Did Dodd-Frank spur the SEC’s $550M Goldman Sachs settlement?

by Kurt Schulzke

Was it mere coincidence that the SEC suddenly settled with Goldman Sachs for $550 million — a figure widely seen as a fraction of what Goldman should have paid — on the same day, July 15, 2010, that the new SEC whistleblower bounty program finally passed both houses of Congress?

While the legislation did not actually become effective until the President signed it on July 21, the timing is interesting.  Consider that the new law, if applicable to the Goldman case, would require the SEC to pay a whistleblower 10%-30%  of the $550 million settlement.  That’s between $55 million and $165 million.  It’s not hard to imagine the SEC wanting to hustle a settlement to avoid a potential obligation to share the $550 million with whistleblowers who might have contributed something to the case after the effective date of the law.*

For aspiring SEC whistleblowers, as outlined in the SEC’s civil complaint, the $550 million Goldman Sachs settlement was a product of alleged misrepresentations that violated three primary federal securities laws: Section 17(a) of the Securities Act of 1933 (15 U.S.C. §77q(a)), Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. §78j(b) and Exchange Act Rule 10b-5, 17 C.F.R. §240.10b-5.  While these code sections may read like Greek to the uninitiated, what they all boil down to is that companies like Goldman who sell “securities” like stocks and bonds to investors are required to provide potential investors ALL material information — positive, negative and neutral — about the proposed investment.

The SEC alleges, in general, that Goldman made

materially misleading statements and omissions in connection with a synthetic collateralized debt obligation (“CDO”) Goldman structured and marketed to investors. This synthetic CDO, ABACUS 2007AC1, was tied to the performance of subprime residential mortgage-backed securities (“RMBS”) and was structured and marketed by Goldman in early 2007 when the United States housing market and related securities were beginning to show signs of distress.

More specifically, the complaint alleges that Goldman and its co-defendant Fabrice Tourre “recklessly or negligently misrepresented in the term sheet, flip book and offering memorandum for ABACUS 2007-AC1 … the significant role in the portfolio selection process played by Paulson & Co., a hedge fund with financial interests in the transaction directly adverse” to investors in the fund:

Undisclosed in the marketing materials and unbeknownst to investors [Paulson] played a significant role in the portfolio selection process.

The complaint also alleges that the defendants misled one investor, ACA, into believing that Paulson invested in the equity of ABACUS 2007AC1 and, accordingly, that Paulson’s interests in the portfolio selection process were closely aligned with ACA’s when in reality Paulson interests were in direct conflict with ACA’s:

After participating in the selection of the reference portfolio, Paulson effectively shorted the RMBS** portfolio it helped select by entering into credit default swaps (“CDS”) with GS&Co to buy protection on specific layers of the ABACUS 2007-AC1 capital structure. Given its financial short interest, Paulson had an economic incentive to choose RMBS that it expected to experience credit events in the near future.

In short, the SEC says, Goldman and Tourre misled ABACUS 2007-AC1’s investors about Paulson’s role in structuring the deal and concealed the fact that Paulson was betting against the fund’s portfolio.  Key whistleblower takeaways: Failure to disclose material information about the deal and the people who put it together can violate the securities laws in multiple ways.

Was the synchronicity of the Goldman settlement and the passage of H.R. 4173 just a coincidence?  I doubt it.  In negotiation, I follow this rule of thumb: There is no such thing as coincidence.

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* Under transitional provisions of Act Section 924(b), information brought to the SEC by whistleblowers is “original” and therefore qualifies for the SEC bounty program as long as it is submitted after enactment of the WSRCPA, no matter how long it takes the SEC to write associated regulations.  The date of enactment was July 21, 2010.

** RMBS stands for Residential Mortgage Backed Securities.

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