Goldman Sachs Settlement May Hinge on How SEC Justifies Penalty

Goldman Sachs has denied wrongdoing
Goldman Sachs Group Inc.'s new headquarters building. Photographer: JB Reed/Bloomberg

Analysts predict Goldman Sachs Group Inc. will pay $1 billion or more to settle a Securities and Exchange Commission fraud suit that triggered a 26 percent drop in the firm’s stock. Extracting such a record-setting penalty may be easier said than done.

When it comes to presenting a settlement for court approval, the SEC will have to “have a good explanation and justification for the number,” said Donald Langevoort, a former SEC attorney who teaches securities law at Georgetown University in Washington.

Looming over negotiations between the SEC and Wall Street’s most profitable investment bank is a reminder from Judge Jed Rakoff that courts can reject settlements -- even when the SEC’s adversary is willing and able to pay. Rakoff, a U.S. district court judge in Manhattan, refused to sign off on a $33 million accord with Bank of America Corp. in September, noting that the SEC didn’t adequately explain how it came up with the dollar amount.

A sanction in the range of $1 billion would be hard to support based on the allegations in the Goldman Sachs complaint, according to James Coffman, a former SEC enforcement official who retired in 2007. That figure would be more than double what any Wall Street firm has agreed to pay as part of a civil settlement with authorities.

Under one formula outlined in securities laws, the SEC could impose a maximum $15 million penalty on the bank to resolve fraud allegations that it misled buyers of mortgage- backed investments. That formula has been routinely ignored in enforcement cases and the SEC will seek more from a firm depicted as an icon of Wall Street greed at congressional hearings, Coffman said.

$1 Billion ‘Goalpost’

The SEC’s April 16 complaint accused Goldman Sachs of defrauding investors in a collateralized debt obligation linked to home loans. The firm concealed the fact that Paulson & Co., a New York-based hedge fund, picked components of the CDO and bet it would collapse, the agency said. Goldman Sachs, which underwrote and marketed the product in 2007, collected about $15 million in fees and Paulson reaped a $1 billion profit. The remaining investors lost more than $1 billion, according to the complaint.

Goldman Sachs, led by Chief Executive Officer Lloyd Blankfein, 55, has denied wrongdoing. Paulson hasn’t been accused of any impropriety and the firm’s founder, John Paulson, has said it didn’t market the transaction or have authority to select securities in the CDO.

The $1 billion loss for investors has become the minimum “goalpost” that the public expects the SEC to reach, according to James Cox, a securities law professor at Duke University in Durham, North Carolina.

‘Whatever it Takes’

A settlement would cost the firm “at least $1 billion, if not more, which they can easily pay,” Matt McCormick, an analyst at Bahl & Gaynor Inc. in Cincinnati, which manages about $2.8 billion, said in an April 30 Bloomberg Television interview. The firm “will do whatever it takes to get this away, or at least they should.”

As the agency’s first effort to punish a bank for creating and selling securities tied to subprime mortgages, the Goldman Sachs case will be dissected by the industry, in Congress and in the media, Coffman said.

“There’s been a lot of attention paid to this on Capitol Hill and in the press,” said Coffman, who predicts Goldman Sachs will pay about $100 million. The SEC will consider “how much public interest there is in sending a strong message and coming up with a settlement that shows the cops are on the beat.”

SEC spokesman John Nester and Goldman Sachs spokesman Michael Duvally declined to comment.

Softening Its Tone

Public statements from Goldman Sachs have softened in the month since the SEC announced its case as the firm’s image and stock price have taken a beating.

In an April 16 press release, Goldman Sachs called the suit “completely unfounded” and pledged to “vigorously” defend its reputation. Four days later, co-General Counsel Greg Palm broached the idea of resolving the case, saying on a conference call with investors that “you always have the option” of settling if both sides forge an agreement.

In the days following an April 27 Senate hearing where Goldman Sachs managers were accused of putting the firm’s interest ahead of clients, two executives at the firm who spoke on condition of anonymity said the company was eager to settle the SEC case in an attempt to contain the reputational damage.

Ramifications of Accord

The subject of how much money the firm may pay hasn’t been raised during early discussions between the SEC and Goldman Sachs, according to a person briefed on the matter, speaking anonymously because the talks were private.

Negotiations are more likely to stall over the way the SEC ultimately describes the firm’s conduct, rather than the size of any fine, said two people familiar with Goldman Sachs’s thinking. Goldman would resist agreeing to a settlement that includes an allegation of fraud, because doing so could hurt the firm’s business, they said.

Settling a fraud case would restrict Goldman Sachs and its employees from managing investment companies registered with the SEC, unless the bank got an exemption from the agency.

Goldman Sachs’s asset management unit currently oversees mutual funds, money-market funds and bond funds, according to its website. Goldman Sachs would also risk losing its ability to raise money quickly through securities sales without meeting certain regulatory burdens.

The SEC and New York-based Goldman Sachs will have to litigate if they can’t agree on an accord.

‘Pecuniary Gain’

The SEC suit cites the Securities Act of 1933 and the Securities Exchange Act of 1934. Both laws limit their most severe fines to either $650,000 per violation or the “pecuniary gain” reaped by the defendant.

SEC investigators don’t have to follow those limitations if they can persuade companies to pay more, a majority of agency commissioners vote to approve the settlement and a judge signs off on the accord, said former SEC Commissioner Paul Atkins.

“It’s basically what the two sides hammer out,” he said.

Goldman Sachs argues the $15 million in commissions it received for putting the CDO together were offset by more than $90 million the firm lost on its own stake in the transaction.

ABN Amro Bank NV lost more than $840 million and Dusseldorf, Germany-based IKB Deutsche Industriebank AG lost most of its $150 million investment, according to the SEC.

The SEC typically requires defendants in a settlement to pay a fine and return ill-gotten profits to victims.

Citigroup’s 2003 Settlement

Citigroup Inc. paid $400 million in 2003 to settle SEC and state allegations that its analysts hyped telecommunications stocks that its researchers privately thought were underperformers.

The SEC said in its complaint that Citigroup made $790 million in revenue from underwriting telecom securities from 1999 through 2001, relying on analysts to “generate substantial profits” for the company’s investment bankers.

Citigroup agreed to a $150 million fine, returned $150 million of ill-gotten gains, and paid $100 million to provide clients with independent research and investor education.

Bank of America, in the second-biggest agreement between the SEC and a bank in the past decade, paid $375 million in 2004 to settle claims the company didn’t disclose that some of its mutual funds allowed clients to make trades detrimental to other investors.

Charlotte, North Carolina-based Bank of America paid a $125 million fine and $250 million in disgorgement. Its fine was 10 times the $12.5 million in revenue the SEC said it received from one of the hedge funds making improper trades.

Prudential’s Choice

Prudential Securities Inc. agreed in a 1993 settlement with the SEC and state regulators to pay $371 million in restitution and fines, and to fully compensate all investors who lost money in oil, gas and real estate partnerships it sold without disclosing the risks. Over time the company paid more than $1 billion to resolve claims dating back to the 1980s.

Goldman Sachs remains the most profitable firm in Wall Street history. It earned $13.4 billion in 2009 and an additional $3.5 billion in the first three months of 2010.

“Money hurts but limitations on business can hurt in a lot more ways and that can be the hurt that keeps on giving,” Coffman said.

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