HE THAT PLAYS WITH GOLDMAN MAKES THE RULES

4/19/20

The big financial story of the last few days has been the SEC suit against Goldman Sachs, alleging that Goldman helped John Paulson’s hedge fund construct a CDO against which Paulson could bet by buying credit default swaps (i.e., going long the protection) and failed to notify prospective purchasers of long positions in the CDO of Paulson’s effective short position. Three things come to mind when thinking about this suit, none of which might be especially insightful but all of which are worth considering.

First, it seems to me that the SEC’s case hinges on two things: the extent to which Paulson & Co. effectively put together the CDO that it bet against and Goldman’s attendant duty to disclose that involvement. The SEC alleges that Paulson was intimately involved in constructing Abacus, the subject CDO, and that ACA Management, the “portfolio selection agent” for the CDO, was, to put it perhaps a little more strongly than would the SEC, a mere laundering device, either a witless dupe or a co-conspirator (The latter is highly unlikely, given the losses ACA ultimately took in this fiasco.). Paulson employees were involved in every meeting, every step of the way in the construction of Abacus. Therefore, the SEC alleges, Goldman engaged in something of a sham, helping a client construct a straw man to set afire at the expense of its other, less favored clients. At the very least, according to the SEC, Goldman should have disclosed to those taking long positions in the CDO the effective short position Paulson was taking. Goldman counters that Paulson’s role in constructing Abacus was advisory at best, that it was ACA who indeed put the portfolio together, even rejecting some of Paulson’s suggestions. That Paulson was taking an effective short position in the CDO was not material and therefore Goldman was not required to disclose Paulson’s effective short position.

If Paulson effectively constructed Abacus to bet against it and Goldman did not disclose Paulson’s short position, Goldman is, to use a technical legal and financial term, screwed. If Paulson was an effective bystander in Abacus’s construction, this case is much adieu about very little, if anything. The ethical issues are more complicated, but the legal issues are as simple as I have just enumerated.

Second, one of Goldman’s defenses, or at least an argument used by its defenders in the press, is that those injured in this alleged fraud, including German bank IKB and ACA, which, in addition to being the “portfolio selection agent” effectively insured Abacus through the use of credit default swaps (i.e., took a position on the other side of Paulson’s) were big boys, “sophisticated investors” in Wall Street and legal parlance and, as such, disclosure requirements were less stringent than they would have been had we been dealing with, I suppose, unsophisticated investors. Further, the drift of the argument, on a broader scale, is that no one should shed a tear for people who should have known better.

As readers of this blog know, I am certainly in profound agreement with this latter argument. However, there are problems with applying the “sophisticated investors” defense here. First, even sophisticated investors need information to conduct effective analysis. If one of those pieces of information was that the people who built this portfolio were betting against it and that piece of information wasn’t disclosed, even sophisticated investors, unless they somehow obtained such knowledge by osmosis or subterfuge, could not conduct the types of analysis we normally associate with sophisticated investors. In short, even sophisticated investors are entitled to information that they need to conduct sophisticated analysis.

Second, the same people making the “sophisticated investor” argument are saying that Paulson’s effective short position in Abacus was not a material fact and therefore did not have to be disclosed. In fact, to disclose Paulson’s position would be unethical because a securities firm should not be discussing its clients’ positions. Why was Paulson’s involvement not material? Because, at that time, the argument goes, John Paulson was not the superstar he is today; he was just another hedge fund manager, so his involvement should not have swayed anyone’s decision making. C’mon. Even back in 2007, Paulson, while not yet a household name (He probably is not a household name even now; note that he has often been confused in the context of this case with Hank Paulson, the former Treasury Secretary and head of Goldman Sachs.), had already achieved a level of success on Wall Street that was the envy of even Goldman partners, much of it from his early forays against the mortgage market. That he became even more wildly successful as the mortgage markets imploded does not mean he was a nobody when Abacus was being assembled. While most people would not have known of John Paulson at that time, certainly anyone considered “sophisticated” in the mortgage markets (i.e., those taking long positions in Abacus) would have known of Paulson and would have found his betting against Abacus worth pondering as they considered a long position in Abacus.

Third, the legal definition of “sophisticated investor” is flawed because it is based largely on the size of an investor’s investable portfolio and net worth rather than his or her level of knowledge of the financial markets. By the SEC’s reckoning, Paris Hilton and Sarah Palin are “sophisticated investors.” Enough said.

My third major point is that the timing of this suit is beyond suspicious; it came just as President Obama is pushing for further regulation of Wall Street. What better way to rouse public sentiment and bring a few Republicans onboard? The timing was blatantly political. But why should this surprise anyone? We are dealing with politicians. They are all, to use a technical, and redundant, political science term, blood sucking leeches with limited understanding of the subject matter they are treating but with, in their own minds, unlimited understanding of the art of spinmeistering.