In Goldman's Defiance, a Hint of Truce

"Goldman's lawyers are certain they played by the rules"

The caning of Goldman Sachs (GS) made for compelling theater. Senators whacked away with populist fury. Defiant traders absorbed bipartisan blows without apology. Yet more went on in the Apr. 27 Senate hearing than may have met the eye. In Goldman's subtle signaling are hints of where this clash between Wall Street and Washington may be headed.

That destination is likely to be a negotiated truce. In the hearing before the Senate's Permanent Subcommittee on Investigations, Chairman Carl Levin punishingly interrogated Goldman traders and top executives over the morality of their actions. Senate Republicans, possibly seeing political peril in siding with Wall Street, the next day stopped blocking floor debate on the financial regulatory overhaul bill.

Now, the Goldman drama shifts to federal court, where the legality of the firm's behavior is in question. The Securities & Exchange Commission has accused Goldman and Fabrice Tourre, the French banker who referred to himself in an e-mail as "Fabulous Fab," of defrauding a client on a mortgage-related investment in 2007. Neither side can risk a loss and the accompanying reputational damage. So, merits aside, a settlement is in both parties' interest.

True, CEO Lloyd Blankfein pronounced himself untroubled even after seven hours of testimony from current and former Goldmanites about how the bank created risky securities out of toxic mortgages, sold those securities to clients, and then bet against the same securities with its own money. "I heard nothing today that makes me think anything went wrong," he told the Senate panel.

The firm's tack, however, is more nuanced, according to two Goldman executives involved with the strategy. The bank wants to appear as if it's trying to be more accessible and cooperative with lawmakers and the media so it can win the PR war and strengthen a weak bargaining hand. All the while, Goldman seeks to cast doubt on the substance of the legal case.

Blankfein's public self-assurance contrasts with some of his firm's private actions. Goldman is so radioactive in Washington—some lawmakers are handing back its campaign contributions—that it has had to quickly assemble a small army of image consultants. It bolstered the legal team with Greg Craig, the former Obama White House chief counsel who is now a partner in the Washington office of Skadden, Arps, Slate, Meagher & Flom. Craig specializes in managing Capitol Hill controversy. Sullivan & Cromwell, Goldman's longtime New York law firm, will seek to fend off the SEC's civil fraud case.

The mission of other retainers is to convince the SEC that perhaps it would be better for all concerned to dial down the volume. That is the message of Arthur Levitt, a venerated former SEC chairman and adviser to Goldman, who is spreading the word in Washington that, having slept through the leverage-happy runup to the Wall Street debacle, the SEC now risks appearing as if it's grandstanding in the Goldman suit. (Levitt is on the board of Bloomberg L.P., parent of Bloomberg Businessweek.)

"This is a suit which I think should be settled promptly, not just for Goldman Sachs, not just for the industry, but for the economy as a whole," Levitt told Bloomberg TV on the day of the Senate hearing.

The SEC, the agency that for years ignored Ponzi master Bernard Madoff, has to worry about the prospect of losing. Goldman's conduct might not play well in front of a lay jury. But the initial audience for the SEC fraud suit will be a federal judge in Manhattan, Barbara Jones.

In coming weeks the bank is expected to file a motion to dismiss the SEC action. Goldman's lawyers at this stage will not have to get into the potentially ugly details concerning how it did or didn't inform its client, IKB Deutsche Industriebank, that a "synthetic" mortgage security bought from Goldman had been designed with the help of a hedge fund. Nor will it have to elaborate on whether the fund, Paulson & Co., intended to bet against the security, as the SEC charges. Instead, Goldman could argue that the suit should be dismissed because it had no legal duty in the first place to make such a disclosure, regardless of Paulson's role.

Blankfein telegraphed the argument at the hearing. He said Goldman doesn't have to inform its customers when it "shorts," or bets against, the very investments it sells to those customers. "No, I don't think we have to tell," the CEO told Levin.

If it turns out that Goldman's boilerplate prospectus disclaimers pass legal muster, the defense could conceivably fly, says John W. Moscow, a partner at the Baker Hostetler law firm. Moscow spent 30 years handling complex financial fraud cases as a prosecutor in the Manhattan district attorney's office. "Goldman's lawyers are certain they played by the rules, whatever ordinary people might think of those rules," he says. "It could work."

That's one big reason why, once testosterone levels have returned to more normal readings, the SEC and Goldman may begin to talk settlement. Goldman certainly has the deep pockets to fund a record-setting truce. The bank might even be willing to agree voluntarily to improve client disclosures, setting a new standard that others on Wall Street would emulate. Such a pact would be one way both sides could begin to restore their credibility.

The bottom line: Neither the SEC nor Goldman Sachs can afford to lose, increasing the odds of a settlement.

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