Loose Legal Concept Gives Goldman Sachs Grounds to Argue

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by Marian Wang, ProPublica

At the heart of the SEC's civil suit against Goldman Sachs—and at the center of our story detailing many similar deals [1]—is a legal standard that is quite cloudy. Here is the first line of the SEC's complaint [2] (emphasis mine):

The Commission brings this securities fraud action against Goldman, Sachs & Co. ("GS&Co") and a GS&Co employee, Fabrice Tourre ("Tourre"), for

making materially misleading statements and omissions

in connection with a synthetic collateralized debt obligation ("CDO") GS&Co structured and marketed to investors.

Financial firms selling securities are required to disclose all the information about their products that is "material" to an investor's decision to invest.

"The legal concept of materiality provides the dividing line between what information companies must disclose—and disclose correctly—and everything else," explained former SEC official Richard Sauer in a 2007 issue of The Business Lawyer. "Materiality, however, is a highly judgmental standard, often colored by a variety of factual presumptions." It's also "inherently situational," according to Sauer.

So what exactly is considered material information? I talked to several experts and got several answers. The only thing they seemed to agree on was this: It's "legally complex." It "depends on the situation." It's "not a clear line."

Generally, if a bank sold the complex investments known as CDOs [3] while presenting investors with information that it knew was false or incomplete, investors could have grounds for legal action. Under securities law, both affirmative misrepresentation and sins of omission can be illegal. You can't say a CDO is risk-free if you know the underlying assets are on fire, and you also "can't make misleadingly partial disclosures," according to Sauer.

If that sounds fairly simple, consider this: Standards of materiality also depend on the type of investor. It's generally understood that banks have fewer disclosure obligations when customers are so-called "sophisticated investors." That's why in a statement on Friday [4], Goldman Sachs argued that the investors in that particular deal "were among the most sophisticated mortgage investors in the world"—the bank was appealing to a distinction in securities law. From Bloomberg [5]:

"Materiality is a lot like a continuum," said Jacob Frenkel, a former SEC lawyer now in private practice at Shulman Rogers Gandal Pordy & Ecker in Potomac, Md. "The amount of information that needs to be disclosed to institutional investors at the highest level, where they're doing their own research and analysis, is less. Their criteria for the investment decisions tend to be far more sophisticated than the individual investor's."

The law doesn't specifically spell out the type of information that is material, but the outcome of the SEC's lawsuit against Goldman could set a legal precedent.

"This is all new territory," said Tom Hazen, professor of law at the University of North Carolina at Chapel Hill. The problem is that short of having more sophisticated rules governing CDO and derivative transactions, "the question is how many of these non-disclosures can fit into just traditional, fraud-based rules? That's why all the answers you're getting are 'Well, it could be,' or 'That's a good question."

It comes down to this: When financial innovation spurs the industry to make new products, and those products are so complex [6] even lawyers are left scratching their heads, what you find is that rules for determining legal liability are also riddled with gray areas.

"Regulatory rules are pretty basic as to making pretty clear distinctions as to what can and cannot be done with many types of routine transactions," explained Hazen. "It's when financial innovation comes around that regulators have to decide, how are we going to adapt our regulations? Are we going to create new ones or not? And here they decided not to."

The gray areas in securities law and banks' disclosure responsibilities have posed significant challenges for individual investors trying to sue their banks for misrepresenting a product's risk.

"These are difficult cases to bring," said James Cox, a professor of securities law at Duke University. Because disclosure requirements are so situational, "CDOs and swaps [7], those markets do not lend themselves to class certification," even for investors in the same CDO. Goldman made 25 Abacus deals, but the SEC lawsuit tackles only one.

The current financial regulation bill in the Senate proposes a one-year study to consider expanding fiduciary duty [8] to apply to more investment situations. Making that a requirement would mean banks would in effect have higher disclosure requirements since it would make more information material for more investors. It would also chip away at the "sophisticated investor" defense. The Senate bill originally had such language expanding banks' responsibilities. But the bill has since been revised to require only that the matter be studied [9].

This means that for the time being, what we're left with is an indeterminate level of obligation to investors and a murky legal standard so complex that it has rendered legal recourse mostly unsuccessful—at least so far.

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One thing that I will find interesting as this suit (and likely more to come against other investment banks) proceeds -- what role will the bank's own purchases of top tranches play in their defense.

In the Magnetar case that was highlighted by ProPublica (and on last week's TAL), Magnetar intentionally bought the lowest equity tranches of the CDO and insured itself against collapse by buying CDS against the mezzanine tranches. However, in many cases the investment banks (I think Merrill was specifically named in the TAL episode) took large positions in the top tranches.

I don't know if Goldman itself took positions in the top tranches of the CDOs it peddled. But if it did, I can see that working to their favor that they gave other investors suitable disclosure. Ie., if you're a sophisticated institutional firm weighing an investment, and the bank itself is buying top tranche, that ought to speak to the safety of the investment. Actions speak louder than words, as it were. In the mindset of the times, I think that's a sustainable logical position for a bank (Goldman or other) to take.

What we now know, of course, is that it's vital to distinguish between the banker and the bank. The individual banker only needed to focus on the short term goal of landing the immediate fees for a successful launch of the CDO. If a billion dollars of top tranche sat on the bank's books and ultimately went south ... well, not his problem, is it? He already got paid.

That's a big part of what went so wrong in the whole housing bubble. Far too many people at every level were being compensated for short term returns, not long term viability. That went for the mortgage broker who sold a loan to new homeowner who obviously couldn't afford the payments all the way to the bankers who profited from selling junk CDOs.

But the legal wiggle room for the banks may well be that they thought the CDOs were safe, witness their own active participation in them.

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Ron, in that expose on This American Life, they talked about how the current structure creates an environment where the the bankers themselves benefited while the banks took the biggest loss:

Many of the bankers who worked on these deals personally benefited, earning millions in annual bonuses. The banks booked profits at the outset. But those gains were fleeting. As it turned out, the banks that assembled and marketed the Magnetar CDOs had trouble selling them. And when the crash came, they were among the biggest losers.

The Obama Administration has talked about these bonuses and I know that people here like AJ think that bonuses should be left out of the equation. What, in your opinion, could be done to eliminate this disconnect between bonus pay and long term performance?

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Ron, in that expose on This American Life, they talked about how the current structure creates an environment where the the bankers themselves benefited while the banks took the biggest loss:

The Obama Administration has talked about these bonuses and I know that people here like AJ think that bonuses should be left out of the equation. What, in your opinion, could be done to eliminate this disconnect between bonus pay and long term performance?

That's a great question. I don't have all the answers, but here are some thoughts on the matter.

During the dotcom bust in 2001-02, what we learned that compensation in the form of stock options didn't always work out as was intended. The theory was that by giving executives (and rank/file employees) stock options, you align their incentives with the success of the firm since they'll want to see the stock price increase which should come from growth. In fact, in many cases options were being granted below market value so they were already in the money immediately and could be 100% exercised within as little as 6 months from grant. Even when the options were priced at market value, we learned that in a bull market the only goal anyone cared about was to have share prices rise in the short term so they could cash out quickly. Employee options, intended to fuel long term organic growth, became an intrinsic part of the bubble itself.

In the housing crisis, the incentive fees and bonuses were typically paid in cash. Whether to mortgage brokers, realtors, investment bankers or fund traders - everybody was skimming cash off the top at every stage of the pyramid. When you're paid in cash - you really don't care if the thing you're doing has any legs to it. Why should you?

So, options didn't work. Cash doesn't work. I think the best incentive has to be something that only pays off for the person when it's been proven out over the long term.

For employees and executives at a public company, I think it could be stock grants. There's less incentive to an immediate cash-out with stock than there would be with options. You really need to hold a position for a while to see it pay off. Alternatively, it could be done with options but only if the grant/exercise period is sufficiently long. Six months is ridiculous. Six years would be more like it.

For bankers working on an investment deal - a CDO or bond launch, or an IPO - maybe hold their fees in an escrow account and pay them out of escrow on a schedule. 20% right up front, the remaining 80% spread over 3 or 5 years -- something long enough that they've got real skin in the game for the launch to be proven in the marketplace before they get their entire reward.

None of this will ever happen, by the way. These guys make way too much money and buy obscene amounts of lobbying with their money to prevent anything like the above from happening. But, it's nice to dream about a better world, I suppose.

[luckytxn 2,263]

Or just use the buyers beware thinking. If it sounds too good to be true it always is. Nice words and sayings but happen to be true.

During the dot com bubble the mutual funds started getting in on the bandwagon because they saw the mutual funds that did so were raking in the cash. They saw the money flow from them to the ones that were making that gamble. They felt no choice but to do the same to stop the bleeding. I was trying to find a new place to park my funds from my retirement accounts at that time and everyone I checked I saw they were heavily invested in the same dot coms and was perplexed on what to do so I parked my funds into some diversified bond funds till I decided. Well I got lucky and the bust happened and my bond funds came gang busters. Right after I started to move back into the market. I got lucky at that time.

I saw the same thing happening with the housing bubble but this time only moved about 40 percent into bond funds. The market tanked but I expect it to return eventually as it always does. I now can see the same forces were happening. The money flowed to keep up with everyone else. They had to do this to satisfy investors. It makes no difference to the money managers where the money goes and if it loses or not. They still make money by doing their jobs. The investors look at where the money is moving and the returns and they want the same. It makes no difference that by the time they see this movement that it is really too late and this increases the bubbles.

Goldman was doing the same as everyone else to make money and doing what their investors pay them for but they unlike most hedged their bets and bought insurance as they saw a potential liability. They to me were smart and are now being punished for having foresight to protect themselves as all the others could have done.

Edited April 19, 2010 by luckytxn

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Or just use the buyers beware thinking. If it sounds too good to be true it always is. Nice words and sayings but happen to be true.

During the dot com bubble the mutual funds started getting in on the bandwagon because they saw the mutual funds that did so were raking in the cash. They saw the money flow from them to the ones that were making that gamble. They felt no choice but to do the same to stop the bleeding. I was trying to find a new place to park my funds from my retirement accounts at that time and everyone I checked I saw they were heavily invested in the same dot coms and was perplexed on what to do so I parked my funds into some diversified bond funds till I decided. Well I got lucky and the bust happened and my bond funds came gang busters. Right after I started to move back into the market. I got lucky at that time.

I saw the same thing happening with the housing bubble but this time only moved about 40 percent into bond funds. The market tanked but I expect it to return eventually as it always does. I now can see the same forces were happening. The money flowed to keep up with everyone else. They had to do this to satisfy investors. It makes no difference to the money managers where the money goes and if it loses or not. They still make money by doing their jobs. The investors look at where the money is moving and the returns and they want the same. It makes no difference that by the time they see this movement that it is really too late and this increases the bubbles.

Goldman was doing the same as everyone else to make money and doing what their investors pay them for but they unlike most hedged their bets and bought insurance as they saw a potential liability. They to me were smart and are now being punished for having foresight to protect themselves as all the others could have done.

So, what you're saying is that you're a savvy market timer who was able -twice- to duck out of the way before the sh!t hit the fan. Congratulations. Unfortunately, most of us are not that good at timing the markets and I put myself in that category. Most of us either directly or indirectly (through pension funds or college savings plans etc.) are passively long in the equity markets and passively long in the housing market. Also, all of us, even you, as taxpayers, have a vested interest in not allowing the nefarious shysters to break the system so that we (via our taxes) are required to provide the ultimate backstop. That hurts, and it's really not fun.

So regardless of your own ability to duck out of the way, surely you see the logic of preventing the worst excesses of bubbles from accumulating. To Steven's question - if the incentives for malfeasance are strong (bonuses out of whack with performance) we're just looking for these excesses to occur again. It's just human nature. I don't really fault people for looking out for themselves, that's only natural. What we need are safeguards to ensure that the system can't be sunk entirely because of such incentives. We need to ensure that the prosperity of the communal (love that communism!!) isn't sacrificed to prosperity of the individual. Certainly the Magnetar situation makes one think that the incentive/reward structure was all wrong.

As to Goldman - if what they did was within the letter and spirit of the law, I agree with you and have no problem with what they did. But if they deliberately and materially misrepresented the structure and composition and risk of the CDOs they sold - then shame on them, and they should get burned. The trial will hing on that - was it deliberate and material misrepresentation.