On April 16, 2010, the Securities and Exchange Commission (“SEC”) filed charges against Goldman Sachs & Co. (“Goldman”) and one of its vice presidents, Fabrice Tourre (“Tourre”), alleging a violation of federal securities laws by making materially misleading statements in connection with a synthetic collateralized debt obligation structure known as ABACUS 2007-AC1. That same day, Goldman issued press releases characterizing the SEC’s allegations as “unfounded in law and fact,” and promising a vigorous defense of the “firm and its reputation.” As of April 19, 2010, however, Goldman and Tourre have not filed a formal answer.
The SEC’s complaint alleges the following facts. Around 2007, a large hedge fund, Paulson & Co., Inc. (“Paulson”), believed specific mid and subprime residential mortgage backed securities (“RMBS”) would experience losses caused by the degradation of mortgages in the underlying portfolio. As such, Paulson approached Goldman to make a market; that is, structure a transaction consistent with Paulson’s negative views on the RMBS market. Goldman, principally through its employee Tourre, then created a synthetic collateralized debt obligation (“SCDO”), known as ABACUS 2007-AC1. This structure allowed Paulson to pick and short the underlying RMBS portfolio references by subsequently entering into collateralized debt securities on the SCDO. This transaction was complex. Restated and more simply put, ABACUS 2007-AC1 effectively allowed Paulson to pick RMBS it believed would experience financial distress and subsequently profit on market moves consistent with that belief.
As with all trades, ABACUS 2007-AC1 required both a buyer (i.e., long position) and a seller (i.e., short position). According to the complaint, Goldman and Tourre “knew it would be difficult, if not impossible, to place the liabilities of a synthetic CDO if they disclosed to investors that a short investor, such as Paulson, played a significant role in the collateral selection process.” Furthermore, they knew at least one investor “was unlikely to invest in the liabilities of a CDO that did not utilize a collateral manager to analyze and select the reference portfolio.” Consequently, Goldman and Tourre failed to disclose Paulson’s role. Goldman approached ACA Management, LLC (“ACA”), to serve as a third-party portfolio selection agent. Nonetheless, Paulson allegedly played a “significant role in the portfolio selection process.” Moreover, Goldman also was alleged to have represented Paulson was taking a long position in ABACUS 2007-AC1.
ABACUS 2007-AC1 disclosure documents prepared by Tourre represented that ACA Management, LLC selected the reference portfolio. The documents said nothing about Paulson’s participation. Goldman sent materials marketing the derivative structure to IKB, an institutional client. Goldman allegedly knew that IKB had no desire to invest in CDOs created without an independent, third-party selection agent. IKB then entered a $150 million long position in ABACUS 2007-AC1 without any knowledge of Paulson’s participation. ACA Capital Holdings, Inc. and affiliates issued protection against $909 million of losses in the transaction in exchange for annual premium payments. By January 29, 2008, long investors had lost approximately $1 billion; Paulson’s short position netted profits of approximately $1 billion.
Based on these alleged facts, the SEC claimed Goldman and Tourre committed securities fraud for two reasons. First, Goldman and Tourre knowingly, recklessly, or negligently misrepresented that an independent, third-party selection agent created the ABACUS 2007-AC1 reference portfolio without disclosing Paulson’s role. Second, Goldman and Tourre knowingly, recklessly, or negligently misled long investors to believe Paulson was not shorting ABACUS 2007-AC1. As a result, the SEC claimed Goldman and Tourre violated Section 17(a) of the Securities Act; Section 10(b) of the Exchange Act; and Rule 10b-5 thereunder. The SEC sought, among other relief, a judgment (1) enjoining Goldman and Tourre from committing future violations of securities laws, (2) ordering disgorgement of ill-gotten gains, and (3) ordering payment of civil money penalties.
On the same day the SEC filed its complaint, Goldman issued two press releases vehemently denying alleged improprieties in connection with ABACUS 2007-AC1. The initial press release states, “[t]he SEC’s charges are completely unfounded in law and fact and we will vigorously contest them and defend the firm and its reputation.”
Goldman then issued a subsequent press release containing “four critical points.” Emphasizing its transaction fee of only $15 million, Goldman stated it lost more than $90 million on ABACUS 2007-AC1. Thus, Goldman would have not have designed the transaction or allowed another to build a reference portfolio that would clearly lose money. Next, long investors were sophisticated CDO market participants that received “extensive” information regarding the underlying reference portfolio. Moreover, they understood the SCDO necessarily required both a long and short market participants.
Furthermore, Goldman emphasized interactions between ACA and Paulson in creating the reference portfolio were “entirely typical of these types of transactions.” Finally, contrary to the SEC’s allegation, Goldman contends it never represented that Paulson had a long position in ABACUS 2007-AC1: “As normal business practice, market makers do not disclose the identities of a buyer to a seller and vice versa.” In sum, Goldman contends its losses of over $90 million, adequate disclosures, and industry standard business practices suggest proper and fair dealings in structuring and marketing ABACUS 2007-AC1.
The primary materials for this post are available on the DU Corporate Governance website.