The SEC’s strike suit

Larry Ribstein —  18 July 2010

The SEC is heralding the $550 million settlement in its suit against Goldman as “the largest penalty ever assessed against a financial services firm in the history of the SEC,” and “a stark lesson to Wall Street firms that no product is too complex, and no investor too sophisticated, to avoid a heavy price if a firm violates the fundamental principles of honest treatment and fair dealing.” Surely the agency had a strong incentive to try to use the Goldman settlement to obscure the memory of Madoff, Stanford and the Bank of America settlement. Meanwhile, today’s NYT concludes its Goldman story with a quote suggesting Goldman got off lightly.

The truth is far more disturbing: the SEC got a big payday in what would have been seen as a strike suit had it been a private securities class action lawyer.

As I said when the suit was filed, there was always a serious problem with materiality. Goldman was accused of not affirmatively disclosing John Paulson’s role in selecting the portfolio that its CDO purchaser IKB bet on. This was supposedly important because Paulson, a notorious bear on the real estate market, was betting against the portfolio. However, the materiality of this non-disclosure was highly questionable given the facts that:

  • IKB, a sophisticated player that had engaged in the same kind of deals for its own gain presumably knew the basic risks in the transaction. Paulson’s presence on the other side was of dubious importance given that, at the time, he was a fairly minor player who had been losing his bets, not some proven super-guru with psychic powers.
  • The portfolio manager, ACA, and not Paulson, was ultimately responsible for the portfolio’s contents. The WSJ quoted a derivatives expert as saying, “if ACA performed an independent analysis and concluded that the [Abacus] portfolio met ACA’s criteria, I’m not sure what the issue is. * * * One sophisticated market participant thought that the portfolio was a good ‘buy’ and another a good ‘sell’ — that happens all the time in financial markets and is what makes markets.”
  • ACA did know about and didn’t disclose Paulson’s involvement and yet was not named in the SEC complaint. As the party charged with the obligation of selecting the portfolio, ACA was a lot closer than Goldman to being a fiduciary with an affirmative duty to disclose.

So why did the SEC sue despite this obvious materiality problem?

  • Its own complaint makes clear the strong connection between the suit and the financial reform bill then pending in Congress by alleging that “[s]ynthetic CDOs like ABACUS 2007-AC1 contributed to the recent financial crisis by magnifying losses associated with the downturn in the United States housing market.” Clearly a suit alleging that Goldman, which had made out quite well from the financial crisis, particularly in the AIG bailout, had fraudulently sold the type of securities that helped trigger the crisis.
  • A WSJ story bolsters this explanation noting that the SEC had begun its probe on the transaction at least by August 2008, never offered Goldman the opportunity to settle, and had not contacted Goldman from September, 2009 until suddenly moving ahead with the charges during the critical final Congressional deliberations on financial reform.
  • The SEC’s usual role is to protect unsophisticated individual investors, not sophisticated market players like IKB. Why did this suddenly change in this case?
  • The SEC was under a lot of political pressure to come up with something out of the financial crisis. This case was evidently the best it could do.
  • The suit was disposed of as soon as it had no more political use – right after financial reform squeaked through Congress. Even Carl Levin expressed pleasure with the settlement. Why shouldn’t he? He got what he wanted.

And so now we have the settlement. What exactly did Goldman admit? Here it is:

Goldman acknowledges that the marketing materials for the ABACUS 2007-ACI transaction contained incomplete information. In particular, it was a mistake for the Goldman marketing materials to state that the reference portfolio was “selected by” ACA Management LLC without disclosing the role of Paulson & Co. Inc. in the portfolio selection process and that Paulson’s economic interests were adverse to CDO investors. Goldman regrets that the marketing materials did not contain that disclosure.

Well, ok, we knew the marketing materials were “incomplete” because they didn’t disclose Paulson’s role. I am not surprised that Goldman now believes this nondisclosure was “a mistake” which Goldman “regrets.” I would regret any actions that cost me $550 million plus attorneys’ fees.

But is that all there is? What about fraud, which would include an admission that the omission was material? Every disclosure is “incomplete” in some way. The materiality requirement is designed to protect parties from having to dump bewilderingly huge amounts of information on the market.

The WSJ quotes a former SEC enforcement lawyer as noting that dropping the strongest fraud charge is “usually a strong indication the SEC had some doubt whether it could prove intentional fraud.” Well, if that’s true, then what supports the extraordinary fine, of which less than half is going to the supposed victims who bought the securities?

Notably, according to the above WSJ story, the same Republican commissioners who opposed bringing the suit also opposed the settlement:

People familiar with the matter say Republican Commissioner Kathleen Casey questioned the SEC staff Thursday on their decision to abandon the strongest fraud charge and strike a settlement involving a lesser allegation, and given that, how the SEC could justify such a large penalty on a lesser charge. The political split over the case comes at a time when the agency remains under fire for its policing of the financial markets during the financial crisis. The SEC commissioners often split on party lines over policy decisions, but rarely do so on such high-profile enforcement cases. The disclosure of the dispute also raises fresh questions about how strong a case the SEC had against Goldman.

The settlement is disturbing for the additional reason that it leaves costly uncertainty about what duties Wall Street players now have. This issue now becomes very important as the SEC must rule on the fiduciary duties of broker-dealers under Section 913 of Dodd-Frank.

As I testified in a Senate hearing (at 7-8) on whether to impose fiduciary duties on investment bankers:

If the facts are as alleged [in the Goldman complaint] and the non-disclosures are material, Goldman may be held liable under existing law and no new fiduciary duty is necessary to create an obligation to disclose. On the other hand, if Goldman did not breach an existing duty to disclose material facts, there is no apparent justification for holding Goldman liable under any theory, including a fiduciary theory. This is true whether or not Goldman can be deemed to have an interest that conflicts with that of its customer.

More specifically, I asked soon after the complaint was brought:

[W]hat lesson should Wall Street take away from this case? What, exactly, does a bank in Goldman’s position have to disclose to a customer? The identity of another customer on the other side, as the complaint suggests? Only when that customer is somebody like Paulson. What does that mean? Only if the customer has selected the portfolio? What does that mean? Many deals are put together with buyers in mind. Suppose ACA (the collateral manager) assembles the portfolio here with Paulson in mind, and then Paulson says, “that’s for me. Now I’ll invest.” Is this more “material” than having Paulson take the initiative? Suppose they collaborate in putting the portfolio together?

What clues on all this can be gleaned from a settlement that involves a huge amount of money but only an admission of a “mistake”?

The bottom line is that this suit has proved to be no more than a common “strike” suit, no better than the sort of private securities class actions that triggered Congressional reform 15 years ago. Instead of attorneys’ fees, the SEC’s objective appears to have been purely political. In the end it extracted a ransom payment from Goldman so the firm could reclaim its reputation and get back to business.

The court must now review the settlement. It should take a cue from the dissenting Commissioners and reject it because of the puzzling and troubling inconsistency between the amount of the settlement and Goldman’s meaningless admissions. The SEC should have to prove exactly what Goldman did wrong. This will force Goldman to either litigate or make a meaningful settlement. Goldman is hardly an object of pity at this point. In any event, the issues here go far beyond Goldman to, among other things, the proper role and function of the SEC.

It is sad that the SEC not only cannot be trusted to find fraud, but that it can no longer be trusted to litigate and settle cases involving the supposed frauds that it finds. But this is where we find ourselves in the days following “financial reform.”

Larry Ribstein

Posts

Professor of Law, University of Illinois College of Law

18 responses to The SEC’s strike suit

  1. 

    Fair enough. I’ve never had an absolute rule against anonymous posting on either of my blogs, and many of my posters are anonymous for reasons you mention. Usually a poster simply makes a point that can stand or fall on its own. But when a poster begins by saying that I “appear[] not to understand basic securities law” he attacks me personally while shielding his own identity. I think it’s fair to draw attention to this fact.

    • 
      Onemantruthsquad 20 July 2010 at 3:20 pm

      Forgive me. I agree it is rude and not productive to start a dialogue with a claim that someone doesn’t understand something. I should have instead stated something like:

      The relevant legal standard doesn’t seem to involve fiduciary duties. The word “fiduciary” doesn’t appear in the SEC complaint. I think the better way to assess the merits and demerits of the SEC’s case is to apply the *actual* *specific* law on fraud and materiality to the specific facts of the case.

      That would involve, for instance, discussing whether a hypothetical reasonable investor would find Paulson’s role important in their investment decision. (Note that the standard is a *hypothetical reasonable investor* and not the actual investors, so the sophistication, or not, of the actual investors doesn’t seem relevant.)

      Perfect markets require perfect information; and imperfect information, including misleading and incomplete statements about the products being sold, yields imperfect markets (and the resultant deadweight losses and unproductive wealth transfers).

      I’m always perplexed by those who argue that gov’t action against fraudulent information asymmetries somehow hurts the market — rather it seems to me that such government action is just as essential to a properly functioning efficient market as the government action providing for the enforcement of contracts.

  2. 

    Also, in onemantruthsquad’s defense, I think anonymous posting has its merits. Not all of us are tenured law professors, Prof. Ribstein . . . some of us have day job’s which might make us reluctant to disclose our identity.

    • 
      Onemantruthsquad 20 July 2010 at 3:50 pm

      Page 19 of the flipbook http://www.scribd.com/doc/30036962/Abacus-2007-Ac1-Flipbook-20070226

      says that ACA is the Portfolio Selection Agent. It doesn’t name Paulson.

      Page 26 of the flipbook describes the Investment Philosophy as “Preserve capital”(!) and “Asset selection and asset management premised on credit fundamentals and then optimized for relative value.” It doesn’t say, “and then further optimized to maximize risk of default.”

      Page 27 of the flipbook:

      “Alignment of Economic Interest” (!)

      And that is just the flipbook, the full prospectus http://www.scribd.com/doc/30414220/ABACUS-Offer-Document has even more cheerleading about how great ACA is, and how they will pick a great portfolio.

      And in that context, is it plausible that an investor would not find it important to their investment decision that this additional disclosure was missing?:

      “The Reference Portfolio will also include securities selected by a party whose interests are not aligned with the noteholders and instead will economically benefit from the failure of the Reference Portfolio. In fact nearly half of the Reference Portfolio will have been selected by this party.”

      That information would not be important in an investor’s decision?

      And note that it doesn’t even have to counterfactually result in a *different* investment decision — only that it would be *important* to their decision.

  3. 

    I’m happy that the anonymous person posing as “onemantruthsquad” (note that I am not afraid to disclose who is standing behind my posts) is back to the same question I have been focusing on — whether there was a material misstatement or omission. Hopefully we won’t hear anymore about “statutory/regulatory obligations” of “underwriters.” And the fiduciary duty issue is relevant in analyzing the SEC’s decision to sue Goldman but not ACA.

    • 
      Onemantruthsquad 20 July 2010 at 8:46 am

      Ribstein asks “[W]hat lesson should Wall Street take away from this case? What, exactly, does a bank in Goldman’s position have to disclose to a customer?”

      Answer provided by the relevant law: “An omitted fact is material if there is a substantial likelihood that a reasonable [investor] would consider it important in deciding [to make the investment].” TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).

      Ignoring the red herrings about annonymity (focusing on someone’s annonymity is always a handy substitute to focusing on their argument) and inapplicable fiduciary duties, what is the argument that Paulson’s role WAS NOT material? What is the legal argument/theory that investors would NOT find that information important? That is what GS defenders, or those who otherwise want to criticize the SEC, must focus on if they are going to say anything relevant or useful.

      Finish this sentance: “Investors in Abacus would not find Paulson’s role in selecting the reference securities important in their investment decision because . . . “

      • 

        I have fully responded to these points in prior posts linked in the subject post, which Mr. Truthsquad apparently hasn’t read.

      • 

        Investors in Abacus would not find Paulson’s role in selecting the reference securities important in their investment decision because . . . “

        (a) they are sophisticated investors who, like countless investors at the time, made the investment with the bullish belief that the real estate market would continue to advance, thus making the content of the portfolio, as well as the identity of the person selecting the portfolio, immaterial;
        (b) they are sophisticated investors who, having engaged in similar transactions in the past, understood that the person on the other side of their transaction may have various information which they do not possesses but nevertheless choose to make the trade because they believe it is worth the risk;
        (c) even if Paulson’s identity been disclosed at the time, they would not have known or cared who he was;
        (d) even if Paulson’s identity been disclosed at the time it would not have been material because ACA would still have a fiduciary duty to ensure that appropriate securities were selected; or
        (e) all of the above

  4. 
    Onemantruthsquad 20 July 2010 at 6:46 am

    Ribstein appears not to understand basic securities law when he writes “ACA was a lot closer than Goldman to being a fiduciary with an affirmative duty to disclose.” That is false. The underwriter has the obligation to do the due diligence and do the disclosure — not the portfolio manager. And fiduciary duties have nothing to do with anything. The legal issue was that the underwriter had an obligation (not a fiduciary obligation, just simple statutory/regulatory obligation) to disclose all material facts. As GS admitted, the disclosure was incomplete b/c it didn’t disclose Paulson’s role and that was a mistake. ACA had no fiduciary, statutory or regulatory obligation to disclose anything to the investors — that is the underwriter’s obligation — and GS didn’t meet that obligation.

    • 

      Mr “onemantruthsquad” is confused. The only statutory obligation the SEC alleged was the obligation to refrain from fraud. As I said, breach of this obligation depends among other things on the materiality of Goldman’s omission concerning Paulson’s role in light of the disclosures Goldman did make concerning the portfolio. Goldman was not being sued as a 1933 Act underwriter, which would have given it special statutory/regulatory obligations, including a statutory “due diligence” duty under Section 11 of the 1933 act. By contrast, the investors relied on the portfolio manager to exercise care in assembling the portfolio. This reliance arguably made ACA a fiduciary with an affirmative disclosure obligation, consistent with my extensive writings on fiduciary duties.

      • 
        Onemantruthsquad 20 July 2010 at 7:43 am

        The fraud rules under Section 17(a) of the Securities Act and Rule 10-b(5) under the Exchange Act have been interpreted to include making material misstatements, including material omissions. “An omitted fact is material if there is a substantial likelihood that a reasonable [investor] would consider it important in deciding [to make the investment]. TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).

        Would the investors in Abacus “consider it important” that the portfolio was put together at least in part by the party that was also going to be on the other side of the transaction and not just ACA who was presented as picking good reference bonds? That’s the key legal issue and it seems pretty hard to argue that reasonable investors wouldn’t consider that information important and thus material.

        In its role as underwriter GS made statements that were incomplete and misleading. That was a mistake. Even GS admits that. Trying to confuse the issue with real and imagined fiduciary duties isn’t helpful.

        GS was simply creating and exploiting information asymmetries. Markets function best when there are fewer information asymmetries, especially those based on misleading statements and other forms of fraud. The SEC’s active enforcement of the anti-fraud rules such as in this case will create more transparent markets and less market failure in the form of exploitation of manufactured information asymmetries.

  5. 

    [...][A]s Ribstein writes: “Instead of attorneys’ fees, the SEC’s objective appears to have been purely political.” And part of that political objective, as he notes, was to alter the obligations that a corporation has to others. Exactly.[...]

  6. 

    You Can’t Cheat an Honest Man is a 1939 comedy film starring and scripted by W.C. Fields. Fields plays “Larsen E. Whipsnade”, the owner of a shady carnival that is constantly on the run from the law. The whimsical title comes from a line in an earlier film, in which he says that his grandfather’s last words, “just before they sprung the trap”, were:

    “You can’t cheat an honest man; never give a sucker an even break, or smarten up a chump.”

    Just remember, if you don’t know who the mark is, it is you.

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