The story of the week is the U.S. Securities and Exchange Commission filing a complaint against international investment firm Goldman Sachs ("Goldman") on April 15 in the U.S. District Court for the Southern District of New York, alleging that Goldman and a Goldman employee, Fabrice Tourre, a former Vice President of Goldman in New York and current Executive Director of Goldman Sachs International in London, allegedly made materially false statements to investors regarding a synthetic collateralized debt obligation, or CDO, which Goldman marketed to investors. A CDO is an asset-backed security which derives its value from underlying assets. The CDO in question was called Abacus 2007-CD1 ("Abacus 2007" or "CDO"), was backed by subprime residential home mortgages. Goldman issued a press release following the filing of the complaint stating that "The SEC’s charges are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation."
The SEC complaint alleges that Goldman used marketing materials for Abacus 2007 which falsely represented that the portfolio of mortgage-backed securities which formed the CDO were selected by ACA Management LLC ("ACA"), a firm with experience in analyzing mortgage-backed securities. However, the complaint contends that Paulson & Co., Inc. ("Paulson"), allegedly participated in the selection of the portfolio in the Spring of 2007 without any mention in Goldman's marketing materials and without the knowledge of Goldman's investors. Paulson also allegedly entered into "credit default swap" ("CDS") agreements with Goldman. Under a CDS agreement, in its basic form, an entity or person purchases "protection" against a potential default or "credit event" involving a credit instrument such as a bond or loan. The purchaser of the protection makes quarterly or premium payments to the seller of the protection. In the event that the instrument goes into default, the seller pays the purchaser the par value of the bond or other fixed amount. CDS agreements may be used for speculative purposes, such as betting on a default in credit or loan obligations. The SEC alleges that Paulson, in selecting the securities which made up Abacus 2007, had a financial incentive to select securities which would experience credit events.
Paulson allegedly was under the belief since 2006 that certain "Triple B" rated subprime mortgage loans would experience "credit events," a/k/a significant losses. Paulson then allegedly approached Goldman and asked it to create a CDO composed of the mortgage-backed securities it believed would experience credit events. Paulson and Goldman would then allegedly "short" the CDO by entering into a CDS agreement.
The complaint alleges that Tourre designed the Abacus 2007 transaction, prepared the marketing materials and communicated with investors. At the time they were structuring the transaction, Goldman, Paulson and Tourre knew that the market for mortgage-backed CDOs was declining. Tourre allegedly sent an e-mail to a friend in January of 2007 in which he stated ""More and more leverage in the system, The whole building is about to collapse anytime now...Only potential survivor, the fabulous Fab[rice Tourre] ... standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstruosities!!!" The following month, Tourre allegedly received an e-mail from the head of Goldman's structured product correlation trading desk stating that "the cdo biz is dead we don't have a lot of time left."
The complaint also alleges that Goldman, Paulson and Tourre chose ACA Management as the portfolio selection agent because they knew they could not attract investors if the investors knew that Paulson had selected the CDO in order to short it. Paulson then allegedly identified over 100 Triple B bonds which it expected to experience credit events, including mortgage-backed securities with a high concentration of subprime adjustable rate mortgages and buyers with low FICO scores.
Tourre and representatives of Goldman, Paulson and ACA met in January and February of 2007 to select the portfolio for Abacus 2007. ACA allegedly had no knowledge that Paulson intended to short the CDO and the complaint alleges that Goldman allegedly mislead ACA into believing that Paulson was investing in the equity of the CDO and had a "long position" in the CDO's success, as opposed to taking a short position adverse to the interests of Goldman investors. ACA allegedly only permitted Paulson to participate in the portfolio selection process because it was led to believe that Paulson was a large equity investor. Tourre allegedly sent an email to a co-worker during these meetings stating "I am at this aca paulson meeting. this is surreal."
By the end of January, 2009, 99% the Abacus 2007 portfolio had been downgraded and investors in the CDO had lost $1 billion. Conversely, Paulson allegedly received $1 billion in profit. Investors in Abacus 2007 included IKB, a commercial bank in Germany, which lost almost all of the $150 million which it invested; and ACA's parent company, ACA Capital Holdings, the largest investor which invested some $951 million.
The SEC alleges that Goldman and Tourre violated Section 17(a) of the Securities and Exchange Act of 1933, 15 U.S.C. s 77q(a) and Section 10(b) of the Securities and Exchange Act of 1934, 15 U.S.C. s 78j(b). It seeks civil penalties and fines against the defendants.
Goldman, by all appearances, intends to fight back against the allegations. In a second press release, it contends that the accusations are unfounded in law and fact. Goldman maintains that it would not structure a portfolio that was designed to lose money, that it retained substantial risk in the transaction, and points out that it lost more than $90 million itself. It contends that its large investors were provided with extensive information relating to the underlying mortgage securities and the risks, and provided input on the underlying mortgage securities. Furthermore, Goldman points out that ACA was the largest investor and had every incentive to select securities which would not experience credit events. Goldman also claims that it never represented to ACA that Paulson would be a long investor, and that the industry practice is not to disclose the identities of buyers to sellers.
The complaint against Goldman is the largest action thus far to emerge out of the financial collapse which began in 2007, and which has angered the public and has lawmakers, law enforcement and the SEC itself feeling the heat. Former Bear Stearns hedge fund managers Ralph Cioffi and Matthew Tannin were acquitted on fraud charges last November relating to a failed hedge fund.
