The Securities and Exchange Commission (SEC) filed an explosive complaint (.pdf) Friday against investment banking titan Goldman Sachs. The civil lawsuit alleges that the bank defrauded investors who it sold a synthetic collateralized debt obligation (CDO) it created. Naturally, Goldman vehemently denies wrongdoing, having released the follow one-sentence statement:
The SEC's charges are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation.
Yet through reading the SEC's complaint, the case sounds rather strong. So how might Goldman choose to respond?
The SEC lays out the facts (which Goldman may dispute) as follows. A hedge fund manager named John Paulson wanted to short the subprime mortgage market in early 2007. He asked Goldman Sachs to create a short position that he could purchase. In order to do so, Goldman had to create a long position to balance it out. A Goldman banker named Fabrice Tourre took on the deal. He sought to create a synthetic CDO for that long position to sell to investors. To do so, he knew he needed a seemingly neutral 3rd party collateral agent to make investors feel comfortable that the assets selected which the CDO referenced were sound. Goldman hired ACA Management for that job, and informed the company that Paulson would be purchasing the first-loss (long equity) piece of the CDO. As a result, ACA allowed Paulson to play a major role in selecting the assets, since it thought their interests were aligned. Of course, Paulson intentionally picked the assets he thought would do poorly instead, as he wanted to short the bonds. After ACA and Paulson agreed on a pool of assets, Goldman sold the resulting bonds to investors, informing them that ACA had selected the assets, without mentioning Paulson's major influence.