4 Defenses Goldman May Use To Fight the SEC Lawsuit

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?

Brief Synopsis

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.

The SEC says Goldman and Tourre intentionally misled both investors and ACA.

Blame ACA

One tactic Goldman might take is to blame ACA for believing that Paulson's interests were aligned with its own. The SEC documents e-mails in the complaint showing that Goldman told ACA that Paulson would purchase a portion of the deal's first-loss equity piece. But the bank could claim that ACA had no way of knowing whether Paulson would ultimately follow through with his agreement. As a result, ACA's poor assumption was to blame -- not Goldman.

The fate of this defense depends whether the court is convinced that ACA acted irresponsibly by allowing Paulson to have an influence on the pool, despite Goldman's assurances that he would be an equity investor. If the evidence is strong that Goldman intentionally misled ACA -- and it appears to be -- then this argument might not be very compelling.

Blame Paulson

Goldman could attempt to say that Paulson misled the bank too. Goldman could say that it thought Paulson did want the equity piece, and claim it thought he would go long on the deal. Proving Goldman knew Paulson wanted to short the deal from the start could be challenging -- I don't see any indisputable evidence in the complaint to support this. But it's extremely implausible that Goldman could have thought Paulson wanted go net-long on the deal. The entire purpose of the transaction was for Paulson to obtain a short position.

A court will probably have trouble finding this argument sound as well. Any reasonable person who understands how markets work would conclude that Goldman must have understood Paulson's strategy, or else it would never have created the deal in the first place.

Blame Tourre

The bank could claim that Tourre was a sort of rogue banker who was acting improperly without their knowledge or consent. Given that he was only a 28-year-old vice-president, this seems a little far-fetched. Is supervision so lax at Goldman that his managing directors were unaware of the details of how he was doing deals? Bank management must have ultimately signed off on most of this stuff, so his managers couldn't have been completely oblivious to the transaction they stamped Goldman's name on.

This defense seems thin. Ultimately, the bank is responsible for the actions of its employees. If Tourre is found to have acted improperly, Goldman should also be held accountable -- unless it can be shown that he misled Goldman management as well.

Blame Investors

Finally, Goldman could attempt to fall back on the old "buyer beware" defense. If investors had done sufficient due diligence, they would have discovered that the deal's bonds were based on bogus collateral. While there's a kernel of truth in that argument, it only holds up if the seller discloses accurate information. In this case, Goldman may have intentionally misled investors by claiming that the collateral was chosen by an independent third party. In reality, it was heavily influenced -- and partially cherry-picked -- by Paulson.

The court's view here will probably hinge on whether it believes Goldman's disclosure to investors explaining the collateral selection was sufficient. A legal judgment will be needed to determine whether Paulson's degree of involvement in the collateral picking process was material to investors.