SEC v. Goldman as a Simple Case

Despite a complex context and heated rhetoric on all sides, the core of the SEC’s complaint against Goldman Sachs is simple: Goldman sold to investors a bet based on a list of securities it said would be hand-picked by an independent expert when the list was allegedly picked in part by a Goldman client with interests diametrically opposed to the investors. The only successful defense to this allegation is that the independent expert did in fact hand-pick the list and neither Goldman nor its other clients played a role in it.

Picking the list is vital and related disclosures or non-disclosures material within the meaning of federal securities laws. If investors are told a list is chosen by an independent party, they are told that the bet will be a fair game—knowing, of course, that other investors will have different views and either refuse to buy the same device or even take short positions against it. But if investors are told that a list will be chosen by someone who will make money only if its value declines, rational investors will eschew such a game as rigged, not fair.

Since the incubation of the asset-backed securities markets decades ago, when I helped to design them, selection of the pool or reference securities has always been seen as vital. In original deals consisting of a bank’s mortgage loans, for example, the selection is to be made using a haphazard selection protocol from across the bank’s entire mortgage loan portfolio. Banks cannot cherry pick their overall portfolio and dump only the worst-performing loans into a pool. Investors would not buy it if they knew that were happening.

The same is true for the kind of deal at issue in SEC v. Goldman Sachs. Multiple bettors would wage gambles on whether a selected reference group of securities is heading up or down over a stated time period. If the group is selected either haphazardly or by an independent agent, no one has a rigged advantage and all face a fair game. If the group is selected by an undisclosed participant with an interest in one direction or the other, a strong case of fraud appears.

The importance of the independent selection is why the Goldman offering circular prominently displays ACA as the Portfolio Selection Agent on page one, prominently describes it and its role on pages 2-3 and 84-85, and makes hundreds of references to it throughout. That’s also why the SEC complaint highlights the importance Goldman attached to identifying and advertising that ACA would perform that role. If investors knew someone lacking ACA’s independence were making the selection, whether Goldman itself or another client, they would have shunned the bet as rigged.

The Goldman circular describes the securities in detail over 176-pages, replete with intensive emphasis on the numerous conflicts of interest Goldman and its various affiliates face in the deal. Never once does it say that the reference list may be chosen by anyone other than the independent expert. There would be no issue in the case if that circular had disclosed that the reference list may be chosen by Goldman or its affiliates or clients.  There will also be no issue if, in fact, no one other than that independent expert chose the reference list.

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6 Responses

  1. Frank says:

    As Sen. Jeff Merkley put it: “The Wall Street meltdown was not just a case of the foxes guarding the henhouse; instead, the foxes designed and built the henhouse, took out insurance on the henhouse, and lit it on fire.”

  2. Deric Ortiz says:

    “But if investors are told that a list will be chosen by someone who will make money only if its value declines, rational investors will eschew such a game as rigged, not fair.”

    Is it not possible for an investor to rationally conclude that the person choosing the list will be wrong?

    Digging up my old outline, which I designed, a common undercurrent in this exchange market seems to be that with every stock exchange, there is a seller who does not believe in the performance capabilities of the stock and a buyer who does.

    I would think the inquiry would should instead fall on whether these sophisticated investors (banks and the like) had access to the same information that the person selecting the list did. If they, through research, they could have determined that the list was comprised of high interest, low-credit mortgages then they only have themselves to blame.

    How wrong am I and why?


  3. Matt says:

    Suppose that ACA had selected the assets that were put in the CDO, would that have changed the value or the advisability of investing in the CDO? Aren’t investors charged with making a determination about whether to invest in the CDO based on their own analysis of the RMBS in the CDO? It might be one thing if GS lied about what was in the CDO or if the CDO’s assets could be changed during its life and GS lied about who would be making the CDO. But the buyers had every opportunity to do their own analysis of the CDO and whether it was ACA who picked the assets or Paulson, it does not change whether the CDO is a good investment. I know that the securities law might not view materiality the same. My question is, why not?

    Full Disclosure, I used to be a securities defense attorney, who made materiality arguments in practice.

  4. Lawrence Cunningham says:

    Deric: Thanks for the nice question; a few thoughts.

    1. Maybe so as between buyers and sellers of stocks traded anonymously in public stock markets. But this is a synthetic instrument created and marketed by a broker who made specific representations to the buyer that, allegedly, the broker knew were false.

    2. We could have a regime in which all investment risk falls on the buyer of securities so that the inquiry is whether buyers of these securities had access to relevant information and beyond that nothing the broker said about the deal would matter. But the law imposes on the broker a duty to speak honestly when speaking at all and the allegations in the SEC complaint challenge whether this broker discharged or breached that duty.

    3. In terms of access to information, I should emphasize that everyone knew and intended for the reference securities to be the lowest rated sub-prime junk–all were rated Baa2 or BBB or thereabouts. The offering circular lists the 90 reference securities and any investor could examine them. That does not change the fact that the broker repeatedly represented that the list was chosen by an independent third party.

    4. Again, if the independent third party chose the list, there is no issue here; if it did not, misrepresentation appears. Its materiality is difficult for me to doubt–though I read of many who disagree with that.

  5. Lawrence Cunningham says:

    Matt: Thanks as well.

    1. I don’t have access to the underlying information about how the list ACA allegedly initially proposed performed compared to how the list actually used performed. It is a useful question on causation and damages.

    2. On the liability issue, investors may have some burden of investigation. But even under the strongest forms of caveat emptor in the common law, and certainly in federal securities law, one who speaks has a duty to speak honestly. If I’m selling hogs of tobacco and the buyer asks whether I know anything calculated to increase its price and I say nothing I’m not liable; but if I speak up, falsely, I am liable. See Laidlaw v. Organ, 15 U.S. (2 Wheat.) 178 (1817).

  6. Deric Ortiz says:

    “Its materiality is difficult for me to doubt–though I read of many who disagree with that.”

    I thought that this would be the case. I would think that this would be an issue where people fall on one side or the other. It is why I think it would be difficult for SEC to prevail if this would be before a jury.

    Would it be before a jury?