The SEC complaint filed on April 16, 2010 in the U.S. District Court, Southern District of New York against Goldman Sachs and its vice president Fabrice Tourre alleges securities fraud in marketing and structuring of a CDO financial instrument called ABACUS 2007-AC1 (ABACUS) in February 2007. ABACUS was sold to Goldman Sachs clients as a "synthetic collateralized debt obligation (CDO) that hinged on the performance of sub-prime residential mortgage-backed securities (RMBS)," states the SEC press release regarding the filing of the civil fraud complaint.
Goldman Sachs Civil Fraud Allegations
Robert Khuzami, Director of the SEC's Division of Enforcement, public statement provided that "Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party."
According to the SEC complaint, the Goldman marketing statement issued to the ABACUS CDO customers disclosed that ACA Management LLC (ACA), an independent third party experienced in analyzing RMBS credit risks, chose which mortgage securities would make up the RMBS used as collateral for the CDO product. Further, the Goldman ABACUS statements to clients did not disclose that hedge fund manager John Alfred Paulson of Paulson & Co., one of the world's largest hedge funds, paid Goldman Sachs to hand pick a group of sub-prime mortgages for the RMBS that would collateralize the ABACUS CDO.
Goldman Sachs' Fiduciary Duty in the ABACUS CDO Deal
Before the district court appears both issues of fact and law. The issue of fact is whether ABACUS investors knew that the RMBS included subprime lending mortgage assets. The issue of law before the court is whether Goldman Sachs had a fiduciary duty to ABACUS investors to disclose both Paulson's involvement in the process and that ACA was not the only party assessing the underlying RMBS for Goldman Sachs transactions.
The SEC alleges that Paulson's hand in the selection process and economic interest in selecting the RMBS should have been disclosed in the collateral selection process. According to the SEC complaint, Paulson bet against or took a short position on these selected subprime mortgage bonds with Goldman Sachs. Paulson & Co. earned $3.7 billion in 2007 when the underlying sub-prime RMBS failed. The $10.9 billion investment in ABACUS lost Goldman's other customers billions. Paulson has not been charged in the SEC civil lawsuit. ACA, the third party RMBS insurer, is no longer in business.
Scope and Impact of Subprime Lending on RMBS Transactions
The ABACUS CDO was one of 25 deals that Goldman Sachs developed for banks and other select clients who wanted Goldman to design financial securities deals that bet against the U.S. housing market. Investors included U.S. pension funds, hedge funds, and insurance companies, as well as foreign investors such as IKB Deutsche Industriebank AG (IKB) and ABN AMRO Bank N.V. (ABN AMRO). The SEC lawsuit claims that the defendants violated Section 17(a) of the Securities Act of 1933, 15 U.S.C. §77q(a) ("the Securities Act"), Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. §78j(b) ("the Exchange Act") and Exchange Act Rule 10b-5, 17 C.F.R. §240.10b-5. Goldman Sachs shares dropped more than ten percent after the SEC civil case filing was publicly announced.
The SEC filed its civil complaint against the Wall Street financial institution at a time when an anticipated federal financial regulatory reform bill pends before the U.S. Senate. The bill before the U.S. Senate seeks to increase banking regulations and financial regulations over new complex financial instruments like CDOs and derivatives market products.
General Disclaimer: This article is for informational purposes only and should not be used as a substitute for legal or tax advice.
Vanessa Cross - Vanessa Cross is a freelance writer who writes about international trade, business law and small business development issues.
Join the Conversation