NEW YORK (Reuters) The civil lawsuit filed by securities regulators against Goldman Sachs Group from the sale of a security linked to subprime mortgages may not open the floodgates for similar enforcement actions of its kind as some believe might happen.
In fact, the case lodged by the Securities and Exchange Commission against Goldman and a 31-year-old bond salesman may prove to be more rare than initially believed, a close reading of legal documents in the matter reveals.
On Friday, the SEC charged Goldman and Fabrice Tourre with failing to disclose to institutional investors that the hedge fund giant Paulson & Co had an economic interest in seeing the security perform poorly and also played a role in helping to put the deal together.
In other words, the SEC contends the security, Abacus 2007-AC1, was built to fail and that fact was kept from investors betting the U.S. residential housing market was not on the verge of collapse in early 2007.
Last September, the SEC informed Goldman’s lawyers that one reason they singled out the Abacaus 2007 deal was because other investment banks selling so-called synthetic collateralized debt obligations had told their customers that a hedge fund betting against the deal may have played a role in arranging the security, according to a legal filing Goldman submitted to regulators last fall.
Lawyers for Goldman countered in the filing that it was not common practice for investment banks to tell potential customers a hedge fund might be shorting a deal and also selecting the underlying portfolio of mortgage-backed securities.
Goldman’s lawyers also said it was generally understood that in a synthetic CDO one party would be shorting the deal and another side would be going long on the housing market. The names of the parties on either side of the bet were irrelevant and there was no need for further disclosure, the banks lawyers argued.
In opting to sue Goldman, the SEC obviously rejected the investment bank’s argument that the Abacus deal was just like any other synthetic CDO.
Yet the SEC’s rationale for suing Goldman would also indicate regulators don’t expect to find many other deals that were marketed to institutional investors in a similar “misleading” manner, which could suggest that those type of deals were not rampant and could be just an issue with this deal and a few others.
Indeed, even legal experts have pointed out that the SEC complaint is careful not to put synthetic CDOs on trial -- even though many now view them as a dubious investment products.
“The key is the disclosure part. Simply creating a situation where one party is long and another party is short is not the issue,” said Scott Berman, a securities lawyer who specializes in representing hedge fund investors. “The problem is the failure to disclose how the vehicle was created.”
Much of the case will depend on whether the SEC can prove its allegation that Goldman misled investors into believing that Paulson had taken an “equity” position in the deal in an essence was long the underlying portfolio.
Goldman’s lawyers claim neither it nor any of its employees ever told investors that Paulson was an equity investor.
The legal filings submitted by Goldman to the SEC last fall also reveal that in all -- five Goldman employees were interviewed by regulators and the investment firm turned over 8 million pages of documents.
One of the people interviewed was Tourre, the lone Goldman employee to be charged by the SEC. But curiously, regulators did not interview Jonathan Egol, a Goldman vice president who worked closely with Tourre in structuring and marketing synthetic CDOs.
No top executives from Goldman were interviewed by the SEC.
Of the five Goldman employees interviewed, all are still employed by the firm except for one, Gail Kreitman. She left Goldman in June 2009, about two months before regulators notified the investment firm that it was considering filing a lawsuit.
Kreitman, who lives in New Jersey, could not be reached for comment. She has not registered with another investment firm since leaving Goldman.
Reporting by Matthew Goldstein; Editing by Bernard Orr
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