By Tom Adams, an attorney and former monoline executive and Yves Smith
A common fallacy is to assume that situations are polar: win/lose, black/white, hot/cold, heads/tails. But more often, given A, “not A” is not the opposite of A.
Conventional wisdom in the financial media is that the settlement announced by the SEC over its lawsuit on a Goldman 2007 Abacus CDO is a home run for Goldman. But a closer reading suggests that Goldman’s victory is qualified, and the enthusiastic press response is in large measure due to the firm’s skillful manipulation of perceptions.
Goldman wins because they managed expectations effectively (it was only $550 million, not $1 or $2 billion bandied about) and because the SEC didn’t hit them with something more severe, such as a multi-year ban from the sector. However, Goldman’s settlement appears to be a loss for CDO banks and issuers and a potential gain for investors and plaintiffs in future actions. In fact, it is hard to see how anything in the settlement, if affirmed, would be negative for private parties considering lawsuits against sellers of CDOs.
As a close observer of the cases and allegations made regarding problem CDOs, we imagine potential CDO investors will be mightily encouraged that Goldman ended up returning the full amount of investment to the one true third party investor in the deal – IKB. While Goldman was permitted to say that they did not admit any wrong doing, the settlement amounted to the same thing: they made inaccurate statements, which were misleading and led to losses for the investor. These losses were refunded in full by Goldman presumably because the inaccurate statements were material. In addition, from the perspective of the investor, Goldman effectively paid punitive damages, in the amount of $300 million (the amount in excess of the damages awarded to IKB and RBS/ABN).
Remember, this case was always going to be a settlement, only the terms were up for discussion. In the range of possible outcomes, this settlement came out tilted against Goldman. Many observers of the SEC’s complaint against Goldman argued the case was weak: Goldman had no duty to disclose Paulson’s role (after all, he was a nobody, “everyone” knew the other side of the deal was a short, and so on). However, in the settlement agreement, Goldman concedes that it was a “mistake” not to disclose Paulson’s role in selecting the bonds and that Paulson’s interests were adverse to the investors. This would seem to imply that the SEC’s case was solid and that they played their cards well.
An investor considering bringing an action against a bank that sold them a CDO that failed (meaning virtually all 2006 and 2007 “mezzanine” CDOs) would probably be encouraged that a bank was required to pay such a large amount for making inaccurate statements about the true nature of the CDO.
1. While Goldman didn’t “admit guilt”, they said their statements misled Investors and caused them to lose money. Since Goldman’s pitchbook and offering document were completely normal for the market, many other deals likely fit in this category. Even if the SEC doesn’t bring more claims, litigants in private claims now have evidence that (a) Goldman will pay on CDOs for misstatements and (b) Goldman has admitted its misstatements misled Investors enough for Goldman to repay them in full (or pretty close).
2. The two remaining long Investors in the deal were in large measure paid back. IKB was reimbursed in full. RBS recouped a large portion of its share, since they stood in for ACA, who probably paid some amount and against whom ABN/RBS certainly had CDS protection.
So if Goldman was willing basically to fully reimburse Investors for their loss, disgorge all of their profits and pay effectively punitive damages for this “weak case”, that seems to be a decent indicator for future actions. Plaintiffs who sue CDO sellers have good reason to be optimistic. If they believe they have a reasonable argument that they were misled in the selling process. The Goldman example suggests they can push for and win major damages.
Private litigants now have good reason to hope that banks that misled them in a material way that produced losses can be pressed to reimburse those costs.
3. Goldman escaped a fraud judgment, but will now be known as the bank that paid the largest SEC penalty ever. As stated earlier, Goldman was always going to settle. They settled paying off most investor losses, admitting misleading Investors and setting a new record. Not so good for Lloyd Blankfein.
4. All the analysis in the world won’t matter if the deal seller makes materially inaccurate statements to an investor when he asks questions and does diligence. Goldman was not forced to admit they committed fraud but they admitted they make inaccurate disclosure and, by their actions (paying large amounts of money to the investors), Goldman conceded that the inaccurate disclosure was a cause of the investor losses. This stands in stark contrast to its claims in April when the SEC filed its lawsuit:
We believe the SEC’s allegations to be completely unfounded both in law and fact, and will vigorously contest this action.
• The core of the SEC’s case is based on the view that one of our employees misled these two professional investors by failing to disclose the role of another market participant in the transaction, namely Paulson & Co., and that the employee thereby orchestrated the creation of materially defective offering materials for which the firm bears responsibility.
• Goldman Sachs would never condone one of its employees misleading anyone, certainly not investors, counterparties or clients. We take our responsibilities as a financial intermediary very seriously and believe that integrity is at the heart of everything that we do.
• Were there ever to emerge credible evidence that such behavior indeed occurred here, we would be the first to condemn it and to take all appropriate actions.
• This particular transaction has been the subject of SEC examination and review for over eighteen months. Based on all that we have learned, we believe that the firm’s actions were entirely appropriate, and will take all steps necessary to defend the firm and its reputation by making the true facts known.
Paulson, by implication, earned his money on the ACA trade thanks to Goldman’s misrepresentations, rather than his shrewdness. The settlement thus tarnishes the popular myth that the subprime shorts were insightful outsiders who executed “the greatest trade ever”. Paulson’s purported $1 billion in profits from this ACA deal depended, in part, upon inaccurate statements made by Goldman for his benefit. In effect, Paulson’s gain cost Goldman $550 million while the parties on the other side of Paulson’s trade (the ones that are still around, since ACA is defunct) got most of their money back. This implies that had Goldman not made the inaccurate disclosure about the deal, the investors might not have bought the bonds and Paulson would not have made such a killing. The settlement does nothing to discourage the notion that other CDO transactions had similar inaccuracies which resulted in ill-gotten gains for the shorts and unwarranted losses for the long investors.
The reason this is good news for Goldman is that they didn’t end up with exposure for fraud or much larger monetary penalties, which could have been devastating. Despite the tough talk by Senator Levin and others at the Senate hearings earlier this year, investigators haven’t found the smoking gun for outright fraud.
But the SEC has opened the door to further inquiries into the CDO-selling business. Other investors in blown up CDOs may now be emboldened to go after Goldman and other manufacturers of CDOs. Goldman has conceded that, on this Abacus transaction, they used inaccurate statements in the offering documents to sell the CDO. With this settlement, the SEC has demonstrated that investors in such a CDO can win a recovery as a result of such inaccurate statements.