Goldman Sachs Must Face Fraud Claims in Timberwolf Suit

Goldman Sachs Group Inc. must face fraud claims in a $1 billion lawsuit filed by an Australian hedge fund over the sale of collateralized debt obligations sold by the bank ahead of the financial crisis, a New York state appeals court ruled.

An appellate court in Manhattan today upheld state Supreme Court Justice Shirley Werner Kornreich’s October 2012 denial of Goldman Sachs’s motion to dismiss the fraud claims, while modifying it to throw out claims of negligent misrepresentation, unjust enrichment and rescission.

Basis Capital Funds Management Ltd.’s Basis Yield Alpha Fund accused New York-based Goldman Sachs of making false and misleading statements on the sale of the securities, known as Timberwolf and Point Pleasant. It seeks to recover more than $67 million it said it lost in the deal and $1 billion in punitive damages.

Timberwolf became a symbol of the financial crisis when an e-mail by former Goldman Sachs executive Thomas Montag describing it as “one shi--y deal,” was released by U.S. Senate lawmakers investigating the bank in April 2010.

SEC Claims

Goldman Sachs in 2010 reached a $550 million settlement with the U.S. Securities and Exchange Commission to resolve claims over the marketing of collateralized debt obligations. The penalty is the largest ever levied by the SEC against a Wall Street firm, according to John Nester, an SEC spokesman.

The appeals court said disclaimers and disclosures made in offering circulars for the securities “fall well short” of tracking the misrepresentations and omissions that Basis Yield alleges were made.

The disclosures “simply provide boilerplate statements regarding the speculative and risky nature of investing in mortgage-backed CDOs and the possibility of market turns,” Judge Dianne T. Renwick wrote.

“If plaintiff’s allegations are accepted as true, there is a ‘vast gap’ between the speculative picture Goldman presented to investors and the events Goldman knew had already occurred,” the judge wrote.

Basis Yield Alpha Fund first sued Goldman Sachs over the securities in June 2010 in Manhattan federal court. U.S. District Judge Barbara Jones threw out that suit, ruling the Australian fund couldn’t use U.S. securities laws to pursue the claims. Basis Capital filed another case in New York State Supreme Court in October 2011.

Sharp Decline

The suit relates to Point Pleasant, a collateralized debt obligation based on subprime residential home mortgages, and two credit default swaps that referenced securities from a similar CDO known as Timberwolf, Basis Capital said in the lawsuit.

Basis Capital accused Goldman Sachs of marketing new CDO investments in early 2007, after the company had determined that the value of securities in that market “would likely go into sharp decline in the near future,” and used the new CDOs as a vehicle to short the market, according to the lawsuit.

Basis Capital said Goldman Sachs was formalizing its Timberwolf deal with the fund during the same week that Montag sent the e-mail describing the Timberwolf investment.

Senate Report

Timberwolf was one of four Goldman Sachs CDOs detailed in a 2011 Senate report that found that the company misled clients about mortgage-backed securities. Another was Abacus, the CDO at the center of the SEC’s civil claim that led to the 2010 settlement.

A federal jury in Manhattan in August found former Goldman Sachs vice president Fabrice Tourre liable for his part in Abacus.

The SEC accused Tourre, a native of France, of intentionally misleading investors in a subprime mortgage entity called Abacus about the role played by Paulson & Co., the hedge fund of billionaire John Paulson which helped choose the portfolio of securities, then made a billion-dollar bet it would fail.

Eric Lewis, an attorney for Basis Capital with Lewis Baach Plc in Washington, said he was pleased with today’s appellate court ruling.

“We’re going to get to go to trial on the fraud,” Lewis said in a telephone interview. “It’s a very strong statement that an investment bank can’t lie to investors about the securities they’re selling and then hide themselves with boilerplate disclaimers.”

Short Position

Goldman Sachs is confident it will ultimately prevail on the remaining claims in the suit by Basis Capital, “which was one of the world’s most sophisticated investors in mortgage products,” said Michael DuVally, a bank spokesman.

Goldman Sachs’s argument that it had disclosed that it was taking a short position in the securities by revealing that an affiliate would be acting as a counterpart and purchasing credit protection didn’t fill in the “vast gap,” the judge said.

While such disclosures would alert a buyer of mortgage-backed securities that the seller would try to profit from arbitrage positions, Basis Yield alleges that Goldman Sachs wasn’t only motivated by profit, but intended to rid itself of longterm exposure to subprime mortgages by selling them to clients and betting against its own position, Renwick wrote.

Kornreich properly declined to dismiss the fraud claims because the disclaimers and disclosures in the offering circulars don’t preclude Basis Yield’s claim that it relied on Goldman Sachs’s misrepresentations and omissions, Renwick said.

“Of course, discovery will flesh out whether Goldman’s misrepresentations and omissions were the reasons plaintiff invested in Point Pleasant CDOs and Timberwolf credit default swaps, or instead whether plaintiff merely entered into a bad deal,” Renwick said.

The case is Basis Yield Alpha Fund (Master), 652996/2011, New York State Supreme Court (Manhattan).

Before it's here, it's on the Bloomberg Terminal.