys for Rabobank have seized on the SEC’s allegations against Goldman to support their own case.

In a filing in state court in Manhattan on the same day the SEC sued Goldman, the Dutch bank drew a parallel between the complaints. Rabobank urged the judge to grant it access to Merrill’s records of how the collateral manager for a synthetic CDO went about selecting investments.

‘Fraudulent Conduct’

Rabobank said the SEC complaint justifies its lawsuit because Merrill is accused of “precisely the same type of fraudulent conduct in the structuring and marketing” of CDOs.

Bill Halldin, a Merrill spokesman, rejected Rabobank’s attempt to link its complaint to the Goldman Sachs case, saying on April 16 that the matters are unrelated.

Rick Werder, a New York attorney for Blavatnik with Quinn Emanuel Urquhart Oliver & Hedges LLP, said the SEC lawsuit against Goldman Sachs supports a broader government inquiry into the CDO market.

“The latest allegations provide further indication that, in the area of mortgage-backed securities, some of our nation’s financial institutions consistently placed their own self-interest ahead of the interests of their customers,” he said.

The case is Securities and Exchange Commission v. Goldman Sachs, 10-cv-03229, U.S. District Court, Southern District of New York (Manhattan).

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