This will sound surprising given how much Goldman’s stock and the equity market have been hammered by the allegations, but here’s our initial take:
The SEC’s case against Goldman Sachs seems very weak.
The SEC’s case against Fabrice Tourre seems slightly stronger, but it’s hardly a slam dunk.
Let’s go to the details…
THERE ARE TWO MAJOR ALLEGATIONS IN THE SEC’S COMPLAINT:
- Goldman failed to disclose to buyers of the ABACUS CDO that Paulson & Co. had been involved in the process of selecting the securities in the CDO
- Fabrice Tourre, the Goldman SVP who put together the deal, gave the outside manager who selected the securities, ACA, the impression that Paulson & Co. would be buying the equity of the CDO instead of shorting it.
Let’s take those one by one.
DID GOLDMAN NEED TO DISCLOSE PAULSON’S INVOLVEMENT?
The SEC alleges that Goldman failed to disclose to investors that Paulson & Co. played a role in selecting the securities that were included in the CDO in question. Instead, the SEC says, Goldman merely told investors that a third-party firm, ACA, was the “Portfolio Selection Agent.”
Based on a close reading of the SEC’s evidence, however, Goldman likely has a strong argument that it was not required to disclose that Paulson & Co. had been involved in the selection process.
Because it is clear from the email snippets the SEC cites that ACA had full control over which securities were selected for the final portfolio.
For example, Paulson picked 123 securities it wanted in the CDO. ACA reviewed Paulson’s picks and then sent an email to Goldman saying it was comfortable using only 55 of them. Later, ACA submitted its draft portfolio to Paulson, and Paulson requested that ACA eliminate 8 securities. ACA agreed to do this–but it clearly still had the authority to approve–or not–the final portfolio.
And here’s an important fact that the SEC omitted. In addition to picking the securities for the deal, ACA was also the lead investor in the transaction.
So the SEC’s evidence does show that Paulson was involved in the security selection. It also suggests, however, that ACA was the final arbiter of what would be included and what wouldn’t. It seems appropriate, therefore, for Goldman to describe ACA as the “Portfolio Selection Agent.” It does NOT seem obviously necessary for Goldman to have mentioned that Paulson was involved in the selection.
Because dozens of things were presumably involved in the security selection. ACA had constructed more than 20 of these products. It had its own analysts and models. It clearly did not just simply rubber-stamp Paulson’s suggestions (on the contrary–it dinged more than half of them).
So the SEC’s claim that Goldman should have disclosed Paulson’s involvement in the selection process seems weak. And the lead investor in the CDO, ACA, also knew full well that Paulson had been involved, because it worked with Paulson itself!
And now on to the second allegation…
DID FABRICE TOURRE MISLEAD ACA ABOUT PAULSON’S INTENTIONS?
The SEC further alleges that Fabrice Tourre, the Goldman SVP who put together the deal, misled ACA about Paulson’s intentions with respect to the CDO.
Specifically, the SEC alleges that Tourre knew or should have known that ACA had the impression that Paulson was planning to BUY the CDO instead of shorting it, and that Tourre should have disabused ACA of this notion.
Upon close examination, this allegation seems somewhat stronger than the first one, but it’s still no slam dunk.
Let’s go to the complaint.
In early January, 2007, Tourre met with ACA and Paulson about the transaction. ACA clearly wanted to know what Paulson’s intentions were with respect to the CDO, and asked Tourre to clarify them. According to the SEC, Tourre sent ACA the following information:
On January 10, 2007, Tourre emailed ACA a “Transaction Summary” that included a description of Paulson as the “Transaction Sponsor” and referenced a “Contemplated Capital Structure” with a “% – %: pre-committed first loss” as part of the Paulson deal structure. The description of this % – % tranche at the bottom of the capital structure was consistent with the description of an equity tranche and ACA reasonably believed it to be a reference to the equity tranche. In fact, GS&Co never intended to market to anyone a “% – %” first loss equity tranche in this transaction.
Now, the exact language in that “Transaction Summary” is going to be very important. It’s not crystal clear from the SEC’s description that Tourre’s misled ACA, but it’s certainly possible.
Later, it becomes clear that ACA believed that Paulson was planning to buy the equity of the CDO (there’s plenty of evidence of this). The SEC then alleges that Tourre knew this and had a duty to disabuse ACA of this notion:
Tourre knew, or was reckless in not knowing, that ACA had been misled into believing Paulson intended to invest in the equity of ABACUS 2007-AC1.
So… there does not appear to be any incontrovertible evidence that Tourre lied to ACA. There is evidence that ACA believed Paulson was going to buy the equity of the CDO and that Tourre knew this. The question, therefore, will be whether he had a duty to disabuse ACA of this.
One important factor here. Presumably, like all investors who have made mistakes, ACA would prefer to believe that it was misled than to accept that its analysts blew it. ACA, therefore, has a motive to blame Tourre for misleading it.
In reality, however, to make this case, ACA is going to have to make the embarrassing admission that knowing what Paulson & Co was going to do affected its judgment with respect to the transaction. This information should NOT have affected ACA’s security selection process. It should also not have affected ACA’s decision to go forward with the deal. ACA is an independent firm staffed with experienced professionals paid millions of dollars to evaluate securities by themselves. What Paulson was or wasn’t planning to do, therefore, should have been irrelevant.
The SEC’s case against Goldman seems weak. The case against Tourre seems somewhat stronger, but it’s not no slam dunk.
Overall, based on a close reading of the evidence, the case against Goldman seems much less clear cut than the press and SEC are making it out to be.
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