Case Hinges on Vital Legal Concept

James A. Cohen in The Wall Street Journal, April 19, 2010

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Regulator and Firm Will Tangle on Which Data Was Relevant For Investors to Make Informed Decision
APRIL 19, 2010
 
By ASHBY JONES, KARA SCANNELL and SUSANNE CRAIG

The Securities and Exchange Commission's case against Goldman Sachs Group largely comes down to a single word central to securities law: material.

Goldman will be judged on whether the information it failed to tell its clients was material, meaning important or relevant, something a buyer would want to know before buying.

The SEC says Goldman had a duty to tell two customers betting on mortgage-related securities that hedge fund Paulson & Co. helped select some of the mortgages in the product, and that Paulson was betting the mortgage market would collapse.

So far, Goldman isn't contesting that participants may not have known about Paulson's involvement.

In a written response to the SEC dated last September, Goldman argued that the facts about Paulson weren't material. In the response, reviewed by The Wall Street Journal, Goldman asserted that hedge-fund manager John Paulson, today a famed figure on Wall Street, was nearly unknown when the securities were sold in early 2007, and participants were unlikely to have cared about his role.

Goldman also said in its response that its clients got the material information needed, including the types of mortgages going into the securities.

Both sides are expected to come out swinging. A successful outcome for the SEC would help repair its image, damaged for missing the signs pointing to the financial crisis and to Bernard Madoff's fraud.

The SEC's chairman, Mary Schapiro took office early last year pledging to crack down on wrongdoers. She brought in a former federal prosecutor as her chief of enforcement, and they reorganized the agency to pursue more cases involving complex financial products. The official, Robert Khuzami, came from Deutsche Bank where he was general counsel for the bank's U.S. operations. A SEC spokesman says he hasn't worked on any Deutsche Bank matters.

Goldman, meanwhile, has its reputation at stake, and money should it lose work as a result of any taint from the charges.
Some securities lawyers not involved in the case said the SEC's 22-page complaint offered strong evidence that Goldman should have disclosed information about Paulson.

The complaint says Goldman sought out an independent mortgage-analysis firm, ACA Management LLC, and told participants that ACA was responsible for designing the product.

James Cox, a securities-law expert and professor at Duke University Law School, suggested Goldman knew Paulson's participation was relevant and it needed an outside firm to give the deal credibility. "That strikes me as plain and simple laundering of the deal," says Mr. Cox. "To me, it goes directly to the materiality of the omission."

Peter Huang, a securities law professor at Temple University, agreed. "If you were buying something, you should care about the fact that the person who was picking the things you were buying was actually betting against them," he said. "That's the part that wasn't disclosed."

Goldman's defense rests on putting the word "material" in context. The firm is likely to argue, as it did in its September response, that it is unfair to use hindsight about the mortgage market's collapse in judging what was material in 2007.

Other lawyers not involved in the case said those buying the securities were sophisticated institutional investors presumably able to size up a product's worth and should be judged by a different disclosure standard.

"This isn't mom and pop getting taken advantage of," said Peter Henning, a professor at Wayne State University Law School in Detroit and a former SEC enforcement lawyer. These clients "might not have known about Paulson, but they had to have known that these securities were extremely risky. To say these products were toxic waste is an insult to toxic waste."

Goldman's product, a "synthetic CDO" called Abacus 2007-AC1, was linked to the performance of certain mortgages. Some experts emphasize that such CDO offerings typically require at least two types of players: one who thinks the product will do well and another who takes a "short position," or bets that the product will fare badly.

"In these types of transactions, the buyer rarely knows who the seller is," said Matthew Farley, a securities lawyer at Drinker Biddle & Reath LLP in New York. "The buyers weren't privy to Paulson's point of view, but so what? Does that fact relieve the buyer from performing its own analysis?"

James Cohen, a law professor at Fordham University, said Goldman had a duty to go the extra mile on disclosure because it had clients on both sides of the deal. "Fundamentally you have a duty which arises out of a conflict and the conflict is what makes it smell," he said. "You see Goldman on too many sides of this transaction."

The SEC also alleges that Goldman misled ACA into thinking that Paulson had taken a "long" position on the product—that is, betting that it would succeed. Goldman is likely to argue, as it did in its response last September, that the evidence the SEC relies on to support the allegation—two emails sent by Goldman—were ambiguous and insufficient to support the claim.

The SEC further alleges Goldman misrepresented in a term sheet that ACA had selected the portfolio, wrongly leaving out any mention of Paulson. In its September response, Goldman disputed this characterization, saying ACA had selected the portfolio with help from Paulson, but that it was under no duty to mention Paulson's advice.

While Goldman says it will fight the charges, lawyers and legal experts are split on whether the case will settle or go to trial. Some uninvolved lawyers said the specter of a jury verdict could drive Goldman to the bargaining table, partly because a finding of liability could spur or move along suits filed by private investors. Already, plaintiffs lawyers are considering suits. "I've already gotten numerous calls from clients asking about their recourse," said Gerald Silk, a plaintiffs' lawyer at Bernstein Litowitz Berger & Grossmann LLP.

At the same time, a settlement is unlikely to cripple Goldman financially. The SEC is limited in its ability to levy huge financial penalties. Any fine levied against Goldman would likely constitute, in the words of Michael Perino, a securities-law expert at St. John's University School of Law, "less than a rounding error" to Goldman, given its market capitalization.

The SEC has a motive to settle. Outside lawyers said the complexity of the deal is a hurdle if the case goes to trial because jurors may have difficulty understanding what happened. Also, the SEC is tied up in other messy cases, including a fraud case against Angelo Mozilo, co-founder of former mortgage giant Countrywide Financial Corp. Mr. Mozilo is fighting the charges. While the SEC is willing to be aggressive, tackling several long trials could strain its resources and test its mettle in the courtroom.

Still, neither side is likely to budge easily. "The SEC is basically saying, 'You didn't put your customers' interest first,' and that's a big allegation," said Mr. Perino, who expects a spirited fight. "If it pans out, it's a severe blow to Goldman and its reputation."